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x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 29, 2008 ¨ TRANSITION REPORT PURSUANT TO SECTION 13 or 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 CARROLS RESTAURANT GROUP, INC. (Address of principal executive office) (Zip Code) CARROLS CORPORATION Registrant’s telephone number including area code: (315) 424-0513 Carrols Corporation meets the conditions set forth in General Instruction H(1) and is therefore filing this form with reduced disclosure format pursuant to General Instruction H(2). Indicate by check mark whether either of the registrants (1) have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrants are large accelerated filers, accelerated filers, non-accelerated filers or smaller reporting companies. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act, (Check one): Large accelerated filer ¨ Accelerated filer x Non-accelerated filer (Do not check if a smaller reporting company) ¨ Smaller reporting company ¨ Large accelerated filer ¨ Accelerated filer ¨ Non-accelerated filer (Do not check if a smaller reporting company) x Smaller reporting company ¨ Indicate by check mark whether either of the registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act) Yes ¨ No x As of August 1, 2008, Carrols Restaurant Group, Inc. had 21,573,809 shares of its common stock, $.01 par value, outstanding. As of August 1, 2008, all outstanding equity securities of Carrols Corporation, which consisted of 10 shares of its common stock, were owned by Carrols Restaurant Group, Inc. QUARTER ENDED JUNE 30, 2008 Carrols Restaurant Group, Inc. and Subsidiary - Consolidated Financial Statements (unaudited): Consolidated Balance Sheets as of June 30, 2008 and December 31, 2007 Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2008 and 2007 Consolidated Statements of Cash Flows for the Six Months ended June 30, 2008 and 2007 Notes to Consolidated Financial Statements Carrols Corporation and Subsidiaries - Consolidated Financial Statements (unaudited): Management’s Discussion and Analysis of Financial Condition and Results of Operations 39 Quantitative and Qualitative Disclosures About Market Risk 54 Controls and Procedures 54 Legal Proceedings 54 Unregistered Sales of Equity Securities and Use of Proceeds 54 Default Upon Senior Securities 54 Submission of Matters to a Vote of Security Holders 54 Other Information 55 Exhibits 55 PART I—FINANCIAL INFORMATION ITEM 1—INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) CARROLS RESTAURANT GROUP, INC. AND SUBSIDIARY (In thousands of dollars, except share and per share amounts) Trade and other receivables Prepaid rent Franchise rights, net (Note 4) Goodwill (Note 4) Intangible assets, net Franchise agreements, at cost less accumulated amortization of $5,681 and $5,646, respectively $ 473,581 $ 465,558 LIABILITIES AND STOCKHOLDERS’ DEFICIT Current portion of long-term debt (Note 5) Accrued interest Accrued payroll, related taxes and benefits Accrued income taxes payable Accrued real estate taxes Long-term debt, net of current portion (Note 5) Lease financing obligations (Note 9) Deferred income—sale-leaseback of real estate Accrued postretirement benefits (Note 8) Other liabilities (Note 7) Stockholders’ deficit: Preferred stock, par value $.01; authorized 20,000,000 shares, issued and outstanding—none Voting common stock, par value $.01; authorized 100,000,000 shares, issued and outstanding—21,571,871 and 21,571,565 shares, respectively (625 ) (1,591 ) (1,977 ) (6,680 ) (141 ) (141 ) Total stockholders’ deficit Total liabilities and stockholders’ deficit The accompanying notes are an integral part of these unaudited consolidated financial statements. THREE AND SIX MONTHS ENDED JUNE 30, 2008 AND 2007 Three months ended June 30, Six months ended June 30, $ 210,331 $ 200,117 $ 405,724 $ 387,983 210,682 200,449 406,435 388,652 63,943 57,375 121,572 109,669 Restaurant wages and related expenses (including stock-based compensation expense of $57, $39, $114 and $76, respectively) 11,568 10,907 23,051 21,586 9,224 8,449 17,048 16,984 General and administrative (including stock-based compensation expense of $435, $315, $852 and $633, respectively) Impairment losses (Note 3) Other income (Note 10) (119 ) — (119 ) (347 ) Loss (gain) on extinguishment of debt (Note 5) (180 ) — (180 ) 1,485 Income before income taxes 5,137 7,760 7,396 10,229 Provision for income taxes (Note 6) $ 3,257 $ 5,098 $ 4,703 $ 6,675 Basic and diluted net income per share (Note 13) $ 0.15 $ 0.24 $ 0.22 $ 0.31 Basic weighted average common shares outstanding (Note 13) 21,571,652 21,550,827 21,571,609 21,550,827 Diluted weighted average common shares outstanding (Note 13) SIX MONTHS ENDED JUNE 30, 2008 AND 2007 (In thousands of dollars) Cash flows provided from operating activities: Adjustments to reconcile net income to net cash provided from operating activities: Loss (gain) on disposals of property and equipment (12 ) 109 (1,044 ) (969 ) Loss (gain) on settlements of lease financing obligations 31 (163 ) 249 (210 ) Accrued income taxes Loss (gain) on extinguishment of debt (180 ) 1,485 Changes in other operating assets and liabilities (2,203 ) 2,524 Net cash provided from operating activities Cash flows used for investing activities: Capital expenditures: (16,385 ) (18,720 ) Other restaurant capital expenditures Properties purchased for sale-leaseback — (2,461 ) Proceeds from sale-leaseback transactions Proceeds from sales of other properties Net cash used for investing activities Cash flows provided from (used for) financing activities: Repayment of term loans under prior credit facility — (118,400 ) Borrowings on revolving credit facility Repayments on revolving credit facility Proceeds from new senior credit facility Principal payments on capital leases (71 ) (205 ) Expenses from initial public offering — (21 ) Financing costs associated with issuance of debt Repurchase of senior subordinated notes (1,820 ) — Settlement of lease financing obligations 2,109 (4,266 ) Net decrease in cash and cash equivalents Supplemental disclosures: Interest paid on long-term debt $ 11,596 $ 12,912 Interest paid on lease financing obligations Increase in accruals for capital expenditures Income taxes paid (refunded), net $ 1,414 $ (195 ) Capital lease obligations incurred $ 117 $ — NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (in thousands of dollars except share and per share amounts) 1. Basis of Presentation Basis of Consolidation. The unaudited consolidated financial statements presented herein include the accounts of Carrols Restaurant Group, Inc. (“Carrols Restaurant Group” or the “Company”) and its wholly-owned subsidiary Carrols Corporation (“Carrols”). Carrols Restaurant Group is a holding company and conducts all of its operations through Carrols and its wholly-owned subsidiaries. Unless the context otherwise requires, Carrols Restaurant Group, Carrols and the direct and indirect subsidiaries of Carrols are collectively referred to as the “Company.” All intercompany transactions have been eliminated in consolidation. The difference between the consolidated financial statements of Carrols Restaurant Group and Carrols is primarily due to additional rent expense of approximately $6 per year for Carrols Restaurant Group and the composition of stockholders’ deficit. Business Description. At June 30, 2008 the Company operated, as franchisee, 319 quick-service restaurants under the trade name “Burger King” in 12 Northeastern, Midwestern and Southeastern states. At June 30, 2008, the Company also owned and operated 88 Pollo Tropical restaurants, of which 85 were located in Florida and three were located in New Jersey, and franchised a total of 27 Pollo Tropical restaurants, 23 in Puerto Rico, two in Ecuador and two on college campuses in Florida. At June 30, 2008, the Company owned and operated 150 Taco Cabana restaurants located primarily in Texas and franchised two Taco Cabana restaurants in New Mexico and one in Georgia. Fiscal Year. The Company uses a 52-53 week fiscal year ending on the Sunday closest to December 31. All references herein to the fiscal years ended December 30, 2007 and December 31, 2006 will be referred to as the fiscal years ended December 31, 2007 and 2006, respectively. Similarly, all references herein to the three and six months ended June 29, 2008 and July 1, 2007 will be referred to as the three and six months ended June 30, 2008 and June 30, 2007, respectively. The years ended December 31, 2007 and 2006 each contained 52 weeks and the three and six months ended June 30, 2008 and 2007 contained thirteen and twenty-six weeks, respectively. Basis of Presentation. The accompanying unaudited consolidated financial statements for the three and six months ended June 30, 2008 and 2007 have been prepared without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission and do not include certain of the information and the footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all normal and recurring adjustments considered necessary for a fair presentation of such financial statements have been included. The results of operations for the three and six months ended June 30, 2008 and 2007 are not necessarily indicative of the results to be expected for the full year. These unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2007 contained in the Company’s 2007 Annual Report on Form 10-K. The December 31, 2007 balance sheet data is derived from those audited financial statements. Reclassification of previously issued interim financial statements. The Company has reclassified certain prior year amounts related to its Pollo Tropical restaurant expenses from cost of sales to other restaurant operating expenses in order to conform to the 2008 presentation in the Company’s interim results of operations and the presentation in the Company’s 2007 Annual Report on Form 10-K. The amount of increase (decrease) in previously reported interim amounts was as follows: June 30, 2007 Six Months Ended $ (264 ) $ (527 ) $ — $ — Use of Estimates. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Significant items subject to such estimates include: accrued occupancy costs, insurance liabilities, legal obligations, income taxes, evaluation for impairment of goodwill, long-lived assets and Burger King franchise rights, lease accounting matters and stock-based compensation. Actual results could differ from those estimates. NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS-(Continued) 2. Stock-Based Compensation The Company adopted an incentive stock plan in 2006 (the “2006 Plan”) under which incentive stock options, non-qualified stock options and restricted shares may be granted to employees and non-employee directors. On January 15, 2008, the Company granted options to purchase 517,820 shares of its common stock, consisting of 160,000 shares of non-qualified stock options and 357,820 shares of incentive stock options (“ISOs”), and issued 7,100 shares of restricted stock. The non-qualified stock options and ISOs granted are exercisable for up to one-fifth of the total number of option shares on or after the first anniversary of the grant date and as of the first day of each month thereafter are exercisable for an additional one-sixtieth of the total number of option shares until fully exercisable. The options expire seven years from the date of the grant and were issued with an exercise price equal to the fair market value of the stock price, or $8.08 per share of common stock, on the date of grant. The restricted stock awards vest 100% on the third anniversary of the award date. During the three months ended June 30, 2008 an aggregate of 10,500 non-qualified stock options were granted to three non-employee directors under the 2006 Plan. The options were issued with an exercise price equal to the fair market value of the stock price, or $6.43 per share of common stock, on the date of grant and generally vest 20% per year. During the three months ended June 30, 2007, there were an aggregate of 1,000 restricted shares granted to certain employees and an aggregate of 10,500 non-qualified options granted to three non-employee directors under the 2006 Plan. The stock options granted to the non-employee directors vest 20% per year and the restricted shares granted to employees vest 33% per year. The Company currently uses and will continue to use the simplified method to estimate the expected term for share option grants until it has enough historical experience to provide a reasonable estimate of expected term in accordance with Staff Accounting Bulletin No. 110 (“SAB 110”). The weighted average fair-value of options granted during the three months ended June 30, 2008 was $1.96 which was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions: Risk-free interest rate Annual dividend yield Expected term Expected volatility Stock-based compensation expense for the three and six months ended June 30, 2008 was $0.5 million and $1.0 million, respectively and for the three and six months ended June 30, 2007 was $0.4 million and $0.7 million, respectively. As of June 30, 2008, the total non-vested stock-based compensation expense relating to the options and restricted shares is approximately $4.7 million and the Company expects to record an additional $1.0 million as compensation expense in 2008. The remaining weighted average vesting period for the stock options is 3.89 years and restricted shares is approximately 2.18 years at June 30, 2008. A summary of all option activity for the six months ended June 30, 2008 was as follows: Options Weighted Exercise Price Average Life Aggregate Value (in thousands) Options outstanding at January 1, 2008 1,214,690 $ 14.31 6.0 $ — 528,320 8.05 (42,712 ) 11.95 Options outstanding at June 30, 2008 Expected to vest at June 30, 2008 Options exercisable at June 30, 2008 358,059 $ 14.31 5.5 $ — (1) The aggregate intrinsic value was calculated using the difference between the market price of the Company’s common stock at June 30, 2008 and the grant price for only those awards that have a grant price that is less than the market price of the Company’s common stock at June 30, 2008. Restricted Shares The restricted stock activity for the six months ended June 30, 2008 was as follows: Shares Weighted Grant Date Nonvested at January 1, 2008 55,398 $ 13.22 Shares granted 7,100 8.08 Shares vested (306 ) 16.00 Shares forfeited (2,664 ) 12.86 Nonvested at June 30, 2008 59,528 12.60 The value of restricted shares is determined based on the Company’s closing price on the date of grant. 3. Impairment of Long-Lived Assets The Company reviews its long-lived assets, principally property and equipment, for impairment at the restaurant level. If an indicator of impairment exists for any of its assets, an estimate of undiscounted future cash flows from the related long-lived assets is compared to that long-lived asset’s carrying value. If the carrying value is greater than the undiscounted cash flow, the Company then determines the fair value of the asset. If an asset is determined to be impaired, the loss is measured by the excess of the carrying amount of the asset over its fair value. For the three and six months ended June 30, 2008 and 2007, the Company recorded impairment losses on long-lived assets for its segments as follows: June 30, Six Months Ended $ 71 $ 14 $ 92 $ 14 $ 81 $ 69 $ 102 $ 69 4. Goodwill and Franchise Rights Goodwill. Goodwill is reviewed for impairment annually, or more frequently when events and circumstances indicate that the carrying amounts may be impaired. The Company performs its annual impairment assessment as of December 31 and does not believe circumstances have changed since the last assessment date which would make it necessary to reassess their values. Goodwill balances are summarized below: Tropical Taco Cabana Burger King Total Balance, June 30, 2008 $ 56,307 $ 67,177 $ 1,450 $ 124,934 Burger King Franchise Rights. Amounts allocated to franchise rights for each Burger King acquisition are amortized using the straight-line method over the average remaining term of the acquired franchise agreements at January 1, 2002 plus one twenty-year renewal period. The Company assesses the potential impairment of franchise rights whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If an indicator of impairment exists, an estimate of the aggregate undiscounted future cash flows from the acquired restaurants is compared to the respective carrying value of franchise rights for each Burger King acquisition. If an asset is determined to be impaired, the loss is measured by the excess of the carrying amount of the asset over its fair value. There were no impairment charges recorded against franchise rights for the three and six months ended June 30, 2008 and 2007. Amortization expense related to Burger King franchise rights was $799 and $804 for the three months ended June 30, 2008 and 2007, respectively. Amortization expense related to Burger King franchise rights was $1,600 and $1,608 for the six months ended June 30, 2008 and 2007. The estimated amortization expense for the year ending December 31, 2008 is $3,197 and for each of the five succeeding years is $3,196. 5. Long-term Debt Long-term debt at June 30, 2008 and December 31, 2007 consisted of the following: Collateralized: Revolving Credit facility $ 9,500 $ — Senior Credit Facility-Term loan A facility Unsecured: 9% Senior Subordinated Notes Less: current portion On March 9, 2007, Carrols terminated and replaced its prior senior credit facility with a new senior credit facility with a syndicate of lenders. Carrols’ credit facility totals approximately $185 million, consisting of $120 million principal amount of term loan A borrowings maturing on March 8, 2013 (or earlier on September 30, 2012 if the 9% Senior Subordinated Notes due 2013 are not refinanced by June 30, 2012) and a $65.0 million revolving facility (including a sub limit of up to $25.0 million for letters of credit and up to $5.0 million for swingline loans), maturing on March 8, 2012. The term loan A borrowings and an additional $4.3 million of revolver borrowings from this facility were used to repay all outstanding borrowings and other obligations under the Carrols’ prior senior credit facility and to pay certain fees and expenses incurred in connection with the new senior credit facility. The Company also recorded a $1.5 million loss on extinguishment of debt in the six months ended June 30, 2007 for the write-off of deferred financing costs related to the prior senior credit facility. The term loan and revolving credit borrowings under the senior credit facility bear interest at a per annum rate, at Carrols’ option, of either: 1) the applicable margin ranging from 0% to 0.25% based on Carrols’ senior leverage ratio (as defined in the new senior credit facility) plus the greater of (i) the prime rate or (ii) the federal funds rate for that day plus 0.5%; or 2) Adjusted LIBOR plus the applicable margin percentage in effect ranging from 1.0% to 1.5% based on Carrols’ senior leverage ratio. Term loan A borrowings shall be due and payable in quarterly installments, beginning on June 30, 2008 as follows: 1) four quarterly installments of $1.5 million beginning on June 30, 2008; 2) eight quarterly installments of $3.0 million beginning on June 30, 2009; 3) four quarterly installments of $4.5 million beginning on June 30, 2011; and 4) four quarterly installments of $18.0 million beginning on June 30, 2012. Under the senior credit facility, Carrols is also required to make mandatory prepayments of principal on term loan A facility borrowings (a) annually in an initial amount equal to 50% of Excess Cash Flow depending upon Carrols’ Total Leverage Ratio (as such terms are defined in the senior credit facility), (b) in the event of certain dispositions of assets (all subject to certain exceptions) and insurance proceeds, in an amount equal to 100% of the net proceeds received by Carrols therefrom, and (c) in an amount equal to 100% of the net proceeds from any subsequent issuance of debt. In general, Carrols’ obligations under the senior credit facility are guaranteed by the Company and all of Carrols’ material subsidiaries and are collateralized by a pledge of Carrols’ common stock and the stock of each of Carrols’ material subsidiaries. The senior credit facility contains certain covenants, including, without limitation, those limiting the Carrols’ ability to incur indebtedness, incur liens, sell or acquire assets or businesses, change the nature of its business, engage in transactions with related parties, make certain investments or pay dividends. In addition, Carrols is required to meet certain financial ratios, including fixed charge coverage, senior leverage, and total leverage ratios (all as defined under the senior credit facility). Carrols was in compliance with the covenants under its senior credit facility as of June 30, 2008. At June 30, 2008, $120.0 million principal amount of term loan borrowings were outstanding under the term loan A facility and $9.5 million principal amount of borrowings were outstanding under the revolving credit facility. After reserving $14.2 million for letters of credit guaranteed by the facility, $41.3 million was available for borrowings under the revolving credit facility at June 30, 2008. On December 15, 2004, Carrols issued $180 million of 9% Senior Subordinated Notes due 2013, which are referred to herein as the “senior subordinated notes”. Restrictive covenants under the senior subordinated notes include limitations with respect to the Carrols’ ability to issue additional debt, incur liens, sell or acquire assets or businesses, pay dividends and make certain investments. On April 7, 2008, Carrols purchased and retired $2.0 million of its senior subordinated notes in an open market transaction. This resulted in a gain on extinguishment of debt of $0.2 million in the three months ended June 30, 2008. At June 30, 2008 and December 31, 2007, $178.0 million and $180.0 million principal amount of the senior subordinated notes were outstanding, respectively. The provision for income taxes for the three and six months ended June 30, 2008 and 2007 was comprised of the following: (65 ) (210 ) 249 (210 ) The provision for income taxes for the three and six months ended June 30, 2008 was derived using an estimated effective annual income tax rate for 2008 of 37.9%, which excludes any discrete tax adjustments. Discrete tax adjustments reduced the provision for income taxes by $66 and $112 for the three and six months ended June 30, 2008. The provision for income taxes for the three and six months ended June 30, 2007 was derived using an estimated effective annual income tax rate for 2007 of 36.0%. The tax provision for the three and six months ended June 30, 2007 includes a reduction of tax expense of $0.4 million related to the recognition of additional employment tax credits, $0.2 million of additional tax expense related to a New York state income tax audit assessment and $0.1 million of additional tax expense associated with changes in New York state tax legislation enacted in the second quarter of 2007. The net reduction of income tax expense of $0.1 million for these items was recorded in the second quarter. The Company recognizes interest and penalties related to uncertain tax positions in income tax expense. As of June 30, 2008, the Company had no unrecognized tax benefits and no accrued interest related to uncertain tax positions. The tax years 2004-2007 remain open to examination by the major taxing jurisdictions to which the Company is subject. It is not possible to reasonably estimate any possible change in the unrecognized tax benefits within the next twelve months. 7. Other Liabilities, Long-Term Other liabilities, long-term, at June 30, 2008 and December 31, 2007 consisted of the following: Unearned purchase discounts Accrued occupancy costs 10,229 9,667 Accrued workers’ compensation costs In 2001, management decided to close seven Taco Cabana restaurants in the Phoenix, Arizona market and discontinue restaurant development underway in that market. At both June 30, 2008 and December 31, 2007, the Company had $0.5 million in lease liability reserves for remaining locations that are included in accrued occupancy costs. 8. Postretirement Benefits The Company provides postretirement medical and life insurance benefits covering substantially all Burger King administrative and restaurant management salaried employees. A December 31 measurement date is used for postretirement benefits. On November 1, 2007 the Company amended its postretirement medical and life insurance benefits to eliminate life insurance benefits for active employees who retire after December 31, 2007 and to increase retiree contributions for both current and future retirees effective January 1, 2008. These amendments reduced the Company’s postretirement benefit obligations and reduced expense in the three and six months ended June 30, 2008. The following summarizes the components of net periodic benefit cost: $ (24 ) $ 128 $ 14 $ 246 Interest cost (18 ) 110 53 203 Amortization of gains and losses Amortization of unrecognized prior service cost (67 ) 10 (180 ) 3 Net periodic postretirement benefit cost (benefit) $ (106 ) $ 279 $ (69 ) $ 500 During the three and six months ended June 30, 2008, the Company made contributions of $31 and $80 to its postretirement plan. 9. Lease Financing Obligations The Company entered into sale-leaseback transactions in various years involving certain restaurant properties that did not qualify for sale-leaseback accounting and as a result, have been classified as financing transactions under Statement of Financial Accounting Standards (“SFAS”) No. 98, “Accounting for Leases” (“SFAS 98”). Under the financing method, the assets remain on the consolidated balance sheet and proceeds received by the Company from these transactions are recorded as a financing liability. Payments under these leases are applied as payments of imputed interest and deemed principal on the underlying financing obligations. In the second quarter of 2008, the Company purchased from the lessor six restaurant properties for $5.5 million that were previously accounted for as lease financing obligations. As a result, the Company reduced its lease financing obligations by $5.5 million and recorded a loss of $31 as an increase to interest expense which represented the amount by which the purchase price exceeded the lease financing obligations. In the second quarter of 2007, the Company exercised its right of first refusal under the leases for five restaurant properties previously accounted for as lease financing obligations and purchased these properties from the lessor. As a result, the Company reduced its lease financing obligations by $4.4 million. The Company also recorded a gain of $0.2 million as a reduction of interest expense which represented the net amount by which the lease financing obligations exceeded the purchase price of the acquired restaurant properties. Interest expense associated with lease financing obligations, including settlement gains and losses, for the three months ended June 30, 2008 and 2007 was $1.4 million and $1.3 million, respectively, and for the six months ended June 30, 2008 and 2007 was $2.7 million and $2.8 million, respectively. 10. Other Income The Company recorded a gain of $0.1 million in the three and six months ended June 30, 2008 and a gain of $0.3 million in the six months ended June 30, 2007 each related to the sale of a Taco Cabana property. 11. Business Segment Information The Company is engaged in the quick-service and quick-casual restaurant industry, with three restaurant concepts: Burger King operating as a franchisee and Pollo Tropical and Taco Cabana, both Company-owned concepts. The Company’s Burger King restaurants are all located in the United States, primarily in the Northeast, Southeast and Midwest. Pollo Tropical is a quick-casual restaurant chain featuring grilled marinated chicken and Caribbean style “made from scratch” side dishes. Pollo Tropical’s core markets are located in South and Central Florida. Taco Cabana is a quick-casual restaurant chain featuring fresh Mexican style food, including flame-grilled beef and chicken fajitas, quesadillas and other Tex-Mex dishes. Taco Cabana’s core markets are primarily located in Texas. The accounting policies of each segment are the same as those described in the summary of significant accounting policies. The following table includes Segment EBITDA which is the measure of segment profit or loss reported to the chief operating decision maker for purposes of allocating resources to the segments and assessing their performance. Segment EBITDA is defined as earnings attributable to the applicable segment before interest, income taxes, depreciation and amortization, impairment losses, stock-based compensation expense, other income and expense and loss (gain) on extinguishment of debt. The “Other” column includes corporate related items not allocated to reportable segments, including stock-based compensation expense. Other identifiable assets consist primarily of cash, certain other assets, corporate property and equipment including restaurant information systems expenditures, goodwill and deferred income taxes. King Other Consolidated June 30, 2008: $ 45,404 $ 63,436 $ 101,842 $ — $ 210,682 15,312 19,540 29,091 — 63,943 10,899 18,594 31,213 57 60,763 General and administrative expenses (1) 2,762 3,006 7,514 435 13,717 2,000 2,091 3,611 375 8,077 Segment EBITDA Capital expenditures, including acquisitions 4,862 6,158 3,479 1,881 16,380 $ 42,747 $ 60,774 $ 96,928 $ — $ 200,449 $ 89,736 $ 123,693 $ 193,006 $ — $ 406,435 29,653 38,376 53,543 — 121,572 22,199 36,244 60,747 114 119,304 5,328 6,012 14,520 852 26,712 11,408 9,040 6,196 2,585 29,229 20,965 33,874 59,595 76 114,510 Identifiable Assets: $ 66,924 $ 81,209 $ 147,460 $ 177,988 $ 473,581 59,609 79,370 148,467 178,112 465,558 (1) For the Pollo Tropical and Taco Cabana segments, such amounts include general and administrative expenses related directly to each segment. For the Burger King segment such amounts include general and administrative expenses related directly to the Burger King segment as well as expenses associated with administrative support to all three of the Company’s segments including executive management, information systems and certain accounting, legal and other administrative functions. A reconciliation of segment EBITDA to consolidated net income is as follows: Segment EBITDA: $ 6,733 $ 7,254 $ 12,737 $ 14,086 Less: Provision for income taxes On November 16, 1998, the Equal Employment Opportunity Commission (“EEOC”) filed suit in the United States District Court for the Northern District of New York (the “Court”), under Title VII of the Civil Rights Act of 1964, as amended, against Carrols. The complaint alleged that Carrols engaged in a pattern and practice of unlawful discrimination, harassment and retaliation against former and current female employees. The EEOC identified approximately 450 individuals (which were subsequently increased to 511 individuals) that it believed represented the class of claimants and was seeking monetary and injunctive relief from Carrols. On April 20, 2005, the Court issued a decision and order granting Carrols’ Motion for Summary Judgment that Carrols filed in January 2004. Subject to possible appeal by the EEOC, the case is dismissed; however the Court noted that it was not ruling on the claims, if any, that individual employees might have against Carrols. On February 27, 2006, Carrols filed a motion for summary judgment to dismiss all but between four and 17 of the individual claims. On July 10, 2006, in its response to that motion, the EEOC asserted that, notwithstanding the Court’s dismissal of the case as a class action, the EEOC may still maintain some kind of collective action on behalf of these claimants. Oral argument before the Court was held on October 4, 2006 and the Company is awaiting the Court’s decision on Carrols’ summary judgment motion. The Company does not believe that any individual claim, if any, would have a material adverse impact on its consolidated financial statements. Although the Company believes that the EEOC’s continued class litigation argument is without merit, it is not possible to predict the outcome of the pending motion. On November 30, 2002, four former hourly employees commenced a lawsuit against Carrols in the United States District Court for the Western District of New York (the “Court”) entitled Dawn Seever, et al. v. Carrols Corporation. The lawsuit alleged, in substance, that Carrols violated certain minimum wage laws under the Federal Fair Labor Standards Act and related state laws by requiring employees to work without recording their time and by retaliating against those who complained. The plaintiffs sought damages, costs and injunctive relief. They also sought to notify and certify, a class consisting of current and former employees who, since 1998, have worked, or are working, for Carrols. On December 17, 2007, the Court issued a decision and order denying Plaintiffs’ motion for notice and class certification and granting the Company’s motion to dismiss all of the claims of the plaintiffs, other than certain nominal claims relating to orientation and managers’ meetings. The Court instructed the parties to confer, in good faith, and settle those nominal claims. Subject to settlement of the amounts for orientation and managers’ meetings and possible appeal by the Plaintiffs, the case is concluded. The Company does not believe that these settlement amounts will be material to its consolidated financial statements. The Company is a party to various other litigation matters incidental to the conduct of business. The Company does not believe that the outcome of any of these other matters will have a material adverse effect on its consolidated financial statements. 13. Net Income Per Share Basic net income per share is computed by dividing net income for the period by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income for the period by the weighted average number of common shares outstanding plus the dilutive effect of outstanding stock options using the treasury stock method. The computation of diluted net income per share excludes options to purchase 1,099,544 and 631,375 shares of common stock for each of the three and six months ended June 30, 2008 and 2007, respectively, because the exercise price of these options was greater than the average market price of the common shares in the periods and therefore, they were antidilutive. In addition, options to purchase 2,538 and 620,875 shares of common stock are excluded from the computation of diluted net income per share in each of the three and six months ended June 30, 2008 and 2007, respectively, as they were antidilutive under the treasury stock method. The following table is a reconciliation of the income and share amounts used in the calculation of basic net income per share and diluted net income per share: Basic net income per share: Basic net income per share Diluted net income per share: Net income for diluted net income per share Shares used in computed basic net income per share Dilutive effect of restricted shares and stock options 3,753 14,381 3,216 10,968 Shares used in computed diluted net income per share Diluted net income per share 14. Comprehensive income SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires the disclosure of certain revenue, expenses, gains and losses that are excluded from net income in accordance with U.S. generally accepted accounting principles. The items that currently impact the Company’s other comprehensive income are changes in postretirement benefit obligations, net of tax. Change in postretirement benefit obligation, net of tax — — 8 — Comprehensive income 15. Recent Accounting Developments In September 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”). This statement defines fair value, establishes a framework for using fair value to measure assets and liabilities and expands disclosures about fair value measurements. The statement applies whenever other pronouncements require or permit assets or liabilities to be measured at fair value. In February 2007, the FASB issued FSP FAS 157-2, delaying the effective date of SFAS 157 for certain nonfinancial assets and liabilities to fiscal years beginning after November 15, 2008. The implementation of SFAS 157 for financial assets and financial liabilities, effective for fiscal 2008, did not have a material impact on the Company’s consolidated financial statements. The Company is currently evaluating the impact SFAS 157 may have for nonfinancial assets and liabilities in its consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities – Including an Amendment of FASB Statement No. 115” (“SFAS 159”). This statement permits entities to choose to measure many financial instruments and certain other items at fair value. SFAS 159 is effective for the Company’s fiscal year beginning January 1, 2008. The Company did not elect to begin reporting any financial assets or liabilities at fair value upon adoption of this standard. In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financials Statements, an Amendment of ARB No. 51” (“SFAS 160”). SFAS 160 clarifies the accounting for non controlling interests and establishes accounting and reporting standards for the noncontrolling interest in a subsidiary, including classification as a component of equity. SFAS 160 is effective for fiscal years beginning after December 15, 2008. The Company is currently evaluating the impact SFAS 160 will have on its consolidated financial statements. In April 2008, the FASB issued FSP SFAS No. 142-3 “Determination of the Useful Life of Intangible Assets” (“SFAS 142-3”). SFAS 142-3 amends the factors that should be considered in developing renewal or extension assumption used to determine the useful life of a recognized intangible asset under SFAS No. 142. The requirement for determining useful lives must be applied prospectively to intangible assets acquired after the effective date and the disclosure requirements applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date. SFAS No. 142-3 is effective for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years, which will require the Company to adopt these provisions in the first quarter of 2009. The Company has reviewed this pronouncement and does not anticipate the adoption of SFAS No. 142-3 will materially impact its financial statements. CARROLS CORPORATION AND SUBSIDIARIES Common stock, par value $1; authorized 1,000 shares, issued and outstanding—10 shares at both dates Accumulated earnings Basis of Consolidation. The unaudited consolidated financial statements presented herein include the accounts of Carrols Corporation and its subsidiaries (“the Company”). The Company is a wholly-owned subsidiary of Carrols Restaurant Group, Inc. (“Carrols Restaurant Group” or the “Parent Company”). All intercompany transactions have been eliminated in consolidation. The difference between the consolidated financial statements of Carrols Corporation and Carrols Restaurant Group is primarily due to additional rent expense of approximately $6 per year for Carrols Restaurant Group and the composition of stockholder’s deficit. Business Description. At June 30, 2008 the Company operated, as franchisee, 319 quick-service restaurants under the trade name “Burger King” in 12 Northeastern, Midwestern and Southeastern states. At June 30, 2008, the Company also owned and operated 88 Pollo Tropical restaurants of which 85 were located in Florida and three were located in New Jersey, and franchised a total of 27 Pollo Tropical restaurants, 23 in Puerto Rico, two in Ecuador and two on college campuses in Florida. At June 30, 2008, the Company owned and operated 150 Taco Cabana restaurants located primarily in Texas and franchised two Taco Cabana restaurants in New Mexico and one in Georgia. Earnings Per Share Presentation. The guidance of Statement of Financial Accounting Standards (“SFAS”) No. 128, “Earnings Per Share,” requires presentation of earnings per share by all entities that have issued common stock or potential common stock if those securities trade in a public market either on a stock exchange (domestic or foreign) or in the over-the-counter market. The Company’s common stock is not publicly traded and therefore, earnings per share amounts are not presented. Carrols Restaurant Group adopted an incentive stock plan in 2006 (the “2006 Plan”) under which incentive stock options, non-qualified stock options and restricted shares may be granted to employees and non-employee directors. On January 15, 2008, Carrols Restaurant Group granted options to purchase 517,820 shares of its common stock, consisting of 160,000 shares of non-qualified stock options and 357,820 shares of incentive stock options (“ISOs”), and issued 7,100 shares of restricted stock. The non-qualified stock options and ISOs granted are exercisable for up to one-fifth of the total number of option shares on or after the first anniversary of the grant date and as of the first day of each month thereafter are exercisable for an additional one-sixtieth of the total number of option shares until fully exercisable. The options expire seven years from the date of the grant and were issued with an exercise price equal to the fair market value of the stock price, or $8.08 per share of common stock, on the date of grant. The restricted stock awards vest 100% on the third anniversary of the award date. During the three months ended June 30, 2008 an aggregate of 10,500 non-qualified stock options were granted to three non-employee directors under the 2006 Plan. The options were issued with an exercise price equal to the fair market value of the stock price, or $6.43 per share of common stock, on the date of grant and generally vest 20% per year. During the three months ended June 30, 2007, there were an aggregate of 1,000 restricted shares granted to certain employees and an aggregate of 10,500 non-qualified stock options granted to three non-employee directors under the 2006 Plan. The stock options granted to the non-employee directors vest 20% per year and the restricted shares granted to employees vest 33% per year. thousands) (1) (1) The aggregate intrinsic value was calculated using the difference between the market price of Carrols Restaurant Group’s common stock at June 30, 2008 and the grant price for only those awards that have a grant price that is less than the market price of Carrols Restaurant Group’s common stock at June 30, 2008. The value of restricted shares is determined based on Carrols Restaurant Group’s closing price on the date of grant. For the three and six months ended June 30, 2008, the Company recorded impairment losses on long-lived assets for its segments as follows: Three Months Ended Six Months Ended June 30, June 30, Burger King Franchise Rights. Amounts allocated to franchise rights for each Burger King acquisition are amortized using the straight-line method over the average remaining term of the acquired franchise agreements at January 1, 2002 plus one twenty-year renewal period. The Company assesses the potential impairment of franchise rights whenever events or changes in circumstances indicate that the carrying value may not be recoverable. If an indicator of impairment exists, an estimate of the aggregate undiscounted future cash flows from the acquired restaurants is compared to the respective carrying value of franchise rights for each Burger King acquisition. If an asset is determined to be impaired, the loss is measured by the excess of the carrying amount of the asset over its fair value. There were no impairment charges recorded against franchise rights for the three and six months ended June 30, 2008 and 2007. On March 9, 2007, the Company terminated and replaced its prior senior credit facility with a new senior credit facility with a syndicate of lenders. The Company’s credit facility totals approximately $185 million, consisting of $120 million principal amount of term loan A borrowings maturing on March 8, 2013 (or earlier on September 30, 2012 if the 9% Senior Subordinated Notes due 2013 are not refinanced by June 30, 2012) and a $65.0 million revolving facility (including a sub limit of up to $25.0 million for letters of credit and up to $5.0 million for swingline loans), maturing on March 8, 2012. The term loan A borrowings and an additional $4.3 million of revolver borrowings from this facility were used to repay all outstanding borrowings and other obligations under the Company’s prior senior credit facility and to pay certain fees and expenses incurred in connection with the new senior credit facility. The Company also recorded a $1.5 million loss on extinguishment of debt in the six months ended June 30, 2007 for the write-off of deferred financing costs related to the prior senior credit facility. The term loan and revolving credit borrowings under the senior credit facility bear interest at a per annum rate, at the Company’s option, of either: 1) the applicable margin ranging from 0% to 0.25% based on the Company’s senior leverage ratio (as defined in the new senior credit facility) plus the greater of (i) the prime rate or (ii) the federal funds rate for that day plus 0.5%; or 2) Adjusted LIBOR plus the applicable margin percentage in effect ranging from 1.0% to 1.5% based on the Company’s senior leverage ratio. Under the senior credit facility, the Company is also required to make mandatory prepayments of principal on term loan A facility borrowings (a) annually in an initial amount equal to 50% of Excess Cash Flow depending upon the Company’s Total Leverage Ratio (as such terms are defined in the senior credit facility), (b) in the event of certain dispositions of assets (all subject to certain exceptions) and insurance proceeds, in an amount equal to 100% of the net proceeds received by the Company therefrom, and (c) in an amount equal to 100% of the net proceeds from any subsequent issuance of debt. In general, the Company’s obligations under the senior credit facility are guaranteed by Carrols Restaurant Group and all of the Company’s material subsidiaries and are collateralized by a pledge of the Company’s common stock and the stock of each of the Company’s material subsidiaries. The senior credit facility contains certain covenants, including, without limitation, those limiting the Company’s ability to incur indebtedness, incur liens, sell or acquire assets or businesses, change the nature of its business, engage in transactions with related parties, make certain investments or pay dividends. In addition, the Company is required to meet certain financial ratios, including fixed charge coverage, senior leverage, and total leverage ratios (all as defined under the senior credit facility). The Company was in compliance with the covenants under its new senior credit facility as of June 30, 2008. On December 15, 2004, the Company issued $180 million of 9% Senior Subordinated Notes due 2013, which are referred to herein as the “senior subordinated notes.” Restrictive covenants under the senior subordinated notes include limitations with respect to the Company’s ability to issue additional debt, incur liens, sell or acquire assets or businesses, pay dividends and make certain investments. On April 7, 2008, the Company purchased and retired $2.0 million of the senior subordinated notes in an open market transaction. This resulted in a gain on extinguishment of debt of $0.2 million in the three months ended June 30, 2008. At June 30, 2008 and December 31, 2007, $178.0 million and $180.0 million principal amount of the senior subordinated notes were outstanding, respectively. June 30, December 31, In 2001, management decided to close seven Taco Cabana restaurants in the Phoenix, Arizona market and discontinue restaurant development underway in that market. At both June 30, 2008 and December 31, 2007, the Company had $0.5 million in lease liability reserves for the remaining locations that are included in accrued occupancy costs. The Company entered into sale-leaseback transactions in various years involving certain restaurant properties that did not qualify for sale-leaseback accounting and as a result, have been classified as financing transactions under SFAS No. 98, “Accounting for Leases” (“SFAS 98”). Under the financing method, the assets remain on the consolidated balance sheet and proceeds received by the Company from these transactions are recorded as a financing liability. Payments under these leases are applied as payments of imputed interest and deemed principal on the underlying financing obligations. Interest expense associated with lease financing obligations, including settlement gains and losses, for the three months ended June 30, 2008 and 2007 was $1.4 million and $1.3 million, respectively and for the six months ended June 30, 2008 and 2007 was $2.7 million and $2.8 million, respectively. (1) For the Pollo Tropical and Taco Cabana segments, such amounts include general and administrative expenses related directly to each segment. For the Burger King segment such amounts include general and administrative expenses related directly to the Burger King segment as well as expenses associated with administrative support to all of the Company’s segments including executive management, information systems and certain accounting, legal and other administrative functions. On November 16, 1998, the Equal Employment Opportunity Commission (“EEOC”) filed suit in the United States District Court for the Northern District of New York (the “Court”), under Title VII of the Civil Rights Act of 1964, as amended, against the Company. The complaint alleged that the Company engaged in a pattern and practice of unlawful discrimination, harassment and retaliation against former and current female employees. The EEOC identified approximately 450 individuals (which were subsequently increased to 511 individuals) that it believed represented the class of claimants and was seeking monetary and injunctive relief from the Company. On April 20, 2005, the Court issued a decision and order granting the Company’s Motion for Summary Judgment that the Company filed in January 2004. Subject to possible appeal by the EEOC, the case is dismissed; however the Court noted that it was not ruling on the claims, if any, that individual employees might have against the Company. On February 27, 2006, the Company filed a motion for summary judgment to dismiss all but between four and 17 of the individual claims. On July 10, 2006, in its response to that motion, the EEOC asserted that, notwithstanding the Court’s dismissal of the case as a class action, the EEOC may still maintain some kind of collective action on behalf of these claimants. Oral argument before the Court was held on October 4, 2006 and the Company is awaiting the Court’s decision on the Company’ summary judgment motion. The Company does not believe that any individual claim, if any, would have a material adverse impact on its consolidated financial statements. Although the Company believes that the EEOC’s continued class litigation argument is without merit, it is not possible to predict the outcome of the pending motion. On November 30, 2002, four former hourly employees commenced a lawsuit against the Company in the United States District Court for the Western District of New York (the “Court”) entitled Dawn Seever, et al. v. the Company. The lawsuit alleged, in substance, that the Company violated certain minimum wage laws under the Federal Fair Labor Standards Act and related state laws by requiring employees to work without recording their time and by retaliating against those who complained. The plaintiffs sought damages, costs and injunctive relief. They also sought to notify and certify, a class consisting of current and former employees who, since 1998, have worked, or are working, for the Company. On December 17, 2007, the Court issued a decision and order denying Plaintiffs’ motion for notice and class certification and granting the Company’s motion to dismiss all of the claims of the plaintiffs, other than certain nominal claims relating to orientation and managers’ meetings. The Court instructed the parties to confer, in good faith, and settle those nominal claims. Subject to settlement of the amounts for orientation and managers’ meetings and possible appeal by the Plaintiffs, the case is concluded. The Company does not believe that these settlement amounts will be material to its consolidated financial statements. SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires the disclosure of certain revenue, expenses, gains and losses that are excluded from net income in accordance with U.S. generally accepted accounting principles. The items that currently impact the Company’s other comprehensive income are changes in the postretirement benefit obligations, net of tax. 15. Guarantor Financial Statements The Company’s obligations under the senior subordinated notes are jointly and severally guaranteed in full on an unsecured senior subordinated basis by certain of the Company’s subsidiaries (“Guarantor Subsidiaries”), all of which are directly or indirectly wholly-owned by the Company. These subsidiaries are: Cabana Beverages, Inc. Cabana Bevco LLC Carrols LLC Carrols Realty Holdings Corp. Carrols Realty I Corp. Carrols Realty II Corp. Carrols J.G. Corp. Quanta Advertising Corp. Pollo Franchise, Inc. Pollo Operations, Inc. Taco Cabana, Inc. TP Acquisition Corp. TC Bevco LLC T.C. Management, Inc. TC Lease Holdings III, V and VI, Inc. Get Real, Inc. Texas Taco Cabana, L.P. TPAQ Holding Corporation The following supplemental financial information sets forth on a consolidating basis, balance sheets as of June 30, 2008 and December 31, 2007 for the Parent Company only, Guarantor Subsidiaries and for the Company and the related statements of operations and cash flows for the three and six months ended June 30, 2008 and 2007. For certain of the Company’s sale-leaseback transactions, the Parent Company has guaranteed on an unsecured basis the rental payments of its subsidiaries. In accordance with Emerging Issues Task Force Issue No. 90-14, “Unsecured Guarantee by Parent of Subsidiary’s Lease Payments in a Sale-Leaseback Transaction,” the Company has included in the following guarantor financial statements amounts pertaining to these leases as if they were accounted for as financing transactions of the Guarantor Subsidiaries. These adjustments are eliminated in consolidation. For purposes of the guarantor financial statements, the Company and its subsidiaries determine the applicable tax provision for each entity generally using the separate return method. Under this method, current and deferred taxes are allocated to each reporting entity as if it were to file a separate tax return. The rules followed by the reporting entity in computing its tax obligation or refund, including the effects of the alternative minimum tax, would be the same as those followed in filing a separate return with the Internal Revenue Service. However, for purposes of evaluating an entity’s ability to realize its tax attributes, the Company assesses whether it is more likely than not that those assets will be realized at the consolidated level. Any differences in the total of the income tax provision for the Parent Company only and the Guarantor Subsidiaries, as calculated on the separate return method and the consolidated income tax provision are eliminated in consolidation. The Company provides some administrative support to its subsidiaries related to executive management, information systems and certain accounting, legal and other administrative functions. For purposes of the guarantor financial statements, the Company allocates such corporate costs on a specific identification basis, where applicable, or based on revenues or the number of restaurants for each subsidiary. Management believes that these allocations are reasonable based on the nature of costs incurred. CONSOLIDATING BALANCE SHEET Only Guarantor Subsidiaries Eliminations Consolidated $ 2,028 $ 2,404 $ — $ 4,432 1,225 4,660 — 5,885 12,545 17,540 — 30,085 61,838 205,634 (55,519 ) 211,953 Franchise rights, net 78,469 — — 78,469 1,450 123,484 — 124,934 — 742 — 742 Franchise agreements, net 5,657 — — 5,657 Intercompany receivable (payable) 171,485 (171,972 ) 487 — Investment in subsidiaries 43,786 — (43,786 ) — 3,617 8,358 (1,639 ) 10,336 $ 385,862 $ 189,899 $ (102,180 ) $ 473,581 Current portion of long-term debt $ 6,075 $ 42 $ — $ 6,117 8,708 7,587 — 16,295 892 2,715 — 3,607 Long-term debt, net of current portion 301,694 1,018 — 302,712 7,581 110,462 (70,728 ) 47,315 18,380 5,500 7,851 31,731 Accrued postretirement benefits 13,433 7,406 570 21,409 386,979 150,026 (62,307 ) 474,698 (1,117 ) 39,873 (39,873 ) (1,117 ) $ 380,572 $ 180,652 $ (95,666 ) $ 465,558 10,436 9,618 — 20,054 933 — — 933 297,117 1,037 298,154 13,065 108,089 (68,465 ) 52,689 CONSOLIDATING STATEMENT OF OPERATIONS Three Months Ended June 30, 2008 $ 101,842 $ 108,489 $ — $ 210,331 101,842 108,840 — 210,682 Restaurant wages and related expenses (including stock-based compensation expense of $57) General and administrative (including stock based compensation expense of $435) 3,843 4,559 (325 ) 8,077 71 10 — 81 — (119 ) — (119 ) 97,183 100,362 1,056 198,601 6,061 2,596 (1,534 ) 7,123 Gain on extinguishment of debt (180 ) — — (180 ) Intercompany interest allocations (4,557 ) 4,557 — — 1,165 436 279 1,880 Equity income from subsidiaries 1,088 — (1,088 ) — $ 3,258 $ 889 $ (889 ) $ 3,258 $ 96,928 $ 103,189 $ — $ 200,117 96,928 103,521 — 200,449 91,633 92,454 1,000 185,087 5,295 11,067 (1,000 ) 15,362 $ 5,099 $ 2,607 $ (2,607 ) $ 5,099 Six Months Ended June 30, 2008 53,543 68,029 — 121,572 Restaurant wages and related expenses (including stock-based compensation expense of $114) 7,727 9,014 (642 ) 16,099 Impairment loss 92 10 — 102 186,129 196,436 2,094 384,659 12,434 5,163 (3,040 ) 14,557 General and administrative (including stock-based compensation expense of $633) 1,643 7,685 904 10,232 507 2,760 287 3,554 CONSOLIDATING STATEMENT OF CASH FLOWS Cash flows provided from (used for) operating activities: Adjustments to reconcile net income to net cash provided from (used for) operating activities: 51 (63 ) — (12 ) 779 187 — 966 567 105 (77 ) 595 (1,077 ) — — (1,077 ) (653 ) (133 ) (258 ) (1,044 ) Loss on settlements of lease financing obligations 31 — — 31 10 110 — 120 259 (402 ) 392 249 (180 ) — (180 ) (13,828 ) 9,274 2,348 (2,206 ) (485 ) 19,865 — 19,380 (1,067 ) (15,318 ) — (16,385 ) (3,532 ) (2,636 ) — (6,168 ) (895 ) (1,690 ) — (2,585 ) 2,557 — 2,100 4,657 (4,534 ) (22,019 ) 2,100 (24,453 ) Cash flows provided from financing activities: (52,900 ) — — (52,900 ) (45 ) (26 ) — (71 ) — (88 ) 88 — Proceeds from lease financing obligations — 2,188 (2,188 ) — Net cash provided from financing activities (2,884 ) (80 ) — (2,964 ) 133 (24 ) — 109 (593 ) (127 ) (249 ) (969 ) Gain on settlements of lease financing obligations (210 ) (323 ) 323 (210 ) (5,561 ) 6,502 5,538 6,479 9,820 19,767 — 29,587 (911 ) (17,809 ) — (18,720 ) (1,386 ) (107 ) — (1,493 )

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professional_accounting

For the transition period from to ITRON, INC. (State of Incorporation) 2111 N Molter Road, Liberty Lake, Washington 99019 (Address and telephone number of registrant's principal executive offices) Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer Non-accelerated filer Smaller reporting company Emerging growth company If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Trading Symbol(s) Name of each exchange on which registered Common stock, no par value As of April 30, 2019, there were outstanding 39,349,003 shares of the registrant's common stock, no par value, which is the only class of common stock of the registrant. PART I: FINANCIAL INFORMATION Item 1: Financial Statements (Unaudited) Consolidated Statements of Comprehensive Income (Loss) Consolidated Statements of Equity Item 2: Management’s Discussion and Analysis of Financial Condition and Results of Operations Item 3: Quantitative and Qualitative Disclosures About Market Risk Item 4: Controls and Procedures PART II: OTHER INFORMATION Item 1: Legal Proceedings Item 1A: Risk Factors Item 2: Unregistered Sales of Equity Securities and Use of Proceeds Item 5: Other Information Item 6: Exhibits In thousands, except per share data Product revenues Service revenues Product cost of revenues Service cost of revenues Sales, general and administrative Total other income (expense) Income tax benefit (provision) Net loss attributable to Itron, Inc. Net income (loss) per common share - Basic Net income (loss) per common share - Diluted The accompanying notes are an integral part of these condensed consolidated financial statements. In thousands Foreign currency translation adjustments Net unrealized gain (loss) on derivative instruments, designated as cash flow hedges Pension benefit obligation adjustment Total comprehensive income (loss), net of tax Comprehensive income attributable to noncontrolling interests, net of tax Comprehensive income (loss) attributable to Itron, Inc. Property, plant, and equipment, net Operating lease right-of-use assets, net Wages and benefits payable Taxes payable Current portion of debt Current portion of warranty Long-term warranty Pension benefit obligation Deferred tax liabilities, net Other long-term obligations Commitments and contingencies (Note 11) Preferred stock, no par value, 10,000 shares authorized, no shares issued or outstanding Common stock, no par value, 75,000 shares authorized, 39,693 and 39,498 shares issued and outstanding Accumulated other comprehensive loss, net Total Itron, Inc. shareholders' equity Balances at January 1, 2019 Other comprehensive income (loss), net of tax Distributions to noncontrolling interests Stock issues and repurchases: Options exercised Restricted stock awards released net of repurchased shares for taxes Issuance of stock-based compensation awards Shares repurchased Balances at March 31, 2019 Cumulative effect of accounting change Restricted stock awards released SSNI acquisition adjustments, net Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization of intangible assets Amortization of operating lease right-of-use assets Amortization of prepaid debt fees Restructuring, non-cash Other adjustments, net Changes in operating assets and liabilities, net of acquisitions: Accounts payable, other current liabilities, and taxes payable Other operating, net Acquisitions of property, plant, and equipment Business acquisitions, net of cash equivalents acquired Other investing, net Proceeds from borrowings Payments on debt Prepaid debt fees Other financing, net Effect of foreign exchange rate changes on cash, cash equivalents, and restricted cash Decrease in cash, cash equivalents, and restricted cash Income taxes, net In this Quarterly Report on Form 10-Q, the terms "we," "us," "our," "Itron," and the "Company" refer to Itron, Inc. The condensed consolidated financial statements presented in this Quarterly Report on Form 10-Q are unaudited and reflect entries necessary for the fair presentation of the Consolidated Statements of Operations, the Consolidated Statements of Comprehensive Income (Loss), Consolidated Statements of Equity, and Consolidated Statements of Cash Flows for the three months ended March 31, 2019 and 2018, and the Consolidated Balance Sheets as of March 31, 2019 and December 31, 2018, of Itron, Inc. and its subsidiaries. All entries required for the fair presentation of the financial statements are of a normal recurring nature, except as disclosed. The results of operations for the three months ended March 31, 2019 are not necessarily indicative of the results expected for the full year or for any other period. Certain information and notes normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (GAAP) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) regarding interim results. These condensed consolidated financial statements should be read in conjunction with the audited financial statements and notes included in our 2018 Annual Report on Form 10-K filed with the SEC on February 28, 2019. There have been no significant changes in financial statement preparation or significant accounting policies since December 31, 2018 other than the adoption of Accounting Standards Codification (ASC) 842, Leases. Restricted Cash and Cash Equivalents Cash and cash equivalents that are contractually restricted from operating use are classified as restricted cash and cash equivalents. The following table provides a reconciliation of cash, cash equivalents, and restricted cash reported within the Consolidated Balance Sheets that sum to the total of the same such amounts shown in the Consolidated Statements of Cash Flows: Current restricted cash included in other current assets Long-term restricted cash Total cash, cash equivalents, and restricted cash Subsequent to the issuance of our March 31, 2018 consolidated financial statements, we determined $150 million of proceeds from borrowings and payments on debt, originally transacted during the first quarter of 2018, had been improperly netted within the financing activities section of the Consolidated Statements of Cash Flows for the first three quarters of 2018. We corrected this presentation for the 2018 Annual Report on Form 10‑K. The accompanying Consolidated Statement of Cash Flows for the three months ended March 31, 2018 has been revised from amounts previously reported to separately present the $150 million of proceeds from borrowings and the payments on debt. We assessed the significance of the misstatement and concluded that it was not material to any prior periods. There were no changes to net cash flows from operating, investing, or financing activities as a result of this change. We determine if an arrangement is a lease at inception. A lease exists when a contract conveys to the customer the right to control the use of identified property, plant, or equipment for a period of time in exchange for consideration. The definition of a lease embodies two conditions: (1) there is an identified asset in the contract that is land or a depreciable asset (i.e., property, plant, and equipment), and (2) the customer has the right to control the use of the identified asset. Operating leases are included in operating lease right-of-use ("ROU") assets, other current liabilities, and operating lease liabilities on our Consolidated Balance Sheets. Finance leases are included in property, plant, and equipment, other current liabilities, and other long-term liabilities on our Consolidated Balance Sheets. ROU assets represent our right to use an underlying asset for the lease term and lease liabilities represent our obligation to make lease payments arising from the lease. Operating lease ROU assets and liabilities are recognized at commencement date based on the present value of lease payments over the lease term. We use the implicit rate when readily determinable. As most of our leases do not provide an implicit rate, we use our incremental borrowing rate based on the information available at commencement date in determining the present value of lease payments. The Operating ROU asset also includes any lease payments made and excludes lease incentives received and initial direct costs incurred. Our lease terms may include options to extend or terminate the lease when it is reasonably certain that we will exercise that option. Lease expense for operating lease payments is recognized on a straight-line basis over the lease term. We have lease agreements, which include lease and nonlease components. For each of our existing asset classes, we have elected the practical expedient to account for the lease and nonlease components as a single lease component when the nonlease components are fixed. We have not elected to utilize the short-term lease exemption for any leased asset class. All leases with a lease term that is greater than one month will be subject to recognition and measurement on the balance sheet. Lease expense for variable lease payments, where the timing or amount of the payment is not fixed, are recognized when the obligation is incurred. Variable lease payments generally arise in our net lease arrangements where executory and other lease-related costs are billed to Itron when incurred by the lessor. Recently Adopted Accounting Standards In February 2016, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2016-02, Leases (Topic 842) (ASU 2016-02), which required substantially all leases be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability, including leases previously accounted for as operating leases. The new standard also resulted in enhanced quantitative and qualitative disclosures, including significant judgments made by management, to provide greater insight into the extent of revenue and expense recognized and expected to be recognized from existing leases. The standard required modified retrospective adoption and was effective for annual reporting periods beginning after December 15, 2018, with early adoption permitted. In July 2018, the FASB issued ASU 2018-10, Codification Improvements to Topic 842, Leases (ASU 2018-10), to clarify, improve, and correct various aspects of ASU 2016-02, and also issued ASU 2018-11, Targeted Improvements to Topic 842, Leases (ASU 2018-11), to simplify transition requirements and, for lessors, provide a practical expedient for the separation of nonlease components from lease components. In March 2019, the FASB issued a second Codification Improvements to Topic 842, Leases (ASU 2019-01) to provide further guidance and clarity on several topics of ASU 2016-02. The effective date and transition requirements in ASU 2018-10, ASU 2018-11, and ASU 2019-01 are the same as the effective date and transition requirements of ASU 2016-02. We adopted Accounting Standards Codification (ASC) 842 on January 1, 2019 and it resulted in an increase to operating lease right-of-use assets, other current liabilities, and operating lease liabilities of $74.6 million, $14.5 million, and $61.5 million, respectively, and a decrease in other current assets and other long-term obligations of $1.5 million and $2.9 million, respectively. In October 2018, the FASB issued ASU 2018-16, Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. We adopted this standard on January 1, 2019, and it did not materially impact our consolidated financial statements. This update establishes OIS rates based on SOFR as an approved benchmark interest rate in addition to existing rates such as the LIBOR swap rate. Recent Accounting Standards Not Yet Adopted In June 2016, the FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326) (ASU 2016-13), which replaces the incurred loss impairment methodology in current GAAP with a methodology based on expected credit losses. This estimate of expected credit losses uses a broader range of reasonable and supportable information. This change will result in earlier recognition of credit losses. ASU 2016-13 is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2019. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems. In August 2018, the FASB issued ASU 2018-13, Disclosure Framework-Changes to the Disclosure Requirements for Fair Value Measurement (ASU 2018-13), which amends the disclosure requirements under ASC 820, Fair Value Measurements. ASU 2018-13 is effective for us beginning with our interim financial reports for the first quarter of 2020. We are currently evaluating the impact this standard will have on our consolidated financial statement disclosures related to assets and liabilities subject to fair value measurement. In August 2018, the FASB issued ASU 2018-14, Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans (ASU 2018-14), which amends the disclosure requirements under ASC 715-20, Compensation-Retirement Benefits-Defined Benefit Plans. ASU 2018-14 is effective for our financial reporting in 2020. We are currently evaluating the impact this standard will have on our financial statement disclosures for our defined benefit plan. Note 2: Earnings Per Share The following table sets forth the computation of basic and diluted earnings (loss) per share (EPS): Net loss available to common shareholders Dilutive effect of stock-based awards Net loss per common share - Basic Net loss per common share - Diluted Stock-based Awards For stock-based awards, the dilutive effect is calculated using the treasury stock method. Under this method, the dilutive effect is computed as if the awards were exercised at the beginning of the period (or at time of issuance, if later) and assumes the related proceeds were used to repurchase common stock at the average market price during the period. Related proceeds include the amount the employee must pay upon exercise and the future compensation cost associated with the stock award. Approximately 1.0 million and 1.0 million stock-based awards were excluded from the calculation of diluted EPS for the three months ended March 31, 2019 and 2018 because they were anti-dilutive. These stock-based awards could be dilutive in future periods. Note 3: Certain Balance Sheet Components A summary of accounts receivable from contracts with customers is as follows: Trade receivables (net of allowance of $4,046 and $6,331) Unbilled receivables Total accounts receivable, net Allowance for doubtful accounts activity Beginning balance Accounts written-off Effect of change in exchange rates Buildings, furniture, and improvements Construction in progress, including purchased equipment Depreciation expense Subsequent to March 31, 2019, we entered into sales contracts for properties in Massy, France and Stretford, United Kingdom, which properties are classified as held-for-sale within other long-term assets. The estimated gains on sale are $1.5 million and $5.0 million, respectively. The Massy, France gain will be classified within operating expenses as a gain on sale of assets, and the Stretford, United Kingdom gain will offset restructuring expense as this property was included in a previous restructuring plan. Note 4: Intangible Assets and Liabilities The gross carrying amount and accumulated amortization (accretion) of our intangible assets and liabilities, other than goodwill, were as follows: (Amortization) Accretion Core-developed technology Customer contracts and relationships Trademarks and trade names Total intangible assets subject to amortization Total intangible assets Intangible Liabilities A summary of intangible assets and liabilities activity is as follows: Beginning balance, intangible assets, gross Intangible assets acquired Ending balance, intangible assets, gross Beginning balance, intangible liabilities, gross Intangible liabilities acquired Ending balance, intangible liabilities, gross On January 5, 2018, we completed our acquisition of Silver Spring Networks, Inc. (SSNI) by purchasing 100% of the voting stock. Acquired intangible assets include in-process research and development (IPR&D), which is not amortized until such time as the associated development projects are completed. Of these projects, $0.2 million were completed during the three months ended March 31, 2019 and are included in core-developed technology. The remaining IPR&D is expected to be completed in 2019. Acquired intangible liabilities reflect the present value of the projected cash outflows for an existing contract where remaining costs are expected to exceed projected revenues. Estimated future annual amortization (accretion) is as follows: Year Ending December 31, Estimated Annual Amortization, net 2019 (amount remaining at March 31, 2019) Total intangible assets subject to amortization (accretion) We have recognized $16.0 million and $17.7 million of net amortization of intangible assets for the three months ended March 31, 2019 and 2018, respectively, within operating expenses in the Consolidated Statement of Operations. These expenses relate to intangible assets and liabilities acquired as part of business combinations. Note 5: Goodwill The following table reflects goodwill allocated to each reporting unit: Device Solutions Goodwill balance at January 1, 2019 Measurement period adjustments to goodwill acquired Goodwill balance at March 31, 2019 Silver Spring Networks, Inc. Acquisition On January 5, 2018, we completed the acquisition of SSNI by purchasing 100% of SSNI's outstanding stock. The acquisition was financed through incremental borrowings and cash on hand. Refer to "Note 6: Debt" for further discussion of our debt. SSNI provided smart network and data platform solutions for electricity, gas, water and smart cities including advanced metering, distribution automation, demand-side management, and street lights. The fair values for the identified trademarks and core-developed technology intangible assets were estimated using the relief from royalty method. The fair value of customer contract and relationship were estimated using the income approach. The IPR&D was valued utilizing the replacement cost method. These consolidated financial statements should be read in conjunction with the audited financial statements and notes included in our 2018 Annual Report on Form 10-K filed with the SEC on February 28, 2019. The purchase price of SSNI was $809.2 million, which is net of $97.8 million of acquired cash and cash equivalents. Of the total consideration, $802.5 million was paid in cash. The remaining $6.7 million relates to the fair value of pre-acquisition service for replacement awards of unvested SSNI options and restricted stock unit awards with an Itron equivalent award. We allocated the purchase price to the assets acquired and liabilities assumed based on estimated fair value assessments. During the three months ended March 31, 2019, we recognized additional contract assets totaling $8.0 million and additional deferred tax liabilities of $2.0 million, for a net reduction in goodwill of $6.0 million. As of the first quarter of 2019, the measurement period for the acquisition of SSNI is complete, and any further adjustments to assets acquired or liabilities assumed will be recognized through the Consolidated Statement of Operations. Note 6: Debt The components of our borrowings were as follows: Credit facility: USD denominated term loan Multicurrency revolving line of credit Less: current portion of debt Less: unamortized prepaid debt fees - term loan Less: unamortized prepaid debt fees - senior notes On January 5, 2018, we entered into a credit agreement providing for committed credit facilities in the amount of $1.2 billion U.S. dollars (the 2018 credit facility), which amended and restated in its entirety our credit agreement dated June 23, 2015 and replaced committed facilities in the amount of $725 million. The 2018 credit facility consists of a $650 million U.S. dollar term loan (the term loan) and a multicurrency revolving line of credit (the revolver) with a principal amount of up to $500 million. The revolver also contains a $300 million standby letter of credit sub-facility and a $50 million swingline sub-facility. Both the term loan and the revolver mature on January 5, 2023 and can be repaid without penalty. Amounts repaid on the term loan may not be reborrowed and amounts borrowed under the revolver may be repaid and reborrowed until the revolver's maturity, at which time all outstanding loans together with all accrued and unpaid interest must be repaid. Amounts not borrowed under the revolver are subject to a commitment fee, which is paid in arrears on the last day of each fiscal quarter, ranging from 0.18% to 0.35% per annum depending on our total leverage ratio as of the most recently ended fiscal quarter. The 2018 credit facility permits us and certain of our foreign subsidiaries to borrow in U.S. dollars, euros, British pounds, or, with lender approval, other currencies readily convertible into U.S. dollars. All obligations under the 2018 credit facility are guaranteed by Itron, Inc. and material U.S. domestic subsidiaries and are secured by a pledge of substantially all of the assets of Itron, Inc. and material U.S. domestic subsidiaries, including a pledge of their related assets. This includes a pledge of 100% of the capital stock of material U.S. domestic subsidiaries and up to 66% of the voting stock (100% of the non-voting stock) of first-tier foreign subsidiaries. In addition, the obligations of any foreign subsidiary who is a foreign borrower, as defined by the 2018 credit facility, are guaranteed by the foreign subsidiary and by its direct and indirect foreign parents. The 2018 credit facility includes debt covenants, which contain certain financial thresholds and place certain restrictions on the incurrence of debt, investments, and the issuance of dividends. We were in compliance with the debt covenants under the 2018 credit facility at March 31, 2019. Under the 2018 credit facility, we elect applicable market interest rates for both the term loan and any outstanding revolving loans. We also pay an applicable margin, which is based on our total leverage ratio as defined in the credit agreement. The applicable rates per annum may be based on either: (1) the LIBOR rate or EURIBOR rate (subject to a floor of 0%), plus an applicable margin, or (2) the Alternate Base Rate, plus an applicable margin. The Alternate Base Rate election is equal to the greatest of three rates: (i) the prime rate, (ii) the Federal Reserve effective rate plus 0.50%, or (iii) one-month LIBOR plus 1.00%. At March 31, 2019, the interest rate for both the term loan and revolver was 4.50%, which includes the LIBOR rate plus a margin of 2.00%. On December 22, 2017 and January 19, 2018, we issued $300 million and $100 million, respectively, of aggregate principal amount of 5.00% senior notes maturing January 15, 2026 (Notes). The proceeds were used to refinance existing indebtedness related to the acquisition of SSNI, pay related fees and expenses, and for general corporate purposes. Interest on the Notes is payable semi-annually in arrears on January 15 and July 15, commencing on July 15, 2018. The Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by each of our subsidiaries that guarantee the senior credit facilities. Prior to maturity we may redeem some or all of the Notes, together with accrued and unpaid interest, if any, plus a "make-whole" premium. On or after January 15, 2021, we may redeem some or all of the Notes at any time at declining redemption prices equal to 102.50% beginning on January 15, 2021, 101.25% beginning on January 15, 2022 and 100.00% beginning on January15, 2023 and thereafter to the applicable redemption date. In addition, before January 15, 2021, and subject to certain conditions, we may redeem up to 35% of the aggregate principal amount of Notes with the net proceeds of certain equity offerings at 105.00% of the principal amount thereof to the date of redemption; provided that (i) at least 65% of the aggregate principal amount of Notes remains outstanding after such redemption and (ii) the redemption occurs within 60 days of the closing of any such equity offering. Debt Maturities The amount of required minimum principal payments on our long-term debt in aggregate over the next five years, are as follows: Minimum Payments Total minimum payments on debt Note 7: Derivative Financial Instruments As part of our risk management strategy, we use derivative instruments to hedge certain foreign currency and interest rate exposures. Refer to "Note 13: Shareholder's Equity" and "Note 14: Fair Values of Financial Instruments" for additional disclosures on our derivative instruments. The fair values of our derivative instruments are determined using the income approach and significant other observable inputs (also known as "Level 2"). We have used observable market inputs based on the type of derivative and the nature of the underlying instrument. The key inputs include interest rate yield curves (swap rates and futures) and foreign exchange spot and forward rates, all of which are available in an active market. We have utilized the mid-market pricing convention for these inputs. We include, as a discount to the derivative asset, the effect of our counterparty credit risk based on current published credit default swap rates when the net fair value of our derivative instruments is in a net asset position. We consider our own nonperformance risk when the net fair value of our derivative instruments is in a net liability position by discounting our derivative liabilities to reflect the potential credit risk to our counterparty through applying a current market indicative credit spread to all cash flows. The fair values of our derivative instruments were as follows: Balance Sheet Location Derivatives designated as hedging instruments under Subtopic 815-20 Interest rate swap contract Interest rate cap contracts Cross currency swap contract Derivatives not designated as hedging instruments under Subtopic 815-20 Foreign exchange forward contracts Total asset derivatives The changes in accumulated other comprehensive income (loss) (AOCI), net of tax, for our derivative and nonderivative hedging instruments designated as hedging instruments, net of tax, were as follows: Net unrealized loss on hedging instruments at January 1, Unrealized gain (loss) on hedging instruments Realized (gains) losses reclassified into net income (loss) Net unrealized loss on hedging instruments at March 31, Reclassification of amounts related to hedging instruments are included in interest expense in the Consolidated Statements of Operations for the periods ended March 31, 2019 and 2018. Included in the net unrealized gain (loss) on hedging instruments at March 31, 2019 and 2018 is a loss of $14.4 million, net of tax, related to our nonderivative net investment hedge, which terminated in 2011. This loss on our net investment hedge will remain in AOCI until such time when earnings are impacted by a sale or liquidation of the associated foreign operation. A summary of the effect of netting arrangements on our financial position related to the offsetting of our recognized derivative assets and liabilities under master netting arrangements or similar agreements is as follows: Offsetting of Derivative Assets Gross Amounts of Recognized Assets Presented in the Consolidated Gross Amounts Not Offset in the Consolidated Balance Sheets Derivative Financial Instruments Cash Collateral Received Offsetting of Derivative Liabilities Gross Amounts of Recognized Liabilities Presented in the Consolidated Balance Sheets Cash Collateral Pledged Our derivative assets and liabilities subject to netting arrangements consist of foreign exchange forwards and options and interest rate contracts with six counterparties at March 31, 2019 and five counterparties at December 31, 2018. No derivative asset or liability balance with any of our counterparties was individually significant at March 31, 2019 or December 31, 2018. Our derivative contracts with each of these counterparties exist under agreements that provide for the net settlement of all contracts through a single payment in a single currency in the event of default. We have no pledges of cash collateral against our obligations nor have we received pledges of cash collateral from our counterparties under the associated derivative contracts. Cash Flow Hedges As a result of our floating rate debt, we are exposed to variability in our cash flows from changes in the applicable interest rate index. We enter into interest rate caps and swaps to reduce the variability of cash flows from increases in the LIBOR based borrowing rates on our floating rate credit facility. These instruments do not protect us from changes to the applicable margin under our credit facility. At March 31, 2019, our LIBOR-based debt balance was $623.8 million. In October 2015, we entered into an interest rate swap, which is effective from August 31, 2016 to June 23, 2020, and converts $214 million of our LIBOR based debt from a floating LIBOR interest rate to a fixed interest rate of 1.42% (excluding the applicable margin on the debt). The notional balance will amortize to maturity at the same rate as required minimum payments on our term loan. Changes in the fair value of the interest rate swap are recognized as a component of other comprehensive income (OCI) and are recognized in earnings when the hedged item affects earnings. The amounts paid or received on the hedge are recognized as an adjustment to interest expense along with the earnings effect of the hedged item. The amount of net gains expected to be reclassified into earnings in the next 12 months is $1.6 million. In November 2015, we entered into three interest rate cap contracts with a total notional amount of $100 million at a cost of $1.7 million. The interest rate cap contracts expire on June 23, 2020 and were entered into in order to limit our interest rate exposure on $100 million of our variable LIBOR based debt up to 2.00%. In the event LIBOR is higher than 2.00%, we will pay interest at the capped rate of 2.00% with respect to the $100 million notional amount of such agreements. As of December 31, 2016, due to the accelerated revolver payments from surplus cash, we elected to de-designate two of the interest rate cap contracts as cash flow hedges and discontinued the use of cash flow hedge accounting. The amounts recognized in AOCI from de-designated interest rate cap contracts were maintained in AOCI as the forecasted transactions were still probable to occur, and subsequent changes in fair value were recognized within interest expense. In April 2018, due to increases in our total LIBOR-based debt, we elected to re-designate the two interest rate cap contracts as cash flow hedges. Future changes in the fair value of these instruments will be recognized as a component of OCI, and these changes together with amounts previously maintained in AOCI will be recognized in earnings when the hedged item affects earnings. The amounts paid or received on the hedge are recognized as an adjustment to interest expense along with the earnings effect of the hedged item. The amount of net losses expected to be reclassified into earnings for all interest rate cap contracts in the next 12 months is $0.3 million. In April 2018, we entered into a cross-currency swap, which converts $56.0 million of floating LIBOR-based U.S. Dollar denominated debt into 1.38% fixed rate euro denominated debt. This cross-currency swap matures on April 30, 2021 and mitigates the risk associated with fluctuations in currency rates impacting cash flows related to U.S. Dollar denominated debt in a euro functional currency entity. Changes in the fair value of the cross-currency swap are recognized as a component of OCI and will be recognized in earnings when the hedged item affects earnings. The amounts paid or received on the hedge are recognized as an adjustment to interest expense along with the earnings effect of the hedged item. The amount of net gains expected to be reclassified into earnings in the next 12 months is $1.6 million. As a result of our forecasted purchases in non-functional currency, we are exposed to foreign exchange risk. We hedge portions of our forecasted foreign currency inventory purchases. During January 2019, we entered into foreign exchange option contracts for a total notional amount of $72 million at a cost of $1.3 million. The contracts will mature ratably through the year with final maturity in October 2019. Changes in the fair value of the option contracts are recognized as a component of OCI and will be recognized in product cost of revenues when the hedged item affects earnings. The before-tax effects of our accounting for derivative instruments designated as hedges on AOCI were as follows: Derivatives in Subtopic 815-20 Hedging Relationships Amount of Gain (Loss) Recognized in OCI on Gain (Loss) Reclassified from AOCI into Income Interest rate swap contracts Other income/(expense), net These reclassification amounts presented above also represent the loss (gain) recognized in net income (loss) on hedging relationships under Subtopic 815-20 on the Consolidated Statements of Operations. For the three months ended March 31, 2019 and 2018, there were no amounts reclassified from AOCI as a result that a forecasted transaction is no longer probable of occurring, and no amounts excluded from effectiveness testing recognized in earnings based on changes in fair value. Derivatives Not Designated as Hedging Relationships We are also exposed to foreign exchange risk when we enter into non-functional currency transactions, both intercompany and third party. At each period-end, non-functional currency monetary assets and liabilities are revalued with the change recognized to other income and expense. We enter into monthly foreign exchange forward contracts, which are not designated for hedge accounting, with the intent to reduce earnings volatility associated with currency exposures. As of March 31, 2019, a total of 51 contracts were offsetting our exposures from the Euro, Pound Sterling, Indonesian Rupiah, Chinese Yuan, Canadian Dollar, Indian Rupee and various other currencies, with notional amounts ranging from $109,000 to $7.6 million. The effect of our derivative instruments not designated as hedges on the Consolidated Statements of Operations was as follows: Derivatives Not Designated as Hedging Instrument under Subtopic 815-20 Gain (Loss) Recognized on Derivatives in Other Income (Expense) Note 8: Defined Benefit Pension Plans We sponsor both funded and unfunded defined benefit pension plans offering death and disability, retirement, and special termination benefits for our international employees, primarily in Germany, France, Italy, Indonesia, Brazil, and Spain. The defined benefit obligation is calculated annually by using the projected unit credit method. The measurement date for the pension plans was December 31, 2018. Amounts recognized on the Consolidated Balance Sheets consist of: Plan assets in other long-term assets Current portion of pension benefit obligation in wages and benefits payable Long-term portion of pension benefit obligation Pension benefit obligation, net Our asset investment strategy focuses on maintaining a portfolio using primarily insurance funds, which are accounted for as investments and measured at fair value, in order to achieve our long-term investment objectives on a risk adjusted basis. Our general funding policy for these qualified pension plans is to contribute amounts sufficient to satisfy regulatory funding standards of the respective countries for each plan. Net periodic pension benefit costs for our plans include the following components: Interest cost Expected return on plan assets Amortization of actuarial net loss Amortization of unrecognized prior service costs Net periodic benefit cost The components of net periodic benefit cost, other than the service cost component, are included in total other income (expense) on the Consolidated Statements of Operations. Note 9: Stock-Based Compensation We maintain the Second Amended and Restated 2010 Stock Incentive Plan (Stock Incentive Plan), which allows us to grant stock-based compensation awards, including stock options, restricted stock units, phantom stock, and unrestricted stock units. Under the Stock Incentive Plan, we have 12,623,538 shares of common stock reserved and authorized for issuance subject to stock splits, dividends, and other similar events. At March 31, 2019, 6,318,953 shares were available for grant under the Stock Incentive Plan. We issue new shares of common stock upon the exercise of stock options or when vesting conditions on restricted stock units are fully satisfied. These shares are subject to a fungible share provision such that the authorized share reserve is reduced by (i) one share for every one share subject to a stock option or share appreciation right granted under the Plan and (ii) 1.7 shares for every one share of common stock that was subject to an award other than an option or share appreciation right. As part of the acquisition of SSNI, we reserved and authorized 2,880,039 shares, collectively, of Itron common stock to be issued under the Stock Incentive Plan for certain SSNI common stock awards that were converted to Itron common stock awards on January 5, 2018 (Acquisition Date) pursuant to the Agreement and Plan of Merger or were available for issuance pursuant to future awards under the Silver Spring Networks, Inc. 2012 Equity Incentive Plan (SSNI Plan). New stock-based compensation awards originally from the SSNI Plan may only be made to individuals who were not employees of Itron as of the Acquisition Date. Notwithstanding the foregoing, there is no fungible share provision for shares originally from the SSNI Plan. We also periodically award phantom stock units, which are settled in cash upon vesting and accounted for as liability-based awards with no impact to the shares available for grant. In addition, we maintain the Employee Stock Purchase Plan (ESPP), for which 272,602 shares of common stock were available for future issuance at March 31, 2019. Unrestricted stock and ESPP activity for the three months ended March 31, 2019 and 2018 was not significant. Total stock-based compensation expense and the related tax benefit were as follows: Restricted stock units Unrestricted stock awards Phantom stock units Total stock-based compensation Related tax benefit A summary of our stock option activity is as follows: Average Exercise Price per Share Contractual Life Average Grant Date Fair Value Outstanding, January 1, 2018 Converted upon acquisition Exercised Outstanding, March 31, 2018 Exercisable, March 31, 2019 Expected to vest, March 31, 2019 At March 31, 2019, total unrecognized stock-based compensation expense related to nonvested stock options was $1.8 million, which is expected to be recognized over a weighted average period of approximately 1.6 years. The weighted-average assumptions used to estimate the fair value of stock options granted and the resulting weighted average fair value are as follows: Expected volatility Risk-free interest rate Expected term (years) There were no employee stock options granted for the three months ended March 31, 2019. The following table summarizes restricted stock unit activity: Vested but not released, March 31, 2019 (1) Shares released is presented gross of shares netted for employee payroll tax obligations. At March 31, 2019, total unrecognized compensation expense on restricted stock units was $36.2 million, which is expected to be recognized over a weighted average period of approximately 2.0 years. The weighted-average assumptions used to estimate the fair value of performance-based restricted stock units granted and the resulting weighted average fair value are as follows: Weighted average fair value The following table summarizes phantom stock unit activity: Number of Phantom Stock Units At March 31, 2019, total unrecognized compensation expense on phantom stock units was $2.5 million, which is expected to be recognized over a weighted average period of approximately 2.1 years. As of both March 31, 2019 and December 31, 2018, we have recognized a phantom stock liability of $0.3 million and $1.5 million, respectively, within wages and benefits payable in the Consolidated Balance Sheets. Note 10: Income Taxes We determine the interim tax benefit (provision) by applying an estimate of the annual effective tax rate to the year-to-date pretax book income (loss) and adjusting for discrete items during the reporting period, if any. Tax jurisdictions with losses for which tax benefits cannot be realized are excluded. Our tax rate for the three months ended March 31, 2019 of 102% differed from the federal statutory rate of 21% due primarily to unbenefitted losses experienced in jurisdictions with valuation allowances on deferred tax assets as well as the forecasted mix of earnings in domestic and international jurisdictions. Our tax rate for the three months ended March 31, 2018 of 7% differed from the federal statutory rate of 21% due primarily to unbenefitted losses experienced in jurisdictions with valuation allowances on deferred tax assets as well as the forecasted mix of earnings in domestic and international jurisdictions, a benefit related to excess stock-based compensation, and uncertain tax positions. We classify interest expense and penalties related to unrecognized tax liabilities and interest income on tax overpayments as components of income tax expense. The net interest and penalties expense recognized were as follows: Net interest and penalties expense Accrued interest and penalties recognized were as follows: Accrued penalties Unrecognized tax benefits related to uncertain tax positions and the amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate were as follows: Unrecognized tax benefits related to uncertain tax positions The amount of unrecognized tax benefits that, if recognized, would affect our effective tax rate At March 31, 2019, we are under examination by certain tax authorities for the 2010 to 2017 tax years. The material jurisdictions where we are subject to examination for the 2010 to 2017 tax years include, among others, the United States, France, Germany, Italy, Brazil and the United Kingdom. No material changes have occurred to previously disclosed assessments. We believe we have appropriately accrued for the expected outcome of all tax matters and do not currently anticipate that the ultimate resolution of these examinations will have a material adverse effect on our financial condition, future results of operations, or liquidity. Based upon the timing and outcome of examinations, litigation, the impact of legislative, regulatory, and judicial developments, and the impact of these items on the statute of limitations, it is reasonably possible that the related unrecognized tax benefits could change from those recognized within the next twelve months. However, at this time, an estimate of the range of reasonably possible adjustments to the balance of unrecognized tax benefits cannot be made. Note 11: Commitments and Contingencies Guarantees and Indemnifications We are often required to obtain standby letters of credit (LOCs) or bonds in support of our obligations for customer contracts. These standby LOCs or bonds typically provide a guarantee to the customer for future performance, which usually covers the installation phase of a contract and may, on occasion, cover the operations and maintenance phase of outsourcing contracts. Our available lines of credit, outstanding standby LOCs, and performance bonds were as follows: Standby LOCs issued and outstanding Net available for additional borrowings under the multi-currency revolving line of credit Net available for additional standby LOCs under sub-facility Unsecured multicurrency revolving lines of credit with various financial institutions Multicurrency revolving lines of credit Short-term borrowings Net available for additional borrowings and LOCs Unsecured surety bonds in force In the event any such standby LOC or bond is called, we would be obligated to reimburse the issuer of the standby LOC or bond; however, we do not believe that any outstanding LOC or bond will be called. We generally provide an indemnification related to the infringement of any patent, copyright, trademark, or other intellectual property right on software or equipment within our sales contracts, which indemnifies the customer from and pays the resulting costs, damages, and attorney's fees awarded against a customer with respect to such a claim provided that (a) the customer promptly notifies us in writing of the claim and (b) we have the sole control of the defense and all related settlement negotiations. We may also provide an indemnification to our customers for third-party claims resulting from damages caused by the negligence or willful misconduct of our employees/agents in connection with the performance of certain contracts. The terms of our indemnifications generally do not limit the maximum potential payments. It is not possible to predict the maximum potential amount of future payments under these or similar agreements. We are subject to various legal proceedings and claims of which the outcomes are subject to significant uncertainty. Our policy is to assess the likelihood of any adverse judgments or outcomes related to legal matters, as well as ranges of probable losses. A determination of the amount of the liability required, if any, for these contingencies is made after an analysis of each known issue. A liability is recognized and charged to operating expense when we determine that a loss is probable and the amount can be reasonably estimated. Additionally, we would disclose contingencies for which a material loss is reasonably possible, but not probable. A summary of the warranty accrual account activity is as follows: Assumed liabilities from acquisition New product warranties Other adjustments and expirations Claims activity Less: current portion of warranty Total warranty expense is classified within cost of revenues and consists of new product warranties issued, costs related to insurance and supplier recoveries, other changes and adjustments to warranties, and customer claims. Warranty expense was as follows: Total warranty expense We are self-insured for a substantial portion of the cost of our U.S. employee group health insurance. We purchase insurance from a third party, which provides individual and aggregate stop loss protection for these costs. Each reporting period, we expense the costs of our health insurance plan including paid claims, the change in the estimate of incurred but not reported (IBNR) claims, taxes, and administrative fees (collectively, the plan costs). Plan costs were as follows: The IBNR accrual, which is included in wages and benefits payable, was as follows: IBNR accrual Our IBNR accrual and expenses may fluctuate due to the number of plan participants, claims activity, and deductible limits. For our employees located outside of the United States, health benefits are provided primarily through governmental social plans, which are funded through employee and employer tax withholdings. Note 12: Restructuring On February 22, 2018, our Board of Directors approved a restructuring plan (the 2018 Projects) to continue our efforts to optimize our global supply chain and manufacturing operations, research and development, and sales and marketing organizations. We expect to substantially complete the plan by the end of 2020. Many of the affected employees are represented by unions or works councils, which require consultation, and potential restructuring projects may be subject to regulatory approval, both of which could impact the timing of charges, total expected charges, cost recognized, and planned savings in certain jurisdictions. The total expected restructuring costs, the restructuring costs recognized, and the remaining expected restructuring costs related to the 2018 Projects are as follows: Total Expected Costs at March 31, 2019 Costs Recognized in Prior Periods Costs Recognized During the Three Months Ended Expected Remaining Costs to be Recognized at Employee severance costs Asset impairments & net loss on sale or disposal Other restructuring costs On September 1, 2016, we announced projects (2016 Projects) to restructure various company activities in order to improve operational efficiencies, reduce expenses and improve competitiveness. We expect to close or consolidate several facilities and reduce our global workforce as a result of the restructuring. The 2016 Projects were initiated during the third quarter of 2016 and were substantially completed at December 31, 2018. The following table summarizes the activity within the restructuring related balance sheet accounts for the 2018 and 2016 Projects during the three months ended March 31, 2019: Accrued Employee Severance

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Pzena Investment Management, Inc. - FORM 10-Q - August 7, 2017 EX-32.2 - EXHIBIT 32.2 - Pzena Investment Management, Inc. pzn2017q2exhibit322.htm Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Quarterly Period Ended June 30, 2017 Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ______to______ Commission file number 001-33761 PZENA INVESTMENT MANAGEMENT, INC. (Former Address of Principal Executive Offices) (Zip Code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. Yes o No o As of August 4, 2017, there were 17,285,307 outstanding shares of the registrant’s Class A common stock, par value $0.01 per share. As of August 4, 2017, there were 51,195,179 outstanding shares of the registrant’s Class B common stock, par value $0.000001 per share. PART I — FINANCIAL INFORMATION Consolidated Statements of Financial Condition of Pzena Investment Management, Inc. as of June 30, 2017 (unaudited) and December 31, 2016 Consolidated Statements of Operations (unaudited) of Pzena Investment Management, Inc. for the Three and Six Months Ended June 30, 2017 and 2016 Consolidated Statements of Comprehensive Income (unaudited) of Pzena Investment Management, Inc. for the Three and Six Months Ended June 30, 2017 and 2016 Consolidated Statement of Changes in Equity (unaudited) of Pzena Investment Management, Inc. for the Six Months Ended June 30, 2017 and 2016 Consolidated Statements of Cash Flows (unaudited) of Pzena Investment Management, Inc. for the Three and Six Months Ended June 30, 2017 and 2016 Notes to the Consolidated Financial Statements (unaudited) PART II — OTHER INFORMATION This Quarterly Report on Form 10-Q contains forward-looking statements. Forward-looking statements provide our current expectations, or forecasts, of future events. Forward-looking statements include statements about our expectations, beliefs, plans, objectives, intentions, assumptions and other statements that are not historical facts. Words or phrases such as “anticipate,” “believe,” “continue,” “ongoing,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential,” “predict,” “project” or similar words or phrases, or the negatives of those words or phrases, may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. Forward-looking statements are subject to known and unknown risks and uncertainties and are based on our views, plans, estimates, and expectations. Potentially inaccurate assumptions could cause actual results to differ materially from those expected or implied by the forward-looking statements. Our actual results could differ materially from those anticipated in forward-looking statements for many reasons, including the factors described in Item 1A, “Risk Factors” in Part I of our Annual Report on Form 10-K for our fiscal year ended December 31, 2016. Accordingly, you should not unduly rely on these forward-looking statements, which speak only as of the date they are made. We undertake no obligation to publicly revise any forward-looking statements included in this Quarterly Report to reflect circumstances or events after the date of this Quarterly Report, or to reflect the occurrence of unanticipated events. You should, however, review the factors and risks we describe in the reports we will file from time to time with the Securities and Exchange Commission ("SEC"), after the date of this Quarterly Report on Form 10-Q. Forward-looking statements include, but are not limited to, statements about: our ability to respond to global economic, market, business and geopolitical conditions; our anticipated future results of operations and operating cash flows; our successful formulation and execution of business strategies and investment policies; our financing plans and the availability of short- or long-term borrowing, or equity financing; our competitive position and the effects of competition on our business; our ability to identify and capture potential growth opportunities available to us; the effective recruitment and retention of our key executives and employees; our expected levels of compensation for our employees; our potential operating performance, achievements, efficiency, and cost reduction efforts; our expected tax rate; changes in interest rates; our expectations with respect to the economy, capital markets, the market for asset management services, and other industry trends; and the impact of future legislation and regulation, and changes in existing legislation and regulation, on our business. The reports that we file with the SEC, accessible on the SEC’s website at www.sec.gov, identify additional factors that can affect forward-looking statements. PART I. FINANCIAL INFORMATION CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (in thousands, except share and per-share amounts) Cash and Cash Equivalents ($3,403 and $3,258)1 Due from Broker ($820 and $0)1 Advisory Fees Receivable Investments in Marketable Securities, at Fair Value ($4,736 and $3,174)1 Receivable from Related Parties Other Receivables ($21 and $9)1 Prepaid Expenses and Other Assets Deferred Tax Asset Property and Equipment, Net of Accumulated Depreciation of $2,540 and $2,260, respectively Accounts Payable and Accrued Expenses ($9 and $18)1 Due to Broker ($570 and $3)1 Securities Sold Short, at Fair Value Liability to Selling and Converting Shareholders Deferred Compensation Liability Commitments and Contingencies (see Note 11) Preferred Stock (Par Value $0.01; 200,000,000 Shares Authorized; None Outstanding) Class A Common Stock (Par Value $0.01; 750,000,000 Shares Authorized; 17,285,307 and 17,340,090 Shares Issued and Outstanding in 2017 and 2016, respectively) Class B Common Stock (Par Value $0.000001; 750,000,000 Shares Authorized; 51,109,592 and 50,461,598 Shares Issued and Outstanding in 2017 and 2016, respectively) Total Pzena Investment Management, Inc.'s Equity Non-Controlling Interests Asset and liability amounts in parentheses represent the aggregated balances at June 30, 2017 and December 31, 2016 attributable to Pzena International Value Service (a series of Pzena Investment Management, LLC) and Pzena Investment Management Special Situations, LLC, which were variable interest entities as of June 30, 2017 and December 31, 2016, respectively. See accompanying notes to unaudited consolidated financial statements. UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS For the Three Months Ended June 30, For the Six Months Ended June 30, Compensation and Benefits Expense General and Administrative Expense OTHER INCOME/ (EXPENSE) Net Realized and Unrealized Gains/ (Losses) from Investments Equity in Earnings/ (Losses) of Affiliates Change in Liability to Selling and Converting Shareholders Total Other Income/ (Expense) Less: Net Income Attributable to Non-Controlling Interests Net Income Attributable to Pzena Investment Management, Inc. Net Income for Basic Earnings per Share Basic Earnings per Share Basic Weighted Average Shares Outstanding1 Net Income for Diluted Earnings per Share Diluted Earnings per Share Diluted Weighted Average Shares Outstanding1 Cash Dividends per Share of Class A Common Stock The Company issues restricted shares of Class A common stock and restricted Class B units that have non-forfeitable dividend rights. Under the "two-class method," these shares and units are considered participating securities and are required to be included in the computation of basic and diluted earnings per share. UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME OTHER COMPREHENSIVE GAIN/ (LOSS) Foreign Currency Translation Adjustment Total Other Comprehensive Gain/ (Loss) Less: Comprehensive Income Attributable to Non-Controlling Interests Total Comprehensive Income Attributable to Pzena Investment Management, Inc. UNAUDITED CONSOLIDATED STATEMENT OF CHANGES IN EQUITY Paid-In Capital Non-Controlling Balance at December 31, 2016 Adjustment for the Cumulative Effect of Applying ASU 2016-09 Adjusted Balance at January 1, 2017 Amortization of Non-Cash Compensation Issuance of Shares under Equity Incentive Plan Sale of Shares under Equity Incentive Plan Directors' Share Grants Foreign Currency Translation Adjustments Repurchase and Retirement of Class A Common Stock (79,717 Repurchase and Retirement of Class B Units Class A Cash Dividends Declared and Paid ($0.31 per share) Contributions from Non-Controlling Interests Distributions to Non-Controlling Interests Balance at June 30, 2017 (1,369,811 Directors' Shares Option Exercise UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS Adjustments to Reconcile Net Income to Cash Provided by Operating Activities: Loss on Disposal of Fixed Assets Non-Cash Compensation Due from Broker Due to Broker Accounts Payable, Accrued Expenses, and Other Liabilities Purchases of Equity Securities and Securities Sold Short Proceeds from Equity Securities and Securities Sold Short Purchases of Investments Proceeds from Sale of Investments Payments to Related Parties Purchases of Property and Equipment Net Cash (Used in)/ Provided by Investing Activities CASH AND CASH EQUIVALENTS - Beginning of Period CASH AND CASH EQUIVALENTS - End of Period Supplementary Cash Flow Information: Issuances of Shares under Equity Incentive Plan Income Taxes Paid Notes to Unaudited Consolidated Financial Statements Note 1—Organization Pzena Investment Management, Inc. (the “Company”) is the sole managing member of its operating company, Pzena Investment Management, LLC (the “operating company”). As a result, the Company: (i) consolidates the financial results of the operating company and reflects the membership interests in the operating company that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) recognizes income generated from its economic interest in the operating company’s net income. The operating company is an investment adviser registered under the Investment Advisers Act of 1940 and is headquartered in New York, New York. As of June 30, 2017, the operating company managed assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets. The Company also serves as the general partner of Pzena Investment Management, LP, a partnership formed with the objective of aggregating employee ownership in the operating company into one entity. The Company, through its interest in the operating company, has consolidated the results of operations and financial condition of the following entities as of June 30, 2017: Ownership at Type of Entity (Date of Formation) Pzena Investment Management, Pty Australian Proprietary Limited Company (12/16/2009) Pzena Financial Services, LLC Delaware Limited Liability Company (10/15/2013) Pzena Investment Management, LTD England and Wales Private Limited Company (01/08/2015) Pzena Investment Management Special Situations, LLC Pzena International Value Service, a series of Pzena Investment Management International, LLC Pzena Long/Short Value Fund, a series of Advisors Series Trust Open-end Management Investment Company, series of Delaware Statutory Trust (3/31/2014) Pzena Mid Cap Value Fund, a series of Advisors Series Trust Note 2—Significant Accounting Policies Basis of Presentation: Principles of Consolidation: The consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and related Securities and Exchange Commission (“SEC”) rules and regulations. The Company’s policy is to consolidate those entities in which it has a direct or indirect controlling financial interest based on either the voting interest model or the variable interest model. As such, the Company consolidates majority-owned subsidiaries in which it has a controlling financial interest, and certain investment vehicles the operating company sponsors for which it is the investment adviser that are considered to be variable-interest entities (“VIEs”), and for which the Company is deemed to be the primary beneficiary. Pursuant to the Consolidation Topic of the FASB Accounting Standards Codification (“FASB ASC”), for legal entities evaluated for consolidation, the Company determines whether interests it holds and fees paid to the entity qualify as a variable interest. If it is determined that the Company does not have a variable interest in the entity, no further analysis is required and the Company does not consolidate the entity. If it is determined that the Company has a variable interest, it considers its direct economic interests and the proportionate indirect interests through related parties to determine if it is the primary beneficiary of the VIE. Notes to Unaudited Consolidated Financial Statements (Continued) For equity investments where the Company does not control the investee, and where it is not the primary beneficiary of a VIE, but can exert significant influence over the financial and operating policies of the investee, the Company follows the equity method of accounting. The evaluation of whether the Company exerts control or significant influence over the financial and operating policies of the investee requires significant judgment based on the facts and circumstances surrounding each investment. Factors considered in these evaluations may include the type of investment, the legal structure of the investee, the terms of the investment agreement, or other agreements with the investee. The Company analyzes entities structured as series funds which comply with the requirements included in the Investment Company Act of 1940 for registered mutual funds as voting interest entities because the shareholders are deemed to have the ability to direct the activities of the fund that most significantly impact the fund's economic performance. Consolidated Entities The Company consolidates the financial results of the operating company and records in its own equity its pro-rata share of transactions that impact the operating company’s net equity, including unit and option issuances, repurchases, and retirements. The operating company’s pro-rata share of such transactions are recorded as an adjustment to additional paid-in capital or non-controlling interests, as applicable, on the consolidated statements of financial condition. The majority-owned subsidiaries in which the Company, through its interest in the operating company, has a controlling financial interest and the VIEs for which the Company is deemed to be the primary beneficiary are collectively referred to as “consolidated subsidiaries.” Non-controlling interests recorded on the consolidated financial statements of the Company include the non-controlling interests of the outside investors in each of these entities, as well as those of the operating company. All significant inter-company transactions and balances have been eliminated through consolidation. During 2014, the Company provided the initial cash investment for three Pzena mutual funds in an effort to generate an investment performance track record to attract third-party investors. During 2016, the Company provided the initial cash investment for the launch of a fourth Pzena mutual fund: the Pzena Small Cap Value Fund. Due to their series fund structure, registration, and compliance with the requirements of the Investment Company Act of 1940, these funds are analyzed for consolidation under the voting interest model. As a result of the Company's initial interests, it consolidated the Pzena Mid Cap Value Fund, Pzena Long/Short Value Fund, Pzena Emerging Markets Value Fund, and Pzena Small Cap Value Fund. On July 11, 2016, due to additional subscriptions into the Pzena Small Cap Value Fund, the Company's ownership decreased to 36.1%. As the entity was no longer deemed to control the fund, the Company deconsolidated the entity, removed the related assets, liabilities and non-controlling interest from its balance sheet and classified the Company's remaining investment as an equity method investment. Upon adoption of ASU No. 2015-02 as of January 1, 2016, the Company was deemed to not have a controlling interest in the Pzena Emerging Markets Value Fund. The Pzena Mid Cap Value Fund and Pzena Long/Short Value Fund will continue to be consolidated to the extent the Company has a majority ownership interest in them. At June 30, 2017, the aggregate of these funds' $11.9 million in net assets was included in the Company's consolidated statements of financial condition. The operating company is the managing member of Pzena International Value Service, a series of Pzena Investment Management International, LLC. The operating company is considered the primary beneficiary of this entity. At June 30, 2017, Pzena International Value Service’s $4.9 million in net assets was included in the Company’s consolidated statements of financial condition. These consolidated mutual funds and investment partnerships are investment companies and apply specialized industry accounting for investment companies. The Company has retained this specialized accounting for these mutual funds and investment partnerships pursuant to U.S. GAAP. Non-Consolidated Variable Interest Entities VIEs that are not consolidated receive investment management services from the operating company and are generally private investment partnerships sponsored by the operating company. The total net assets of these VIEs was approximately $47.4 million and $44.3 million at June 30, 2017 and December 31, 2016, respectively. As of June 30, 2017 and December 31, 2016, in order to satisfy certain of the Company's obligations under its deferred compensation programs, the operating company had $3.0 million and $3.2 million in investments, respectively, in certain of these firm-sponsored vehicles, for which the Company was not deemed to be the primary beneficiary. The Company's exposure to risk in the non-consolidated VIEs is generally limited to any equity investment and any uncollected management fees. As of June 30, 2017 and December 31, 2016, the Company's maximum exposure to loss as a result of its involvement with the non-consolidated VIEs was $3.1 million and $3.3 million, respectively. Accounting Pronouncements Adopted in 2017: In March 2016, the FASB issued ASU No. 2016-09, "Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting." The Company adopted ASU No. 2016-09 as of January 1, 2017. This standard requires excess tax benefits and tax deficiencies to be recorded in the consolidated statements of operations as a component of Income Tax Expense/ (Benefit) when equity awards vest or are settled. The Company is no longer required to delay recognition of an excess tax benefit until it reduces current taxes payable. The standard also requires excess tax benefits to be classified as operating activities along with other income tax cash flows within the consolidated statements of cash flows. In addition, ASU No. 2016-09 allows entities to make an accounting policy election to either estimate the number of forfeitures expected to occur, as was previously required, or to account for actual forfeitures as they occur. The Company has elected to account for forfeitures as they occur, rather than estimate expected forfeitures. The adoption of ASU No. 2016-09 resulted in a net cumulative effect adjustment reflecting a $1.4 million increase to retained earnings and the deferred tax asset as of January 1, 2017, related to the recognition of the previously unrecognized excess tax benefits using the modified retrospective method. Estimates of forfeitures in prior periods were immaterial, and therefore are not included in the cumulative effect adjustment. The amendments related to the classification of the excess tax benefits in the consolidated statements of cash flows were adopted on a prospective basis, which did not require the restatement of prior periods. Management’s Use of Estimates: The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses for the period. Actual results could materially differ from those estimates. Revenue Recognition: Revenue, comprised of advisory fee income, is recognized over the period in which advisory services are provided. Advisory fee income includes management fees that are calculated based on percentages of assets under management (“AUM”), generally billed quarterly, either in arrears or advance, depending on the applicable contractual terms. Advisory fee income also includes performance fees that may be earned by the Company depending on the investment return of the AUM, as well as fulcrum fee arrangements. Performance fee arrangements generally entitle the Company to participate, on a fixed-percentage basis, in any returns generated in excess of an agreed-upon benchmark. The Company’s participation percentage in such return differentials is then multiplied by AUM to determine the performance fees earned. In general, returns are calculated on an annualized basis over the contract’s measurement period, which usually extends to three years. Performance fees are generally payable annually. Fulcrum fee arrangements require a reduction in the base fee, or allow for a performance fee if the relevant investment strategy underperforms or outperforms, respectively, the agreed-upon benchmark over the contract's measurement period, which extends to three years. Fulcrum fees are generally payable quarterly. Following the preferred method identified in the Revenue Recognition Topic of the FASB ASC, performance fee income is recorded at the conclusion of the contractual performance period, when all contingencies are resolved. For the three and six months ended June 30, 2017, the Company recognized $0.4 million and $0.7 million in performance fee income. The Company did not recognize performance fee income during three months ended June 30, 2016. For the six months ended June 30, 2016 the Company recognized approximately $0.1 million in performance fee income. For the three months ended June 30, 2017, the Company did not recognize a reduction in base fees related to fulcrum fee arrangements. For the six months ended June 30, 2017, the Company recognize a $0.1 million reduction in base fees related to fulcrum fee arrangements. For the three and six months ended June 30, 2016, the Company did not recognize a reduction in base fees related to fulcrum fee arrangements. At June 30, 2017 and December 31, 2016, Cash and Cash Equivalents was $34.7 million and $43.5 million, respectively. The Company considers all highly-liquid debt instruments with an original maturity of three months or less at the time of purchase to be cash equivalents. The Company maintains its cash in bank deposits and other accounts whose balances often exceed federally insured limits. Interest on cash and cash equivalents is recorded as interest income on an accrual basis in the consolidated statements of operations. Restricted Cash: At June 30, 2017 and December 31, 2016, the Company had $4.3 million and $3.6 million, respectively, of compensating balances recorded in Restricted Cash in the consolidated statements of financial condition. Included in these balances at June 30, 2017 and December 31, 2016, is a $1.0 million letter of credit issued by a third party in lieu of a cash security deposit, as required by the Company’s lease for its corporate headquarters. Also included in these balances at June 30, 2017 and December 31, 2016, were amounts of cash collateral for margin accounts established by the Pzena Long/Short Value Fund required to maintain to support securities sold short, not yet purchased of $3.3 million and $2.6 million, respectively. Due to/from Broker: Due to/from Broker consists primarily of amounts payable/receivable for unsettled securities transactions held/initiated at the clearing brokers of the Company’s consolidated subsidiaries. Non-Cash Compensation: All non-cash compensation awards granted have varying vesting schedules and are issued at prices equal to the assessed fair market value at the time of issuance. Expenses associated with these awards are recognized over the period during which employees are required to provide service. The Company accounts for forfeitures as they occur. Investments: Investment Securities, trading Investments classified as trading securities consist of equity securities held by the Company and its consolidated subsidiaries. Dividends associated with the Company's investments and the investments of the Company's consolidated subsidiaries are recognized as dividend income on an ex-dividend basis in the consolidated statements of operations. Securities Sold Short represents securities sold short, not yet purchased by the Pzena Long/Short Value Fund, which is consolidated with the Company's financial statements. Dividend expense associated with these investments is recognized in Other Income/ (Expense) on an ex-dividend basis in the consolidated statements of operations. All such investments are recorded at fair value, with net realized and unrealized gains and losses reported in earnings. Net realized and unrealized gains and losses are recognized as a component of Net Realized and Unrealized Gains/ (Losses) from Investments in the consolidated statements of operations. Investments in equity method investees During the three and six months ended June 30, 2017, the Company accounted for its investments in certain private investment partnerships, the Pzena Emerging Markets Value Fund and the Pzena Small Cap Value Fund, in which the Company has non-controlling interests and exercises significant influence, using the equity method. These investments are included in Investments in the Company's consolidated statements of financial condition. The carrying value of these investments are recorded at the amount of capital reported by the private investment partnership or mutual fund. The capital account for each entity reflects any contributions paid to, distributions received from, and equity earnings of, the relevant entity. The earnings of these investments are recognized as equity in the earnings of affiliates and reflected as a component of Equity in Earnings/ (Losses) of Affiliates in the consolidated statements of operations. Investments in equity method investees are evaluated for impairment as events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. If the carrying amounts of the assets exceed their respective fair values, additional impairment tests are performed to measure the amounts of impairment losses, if any. During the three and six months ended June 30, 2017 and 2016, no impairment losses were recognized. Securities Valuation: Investments in equity securities and securities sold short for which market quotations are available are valued at the last reported price or closing price on the primary market or exchange on which they trade. If no reported equity sales occurred on the valuation date, equity investments are valued at the bid price. Transactions are recorded on a trade date basis. The net realized gain or loss on sales of equity securities and securities sold short is determined on a specific identification basis and is included in Net Realized and Unrealized Gains/ (Losses) from Investments in the consolidated statements of operations. Concentrations of Credit Risk: Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, amounts due from brokers, and advisory fees receivable. The Company maintains its cash and cash equivalents in bank deposits and other accounts whose balances often exceed federally insured limits. The concentration of credit risk with respect to advisory fees receivable is generally limited due to the short payment terms extended to clients by the Company. On a periodic basis, the Company evaluates its advisory fees receivable and establishes an allowance for doubtful accounts, if necessary, based on a history of past write-offs, collections, and current credit conditions. For both the three and six months ended June 30, 2017, approximately 11.1% of the Company's advisory fees were generated from advisory agreements with one client relationship. For the three and six months ended June 30, 2016, approximately 11.0% and 10.9% of the Company's advisory fees, respectively, were generated from advisory agreements with one client relationship. At June 30, 2017 and December 31, 2016, there was no allowance for doubtful accounts. Property and Equipment: Property and equipment is carried at cost, less accumulated depreciation and amortization. Depreciation is provided on a straight-line basis over the estimated useful lives of the respective assets, except for leasehold improvements, which range from three to seven years. Leasehold improvements are amortized on a straight-line basis over the shorter of the useful life of the improvements or the remaining lease term. Business Segments: The Company views its operations as comprising one operating segment. Income Taxes: The Company is a “C” corporation under the Internal Revenue Code, and thus liable for federal, state, and local taxes on the income derived from its economic interest in its operating company. The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes. It has not made a provision for federal or state income taxes because it is the individual responsibility of each of the operating company’s members (including the Company) to separately report their proportionate share of the operating company’s taxable income or loss. The operating company has made a provision for New York City Unincorporated Business Tax (“UBT”) and its consolidated subsidiary Pzena Investment Management, LTD has made a provision for U.K. income taxes. The effective tax rate for interim periods represents the Company’s best estimate of the effective tax rate expected to be applied to the full fiscal year, adjusted for discrete items recognized during the quarter. Judgment is required in evaluating the Company's uncertain tax positions and determining its provision for income taxes. The Company establishes liabilities for tax-related uncertainties based on estimates of whether, and the extent to which, additional taxes will be due. These liabilities are established when the Company believes that certain positions might be challenged despite its belief that its tax return positions are in accordance with applicable tax laws. The Company adjusts these liabilities in light of changing facts and circumstances, such as the closing of a tax audit, new tax legislation or the change of an estimate. To the extent that the final tax outcome of these matters is different than the amounts recorded, such differences will affect the provision for income taxes in the period in which such determination is made. The provision for income taxes includes the effect of reserve provisions and changes to reserves that are considered appropriate. It is also the Company’s policy to recognize accrued interest, and penalties associated with uncertain tax positions in Income Tax Expense on the consolidated statements of operations. The Company and its consolidated subsidiaries account for all U.S. federal, state, local, and U.K. taxation pursuant to the asset and liability method, which requires deferred income tax assets and liabilities to be recorded for temporary differences between the carrying amount and tax bases of assets and liabilities that will result in taxable or deductible amounts in the future, based on enacted tax laws and rates applicable to the periods in which the temporary differences are expected to affect taxable income. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount more-likely-than-not to be realized. At June 30, 2017, the Company did not have a valuation allowance recorded against its deferred tax assets. The income tax expense, or benefit, is the tax payable or refundable for the period, plus or minus the change during the period in deferred tax assets and liabilities. The Company records its deferred tax liabilities as a component of other liabilities in the consolidated statements of financial condition. Upon adoption of ASU No. 2016-09 as of January 1, 2017, all excess tax benefits or tax deficiencies related to stock- and unit-transactions are reflected in the consolidated statements of operations as a component of the provision for income taxes. Previously, these excess tax benefits were not recognized until they resulted in a reduction of cash taxes payable, and were subsequently recorded in equity when they reduced cash taxes payable. The Company only recognized a tax benefit from stock- and unit-based awards in Additional Paid-In Capital if an incremental tax benefit was realized after all other tax benefits available had been utilized. The adoption of ASU No. 2016-09 resulted in a net cumulative effect adjustment reflecting a $1.4 million increase to retained earnings and the deferred tax asset as of January 1, 2017, related to the recognition of the previously unrecognized excess tax benefits using the modified retrospective method. Tax Receivable Agreement: The Company’s purchase of membership units of the operating company concurrent with the initial public offering, and the subsequent and future exchanges by holders of Class B units of the operating company for shares of Class A common stock (pursuant to the exchange rights provided for in the operating company’s operating agreement), have resulted in, and are expected to continue to result in, increases in the Company’s share of the tax basis of the tangible and intangible assets of the operating company, which will increase the tax depreciation and amortization deductions that otherwise would not have been available to the Company. These increases in tax basis and tax depreciation and amortization are each deductible for tax purposes over a period of 15 years and have reduced, and are expected to continue to reduce, the amount of cash taxes that the Company would otherwise be required to pay in the future. The Company has entered into a tax receivable agreement with past, current, and future members of the operating company that requires the Company to pay to any member involved in any exchange transaction 85% of the amount of cash tax savings, if any, in U.S. federal, state and local income tax or foreign or franchise tax that it realizes as a result of these increases in tax basis and, in limited cases, transfers or prior increases in tax basis. The Company expects to benefit from the remaining 15% of cash tax savings, if any, in income tax it realizes. Payments under the tax receivable agreement will be based on the tax reporting positions that the Company will determine. The Company will not be reimbursed for any payments previously made under the tax receivable agreement if a tax basis increase is successfully challenged by the Internal Revenue Service. The Company records an increase in deferred tax assets for the estimated income tax effects of the increases in tax basis based on enacted federal and state tax rates at the date of the exchange. The Company records 85% of the estimated realizable tax benefit (which is the recorded deferred tax asset less any recorded valuation allowance) as an increase to the liability due under the tax receivable agreement, which is reflected as the liability to selling and converting shareholders in the accompanying consolidated financial statements. The remaining 15% of the estimated realizable tax benefit is initially recorded as an increase to the Company’s additional paid-in capital. All of the effects to the deferred tax asset of changes in any of the estimates after the tax year of the exchange will be reflected in the provision for income taxes. Similarly, the effect of subsequent changes in the enacted tax rates will be reflected in the provision for income taxes. If the Company exercises its right to terminate the tax receivable agreement early, the Company will be obligated to make an early termination payment to the selling and converting shareholders, based upon the net present value (based upon certain assumptions and deemed events set forth in the tax receivable agreement) of all payments that would be required to be paid by the Company under the tax receivable agreement. If certain change of control events were to occur, the Company would be obligated to make an early termination payment. Foreign Currency: The functional currency of the Company is the U.S. Dollar. Assets and liabilities of foreign operations whose functional currency is not the U.S. Dollar are translated at the exchange rate in effect at the applicable reporting date, and the consolidated statements of operations are translated at the average exchange rates in effect during the applicable period. A charge or credit is recorded to other comprehensive income/ (loss) to reflect the translation of these amounts to the extent the non-U.S. currency is designated the functional currency of the subsidiary. Non-functional currency related transaction gains and losses are immediately recorded in the consolidated statements of operations. For the three and six months ended June 30, 2017, the Company recorded less than $0.1 million and $0.1 million, respectively, of other comprehensive income associated with foreign currency translation adjustments. For the three and six months ended June 30, 2016, the Company recorded less than $0.1 million of such income. Investment securities and other assets and liabilities denominated in foreign currencies are remeasured into U.S. Dollar amounts at the date of valuation. Purchases and sales of investment securities, and income and expense items denominated in foreign currencies, are remeasured into U.S. Dollar amounts on the respective dates of such transactions. The Company does not isolate the portion of the results of its operations resulting from the impact of fluctuations in foreign exchange rates on its non-U.S. investments. Such fluctuations are included in Net Realized and Unrealized Gains/ (Losses) from Investments in the consolidated statements of operations. Reported net realized foreign exchange gains or losses arise from sales of foreign currencies, currency gains or losses realized between the trade and settlement dates on securities transactions, and the difference between the amounts of dividends, interest, foreign withholding taxes, and other receivables and payables recorded on the Company’s consolidated statements of financial condition and the U.S. Dollar equivalent of the amounts actually received or paid. Net unrealized foreign exchange gains and losses arise from changes in the fair values of assets and liabilities resulting from changes in exchange rates. Recently Issued Accounting Pronouncements Not Yet Adopted: In November 2016, the FASB issued ASU No. 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash." This update requires entities to show the changes in the total cash, cash equivalents, restricted cash, and restricted cash equivalents in the statement of cash flows. This guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2017. The guidance should be applied using a retrospective approach. Upon adoption, the net change in cash presented in the consolidated statement of cash flows will reflect the total of cash, cash equivalents, and restricted cash. In August 2016, the FASB issued ASU No. 2016-15, "Statement of Cash Flows (Topic 230)." This update provides specific guidance on cash flow classification issues, which is intended to reduce the diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows. The guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2017. The guidance should be applied using a modified retrospective approach. The Company is assessing the impact this standard will have on the consolidated financial statements and related disclosures. In June 2016, the FASB issued ASU No. 2016-13, "Financial Instruments - Credit Losses (Topic 326)." This new guidance requires the use of an “expected loss” model, rather than an “incurred loss” model, for financial instruments measured at amortized cost and also requires companies to record allowances for available-for-sale debt securities rather than reduce the carrying amount. The guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2019. The guidance should be applied using a retrospective approach. The Company is currently assessing the impact of this standard, however, does not expect the standard to have a material impact on the consolidated financial statements. In February 2016, the FASB issued ASU No. 2016-02, "Leases (Topic 842)." This amended standard was written to increase transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. The new standard requires lessees to recognize a right-of-use asset and lease liability for all leases with terms of more than 12 months. Recognition, measurement and presentation of expenses will depend on classification as a finance or operating lease. The amendments also require certain quantitative and qualitative disclosure. Accounting guidance for lessors is largely unchanged. This guidance is effective for the fiscal years and interim periods within those years beginning after December 15, 2018, and requires a modified retrospective approach to adoption. The Company is currently evaluating the impact of adoption on its consolidated financial statements. The standard is expected to result in an increase in total assets and total liabilities, but will not have a significant impact on the consolidated statement of operations. In May 2014, the FASB issued ASU No. 2014-09, "Revenue from Contracts with Customers (Topic 606)." The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for the goods or services. In July 2015, the FASB postponed the effective date of this new guidance from January 1, 2017 to January 1, 2018. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is currently evaluating its transition method and continues to assess the impact of adoption. While we have not identified material changes in the timing of revenue recognition, we continue to evaluate the presentation of certain revenue related costs on a gross versus net basis as well as the additional disclosures required by the standard. However, based on current evaluations, the Company does not expect the adoption to have a material impact on its consolidated financial statements. Note 3—Compensation and Benefits Compensation and benefits expense to employees and members is comprised of the following: Cash Compensation and Other Benefits Total Compensation and Benefits Expense All non-cash compensation awards granted have varying vesting schedules and are issued at prices equal to the assessed fair market value at the time of issuance, as discussed below. No new non-cash compensation awards were issued during the three months ended June 30, 2017 and 2016. Details of non-cash compensation awards granted during the six months ended June 30, 2017 and 2016 are as follows: Restricted Class B Units Options to Purchase Shares of Class A Common Stock2 Options to Purchase Delayed Exchange Class B Units3 Options to Purchase Class B Units2 Deferred Compensation Phantom Delayed Exchange Class B Units4 Represents the grant date fair value per share, unit, or option. Represents options to purchase shares of Class A common stock or Class B units. These options become exercisable five years from the date of grant. Represents options to purchase Delayed Exchange Class B units issued under 2006 Equity Incentive Plan (as defined below). These options become exercisable five years from the date of grant. Upon exercise, the resulting Delayed Exchange Class B units may not be exchanged pursuant the Amended and Restated Operating Agreement until the seventh anniversary of the exercise date and are not entitled to any benefits under the Tax Receivable Agreement. Represents phantom Delayed Exchange Class B units issued under the Bonus Plan (as defined below). These units vest ratably over four years and become Delayed Exchange Class B units upon vesting which may not be exchanged pursuant the Amended and Restated Operating Agreement until the seventh anniversary of the vesting date and are not entitled to any benefits under the Tax Receivable Agreement. As part of the Company's year-end bonus structure, certain employee members may elect to have all or part of year-end cash compensation paid in the form of cash, or equity issued pursuant to Pzena Investment Management, LLC Amended and Restated 2006 Equity Incentive Plan (“the 2006 Equity Incentive Plan”). For the year ended December 31, 2016, $4.5 million of cash compensation was elected to be paid in the form of equity, which was issued and vested immediately on January 1, 2017. Details of awards associated with these elections issued on January 1, 2017 are as follows: January 1, Fair Value1 Phantom Class B Units2 Delayed Exchange Class B Units3 Represents the grant date fair value per share or unit. Represents phantom Class B units issued under the 2006 Equity Incentive Plan. These phantom units vest ratably over ten years starting immediately and are not entitled to receive dividend or dividend equivalents until vested. Represents Class B units issued under the 2006 Equity Incentive Plan. These units vest immediately upon grant, but may not be exchanged pursuant to the Amended and Restated Operating Agreement of the operating company until the seventh anniversary of the date of grant. These units are also not entitled to any benefits under the Tax Receivable Agreement between the Company and members of the operating company. Pursuant to the 2006 Equity Incentive Plan, the operating company issues Class B units, phantom Class B units and options to purchase Class B units. The operating company also issues Delayed Exchange Class B units pursuant to the 2006 Equity Incentive Plan. These Delayed Exchange Class B units vest immediately upon grant, but may not be exchanged pursuant to the Amended and Restated Operating Agreement of the operating company until at least the seventh anniversary of the date of grant. These Delayed Exchange Class B units are also not entitled to any benefit under the Tax Receivable Agreement between the Company and members of the operating company. Under the Pzena Investment Management, Inc. 2007 Equity Incentive Plan (“the 2007 Equity Incentive Plan”), the Company issues shares of restricted Class A common stock and contingently vesting options to acquire shares of Class A common stock. During each of the three and six months ended June 30, 2017 and 2016, no contingently vesting options vested. During the three months ended June 30, 2017 and 2016, 9,789 and 57,283 Delayed Exchange Class B units were issued to certain employee members, respectively, for approximately $0.1 million and $0.3 million in cash, respectively. During the six months ended June 30, 2017 and 2016, 13,677 and 69,978 Delayed Exchange Class B units were issued to certain employee members, respectively, for approximately $0.1 million and $0.3 million in cash, respectively. Under the Pzena Investment Management, LLC Amended and Restated Bonus Plan (the “Bonus Plan”), eligible employees whose compensation is in excess of certain thresholds are required to defer a portion of that excess. These deferred amounts may be invested, at the employee’s discretion, in certain investment options designated by the Compensation Committee of the Company's Board of Directors. Amounts deferred in any calendar year reduce that year’s compensation expense and are amortized and vest ratably over a four-year period commencing the following year. The Company also issued to certain of its employees deferred compensation with certain investment options that also vest ratably over a four-year period. As of both June 30, 2017 and December 31, 2016, the liability associated with all deferred compensation investment accounts was $2.2 million and $4.2 million, respectively. Pursuant to the Pzena Investment Management, Inc. Non-Employee Director Deferred Compensation Plan (the “Director Plan”), non-employee directors may elect to have all or part of their compensation otherwise payable in cash, deferred in the form of phantom shares of Class A common stock of the Company issued under the 2007 Equity Incentive Plan. Elections to defer compensation under the Director Plan are made on a year-to-year basis. Distributions under the Director Plan are made in a single distribution of shares of Class A common stock at such time as elected by the participant when the deferral was made. Since inception of the Director Plan in 2009, the Company’s directors have elected to defer 100% of their compensation in the form of phantom shares of Class A common stock. Amounts deferred in any calendar year are amortized over the calendar year and reflected as General and Administrative Expense. As of June 30, 2017 and December 31, 2016, there were 334,133 and 291,230 phantom shares of Class A common stock outstanding, respectively. For the three and six months ended June 30, 2017 and 2016, no distributions were made under the Director Plan. As of June 30, 2017 and December 31, 2016, the Company had approximately $33.7 million and $30.0 million, respectively, in unrecorded compensation expense related to unvested awards issued pursuant to its Bonus Plan and certain agreements; Class B units, Delayed Exchange Class B units, and phantom Class B units issued under the 2006 Equity Incentive Plan; and restricted Class A common stock and contingently vesting option grants issued under the 2007 Equity Incentive Plan. The Company anticipates that this unrecorded cost will amortize over the respective vesting periods of the awards. Note 4 – Employee Benefit Plans The operating company has a Profit Sharing and Savings Plan for the benefit of substantially all employees. The Profit Sharing and Savings Plan is a defined contribution profit sharing plan with a 401(k) deferral component. All full-time employees and certain part-time employees who have met the age and length of service requirements are eligible to participate in the plan. The plan allows participating employees to make elective deferrals of compensation up to the annual limits which are set by law. The plan provides for a discretionary annual contribution by the operating company which is determined by a formula based on the salaries of eligible employees as defined by the plan. For the three and six months ended June 30, 2017, the expense recognized in connection with this plan was $0.1 million and $0.8 million, respectively. For the three and six months ended June 30, 2016, the expense recognized in connection with this plan was $0.2 million and $0.6 million, respectively. Note 5—Earnings per Share Basic earnings per share is computed by dividing the Company’s net income attributable to its common stockholders by the weighted average number of shares outstanding during the reporting period. Under the two-class method of computing basic earnings per share, basic earnings per share is calculated by dividing net income for basic earnings per share by the weighted average number of common shares outstanding during the period. The two-class method includes an earnings allocation formula that determines earnings per share for each participating security according to dividends declared and undistributed earnings for the period. The Company’s net income for basic earnings per share is reduced by the amount allocated to participating restricted shares of Class A common stock which participate for purposes of calculating earnings per share. For the three and six months ended June 30, 2017 and 2016, the Company’s basic earnings per share was determined as follows: (in thousands, except share and per share amounts) Net Income for Basic Earnings per Share Allocated to: Class A Common Stock Participating Shares of Restricted Class A Common Stock Total Net Income for Basic Earnings per Share Basic Weighted-Average Shares Outstanding Add: Participating Shares of Restricted Class A Common Stock1 Total Basic Weighted-Average Shares Outstanding Certain unvested shares of Class A common stock granted to employees have nonforfeitable rights to dividends and therefore participate fully in the results of the Company from the date they are granted. They are included in the computation of basic earnings per share using the two-class method for participating securities. Diluted earnings per share adjusts this calculation to reflect the impact of all outstanding membership units of the operating company, phantom Class B units, phantom Delayed Exchange Class B units, phantom Class A common stock, outstanding Class B unit options, options to purchase Class A common stock, and restricted Class A common stock, to the extent they would have a dilutive effect on net income per share for the reporting period. Net income for diluted earnings per share assumes that all outstanding operating company membership units are converted into Company stock at the beginning of the reporting period and the resulting change to the Company's net income associated with its increased interest in the operating company is taxed at the Company’s effective tax rate, exclusive of one-time charges and adjustments associated with both the valuation allowance and the liability to selling and converting shareholders and other one-time charges. For the three and six months ended June 30, 2017 and 2016, the Company’s diluted net income was determined as follows: Net Income Attributable to Non-Controlling Interests of Pzena Investment Management, LLC Less: Assumed Corporate Income Taxes Assumed After-Tax Income of Pzena Investment Management, LLC Net Income of Pzena Investment Management, Inc. Diluted Net Income Under the two-class method of computing diluted earnings per share, diluted earnings per share is calculated by dividing net income for diluted earnings per share by the weighted average number of common shares outstanding during the period, plus the dilutive effect of any potential common shares outstanding during the period using the more dilutive of the treasury method or two-class method. The two-class method includes an earnings allocation formula that determines earnings per share for each participating security according to dividends declared and undistributed earnings for the period. The Company’s net income for diluted earnings per share is reduced by the amount allocated to participating restricted Class B units for purposes of calculating earnings per share. Dividend equivalent distributions paid per share on the operating company’s unvested restricted Class B units are equal to the dividends paid per Company Class A common stock. For the three and six months ended June 30, 2017 and 2016, the Company’s diluted earnings per share were determined as follows: (in thousands, except share and per share amounts) Diluted Net Income Allocated to: Participating Class B Units Total Diluted Net Income Attributable to Shareholders Dilutive Effect of Class B Units Dilutive Effect of Options 1 Dilutive Effect of Phantom Class B Units & Phantom Shares of Class A Common Stock Dilutive Effect of Restricted Shares of Class A Common Stock 2 Dilutive Weighted-Average Shares Outstanding Add: Participating Class B Units3 Total Dilutive Weighted-Average Shares Outstanding Represents the dilutive effect of options to purchase operating company Class B units and Company Class A common stock. Certain restricted shares of Class A common stock granted to employees are not entitled to dividend or dividend equivalent payments until they are vested and are therefore non-participating securities and are not included in the computation of basic earnings per share. They are included in the computation of diluted earnings per share when the effect is dilutive using the treasury stock method. Unvested Class B Units granted to employees have nonforfeitable rights to dividend equivalent distributions and therefore participate fully in the results of the operating company's operations from the date they are granted. They are included in the computation of diluted earnings per share using the two-class method for participating securities. Approximately 0.7 million options to purchase Class B units, 0.1 million options to purchase shares of Class A common stock, and 3.0 million contingent options to purchase shares of Class A common stock were excluded from the calculation of diluted earnings per share for the three and six months ended June 30, 2017, as their inclusion would have had an antidilutive effect based on current market prices or because the option had contingent vesting requirements. Approximately 0.6 million and 1.0 million options to purchase Class B units were excluded from the calculation of diluted earnings per share for the three and six months ended June 30, 2016, respectively, as their inclusion would have had an antidilutive effect based on current market prices. Approximately 0.7 million options to purchase shares of Class A common stock and 3.0 million contingent options to purchase shares of Class A common stock were also excluded from the calculation of diluted earnings per share for the three and six months ended June 30, 2016, as their inclusion would have had an antidilutive effect based on current market prices or because the option had contingent vesting requirements. Note 6—Shareholders’ Equity The Company functions as the sole managing member of the operating company. As a result, the Company: (i) consolidates the financial results of the operating company and reflects the membership interest in it that it does not own as a non-controlling interest in its consolidated financial statements; and (ii) recognizes income generated from its economic interest in the operating company’s net income. Class A and Class B units of the operating company have the same economic rights per unit. As of June 30, 2017, the holders of Class A common stock of the Company and the holders of Class B units of the operating company held approximately 25.3% and 74.7%, respectively, of the economic interests in the operations of the business. As of December 31, 2016, the holders of Class A common stock of the Company and the holders of Class B units of the operating company held approximately 25.6% and 74.4%, respectively, of the economic interests in the operations of the business. Each Class B unit of the operating company is issued with a corresponding share of the Company’s Class B common stock, par value $0.000001 per share. Holders of Class B common stock have the right to receive the par value of the Class B common stock held by them upon our liquidation, dissolution or winding up, but do not share in dividends. Each share of the Company’s Class B common stock entitles its holder to five votes, until the first time that the number of shares of Class B common stock outstanding constitutes less than 20% of the number of all shares of the Company’s common stock outstanding. From such time and thereafter, each share of the Company’s Class B common stock entitles its holder to one vote. When a Class B unit is exchanged for a share of the Company’s Class A common stock or forfeited, a corresponding share of the Company’s Class B common stock will automatically be redeemed and canceled. Conversely, to the extent that the Company causes the operating company to issue additional Class B units to employees pursuant to its equity incentive plan, these additional holders of Class B units would be entitled to receive a corresponding number of shares of the Company’s Class B common stock (including if the Class B units awarded are subject to vesting). All holders of the Company’s Class B common stock have entered into a stockholders’ agreement, pursuant to which they agreed to vote all shares of Class B common stock then held by them, with the majority of votes of Class B common stockholders taken in a preliminary vote of the Class B common stockholders. The outstanding shares of the Company’s Class A common stock represent 100% of the rights of the holders of all classes of the Company’s capital stock to receive distributions, except that holders of Class B common stock will have the right to receive the class’s par value upon the Company’s liquidation, dissolution or winding up. Pursuant to the operating agreement of the operating company, each vested Class B unit is exchangeable for a share of the Company’s Class A common stock, subject to certain exchange timing and volume limitations. These acquisition of additional operating company membership was treated as a reorganization of entities under common control as required by the Business Combinations Topic of the FASB ASC. The Company’s share repurchase program was announced on April 24, 2012. The Board of Directors authorized the Company to repurchase up to an aggregate of $10 million of the Company’s outstanding Class A common stock and the operating company’s Class B units on the open market and in private transactions in accordance with applicable securities laws. On February 11, 2014, the Company announced that its Board of Directors approved an increase of $20 million in the aggregate amount authorized under the program. The timing, number and value of common shares and units repurchased are subject to the Company’s discretion. The Company’s share repurchase program is not subject to an expiration date and may be suspended, discontinued, or modified at any time, for any reason. During the six months ended June 30, 2017, the Company purchased and retired 79,717 shares of Class A common stock and 2,897 Class B units under the current repurchase authorization at a weighted average price per share of $8.88 and $11.11, respectively. During the six months ended June 30, 2016, the Company purchased and retired 190,780 shares of Class A common stock and 8,574 Class B units under the repurchase authorization at a weighted average price per unit of $7.89 and $7.81, respectively. The Company records the repurchase of shares and units at cost based on the trade date of the transaction. During the six months ended June 30, 2016, 37,039 Class B unit options exercised resulted in the issuance of 13,576 net Class B units as a result of the redemption of 23,463 Class B units for the cashless exercise of options. No options were exercised during the six months ended June 30, 2017. Note 7—Non-Controlling Interests Net Income Attributable to Non-Controlling Interests in the operations of the Company’s operating company and consolidated subsidiaries is comprised of the following: Non-Controlling Interests of Pzena Investment Management, LLC Non-Controlling Interests of Consolidated Subsidiaries Net Income Attributable to Non-Controlling Interests Distributions to non-controlling interests represent tax allocations and dividend equivalents paid to the members of the operating company, as well as withdrawals from the Company’s consolidated subsidiaries. Contributions from non-controlling interests represent contributions to the Company's consolidated subsidiaries. Note 8—Investments The following is a summary of Investments: Total Investment Securities, Trading Investments, at Fair Value consisted of the following at June 30, 2017: Securities Sold Short, at Fair Value consisted of the following at June 30, 2017: (Gain)/ Loss Securities Sold Short Investments, at Fair Value consisted of the following at December 31, 2016: Securities Sold Short, at Fair Value consisted of the following at December 31, 2016: The operating company sponsors and provides investment management services to certain private investment partnerships and Pzena mutual funds through which it offers its investment strategies. The Company has made investments in certain of these private investment partnerships and mutual funds to satisfy its obligations under the Company's deferred compensation program and provide the initial cash investment in our mutual funds. The Company holds a non-controlling interest and exercises significant influence in these entities, and accounts for its investments as equity method investments which are included in Investments on the consolidated statements of financial condition. On July 11, 2016, due to additional subscriptions into the Pzena Small Cap Value Fund, the Company's ownership decreased to 36.1%. As the entity was no longer deemed to control the fund, the Company deconsolidated the entity, removed the related assets, liabilities and non-controlling interest from its balance sheet and classified the Company's remaining investment as an equity method investment. As of June 30, 2017, the Company's investments range between 4% and 21% of the capital of these entities and have an aggregate carrying value of $8.1 million. Note 9—Fair Value Measurements The Fair Value Measurements and Disclosures Topic of the FASB ASC defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date. The Fair Value Measurements and Disclosures Topic of the FASB ASC also establishes a framework for measuring fair value and a valuation hierarchy based upon the transparency of inputs used in the valuation of an asset or liability. Classification within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The valuation hierarchy contains three levels: (i) valuation inputs are unadjusted quoted market prices for identical assets or liabilities in active markets (Level 1); (ii) valuation inputs are quoted prices for identical assets or liabilities in markets that are not active, quoted market prices for similar assets and liabilities in active markets, and other observable inputs directly or indirectly related to the asset or liability being measured (Level 2); and (iii) valuation inputs are unobservable and significant to the fair value measurement (Level 3). Included in the Company’s consolidated statements of financial condition are investments in equity securities and securities sold short, both of which are exchange-traded securities with quoted prices in active markets. The fair value measurements of the equity securities, securities sold short, have been classified as Level 1. The investments in equity method investees are held at their carrying value. The following table presents these instruments’ fair value at June 30, 2017: Investments Not Held at Fair Value Total Fair Value The following table presents these instruments’ fair value at December 31, 2016: For each of the three and six months ended June 30, 2017 and 2016, there were no transfers between levels. In addition, the Company did not hold any Level 2 or Level 3 securities during these periods. Note 10—Property and Equipment Property and Equipment, Net of Accumulated Depreciation is comprised of the following: Less: Accumulated Depreciation and Amortization Depreciation is included in general and administrative expense and totaled approximately $0.2 million and $0.5 million for the three and six months ended June 30, 2017, respectively. For the three and six months ended June 30, 2016, depreciation totaled approximately $0.3 million and $0.5 million, respectively. Note 11—Related Party Transactions For each of the three months ended June 30, 2017 and 2016, the Company earned $0.1 million in investment advisory fees from unconsolidated VIEs that receive investment management services from the Company. For each of the six months ended June 30, 2017 and 2016, the Company earned $0.2 million in such fees. The Company offers loans to employees, excluding executive officers, for the purpose of financing tax obligations associated with compensatory stock and unit vesting. Loans are generally written for a seven-year period, at an interest rate equivalent to the Applicable Federal Rate, payable in annual installments, and collateralized by shares and units held by the employee. As of June 30, 2017 and December 31, 2016, the Company had approximately $1.3 million and $0.9 million, respectively, of such loans outstanding. The operating company, as investment adviser for certain Pzena branded SEC-registered mutual funds, private placement funds, and non-U.S. funds, has contractually agreed to waive a portion or all of its management fees and pay fund expenses to ensure that the annual operating expenses of the funds stay below certain established total expense ratio thresholds. For the three and six months ended June 30, 2017, the Company recognized $0.3 million and $0.5 million of such expenses, respectively. For the three and six months ended June 30, 2016, the Company recognized $0.3 million and $0.5 million of such expenses. The operating company manages personal funds of certain of the Company’s employees, including the CEO, its two Presidents, and its Executive Vice President. The operating company also manages accounts beneficially owned by a private fund in which certain of the Company’s executive officers invest. Investments by employees in individual accounts are permitted only at the discretion of the executive committee of the operating company, but are generally not subject to the same minimum investment levels that are required of outside investors. The operating company also manages personal funds of some of its employees’ family members. Pursuant to the respective investment management agreements, the operating company waives or reduces its regular advisory fees for these accounts and personal funds. In addition, the operating company pays custody and administrative fees for certain of these accounts and personal funds in order to incubate products or preserve performance history. The aggregate value of the fees that the Company waived related to the Company’s executive officers, other employees, and family members, was approximately $0.2 million and $0.4 million for the three and six months ended June 30, 2017, respectively. For each of the three and six months ended June 30, 2016, the Company waived $0.2 million and $0.3 million in such fees, respectively. Note 12—Commitments and Contingencies In the normal course of business, the Company enters into agreements that include indemnities in favor of third parties, such as engagement letters with advisers and consultants. In certain cases, the Company may have recourse against third parties with respect to these indemnities. The Company maintains insurance policies that may provide coverage against certain claims under these indemnities. The Company has had no claims or payments pursuant to these agreements, and it believes the likelihood of a claim being made is remote. Utilizing the methodology in the Guarantees Topic of the FASB ASC, the Company’s estimate of the value of such guarantees is de minimis, therefore, no accrual has been made in the consolidated financial statements. The Company leases office space under a non-cancelable operating lease agreement, which expires on December 31, 2025. The Company recognizes minimum lease expense for its headquarters on a straight-line basis over the lease term. During the third quarter of 2016, the Company terminated its five-year sublease agreement which commenced on May 1, 2015. The Company entered into a new four-year sublease agreement commencing on October 1, 2016 that is cancelable by either the Company or sublessee given appropriate notice after the thirty-first month following the commencement of the sublease agreement. The sublease agreement is for certain office space associated with the Company's operating lease agreement in its corporate headquarters. Sublease income will continue to decrease annual lease expense by approximately $0.4 million per year. During the three and six months ended June 30, 2017, lease expenses were $0.5 million and $1.0 million, respectively, and are included in general and administrative expense. During the three and six months ended June 30, 2016, lease expenses were $0.4 million and $0.9 million, respectively. This lease expense includes expenses associated with the Company's office spaces in the U.K. and Australia. Lease expenses for the three and six months ended June 30, 2017 were net of $0.1 million and $0.2 million of sublease income, respectively. Lease expenses for the three and six months ended June 30, 2016 were net of $0.1 million and $0.2 million of sublease income, respectively. Note 13—Income Taxes The operating company is a limited liability company that has elected to be treated as a partnership for tax purposes. The Company's provision for income taxes reflects U.S. federal, state, and local incomes taxes on its allocable portion of the operating company's income. The Company's effective tax rate for the six months ended June 30, 2017 and 2016 was 12.5% and 11.7%, respectively. The effective tax rate includes a rate benefit attributable to the fact that approximately 74.7% and 75.6% of the operating company's earnings were not subject to corporate-level taxes for the six months ended June 30, 2017 and 2016, respectively. Income before income taxes includes net income attributable to non-controlling interests and not taxable to the Company, which reduces the effective tax rate. This favorable impact is partially offset by the impact of certain permanently non-deductible items. The Income Taxes Topic of the FASB ASC establishes the minimum threshold for recognizing, and a system for measuring, the benefits of tax return positions in financial statements. As of June 30, 2017 and December 31, 2016, the Company had $3.7 million and $2.8 million in unrecognized tax benefits that, if recognized, would affect the provision for income taxes. As of both June 30, 2017 and December 31, 2016, the Company had interest related to unrecognized tax benefits of $0.3 million. As of June 30, 2017 and December 31, 2016, no penalty accruals were recorded. As of June 30, 2017 and December 31, 2016, the net values of all deferred tax assets were approximately $72.2 million and $73.4 million, respectively. These deferred tax assets primarily reflect the future tax benefits associated with the Company's initial public offering, and the subsequent and future exchanges by holders of Class B units of the operating company for shares of Class A common stock. At June 30, 2017 and December 31, 2016, the Company did not have a valuation allowance recorded against its deferred tax assets. Note 14—Subsequent Events On July 18, 2017, the Company declared a quarterly dividend of $0.03 per share of its Class A common stock that will be paid on August 24, 2017 to holders of record on July 28, 2017. No other subsequent events necessitated disclosures and/or adjustments. We are an investment management firm that utilizes a classic value investment approach across all of our investment strategies. We currently manage assets in a variety of value-oriented investment strategies across a wide range of market capitalizations in both U.S. and non-U.S. capital markets. At June 30, 2017, our assets under management, or AUM, was $33.5 billion. We manage separate accounts on behalf of institutions, act as sub-investment adviser for a variety of SEC-registered mutual funds and non-U.S. funds, and act as investment adviser for the Pzena mutual funds, private placement funds and non-U.S. funds. We function as the sole managing member of our operating company, Pzena Investment Management, LLC (the “operating company”). As a result, we: (i) consolidate the financial results of our operating company with our own, and reflect the membership interest in it that we do not own as a non-controlling interest in our consolidated financial statements; and (ii) recognize income generated from our economic interest in our operating company’s net income. As of June 30, 2017, the holders of Class A common stock (through the Company) and the holders of Class B units of our operating company held approximately 25.3% and 74.7%, respectively, of the economic interests in the operations of our business. The Company also serves as the general partner of Pzena Investment Management, LP, a partnership formed with the objective of aggregating employee ownership in one entity. Certain of our named executive officers and employees have interests in Pzena Investment Management, LP and certain estate planning vehicles through which they indirectly own Class B units of our operating company. As of June 30, 2017, through direct and indirect interests, our five named executive officers; 39 other employee members; and certain other members of our operating company, including one of our directors, his related entities, and certain former employees, collectively held 54.2%, 4.6%, and 15.9% of the economic interests in our operating company, respectively. GAAP and Non-GAAP Net Income GAAP diluted net income and GAAP diluted earnings per share were $10.5 million and $0.15, respectively, for the three months ended June 30, 2017, and $6.5 million and $0.09, respectively, for the three months ended June 30, 2016. GAAP diluted net income and GAAP diluted earnings per share were $19.2 million and $0.27, respectively, for the six months ended June 30, 2017, and $13.0 million and $0.19, respectively, for the six months ended June 30, 2016. Our results for the three and six months ended June 30, 2016 include accounting adjustments related to our deferred tax asset generated by the Company's initial public offering and subsequent Class B unit conversions, as well as our tax receivable agreement and the associated liability to our selling and converting shareholders. We believe that these accounting adjustments add a measure of non-operational complexity that partially obscures a clear understanding of the underlying performance of our business. Therefore, in evaluating our financial condition and results of operations, we also review certain non-GAAP measures of earnings, which are adjusted to exclude these items. As adjusted, non-GAAP diluted net income and non-GAAP diluted earnings per share were $6.6 million and $0.10, respectively, for the three months ended June 30, 2016. As adjusted, non-GAAP diluted net income and non-GAAP diluted earnings

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form10q.htm QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2009 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission File Number Exact Name of Registrant as Specified in its Charter, Principal Office Address and Telephone Number State of Incorporation I.R.S. Employer Identification No UAL Corporation United Air Lines, Inc. 77 W. Wacker Drive Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes R No £ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes £ No £ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer R Accelerated filer £ Non-accelerated filer £ Smaller reporting company £ (Do not check if a smaller reporting company) Large accelerated filer £ Non-accelerated filer R Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes £ No R Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Section 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. OMISSION OF CERTAIN INFORMATION United Air Lines, Inc. meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format allowed under that General Instruction. Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of October 16, 2009. 167,040,862 shares of common stock ($0.01 par value) 205 (100% owned by UAL Corporation) There is no market for United Air Lines, Inc. common stock. UAL Corporation and Subsidiary Companies and United Air Lines, Inc. and Subsidiary Companies Report on Form 10-Q For the Quarter Ended September 30, 2009 PART I. FINANCIAL INFORMATION Item 1. Financial Statements UAL Corporation: Condensed Statements of Consolidated Operations (Unaudited) Condensed Statements of Consolidated Financial Position (Unaudited) Condensed Statements of Consolidated Cash Flows (Unaudited) United Air Lines, Inc.: Combined Notes to Condensed Consolidated Financial Statements (Unaudited) (UAL Corporation and United Air Lines, Inc.) Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures About Market Risk Item 4. Controls and Procedures PART II. OTHER INFORMATION Item 1. Legal Proceedings Item 1A. Risk Factors Item 2. Unregistered Sales of Equity Securities and Use of Proceeds Item 6. Exhibits Exhibit Index UAL Corporation and Subsidiary Companies Three Months Ended September 30, (Adjusted) Operating revenues: Passenger — United Airlines Passenger — Regional Affiliates Other operating revenues Salaries and related costs Regional Affiliates Purchased services Aircraft maintenance materials and outside repairs Landing fees and other rent Distribution expenses Aircraft rent Cost of third party sales Other impairments and special items (Note 14) 43 (9 ) Other operating expenses Earnings (loss) from operations 88 (491 ) (146 ) (144 ) Miscellaneous, net (10 ) (186 ) Loss before income taxes and equity in earnings of affiliates Income tax expense (benefit) (4 ) 2 Loss before equity in earnings of affiliates Equity in earnings of affiliates, net of tax $ (57 ) $ (792 ) Loss per share, basic and diluted $ (0.39 ) $ (6.22 ) See accompanying Combined Notes to Condensed Consolidated Financial Statements (Unaudited). Nine Months Ended September 30, $ 8,909 $ 11,924 Goodwill impairment (Note 14) - 2,277 Loss from operations (87 ) (3,626 ) (460 ) (4,115 ) (46 ) (30 ) $ (411 ) $ (4,081 ) $ (2.83 ) $ (32.62 ) (In millions, except shares) Receivables, less allowance for doubtful accounts (2009—$14; 2008—$24) Prepaid fuel Aircraft fuel, spare parts and supplies, less obsolescence allowance (2009—$70; 2008—$48) Fuel hedge collateral deposits Prepaid expenses and other Operating property and equipment: Other property and equipment Less—accumulated depreciation and amortization (1,932 ) (1,598 ) Capital leases: Less—accumulated amortization Other assets: Intangibles, less accumulated amortization (2009—$391; 2008—$339) Aircraft lease deposits $ 18,347 $ 19,465 Liabilities and Stockholders’ Deficit Advance ticket sales Mileage Plus deferred revenue Accrued salaries, wages and benefits Long-term debt maturing within one year Fuel purchase commitments Current obligations under capital leases Accrued interest Derivative instruments Long-term obligations under capital leases Other liabilities and deferred credits: Postretirement benefit liability Advanced purchase of miles Commitments and contingent liabilities (Note 12) Stockholders’ deficit: Common stock at par, $0.01 par value; authorized 1,000,000,000 shares; outstanding 148,032,041 and 140,037,928 shares at September 30, 2009 and December 31, 2008, respectively Additional capital invested Retained deficit Stock held in treasury, at cost Accumulated other comprehensive income Cash flows provided (used) by operating activities: Adjustments to reconcile to net cash provided (used) by operating activities— Goodwill impairment Other impairments and special items Proceeds from lease amendment Increase in Mileage Plus deferred revenue and advanced purchase of miles Increase in advance ticket sales Net change in fuel derivative instruments and related pending settlements (870 ) 272 (Increase) decrease in fuel hedge collateral 903 (378 ) Increase in receivables (70 ) 25 Cash flows provided (used) by investing activities: Net sales of short-term investments (Increase) decrease in restricted cash (37 ) 508 Proceeds from asset sale-leasebacks Proceeds from litigation on advance deposits Additions to property, equipment and deferred software Proceeds from asset dispositions (52 ) 2,576 Cash flows provided (used) by financing activities: Proceeds from issuance of common stock Decrease in lease deposits Repayment of Credit Facility Repayment of other debt Special distribution to common shareholders - (253 ) Principal payments under capital leases Increase in deferred financing costs (9 ) (118 ) (2 ) (9 ) Increase in cash and cash equivalents during the period Cash and cash equivalents at beginning of the period Cash and cash equivalents at end of the period Receivables, less allowance for doubtful accounts (2009 — $14; 2008 — $24) Aircraft fuel, spare parts and supplies, less obsolescence allowance (2009 — $70; 2008 — $48) Receivables from related parties Owned — Less — accumulated depreciation and amortization Less — accumulated amortization Intangibles, less accumulated amortization (2009 — $391; 2008 — $339) Common stock at par, $5 par value; authorized 1,000 shares; outstanding 205 at both September 30, 2009 and December 31, 2008 Capital contribution from parent Dividend to parent (1) Basis of Presentation UAL Corporation (together with its consolidated subsidiaries, “UAL”), is a holding company and its principal, wholly-owned subsidiary is United Air Lines, Inc. (together with its consolidated subsidiaries, “United”). We sometimes use the words “we,” “our,” “us,” and the “Company” in this Form 10-Q for disclosures that relate to both UAL and United. This Quarterly Report on Form 10-Q is a combined report of UAL and United. Therefore, these Combined Notes to Condensed Consolidated Financial Statements (Unaudited) (the “Footnotes”), apply to both UAL and United, unless otherwise noted. As UAL consolidates United for financial statement purposes, disclosures that relate to activities of United also apply to UAL. Interim Financial Statements. The UAL and United unaudited condensed consolidated financial statements (the “Financial Statements”) shown here have been prepared as required by the U.S. Securities and Exchange Commission (the “SEC”). Some information and footnote disclosures normally included in financial statements that meet accounting principles generally accepted in the United States (“GAAP”) have been condensed or omitted as permitted by the SEC. The Company believes that the disclosures presented here are not misleading. The Financial Statements include all adjustments, including asset impairments, severance and normal recurring adjustments, which are considered necessary for a fair presentation of the Company’s financial position and results of operations. Certain historical amounts have been reclassified to conform to the current year’s presentation, including reclassification of December 31, 2008 derivative counterparty settlement payables of $140 million from Fuel derivative instruments to Other current liabilities in the Company’s Financial Statements. These Financial Statements should be read together with the information included in the combined UAL and United Annual Report on Form 10-K for the year ended December 31, 2008 as updated by the Current Report on Form 8-K dated May 1, 2009 (the “2008 Annual Report”). Restricted Cash. For the 2009 and 2008 periods, restricted cash primarily includes cash collateral to secure workers’ compensation obligations and reserves for institutions that process credit card ticket sales. Industry practice includes classification of restricted cash flows as operating cash flows by some airlines and investing cash flows by others. The Company classifies changes in restricted cash balances associated with workers’ compensation obligations and credit card reserves as an investing activity in its Financial Statements because it considers restricted cash arising from these activities similar to an investment. If UAL had classified these changes in its restricted cash balances as operating activities in the nine months ended September 30, 2009 and 2008, its cash provided (used) by operating activities of $878 million and $(250) million, respectively, would have been reported as $841 million and $258 million, respectively. Additionally, cash provided (used) by investing activities for the nine months ended September 30, 2009 and 2008 of $(52) million and $2,576 million, respectively, would have been reported as $(15) million and $2,068 million, respectively. (2) New Accounting Pronouncements In the third quarter of 2009, the Company adopted the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”). The ASC is the single official source of authoritative, nongovernmental GAAP, other than guidance issued by the SEC. The adoption of the ASC did not have any impact on the financial statements included herein. In October 2009, the FASB issued Accounting Standards Update, 2009-13, Revenue Recognition (Topic 605): Multiple Deliverable Revenue Arrangements – A Consensus of the FASB Emerging Issues Task Force.” This update provides application guidance on whether multiple deliverables exist, how the deliverables should be separated and how the consideration should be allocated to one or more units of accounting. This update establishes a selling price hierarchy for determining the selling price of a deliverable. The selling price used for each deliverable will be based on vendor-specific objective evidence, if available, third-party evidence if vendor-specific objective evidence is not available, or estimated selling price if neither vendor-specific or third-party evidence is available. The Company will be required to apply this guidance prospectively for revenue arrangements entered into or materially modified after January 1, 2011; however, earlier application is permitted. The Company has not determined the impact that this update may have on its financial statements. In August 2009, the FASB issued Accounting Standards Update No. 2009-05 (“ASC Update 2009-05”), an update to ASC 820, Fair Value Measurements and Disclosures. This update provides amendments to reduce potential ambiguity in financial reporting when measuring the fair value of liabilities. Among other provisions, this update provides clarification that in circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the valuation techniques described in ASC Update 2009-05. ASC Update 2009-05 will become effective for the Company’s annual financial statements for the year ended December 31, 2009. The Company has not determined the impact that this update may have on its financial statements. In June 2009, the FASB issued guidance related to accounting for transfers of financial assets. This guidance improves the information that a reporting entity provides in its financial reports about a transfer of financial assets; the effects of a transfer on its financial position, financial performance and cash flows; and a continuing interest in transferred financial assets. In addition, this guidance amends various ASC concepts with respect to accounting for transfers and servicing of financial assets and extinguishments of liabilities, including removing the concept of qualified special purpose entities. This guidance must be applied to transfers occurring on or after the effective date. The Company will adopt this guidance in its first annual and interim reporting periods beginning after November 15, 2009. The Company has not determined the impact that this guidance may have on its financial statements. In June 2009, the FASB issued guidance which amends certain ASC concepts related to consolidation of variable interest entities. Among other accounting and disclosure requirements, this guidance replaces the quantitative-based risks and rewards calculation for determining which enterprise has a controlling financial interest in a variable interest entity with an approach focused on identifying which enterprise has the power to direct the activities of a variable interest entity and the obligation to absorb losses of the entity or the right to receive benefits from the entity. The Company will adopt this guidance in its first annual and interim reporting periods beginning after November 15, 2009. The Company has not determined the impact that this guidance may have on its financial statements. Adoption of ASC 470 Update. The Company adopted new accounting guidance related to accounting for convertible debt instruments that may be settled in cash upon conversion (“ASC 470 Update”), effective January 1, 2009, which required retrospective application. This standard requires the issuer of certain convertible debt instruments that may be settled in cash (or other assets) on conversion to separately account for the liability (debt) and equity (conversion option) components of the instrument in a manner that reflects the issuer’s non-convertible debt borrowing rate. The Company has two currently outstanding convertible debt instruments that are impacted by the ASC 470 Update. Upon the original issuance of these two debt instruments in 2006, the Company recorded the net debt obligation as long-term debt in accordance with applicable accounting standards at that time. To adopt this standard effective January 1, 2009, the Company estimated the fair value, as of the date of issuance, of its two applicable convertible debt instruments as if the instruments were issued without the conversion options. The difference between the fair value and the principal amounts of the instruments was $254 million. This amount was retrospectively applied to the Company’s Financial Statements from the issuance date of the debt instruments in 2006, and was retrospectively recorded as a debt discount and as a component of equity. The discount is being amortized over the expected five-year life of the notes resulting in non-cash increases to interest expense in historical and future periods. The full year 2008 interest expense impact is $48 million. The following tables reflect UAL and United’s previously reported amounts, along with the adjusted amounts after adoption. (In millions, except per share) As Adjusted Effect of Change Statement of Consolidated Operations (Unaudited) $ (131 ) $ (144 ) $ (13 ) $ (132 ) $ (144 ) $ (12 ) Nonoperating expense (287 ) (300 ) (13 ) (287 ) (299 ) (12 ) Loss before income taxes and equity earnings in affiliates (6.13 ) (6.22 ) (0.09 ) Total comprehensive loss (4,079 ) (4,115 ) (36 ) (4,067 ) (4,102 ) (35 ) (32.34 ) (32.62 ) (0.28 ) Statement of Consolidated Financial Position (Unaudited) (a) As of December 31, 2008 $ 6,007 $ 5,862 $ (145 ) $ 6,007 $ 5,861 $ (146 ) 2,666 2,919 253 2,578 2,831 253 (5,199 ) (5,308 ) (109 ) (5,151 ) (5,260 ) (109 ) The adoption of the ASC 470 Update also had minor impacts on Other assets and Deferred income taxes as reported in the Company’s Financial Statements. The adoption required an increase to the Company’s deferred tax liability and a decrease to its additional paid in capital. However, these impacts were substantially offset by a corresponding decrease in the valuation allowance for deferred tax assets and increase to additional paid in capital. The following table provides additional information about UAL’s convertible debt instruments that may be settled for cash. ($ and shares in millions, except conversion prices) $726 million notes Carrying amount of the equity component $ 216 $ 38 $ 216 $ 38 Principal amount of the liability component Unamortized discount of liability component Net carrying amount of liability component Remaining amortization period of discount Conversion price Number of shares to be issued upon conversion Effective interest rate on liability component 12.8 % 12.1 % Not required to be disclosed. The following table presents the associated interest cost related to UAL’s convertible debt instruments that may be settled for cash, which consists of both the contractual interest coupon and amortization of the discount on the liability component. Three Months Ended Nine Months Ended Three Months Ended Nine Months Ended September 30, Non-cash interest cost recognized (a) $ 12 $ 11 $ 34 $ 30 $ 2 $ 2 $ 6 $ 6 Cash interest cost recognized 8 8 24 24 2 2 6 6 Amounts represent the adoption impact of the ASC 470 Update on interest expense for the three and nine months ended September 30, 2009 and 2008. The related negative adoption impact on loss per share for the three and nine months ended September 30, 2009 is $0.10 and $0.28, respectively. Adoption of ASC 260 Update. The Company adopted new accounting guidance related to determining whether instruments granted in share-based payment transactions are participating securities (“ASC 260 Update”), effective January 1, 2009, requiring retrospective application. The ASC 260 Update clarifies that instruments granted in share-based payment transactions that are considered participating securities prior to vesting should be included in the earnings allocation under the two-class method of calculating earnings per share. The Company determined that its restricted shares granted under UAL’s share-based compensation plans are participating securities because the restricted shares participate in dividends. However, the impact of these shares was not included in the common shareholder basic loss per share computation for the three and nine months ended September 30, 2009 and 2008, because of losses in these periods. There were 0.8 million and 1.5 million nonvested restricted shares at September 30, 2009 and 2008, respectively, that would have been included in the common shareholder basic earnings per share computation had there been income in these periods. Other Standards Adopted. Effective January 1, 2009, the Company prospectively adopted ASC guidance related to disclosures about derivative instruments and hedging activities and new ASC guidance related to fair value measurements required for the Company’s nonfinancial assets and nonfinancial liabilities. See Note 11, “Fair Value Measurements and Derivative Instruments,” for disclosures related to the adoption of these ASC updates and the Company’s adoption of ASC updates related to interim disclosures about fair value of financial instruments and recognition and presentation of other-than-temporary impairments, effective April 1, 2009. (3) Company Operational Plans Since the second quarter of 2008, the Company has been implementing a plan to address volatility in crude oil prices, industry over-capacity and the severe global recession. The Company is reducing capacity and permanently removing 100 aircraft from its Mainline fleet by the end of 2009, including its entire B737 fleet and six B747 aircraft. In connection with the capacity reductions, the Company is further streamlining its operations and corporate functions in order to cumulatively reduce the size of its workforce by approximately 9,000 positions by the end of 2009. The Company’s workforce reductions have occurred through furloughs and furlough-mitigation programs, such as voluntary early-out options. Future workforce reductions may occur through similar programs. The tables below summarize the accrual activity and expense related to the Company’s implementation of its operational plans. Reserve Activity Leased Aircraft Balance at September 30, 2009 Expense Recognized $ 22 $ 6 $ 23 $ 88 24 - 48 - All of these charges are within the Mainline segment where the fleet reductions are occurring. Severance expense and leased aircraft expense are classified within Salaries and related costs and Other impairments and special items, respectively, in the Company’s Financial Statements. The charges related to leased aircraft consist of the present value of future lease payments for aircraft that have been removed from service in advance of their lease termination dates as of September 30, 2009, estimated payments for lease return maintenance conditions related to B737 aircraft and write-off of associated lease fair value valuation balances, which were initially established as part of fresh-start reporting when the Company emerged from bankruptcy. Periodic lease payments will be made over the lease terms of these aircraft unless early return agreements are reached with the lessors; and, lease return maintenance condition payments, if any, will be made upon return of the aircraft to the lessors. The total expected future payments for leased aircraft that were removed from service at September 30, 2009 and that are expected to be removed from service during the fourth quarter of 2009 are $96 million, payable through 2013. Actual lease payments may be less if the Company is able to negotiate early termination of any of its leases. The following table provides information regarding the Company’s operating fleet. Amounts reported are applicable to UAL and United, except where noted otherwise. B737s (Mainline) All Other Mainline Aircraft at December 31, 2008 Added to (removed from) operating fleet (18 ) (17 ) (35 ) (2 ) (1 ) (3 ) (38 ) 12 (26) Transferred from owned to leased — — — (14 ) 14 — — — — Transferred from leased to owned — — — 1 (1 ) — — — — Aircraft at September 30, 2009 — 11 11 176 184 360 371 292 663 Nonoperating at December 31, 2008 (a) 24 12 36 3 — 3 39 — 39 Removed from operating fleet 18 17 35 2 1 3 38 — 38 Returned to lessors — (9 ) (9 ) — — — (9 ) — (9) Nonoperating at September 30, 2009 (a) At December 31, 2008 and September 30, 2009, United had one less owned and one more leased nonoperating B737 aircraft as compared to the UAL amounts shown in this table. Other Costs. As the Company continues to complete its operational plans discussed above, it may incur additional costs related to its conversion of the Company’s fleet of Ted aircraft (including seat reconfiguration to include United First and Economy Plus seating), costs to exit additional facilities such as airports no longer served, lease termination costs, additional severance costs and asset impairment charges, among others. Such future costs and charges may be material. Common Stockholders’ Deficit During the nine months ended September 30, 2009, UAL received net proceeds of $89 million from the issuance of 8.5 million shares of common stock, of which 7.1 million shares were sold during the first nine months of 2009 and 1.4 million shares were sold in 2008. UAL contributed the $89 million of common stock sale proceeds to United. For the nine months ended September 30, 2009, UAL acquired 202,384 common shares for treasury. These shares were acquired from participants for tax withholding obligations under UAL’s share-based compensation plans. In addition, UAL distributed approximately 1.1 million shares according to the bankruptcy plan of reorganization in the nine months ended September 30, 2009. Approximately 967,000 shares remain to be issued under the reorganization plan. (5) Per Share Amounts (UAL Only) UAL basic per share amounts were computed by dividing loss available to common shareholders by the weighted-average number of shares of common stock outstanding. UAL’s $563 million of 6% senior notes are callable at any time at 100% of par value, and can be redeemed with either cash or UAL common stock at UAL’s option. These notes are not deemed potentially dilutive shares, as UAL has the ability and intent to redeem these notes with cash. The table below represents the computation of UAL basic and diluted per share amounts and the number of securities that have been excluded from the computation of diluted per share amounts. Nonvested, participating restricted shares did not impact basic or diluted loss per share in the 2009 and 2008 periods that had losses. See Note 2, “New Accounting Pronouncements,” for additional information related to the adoption of the ASC 260 Update. Basic loss per share: $ (57 ) $ (792 ) $ (411 ) $ (4,081 ) Preferred stock dividend requirements - - - (2 ) Loss available to common stockholders (a) Basic weighted average shares outstanding 145.6 127.3 145.1 125.2 Loss per basic share $ (0.39 ) $ (6.22 ) $ (2.83 ) $ (32.62 ) Diluted loss per share: Loss available to common stockholders Diluted weighted average shares outstanding Loss per share, diluted Potentially dilutive shares excluded from diluted per share amounts: Restricted shares (a) 2% preferred securities - 2.1 - 4.1 4.5% senior limited-subordination convertible notes Losses are not allocated to participating securities in the computation of loss per common share. (6) Share-Based Compensation Plans Effective April 1, 2009, the Company made a general grant of 1,773,600 restricted stock units (“RSUs”) and 2,431,800 stock options to certain of its management employees. These grants were made pursuant to the UAL 2008 Incentive Compensation Plan which was approved by UAL’s Board of Directors and shareholders in 2008 and replaced the 2006 Management Equity Incentive Plan, effective June 12, 2008. These awards vest pro-rata over three years on the anniversary of the grant date. The terms of the awards do not provide for the acceleration of vesting upon retirement. The RSUs may be settled in cash or stock at the discretion of the Human Resources Subcommittee of the UAL Board of Directors. The Company’s intent is to settle the RSUs in cash; therefore, the obligations related to these RSUs are classified as liabilities on the Company’s Financial Statements and will be remeasured each reporting period throughout the requisite service period. The remeasurement is based upon the market share price on the last day of the reporting period. A cumulative adjustment is recorded during each reporting period to adjust compensation expense based on the current value of the awards. Compensation expense associated with the UAL share-based compensation plans has been pushed down to United. The Company recognized share-based compensation expense of $8 million and $13 million during the three and nine months ended September 30, 2009, respectively. The Company recognized share-based compensation expense of $5 million and $23 million during the three and nine months ended September 30, 2008, respectively. The Company’s unrecognized share-based compensation expense was $26 million and $18 million as of September 30, 2009 and December 31, 2008, respectively. At September 30, 2009 and December 31, 2008, 3.1 million and 8.1 million awards were available for future issuance under the Company’s share-based compensation plans for employees, respectively. The weighted average grant date fair value and exercise price of options awarded in the nine months ended September 30, 2009 was $3.70 and $4.91, respectively. The table below summarizes stock option activity for the nine months ended September 30, 2009. Outstanding at beginning of period Outstanding at end of period Exercisable (vested) at end of period The fair value of RSUs was $16 million at September 30, 2009, which was based upon the closing share price on September 30, 2009. The table below summarizes UAL’s RSU and restricted stock activity for the nine months ended September 30, 2009. Restricted Stock Units Restricted Stock Nonvested at beginning of period - 1,430,675 1,815,600 42,400 - (608,306 ) (47,800 ) (36,727 ) Nonvested at end of period (7) Income Taxes For the three and nine months ended September 30, 2009, UAL and United each recorded $4 million and $46 million, respectively, of tax benefits primarily due to impairment of indefinite-lived intangibles. For the nine months ended September 30, 2009, UAL and United each had an effective tax rate of approximately 10%. In the 2008 periods, the Company had an insignificant effective tax rate, as compared to the U.S. federal statutory rate of 35%, principally because of goodwill impairment charges in the second quarter that are not deductible for income tax purposes and the tax benefits of the Company’s remaining net operating losses for the periods were almost completely offset by a valuation allowance. The Company’s tax benefit in the 2008 nine month period was primarily due to an indefinite-lived intangible asset impairment. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income, including the reversals of deferred tax liabilities during the periods in which those temporary differences will become deductible. The Company’s management assesses the realizability of its deferred tax assets, and records a valuation allowance for the deferred tax assets when it is more likely than not that a portion, or all of the deferred tax assets will not be realized. As a result, the Company has a valuation allowance against its deferred tax assets as of September 30, 2009 and December 31, 2008, to reflect management’s assessment regarding the realizability of those assets. The Company expects to continue to maintain a valuation allowance on deferred tax assets until there is sufficient positive evidence of future realization. If reversed, the current valuation allowance of $2,988 million and $2,911 million for UAL and United, respectively, will be allocated to reduce income tax expense. As of December 31, 2008, UAL and United had a valuation allowance of $2,886 million (as adjusted) and $2,812 million (as adjusted), respectively. The valuation allowance as of December 31, 2008, as previously reported, was retrospectively adjusted for the adoption of APB 14-1 which is discussed in Note 2, “New Accounting Pronouncements.” UAL’s valuation allowance increased by $102 million in the first nine months of 2009 primarily due to an increase in its net operating loss carryforward. As of September 30, 2009, UAL and United had a federal net operating loss (“NOL”) carry forward of approximately $7.4 billion, and a combined federal and state income tax NOL carry forward tax benefit of approximately $2.8 billion, which may be used to reduce taxes in future years. If not used, federal tax benefits of $1.0 billion expire in 2022, $0.4 billion expire in 2023, $0.5 billion expire in 2024, $0.4 billion expire in 2025, $20 million expire in 2026, $0.1 billion in 2028 and $0.2 billion in 2029. In addition, the state tax benefit of $179 million, if not used, expires over a five to twenty year period. The Company’s ability to utilize these benefits may be impaired if the Company were to have a change of ownership within the meaning of Section 382 of the Internal Revenue Code. To reduce the possibility of a potential adverse effect on the Company’s ability to utilize its NOL carry forward benefits, the Company’s certificate of incorporation contains a “5% Ownership Limitation,” applicable to all stockholders except the Pension Benefit Guaranty Corporation (“PBGC”). The 5% Ownership Limitation remains effective until February 1, 2011. Generally, the 5% limitation prohibits (i) the acquisition by a single stockholder of shares representing 5% or more of the common stock of UAL and (ii) any acquisition or disposition of common stock by a stockholder that already owns 5% or more of UAL’s common stock, unless prior written approval is granted by the UAL Board of Directors. At this time, the Company does not believe the limitations imposed by the Internal Revenue Code on the usage of the NOL carry forward and other tax attributes following an ownership change will have an effect on the Company. Therefore, the Company does not believe its exit from bankruptcy has had any material impact on the use of its remaining NOL carry forward and other tax attributes. In addition to the deferred tax assets listed above, the Company had an $809 million unrecorded tax benefit at September 30, 2009 attributable to the difference between the amount of the financial statement expense and the allowable tax deduction for UAL common stock issued to certain unsecured creditors and employees pursuant to the bankruptcy plan of reorganization. The Company is accounting for this unrecorded tax benefit by analogy to ASC guidance with respect to accounting for share-based payment arrangements which requires recognition of the tax benefit to be deferred until it is realized as a reduction of taxes payable. If not realized, the unrecognized tax benefits of $161 million will expire in 2025, $489 million in 2026 and $159 million over a period from 2027 through 2050. UAL’s income tax returns for tax years after 2003 remain subject to examination by the Internal Revenue Service and state taxing jurisdictions. United is included in UAL’s consolidated income tax returns. (8) Retirement and Postretirement Plans UAL and United contribute to defined contribution plans on behalf of most of their employees, particularly within the U.S. Internationally, the Company maintains a number of small pension plans covering much of its local, non-U.S. workforce. The Company also provides certain health care benefits, primarily in the U.S., to retirees and eligible dependents, as well as certain life insurance benefits to certain retirees, which are reflected as “Other Benefits” in the tables below. The Company has reserved the right, subject to collective bargaining and other agreements, to modify or terminate the health care and life insurance benefits for both current and future retirees. The curtailment gain in the nine months ended September 30, 2009 is attributed to a reduction in future service for certain of the Company’s postretirement plans due to reductions in workforce. The Company’s net periodic benefit cost included the following components. $ 2 $ 2 $ 5 $ 5 $ 7 $ 8

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Print Document View Excel Document Condensed Balance Sheets Condensed Balance Sheets (Parenthetical) Condensed Statements of Operations and Comprehensive Loss (Unaudited) Condensed Statements of Stockholders' Equity (Unaudited) Condensed Statements of Cash Flows (Unaudited) Formation and Business of the Company; Basis of Presentation Summary of Significant Accounting Policies Marketable Securities Zai License Agreements Stockholders' Equity Summary of Significant Accounting Policies (Policies) Summary of Significant Accounting Policies (Tables) Marketable Securities (Tables) Property and Equipment, Net (Tables) Accrued Expenses and Other Current Liabilities (Tables) Stockholders' Equity (Tables) Formation and Business of the Company; Basis of Presentation - Additional Information (Details) Summary of Significant Accounting Policies - Schedule of Reconciliation of Cash, Cash Equivalents and Restricted Cash to Amounts (Details) Summary of Significant Accounting Policies - Additional Information (Details) Summary of Significant Accounting Policies - Schedule of Outstanding Anti-Dilutive Securities not Included in Diluted Net Loss Per Share Calculation (Details) Marketable Securities - Summary of Marketable Securities (Details) Fair Value Measurements - Schedule of Financial Assets Subject to Fair Value Measurements on a Recurring Basis and the Level of Inputs (Details) Property and Equipment, Net - Summary of Property and Equipment, Net (Details) Property and Equipment, Net - Additional Information (Details) Accrued Expenses and Other Current Liabilities - Summary of Accrued Expenses and Other Current Liabilities (Details) Zai License Agreements - Additional Information (Details) Commitments and Contingencies - Additional Information (Details) Commitments and Contingencies - Summary of Operating Leases Future Minimum Payments (Details) Stockholders' Equity - Additional Information (Details) Stockholders' Equity - Schedule of Option Activity (Details) Stockholders' Equity - Schedule of Fair Values of Employee Stock Options Granted (Details) Stockholders' Equity - Summary of Restricted Stock Unit Activity (Details) Stockholders' Equity - Summary of PSU Activity (Details) Stockholders' Equity - Schedule of Stock Based Compensation Expense (Details) Stockholders' Equity - Schedule of Common Stock Reserved for Future Issuance (Details) Document and Entity Information - shares Cover [Abstract] Document Type 10-Q Amendment Flag false Document Period End Date Sep. 30, 2021 Document Fiscal Year Focus 2021 Document Fiscal Period Focus Q3 Trading Symbol TPTX Entity Registrant Name Turning Point Therapeutics, Inc. 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Name: dei_EntityIncorporationStateCountryCode Data Type: dei:edgarStateCountryItemType Boolean flag that is true when the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). -Name Regulation S-T Name: dei_EntityInteractiveDataCurrent The exact name of the entity filing the report as specified in its charter, which is required by forms filed with the SEC. Name: dei_EntityRegistrantName Boolean flag that is true when the registrant is a shell company as defined in Rule 12b-2 of the Exchange Act. Name: dei_EntityShellCompany Indicates that the company is a Smaller Reporting Company (SRC). Name: dei_EntitySmallBusiness The Tax Identification Number (TIN), also known as an Employer Identification Number (EIN), is a unique 9-digit value assigned by the IRS. Name: dei_EntityTaxIdentificationNumber Data Type: dei:employerIdItemType Local phone number for entity. Name: dei_LocalPhoneNumber Title of a 12(b) registered security. -Name Exchange Act -Subsection b Name: dei_Security12bTitle Data Type: dei:securityTitleItemType Name of the Exchange on which a security is registered. -Subsection d1-1 Name: dei_SecurityExchangeName Data Type: dei:edgarExchangeCodeItemType Trading symbol of an instrument as listed on an exchange. Name: dei_TradingSymbol Data Type: dei:tradingSymbolItemType Condensed Balance Sheets - USD ($) Cash and cash equivalents $ 404,203 $ 554,101 Marketable securities 631,811 568,407 Prepaid and other current assets 11,127 8,171 Total current assets 1,047,141 1,130,679 Property and equipment, net 3,858 2,604 Right-of-use lease assets 5,965 3,357 Other assets 2,021 73 Total assets 1,058,985 1,136,713 Accounts payable 3,188 5,225 Accrued expenses and other current liabilities 23,045 9,183 Accrued compensation 9,025 8,588 Current portion of operating lease liabilities 3,495 1,396 Operating lease liabilities, long-term 2,895 2,423 Commitments and contingencies (Note 8) Stockholders' equity: Preferred stock, $0.0001 par value; 10,000,000 shares authorized at September 30, 2021 and December 31, 2020, zero shares outstanding at September 30, 2021 and December 31, 2020 Common stock, $0.0001 par value; 200,000,000 shares authorized at September 30, 2021 and December 31, 2020; 49,464,156 and 48,678,540 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively 5 5 Additional paid-in capital 1,455,626 1,389,860 Accumulated other comprehensive (loss)/income (16) 209 Accumulated deficit (438,278) (280,176) Total stockholders' equity 1,017,337 1,109,898 Total liabilities and stockholders’ equity $ 1,058,985 $ 1,136,713 Accrued expenses and other current liabilities. 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This excludes temporary equity and is sometimes called permanent equity. -Subparagraph (SAB Topic 4.E) Name: us-gaap_StockholdersEquity Name: us-gaap_StockholdersEquityAbstract Condensed Balance Sheets (Parenthetical) - $ / shares Statement Of Financial Position [Abstract] Preferred stock, par value $ 0.0001 $ 0.0001 Preferred stock, shares authorized 10,000,000 10,000,000 Preferred stock, shares outstanding 0 0 Common stock, par value $ 0.0001 $ 0.0001 Common stock, shares authorized 200,000,000 200,000,000 Common stock, shares issued 49,464,156 48,678,540 Common stock, shares outstanding 49,464,156 48,678,540 Face amount or stated value per share of common stock. Name: us-gaap_CommonStockParOrStatedValuePerShare Data Type: dtr-types:perShareItemType The maximum number of common shares permitted to be issued by an entity's charter and bylaws. 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Excludes changes in equity resulting from investments by owners and distributions to owners. Name: us-gaap_ComprehensiveIncomeNetOfTax The amount of net income or loss for the period per each share in instances when basic and diluted earnings per share are the same amount and reported as a single line item on the face of the financial statements. Basic earnings per share is the amount of net income or loss for the period per each share of common stock or unit outstanding during the reporting period. Diluted earnings per share includes the amount of net income or loss for the period available to each share of common stock or common unit outstanding during the reporting period and to each share or unit that would have been outstanding assuming the issuance of common shares or units for all dilutive potential common shares or units outstanding during the reporting period. 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Name: us-gaap_OtherOperatingIncome The aggregate costs incurred (1) in a planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service, a new process or technique, or in bringing about a significant improvement to an existing product or process; or (2) to translate research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or the entity's use, during the reporting period charged to research and development projects, including the costs of developing computer software up to the point in time of achieving technological feasibility, and costs allocated in accounting for a business combination to in-process projects deemed to have no alternative future use. -URI http://asc.fasb.org/extlink&oid=6472174&loc=d3e58812-109433 Name: us-gaap_ResearchAndDevelopmentExpense Amount, excluding tax collected from customer, of revenue from satisfaction of performance obligation by transferring promised good or service to customer. Tax collected from customer is tax assessed by governmental authority that is both imposed on and concurrent with specific revenue-producing transaction, including, but not limited to, sales, use, value added and excise. -Subparagraph (SAB Topic 11.L) Name: us-gaap_RevenueFromContractWithCustomerExcludingAssessedTax Average number of shares or units issued and outstanding that are used in calculating basic and diluted earnings per share (EPS). Name: us-gaap_WeightedAverageNumberOfShareOutstandingBasicAndDiluted Condensed Statements of Stockholders' Equity (Unaudited) - USD ($) Accumulated Other Comprehensive Income (Loss) Balance at Dec. 31, 2019 $ 404,351 $ 4 $ 526,960 $ 271 $ (122,884) Balance, Shares at Dec. 31, 2019 35,915,119 Option exercises 25 25 Option exercises, Shares 7,129 Stock-based compensation expense 38,365 38,365 Net loss (60,718) (60,718) Other comprehensive (loss) income (316) (316) Balance at Mar. 31, 2020 381,707 $ 4 565,350 (45) (183,602) Balance, Shares at Mar. 31, 2020 35,922,248 Balance at Dec. 31, 2019 404,351 $ 4 526,960 271 (122,884) Net loss (109,916) Balance at Sep. 30, 2020 701,588 $ 5 933,971 412 (232,800) Balance, Shares at Sep. 30, 2020 42,213,364 Shares issued under employee stock purchase plan 504 504 Shares issued under employee stock purchase plan, Shares 14,425 Issuance of common stock in connection with a public offering, net of underwriting discounts, commissions, and offering costs 351,611 $ 1 351,610 Issuance of common stock in connection with a public offering, net of underwriting discounts, commissions, and offering costs, Shares 6,229,167 Stock-based compensation expense 7,404 7,404 Other comprehensive (loss) income 1,063 1,063 Balance at Jun. 30, 2020 710,827 $ 5 924,899 1,018 (215,095) Balance, Shares at Jun. 30, 2020 42,168,889 Option exercises 508 508 Option exercises, Shares 44,475 Balance at Dec. 31, 2020 $ 1,109,898 $ 5 1,389,860 209 (280,176) Balance, Shares at Dec. 31, 2020 48,678,540 48,678,540 Option exercises $ 9,679 9,679 Option exercises, Shares 438,500 Balance at Mar. 31, 2021 1,101,165 $ 5 1,416,817 23 (315,680) Net loss $ (158,102) Balance at Sep. 30, 2021 $ 1,017,337 $ 5 1,455,626 (16) (438,278) Balance, Shares at Sep. 30, 2021 49,464,156 49,464,156 Balance at Mar. 31, 2021 $ 1,101,165 $ 5 1,416,817 23 (315,680) Option exercises 8,398 8,398 Other comprehensive (loss) income (21) (21) Balance at Jun. 30, 2021 1,067,507 $ 5 1,439,453 2 (371,953) Balance at Sep. 30, 2021 $ 1,017,337 $ 5 $ 1,455,626 $ (16) $ (438,278) Amount of increase to additional paid-in capital (APIC) for recognition of cost for award under share-based payment arrangement. Name: us-gaap_AdjustmentsToAdditionalPaidInCapitalSharebasedCompensationRequisiteServicePeriodRecognitionValue Amount after tax and reclassification adjustments of other comprehensive income (loss). Name: us-gaap_OtherComprehensiveIncomeLossNetOfTax Number of shares issued during the period as a result of an employee stock purchase plan. Name: us-gaap_StockIssuedDuringPeriodSharesEmployeeStockPurchasePlans Number of new stock issued during the period. Name: us-gaap_StockIssuedDuringPeriodSharesNewIssues Number of share options (or share units) exercised during the current period. -Subparagraph (c)(1)(iv)(2) Name: us-gaap_StockIssuedDuringPeriodSharesStockOptionsExercised Aggregate change in value for stock issued during the period as a result of employee stock purchase plan. Name: us-gaap_StockIssuedDuringPeriodValueEmployeeStockPurchasePlan Equity impact of the value of new stock issued during the period. Includes shares issued in an initial public offering or a secondary public offering. Name: us-gaap_StockIssuedDuringPeriodValueNewIssues Value of stock issued as a result of the exercise of stock options. -Subparagraph (SX 210.5-02.29-31) Name: us-gaap_StockIssuedDuringPeriodValueStockOptionsExercised Condensed Statements of Cash Flows (Unaudited) - USD ($) Net loss $ (158,102) $ (109,916) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 846 647 Accretion of discount on marketable securities 4,093 175 Amortization of right-of-use operating lease asset 1,847 1,139 Prepaid expenses and other current assets (3,102) (905) Accounts payable (2,099) 2,686 Accrued compensation 437 (929) Net cash used in operating activities (99,734) (49,347) Purchases of marketable securities (391,344) (351,167) Sales and maturities of marketable securities 323,624 312,986 Purchases of property and equipment (2,040) (874) Net cash used in investing activities (69,760) (39,055) Proceeds from issuance of common stock under equity incentive plans 21,399 1,068 Proceeds from issuance of common stock in public offering, net of offering costs 351,611 Costs paid in connection with financing (114) Net cash provided by financing activities 21,399 352,565 Net (decrease) increase in cash, cash equivalents and restricted cash (148,095) 264,163 Cash, cash equivalents and restricted cash at the beginning of period 554,174 48,188 Cash, cash equivalents and restricted cash at the end of period 406,079 312,351 Supplemental disclosure of cash flow information: Cash paid for income taxes 1 1 Supplemental disclosure of non-cash investing and financing information: Purchases of property and equipment in accounts payable 68 108 Costs incurred in connection with a public offering included in accounts payable and accrued expenses $ 81 Operating lease liabilities arising from obtaining right-of-use assets $ 4,007 Costs incurred in connection with the initial public offering included in accounts payable and accrued expenses. Name: tptx_CostsIncurredInConnectionWithInitialPublicOfferingIncludedInAccountsPayableAndAccruedExpenses Purchase of property and equipment in accounts payable. Name: tptx_PurchaseOfPropertyAndEquipmentInAccountsPayable The sum of the periodic adjustments of the differences between securities' face values and purchase prices that are charged against earnings. This is called accretion if the security was purchased at a discount and amortization if it was purchased at premium. As a noncash item, this element is an adjustment to net income when calculating cash provided by or used in operations using the indirect method. Name: us-gaap_AccretionAmortizationOfDiscountsAndPremiumsInvestments Name: us-gaap_AdjustmentsToReconcileNetIncomeLossToCashProvidedByUsedInOperatingActivitiesAbstract The expense charged against earnings for the periodic recognition of capitalized leases. This element may apply to energy companies that lease mineral producing properties and to other enterprises that capitalize property, plant, or equipment obtained through capital leases. Reference 1: http://fasb.org/us-gaap/role/ref/otherTransitionRef Name: us-gaap_AmortizationOfLeasedAsset Amount of cash and cash equivalents, and cash and cash equivalents restricted to withdrawal or usage; including, but not limited to, disposal group and discontinued operations. Cash includes, but is not limited to, currency on hand, demand deposits with banks or financial institutions, and other accounts with general characteristics of demand deposits. Cash equivalents include, but are not limited to, short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Name: us-gaap_CashCashEquivalentsRestrictedCashAndRestrictedCashEquivalentsIncludingDisposalGroupAndDiscontinuedOperations Amount of increase (decrease) in cash, cash equivalents, and cash and cash equivalents restricted to withdrawal or usage; including effect from exchange rate change. Cash includes, but is not limited to, currency on hand, demand deposits with banks or financial institutions, and other accounts with general characteristics of demand deposits. Cash equivalents include, but are not limited to, short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Name: us-gaap_CashCashEquivalentsRestrictedCashAndRestrictedCashEquivalentsPeriodIncreaseDecreaseIncludingExchangeRateEffect Name: us-gaap_CashFlowNoncashInvestingAndFinancingActivitiesDisclosureAbstract The amount of expense recognized in the current period that reflects the allocation of the cost of tangible assets over the assets' useful lives. Includes production and non-production related depreciation. Name: us-gaap_Depreciation The amount of cash paid during the current period to foreign, federal, state, and local authorities as taxes on income, net of any cash received during the current period as refunds for the overpayment of taxes. Name: us-gaap_IncomeTaxesPaidNet The increase (decrease) during the reporting period in the aggregate amount of liabilities incurred (and for which invoices have typically been received) and payable to vendors for goods and services received that are used in an entity's business. Name: us-gaap_IncreaseDecreaseInAccountsPayable Amount of increase (decrease) in accrued expenses, and obligations classified as other. Name: us-gaap_IncreaseDecreaseInAccruedLiabilitiesAndOtherOperatingLiabilities The increase (decrease) during the reporting period in the aggregate amount of obligations related to services received from employees, such as accrued salaries and bonuses, payroll taxes and fringe benefits. Name: us-gaap_IncreaseDecreaseInEmployeeRelatedLiabilities Name: us-gaap_IncreaseDecreaseInOperatingCapitalAbstract Amount of increase (decrease) in prepaid expenses, and assets classified as other. Name: us-gaap_IncreaseDecreaseInPrepaidDeferredExpenseAndOtherAssets Amount of cash inflow (outflow) from financing activities, including discontinued operations. Financing activity cash flows include obtaining resources from owners and providing them with a return on, and a return of, their investment; borrowing money and repaying amounts borrowed, or settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit. Name: us-gaap_NetCashProvidedByUsedInFinancingActivities Name: us-gaap_NetCashProvidedByUsedInFinancingActivitiesAbstract Amount of cash inflow (outflow) from investing activities, including discontinued operations. Investing activity cash flows include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets. Name: us-gaap_NetCashProvidedByUsedInInvestingActivities Name: us-gaap_NetCashProvidedByUsedInInvestingActivitiesAbstract Amount of cash inflow (outflow) from operating activities, including discontinued operations. Operating activity cash flows include transactions, adjustments, and changes in value not defined as investing or financing activities. Name: us-gaap_NetCashProvidedByUsedInOperatingActivities Name: us-gaap_NetCashProvidedByUsedInOperatingActivitiesAbstract The cash outflow for loan and debt issuance costs. Name: us-gaap_PaymentsOfFinancingCosts Amount of cash outflow for purchase of marketable security. Name: us-gaap_PaymentsToAcquireMarketableSecurities The cash outflow associated with the acquisition of long-lived, physical assets that are used in the normal conduct of business to produce goods and services and not intended for resale; includes cash outflows to pay for construction of self-constructed assets. Name: us-gaap_PaymentsToAcquirePropertyPlantAndEquipment The cash inflow associated with the amount received from entity's first offering of stock to the public. Name: us-gaap_ProceedsFromIssuanceInitialPublicOffering The cash inflow associated with the aggregate amount received by the entity through sale or maturity of marketable securities (held-to-maturity or available-for-sale) during the period. Name: us-gaap_ProceedsFromSaleAndMaturityOfMarketableSecurities The cash inflow associated with the amount received from the stock plan during the period. Name: us-gaap_ProceedsFromStockPlans Amount of increase in right-of-use asset obtained in exchange for operating lease liability. Name: us-gaap_RightOfUseAssetObtainedInExchangeForOperatingLeaseLiability Amount of noncash expense for share-based payment arrangement. Name: us-gaap_ShareBasedCompensation Name: us-gaap_SupplementalCashFlowInformationAbstract Organization Consolidation And Presentation Of Financial Statements [Abstract] 1. Formation and Business of the Company; Basis of Presentation Turning Point Therapeutics, Inc. (the Company) was organized in 2013 and commenced operations in 2014. The Company is a clinical-stage precision oncology biopharmaceutical company designing and developing novel small molecule, targeted oncology therapies. The Company’s principal operations are in the United States and the Company operates in one segment, with its headquarters in San Diego, California. The Company’s primary activities since inception have been to build infrastructure, conduct research and development, including clinical trials, perform business and financial planning, and raise capital. Basis of Presentation The accompanying unaudited condensed financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and pursuant to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (SEC). Accordingly, since they are interim statements, the accompanying condensed financial statements do not include all of the information and notes required by GAAP for complete financial statements. The unaudited interim financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. The condensed balance sheet at December 31, 2020 has been derived from the audited financial statements at that date, but does not include all information and footnotes required by GAAP for complete financial statements. The operating results presented in these unaudited condensed financial statements are not necessarily indicative of the results that may be expected for any future periods. These unaudited condensed financial statements should be read in conjunction with the audited financial statements and the notes thereto for the year ended December 31, 2020 included in the Company’s Annual Report on Form 10-K for the year ended December 31 2020 filed with the SEC. In the opinion of management, the unaudited condensed financial statements and notes thereto include all adjustments that are of a normal and recurring nature that are necessary for the fair presentation of the Company’s financial position and of the results of operations and cash flows for the periods presented. Substantial doubt about an entity’s ability to continue as a going concern exists when relevant conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year from the financial statement issuance date. The Company determined that there are no conditions or events that raise substantial doubt about its ability to continue as a going concern within one year after the date that the unaudited condensed financial statements for the quarter ended September 30, 2021 are issued. The COVID-19 pandemic continues to rapidly evolve and has already resulted in a significant disruption of global financial markets. The Company’s ability to raise additional capital may be adversely impacted by potential worsening global economic conditions and further disruptions to, and volatility in, the credit and financial markets in the United States and worldwide resulting from the pandemic. If such further disruption occurs, the Company could experience an inability to access additional capital. Name: us-gaap_OrganizationConsolidationAndPresentationOfFinancialStatementsAbstract The entire disclosure for the general note to the financial statements for the reporting entity which may include, descriptions of the basis of presentation, business description, significant accounting policies, consolidations, reclassifications, new pronouncements not yet adopted and changes in accounting principles. -URI http://asc.fasb.org/topic&trid=2197479 Name: us-gaap_OrganizationConsolidationBasisOfPresentationBusinessDescriptionAndAccountingPoliciesTextBlock Data Type: dtr-types:textBlockItemType Accounting Policies [Abstract] 2. Summary of Significant Accounting Policies The Company’s significant accounting policies are described in Note 2 of the Notes to Financial Statements included in its Annual Report on Form 10‑K for the year ended December 31, 2020. The Company recognizes revenue in accordance with Accounting Standards Codification (ASC) Topic 606, Revenue From Contracts With Customers (ASC 606). Under ASC 606, an entity recognizes revenue when its customer obtains control of promised goods or services, in an amount that reflects the consideration that the entity expects to receive in exchange for those goods or services. To determine revenue recognition for arrangements within the scope of ASC 606, the entity performs the following five steps: (i) identify the contract(s) with a customer; (ii) identify the performance obligations in the contract; (iii) determine the transaction price, including variable consideration, if any; (iv) allocate the transaction price to the performance obligations in the contract; and (v) recognize revenue when (or as) the entity satisfies a performance obligation. The Company only applies the five-step model to contracts when it is probable that the entity will collect the consideration to which it is entitled in exchange for the goods or services it transfers to the customer. The Company assesses the goods or services promised within each contract and determines those that are performance obligations. Arrangements that include rights to additional goods or services that are exercisable at a customer’s discretion are generally considered options. The Company assesses if these options provide a material right to the customer and if so, they are considered performance obligations. The Company assesses whether each promised good or service is distinct for the purpose of identifying the performance obligations in the contract. This assessment involves subjective determinations and requires management to make judgments about the individual promised goods or services and whether such are separable from the other aspects of the contractual relationship. Promised goods and services are considered distinct provided that: (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer (that is, the good or service is capable of being distinct) and (ii) the entity’s promise to transfer the good or service to the customer is separately identifiable from other promises in the contract (that is, the promise to transfer the good or service is distinct within the context of the contract). In assessing whether a promised good or service is distinct, the Company considers factors such as the research, manufacturing and commercialization capabilities of the collaboration partner and the availability of the associated expertise in the general marketplace. The Company also considers the intended benefit of the contract in assessing whether a promised good or service is separately identifiable from other promises in the contract. If a promised good or service is not distinct, an entity is required to combine that good or service with other promised goods or services until it identifies a bundle of goods or services that is distinct. The transaction price is then determined and allocated to the identified performance obligations in proportion to their standalone selling prices (SSP) on a relative SSP basis. SSP is determined at contract inception and is not updated to reflect changes between contract inception and when the performance obligations are satisfied. Determining the SSP for performance obligations requires significant judgment. In developing the SSP for a performance obligation, the Company considers applicable market conditions and relevant entity-specific factors, including factors that were contemplated in negotiating the agreement with the customer and estimated costs. If the consideration promised in a contract includes a variable amount, the Company estimates the amount of consideration to which it will be entitled in exchange for transferring the promised goods or services to a customer. The Company determines the amount of variable consideration by using the expected value method or the most likely amount method. The Company includes the unconstrained amount of estimated variable consideration in the transaction price. The amount included in the transaction price is constrained to the amount for which it is probable that a significant reversal of cumulative revenue recognized will not occur. At the end of each subsequent reporting period, the Company re-evaluates the estimated variable consideration included in the transaction price and any related constraint, and if necessary, adjusts its estimate of the overall transaction price. Any such adjustments are recorded on a cumulative catch-up basis in the period of adjustment. If an arrangement includes development and regulatory milestone payments, the Company evaluates whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method. If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price. Milestone payments that are not within the Company’s control or the licensee’s control, such as regulatory approvals, are generally not considered probable of being achieved until those approvals are received. For arrangements with licenses of intellectual property that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, the Company recognizes royalty revenue and sales-based milestones at the later of (i) when the related sales occur, or (ii) when the performance obligation to which the royalty has been allocated has been satisfied. In determining the transaction price, the Company adjusts consideration for the effects of the time value of money if the timing of payments provides the Company with a significant benefit of financing. The Company does not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the licensees and the transfer of the promised goods or services to the licensees will be one year or less. The Company then recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when (or as) each performance obligation is satisfied, either at a point in time or over time, and if over time, recognition is based on the use of an output or input method. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that impact the reported amounts of assets, liabilities and expenses and the disclosure of contingent liabilities in the Company’s financial statements and accompanying notes. The most significant estimates in the Company’s financial statements relate to determining the SSP of performance obligations associated with license arrangements, preclinical and clinical trial costs and accruals and stock-based compensation costs. Management bases its estimates on historical experience and on various other market-specific and relevant assumptions that management believes to be reasonable under the circumstances. Although these estimates are based on the Company’s knowledge of current events and actions it may undertake in the future, actual results may ultimately materially differ from these estimates and assumptions. Although the impact of the COVID-19 pandemic to the Company’s business and operating results presents additional uncertainty, the Company continues to use the best information available to update its critical accounting estimates. Cash, Cash Equivalents and Restricted Cash The following table presents a reconciliation of cash, cash equivalents and restricted cash to amounts shown in the unaudited condensed statement of cash flows (in thousands): Restricted cash, as part of other assets Total cash, cash equivalents and restricted cash Concentration of Credit Risk Substantially all of the Company’s cash, cash equivalents, and marketable securities are held at two financial institutions. Due to the financial strength of the depository institutions, the Company believes these financial institutions represent minimal credit risk. Cash amounts held at financial institutions are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000. At September 30, 2021, cash and cash equivalents and marketable securities totaling $1,035.8 million are either not subject to FDIC insurance, or exceed the FDIC insured limit. The Company’s cash and cash equivalents and marketable securities are invested in short term, high credit quality securities, and as a result, the Company believes represent a minimal credit risk. Clinical Trial Costs and Accruals A significant portion of the Company’s clinical trial costs relate to contracts with contract research organizations (CROs). The financial terms of the Company’s CRO contracts may result in payment flows that do not match the periods over which materials or services are provided to the Company under such contracts. The Company’s objective is to reflect the appropriate clinical trial expenses in the Company’s financial statements by matching those expenses with the period in which services and efforts are expended. As part of the process of preparing the Company’s financial statements, the Company evaluates cost information provided by the Company’s CROs concerning estimated monthly expenses for services rendered and unbilled obligations as the sponsor of the Company’s clinical trials. Accordingly, the Company’s clinical trial accrual is dependent upon the timely and accurate reporting of CROs and other third-party vendors, and the Company’s ability to accurately estimate any unbilled obligations. If the contracted amounts are modified, for instance, as a result of changes in the clinical trial protocol or scope of work to be performed, the Company modifies its accruals accordingly on a prospective basis. Revisions in the scope of a contract are charged to research and development expense in the period in which the facts that give rise to the revision become reasonably certain. Research and development costs are expensed as incurred. These costs consist primarily of salaries and other personnel-related expenses, including stock-based compensation; facility-related expenses; depreciation of facilities and equipment; laboratory consumables; and services performed by clinical research organizations, research institutions, and other outside service providers. The Company recorded the estimated costs of research and development activities based upon the estimated amount of services provided but not yet invoiced and include these costs in accrued expenses and other current liabilities in the balance sheet and within research and development expense in the statement of operations and comprehensive loss. As actual costs become known, the Company will adjust its accrued expenses and other current liabilities. Net Loss Per Share The Company computes basic loss per share by dividing the net loss available to common stockholders by the weighted average number of common shares outstanding for the period, without consideration for common stock equivalents. Diluted net loss assumes the conversion, exercise or issuance of all potential common stock equivalents, unless the effect of inclusion would be anti-dilutive. For purposes of this calculation, common stock equivalents include the Company’s stock options, restricted stock units (RSUs) and contingently issuable shares. The Company excluded stock options to purchase common stock, RSUs and contingently issuable shares from the number of shares used to calculate diluted shares outstanding because the inclusion of these potentially dilutive securities would have been antidilutive. Historical outstanding anti-dilutive securities not included in the diluted net loss per share calculation include the following: Nine Months Ended September 30, Options to purchase common stock RSUs Name: us-gaap_AccountingPoliciesAbstract The entire disclosure for all significant accounting policies of the reporting entity. Name: us-gaap_SignificantAccountingPoliciesTextBlock Investments Debt And Equity Securities [Abstract] 3. Marketable Securities The Company invests its excess cash in marketable securities, including debt instruments of financial institutions, corporations with investment grade credit ratings, commercial paper and government agencies. At September 30, 2021, marketable securities consisted of the following (in thousands): Unrealized Maturity in Years Amortized Cost U.S. Treasuries 2 years or less U.S. Government agency securities Non-U.S. Government agency securities Corporate debt securities Total marketable securities At December 31, 2020, marketable securities consisted of the following (in thousands): The Company segments its portfolio based on the underlying risk profiles of their current securities being held. The Company regularly reviews the securities in an unrealized loss position and evaluates the current expected credit loss by considering factors such as historical experience, market data, issuer-specific factors, current and expected future economic conditions. As of September 30, 2021, the Company did not record an allowance for credit loss related to its investment portfolio. Name: us-gaap_InvestmentsDebtAndEquitySecuritiesAbstract The entire disclosure for investments in certain debt and equity securities. -URI http://asc.fasb.org/subtopic&trid=2209399 -Name Regulation S-K (SK) -Section 1403 -Paragraph (b) Name: us-gaap_InvestmentsInDebtAndMarketableEquitySecuritiesAndCertainTradingAssetsDisclosureTextBlock Fair Value Disclosures [Abstract] 4. Fair Value Measurements Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants at the measurement date. Fair value should maximize the use of observable inputs and minimize the use of unobservable inputs. The Company determines the fair value of financial assets and liabilities using three levels of inputs as follows: Level 1—Inputs which include quoted prices in active markets for identical assets or liabilities at the measurement date. Level 2—Inputs (other than quoted market prices included in Level 1) that are either directly or indirectly observable, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the instrument’s anticipated life. Level 3—Unobservable inputs for assets or liabilities and include little or no market activity. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The Company’s financial assets subject to fair value measurements on a recurring basis and the level of inputs used for such measurements were as follows (in thousands): Fair Value Measurements at September 30, 2021 Using: Non-U.S. Government securities Total cash equivalents and marketable securities Fair Value Measurements at December 31, 2020 Using: Name: us-gaap_FairValueDisclosuresAbstract The entire disclosure for the fair value of financial instruments (as defined), including financial assets and financial liabilities (collectively, as defined), and the measurements of those instruments as well as disclosures related to the fair value of non-financial assets and liabilities. Such disclosures about the financial instruments, assets, and liabilities would include: (1) the fair value of the required items together with their carrying amounts (as appropriate); (2) for items for which it is not practicable to estimate fair value, disclosure would include: (a) information pertinent to estimating fair value (including, carrying amount, effective interest rate, and maturity, and (b) the reasons why it is not practicable to estimate fair value; (3) significant concentrations of credit risk including: (a) information about the activity, region, or economic characteristics identifying a concentration, (b) the maximum amount of loss the entity is exposed to based on the gross fair value of the related item, (c) policy for requiring collateral or other security and information as to accessing such collateral or security, and (d) the nature and brief description of such collateral or security; (4) quantitative information about market risks and how such risks are managed; (5) for items measured on both a recurring and nonrecurring basis information regarding the inputs used to develop the fair value measurement; and (6) for items presented in the financial statement for which fair value measurement is elected: (a) information necessary to understand the reasons for the election, (b) discussion of the effect of fair value changes on earnings, (c) a description of [similar groups] items for which the election is made and the relation thereof to the balance sheet, the aggregate carrying value of items included in the balance sheet that are not eligible for the election; (7) all other required (as defined) and desired information. Name: us-gaap_FairValueDisclosuresTextBlock Property Plant And Equipment [Abstract] 5. Property and Equipment, Net Property and equipment, net consisted of the following (in thousands): Computer equipment and software Furniture and fixtures Property and equipment Less: accumulated depreciation Depreciation expense for the three months ended September 30, 2021 and 2020 was $0.3 million and $0.2 million, respectively. Depreciation expense for the nine months ended September 30, 2021 and 2020 was $0.8 million and $0.6 million, respectively. Name: us-gaap_PropertyPlantAndEquipmentAbstract The entire disclosure for long-lived, physical asset used in normal conduct of business and not intended for resale. Includes, but is not limited to, work of art, historical treasure, and similar asset classified as collections. Name: us-gaap_PropertyPlantAndEquipmentDisclosureTextBlock Payables And Accruals [Abstract] 6. Accrued Expenses and Other Current Liabilities Accrued expenses and other current liabilities consisted of the following (in thousands): Accrued research and development expenses Accrued general and administrative expenses The entire disclosure for accounts payable, accrued expenses, and other liabilities that are classified as current at the end of the reporting period. Name: us-gaap_AccountsPayableAccruedLiabilitiesAndOtherLiabilitiesDisclosureCurrentTextBlock Name: us-gaap_PayablesAndAccrualsAbstract Research And Development [Abstract] 7. Zai License Agreements Zai Repotrectinib Agreement In July 2020, the Company entered into a license agreement (the Zai Repotrectinib Agreement) with Zai Lab (Shanghai) Co., Ltd. (Zai), pursuant to which the Company granted Zai exclusive rights to develop and commercialize products containing the Company’s drug candidate, repotrectinib (the Repotrectinib Products), in Mainland China, Hong Kong, Macau and Taiwan (collectively, the Zai Territory or Greater China). The Company retains exclusive rights to, among other things, develop, manufacture and commercialize the Repotrectinib Products outside the Zai Territory. The Company will supply or have supplied to Zai the Repotrectinib Products for use in the Zai Territory pursuant to a supply agreement for agreed upon consideration, except that Zai has the right, at its election, to package and label the Repotrectinib Products in or outside the Zai Territory for use in the Zai Territory. Pursuant to the terms of the Zai Repotrectinib Agreement, the Company has received an upfront cash payment of $25.0 million and is eligible to receive up to $151.0 million in development and sales milestone payments, consisting of up to $46.0 million of development milestones and up to $105.0 million of sales milestones. In addition, during the term of the Zai Repotrectinib Agreement, Zai is obligated to pay the Company tiered percentage royalties ranging from mid-to-high teens on annual net sales of the Repotrectinib Products in the Zai Territory, subject to adjustments in specified circumstances. Zai is responsible for conducting the development and commercialization activities in the Zai Territory related to the Repotrectinib Products at Zai’s own expense, subject to limited exceptions pursuant to which the Company may be responsible for the cost. The Company is responsible for global clinical studies of the Repotrectinib Products, including the portions that may be conducted in the Zai Territory, at the Company’s expense, except that Zai will participate in global clinical studies of the Repotrectinib Products through clinical trial sites in the Zai Territory as agreed as of the effective date of the Zai Repotrectinib Agreement and may, at Zai’s election, participate in future global clinical studies of the Repotrectinib Products through clinical trial sites in the Zai Territory, in each case at Zai’s expense. The Zai Repotrectinib Agreement will continue in effect until expiration of the last royalty term for a Repotrectinib Product in any region in the Zai Territory, where the royalty term for a Repotrectinib Product in a region continues until the later of (i) the date of the last-to-expire valid claim within Company’s patent rights that covers the Repotrectinib Product in such region in the Zai Territory; (ii) the expiry of the regulatory exclusivity for such Repotrectinib Product in such region; or (iii) the close of business of the day that is exactly 10 years after the date of the first commercial sale of such Repotrectinib Product in such region. Subject to the terms of the Zai Repotrectinib Agreement, Zai may terminate the Zai Repotrectinib Agreement for convenience by providing written notice to the Company, which termination will be effective following a prescribed notice period. In addition, the Company may terminate the Zai Repotrectinib Agreement under specified circumstances if Zai or certain other parties challenge the Company’s patent rights. Either party may terminate the Zai Repotrectinib Agreement for the other party’s uncured material breach of the Zai Repotrectinib Agreement, with a customary notice and cure period, for the other party’s insolvency or if the other party acquires a third party and the acquired party is engaged in activities with a competing product that is not divested or discontinued within a specified period. After termination (but not natural expiration), other than certain terminations by Zai for cause, the Company is entitled to retain a worldwide and perpetual license from Zai to exploit the Repotrectinib Products. The Company determined that two performance obligations existed: (1) the exclusive license, bundled with the associated know-how and (2) the Company's initial obligation to supply repotrectinib for clinical development in the Zai Territory. The total transaction price of $25.7 million was allocated to the performance obligations on the basis of the relative stand-alone selling price estimated for each performance obligation. In estimating the stand-alone selling price for each performance obligation, the Company developed assumptions that require judgment and included forecasted revenues, expected development timelines, discount rates, probabilities of technical and regulatory success and costs for manufacturing clinical supplies. The Company delivered the license and technical know-how to Zai in the third quarter of 2020 to satisfy this performance obligation, and accordingly the Company recognized license revenue of $25.0 million in the third quarter of 2020. The $0.7 million in consideration allocable to the clinical supply performance obligation will be recognized when clinical trial material has been shipped by the Company and Zai obtains control of the goods, upon delivery, over the period of the obligation. For the three and nine months ended September 30, 2021, the Company recognized $0.5 million and $0.8 million, respectively in revenue associated with the clinical supply performance obligation. The Company assessed the Zai Repotrectinib Agreement to determine whether a significant financing component exists and concluded that a significant financing component does not exist. For the nine months ended September 30, 2021, the Company recognized $5.0 million in development milestones. The development milestones were subject to foreign tax withholdings. The Company recorded this tax expense to general and administrative expense in the condensed statements of operations and comprehensive loss. As of September 30, 2021, the Company has not recognized any revenue associated with sales milestones. Zai Elzovantinib Agreement On January 10, 2021, the Company entered into a license agreement with Zai, which was amended on March 31, 2021 (the Zai Elzovantinib Agreement), pursuant to which the Company granted Zai exclusive rights to develop and commercialize products containing the Company’s drug candidate, Elzovantinib (the Elzovantinib Products), in the Zai Territory. The Company retains exclusive rights to, among other things, develop, manufacture and commercialize the Elzovantinib Products outside the Zai Territory. Pursuant to the terms of the Zai Elzovantinib Agreement, the Company has received an upfront cash payment of $25.0 million and is eligible to receive up to $336.0 million in development and sales milestone payments, consisting of up to $121.0 million of development milestones and up to $215.0 million of sales milestones. In addition, during the term of the Zai Elzovantinib Agreement, Zai is obligated to pay the Company tiered percentage royalties ranging from mid-teens to low twenties on annual net sales of the Elzovantinib Products in the Zai Territory, subject to adjustments in specified circumstances. Zai is responsible for conducting the development and commercialization activities in the Zai Territory related to the Elzovantinib Products at Zai’s own expense, subject to limited exceptions pursuant to which the Company may be responsible for the cost. The Company is responsible for global clinical studies of the Elzovantinib Products, including the portions that may be conducted in the Zai Territory, at the Company’s expense, except that Zai will participate in global clinical studies of the Elzovantinib Products through clinical trial sites in the Zai Territory as agreed as of the effective date of the Zai Elzovantinib Agreement and may, at Zai’s election subject to specified exceptions, participate in future global clinical studies of the Elzovantinib Products through clinical trial sites in the Zai Territory, in each case at Zai’s expense. The Zai Elzovantinib Agreement will continue in effect until expiration of the last royalty term for a Elzovantinib Product in any region in the Zai Territory, where the royalty term for a Elzovantinib Product in a region continues until the later of (i) the date of the last-to-expire valid claim within Company’s patent rights that covers the Elzovantinib Product in such region in the Zai Territory; (ii) the expiry of the regulatory exclusivity for such Elzovantinib Product in such region; or (iii) the close of business of the day that is exactly 10 years after the date of the first commercial sale of such Elzovantinib Product in such region. Subject to the terms of the Zai Elzovantinib Agreement, Zai may terminate the Zai Elzovantinib Agreement for convenience by providing written notice to the Company, which termination will be effective following a prescribed notice period. In addition, the Company may terminate the Zai Elzovantinib Agreement under specified circumstances if Zai or certain other parties challenge the Company’s patent rights. Either party may terminate the Zai Elzovantinib Agreement for the other party’s uncured material breach of the Zai Elzovantinib Agreement, with a customary notice and cure period, for the other party’s insolvency or if the other party acquires a third party and the acquired party is engaged in activities with a competing product that is not divested or discontinued within a specified period. After termination (but not natural expiration), other than certain terminations by Zai for cause, the Company is entitled to retain a worldwide and perpetual license from Zai to exploit the Elzovantinib Products. The Company determined that two performance obligations existed: (1) the exclusive license, bundled with the associated know-how and (2) the Company’s initial obligation to supply elzovantinib for clinical development in the Zai Territory. The Company delivered the license and technical know-how to Zai in the first quarter of 2021 to satisfy this performance obligation, and accordingly the Company recognized license revenue of $25.0 million in the first quarter of 2021. The $0.9 million in consideration allocable to the clinical supply performance obligation will be recognized when clinical trial material has been shipped by the Company and Zai obtains control of the goods, upon delivery, over the period of the obligation. As of September 30, 2021, the Company has not recognized any revenue associated with the clinical supply performance obligation under the Zai Elzovantinib Agreement. The Company assessed the Zai Elzovantinib Agreement to determine whether a significant financing component exists and concluded that a significant financing component does not exist. The upfront payment received by the Company was subject to foreign tax withholdings. The Company recorded this tax expense to general and administrative expense in the condensed statements of operations and comprehensive loss. License agreement. Name: tptx_LicenseAgreementTextBlock Name: us-gaap_ResearchAndDevelopmentAbstract Commitments And Contingencies Disclosure [Abstract] Operating Leases The Company has an operating lease for its corporate headquarters and laboratory space with a term that expires June 30, 2023, which resulted in an initial lease liability of $4.0 million and a right-of-use asset of $3.7 million, which is net of $0.3 million of the Company’s deferred gain from the office and laboratory space surrendered in 2019. In connection with this operating lease, in lieu of a cash security deposit, the Company’s bank issued a letter of credit on its behalf, which is secured by a deposit totaling $0.1 million and is included in other assets on the condensed balance sheet. In February 2021, the Company entered into a lease agreement for additional office and laboratory space, which commenced on April 20, 2021, with an initial expiration date of December 31, 2021. In May 2021, the lease was amended to extend the expiration date to June 30, 2023. The Company recorded an operating lease liability and corresponding right-of-use asset of approximately $1.2 million as of the lease commencement date. In April 2021, the Company entered into a lease agreement for additional office space, which commenced on May 24, 2021 and expires June 30, 2023 with no options to extend. In June 2021, the lease terms were amended to add additional office space which commenced on July 30, 2021. The Company recorded an operating lease liability of approximately $2.8 million and a right-of-use asset of $2.9 million, which includes lease incentives. In May 2021, the Company entered into a lease agreement with HCP Callan Road, LLC (Landlord) for the lease of approximately 185,000 square feet of office and laboratory space, delivered in two phases, for the Company’s future principal executive offices and laboratory space. The term of the lease is approximately 11 years and nine months and is expected to commence in March 2023, with an option by the Company to extend for an additional five years. The base rent will be $1.0 million per month, and the Landlord will provide the Company with a tenant improvement allowance of up to $220 per square foot. The Landlord's construction activity of the building was minimal as of September 30, 2021. In connection with the lease, the Company is required to maintain a letter of credit for the benefit of the Landlord in the amount of $1.8 million, which was delivered in May 2021 and is included in other assets on the condensed balance sheet. Future minimum payments under the leases as of September 30, 2021 are as follows (in thousands): Year Ending December 31, 2021 (remaining) Total future minimum lease payments Less: amounts representing interest Total lease liability Remaining lease term Amounts presented in the table above exclude non-cancelable future minimum lease payments for operating leases that have not commenced. Rent expense was $0.9 million and $0.4 million for the three months ended September 30, 2021 and 2020, respectively. The Company paid $0.7 million and $0.4 million of cash payments related to its operating lease agreements for each of the three months ended September 30, 2021 and 2020, respectively. Rent expense was $1.9 million and $1.1 million for the nine months ended September 30, 2021 and 2020, respectively. The Company paid $1.6 million and $1.2 million of cash payments related to its operating lease agreement for the nine months ended September 30, 2021 and 2020, respectively. The Company’s operating leases had a weighted average remaining lease term of 1.8 years as of September 30, 2021 and 2.6 years as of December 31, 2020, and a weighted average discount rate of 7.1% as of September 30, 2021 and 8.5% as of December 31, 2020. Name: us-gaap_CommitmentsAndContingenciesDisclosureAbstract The entire disclosure for commitments and contingencies. Name: us-gaap_CommitmentsAndContingenciesDisclosureTextBlock Equity [Abstract] 9. Stockholders’ Equity At the Market Offering In August 2020, the Company entered into an Open Market Sale AgreementSM with Jefferies LLC (ATM facility), under which the Company may offer and sell, from time to time, at its sole discretion, up to $250.0 million shares of the Company’s common stock. As of September 30, 2021, the Company had not yet sold any shares of common stock under the ATM facility. Equity Compensation Plans The Company’s 2019 Equity Incentive Plan (the Plan) provides for the grant of stock options, restricted stock and other equity awards of the Company’s common stock to employees, officers, consultants, and directors. In addition, the number of shares of common stock available for issuance under the Plan will be automatically increased on the first day of each calendar year through January 1, 2029, by an amount equal to 4% of the outstanding number of shares of the Company’s common stock on December 31 of the preceding calendar year or such lesser amount as determined by the Company’s board of directors. On January 1, 2021, the Company added 1,947,141 shares to the Plan. At September 30, 2021, the Plan had 3,432,812 total shares available for issuance. Options expire within a period of not more than ten years from the date of grant. Initial option grants to employees typically vest 25% after one year and monthly thereafter over a three-year period and expire three months after employee termination. Subsequent option grants to employees and grants to non-employees typically vest monthly over a four-year period. The majority of options outstanding at September 30, 2021 had vesting periods of four years. The following summarizes option activity under the Plan for the periods presented: Value (in thousands) Balance as of December 31, 2020 Options granted Options exercised Options forfeited or cancelled Balance as of September 30, 2021 Options vested and exercisable as of September 30, 2021 The fair values of the employee stock options granted during the three and nine months ended September 30, 2021 and 2020 were estimated at the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: Three Months Ended September 30, Risk-free interest rate Expected term (in years) The weighted-average grant-date fair value of options granted to employees was $47.79 and $44.97 for the three months ended September 30, 2021 and 2020, respectively and was $71.77 and $41.96 for the nine months ended September 30, 2021 and 2020, respectively. As of September 30, 2021, there was $123.7 million in total unrecognized compensation expense expected to be recognized over a weighted average period of 2.38 years. Restricted Stock Units The summary of the Company’s restricted stock unit activity for the periods presented is as follows: Restricted Stock Units Outstanding Weighted Average Grant Date Fair Value Aggregate Intrinsic Value (in thousands) Vested Forfeited Outstanding as of September 30, 2021 As of September 30, 2021, the total unrecognized compensation related to restricted stock units granted was $20.3 million, which the Company expects to recognize over a weighted-average period of approximately 3.43 years. Performance Stock Units The Company has granted performance stock units (PSUs) which vest based on the achievement of certain predefined Company-specific performance criteria and expire as of December 31, 2023. The fair value of PSUs is estimated based on the closing sale price of the Company’s common stock on the date of grant. The Company will recognize expense in proportion to the number of PSUs that are deemed probable of vesting, based on the Company’s evaluation of the respective performance-based criteria, at each reporting date. The summary of the Company’s PSU activity for the periods presented is as follows: Performance Stock Units Outstanding As of September 30, 2021, the Company does not estimate that the achievement of any performance-based criteria is probable, and no PSUs vested during the nine months ended September 30, 2021. 2019 Employee Stock Purchase Plan In April 2019, the Company’s board of directors and stockholders approved and adopted the 2019 Employee Stock Purchase Plan (the ESPP). The ESPP became effective immediately prior to the date of the underwriting agreement related to the Company’s initial public offering. The ESPP permits eligible employees who elect to participate in an offering under the ESPP to have up to 15% of their eligible earnings withheld, subject to certain limitations, to purchase shares of common stock pursuant to the ESPP. The price of common stock purchased under the ESPP is equal to 85 percent of the lower of the fair market value of the common stock at the commencement date of each offering period or the relevant date of purchase. Each offering period is 24 months, with new offering periods commencing every six months on the dates of June 11 and December 11 of each year. Each offering period consists of four six month purchase periods (each a Purchase Period) during which payroll deductions of the participants are accumulated under the ESPP. The last business day of each Purchase Period is referred to as the “Purchase Date.” Purchase Dates are every six months on the dates of June 10 and December 10 of each year. As of September 30, 2021, a total of 228,156 shares of common stock were available for purchase under the ESPP. The assumptions used for the nine months ended September 30, 2021 and 2020 and the resulting estimates of weighted-average fair value per share for stock purchased under the ESPP during such periods were as follows: 0.04 - 0.16% 69.9 - 79.8% Modifications to Outstanding Equity Awards On March 30, 2021, Sheila Gujrathi, M.D. and Jacob M. Chacko, M.D. resigned from the Board of Directors (the Board) of the Company, effective immediately, to focus on other endeavors. Dr. Gujrathi also resigned from her position as Chair of the Board and Dr. Chacko resigned from each committee of the Board for which he was a member. In connection with the foregoing, the Board approved an amendment to the option awards held by Drs. Gujrathi and Chacko to provide that (i) all shares subject to such option awards are fully vested and exercisable as of the resignation date and (ii) the post-resignation exercise period shall be extended to September 30, 2022. The Company determined that the modification to extend the term of vested stock options was a Type I modification pursuant to ASC 718, Compensation – Stock Compensation (ASC 718). The acceleration of the vesting of the unvested stock options was deemed a Type III modification pursuant to ASC 718, because without Board approval, these stock options would have been forfeited on the date of resignation. As a result of these modifications the Company recognized $5.6 million in stock-based compensation expense in the first quarter of 2021 in general and administrative expenses in the condensed statements of operations and comprehensive loss. On January 9, 2020, the Company entered into a Transition Separation and Consulting Agreement (the Transition Agreement) with the Company’s former Chief Scientific Officer (CSO), Dr. Jingrong Jean Cui. In connection with this Transition Agreement, Dr. Cui resigned from her position as CSO effective January 31, 2020 and thereafter agreed to serve as a consultant to the Company on an as needed basis until June 30, 2020. In accordance with the terms of the Transition Agreement, the Company recorded $1.2 million in expense during the first quarter of 2020 representing the cash severance that was paid to Dr. Cui during 2020. The terms of the Transition Agreement allowed Dr. Cui to continue to vest her outstanding options through to the end of the consulting period on June 30, 2020. At the termination of the consulting period, Dr. Cui immediately received an additional eighteen months vesting of her stock options. In addition, the Company extended Dr. Cui’s period to exercise her vested stock options from 90 days to 12 months from the date of the termination of the consulting period. The Company determined that the modification to extend the term of vested stock options was a Type I modification pursuant to ASC 718. The acceleration of the vesting of the unvested stock options was deemed a Type III modification pursuant to ASC 718, because pursuant to Dr. Cui’s existing employment agreement as of her resignation date, these stock options would have been forfeited on the date of termination. As a result of these modifications the Company recognized $31.4 million in stock-based compensation expense in the first quarter of 2020. Because the services performed during the consulting period were considered nonsubstantive, the Company recognized the full $31.4 million in stock-based compensation expense on the date of the modification and presented this amount in general and administrative expenses in the statement of operations and comprehensive loss. Stock-based compensation expense for awards granted under the Company’s equity plans totaled the following (in thousands):

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FOR THE QUARTERLY PERIOD ENDED APRIL 1, 2017 FOR THE TRANSITION PERIOD FROM __________ TO __________ LATTICE SEMICONDUCTOR CORPORATION State of Delaware (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 111 SW Fifth Ave, Ste 700, Portland, OR (Registrant's telephone number, including area code) Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period as the registrant was required to submit and post such files). Yes [X] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer [ ] Accelerated filer [X] Non-accelerated filer [ ] (Do not check if a smaller reporting company) Smaller reporting company [ ] Emerging growth company [ ] If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Number of shares of common stock outstanding as of May 9, 2017 122,180,894 QUARTERLY REPORT ON FORM 10-Q Consolidated Statements of Operations – Three Months Ended April 1, 2017 and April 2, 2016 (unaudited) Consolidated Statements of Comprehensive Loss – Three Months Ended April 1, 2017 and April 2, 2016 (unaudited) Consolidated Balance Sheets - April 1, 2017 and December 31, 2016 (unaudited) Consolidated Statements of Cash Flows – Three Months Ended April 1, 2017 and April 2, 2016 (unaudited) Notes to Consolidated Financial Statements (unaudited) This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These involve estimates, assumptions, risks, and uncertainties. Any statements about our expectations, beliefs, plans, objectives, assumptions, or future events or performance are not historical facts and may be forward-looking. We use words or phrases such as “anticipates,” “believes,” “could,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “may,” “will,” “should,” “continue,” “ongoing,” “future,” “potential,” and similar words or phrases to identify forward-looking statements. Examples of forward-looking statements include, but are not limited to, statements about: our strategies and beliefs regarding the markets we serve or may serve; growth opportunities and growth in markets we may serve; the advantages our products provide to our customers, including faster time to market and advanced features in an increasingly intense global technology market; our future product development and marketing plans; our intention to continually introduce new products and enhancements and reduce manufacturing costs; the anticipation that we will become increasingly dependent on revenue from newer products; our expectation of production volumes and the associated revenue stream for certain mobile handset providers; acceptance of our devices; our continued participation in consortia that develop and promote the High-Definition Multimedia Interface ("HDMI"), Mobile High-Definition Link ("MHL") and WirelessHD specifications, and our participation in other standard setting initiatives and deep engagement with the standards bodies; the effect of termination of our agent functions regarding the HDMI consortium, related reduction in adopter fees impairment charges and any other changes in the agreements relating to various intellectual property or standards consortia and their sharing of past or present fees or royalties; the Asia Pacific market being the primary source of our revenue; a significant portion of our revenue being through our sell-through distributors; our estimates and judgment to reconcile distributors’ inventories; the likelihood of bankruptcy of certain distributors; our making significant future investments in research and development at approximately the percentage of revenue realized in the first quarter of fiscal 2017; the costs of making and developing various products; our expectation that we will continue to transition to increasingly smaller geometry process technologies; our ability to maintain or develop successful foundry relationships to produce new products; the adequacy of assembly and test capacity commitments; the impact of products, customers and downward pressure on pricing and effects on gross margin; the expected cost and timing of our internal restructuring plans; our expectations regarding protection of and defenses to claims against our intellectual property; our defenses to claims and the finalization and settlement of litigation or administrative proceedings; the impact of our global tax structure and expectations regarding taxes and tax adjustments; our conclusion that we should maintain a valuation allowance against certain tax assets; our belief that we may recognize certain tax benefits during the next twelve months; our ability to forecast uncertain tax positions; our ability to forecast future sales and the relative product mix of those revenues; our expectation that we may consider acquisition opportunities to further extend our product or technology portfolios and further expand our product offerings; the impact of our adoption of new accounting pronouncements on our financial statements; our beliefs regarding the adequacy of our liquidity and facilities, our ability to meet our operating and capital requirements and obligations, and the sufficiency of our financial resources to meet our working capital needs through at least the next 12 months; our ability to implement a company-wide enterprise resource planning system; and our expectation that the proposed acquisition of the outstanding shares of the Company by Canyon Bridge Acquisition Company, Inc. will occur in 2017. Forward-looking statements involve estimates, assumptions, risks, and uncertainties that could cause actual results to differ materially from those expressed in the forward-looking statements. The key factors, among others, that could cause our actual results to differ materially from the forward-looking statements included global economic conditions and uncertainty, the concentration of our sales in the Mobile and Consumer and Communications and Computing end markets, particularly as it relates to the concentration of our sales in the Asia Pacific region, market acceptance and demand for our new products, our ability to license our intellectual property, any disruption of our distribution channels, the impact of competitive products and pricing, unexpected charges, delays or results relating to our restructuring plans, unexpected changes to our implementation of a company-wide enterprise resource planning system, the effect of the downturn in the economy on capital markets and credit markets, unanticipated taxation requirements or positions of the U.S. Internal Revenue Service, or unexpected impacts of recent accounting guidance. In addition, actual results are subject to other risks and uncertainties that relate more broadly to our overall business, including those more fully described herein and that are otherwise described from time to time in our filings with the Securities and Exchange Commission, including, but not limited to, the items discussed in “Risk Factors” in Item 1A of Part II of this Quarterly Report on Form 10-Q. You should not unduly rely on forward-looking statements because our actual results could differ materially from those expressed in any forward-looking statements made by us. In addition, any forward-looking statement applies only as of the date on which it is made. We do not plan to, and undertake no obligation to, update any forward-looking statements to reflect events or circumstances that occur after the date on which such statements are made or to reflect the occurrence of unanticipated events. ITEM 1. FINANCIAL STATEMENTS CONSOLIDATED STATEMENTS OF OPERATIONS Licensing and services Cost of product revenue Cost of licensing and services revenue Selling, general, and administrative Amortization of acquired intangible assets Restructuring charges Acquisition related charges Total costs and expenses Other (expense) income, net Loss before income taxes and equity in net loss of an unconsolidated affiliate Equity in net loss of an unconsolidated affiliate, net of tax Net loss per share, basic and diluted Shares used in per share calculations, basic and diluted See Accompanying Notes to Unaudited Consolidated Financial Statements. CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS Other comprehensive loss: Unrealized loss related to marketable securities, net of tax Reclassification adjustment for losses related to marketable securities included in other (expense) income, net of tax Translation adjustment, net of tax (In thousands, except share and par value data) Short-term marketable securities Accounts receivable, net of allowance for doubtful accounts Property and equipment, less accumulated depreciation of $127,221 at April 1, 2017 and $134,786 at December 31, 2016 Intangible assets, net of amortization Deferred income taxes LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable and accrued expenses (includes restructuring) Accrued payroll obligations Deferred income and allowances on sales to sell-through distributors Deferred licensing and services revenue Contingencies (Note 15) Stockholders' equity: Preferred stock, $.01 par value, 10,000,000 shares authorized, none issued and outstanding Common stock, $.01 par value, 300,000,000 shares authorized; 121,999,000 shares issued and outstanding as of April 1, 2017 and 121,645,000 shares issued and outstanding as of December 31, 2016 Total stockholders' equity Total liabilities and stockholders' equity Adjustments to reconcile net loss to net cash provided by operating activities: Amortization of debt issuance costs and discount Loss on sale or maturity of marketable securities (Gain) loss on forward contracts Changes in assets and liabilities: Accounts receivable, net Prepaid expenses and other assets Proceeds from sales of and maturities of short-term marketable securities Cash paid for software licenses Restricted stock unit withholdings Repayment of debt Net cash used in financing activities Effect of exchange rate change on cash Beginning cash and cash equivalents Ending cash and cash equivalents Supplemental cash flow information: Change in unrealized loss related to marketable securities, net of tax, included in Accumulated other comprehensive loss Income taxes paid, net of refunds Accrued purchases of plant and equipment NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 - Basis of Presentation and Significant Accounting Policies The accompanying Consolidated Financial Statements are unaudited and have been prepared by Lattice Semiconductor Corporation (“Lattice,” the “Company,” “we,” “us,” or “our”) pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and in our opinion include all adjustments, consisting only of normal recurring adjustments, necessary for the fair statement of results for the interim periods. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles ("U.S. GAAP") have been condensed or omitted pursuant to such rules and regulations. These Consolidated Financial Statements should be read in conjunction with our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2016. Fiscal Reporting Period We report based on a 52 or 53-week fiscal year ending on the Saturday closest to December 31. Our first quarter of fiscal 2017 and first quarter of fiscal 2016 ended on April 1, 2017 and April 2, 2016, respectively. All references to quarterly or three months ended financial results are references to the results for the relevant 13-week fiscal period. Principles of Consolidation and Presentation The accompanying Consolidated Financial Statements include the accounts of Lattice and its subsidiaries after the elimination of all intercompany balances and transactions. The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts and classification of assets, such as marketable securities, accounts receivable, inventory, goodwill (including the assessment of reporting units), intangible assets, current and deferred income taxes, accrued liabilities (including restructuring charges and bonus arrangements), deferred income and allowances on sales to sell-through distributors, disclosure of contingent assets and liabilities at the date of the financial statements, amounts used in acquisition valuations and purchase accounting, and the reported amounts of product revenue, licensing and services revenue, and expenses during the fiscal periods presented. Actual results could differ from those estimates. Cash Equivalents and Marketable Securities We consider all investments that are readily convertible into cash and have original maturities of three months or less to be cash equivalents. Cash equivalents consist primarily of highly liquid investments in time deposits or money market accounts and are carried at cost. We account for marketable securities as available-for-sale investments, as defined by U.S. GAAP, and record unrealized gains or losses to Accumulated other comprehensive loss on our Consolidated Balance Sheets, unless losses are considered other than temporary, in which case, those are recorded directly to the Consolidated Statements of Operations and Statements of Comprehensive Loss. Deposits with financial institutions at times exceed Federal Deposit Insurance Corporation insurance limits. We invest in various financial instruments, which may include corporate and government bonds, notes, and commercial paper. We value these instruments at their fair value and monitor our portfolio for impairment on a periodic basis. In the event that the carrying value of an investment exceeds its fair value and the decline in value is determined to be other than temporary, we would record an impairment charge and establish a new carrying value. We assess other than temporary impairment of marketable securities in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 820, “Fair Value Measurements and Disclosures.” The framework under the provisions of ASC 820 establishes three levels of inputs that may be used to measure fair value. Each level of input has different levels of subjectivity and difficulty involved in determining fair value. Level 1 instruments generally represent quoted prices for identical assets or liabilities in active markets. Therefore, determining fair value for Level 1 instruments generally does not require significant management judgment, and the estimation is not difficult. Our Level 1 instruments consist of U.S. Government agency, corporate notes and bonds, and commercial paper that are traded in active markets and are classified as Short-term marketable securities on our Consolidated Balance Sheets. Level 2 instruments include inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities, quoted prices for identical instruments in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Our Level 2 instruments consist of certificates of deposit and foreign currency exchange contracts, entered into to hedge against fluctuation in the Japanese yen. Level 3 instruments include unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. As a result, the determination of fair value for Level 3 instruments requires significant management judgment and subjectivity. We did not have any Level 3 instruments during the periods presented. Foreign Exchange and Translation of Foreign Currencies While our revenues and the majority of our expenses are denominated in U.S. dollars, we have international subsidiary and branch operations that conduct some transactions in foreign currencies. In addition, a portion of our silicon wafer and other purchases were historically denominated in Japanese yen, we billed certain Japanese customers in yen, and we continue to collect a Japanese consumption tax refund in yen. Gains or losses from foreign exchange rate fluctuations on balances denominated in foreign currencies are reflected in Other (expense) income, net. Realized and unrealized gains or losses on foreign currency transactions were not significant for the periods presented. We translate accounts denominated in foreign currencies in accordance with ASC 830, “Foreign Currency Matters,” using the current rate method under which asset and liability accounts are translated at the current rate, while stockholders' equity accounts are translated at the appropriate historical rates, and revenue and expense accounts are translated at average monthly exchange rates. Translation adjustments related to the consolidation of foreign subsidiary financial statements are reflected in Accumulated other comprehensive loss in Stockholders' equity. Derivative Financial Instruments We mitigate foreign currency exchange rate risk by entering into foreign currency forward exchange contracts, details of which are presented in the following table: Total cost of contracts for Japanese yen (thousands) Number of contracts Settlement month Although these hedges mitigate our foreign currency exchange rate exposure from an economic perspective, they were not designated as "effective" hedges for accounting purposes and as such are adjusted to fair value through Other (expense) income, net, with gains of approximately $0.1 million and approximately $0.2 million, respectively, for the fiscal quarters ended April 1, 2017 and December 31, 2016. We do not hold or issue derivative financial instruments for trading or speculative purposes. Concentration Risk Potential exposure to concentration risk may impact revenue, trade receivables, marketable securities, and supply of wafers for our products. Customer concentration risk may impact revenue. The percentage of total revenue attributable to our top five end customers and largest end customer is presented in the following table: Revenue attributable to top five end customers Revenue attributable to largest end customer No other end customer accounted for more than 10% of total revenue during these periods. Sales through distributors have historically accounted for a significant portion of our total revenue. Revenue attributable to resale of products by sell-through distributors as a percentage of total revenue is presented in the following table: Revenue attributable to sell-through distributors Our two largest distributor groups also account for a substantial portion of our trade receivables. At April 1, 2017 and December 31, 2016, one distributor group accounted for 42% and 38%, respectively, and the other accounted for 25% and 24%, respectively, of gross trade receivables. No other distributor group or end customer accounted for more than 10% of gross trade receivables at these dates. Concentration of credit risk with respect to trade receivables is mitigated by our credit and collection process, including active management of collections, credit limits, routine credit evaluations for essentially all customers, and secure transactions with letters of credit or advance payments where appropriate. We regularly review our allowance for doubtful accounts and the aging of our accounts receivable. Accounts receivable do not bear interest and are shown net of allowances for doubtful accounts of $9.3 million at both April 1, 2017 and December 31, 2016. During the third quarter of fiscal 2016, we received notice from one of our distributor groups that indicated a high likelihood of their bankruptcy. As a result, we recorded a full allowance on our accounts receivable, net of deferred revenue, from that distributor group, which accounts for $9.0 million of the allowance for doubtful accounts. Bad debt expense was negligible for both the first quarter of fiscal 2017 and the first quarter of fiscal 2016. We place our investments primarily through one financial institution and mitigate the concentration of credit risk by limiting the maximum portion of the investment portfolio which may be invested in any one instrument. Our investment policy defines approved credit ratings for investment securities. Investments on-hand in marketable securities consisted primarily of money market instruments, “AA” or better corporate notes and bonds and commercial paper, and U.S. government agency obligations. See Note 3 for a discussion of the liquidity attributes of our marketable securities. We rely on a limited number of foundries for our wafer purchases, including Fujitsu Limited, Seiko Epson Corporation, Taiwan Semiconductor Manufacturing Company, Ltd, and United Microelectronics Corporation. We seek to mitigate the concentration of supply risk by establishing, maintaining and managing multiple foundry relationships; however, certain of our products are sourced from a single foundry and changing from one foundry to another can have a significant cost. Revenue Recognition and Deferred Income Product Revenue We sell our products directly to end customers, through a network of independent manufacturers' representatives, and indirectly through a network of independent sell-in and sell-through distributors. Distributors provide periodic data regarding the product, price, quantity, and end customer when products are resold, as well as the quantities of our products they still have in stock. Revenue from sales to original equipment manufacturers ("OEMs") and sell-in distributors is generally recognized upon shipment. Reserves for sell-in stock rotations, where applicable, are estimated based primarily on historical experience and provided for at the time of shipment. Revenue from sales by our sell-through distributors is recognized at the time of reported resale. Under both types of revenue recognition, persuasive evidence of an arrangement exists, the price is fixed or determinable, title has transferred, collection of resulting receivables is reasonably assured, and there are no remaining customer acceptance requirements and no remaining significant performance obligations. Orders from our sell-through distributors are initially recorded at published list prices; however, for a majority of our sales, the final selling price is determined at the time of resale and in accordance with a distributor price agreement. For this reason, we do not recognize revenue until products are resold by sell-through distributors to an end customer. In certain circumstances, we allow sell-through distributors to return unsold products. At times, we protect our sell-through distributors against reductions in published list prices. At the time of shipment to sell-through distributors, we (a) record accounts receivable at published list price since there is a legally enforceable obligation from the distributor to pay us currently for product delivered, (b) relieve inventory for the carrying value of goods shipped since legal title has passed to the distributor, and (c) record deferred revenue and deferred cost of sales in deferred income and allowances on sales to sell-through distributors in the liability section of our Consolidated Balance Sheets. Revenue and cost of sales to sell-through distributors are deferred until either the product is resold by the distributor or, in certain cases, return privileges terminate, at which time Revenue and Cost of products sold are reflected in Net loss, and Accounts receivable, net is adjusted to reflect the final selling price. The components of Deferred income and allowances on sales to sell-through distributors are presented in the following table: Inventory valued at published list prices and held by sell-through distributors with right of return Allowance for distributor advances Deferred cost of sales related to inventory held by sell-through distributors Total Deferred income and allowances on sales to sell-through distributors We use estimates and apply judgment to reconcile sell-through distributors' inventories. Errors in our estimates or judgments could result in inaccurate reporting of our Revenue, Cost of products sold, Deferred income and allowances on sales to sell-through distributors, and Net loss. Licensing and Services Revenue Our licensing and services revenue is comprised of revenue from our intellectual property ("IP") core licensing activity, patent monetization activities, and royalty and adopter fee revenue from our standards activities. These activities are complementary to our product sales and help us monetize our IP and accelerate market adoption curves associated with our technology and standards. From time to time we enter into patent sale and licensing agreements to monetize and license a broad portfolio of our patented inventions. Such licensing agreements may include upfront license fees and ongoing royalties. The contractual terms of the agreements generally provide for payments of upfront license fees and/or royalties over an extended period of time. Revenue from such license fees is recognized when payments become due and payable as long as all other revenue recognition criteria are met, while revenue from royalties is recognized when reported to us by customers. We enter into IP licensing agreements that generally provide licensees the right to incorporate our IP components into their products pursuant to terms and conditions that vary by licensee. Revenue earned under these agreements is classified as licensing and services revenue. Our IP licensing agreements generally include multiple elements, which may include one or more off-the-shelf or customized IP licenses bundled with support services covering a fixed period of time, generally one year. If the different elements of a multiple-element arrangement qualify as separate units of accounting, we allocate the total arrangement consideration to each element based on relative selling price. Amounts allocated to off-the-shelf IP licenses are recognized at the time of sale provided the other conditions for revenue recognition have been met. Amounts allocated to the support services are deferred and recognized on a straight-line basis over the support period, generally one year. Certain licensing agreements provide for royalty payments based on agreed-upon royalty rates, which may be fixed or variable depending on the terms of the agreement. The amount of revenue we recognize is based on a specified time period or on the agreed-upon royalty rate multiplied by the reported number of units shipped by the customer. From time to time, we enter into IP licensing agreements that involve significant modification, customization or engineering services. Revenues derived from these contracts are accounted for using the percentage-of-completion method or completed contract method. The completed contract method is used for contracts where there is a risk associated with final acceptance by the customer or for short-term contracts. HDMI royalty revenue is determined by a contractual allocation formula agreed to by the Founders of the HDMI consortium. Evidence of an arrangement, as it relates to HDMI royalty revenue, is deemed complete when all of the Founders agree on the royalty sharing formula. The contractual allocation formula is subject to periodic adjustment, generally every three years. The most recent agreement expired on December 31, 2016 and a new agreement has not yet been entered into covering the period January 1, 2017 and beyond. As a result the HDMI agent is unable to distribute royalties collected to Founders and, given the lack of evidence of an arrangement, we are unable to recognize HDMI royalty revenue for the three months ended April 1, 2017. We acted as the agent of the HDMI consortium until December 31, 2016. From time to time, as the agent, we performed audits on royalty reporting customers to ensure compliance. As a result of those compliance efforts, we entered into settlement agreements for the payment of unreported royalties. The contractual terms of those agreements provided for upfront payment of unreported royalties or payment over a period of time, generally not to exceed one year. Revenue from those arrangements was recognized when the agreement was executed by both parties, as long as price was fixed and determinable and collection was reasonably assured. Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method for financial reporting purposes over the estimated useful lives of the related assets, generally three to five years for equipment and software, one to three years for tooling, and thirty years for buildings and building space. Leasehold improvements are amortized over the shorter of the non-cancelable lease term or the estimated useful life of the assets. Upon disposal of property and equipment, the accounts are relieved of the costs and related accumulated depreciation and amortization, and resulting gains or losses are reflected in the Consolidated Statements of Operations for recognized gains and losses or in the Consolidated Balance Sheets for deferred gains and losses. Repair and maintenance costs are expensed as incurred. Recently Adopted Accounting Standards In July 2015, the FASB issued ASU 2015-11, Simplifying the Measurement of Inventory. Under this ASU, inventory will be measured at the “lower of cost or net realizable value” and options that currently exist for “market value” will be eliminated. The ASU defines net realizable value as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” We adopted this ASU in the first quarter of 2017, and it did not have a material impact on our consolidated financial statements. In March 2016, the FASB issued ASU 2016-09, Compensation - Stock Compensation, Improvements to Employee Share-Based Payment Accounting (Topic 718). This ASU simplifies several aspects of the accounting for share-based payment transactions, including accounting for income taxes, forfeitures, classification of awards as either equity or liabilities, statutory tax withholding requirements, and classification within the statement of cash flows. We adopted this ASU in the first quarter of fiscal 2017. As a result of the adoption of this ASU, we recognized deferred tax assets of $5.7 million for the excess tax benefits that arose directly from tax deductions related to equity compensation greater than amounts recognized for financial reporting and also recognized an increase of an equal amount in the valuation allowance against those deferred tax assets. The adoption of this ASU did not have any other material impacts on our consolidated financial statements. In October 2016, the FASB issued ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. This update is intended to recognize the income tax consequences of intra-entity transfers of assets other than inventory when they occur by removing the exception to postpone recognition until the asset has been sold to an outside party. For public business entities, this guidance is effective for interim and annual periods beginning after December 15, 2017. Early adoption is permitted, and it is required to be applied on a modified retrospective basis through a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. We early adopted this accounting standard in the first quarter of fiscal 2017 and recorded a nominal amount to accumulated deficit based on the guidance, as detailed in Note 10. Recently Issued Accounting Standards In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. In August 2015, the FASB issued ASU 2015-14 deferring the effective date of ASU 2014-09 to periods beginning on or after December 15, 2017, with early adoption permitted for annual reporting periods beginning after December 15, 2016, and interim periods within that year. We intend to adopt ASU 2014-09 on December 31, 2017 which is the first day of our fiscal 2018. The new standard allows for two transition methods - (i) apply it retrospectively to each prior reporting period presented, or (ii) apply it prospectively with the cumulative effect of adoption recognized on December 31, 2017, the first day of our fiscal 2018. We have not yet concluded upon our selection of the transition method. We have commenced our implementation efforts, which have thus far focused on developing a project plan and performing a preliminary assessment of potential impacts of the new standard to our financial statements. Key elements of our project plan include the final determination of the impacts of the standard to revenues, contract acquisition costs, income taxes and various balance sheet accounts; the identification of additional system requirements, if any, to support our application of the new standard; and the design and implementation of relevant internal controls. We believe that we have sufficient time and resources to complete our implementation efforts no later than the fourth quarter of fiscal 2017. Based on our initial assessment, we believe the most significant impact of the new standard will be to accelerate the timing of revenue recognition on product shipments to our sell-through distributors (which accounted for approximately two-thirds of product revenue and approximately 60% of total revenue during both the first quarter of fiscal 2017 and the year ended December 31, 2016). Assuming all other revenue recognition criteria have been met, the new guidance would require us to recognize revenue and costs relating to such sales upon shipment to the distributor - subject to reductions for estimated reserves for price adjustments and returns - rather than upon the ultimate sale by the distributor to its end customer, as is our current practice. In January 2016, the FASB issued ASU No. 2016-01, Recognition and Measurement of Financial Assets and Financial Liabilities, to mainly change the accounting for investments in equity securities and financial liabilities carried at fair value as well as to modify the presentation and disclosure requirements for financial instruments. The ASU is effective for interim and annual periods beginning after December 15, 2017, with early adoption permitted. Adoption of the ASU is retrospective with a cumulative adjustment to retained earnings or accumulated deficit as of the adoption date. We are currently evaluating the impact of ASU 2016-01 on our consolidated financial statements and related disclosures. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which requires that substantially all leases, including current operating leases, be recognized by lessees on their balance sheet as a right-of-use asset and corresponding lease liability. For public business entities, the standard is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted for all entities. We are currently evaluating the impact of ASU 2016-02 on our consolidated financial statements and related disclosures. In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments. The new guidance is intended to reduce diversity in practice in how cash receipts and cash payments are classified in the statement of cash flows. For public business entities, this guidance will be effective for interim and annual periods beginning after December 15, 2017. Early adoption is permitted. We are currently evaluating the impact of ASU 2016-15 on our consolidated financial statements and related disclosures. In January 2017, the FASB issued ASU No. 2017-01, Clarifying the Definition of a Business, which narrows the existing definition of a business and provides a framework for evaluating whether a transaction should be accounted for as an acquisition (or disposal) of assets or a business. This update requires an entity to evaluate if substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets; if so, the set of transferred assets and activities (collectively, the set) is not a business. To be considered a business, the set would need to include an input and a substantive process that together significantly contribute to the ability to create outputs. The standard also narrows the definition of outputs. The definition of a business affects areas of accounting such as acquisitions, disposals and goodwill. Under the new guidance, fewer acquired sets are expected to be considered businesses. For public business entities, this guidance is effective for interim and annual periods beginning after December 15, 2017. We are currently evaluating the impact of ASU 2017-01 on our consolidated financial statements and related disclosures. In January 2017, the FASB issued ASU 2017-04, Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which simplifies the subsequent measurement of goodwill by eliminating step two from the goodwill impairment test. Under the new guidance, an entity will recognize an impairment charge for the amount by which the carrying value exceeds the fair value. This standard is effective for annual or any interim goodwill impairment tests in fiscal years beginning after December 15, 2019. Early adoption is permitted for interim or annual goodwill impairment tests performed on testing dates after January 1, 2017 and requires a prospective transition method. We are currently evaluating the impact of ASU 2017-04 on our consolidated financial statements and related disclosures. Note 2 - Net Loss per Share We compute basic net loss per share by dividing net loss by the weighted average number of common shares outstanding during the period. To determine diluted share count, we apply the treasury stock method to determine the dilutive effect of outstanding stock option shares, restricted stock units ("RSUs"), and Employee Stock Purchase Plan ("ESPP") shares. Our application of the treasury stock method includes, as assumed proceeds, the average unamortized stock-based compensation expense for the period and the impact of the pro forma deferred tax benefit or cost associated with stock-based compensation expense. When we are in a net loss position, we do not include dilutive securities as their inclusion would reduce the net loss per share. A summary of basic and diluted net loss per share is presented below: Basic and diluted net loss Shares used in basic and diluted net loss per share The computation of diluted net loss per share for the three months ended April 1, 2017 and April 2, 2016 excludes the effects of stock options, RSUs, and ESPP shares that are antidilutive, aggregating approximately the following number of shares: Stock options, RSUs, and ESPP shares excluded as they are antidilutive Stock options, RSUs, and ESPP shares are considered antidilutive when the aggregate of exercise price and unrecognized stock-based compensation expense are greater than the average market price for our common stock during the period or when the Company is in a net loss position, as the effects would reduce the loss per share. Stock options, RSUs, and ESPP shares that are antidilutive at April 1, 2017 could become dilutive in the future. Note 3 - Marketable Securities We classify our marketable securities as short-term based on their nature and availability for use in current operations. Our short-term marketable securities currently have contractual maturities of up to two years. The following table summarizes the remaining maturities of our marketable securities at fair value: Short-term marketable securities: Maturing within one year Maturing between one and two years Total marketable securities The following table summarizes the composition of our marketable securities at fair value: Corporate and government bonds and notes, and commercial paper Note 4 - Fair Value of Financial Instruments Fair value measurements as of Foreign currency forward exchange contracts, net Total fair value of financial instruments We invest in various financial instruments that may include corporate and government bonds and notes, commercial paper, and certificates of deposit. In addition, we enter into foreign currency forward exchange contracts to mitigate our foreign currency exchange rate exposure. We carry these instruments at their fair value in accordance with ASC 820, "Fair Value Measurements and Disclosures." The framework under the provisions of ASC 820 establishes three levels of inputs that may be used to measure fair value. Each level of input has different levels of subjectivity and difficulty involved in determining fair value, as summarized in Note 1. There were no transfers between any of the levels during the first three months of fiscal 2017 or 2016. In accordance with ASC 320, “Investments-Debt and Equity Securities,” we recorded an unrealized loss of less than $0.1 million during each of the three months ended April 1, 2017 and April 2, 2016 on certain short-term marketable securities (Level 1 instruments), which have been recorded in accumulated other comprehensive loss. Future fluctuations in fair value related to these instruments that we deem to be temporary, including any recoveries of previous write-downs, would be recorded to accumulated other comprehensive loss. If we were to determine in the future that any further decline in fair value is other-than-temporary, we would record an impairment charge, which could have a material adverse effect on our operating results. If we were to liquidate our position in these securities, it is likely that the amount of any future realized gain or loss would be different from the unrealized gain or loss reported in accumulated other comprehensive loss. Note 5 - Inventories Note 6 - Goodwill Goodwill represents the excess of the purchase price over the fair value of the underlying net tangible and intangible assets. Goodwill is not amortized, but is instead tested for impairment annually or more frequently if certain indicators of impairment are present. We do not expect goodwill impairment to be tax deductible for income tax purposes. No impairment charges relating to goodwill were recorded for the first three months of fiscal 2017 or fiscal 2016 as no indicators of impairment were present. In the first quarter of 2016, we finalized our valuation and allocation of purchase price consideration resulting in $2.1 million of additional long-term liabilities related to an uncertain tax position with an equivalent revision to Goodwill, which is reflected in the Consolidated Balance Sheets for the period ended December 31, 2016. The goodwill balance of $270 million at both April 1, 2017 and December 31, 2016 is comprised of $45 million from prior acquisitions combined with the $238 million from the acquisition of Silicon Image, reduced by the fiscal 2015 goodwill impairment charge of $13 million. Note 7 - Intangible Assets In connection with our acquisitions of Silicon Image in March 2015 and SiliconBlue in December 2011 we recorded identifiable intangible assets related to developed technology, customer relationships, licensed technology, patents, and in-process research and development based on guidance for determining fair value under the provisions of ASC 820, "Fair Value Measurements and Disclosures." Additionally, during fiscal 2015, we licensed additional third-party technology. On our Consolidated Balance Sheets, intangible assets are shown net of accumulated amortization of $84.9 million and $78.5 million at April 1, 2017 and December 31, 2016, respectively. During the first quarter of fiscal 2017, we sold a portfolio of patents that had been acquired from Silicon Image. As a result of this transaction, intangible assets, net of amortization was reduced by approximately $3.5 million. We monitor the carrying value of our intangible assets for potential impairment and test the recoverability of such assets annually during the fourth quarter and whenever events or changes in circumstances indicate that their carrying amounts may not be recoverable. No impairment charges related to intangible assets were recorded for the first three months of either fiscal 2017 or fiscal 2016 as no indicators of impairment were present. We recorded amortization expense related to intangible assets on the Consolidated Statements of Operations as follows: Note 8 - Equity Method Investment In the first and third quarters of fiscal 2015, we purchased a preferred stock ownership interest in a privately-held company that designs human-computer interaction technology for total consideration of $3.0 million. This investment accounted for a 15.8% ownership interest by the end of the third quarter of fiscal 2015 and was accounted for under the cost method as we did not have the ability to exert significant influence over the investee. In the fourth quarter of fiscal 2015, we increased our ownership interest to 22.7% by making an additional investment of $2.0 million. This increased our gross investment in the investee to $5.0 million. As a result of the change in ownership interest and after considering the changes in the level of our participation in the management of and interaction with the investee, we determined that we have the ability to exert significant influence over the investee. Accordingly, we changed our accounting for the investment from the cost method to the equity method and have hence recognized our proportionate share of the investee’s operating results in the Consolidated Statements of Operations. In the third quarter of fiscal 2016, we made an additional investment of $1.0 million via a convertible debt instrument, bringing our gross investment in the investee to $6.0 million. We have determined that this additional investment is an in-substance common stock and has been included in our equity method accounting. Applying the equity method, the proportionate share of the investee's net loss that we have recognized in the Consolidated Statements of Operations for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Through April 1, 2017, we have reduced the value of our investment by approximately $2.3 million, representing our cumulative proportionate share of the privately-held company’s net loss accumulated to that date. The net balance of our investment included in other long-term assets in the Consolidated Balance Sheets is detailed in the following table: Balance at April 1, 2017 Note 9 - Accounts Payable and Accrued Expenses Included in accounts payable and accrued liabilities as of April 1, 2017 and December 31, 2016 were the following balances: Trade accounts payable Liability for non-cancelable contracts Payable to members of the MHL and HDMI consortia* Other accrued expenses Total accounts payable and accrued expenses * As an agent of the MHL consortium, we administer royalty reporting and distributions to the members of this consortium. This excludes amounts payable to us, and is payable quarterly based on collections from MHL customers. Our role as the agent of the HDMI consortium terminated on January 1, 2017 and, therefore, the balance as of April 1, 2017 is due to MHL consortium members only. Note 10 - Changes in Stockholders' Equity and Accumulated Other Comprehensive Loss Additional Paid-in Balances, December 31, 2016 Net loss for the three months ended April 1, 2017 Recognized loss on redemption of marketable securities, previously unrealized Translation adjustments, net of tax Common stock issued in connection with the exercise of stock options, ESPP and vested RSUs, net of tax Stock-based compensation expense related to stock options, ESPP and RSUs Accounting method transition adjustment Balances, April 1, 2017 During the first quarter of fiscal 2017, we early adopted ASU 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory. This guidance is required to be applied on a modified retrospective basis through a cumulative-effect adjustment to the balance sheet as of the beginning of the fiscal year of adoption. As a result of this adoption, we recorded a nominal amount to accumulated deficit, as detailed in the table above. Note 11 - Income Taxes For the three months ended April 1, 2017 and April 2, 2016, we recorded an income tax provision of approximately $0.5 million and $1.9 million, respectively. The income tax provision for the three months ended April 1, 2017 represents tax at the federal, state, and foreign statutory tax rates adjusted for withholding taxes, changes in uncertain tax positions, changes in the U.S. valuation allowance, as well as other non-deductible items in the United States and foreign jurisdictions. The difference between the U.S. federal statutory tax rate of 35% and our negative effective tax rates for the three months ended April 1, 2017 is primarily due to a valuation allowance increase that offsets the otherwise expected tax benefit from the pretax loss in the United States, and to the zero tax rate in Bermuda which results in no tax benefit for the pretax loss in Bermuda. In 2016, we evaluated the valuation allowance position in the United States and concluded that we should maintain a valuation allowance against our federal and state deferred tax assets. We reached the same conclusion through April 1, 2017. We will continue to evaluate both positive and negative evidence in future periods to determine if we should recognize more deferred tax assets. We don't have a valuation allowance in any foreign jurisdictions as it has been concluded it is more-likely-than-not that we will realize the net deferred tax assets in future periods. We are subject to federal and state income tax as well as income tax in the various foreign jurisdictions in which we operate. Additionally, the years that remain subject to examination are 2013 for federal income taxes, 2012 for state income taxes, and 2010 for foreign income taxes, including years ending thereafter. However, to the extent allowed by law, the tax authorities may have the right to examine prior periods where net operating losses or tax credits were generated and carried forward, and make adjustments up to the amount of the net operating losses or credit carryforward amount. Our income tax return for India is currently under examination for the fiscal year ended March 31, 2015. We are not under examination in any other jurisdiction. We believe that it is reasonably possible that $1.7 million of unrecognized tax benefits and $0.1 million of associated interest and penalties could be recognized during the next twelve months. The $1.7 million potential change would represent a decrease in unrecognized tax benefits, comprised of items related to tax filings for years that will no longer be subject to examination under expiring statutes of limitations. At December 31, 2016, we had U.S. federal net operating loss ("NOL") carryforwards (pretax) of approximately $367.0 million that expire at various dates between 2025 and 2036. We had state NOL carryforwards (pretax) of approximately $193.3 million that expire at various dates from 2017 through 2036. We also had federal and state credit carryforwards of $49.2 million and $56.7 million, respectively. Of the total $105.9 million credit carryforwards, $55.5 million do not expire. The remaining credits expire at various dates from 2017 through 2036. Our liability for uncertain tax positions (including penalties and interest) was $28.0 million and $29.6 million at April 1, 2017 and December 31, 2016, respectively, and is recorded as a component of other long-term liabilities on our Consolidated Balance Sheets. The remainder of our uncertain tax position exposure is netted against deferred tax assets. We are not currently paying U.S. federal income taxes and do not expect to pay such taxes until we fully utilize our tax NOL and credit carryforwards. We expect to pay a nominal amount of state income tax. We are paying foreign income and withholding taxes, which are reflected in income tax expense in our Consolidated Statements of Operations and are primarily related to the cost of operating offshore activities and subsidiaries. We accrue interest and penalties related to uncertain tax positions in income tax expense. Note 12 - Restructuring In March 2015, our Board of Directors approved an internal restructuring plan (the "March 2015 Plan"), in connection with our acquisition of Silicon Image. The March 2015 Plan was designed to realize synergies from the acquisition by eliminating redundancies created as a result of combining the two companies. This included reductions in our worldwide workforce, consolidation of facilities, and cancellation of software contracts and engineering tools. The March 2015 Plan is substantially complete subject to certain remaining expected costs that we do not expect to be material and any changes in sublease assumptions should they occur, which will be expensed as incurred according to U.S. GAAP. Under this plan, approximately $0.3 million and $3.6 million of expense was incurred during the three months ended April 1, 2017 and April 2, 2016, respectively. Approximately $20.9 million of total expense has been incurred through April 1, 2017 under the March 2015 Plan. We expect the total cost of the March 2015 Plan to be approximately $21.0 million. In September 2015, we implemented a further reduction of our worldwide workforce (the "September 2015 Reduction") separate from the March 2015 Plan. The September 2015 Reduction was designed to resize the company in line with the market environment and to better balance our workforce with the long-term strategic needs of our business. The September 2015 Reduction is substantially complete subject to certain remaining expected costs, which we do not expect to be material but which will be expensed as incurred according to U.S. GAAP. Under this reduction, approximately $0.2 million of credit and $1.8 million of expense were incurred during the three months ended April 1, 2017 and April 2, 2016, respectively. Approximately $7.7 million of total expense has been incurred through April 1, 2017 under the September 2015 Reduction. We expect the total cost of the September 2015 Reduction to be approximately $8.0 million. These expenses were recorded to restructuring charges on our Consolidated Statements of Operations. The restructuring accrual balance is presented in accounts payable and accrued expenses (includes restructuring) on our Consolidated Balance Sheets. The following table displays the combined activity related to the restructuring actions described above: Severance & related * Lease Termination Software Contracts & Engineering Tools ** Balance at January 2, 2016 Costs paid or otherwise settled * Includes employee relocation costs **Includes cancellation of contracts, asset impairments, and accelerated depreciation on certain enterprise resource planning and customer relationship management systems Note 13 - Long-Term Debt On March 10, 2015, we entered into a secured credit agreement (the "Credit Agreement") with Jefferies Finance, LLC and certain other lenders for purposes of funding, in part, our acquisition of Silicon Image. The Credit Agreement provided for a $350 million term loan (the "Term Loan") maturing on March 10, 2021 (the "Term Loan Maturity Date"). We received $346.5 million net of an original issue discount of $3.5 million and we paid debt issuance costs of $8.3 million. The Term Loan bears variable interest equal to the 3-month LIBOR as of April 1, 2017, subject to a 1.00% floor if necessary, plus a spread of 4.25%. The current effective interest rate on the Term Loan is 5.97%. The Term Loan is payable through a combination of (i) quarterly installments of approximately $0.9 million, (ii) annual excess cash flow payments as defined in the Credit Agreement, which are due 95 days after the last day of our fiscal year, and (iii) any payments due upon certain issuances of additional indebtedness and certain asset dispositions, with any remaining outstanding principal amount due and payable on the Term Loan Maturity Date. The percentage of excess cash flow we are required to pay ranges from 0% to 75%, depending on our leverage and other factors as defined in the Credit Agreement. Currently, the Credit Agreement would require a 75% excess cash flow payment. In the first quarter of fiscal 2017, we made a required additional principal payment of $9.9 million due to a sale of patents. Since the end of the first quarter of fiscal 2017, we made a required annual excess cash flow payment of $13.7 million. Over the next twelve months, our principal payments will be comprised mainly of regular quarterly installments and a required additional principal payment driven by the final installment expected for the previously mentioned sale of patents. While the Credit Agreement does not contain financial covenants, it does contain informational covenants and certain restrictive covenants, including limitations on liens, mergers and consolidations, sales of assets, payment of dividends, and indebtedness. We were in compliance with all such covenants at April 1, 2017. The original issue discount and the debt issuance costs have been accounted for as a reduction to the carrying value of the Term Loan on our Consolidated Balance Sheets and are being amortized to interest expense in our Consolidated Statements of Operations over the contractual term, using the effective interest method. The fair value of the Term Loan approximates the carrying value, which is reflected in our Consolidated Balance Sheets as follows: Unamortized original issue discount and debt costs Less: Current portion of long-term debt Interest expense related to the Term Loan was included in Interest expense on our Consolidated Statements of Operations as follows: Contractual interest Total Interest expense related to the Term Loan As of April 1, 2017, expected future principal payments on the Term Loan were as follows: 2017 (remaining 9 months) Note 14 - Stock-Based Compensation Total stock-based compensation expense included in our Consolidated Statements of Operations was as follows: Cost of products sold Total stock-based compensation We granted stock options with a market condition to certain executives in fiscal years 2015 and 2016. The options have a two year vesting and vest between 0% and 200% of the target amount, based on the Company's relative Total Shareholder Return (TSR) when compared to the TSR of a component of companies of the PHLX Semiconductor Sector Index over a two year period. TSR is a measure of stock price appreciation plus dividends paid, if any, in the performance period. The fair values of the options were determined and fixed on the date of grant using a lattice-based option-pricing valuation model, which incorporates a Monte-Carlo simulation, and considered the likelihood that we would achieve the market condition. Of these grants with a market condition, approximately 596,600 were outstanding and unvested at December 31, 2016. During the first quarter of fiscal 2017, approximately 91,500 grants vested, and approximately 183,200 were canceled due to the expiration of the vesting period for the 2015 tranche. A total of approximately 413,400 stock options were outstanding as of April 1, 2017, which includes the approximately 91,500 that vested but were not exercised. We incurred stock compensation expense related to these market condition awards of approximately $0.2 million in the first quarter of fiscal 2017 and approximately $0.1 million in the first quarter of fiscal 2016. Note 15 - Contingencies In February 2016, we filed a complaint against Technicolor SA and its affiliates in the United States District Court for the Northern District of California alleging that Technicolor had infringed on certain patents relating to the HDMI specification. Technicolor filed an answer to our complaint on April 11, 2016, which included various defenses to the alleged patent infringement. In November 2016, Technicolor amended its answer and asserted a counterclaim, alleging that the Company’s action constituted a breach of the HDMI Founders Agreement to provide licenses on fair, reasonable and non-discriminatory terms. Technicolor seeks declaratory relief and compensation for the alleged breach. At this stage of the proceedings, we do not have an estimate of the likelihood or the amount of any financial consequences to us. On or about January 9, 2017, Lattice, members of our Board, Canyon Bridge Capital Partners, Inc., Canyon Bridge Acquisition Company, Inc. and Canyon Bridge Merger Sub Inc. were named as defendants in a complaint filed in the United States District Court for the District of Oregon by an alleged stockholder of the Company in connection with the proposed acquisition of the Company by Canyon Bridge. The complaint was captioned Paul Parshall, et al. v. Lattice, et al. and alleges violations of federal securities laws based on alleged deficiencies in the disclosure provided to shareholders regarding the transaction. An additional complaint was subsequently filed on or about January 27, 2017, naming Lattice and members of our Board, in the United States District Court for the District of Delaware. This complaint is captioned Robert Sellers, et al. v. Lattice, et al. The Company supplemented its disclosures to the Company’s shareholders regarding the transaction prior to the meeting of shareholders to approve the transaction. As a result of the supplemented disclosure, counsel for plaintiffs in both actions entered into stipulations to dismiss the actions and the Oregon and Delaware actions were dismissed by stipulation on March 13, 2017 and March 21, 2017, respectively. In both cases, the courts retained jurisdiction to determine the mootness fees to be paid to plaintiffs’ counsel. At this stage of the proceedings, we do not have an estimate of the likelihood or the amount of any potential exposure to the Company but such amount is not expected to have a material adverse effect on the financial position of the Company. We are exposed to certain other asserted and unasserted potential claims. There can be no assurance that, with respect to potential claims made against us, we could resolve such claims under terms and conditions that would not have a material adverse effect on our business, our liquidity or our financial results. Periodically, we review the status of each significant matter and assess its potential financial exposure. If the potential loss from any claim or legal proceeding is considered probable and a range of possible losses can be estimated, we then accrue a liability for the estimated loss based on the provisions of FASB ASC 450, “Contingencies" (“ASC 450”). Legal proceedings are subject to uncertainties, and the outcomes are difficult to predict. Because of such uncertainties, accruals are based only on the best information available at the time. As additional information becomes available, we reassess the potential liability related to pending claims and litigation and may revise estimates. Note 16 - Segment and Geographic Information As of April 1, 2017, Lattice had one operating segment: the core Lattice business, which includes IP and semiconductor devices. Qterics, a discrete software-as-a-service business unit, was previously an immaterial operating segment in the Lattice legal entity structure. In April 2016, we sold Qterics to an unrelated third party for net proceeds of $2.0 million, net of cash sold, resulting in a gain of $2.6 million. The gain was included in Other (expense) income, net in the Consolidated Statements of Operations in the period of sale. Our revenue by major geographic area, based on ship-to location, was as follows: We assign revenue to geographies based on the customer ship-to address at the point where revenue is recognized. In the case of sell-in distributors and OEM customers, revenue is typically recognized, and geography is assigned, when products are shipped to our distributor or customer. In the case of sell-through distributors, revenue is recognized when resale occurs and geography is assigned based on the customer location on the resale reports provided by the distributor. There were no material changes to property and equipment by major geographic area as of April 1, 2017 as compared to December 31, 2016. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Lattice Semiconductor (“Lattice,” the “Company,” “we,” “us,” or “our”) engages in smart connectivity solutions, providing intellectual property ("IP") and low-power, small form-factor devices that enable global customers to quickly deliver innovative and differentiated cost and power efficient products. Our broad end-market exposure extends from mobile devices and consumer electronics to industrial and automotive equipment, communications and computing infrastructure, and licensing. Lattice was founded in 1983 and is headquartered in Portland, Oregon. Plan of Merger and Reorganization On November 3, 2016, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Canyon Bridge Acquisition Company, Inc., a Delaware corporation (“Parent”), and Canyon Bridge Merger Sub, Inc., a Delaware corporation and wholly owned subsidiary of Parent (“Merger Sub”), providing for the merger of Merger Sub with and into the Company (the “Merger”), with the Company surviving the Merger as a wholly owned subsidiary of Parent. At the effective time of the Merger, each share of common stock, par value $0.01 per share, of the Company (the “Shares”) that is outstanding immediately prior to such time (other than (i) Shares owned by Parent, Merger Sub, the Company (including any Shares held in the treasury of the Company) or by any direct or indirect wholly owned subsidiary of Parent, Merger Sub or the Company, or (ii) Shares held by stockholders of the Company who not have voted in favor of the Merger and who are entitled to demand and properly demand their statutory rights of appraisal in accordance with the Delaware General Corporation Law) will be canceled and extinguished and automatically converted into the right to receive cash in an amount equal to $8.30 per share (without interest and subject to deduction for any required withholding tax). Completion of the Merger is subject to various conditions, including the receipt of any required regulatory clearances related to the Merger from the Committee on Foreign Investment in the United States ("CFIUS") within the timeframe provided in the Merger Agreement. On March 24, 2017, to allow more time of review and discussion with CFIUS in connection with the Merger, the Company announced that it withdrew and re-filed the joint voluntary notice to CFIUS under the Defense Production Act of 1950, as amended. Critical Accounting Policies and Estimates Critical accounting policies are those that are both most important to the portrayal of a company's financial condition and results and require management's most difficult, subjective, and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management believes that there have been no significant changes to the items that we disclosed as our critical accounting policies and estimates in Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on form 10-K for the fiscal year ended December 31, 2016. The preparation of financial statements in conformity with U.S. generally accepted accounting principles ("U.S. GAAP") requires management to make estimates and assumptions that affect the reported amounts and classification of assets, such as marketable securities, accounts receivable, inventory, goodwill (including the assessment of reporting unit), intangible assets, current and deferred income taxes, accrued liabilities (including restructuring charges and bonus arrangements), deferred income and allowances on sales to sell-through distributors, disclosure of contingent assets and liabilities at the date of the financial statements, amounts used in acquisition valuations and purchase accounting, and the reported amounts of product revenue, licensing and services revenue, and expenses during the fiscal periods presented. Actual results could differ from those estimates. Key elements of our Consolidated Statements of Operations were as follows: (0.7 )% (13.8 Revenue by End Market The end market data below is derived from data provided to us by our distributors and end customers. With a diverse base of customers who may manufacture end products spanning multiple end markets, the assignment of revenue to a specific end market requires the use of estimates and judgment. Therefore, actual results may differ from those reported. Our Licensing and services end market includes revenue from the licensing of our IP, the collection of certain royalties, patent sales, the revenue related to our participation in consortia and standard-setting activities, and services. While Licensing products are primarily sold into the Mobile and Consumer market, Licensing and services revenue is reported separately as it has characteristics that differ from other categories, most notably its higher gross margin. The following are examples of end market applications: Communications and Computing Mobile and Consumer Industrial and Automotive IP Royalties Adopter Fees Data Backhaul IP Licenses Patent Sales The composition of our revenue by end market for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Revenue from the Communications and Computing end market decreased by 9% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 as additional purchases by a certain large customer in the prior year period did not recur in the current year period. Revenue from the Mobile and Consumer end market increased 28% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016. The increase was predominately due to a significant increase in volume for a major mobile handset provider. The production volume for this mobile handset appears to have peaked in the fourth quarter of fiscal 2016, and we expect the associated revenue stream to decline in future quarters as the device completes its lifecycle. Revenue from the Industrial and Automotive end market increased approximately 2% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 due to modestly increased shipments to a broad range of customers in this market. Revenue from the Licensing and Services end market increased 44% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016. This increase was predominantly due to a patent sale transaction, substantially offset by lower royalties for HDMI licensing as a new royalty sharing agreement had not been finalized, and by the termination of our role as agent for the HDMI consortium. Revenue by Geography We assign revenue to geographies based on customer ship-to address at the point where revenue is recognized. In the case of sell-in distributors and OEM customers, revenue is typically recognized, and geography is assigned, when products are shipped to our distributor or OEM customer. In the case of sell-through distributors, revenue is recognized when resale to the end customer occurs and geography is assigned based on the end customer location on the resale reports provided by the distributor. Both foreign and domestic sales are denominated in U.S. dollars. The composition of our revenue by geography, based on ship-to location, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Revenue in Asia increased 12% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016. Asia revenue is heavily affected by revenue from both the Mobile and Consumer and the Communications and Computing end markets. The increase was predominantly due to a significant increase in volume for a major mobile handset provider. The production volume for this mobile handset appears to have peaked in the fourth quarter of fiscal 2016, and we expect the associated revenue stream to decline in future quarters as the device completes its lifecycle. Revenue in Europe decreased 31% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 as the packaging line item reduction and related CPLD conversion programs neared completion. Revenue from the Americas increased 34% for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016. This revenue increase was predominantly the result of the patent sale transaction. Revenue from End Customers Our top five end customers constituted approximately 37% of our revenue for the first quarter of fiscal 2017, compared to approximately 27% for the first quarter of fiscal 2016. Our largest end customer accounted for approximately 12% of total revenue in the first quarter of fiscal 2017 and for approximately 8% of total revenue in the first quarter of fiscal 2016. No other customers accounted for more than 10% of total revenue during these periods. Revenue from Sell-Through Distributors Sales through distributors have historically accounted for a significant portion of our total revenue. Revenue attributable to resale of products by our primary sell-through distributors for the first quarter of fiscal 2017 and fiscal 2016 was as follows: % of Total Revenue Three Months Ended Arrow Electronics Inc. Weikeng Group All sell-through distributors Revenue from sell-through distributors increased to 60% of total revenue in the first quarter of fiscal 2017 from 53% in the first quarter of fiscal 2016. The increase on a percentage basis of revenue from sell-through distributors was due to an increase in volume for a major mobile handset provider through a sell-through distributor in the first quarter of fiscal 2017. The production volume for this mobile handset appears to have peaked in the fourth quarter of fiscal 2016, and we expect the associated revenue stream to decline in future quarters as the device completes its lifecycle. The composition of our gross margin, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Percentage of net revenue Product gross margin % Licensing and services gross margin % For the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016, gross margin decreased by 1.0 percentage point due to decreases in both product gross margin and licensing and services gross margin. The primary contributor to the 0.7 percentage point decrease in product gross margin was increased revenue from the lower margin mobile and consumer end market, partially offset by lower effective overhead rates and other favorable manufacturing cost variances. The primary contributor to the 13.2 percentage point decrease in licensing and services gross margin was due to the patent sale that occurred during the first quarter of 2017. The costs associated with the patent sale, primarily the net book value of the patents acquired from Silicon Image, were greater than usual for this category and had a substantial impact on licensing and services gross margin. Because of its higher margin, the licensing and services portion of our overall revenue can have a disproportionate impact on gross margin and profitability. For programmable and standard products, we expect that product, end market, and customer mix will subject our gross margin to fluctuation, while we expect downward pressure on average selling price to adversely affect our gross margin in the future. If we are unable to realize additional or sufficient product cost reductions in the future to balance changes in product and customer mix, we may experience degradation in our product gross margin. The composition of our research and development expense, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Percentage of revenue Mask costs included in Research and development Research and development expense includes costs for compensation and benefits, stock compensation, development masks, engineering wafers, depreciation, licenses, and outside engineering services. These expenditures are for the design of new products, IP cores, processes, packaging, and software to support new products. The decrease in research and development expense for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 is due mainly to the restructuring and integration of operations undertaken since the acquisition of Silicon Image, predominantly headcount reductions and site consolidations, along with reductions in mask costs, time-based licenses, and outside services, partially offset by higher bonus expenses. We believe that a continued commitment to research and development is essential to maintaining product leadership and providing innovative new product offerings and, therefore, we expect to continue to make significant future investments in research and development at approximately the percentage of revenue realized in the first quarter of fiscal 2017. Selling, General, and Administrative Expense The composition of our selling, general, and administrative expense, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Selling, general, and administrative expense includes costs for compensation and benefits related to selling, general, and administrative employees, commissions, depreciation, professional and outside services, trade show, and travel expenses. The increase in selling, general, and administrative expense for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 is due mainly to higher bonus and royalty expenses, substantially offset by lower travel costs, accounting fees, and outside services expenses. The composition of our amortization of acquired intangible assets, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: For the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016, amortization of acquired intangible assets decreased approximately $0.2 million. This is comprised of approximately $1.0 million less expense due to the reduction of certain intangibles as a result of patent sales or impairment charges, partially offset by approximately $0.8 million of additional amortization due to the completion of certain in-process research and development projects acquired from Silicon Image. The composition of our restructuring charges, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Restructuring charges include expenses resulting from reductions in our worldwide workforce, consolidation of our facilities, and cancellation of software contracts and engineering tools. In March 2015, our Board of Directors approved an internal restructuring plan (the "March 2015 Plan"), in connection with our acquisition of Silicon Image. The March 2015 Plan was designed to realize synergies from the acquisition by eliminating redundancies created as a result of combining the two companies. The March 2015 Plan is substantially complete subject to certain remaining expected costs that we do not expect to be material and any changes in sublease assumptions should they occur, which will be expensed as incurred according to U.S. GAAP. Approximately $20.9 million of total expense has been incurred through April 1, 2017 under the March 2015 Plan. We expect the total cost of the March 2015 Plan to be approximately $21.0 million. In September 2015, we implemented a further reduction of our worldwide workforce (the "September 2015 Reduction") separate from the March 2015 Plan. The September 2015 Reduction was designed to resize the company in line with the market environment and to better balance our workforce with the long-term strategic needs of our business. The September 2015 Reduction is substantially complete, subject to certain remaining expected costs that we do not expect to be material, which will be expensed as incurred according to U.S. GAAP. Approximately $7.7 million of total expense has been incurred through April 1, 2017 under the September 2015 Reduction. We expect the total cost of the September 2015 Reduction to be approximately $8.0 million. The $5.4 million decrease in restructuring expense in the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 is driven by significant headcount-related, lease and systems restructuring charges in the prior year quarter versus only residual restructuring activity occurring in the first quarter of fiscal 2017. The composition of our acquisition related charges, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: For the first quarter of fiscal 2017, acquisition related charges were entirely attributable to legal fees and outside services in connection with our pending acquisition by Canyon Bridge Acquisition Company, Inc. The acquisition related charges for the first quarter of fiscal 2016 were residual expenses related to consolidation of legal entities due to our acquisition of Silicon Image in March 2015. Interest expense, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: The increase in interest expense for the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016 was primarily driven by increased amortization of the original issue discount and debt issuance costs related to our long-term debt. This amortization is based on the effective interest method and the increase was the result of a change in the expected annual excess cash flow payments on the debt. See the Credit Arrangements section under Liquidity and Capital Resources for further discussion of the debt. The composition of our other (expense) income, net, including as a percentage of revenue, for the first quarter of fiscal 2017 and fiscal 2016 was as follows: For the first quarter of fiscal 2017 compared to the first quarter of fiscal 2016, the change in other (expense) income, net is primarily driven by increased foreign exchange losses in the current quarter versus exchange gains in the first quarter of fiscal 2016 combined with proceeds from the distribution of a bankruptcy settlement of a prior customer received in the prior year which did not recur in the current quarter. The composition of our income taxes for the first quarter of fiscal 2017 and fiscal 2016 was as follows: Our tax expense for the first quarter of fiscal 2017 decreased as compared to the first quarter of fiscal 2016 primarily due to the decrease in foreign withholding taxes as a result of the termination of our role as the HDMI agent. We are not currently paying U.S. federal income taxes and do not expect to pay such taxes until we fully utilize our tax net operating loss and credit carryforwards. We expect to pay a nominal amount of state income tax. We are paying foreign income taxes, which are primarily related to withholding taxes on income from foreign royalties, and related to foreign sales and to the cost of operating offshore research and development, marketing, and sales subsidiaries. We accrue interest and penalties related to uncertain tax positions in income tax expense on our Consolidated Statements of Operations. The inherent uncertainties related to the geographical distribution and relative level of profitability among various high and low tax jurisdictions make it difficult to estimate the impact of the global tax structure on our future effective tax rate. Equity in net loss of an unconsolidated affiliate The composition of our equity in net loss of an unconsolidated affiliate for the first quarter of fiscal 2017 and fiscal 2016 was as follows: As of April 1, 2017, we held a 22.7% preferred stock ownership interest in a privately-held company that designs human-computer interaction technology for a total investment of $6.0 million. Due to the level of our ownership interest and after considering the nature of our participation in the management and interaction with the investee, we have determined that we have the ability to exert significant influence on the investee. Accordingly, we have accounted for the investment using the equity method and have recognized our proportionate share of the investee's net loss in the Consolidated Statements of Operations. Through April 1, 2017, we have reduced the value of our investment by approximately $2.3 million, representing our proportionate share of the privately-held company’s net loss accumulated to that date. The following sections discuss the effects of changes in our Consolidated Balance Sheets and the effects of our credit arrangements and contractual obligations on our liquidity and capital resources, as well as our non-GAAP measures. We classify our marketable securities as short-term based on their nature and availability for use in current operations. Our cash equivalents and short-term marketable securities consist primarily of high quality, investment-grade securities. We have historically financed our operating and capital resource requirements through cash flows from operations. Cash provided by or used in operating activities will fluctuate from period to period due to fluctuations in operating results, the timing and collection of accounts receivable, and required inventory levels, among other things. We believe that our financial resources will be sufficient to meet our working capital needs through at least the next 12 months. As of April 1, 2017, we did not have significant long-term commitments for capital expenditures. In the future, and to the extent our Credit Agreement permits, we may continue to consider acquisition opportunities to further extend our product or technology portfolios and further expand our product offerings. In connection with funding capital expenditures, completing other acquisitions, securing additional wafer supply, or increasing our working capital, we may seek to obtain equity or additional debt financing, or advance purchase payments or similar arrangements with wafer manufacturers. We may also need to obtain equity or additional debt financing if we experience downturns or cyclical fluctuations in our business that are more severe or longer than we anticipated when determining our current working capital needs, which financing may now be more difficult to obtain in light of our indebtedness related to the Credit Agreement. Cash and cash equivalents and Short-term marketable securities $ Change Total Cash and cash equivalents and Short-term marketable securities As of April 1, 2017, we had total cash and cash equivalents and short-term marketable securities of $109.4 million, of which approximately $53.5 million in cash and cash equivalents was held by our foreign subsidiaries. We manage our global cash requirements considering (i) available funds among the subsidiaries through which we conduct business, (ii) the geographic location of our liquidity needs, and (iii) the cost to access international cash balances. The repatriation of non-U.S. earnings may have adverse tax consequences as we may be required to pay and record income tax expense on those funds to the extent they were previously considered permanently reinvested. As of April 1, 2017, we could access all cash held by our foreign subsidiaries without incurring significant additional expense. The net decrease in cash and cash equivalents and short-term marketable securities of $7.4 million between December 31, 2016 and April 1, 2017 was primarily driven by $10.8 million cash used in the repayment of debt and $5.0 million of cash used in capital expenditures and payment for software licenses, offset by $7.7 million in cash provided by operations, which includes $10.0 million received from a patent sale transaction. Days sales outstanding - Overall Days sales outstanding - Product Days sales outstanding - Licensing and services Accounts receivable, net as of April 1, 2017 decreased by $33.6 million, or 34%, compared to December 31, 2016 due to a decrease in billings in the quarter mainly to our sell-through customers. Overall days sales outstanding at April 1, 2017 was 57 days, a decrease of 20 days from 77 days at December 31, 2016. Days sales outstanding at April 1, 2017 related to Product revenue was 61 days, a decrease of 14 days from 75 days at December 31, 2016, due to a larger decrease in product receivables as compared to the decrease in product revenue from prior quarter. Days sales outstanding at April 1, 2017 related to Licensing and services revenue was 32 days, a decrease of 74 days from 106 days at December 31, 2016, due to an increase in cash sales, mainly related to the patent sale transaction during the quarter. Months of inventory on hand Inventories as of April 1, 2017 decreased $1.4 million, or 2%, compared to December 31, 2016 as inventory related to a major consumer product declined in response to the ramp down of this product's sales program. Additionally, we continued to clear inventory related to packaging line item reductions and related CPLD conversions, and from the consumption of older product line stocks. Months of inventory on hand increased to 5.3 months at April 1, 2017 from 4.3 months at December 31, 2016. Credit Arrangements On March 10, 2015, we entered into a secured credit agreement (the "Credit Agreement") with Jefferies Finance, LLC and certain other lenders for purposes of funding, in part, our acquisition of Silicon Image. The Credit Agreement provided for a $350 million term loan (the "Term Loan") maturing on March 10, 2021 (the "Term Loan Maturity Date"). We received $346.5 million, net of an original issue discount of $3.5 million and we paid debt issuance costs of $8.3 million. The Term Loan bears variable interest equal to the 3-month LIBOR, subject to a 1.00% floor if necessary, plus a spread of 4.25%. The current effective interest rate on the Term Loan is 5.97%. As of April 1, 2017, we had no significant long-term purchase commitments for capital expenditures or existing used or unused credit arrangements. Contractual Cash Obligations There have been no significant changes to our contractual obligations outside of the ordinary course of business in the first three months of fiscal 2017 as summarized in Management's Discussion and Analysis of Financial Condition and Results of Operations in the Company's Annual Report on Form 10-K for the year ended December 31, 2016. As of April 1, 2017, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K. To supplement our consolidated financial results presented in accordance with U.S. Generally Accepted Accounting Principles ("GAAP"), we also present non-GAAP financial measures which are adjusted from the most directly comparable U.S. GAAP financial measures. The non-GAAP measures set forth below exclude charges and adjustments primarily related to stock-based compensation, restructuring charges, acquisition-related charges, amortization of acquired intangible assets, purchase accounting adjustments, and the estimated tax effect of these items. These charges and adjustments may be nonrecurring in nature but are a result of periodic or non-core operating activities of the company. Management believes that these non-GAAP financial measures provide an additional and useful way of viewing aspects of our performance that, when viewed in conjunction with our U.S. GAAP results, provide a more comprehensive understanding of the various factors and trends affecting our ongoing financial performance and operating results than GAAP measures alone. In particular, investors may find the non-GAAP measures useful in reviewing our operating performance without the significant accounting charges resulting from the Silicon Image acquisition, alongside the comparably adjusted prior year results. Management also uses these non-GAAP measures for strategic and business decision-making, internal budgeting, forecasting, and resource allocation processes and believes that investors should have access to similar data when making their investment decisions. In addition, these non-GAAP financial measures facilitate management’s internal comparisons to our historical operating results and comparisons to competitors’ operating results. These non-GAAP measures are included solely for informational and comparative purposes and are not meant as a substitute for GAAP and should be considered together with the consolidated financial information located in this report. Pursuant to the requirements of Regulation S-K and to make clear to our investors the adjustments we make to U.S. GAAP measures, we have provided the following reconciliations of the non-GAAP measures to the most directly comparable U.S. GAAP financial measures. Reconciliation of U.S. GAAP to Non-GAAP Financial Measures Gross Margin Reconciliation GAAP Gross margin Acquisition related inventory fair value effect (1) Stock-based compensation expense - gross margin Non-GAAP Gross margin Gross Margin % Reconciliation GAAP Gross margin % Cumulative effect of non-GAAP Gross Margin adjustments Non-GAAP Gross margin % Operating Expenses Reconciliation GAAP Operating expenses Acquisition related charges (2) Stock-based compensation expense - operations Non-GAAP Operating expenses Income (Loss) from Operations Reconciliation GAAP Loss from operations Non-GAAP Income (loss) from operations (1) Fair value adjustment for inventory step-up from purchase accounting (2) Legal fees and outside services in connection with our pending acquisition by Canyon Bridge Acquisition Company, Inc. Income (Loss) from Operations % Reconciliation GAAP Loss from operations % Cumulative effect of non-GAAP Gross Margin and Operating adjustments Non-GAAP Income from operations % Income Tax Expense Reconciliation GAAP Income tax expense Estimated tax effect of non-GAAP Adjustments (3) Non-GAAP Income tax expense Net Income (Loss) Reconciliation GAAP Net loss Non-GAAP Net income (loss) Net Income (Loss) Per Share Reconciliation GAAP Net loss per share - basic and diluted Cumulative effect of Non-GAAP adjustments Non-GAAP Net income (loss) per share - basic and diluted Shares used in per share calculations: Diluted - GAAP Diluted - non-GAAP (4) (3) During the second quarter of fiscal 2016, we refined our calculation of non-GAAP tax expense by applying our tax provision model to year-to-date and projected income after adjusting for non-GAAP items. The difference between calculated values for GAAP and non-GAAP tax expense has been included as the “Estimated tax effect of non-GAAP adjustments.” Prior periods have been similarly recalculated to conform to the current presentation. (4) Diluted shares are calculated using the GAAP treasury stock method. In a loss position, diluted shares equal basic shares. Foreign Currency Exchange Rate Risk A portion of our silicon wafer and other purchases were historically denominated in Japanese yen, we billed our Japanese customers in yen, and we continue to collect a Japanese consumption tax refund in yen. As a result of this, as well as having various international subsidiary and branch operations, our financial position and results of operations are subject to foreign currency exchange rate risk. We mitigate the resulting foreign currency exchange rate exposure by entering into foreign currency forward exchange contracts, details of which are presented in the following table: Although these hedges mitigate our foreign currency exchange rate exposure from an economic perspective, they were not designated as "effective" hedges under U.S. GAAP and as such are adjusted to fair value through Other (expense) income, net. We do not engage in speculative trading in any financial or capital market. The net fair value of these contracts was favorable by less than $0.1 million at April 1, 2017 and favorable by approximately $0.2 million at December 31, 2016. A hypothetical 10% unfavorable exchange rate change in the yen against the U.S. dollar would have resulted in an unfavorable change in net fair value of $0.2 million at both April 1, 2017 and December 31, 2016. Changes in fair value resulting from foreign exchange rate fluctuations would be substantially offset by the change in value of the underlying hedged transactions. Interest Rate Risk At April 1, 2017, we had $331.4 million outstanding on the original $350 million term loan outstanding under our Credit Agreement, with a variable contractual interest rate based on the 3-month LIBOR as of April 1, 2017, subject to a 1.00% floor, plus a spread of 4.25%. A hypothetical 10% increase in the 3-month LIBOR would not have increased the 3-month LIBOR above this 1.00% floor used in the interest rate calculation, and thus would not have had an impact on Interest expense for the three month period ended April 1, 2017. Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures Based on management’s evaluation (with the participation of our principal executive officer and principal financial officer), as of the end of the period covered by this report, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, (the “Exchange Act”)) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in Securities and Exchange Commission rules and forms and is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. On March 10, 2015, we acquired Silicon Image, which had operated under its own set of systems and internal controls. Our financial reporting control environment includes Silicon Image's systems and much of its continuing control environment, which we are maintaining until we incorporate those processes into our implementation of a new company-wide enterprise resource planning ("ERP") system. At the beginning of the second quarter of fiscal 2017, we converted to our new ERP system, and we are currently updating our control environment for this integration and ERP transition. This plan was reviewed as part of management's evaluation and conclusion noted above in "Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures." Other than as described above, there were no changes in our internal controls over financial reporting (as defined in Rules 13a - 15(f) and 15(d) - 15(f) under the Exchange Act) that occurred during the first quarter of fiscal 2017 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. The information set forth above under Note 15 contained in the “Notes to Consolidated Financial Statements” is incorporated herein by reference. The following risk factors and other information included in this Report include any material changes to and supersede the description of the risk factors associated with our business previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016 and should be carefully considered before making an investment decision relating to our common stock. If any of the following risks occur, our business, financial condition, operating results, and cash flows could be materially adversely affected. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations and financial results. The announcement and pendency of our proposed acquisition by Canyon Bridge Acquisition Company, Inc. could materially adversely affect our business, financial condition, and results of operations. On November 3, 2016, Lattice Semiconductor Corporation and Canyon Bridge Capital Partners, Inc. (“Canyon Bridge”) announced that the Company and Canyon Bridge Acquisition Company, Inc. (“Parent”), an affiliate of Canyon Bridge, have signed a definitive agreement (the "Merger Agreement") under which Parent will acquire all outstanding shares of Lattice for approximately $1.3 billion inclusive of Lattice’s net debt, or $8.30 per share in cash. The transaction (the "Merger") was unanimously approved by both companies’ boards of directors and is subject to customary closing conditions and regulatory approval. If completed, Lattice would become a wholly owned subsidiary of Parent. The announcement and pendency of our proposed acquisition by Parent could disrupt our business and create uncertainty about our future, which could have a material and negative impact on our business, financial condition, and results of operations, regardless of whether the acquisition is completed. These risks to our business, all of which could be exacerbated by any delay in the closing of the acquisition, include: restrictions in the Merger Agreement on the conduct of our business prior to the closing of the acquisition, which prevent us from taking specified actions without the prior consent of Parent, which actions we might otherwise take in the absence of the Merger Agreement; the attention of our management may be directed towards the closing of the acquisition and may be diverted from our day-to-day business operations, and matters related to the acquisition may require commitments of time and resources that could otherwise have been devoted to other opportunities that might have been beneficial to us; our customers, suppliers and other third parties may decide not to renew or seek to terminate, change or renegotiate their relationships with us, whether pursuant to the terms of their existing agreements with us or otherwise; our employees may experience uncertainty regarding their future roles, which might adversely affect our ability to retain, recruit and motivate key personnel; and potential litigation relating to the merger and the related costs. Any of these matters could adversely affect our stock price, business, financial condition, results of operations, or business prospects. The parties may be unable to satisfy the conditions to the closing of our acquisition by Parent and the acquisition may not be consummated, and the failure of the acquisition to be completed may adversely affect our business and our share price. Consummation of our acquisition by Parent is subject to various closing conditions, including, among other things, (i) the absence of any legal restraints or prohibitions on the consummation of the Merger, and (ii) approval from the Committee on Foreign Investment in the United States (CFIUS) and other regulatory approvals. The obligation of each party to consummate the Merger is also conditioned upon the other party’s representations and warranties being true and correct (subject to certain materiality exceptions), and the other party having performed in all material respects its obligations under the Merger Agreement. The obligation of Parent to consummate the Merger is also conditioned upon our not having suffered a Company Material Adverse Effect (as defined in the Merger Agreement). These and other conditions to the consummation of the Merger may fail to be satisfied and may take longer than expected. The satisfaction of all of the required conditions could delay the completion of the Merger for a significant period of time or prevent it from occurring. Thus, there can be no assurance that the conditions to the Merger will be satisfied or waived or that the Merger will be consummated. On March 24, 2017, to allow more time of review and discussion with CFIUS in connection with the Merger, the Company announced that it withdrew and re-filed the joint voluntary notice to CFIUS under the Defense Production Act of 1950, as amended. In addition, the Merger Agreement may be terminated under specified circumstances. Failure to complete the Merger could adversely affect our business and the market price of our common stock in a number of ways, including: our current stock price may reflect a market assumption that the proposed acquisition will occur, meaning that a failure to complete the proposed transaction could result in a decline in the price of our common stock; we are subject to legal proceedings related to the Merger; the failure of the Merger to be consummated may result in negative publicity and a negative impression of us in the investment community; any disruptions to our business resulting from the announcement and pendency of the Merger, including any adverse changes in our relationships with our customers, vendors and employees, may continue or intensify in the event the Merger is not consummated; we may not be able to take advantage of alternative business opportunities or effectively respond to competitive pressures; we may be required to pay a termination fee of $34.18 million if the Merger Agreement is terminated under certain circumstances; we expect to incur substantial transaction costs in connection with the proposed transaction, whether or not it is completed; and we may not be entitled to receive a termination payment from Parent in all circumstances where the Merger Agreement is terminated due to Parent’s breach of its obligations under the Merger Agreement or where we fail to obtain CFIUS approval. Litigation challenging the Merger Agreement may prevent the Merger from being consummated at all or within the expected timeframe. Lawsuits have been filed and additional lawsuits may be filed against us, our Board of Directors and other parties to the Merger Agreement, challenging our acquisition by Parent. Such lawsuits have been and may be brought by our purported stockholders and may seek, among other things, to enjoin consummation of the Merger. One of the conditions to the consummation of the Merger is that no order will be in effect that prevents, makes illegal or prohibits the consummation of the Merger. As such, if the plaintiffs in such potential lawsuits are successful in obtaining an injunction prohibiting the defendants from completing the Merger on the agreed upon terms, then such injunction may prevent the Merger from becoming effective, or from becoming effective within the expected timeframe. We rely on a limited number of independent suppliers for the manufacture of all of our products and a failure by our suppliers to provide timely, cost-effective, and quality products could adversely affect our operations and financial results. We depend on independent foundries to supply silicon wafers for our products. These foundries include Fujitsu in Japan and United Microelectronics Corporation in Taiwan, which supply the majority of our programmable logic wafers, and Taiwan Semiconductor Manufacturing, which supplies most of our HDMI and MHL integrated circuits. We negotiate wafer volumes, prices, and other terms with our foundry partners and their respective affiliates on a periodic basis typically resulting in short-term agreements which do not ensure long-term supply or allocation commitments. We rely on our foundry partners to produce wafers with competitive performance attributes. If the foundries that supply our wafers experience manufacturing problems, including unacceptable yields, delays in the realization of the requisite process technologies, or difficulties due to limitations of new and existing process technologies, our operating results could be adversely affected. If for any reason the foundries are unable to, or do not manufacture sufficient quantities of our products or continue to manufacture a product for the full life of the product, we may be required to prematurely limit or discontinue the sales of certain products or incur significant costs to transfer products to other foundries, and our customer relationships and operating results could be adversely affected. In addition, weak economic conditions may adversely impact the financial health and viability of the foundries and cause them to limit or discontinue their business operations, resulting in shortages of supply and an inability to meet their commitments to us, which could adversely affect our financial condition and operating results. A disruption of one or more of our foundry partners' operations as a result of a fire, earthquake, act of terrorism, political or labor unrest, governmental uncertainty, war, disease, or other natural disaster or catastrophic event, or any other reason, could disrupt our wafer supply and could adversely affect our operating results. Establishing, maintaining and managing multiple foundry relationships requires the investment of management resources as well as additional costs. If we fail to maintain our foundry relationships, or elect or are required to change foundries, we will incur significant costs and manufacturing delays. The success of certain of our next generation products is dependent upon our ability to successfully partner with Fujitsu, Taiwan Semiconductor, Seiko Epson, and other foundry partners. If for any reason one or more of our foundry partners does not provide its facilities and support for our development efforts, we may be unable to effectively develop new products in a timely manner. Should a change in foundry relationships be required, we may be unsuccessful in establishing new foundry relationships for our current or next generation products, or we may incur substantial cost and or manufacturing delays until we form and ramp relationships and migrate products, each of which could adversely affect our operating results. The Mobile and Consumer end market is rapidly changing and cyclical, and a downturn in this end market or our failure to accurately predict the frequency, duration, timing, and severity of these cycles could adversely affect our financial condition and results. With the acquisition of Silicon Image, the Mobile and Consumer end market has increased in importance to us. Revenue from the Mobile and Consumer end market accounted for 30% of our revenue in fiscal 2016. Revenue from the Mobile and Consumer end market consists primarily of revenue from our products designed and used in a broad range of consumer electronics products including smartphones, tablets and e-readers, wearables, accessories such as chargers and docks, Ultra High-Definition (UHD) TVs, Digital SLR cameras, drones, and other connected devices. This market is characterized by rapidly changing requirements and product features and volatility in consumer demand. Our success in this market will depend principally on our ability to: meet the market windows for consumer products; predict technology and market trends; develop IP cores to meet emerging market needs; develop products on a timely basis; maintain multiple design wins across different markets and customers to dampen the effects of market volatility; be designed into our customers' products; and avoid cancellations or delay of products. Our inability to accomplish any of the foregoing, or to offset the volatility of this end market through diversification into other markets, could materially and adversely affect our business, financial condition, and results of operations. Cyclicality in the Mobile and Consumer end market could periodically result in higher or lower levels of revenue and revenue concentration with a single or small number of customers. In addition, rapid changes in this market may affect demand for our products, and may cause our revenue derived from sales in this market to vary significantly over time, adversely affecting our financial results. A downturn in the Communications and Computing end market could cause a meaningful reduction in demand for our products and limit our ability to maintain revenue levels and operating results. Revenue from the Communications and Computing end market accounted for 29% of our revenue in fiscal 2016. Three of our top five programmable logic customers participate primarily in the Communications and Computing end market. In the past, cyclical weakening in demand for programmable logic products from customers in the Communications and Computing end market has adversely affected our revenue and operating results. In addition, telecommunication equipment providers are building network infrastructure for which we compete for product sales. Any deterioration in the Communications and Computing end market, our end customers' reduction in spending, or a reduction in spending by their customers to support this end market or use of our competitors’ products could lead to a reduction in demand for our products which could adversely affect our revenue and results of operations. This type of decline impacted our results in the past and could do so again in the future. We depend on a concentrated group of customers for a significant portion of our revenues. If any of these customers reduce their use of our products, our revenue could decrease significantly. A significant portion of our revenue depends on sales to a limited number of customers. In the first quarter of fiscal 2017, our largest end customer accounted for 12% of our total revenue, and our top five end customers accounted for approximately 37% of our total revenue. For the full year of fiscal 2016, our largest end customers accounted for 10% of our total revenue, and our top five end customers accounted for approximately 27% of our total revenue. If any of these relationships were to diminish, if these customers were to develop their own solutions or adopt alternative solutions or competitors' solutions, or if our relationship with any future customer which accounts for a significant portion of our revenue were to diminish due to these factors, our results could be adversely affected. While we strive to maintain strong relationships with our customers, their continued use of our products is frequently reevaluated, as certain of our customers' product life cycles are relatively short and they continually develop new products. The selection process for our products to be included in our customers' new products is highly competitive. There are no guarantees that our products will be included in the next generation of products introduced by these customers. For example, in December 2014, one of its largest customers informed Silicon Image that the customer had decided not to include Silicon Image’s MHL functionality in certain designs in order to reduce costs. Any significant loss of, or a significant reduction in purchases by, one or more of these customers or their failure to meet their commitments to us, could have an adverse effect on our financial condition and results of operations. If any one or more of our concentrated groups of customers were to experience significantly adverse financial conditions, our financial condition and business could be adversely affected as well, as occurred when Silicon Image’s fiscal 2014 mobile product revenue decreased as a result of a significant production slowdown by one of its key customers. Our outstanding indebtedness could reduce our strategic flexibility and liquidity and may have other adverse effects on our results of operations. In connection with our acquisition of Silicon Image, we entered into a secured Credit Agreement providing for a $350 million term loan. Our obligations under the Credit Agreement are guaranteed by our U.S. subsidiaries. Our obligations include a requirement to pay up to 75% of our excess cash flow toward repayment of the facility. The Credit Agreement also contains certain restrictive covenants, including limitations on liens, mergers and consolidations, sales of assets, payment of dividends, and additional indebtedness. The amount and terms of our indebtedness, as well as our credit rating, could have important consequences, including the following: we may be more vulnerable to economic downturns, less able to withstand competitive pressures, and less flexible in responding to changing business and economic conditions; our cash flow from operations may be allocated to the payment of outstanding indebtedness, and not to research and development, operations or business growth; we might not generate sufficient cash flow from operations or other sources to enable us to meet our payment obligations under the facility and to fund other liquidity needs; our ability to make distributions to our stockholders in a sale or liquidation may be limited until any balance on the facility is repaid in full; and our ability to incur additional debt, including for working capital, acquisitions, or other needs, is more limited. If we breach a loan covenant, the lenders could accelerate the repayment of the term loan. We might not have sufficient assets to repay such indebtedness upon acceleration. If we are unable to repay the indebtedness, the lenders could initiate a bankruptcy proceeding against us or collection proceedings with respect to our assets and subsidiaries securing the facility, which could materially decrease the value of our common stock. We depend on distributors to generate a significant portion of our revenue and complete order fulfillment and any adverse change in our relationship or our distributors' financial health, reduction of selling efforts, or inaccuracy in resale reports could harm our sales or result in misreporting our results. We depend on our distributors to sell our products to end customers, complete order fulfillment, and maintain sufficient inventory of our products. Our distributors also provide technical support and other value-added services to our end customers. Resales of product through sell-through distributors accounted for 61% of our revenue in 2016, with two distributors accounting for 46% of our revenue in 2016. We expect our distributors to generate a significant portion of our revenue in the future. Any adverse change to our relationships with our distributors or a failure by one or more of our distributors to perform its obligations to us could have a material impact on our business. In addition, a significant reduction of effort by a distributor to sell our products or a material change in our relationship with one or more distributors may reduce our access to certain end customers and adversely affect our ability to sell our products. The financial health of our distributors is important to our success. Economic conditions may adversely impact the financial health of one or more of our distributors. This could result in the inability of distributors to finance the purchase of our products or cause the distributors to delay payment of their obligation to us and increase our credit risk. If the financial health of our distributors impairs their performance and we are unable to secure alternate distributors, our financial condition and results of operations may be negatively impacted. Since we have limited ability to forecast inventory levels of our end customers, it is possible that there may be significant build-up of inventories in the distributor channel, with the OEM or the OEM’s contract manufacturer. Such a buildup could result in a slowdown in orders, requests for returns from customers, or requests to move out planned shipments. This could adversely affect our revenues and profits. Any failure to manage these challenges could disrupt or reduce sales of our products and unfavorably impact our financial results. We depend on the timeliness and accuracy of resale reports from our distributors. Late or inaccurate resale reports could have a detrimental effect on our ability to properly recognize revenue and our ability to predict future sales. We rely on information technology systems, and failure of these systems to function properly may cause business disruptions. We rely in part on various information technology ("IT") systems to manage our operations, including financial reporting, and we regularly make changes to improve them as necessary by periodically implementing new, or upgrading or enhancing existing, operational and IT systems, procedures, and controls. We have undergone a significant integration and systems implementation following the acquisition of Silicon Image. We have recently implemented a new enterprise resource planning ("ERP") system to standardize our processes worldwide and adopt best-in-class capabilities, and we have converted to the new ERP system as of the beginning of the second quarter of fiscal 2017. We have committed significant resources to this new ERP system, which replaces multiple legacy systems, and realizing the full functionality of this conversion is extremely complex, in part, because of the wide range of processes and the multiple legacy systems that must be integrated. As a result of the conversion process and during our initial use of the new ERP system, we may experience delays or disruptions in the integration of our new or enhanced systems, procedures, or controls. We may also encounter errors in data, an inability to accurately process or record transactions, and security or technical reliability issues. All of these could harm our ability to conduct core operating functions such as processing invoices, shipping and receiving, recording and reporting financial and management information on a timely and accurate basis, and could impact our internal control compliance efforts. If the technical solution or end user training are inadequate, it could limit our ability to manufacture and ship products as planned. These systems are also subject to power and telecommunication outages or other general system failures. Failure of our IT systems or difficulties or delays in managing and integrating them could impact the company's ability to perform necessary operations, which could materially adversely affect our business. Acquisitions, strategic investments and strategic partnerships present risks, and we may not realize the goals that were contemplated at the time of a transaction. On March 10, 2015, we acquired Silicon Image, and we may make further acquisitions and strategic investments in the future. Acquisitions and strategic investments, including our acquisition of Silicon Image, present risks, including: our ongoing business may be disrupted and our management's attention may be diverted by investment, acquisition, transition, or integration activities; an acquisition or strategic investment may not perform as well or further our business strategy as we expected, and we may not integrate an acquired company or technology as successfully as we expected; we may incur unexpected costs, claims, or liabilities that we assume from an acquired company or technology or that are otherwise related to an acquisition; we may discover adverse conditions post-acquisition that are not covered by representations and warranties; we may increase some of our risks, such as increasing customer or end product concentration; we may have difficulty incorporating acquired technologies or products with our existing product lines; we may have higher than anticipated costs in continuing support and development of acquired products, and in general and administrative functions that support such products; we may have difficulty integrating and retaining key personnel; we may have difficulty integrating business systems, processes, and tools, such as accounting software, inventory management systems, or revenue systems which may have an adverse effect on our business; our liquidity and/or capital structure may be adversely impacted; our strategic investments may not perform as expected; we may experience unexpected changes in how we are required to account for our acquisitions and strategic investments pursuant to U.S. GAAP; we may have difficulty integrating acquired entities into our global tax structure with potentially negative impacts on our effective tax rate; if the acquisition or strategic investment does not perform as projected, we might take a charge to earnings due to impaired goodwill; we may divest certain assets of acquired businesses, leading to charges against earnings; we may experience unexpected negative responses from vendors or customers to the acquisition, which may adversely impact our operations; and we may have difficulty integrating the processes and control environment from Silicon Image. The occurrence of any of these risks could have a material adverse effect on our business, results of operations, financial condition, or cash flows, particularly in the case of a larger acquisition or several concurrent acquisitions or strategic investments. In addition, we may enter into strategic partnerships with third parties with the goal of gaining access to new and innovative products and technologies. Strategic partnerships pose many of the same risks as acquisitions or investments. We cannot guarantee that we will be able to complete any future acquisitions or that we will realize any anticipated benefits from any of our past or future acquisitions, strategic investments, or strategic partnerships. We may not be able to find suitable acquisition opportunities that are available at attractive valuations, if at all. A sustained decline in the price of our common stock may make it more difficult and expensive to initiate or complete additional acquisitions on commercially acceptable terms. We are required under U.S. GAAP to test goodwill for possible impairment on an annual basis and to test goodwill and long-lived assets, including amortizable intangible assets, for impairment at any other time that circumstances arise indicating the carrying value may not be recoverable. For purposes of testing for impairment, the Company currently operates as one reporting unit: the core Lattice ("Core") business, which includes intellectual property and semiconductor devices. No impairment charges were recorded in the first quarter of fiscal 2017, no impairment charges related to goodwill were recorded in fiscal 2016, and no impairment charges were recorded for the Core segment in fiscal 2015. There is no assurance that future impairment tests will indicate that goodwill will be deemed recoverable. As we continue to review our business operations and test for impairment or in connection with possible sales of assets, we may have impairment charges in the future, which may be material. Our success and future revenue depends on our ability to innovate, develop and introduce new products that achieve customer and market acceptance and to successfully compete in the highly competitive semiconductor industry, and failure to do so could have a material adverse effect on our financial condition and results of operations. The semiconductor industry is highly competitive and many of our direct and indirect competitors have substantially greater financial, technological, manufacturing, marketing, and sales resources. Consolidation in our industry may increasingly mean that our competitors have greater resources, or other synergies, that could put us at a competitive disadvantage. We currently compete directly with companies that have licensed our technology or have developed similar products, as well as numerous semiconductor companies that offer products based on alternative solutions, such as applications processor, application specific standard product, microcontroller, analog, and digital signal processing technologies. Competition from these semiconductor companies may intensify as we offer more products in any of our end markets. These competitors include established, multinational semiconductor companies, as well as emerging companies. The markets in which we compete are characterized by rapid technology and product evolution, generally followed by a relatively longer process of ramping up to volume production on advanced technologies. Our markets are also characterized by evolving industry standards, frequent new product introduction, short product life cycles, and increased demand for higher levels of integration and smaller process geometry. Our competitive position and success depends on our ability to innovate, develop, and introduce new products that compete effectively on the basis of price, density, functionality, power consumption, form factor, and performance addressing the evolving needs of the markets we serve. These new products typically are more technologically complex than their predecessors. Our future growth and the success of new product introductions depend upon numerous factors, including: timely completion and introduction of new product designs; ability to generate new design opportunities and design wins, including those which result in sales of significant volume; availability of specialized field application engineering resources supporting demand creation and customer adoption of new products; ability to utilize advanced manufacturing process technologies; achieving acceptable yields and obtaining adequate production capacity from our wafer foundries and assembly and test subcontractors; ability to obtain advanced packaging; availability of supporting software design tools; utilization of predefined IP logic; market acceptance of our MHL-enabled and wireless mobile products, and our 60 GHz wireless products; customer acceptance of advanced features in our new products; availability of competing alternative technologies; and market acceptance of our customers' products. Our product innovation and development efforts may not be successful; our new products, MHL-enabled products, and 60GHz wireless products may not achieve market or customer acceptance; and we may not achieve the necessary volume of production to achieve acceptable cost. Revenue relating to our mature products is expected to decline in the future, which is normal for our product life cycles. As a result, we may be increasingly dependent on revenue derived from our newer products as well as anticipated cost reductions in the manufacture of our current products. We rely on obtaining yield improvements and corresponding cost reductions in the manufacture of existing products and on introducing new products that incorporate advanced features and other price/performance factors that enable us to increase revenues while maintaining acceptable margins. To the extent such cost reductions and new product introductions do not occur in a timely manner, or that our products do not achieve market acceptance or market acceptance at acceptable pricing, our forecasts of future revenue, financial condition, and operating results could be materially adversely affected. General economic conditions and deterioration in the global business environment could have a material adverse effect on our business, operating results, and financial condition.

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For the transition period from ______________ to _______________ Commission file number: 1-2207 THE WENDY’S COMPANY (Exact name of registrants as specified in its charter) One Dave Thomas Blvd., Dublin, Ohio Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [x] No [ ] Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes [x] No [ ] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer [x] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [ ] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [x] There were 273,479,452 shares of The Wendy’s Company common stock outstanding as of October 29, 2015. THE WENDY’S COMPANY AND SUBSIDIARIES INDEX TO FORM 10-Q PART I: FINANCIAL INFORMATION Item 1. Financial Statements Unaudited Condensed Consolidated Balance Sheets as of September 27, 2015 and December 28, 2014 Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 27, 2015 and September 28, 2014 Unaudited Condensed Consolidated Statements of Comprehensive (Loss) Income for the three and nine months ended September 27, 2015 and September 28, 2014 Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 27, 2015 and September 28, 2014 Item 3. Quantitative and Qualitative Disclosures about Market Risk PART II: OTHER INFORMATION Item 1A. Risk Factors PART I. FINANCIAL INFORMATION Item 1. Financial Statements. Accounts and notes receivable Prepaid expenses and other current assets Deferred income tax benefit Advertising funds restricted assets Current assets of discontinued operations Other intangible assets Noncurrent assets of discontinued operations Accrued expenses and other current liabilities Advertising funds restricted liabilities Current liabilities of discontinued operations Noncurrent liabilities of discontinued operations Common stock, $0.10 par value; 1,500,000 shares authorized; 470,424 shares issued Common stock held in treasury, at cost; 197,090 and 104,614 shares, respectively CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In Thousands Except Per Share Amounts) Franchise revenues Costs and expenses: General and administrative System optimization losses (gains), net Reorganization and realignment costs Impairment of long-lived assets Other operating expense, net Loss on early extinguishment of debt Other income, net (Loss) income from discontinued operations, net of income taxes (Loss) gain on disposal of discontinued operations, net of income taxes Net (loss) income from discontinued operations Basic and diluted income (loss) per share: CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME Other comprehensive loss, net: Foreign currency translation adjustment Change in unrecognized pension loss, net of income tax benefit (provision) of $124 and $(213), respectively Effect of cash flow hedges, net of income tax (provision) benefit of $(273) and $(549) for the three months and $1,217 and $972 for the nine months ended September 27, 2015 and September 28, 2014, respectively Other comprehensive loss, net Comprehensive (loss) income Adjustments to reconcile net income to net cash provided by Share-based compensation Excess tax benefits from share-based compensation Non-cash rent expense, net Net receipt of deferred vendor incentives System optimization gains, net Gain on disposal of the Bakery Gain on sales of investments, net Distributions received from TimWen joint venture Equity in earnings in joint venture, net Long-term debt-related activities, net (see below) Other, net Proceeds from sale of the Bakery Proceeds from sales of investments Payments for investments Notes receivable from franchisees, net Changes in restricted cash Proceeds from long-term debt Repayments of long-term debt Deferred financing costs Change in restricted cash Repurchases of common stock Proceeds from stock option exercises Net cash used in operations before effect of exchange rate changes on cash Effect of exchange rate changes on cash CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS—CONTINUED Details of cash flows from operating activities: Long-term debt-related activities, net: Accretion of long-term debt Payments for termination of cash flow hedges Reclassification of unrealized losses on cash flow hedges Supplemental cash flow information: Cash paid for: Income taxes, net of refunds Supplemental non-cash investing and financing activities: Capital expenditures included in accounts payable Capitalized lease obligations Accrued debt issuance costs (1) Basis of Presentation The accompanying unaudited condensed consolidated financial statements (the “Financial Statements”) of The Wendy’s Company (“The Wendy’s Company” and, together with its subsidiaries, the “Company,” “we,” “us” or “our”) have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and, therefore, do not include all information and footnotes required by GAAP for complete financial statements. In our opinion, the Financial Statements contain all adjustments necessary to present fairly our financial position as of September 27, 2015 and the results of our operations for the three and nine months ended September 27, 2015 and September 28, 2014 and cash flows for the nine months ended September 27, 2015 and September 28, 2014. The results of operations for the three and nine months ended September 27, 2015 are not necessarily indicative of the results to be expected for the full 2015 fiscal year. These Financial Statements should be read in conjunction with the audited consolidated financial statements for The Wendy’s Company and notes thereto, included in our Annual Report on Form 10-K for the fiscal year ended December 28, 2014 (the “Form 10-K”). The principal subsidiary of the Company is Wendy’s International, LLC and its subsidiaries (“Wendy’s”). The Company manages and internally reports its business geographically. The operation and franchising of Wendy’s® restaurants in North America (defined as the United States of America (“U.S.”) and Canada) comprises virtually all of our current operations and represents a single reportable segment. The revenues and operating results of Wendy’s restaurants outside of North America are not material. We report on a fiscal year consisting of 52 or 53 weeks ending on the Sunday closest to December 31. All three month and nine month periods presented herein contain 13 weeks and 39 weeks, respectively. Our current 2015 fiscal year, ending on January 3, 2016, will contain 53 weeks and, accordingly, our fourth quarter of 2015 will contain 14 weeks. All references to years and quarters relate to fiscal periods rather than calendar periods. On May 31, 2015, Wendy’s completed the sale of its company-owned bakery, The New Bakery Company, LLC (the “Bakery”), a 100% owned subsidiary of Wendy’s. As a result of the sale of the Bakery, as further discussed in Note 2, the Bakery’s results of operations for all periods presented and the (loss) gain on disposal have been included in “Net (loss) income from discontinued operations” in our condensed consolidated statements of operations. Additionally, the Bakery’s assets and liabilities have been presented as discontinued operations in our condensed consolidated balance sheet as of December 28, 2014. In connection with the reimaging of restaurants as part of our Image Activation program, we have recorded $2,475 and $6,578 of accelerated depreciation and amortization during the three and nine months ended September 27, 2015, respectively, and $1,180 and $16,199 during the three and nine months ended September 28, 2014, respectively, on certain long-lived assets to reflect their use over shortened estimated useful lives. We describe the circumstances under which we record accelerated depreciation and amortization for properties in our Form 10-K. Certain reclassifications have been made to the prior year presentation to conform to the current year presentation. During the second quarter of 2015, the Company early adopted an amendment requiring debt issuance costs to be presented in the balance sheet as a direct reduction of the related debt liability rather than as an asset. The adoption of this guidance resulted in the reclassification of debt issuance costs of $8,243 from “Other assets” to “Long-term debt” in our condensed consolidated balance sheet as of December 28, 2014. Refer to Note 7 and Note 16 for further information. Prior to fiscal 2015, the Company reported its system optimization initiative as a discrete event and separately included the related gain or loss on sales of restaurants, impairment losses and other associated costs, along with other restructuring initiatives, in “Facilities action charges (income), net.” In February 2015, the Company announced plans to reduce its ongoing company-owned restaurant ownership to approximately 5% of the total system and further emphasized that restaurant dispositions and acquisitions are a continuous and integrated part of the overall strategy to optimize its restaurant portfolio. As a result, commencing with the first quarter of 2015, all gains and losses on dispositions are included on a separate line in our condensed consolidated statements of operations, “System optimization losses (gains), net” and impairment losses recorded in connection with the sale or anticipated sale of restaurants (“System Optimization Remeasurement”) are reclassified to “Impairment of long-lived assets.” In addition, the Company retitled the line, “Facilities action charges (income), net” to “Reorganization and realignment costs” in our condensed consolidated statements of operations to better describe the current and historical initiatives included given the reclassifications described above. The Company believes the new presentation will aid users in understanding its results of operations. The prior periods reflect reclassifications to conform to the current year presentation. All amounts being reclassified in our statements of operations were separately disclosed in the notes to our consolidated financial statements included in our Form 10-Q for the fiscal quarter ended September 28, 2014 and Form 10-K. Such reclassifications had no impact on operating profit, net income or net income per share. The following table illustrates the reclassifications made to the condensed consolidated statements of operations for the three and nine months ended September 28, 2014: Reclassifications As Previously Reported (b) Gain on dispositions, net (c) System Optimization Remeasurement (d) As Currently Reported System optimization losses, net Reorganization and realignment costs (a) (a) Previously titled “Facilities action charges (income), net.” “As Previously Reported,” reflects adjustments to reclassify the Bakery’s other operating income, net of $24 and $61 for the three and nine months ended September 28, 2014, respectively, from “Other operating expense, net” to “(Loss) income from discontinued operations, net of income taxes.” (c) Reclassified the gain on sales of restaurants, net, previously included in “Facilities action charges (income), net” and the gain on disposal of assets, net, which included sales of restaurants and other assets, and was previously reported in “Other operating expense, net” to a separate line in our condensed consolidated statements of operations, “System optimization losses (gains), net.” Reclassified impairment losses recorded in connection with the sale or anticipated sale of restaurants (“System Optimization Remeasurement”), previously included in “Facilities action charges (income), net” to “Impairment of long-lived assets.” (2) Discontinued Operations On May 31, 2015, Wendy’s completed the sale of 100% of its membership interest in The New Bakery Company, LLC (the “Bakery”), its 100% owned subsidiary, to East Balt US, LLC (the “Buyer”) for $78,500 in cash (subject to customary purchase price adjustments). The Company also assigned certain capital leases for transportation equipment to the Buyer but retained the related obligation. Pursuant to the sale agreement, the Company is obligated to continue to provide health insurance benefits to the Bakery’s employees at the Company’s expense through December 31, 2015. The Company recorded a pre-tax gain on the disposal of the Bakery of $27,526 during the nine months ended September 27, 2015, which included transaction closing costs and a reduction of goodwill. The Company recognized income tax expense associated with the gain on disposal of $12,709 during the nine months ended September 27, 2015, which included the impact of the disposal of non-deductible goodwill. In conjunction with the Bakery sale, Wendy’s entered into a transition services agreement with the Buyer, pursuant to which Wendy’s will provide certain continuing corporate and shared services to the Buyer through March 31, 2016 for no additional consideration. A purchasing cooperative, Quality Supply Chain Co-op, Inc. (“QSCC”), established by Wendy’s and its franchisees, agreed to continue to source sandwich buns from the Bakery, for a specified time period following the sale of the Bakery. As a result, Wendy’s paid the Buyer $4,699 for the purchase of sandwich buns during the period from June 1, 2015 through the end of the third quarter of 2015, which has been recorded to “Cost of sales.” Information related to the Bakery has been reflected in the accompanying condensed consolidated financial statements as follows: Balance sheets - As a result of our sale of the Bakery on May 31, 2015, there are no remaining Bakery assets and liabilities. The Bakery’s assets and liabilities as of December 28, 2014 have been presented as discontinued operations. Statements of operations - The Bakery’s results of operations for the period from December 29, 2014 through May 31, 2015 and the three and nine months ended September 28, 2014 have been presented as discontinued operations. In addition, the (loss) gain on disposal of the Bakery has been included in “Net (loss) income from discontinued operations” for the three and nine months ended September 27, 2015. Statements of cash flows - The Bakery’s cash flows prior to its sale (for the period from December 29, 2014 through May 31, 2015 and for the nine months ended September 28, 2014) have been included in, and not separately reported from, our consolidated cash flows. The consolidated statement of cash flows for the nine months ended September 27, 2015 also includes the effects of the sale of the Bakery. The following table presents the Bakery’s results of operations and the (loss) gain on disposal which have been included in discontinued operations: September 27, 2015 (e) Revenues (a) Cost of sales (b) Depreciation and amortization (c) Other income (expense), net (d) (Loss) income from discontinued operations before income taxes Gain on disposal of discontinued operations before income taxes Provision for income taxes on gain on disposal Includes sales of sandwich buns and related products previously reported in “Sales” as well as rental income. The nine months ended September 27, 2015 include employee separation-related costs of $791 as a result of the sale of the Bakery. In addition, the nine months ended September 27, 2015 includes a reduction to cost of sales of $12,486 resulting from the reversal of a liability associated with the Bakery’s withdrawal from a multiemployer pension plan. See Note 15 for further discussion. Included in “Depreciation and amortization” in our condensed consolidated statements of cash flows for the periods presented. Includes net gains on sales of other assets. During the nine months ended September 27, 2015, the Bakery received cash proceeds of $50 resulting in net gains on sales of other assets of $32. During the three and nine months ended September 28, 2014, the Bakery received cash proceeds of $10 and $47, resulting in net gains on sales of other assets of $28 and $65, respectively. Represents post-closing adjustments recorded during the third quarter of 2015. The Bakery’s capital expenditures were $2,693 for the nine months ended September 27, 2015, and $808 and $2,361 for the three and nine months ended September 28, 2014, respectively, which are included in “Capital expenditures” in our condensed consolidated statements of cash flows. The following table summarizes the gain on the disposal of our Bakery, which has been included in discontinued operations: Proceeds from sale of the Bakery (a) Net working capital (b) Net properties sold (c) Goodwill allocated to the sale of the Bakery Other (d) Post-closing adjustments on the sale of the Bakery Provision for income taxes (e) Gain on disposal of discontinued operations, net of income taxes Represents net proceeds received, which includes the purchase price of $78,500 less transaction closing costs paid directly by the Buyer on the Company’s behalf. Primarily represents accounts receivable, inventory, prepaid expenses and accounts payable. Net properties sold consisted primarily of buildings, equipment and capital leases for transportation equipment. Primarily includes the recognition of the Company’s obligation, pursuant to the sale agreement, to provide health insurance benefits to the Bakery’s employees through December 31, 2015 of $1,993 and transaction closing costs paid directly by the Company. Includes the impact of non-deductible goodwill disposed of as a result of the sale. (3) System Optimization Losses (Gains), Net In July 2013, the Company announced a system optimization initiative, as part of its brand transformation, which includes a shift from company-owned restaurants to franchised restaurants over time, through acquisitions and dispositions, as well as helping to facilitate franchisee-to-franchisee restaurant transfers. During 2013 and 2014, the Company completed the sale of 244 and 255 company-owned restaurants to franchisees, respectively. During the second quarter of 2015, the Company completed its plan to sell all of its company-owned restaurants in Canada to franchisees, with the sale of 83 Canadian restaurants, bringing the aggregate total of Canadian restaurants sold to franchisees to 129 during 2014 and 2015. In February 2015, the Company announced plans to sell approximately 540 additional restaurants to franchisees and reduce its ongoing company-owned restaurant ownership to approximately 5% of the total system by the end of 2016. During the third quarter of 2015, the Company completed the sale of nine restaurants. As of September 27, 2015, the company had classified 274 restaurants as held for sale. Gains and losses recognized on dispositions are recorded to “System optimization losses (gains), net” in our condensed consolidated statements of operations. Costs related to our system optimization initiative are recorded to “Reorganization and realignment costs,” and include severance and employee related costs, professional fees and other associated costs, which are further described in Note 5. The following is a summary of the disposition activity recorded as a result of our system optimization initiative: Number of restaurants sold to franchisees Proceeds from sales of restaurants Net assets sold (a) Goodwill related to sales of restaurants Net (unfavorable) favorable leases (b) Other (c) Post-closing adjustments on sales of restaurants (d) (Loss) gain on sales of restaurants, net Gain on sales of other assets, net (e) System optimization (losses) gains, net Net assets sold consisted primarily of cash, inventory and equipment. During the three and nine months ended September 27, 2015, the Company recorded favorable lease assets of $185 and $25,992, respectively, and unfavorable lease liabilities of $1,691 and $20,103, respectively, as a result of leasing and/or subleasing land, buildings, and/or leasehold improvements to franchisees, in connection with sales of restaurants. During the three and nine months ended September 28, 2014, the Company recorded favorable lease assets of $1,814 and $49,206, respectively, and unfavorable lease liabilities of $2,894 and $25,305, respectively. The nine months ended September 27, 2015 includes a deferred gain of $2,658 related to the sale of 14 Canadian restaurants to a franchisee during the second quarter of 2015, as a result of certain contingencies related to the extension of lease terms. The deferred gain is included in “Other liabilities.” The nine months ended September 27, 2015 also includes a note receivable of $1,801 from a franchisee in connection with the sale of 16 Canadian restaurants, which was recognized as part of the overall loss on sale during the second quarter of 2015. During the nine months ended September 27, 2015, notes receivable from franchisees in connection with sales of restaurants in 2014 were repaid and as a result, we recognized the related gain on sale of $2,450. During the three and nine months ended September 27, 2015, Wendy’s received cash proceeds of $4,576 and $7,174, respectively, primarily from the sale of surplus properties. During the three and nine months ended September 28, 2014, Wendy’s received cash proceeds of $989 and $15,596, respectively, primarily from the sale of surplus properties and the sale of a company-owned aircraft. Reclassifications have been made to the prior year presentation to include sales of restaurants previously reported in “Other operating expense, net” to conform to the current year presentation. Reclassifications have also been made to reflect the Bakery’s gain on sales of other assets as discontinued operations. See Note 1 for further details. Assets Held for Sale December 28, 2014 (a) Number of restaurants classified as held for sale Net restaurant assets held for sale (b) Other assets held for sale (b) Reclassifications have been made to the prior year presentation to include restaurants previously excluded from our system optimization initiative to conform to the current year presentation. See Note 1 for further details. (b) Net restaurant assets held for sale include company-owned restaurants and consist primarily of cash, inventory, equipment and an estimate of allocable goodwill. Other assets held for sale primarily consist of surplus properties. Assets held for sale are included in “Prepaid expenses and other current assets.” (4) Acquisitions The following is a summary of the acquisition activity recorded for acquisitions of franchised restaurants during the periods presented and includes adjustments to the allocation of the purchase price for prior acquisitions within the one year measurement period: Restaurants acquired from franchisees Acquired franchise rights Deferred taxes and other assets Capital leases obligations Unfavorable leases Deferred taxes and other liabilities Gain on acquisition of restaurants Total consideration paid, net of cash received (5) Reorganization and Realignment Costs The following is a summary of the initiatives included in “Reorganization and realignment costs:” G&A realignment System optimization initiative In November 2014, the Company initiated a plan to reduce its general and administrative expenses. The plan includes a realignment and reinvestment of resources to focus primarily on accelerated restaurant development and consumer-facing restaurant technology to drive long-term growth. The Company expects to achieve the majority of the expense reductions through the realignment of its U.S. field operations and savings at its Restaurant Support Center in Dublin, Ohio, which was substantially completed by the end of the second quarter of 2015. The Company recognized costs totaling $9,996 during the first nine months of 2015 and $22,922 in aggregate since inception. The Company expects to incur additional costs aggregating approximately $3,000 during the remainder of 2015 and 2016, comprised primarily of recruitment and relocation costs for the reinvestment in resources to drive long-term growth. The following is a summary of the activity recorded as a result of our G&A realignment plan: Incurred Since Inception Severance and related employee costs Recruitment and relocation costs Share-based compensation (a) Total G&A realignment Represents incremental share-based compensation resulting from the modification of stock options and performance-based awards in connection with the termination of employees under our G&A realignment plan. The table below presents a rollforward of our accruals for our G&A realignment plan, which are included in “Accrued expenses and other current liabilities” and “Other liabilities.” The Company has recognized costs related to its system optimization initiative which includes a shift from company-owned restaurants to franchised restaurants over time, through acquisitions and dispositions, as well as helping to facilitate franchisee-to-franchisee restaurant transfers. In connection with its system optimization initiative, the Company expects to incur additional costs of approximately $10,000 in aggregate during the remainder of 2015 and 2016. Such costs are primarily comprised of accelerated amortization of previously acquired franchise rights related to company-owned restaurants in territories that will be sold to franchisees of approximately $3,000 and professional fees of approximately $7,000. The following is a summary of the costs recorded as a result of our system optimization initiative: Other (a) Accelerated depreciation and amortization (b) Share-based compensation (c) Total system optimization initiative The nine months ended September 27, 2015 includes a reversal of an accrual of $210 as a result of a change in estimate. Primarily includes accelerated amortization of previously acquired franchise rights related to company-owned restaurants in territories that will be or have been sold in connection with our system optimization initiative. Represents incremental share-based compensation resulting from the modification of stock options and performance-based awards in connection with the termination of employees under our system optimization initiative. The table below presents a rollforward of our accrual for our system optimization initiative, which is included in “Accrued expenses and other current liabilities.” (6) Investments Investment in TimWen Wendy’s is a partner in a Canadian restaurant real estate joint venture (“TimWen”) with a subsidiary of Restaurant Brands International Inc., a quick-service restaurant company that owns the Tim Hortons® brand. (Tim Hortons is a registered trademark of The TDL Group Corp./Groupe TDL Corporation.) Wendy’s 50% share of the joint venture is accounted for using the equity method of accounting. Our equity in earnings from TimWen is included in “Other operating expense, net.” As described in Note 3, the Company completed its plan to sell all of its company-owned restaurants in Canada to franchisees during the second quarter of 2015; however, the Company plans to retain its ownership in TimWen. Presented below is an unaudited summary of activity related to our investment in TimWen included in “Investments” in our condensed consolidated financial statements: Balance at beginning of period Equity in earnings for the period Amortization of purchase price adjustments (a) Distributions received Foreign currency translation adjustment included in “Other comprehensive loss, net” Balance at end of period Based upon an average original aggregate life of 21 years. (7) Long-Term Debt Long-term debt consisted of the following: Series 2015-1 Class A-2 Notes: Series 2015-1 Class A-2-I Notes Series 2015-1 Class A-2-II Notes Series 2015-1 Class A-2-III Notes Term A Loans, repaid in June 2015 Term B Loans, repaid in June 2015 7% debentures, due in 2025 Capital lease obligations, due through 2045 (a) Unamortized debt issuance costs (b) Less amounts payable within one year (a) Capital lease obligations as of December 28, 2014 and the related amounts payable within one year have been updated to exclude the Bakery’s capital lease obligations as a result of the sale of the Bakery during the second quarter of 2015 and the presentation as discontinued operations in our condensed consolidated balance sheet as of December 28, 2014. During the second quarter of 2015, the Company early adopted an amendment requiring debt issuance costs be presented in the balance sheet as a direct reduction of the related debt liability rather than as an asset. The adoption of this guidance resulted in the reclassification of debt issuance costs of $8,243 from “Other assets” to “Long-term debt” in our condensed consolidated balance sheet as of December 28, 2014. See Note 1 and Note 16 for further information. Aggregate annual maturities of long-term debt, excluding the effect of purchase accounting adjustments, as of September 27, 2015 were as follows: 2015 (a) Represents maturities of long-term debt for the remainder of our 2015 fiscal year, from September 28, 2015 through January 3, 2016. Except as described below, the Company did not have any significant changes to its long-term debt as disclosed in the notes to our consolidated financial statements included in the Form 10-K. On June 1, 2015, Wendy’s Funding, LLC (“Wendy’s Funding” or the “Master Issuer”), a limited-purpose, bankruptcy-remote, wholly-owned indirect subsidiary of The Wendy’s Company, entered into a base indenture and a related supplemental indenture (collectively, the “Indenture”) under which the Master Issuer may issue multiple series of notes. On the same date, the Master Issuer issued Series 2015-1 3.371% Fixed Rate Senior Secured Notes, Class A-2-I (the “Class A-2-I Notes”) with an initial principal amount of $875,000, Series 2015-1 4.080% Fixed Rate Senior Secured Notes, Class A-2-II (the “Class A-2-II Notes”) with an initial principal amount of $900,000 and the Series 2015-1 4.497% Fixed Rate Senior Secured Notes, Class A-2-III, (the “Class A-2-III Notes”) with an initial principal amount of $500,000 (collectively the “Series 2015-1 Class A-2 Notes”). In addition, the Master Issuer entered into a revolving financing facility of Series 2015-1 Variable Funding Senior Secured Notes, Class A-1 (the “Series 2015-1 Class A-1 Notes” and, together with the Series 2015-1 Class A-2 Notes, the “Series 2015-1 Senior Notes”), which allows for the drawing of up to $150,000 under the Series 2015-1 Class A-1 Notes, which include certain credit instruments, including a letter of credit facility. The Series 2015-1 Class A-1 Notes were issued under the Indenture and allow for drawings on a revolving basis. During the third quarter of 2015, the Company borrowed and repaid $19,000 under the Series 2015-1 Class A-1 Notes. The Series 2015-1 Senior Notes were issued in a securitization transaction pursuant to which certain of the Company’s domestic and foreign revenue-generating assets, consisting principally of franchise-related agreements, real estate assets, and intellectual property and license agreements for the use of intellectual property, were contributed or otherwise transferred to the Master Issuer and certain other limited-purpose, bankruptcy-remote, wholly-owned indirect subsidiaries of the Company that act as guarantors (the “Guarantors”) of the Series 2015-1 Senior Notes and that have pledged substantially all of their assets, excluding certain real estate assets and subject to certain limitations, to secure the Series 2015-1 Senior Notes. The Company has guaranteed the obligations of the Master Issuer under the Indenture and the Series 2015-I Senior Notes and pledged substantially all of its assets to secure such obligations. Interest and principal payments on the Series 2015-1 Class A-2 Notes are payable on a quarterly basis. The requirement to make such quarterly principal payments on the Series 2015-1 Class A-2 Notes is subject to certain financial conditions set forth in the Indenture. The legal final maturity date of the Series 2015-I Class A-2 Notes is in June 2045, but, unless earlier prepaid to the extent permitted under the Indenture, the anticipated repayment dates of the Class A-2-I Notes, the Class A-2-II Notes and the Class A-2-III Notes will be 4.25, 7 and 10 years, respectively, from the date of issuance (the “Anticipated Repayment Dates”). If the Master Issuer has not repaid or refinanced the Series 2015-1 Class A-2 Notes prior to the respective Anticipated Repayment Dates, additional interest will accrue pursuant to the Indenture. The Series 2015-1 Class A-1 Notes will accrue interest at a variable interest rate based on (i) the prime rate, (ii) overnight federal funds rates, (iii) the London interbank offered rate for U.S. Dollars or (iv) with respect to advances made by conduit investors, the weighted average cost of, or related to, the issuance of commercial paper allocated to fund or maintain such advances, in each case plus any applicable margin and as specified in the Series 2015-1 Class A-1 note agreement. There is a commitment fee on the unused portion of the Series 2015-1 Class A-1 Notes which ranges from 0.50% to 0.85% based on utilization. It is anticipated that the principal and interest on the Series 2015-1 Class A-1 Notes will be repaid in full on or prior to June 2020, subject to two additional one-year extensions. Following the anticipated repayment date (and any extensions thereof), additional interest will accrue on the Series 2015-1 Class A-1 Notes equal to 5.0% per year. As of September 27, 2015, $22,052 of letters of credit were outstanding against the Series 2015-1 Class A-1 Notes, which relate primarily to interest reserves required under the Indenture. During the nine months ended September 27, 2015, the Company incurred debt issuance costs of $43,751 in connection with the issuance of the Series 2015-1 Senior Notes. The debt issuance costs are being amortized to “Interest expense” through the Anticipated Repayment Dates of the Series 2015-1 Senior Notes utilizing the effective interest rate method. As of September 27, 2015, the effective interest rates, including the amortization of debt issuance costs, were 3.789%, 4.338% and 4.681% for the Class A-2-I Notes, Class A-2-II Notes and Class A-2-III Notes, respectively. The Series 2015-1 Senior Notes are subject to a series of covenants and restrictions customary for transactions of this type, including (i) that the Master Issuer maintains specified reserve accounts to be used to make required payments in respect of the Series 2015-1 Senior Notes, (ii) provisions relating to optional and mandatory prepayments and the related payment of specified amounts, including specified make-whole payments in the case of the Series 2015-1 Class A-2 Notes under certain circumstances, (iii) certain indemnification payments in the event, among other things, the assets pledged as collateral for the Series 2015-1 Senior Notes are in stated ways defective or ineffective and (iv) covenants relating to recordkeeping, access to information and similar matters. The Series 2015-1 Senior Notes are also subject to customary rapid amortization events provided for in the Indenture, including events tied to failure to maintain stated debt service coverage ratios, the sum of global gross sales for specified restaurants being below certain levels on certain measurement dates, certain manager termination events, an event of default, and the failure to repay or refinance the Series 2015-1 Class A-2 Notes on the applicable scheduled maturity date. The Series 2015-1 Senior Notes are also subject to certain customary events of default, including events relating to non-payment of required interest, principal, or other amounts due on or with respect to the Series 2015-1 Senior Notes, failure to comply with covenants within certain time frames, certain bankruptcy events, breaches of specified representations and warranties, failure of security interests to be effective, and certain judgments. In accordance with the Indenture, certain cash accounts have been established with the Indenture trustee for the benefit of the trustee and the noteholders, and are restricted in their use. As of September 27, 2015, Wendy’s Funding had restricted cash of $29,373, which primarily represented cash collections and cash reserves held by the trustee to be used for payments of principal, interest and commitment fees required for the Series 2015-1 Class A-2 Notes. Such restricted cash is included in “Prepaid expenses and other current assets” in the condensed consolidated balance sheet as of September 27, 2015. Changes in such restricted cash have been presented as a component of cash flows from operating and financing activities in the condensed consolidated statement of cash flows since the cash is restricted to the payment of interest and principal, respectively. The proceeds from the issuance of the Series 2015-1 Class A-2 Notes, were used to repay all amounts outstanding on the Term A Loans and Term B Loans under the Company’s May 16, 2013 Restated Credit Agreement amended on September 24, 2013 (the “2013 Restated Credit Agreement”). In connection with the repayment of the Term A Loans and Term B Loans, Wendy’s terminated the related interest rate swaps with notional amounts totaling $350,000 and $100,000, respectively, which had been designated as cash flow hedges. See Note 8 for more information on the interest rate swaps. As a result, the Company recorded a loss on early extinguishment of debt of $7,295 during the second quarter of 2015, primarily consisting of the write-off of deferred costs related to the 2013 Restated Credit Agreement of $7,233 and fees paid to terminate the related interest rate swaps of $62. (8) Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Valuation techniques under the accounting guidance related to fair value measurements are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect our market assumptions. These inputs are classified into the following hierarchy: Level 1 Inputs - Quoted prices for identical assets or liabilities in active markets. Level 2 Inputs - Quoted prices for similar assets or liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable. Level 3 Inputs - Pricing inputs are unobservable for the assets or liabilities and include situations where there is little, if any, market activity for the assets or liabilities. The inputs into the determination of fair value require significant management judgment or estimation. The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments: Non-current cost method investments (a) Financial liabilities Series 2015-1 Class A-2-I Notes (b) Series 2015-1 Class A-2-II Notes (b) Series 2015-1 Class A-2-III Notes (b) Term A Loans, repaid in June 2015 (b) Term B Loans, repaid in June 2015 (b) 7% debentures, due in 2025 (b) Cash flow hedges (c) Guarantees of franchisee loan obligations (d) The fair value of our indirect investment in Arby’s Restaurant Group, Inc. (“Arby’s”) is based on applying a multiple to Arby’s earnings before income taxes, depreciation and amortization per its current unaudited financial information. The carrying value of our indirect investment in Arby’s was reduced to zero during 2013 in connection with the receipt of a dividend. The fair values of our remaining investments are not significant and are based on our review of information provided by the investment managers or investees which was based on (1) valuations performed by the investment managers or investees, (2) quoted market or broker/dealer prices for similar investments and (3) quoted market or broker/dealer prices adjusted by the investment managers for legal or contractual restrictions, risk of nonperformance or lack of marketability, depending upon the underlying investments. The fair values were based on quoted market prices in markets that are not considered active markets. The fair values were developed using market observable data for all significant inputs. Wendy’s has provided loan guarantees to various lenders on behalf of franchisees entering into debt arrangements for new restaurant development and equipment financing. In addition during 2012, Wendy’s provided a guarantee to a lender for a franchisee in connection with the refinancing of the franchisee’s debt. We have accrued a liability for the fair value of these guarantees, the calculation of which was based upon a weighted average risk percentage established at inception adjusted for a history of defaults. The carrying amounts of cash, accounts payable and accrued expenses approximated fair value due to the short-term nature of those items. The carrying amounts of accounts and notes receivable (both current and non-current) approximated fair value due to the effect of the related allowance for doubtful accounts. Our derivative instruments, cash and cash equivalents and guarantees are the only financial assets and liabilities measured and recorded at fair value on a recurring basis. The Company’s primary objective for entering into interest rate swap agreements was to manage its exposure to changes in interest rates, as well as to maintain an appropriate mix of fixed and variable rate debt. Our derivative instruments for the periods presented included seven forward starting interest rate swaps designated as cash flow hedges to change the floating rate interest payments associated with $350,000 and $100,000 in borrowings under the Term A Loans and Term B Loans, respectively, to fixed rate interest payments beginning June 30, 2015 and maturing on December 31, 2017. In May 2015, the Company terminated these interest rate swaps and paid $7,275, which was recorded against the derivative liability. In addition, the Company incurred $62 in fees to terminate the interest rate swaps which was included in “Loss on early extinguishment of debt.” See Note 7 for further information. The unrealized loss on the cash flow hedges at termination of $7,275 is being reclassified on a straight-line basis from “Accumulated other comprehensive loss” to “Interest expense” beginning June 30, 2015, the original effective date of the interest rate swaps through December 31, 2017, the original maturity date of the interest rate swaps. As a result, the three and nine months ended September 27, 2015 include the reclassification of unrealized losses on the cash flow hedges of $708 from “Accumulated other comprehensive loss” to “Interest expense.” As of December 28, 2014, the fair value of the cash flow hedges of $3,343 was included in “Other liabilities” and a corresponding offset to “Accumulated other comprehensive loss.” All of the Company’s financial instruments were in a liability position as of December 28, 2014 and therefore presented gross in the condensed consolidated balance sheet. There was no hedge ineffectiveness from these cash flows hedges through their termination in May 2015. Non-Recurring Fair Value Measurements Assets and liabilities remeasured to fair value on a non-recurring basis during the nine months ended September 27, 2015 and the year ended December 28, 2014 resulted in impairment which we have recorded to “Impairment of long-lived assets” in our condensed consolidated statements of operations. Total losses for the nine months ended September 27, 2015 and the year ended December 28, 2014 reflect the impact of remeasuring long-lived assets held and used (including land, buildings, leasehold improvements and favorable lease assets) to fair value as a result of (1) the Company’s decision to lease and/or sublease the land and/or buildings to franchisees in connection with the sale or anticipated sale of restaurants and (2) declines in operating performance at company-owned restaurants. The fair value of long-lived assets held and used presented in the tables below represents the remaining carrying value and was estimated based on either discounted cash flows of future anticipated lease and sublease income or current market values. Total losses for the nine months ended September 27, 2015 and the year ended December 28, 2014 also include the impact of remeasuring long-lived assets held for sale which primarily include surplus properties. The fair values of long-lived assets held for sale presented in the tables below represent the remaining carrying value and were estimated based on current market values. See Note 9 for more information on impairment of our long-lived assets. Total Losses Held and used Held for sale (9) Impairment of Long-Lived Assets During the three and nine months ended September 27, 2015 and September 28, 2014, the Company recorded impairment charges on long-lived assets as a result of (1) the Company’s decision to lease and/or sublease properties to franchisees in connection with the sale or anticipated sale of company-owned restaurants, (2) closing company-owned restaurants and classifying such properties as held for sale and (3) the deterioration in operating performance of certain company-owned restaurants and charges for capital improvements in restaurants impaired in prior years which did not subsequently recover. The Company may recognize additional impairment charges resulting from leasing or subleasing additional properties to franchisees in connection with sales of company-owned restaurants to franchisees. The following is a summary of impairment losses recorded, which represent the excess of the carrying amount over the fair value of the affected assets and are included in “Impairment of long-lived assets.” Restaurants leased or subleased to franchisees Company-owned restaurants (10) Income Taxes The Company’s effective tax rate on income from continuing operations for the three months ended September 27, 2015 and September 28, 2014 was 70.5% and 32.8%, respectively. The Company’s effective tax rate varies from the U.S. federal statutory rate of 35% due to the effect of (1) changes to valuation allowances on state net operating loss carryforwards due primarily to the expected sale of restaurants in certain states, which have been classified as held for sale under our system optimization initiative, (2) the impact of non-deductible goodwill disposed of in connection with our system optimization initiative, (3) state income taxes net of federal benefits, (4) employment credits and (5) foreign rate differential. The Company’s effective tax rate on income from continuing operations for the nine months ended September 27, 2015 and September 28, 2014 was 45.3% and 39.8%, respectively. The Company’s effective tax rate varies from the U.S. federal statutory rate of 35% due to the effect of (1) state income taxes net of federal benefits, partially resulting from changes to state deferred taxes, (2) changes to valuation allowances on state net operating loss carryforwards due primarily to the expected sale of restaurants classified as held for sale under our system optimization initiative, (3) the impact of non-deductible goodwill disposed of in connection with our system optimization initiative, (4) foreign rate differential, (5) adjustments related to prior year tax matters including changes to unrecognized tax benefits and (6) employment credits. The changes to state deferred taxes during the nine months ended September 27, 2015 were primarily due to the deferred tax impact of an internal restructuring required to complete the securitized financing facility discussed in Note 7, and the expected sale of restaurants under our system optimization initiative described in Note 3. The changes to state deferred taxes during the nine months ended September 28, 2014 were primarily due to the enactment of a mandatory consolidated return filing requirement in New York. During the first quarter of 2015, we concluded two state income tax examinations which resulted in the recognition of a net tax benefit of $1,872 and the reduction of our unrecognized tax benefits by $3,686. Additionally, during the second quarter of 2015, unfavorable state court decisions and audit experience led us to abandon certain refund claims, which resulted in a reduction of our unrecognized tax benefits by $1,274. There were no other significant changes to unrecognized tax benefits or related interest and penalties for the Company during the nine months ended September 27, 2015. During the next twelve months it is reasonably possible the Company will reduce its unrecognized tax benefits by up to $620, primarily due to the completion of state tax examinations. (11) Net Income Per Share Basic net income per share was computed by dividing net income amounts by the weighted average number of common shares outstanding. The weighted average number of shares used to calculate basic and diluted net income per share were as follows: Weighted average basic shares outstanding Dilutive effect of stock options and restricted shares Weighted average diluted shares outstanding Diluted net income per share for the three and nine months ended September 27, 2015 and September 28, 2014 was computed by dividing net income by the weighted average number of basic shares outstanding plus the potential common share effect of dilutive stock options and restricted shares. We excluded potential common shares of 3,118 and 1,439 for the three and nine months ended September 27, 2015, respectively, and 3,886 and 4,833 for the three and nine months ended September 28, 2014, respectively, from our diluted net income per share calculation as they would have had anti-dilutive effects. (12) Stockholders’ Equity The following is a summary of the changes in stockholders’ equity: Exercises of stock options Vesting of restricted shares Tax benefit from share-based compensation In August 2014, our Board of Directors authorized a repurchase program for up to $100,000 of our common stock through December 31, 2015, when and if market conditions warrant and to the extent legally permissible. On June 1, 2015, our Board of Directors authorized a new repurchase program for up to $1,400,000 of our common stock through January 1, 2017, when and if market conditions warrant and to the extent legally permissible. As part of the August 2014 authorization, $76,111 remained available as of December 28, 2014. During the first and second quarters of 2015, the Company repurchased 5,655 shares with an aggregate purchase price of $61,631, excluding commissions of $86. During the third quarter of 2015, the Company repurchased $14,480 through the accelerated share repurchase agreement described below. As a result, the $100,000 share repurchase program authorized in August 2014 was completed. As part of the June 2015 authorization, the Company commenced an $850,000 share repurchase program on June 3, 2015, which included (1) a modified Dutch auction tender offer to repurchase up to $639,000 of our common stock and (2) a separate stock purchase agreement to repurchase up to $211,000 of our common stock from the Trian Group (as defined below in Note 13). For additional information on the separate stock purchase agreement see Note 13. On June 30, 2015, the tender offer expired and on July 8, 2015, the Company repurchased 55,808 shares at $11.45 per share for an aggregate purchase price of $639,000. On July 17, 2015, the Company repurchased 18,416 shares, pursuant to the separate stock purchase agreement, for an aggregate purchase price of $210,867. As a result, the $850,000 share repurchase program that commenced on June 3, 2015 was completed during the third quarter of 2015. During the nine months ended September 27, 2015, the Company incurred costs of $2,288 in connection with the tender offer and Trian Group stock purchase agreement, which were recorded to treasury stock. In August 2015, the Company entered into an accelerated share repurchase agreement (the “ASR Agreement”) with a third-party financial institution to repurchase common stock as part of the Company’s existing share repurchase programs. Under the ASR Agreement, the Company paid the financial institution an initial purchase price of $164,500 in cash and received an initial delivery of 14,385 shares of common stock, representing an estimate of 85% of the total shares expected to be delivered under the ASR Agreement. The total number of shares of common stock ultimately purchased by the Company under the ASR Agreement was based on the average of the daily volume-weighted average prices of the common stock during the term of the ASR Agreement, less an agreed discount. On September 25, 2015, the Company completed the ASR Agreement and received an additional 3,551 shares of common stock. After the completion of the ASR Agreement, the Company had $400,114 remaining availability under its June 2015 authorization. During the three and nine months ended September 27, 2015, the Company incurred costs of $32 in connection with the ASR Agreement, which were recorded to treasury stock. During the nine months ended September 28, 2014, the Company repurchased 1,739 shares with an aggregate purchase price of $13,935, excluding commissions of $30, as part of the August 2014 authorization. In January 2014, our Board of Directors authorized a repurchase program, which the Company fully utilized through completion of a modified Dutch auction tender offer on February 19, 2014 resulting in 29,730 shares repurchased for an aggregate purchase price of $275,000. The Company incurred costs of $2,275 in connection with the tender offer, which were recorded to treasury stock. The following table provides a rollforward of the components of accumulated other comprehensive loss, net of tax as applicable: Cash Flow Hedges (a) Current-period other comprehensive loss Current-period other comprehensive (loss) income Current-period other comprehensive (loss) income for the nine months ended September 27, 2015 and September 28, 2014 includes the effect of changes in unrealized losses on cash flow hedges, net of tax. The three and nine months ended September 27, 2015 also include the reclassification of unrealized losses on cash flow hedges of $435 from “Accumulated other comprehensive loss” to our condensed consolidated statements of operations consisting of $708 recorded to “Interest expense,” net of the related income tax benefit of $273 recorded to “Provision for income taxes.” See Note 8 for more information. The cumulative losses on these items are included in “Accumulated other comprehensive loss” in the condensed consolidated balance sheets. (13) Transactions with Related Parties Except as described below, the Company did not have any significant changes in or transactions with its related parties during the current fiscal period since those reported in the Form 10-K. Stock Purchase Agreement On June 2, 2015, the Company entered into a stock purchase agreement to repurchase our common stock from Nelson Peltz, Peter W. May and Edward P. Garden (who are members of the Company’s Board of Directors) and certain of their family members and affiliates, investment funds managed by Trian Fund Management, L.P. (an investment management firm controlled by Messrs. Peltz, May and Garden, “TFM”) and the general partner of certain of those funds (together with Messrs. Peltz, May and Garden, certain of their family members and affiliates and TFM, the “Trian Group”), who in the aggregate owned approximately 24.8% of the Company’s outstanding shares as of May 29, 2015. Pursuant to the agreement, the Trian Group agreed not to tender or sell any of its shares in the modified Dutch auction tender offer the Company commenced on June 3, 2015. Also pursuant to the agreement, the Company agreed, following completion of the tender offer, to purchase from the Trian Group a pro rata amount of its shares based on the number of shares the Company purchases in the tender offer, at the same price received by shareholders who participated in the tender offer. On July 17, 2015, after completion of the modified Dutch auction tender offer, the Company repurchased 18,416 shares of its common stock from the Trian Group at the price paid in the tender offer of $11.45 per share, for an aggregate purchase price of $210,867. Transactions with QSCC Wendy’s received $138 of lease income from its purchasing cooperative, Quality Supply Chain Co-op, Inc. (“QSCC”) during both the nine months ended September 27, 2015 and September 28, 2014, respectively, which has been recorded as a reduction to “General and administrative.” TimWen Lease and Management Fee Payments A wholly-owned subsidiary of Wendy’s leases restaurant facilities from TimWen for the operation of Wendy’s/Tim Hortons combo units in Canada. Prior to the second quarter of 2015, Wendy’s operated certain of the Wendy’s/Tim Hortons combo units in Canada and subleased some of the restaurant facilities to franchisees. As a result of the Company completing its plan to sell all of its company-owned restaurants in Canada to franchisees during the second quarter of 2015, all of the restaurant facilities are subleased to franchisees. During the nine months ended September 27, 2015 and September 28, 2014, Wendy’s paid TimWen $9,066 and $4,843, respectively, under these lease agreements. Prior to 2015, franchisees paid TimWen directly for these subleases. TimWen paid Wendy’s a management fee under the TimWen joint venture agreement of $164 and $189 during the nine months ended September 27, 2015 and September 28, 2014, respectively, which has been included as a reduction to “General and administrative.” (14) Legal and Environmental Matters We are involved in litigation and claims incidental to our current and prior businesses. We provide accruals for such litigation and claims when payment is probable and reasonably estimable. As of September 27, 2015, the Company had accruals for all of its legal and environmental matters aggregating $2,425. We cannot estimate the aggregate possible range of loss due to most proceedings being in preliminary stages, with various motions either yet to be submitted or pending, discovery yet to occur, and significant factual matters unresolved. In addition, most cases seek an indeterminate amount of damages and many involve multiple parties. Predicting the outcomes of settlement discussions or judicial or arbitral decisions is thus inherently difficult. Based on currently available information, including legal defenses available to us, and given the aforementioned accruals and our insurance coverage, we do not believe that the outcome of these legal and environmental matters will have a material effect on our consolidated financial position or results of operations. (15) Multiemployer Pension Plan As further described in the Form 10-K, in December 2013, The New Bakery Co. of Ohio, Inc. (the “Bakery Company”), a 100% owned subsidiary of Wendy’s, now known as The New Bakery Company, LLC, terminated its participation in the Bakery and Confectionery Union and Industry International Pension Fund (the “Union Pension Fund”) and formally notified the plan’s trustees of its withdrawal from the plan. The Union Pension Fund administrator acknowledged the withdrawal, which required Wendy’s to assume an estimated withdrawal liability of $13,500 based on the applicable requirements of the Employee Retirement Income Security Act, as amended, and which was included in “Cost of sales” during the fourth quarter of 2013. As a result, Wendy’s made payments to the Union Pension Fund aggregating $1,014 during 2014 and 2015 which were recorded as reductions to the withdrawal liability. The Bakers Local No. 57, Bakery, Confectionery, Tobacco Workers & Grain Millers International Union of America, AFL-CIO (the “Union”) filed a charge with the National Labor Relations Board (the “NLRB”) related to the Bakery Company’s withdrawal from the Union Pension Fund. On July 22, 2014, The New Bakery of Zanesville, LLC (“Zanesville”), a 100% owned subsidiary of Wendy’s, and the Union entered into a settlement agreement with the NLRB. The terms of the settlement include an agreement by Zanesville and the Union to recommence negotiations. On March 27, 2015, Zanesville and the Union signed a memorandum of agreement outlining the terms for a new collective bargaining agreement, including re-entering the Union Pension Fund and signing the collective bargaining agreement on or about May 15, 2015. The terms of the collective bargaining agreement were ratified by the Union and became effective upon execution of the collective bargaining agreement. During the first quarter of 2015, the Company began negotiating the potential sale of the Bakery Company which would result in the buyer signing the collective bargaining agreement and re-entering the Union Pension Fund. As a result, the Company concluded that its loss contingency for the pension withdrawal payments was no longer probable and, as such, reversed $12,486 of the outstanding withdrawal liability to “Cost of sales” during the first quarter of 2015. During the second quarter of 2015, with negotiations ongoing, Zanesville and the Union agreed to an extension of the May 15, 2015 deadline for re-entering the Union Pension Fund. On May 15, 2015, in preparation for the sale of the Bakery, Zanesville merged into the Bakery Company. The Bakery Company was sold on May 31, 2015 and subsequently the Bakery Company signed the collective bargaining agreement and re-entered the Union Pension Fund. As a result of the sale of its membership interest in the Bakery Company, Wendy’s no longer has any obligations related to the Union Pension Fund. See Note 2 for more information on the sale of the Bakery. (16) New Accounting Standards New Accounting Standards In September 2015, the Financial Accounting Standards Board (the “FASB”) issued an amendment that requires an acquirer to recognize adjustments to provisional amounts during the measurement period, in the period such adjustments are identified, rather than retrospectively adjusting previously reported amounts. The Company does not expect the amendment, which is effective commencing with our 2016 fiscal year, to have a material impact on our consolidated financial statements. In August 2015, the FASB issued an amendment to defer for one year the effective date of the new standard on revenue recognition issued in May 2014. The new standard outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. The new standard is now effective commencing with our 2018 fiscal year and requires enhanced disclosures. We are currently evaluating the impact of the adoption of this standard on our consolidated financial statements. In July 2015, the FASB issued an amendment that requires entities to measure inventory at the lower of cost and net realizable value, rather than the lower of cost or market, with market value represented by replacement cost, net realizable value or net realizable value less a normal profit margin. The Company does not expect the amendment, which is effective commencing with our 2017 fiscal year, to have a material impact on our consolidated financial statements. In April 2015, the FASB issued an amendment that clarifies the accounting for fees paid in a cloud computing arrangement. The amendment provides guidance to customers about whether a cloud computing arrangement includes a software license. The amendment is effective commencing with our 2016 fiscal year. We are currently evaluating the impact of the adoption of this amendment on our consolidated financial statements. In February 2015, the FASB issued an amendment which revises the consolidation requirements and significantly changes the consolidation analysis required under current guidance. The amendment is effective commencing with our 2016 fiscal year. We are currently evaluating the impact of the adoption of this amendment on our consolidated financial statements. New Accounting Standards Adopted In April 2015, the FASB issued an amendment that modifies the presentation of debt issuance costs. The amendment requires debt issuance costs be presented in the balance sheet as a direct reduction of the related debt liability rather than as an asset. The Company early adopted this amendment, which required retrospective application, during the second quarter of 2015. The adoption of this guidance resulted in the reclassification of debt issuance costs of $8,243 from “Other assets” to “Long-term debt” in our condensed consolidated balance sheet as of December 28, 2014. See Note 7 for more information. In April 2014, the FASB issued an amendment that modifies the criteria for reporting a discontinued operation. The amendment changes the definition of a discontinued operation including the implementation guidance and requires expanded disclosures. The Company adopted this amendment, prospectively, during the first quarter of 2015. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of The Wendy’s Company (“The Wendy’s Company” and, together with its subsidiaries, the “Company,” “we,” “us,” or “our”) should be read in conjunction with the accompanying unaudited condensed consolidated financial statements and the related notes included elsewhere within this report and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 28, 2014 (the “Form 10-K”). There have been no material changes as of September 27, 2015 to the application of our critical accounting policies as described in Item 7 of the Form 10-K. Certain statements we make under this Item 2 constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. See “Special Note Regarding Forward-Looking Statements and Projections” in “Part II - Other Information” preceding Item 1 of Part II. You should consider our forward-looking statements in light of our unaudited condensed consolidated financial statements, related notes and other financial information appearing elsewhere in this report, the Form 10-K and our other filings with the Securities and Exchange Commission. The Wendy’s Company is the parent company of its 100% owned subsidiary holding company, Wendy’s Restaurants, LLC (“Wendy’s Restaurants”). The principal 100% owned subsidiary of Wendy’s Restaurants is Wendy’s International, LLC and its subsidiaries (“Wendy’s”). Wendy’s franchises and operates company-owned Wendy’s® quick-service restaurants throughout North America (defined as the United States of America (“U.S.”) and Canada). Wendy’s also has franchised restaurants in 27 foreign countries and U.S. territories. Wendy’s restaurants offer an extensive menu specializing in hamburger sandwiches and featuring fillet of chicken breast sandwiches, chicken nuggets, chili, french fries, baked potatoes, freshly prepared salads, soft drinks, Frosty® desserts and kids’ meals. In addition, the restaurants sell a variety of promotional products on a limited basis. The Company manages and internally reports its business geographically. The operation and franchising of Wendy’s restaurants in North America comprises virtually all of our current operations and represents a single reportable segment. The revenues and operating results of Wendy’s restaurants outside of North America are not material. The results of operations discussed below may not necessarily be indicative of future results. The Company reports on a fiscal year consisting of 52 or 53 weeks ending on the Sunday closest to December 31. All three month and nine month periods presented herein contain 13 weeks and 39 weeks, respectively. Our current fiscal year, ending on January 3, 2016, will contain 53 weeks and, accordingly, our fourth quarter of 2015 will contain 14 weeks. All references to years and quarters relate to fiscal periods rather than calendar periods. On May 31, 2015, Wendy’s completed the sale of its company-owned bakery, The New Bakery Company, LLC (the “Bakery”), a 100% owned subsidiary of Wendy’s. As a result of the sale of the Bakery, as further discussed below in “Sale of the Bakery,” the Bakery’s results of operations for all periods presented and the (loss) gain on disposal have been included in “Net (loss) income from discontinued operations” in our condensed consolidated statements of operations. Prior to fiscal 2015, the Company reported its system optimization initiative as a discrete event and separately included the related gain or loss on sales of restaurants, impairment losses and other associated costs, along with other restructuring initiatives, in “Facilities action charges (income), net.” In February 2015, the Company announced plans to reduce its ongoing company-owned restaurant ownership to approximately 5% of the total system and further emphasized that restaurant dispositions and acquisitions are a continuous and integrated part of the overall strategy to optimize its restaurant portfolio. As a result, commencing with the first quarter of 2015, all gains and losses on dispositions are included on a separate line in our condensed consolidated statements of operations, “System optimization losses (gains), net” and impairment losses recorded in connection with the sale or anticipated sale of restaurants (“System Optimization Remeasurement”) are reclassified to “Impairment of long-lived assets.” In addition, the Company retitled the line, “Facilities action charges (income), net” to “Reorganization and realignment costs” in our condensed consolidated statements of operations to better describe the current and historical initiatives included given the reclassifications described above. The Company believes the new presentation will aid users in understanding its results of operations. The prior periods reflect reclassifications to conform to the current year presentation. All amounts being reclassified in our statements of operations were separately disclosed in the notes to our consolidated financial statements included in our Form 10-Q for the fiscal quarter ended September 28, 2014 and Form 10-K. Such reclassifications had no impact on operating profit, net income or net income per share. See Note 1 of the Financial Statements contained in Item 1 herein for a tabular illustration of the reclassifications. Executive Overview Sale of the Bakery On May 31, 2015, Wendy’s completed the sale of 100% of its membership interest in the Bakery to East Balt US, LLC (the “Buyer”) for $78.5 million in cash (subject to customary purchase price adjustments). The Company recorded a pre-tax gain on the disposal of the Bakery of $27.5 million during the nine months ended September 27, 2015, which included transaction closing costs and a reduction of goodwill. The Company recognized income tax expense associated with the gain on disposal of $12.7 million during the nine months ended September 27, 2015, which included the impact of the disposal of non-deductible goodwill. In conjunction with the Bakery sale, Wendy’s entered into a transition services agreement with the Buyer, pursuant to which Wendy’s will provide certain continuing corporate and shared services to the Buyer through March 31, 2016 for no additional consideration. Our Continuing Business As of September 27, 2015, the Wendy’s restaurant system was comprised of 6,487 restaurants, of which 852 were owned and operated by the Company. All of our company-owned restaurants are located in the U.S. as a result of the Company completing its initiative during the second quarter of 2015 to sell all company-owned restaurants in Canada to franchisees. Wendy’s operating results are impacted by a number of external factors, including unemployment, general economic trends, intense price competition, commodity costs and weather. Wendy’s long-term growth opportunities will be driven by a combination of brand relevance and economic relevance. Key components of growth include (1) North America systemwide same-restaurant sales growth through continuing core menu improvement and product innovation, (2) investing in our Image Activation program, which includes innovative exterior and interior restaurant designs for our new and reimaged restaurants and focused execution of operational excellence, (3) growth in new restaurants, including global growth, (4) increased restaurant utilization in various dayparts and brand access utilizing mobile technology, (5) building shareholder value through financial management strategies and (6) our system optimization initiative. Wendy’s revenues for the first nine months of 2015 include: (1) $1,101.6 million of sales at company-owned restaurants and (2) $235.3 million of royalty revenue, $60.5 million of rental income and $8.5 million of franchise fees from franchisees. Substantially all of our Wendy’s royalty agreements provide for royalties of 4.0% of franchisees’ revenues. Key Business Measures We track our results of operations and manage our business using the following key business measures: Same-Restaurant Sales We report Wendy’s same-restaurant sales commencing after new restaurants have been open for at least 15 continuous months and after remodeled restaurants have been reopened for three continuous months. This methodology is consistent with the metric used by our management for internal reporting and analysis. The tables summarizing same-restaurant sales below in “Results of Operations” provides the same-restaurant sales percent changes. Same-restaurant sales exclude the impact of currency translation. •Restaurant Margin We define restaurant margin as sales from company-owned restaurants less cost of sales divided by sales from company-owned restaurants. Cost of sales includes food and paper, restaurant labor and occupancy, advertising and other operating costs. Restaurant margin is influenced by factors such as restaurant openings and closures, price increases, the effectiveness of our advertising and marketing initiatives, featured products, product mix, the level of our fixed and semi-variable costs and fluctuations in food and labor costs. In July 2013, the Company announced a system optimization initiative, as part of its brand transformation, which includes a shift from company-owned restaurants to franchised restaurants over time, through acquisitions and dispositions, as well as helping to facilitate franchisee-to-franchisee restaurant transfers. During 2013 and 2014, the Company completed the sale of 244 and 255 company-owned restaurants to franchisees, respectively. During the second quarter of 2015, the Company completed its plan to sell all of its company-owned restaurants in Canada to franchisees, with the sale of 83 Canadian restaurants, bringing the aggregate total of Canadian restaurants sold to franchisees to 129 during 2014 and 2015. In February 2015, the Company announced plans to sell approximately 540 additional restaurants to franchisees and reduce its ongoing company-owned restaurant ownership to approximately 5% of the total system by the end of 2016. During the third quarter of 2015, the Company completed the sale of nine restaurants. As of September 27, 2015, the company had classified 274 restaurants as held for sale. Gains and losses recognized on dispositions are recorded to “System optimization losses (gains), net” in our condensed consolidated statements of operations. During the first nine months of 2015 and 2014, the Company completed the sale of 109 and 190 company-owned restaurants to franchisees, respectively, as well as other assets, and recognized net gains totaling $14.8 million and $74.0 million, respectively. Costs related to our system optimization initiative are recorded to “Reorganization and realignment costs.” During the first nine months of 2015 and 2014, the Company recognized costs totaling $6.6 million and $17.4 million, respectively, which primarily included severance and related employee costs, accelerated depreciation and amortization, share-based compensation expense and professional fees. The Company expects to incur additional costs of approximately $10.0 million in aggregate during the remainder of 2015 and 2016 in connection with its system optimization initiative. Such costs are primarily comprised of accelerated amortization of previously acquired franchise rights related to company-owned restaurants in territories that will be sold to franchisees of approximately $3.0 million and professional fees of approximately $7.0 million. In November 2014, the Company initiated a plan to reduce its general and administrative expenses. The plan includes a realignment and reinvestment of resources to focus primarily on accelerated restaurant development and consumer-facing restaurant technology to drive long-term growth. The Company expects to achieve the majority of the expense reductions through the realignment of its U.S. field operations and savings at its Restaurant Support Center in Dublin, Ohio, which was substantially completed by the end of the second quarter of 2015. The Company recognized costs totaling $10.0 million in the first nine months of 2015, which primarily included severance and related employee costs and share-based compensation and were recorded to “Reorganization and realignment costs.” The Company expects to incur additional costs aggregating approximately $3.0 million during the remainder of 2015 and 2016, comprised primarily of recruitment and relocation costs for the reinvestment in resources to drive long-term growth. Securitized Financing Facility As further described below in “Liquidity and Capital Resources - Securitized Financing Facility,” on June 1, 2015, the Company completed a $2,275.0 million securitized financing facility, which consists of the following: $875.0 million of 3.371%, $900.0 million of 4.080% and $500.0 million of 4.497% Series 2015-1 fixed rate senior secured notes (collectively the “Series 2015-1 Class A-2 Notes”). In addition, the Company entered into a purchase agreement for the issuance of Series 2015-1 variable funding senior secured notes, Class A-1 (the “Series 2015-1 Class A-1 Notes” and, together with the Series 2015-1 Class A-2 Notes, the “Series 2015-1 Senior Notes”), which allows for the issuance of up to $150.0 million of variable funding notes and certain other credit instruments, including letters of credit. The proceeds from the issuance of the Series 2015-1 Class A-2 Notes, were used to repay all amounts outstanding on the Term A Loans and Term B Loans under the Company’s May 16, 2013 Restated Credit Agreement amended on September 24, 2013 (the “2013 Restated Credit Agreement”). In connection with the repayment of the Term A Loans and Term B Loans, the Company terminated the related interest rate swaps with notional amounts totaling $350.0 million and $100.0 million, respectively, which had been designated as cash flow hedges. As a result, the Company recorded a loss on early extinguishment of debt of $7.3 million during the second quarter of 2015, primarily consisting of the write-off of deferred costs related to the 2013 Restated Credit Agreement of $7.2 million and fees paid to terminate the related interest rate swaps of $0.1 million. On June 2, 2015, the Company entered into a stock purchase agreement to repurchase our common stock from Nelson Peltz, Peter W. May and Edward P. Garden (who are members of the Company’s Board of Directors) and certain of their family members and affiliates, investment funds managed by Trian Fund Management, L.P. (an investment management firm controlled by Messrs. Peltz, May and Garden, “TFM”) and the general partner of certain of those funds (together with Messrs. Peltz, May and Garden, certain of their family members and affiliates and TFM, the “Trian Group”), who in the aggregate owned approximately 24.8% of the Company’s outstanding shares as of May 29, 2015. Pursuant to the agreement, the Trian Group agreed not to tender or sell any of its shares in the modified Dutch auction tender offer the Company commenced on June 3, 2015. Also pursuant to the agreement, the Company agreed, following completion of the tender offer, to purchase from the Trian Group a pro rata amount of its shares based on the number of shares the Company purchases in the tender offer, at the same price received by shareholders who participated in the tender offer. On July 17, 2015, after completion of the modified Dutch auction tender offer, the Company repurchased 18.4 million shares of its common stock from the Trian Group at the price paid in the tender offer of $11.45 per share, for an aggregate purchase price of $210.9 million. TimWen Lease and Management Fees A wholly-owned subsidiary of Wendy’s leases restaurant facilities from TimWen for the operation of Wendy’s/Tim Hortons combo units in Canada. Prior to the second quarter of 2015, Wendy’s operated certain of the Wendy’s/Tim Hortons combo units in Canada and subleased some of the restaurant facilities to franchisees. As a result of the Company completing its plan to sell all of its company-owned restaurants in Canada to franchisees during the second quarter of 2015, all of the restaurant facilities are subleased to franchisees. During the nine months ended September 27, 2015 and September 28, 2014, Wendy’s paid TimWen $9.1 million and $4.8 million, respectively, under these lease agreements. Prior to 2015, franchisees paid TimWen directly for these subleases. TimWen paid Wendy’s a management fee under the TimWen joint venture agreement of $0.2 million during both the nine months ended September 27, 2015 and September 28, 2014, which has been included as a reduction to “General and administrative.” The tables included throughout Results of Operations set forth in millions the Company’s consolidated results of operations for the three months ended September 27, 2015 and September 28, 2014. As a result of the sale of the Bakery discussed above in “Introduction - Sale of the Bakery,” the Bakery’s results of operations for the three months ended September 28, 2014 have been included in “(Loss) income from discontinued operations, net of income taxes” in the table below. (Loss) gain on disposal of discontinued operations, net of income

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Question: Case Description Device Co. Is A Telecom Company Offering A Variety Of Services Across The Spectrum – App Development, App Support, Data Centre, Data Network, Voice Network Etc. The Company Has Gone Through Several Divestitures In Recent Years, But Its IT Cost Base Has Grown Disproportionately To Revenue. The Company Has Outsourced Some Of Its Functions … Sexuality affects individuals and society across a broad spectrum of activities through health. Get college assignment help at uniessay writers SE 8. Assume that the step in SE 6 is depreciated using the double-declining-balance method. How much would depreciation expense be in each year? 25. The Francis Company is expected to pay a dividend of 25. The Francis Company is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company’s beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company’s current stock price? SE 8. Assume that the step in SE 6 is depreciated SE 8. Assume that the step in SE 6 is depreciated using the double-declining-balance method. How much would depreciation expense be in each year? You are given the following information for transactions by Schwinghamer Co. You are given the following information for transactions by Schwinghamer Co. All transactions are set Record P6-6B in cash. Schwinghamer uses a perpetual inventory system and the FIFO cost formula. Unit Cost/ Units Selling Price perpet LCNR Date Transaction Oct. 1Beginning inventory 5 Purchase 8 Sale 15 Purchase 20 Sale 25 Purchase 60 110 (140) 52 (70) 15 $14 13 20 12 16 Instructions e) Prepare the required journal entries for the month of October for Schwinghamer Co. b) Determine the ending inventory for Schwinghamer. ) On October 31, Schwinghamer determines that the product has a net realizable value of $10 per unit. What amount should the inventory be valued at on the October 31 balance sheet? Prepare any required journal entries Panza Corporation had net income of $250,000 and paid dividends to Panza Corporation had net income of $250,000 and paid dividends to common stockholders of $50,000 in 2010. The weighted average number of shares outstanding in 2010 was 50,000 shares. Panza Corporation’s common stock is selling for $40 per share on the New York Stock Exchange. Panza Corporation’s price-earnings ratio is A, B, . The April 30 cash balance according to the accounting records . The April 30 cash balance according to the accounting records is $78,356, and the bank statement cash balance for that date is $83,525. As of December 31, 2008, Stand Still Industries had $1,500 of As of December 31, 2008, Stand Still Industries had $1,500 of raw materials inventory. At the beginning of 2008, there was $1,200 of materials on hand. During the year, the company purchased $183,000 of materials; however, it paid for only $175,500. How much inventory was requisitioned for use on jobs during 2008? Where is the actuarial liability shown in a Comprehensive Annual Financial Where is the actuarial liability shown in a Comprehensive Annual Financial Report for a pension trust fund? A) The Statement of Fiduciary Net Assets. B) The Schedule of Funding Progress (RSI). C) The General Fund Balance Sheet only. D) The Government-wide Statement of Net Assets. For better management acceptance, the flow of input data for budgeting For better management acceptance, the flow of input data for budgeting should begin with the Accounting Problem – Leases On Jan 1, 2004, Haden company [ Get college assignment help at uniessay writers Accounting Problem – Leases On Jan 1, 2004, Haden company [ lessor] entered into a non-cancelable cancelable lease agreement with Sandy company[ lessee] for machinery was carried on the accounting records of Haden at $4,530,000 and had a market value of $4,800,000. Minimum lease payments under the lease agreement which expires on December 31, 2013 total $7,100,000. Payments of $710,000 are due each January 1. The first payment was made on January 1, 2004 when the lease agreement was finalized. The interest rate of 10 % which was stipulated in the lease agreement is the implicit rate set by the lessor. The effective interest method of amortization is being used. Sandy expects the machine to have a ten year life with no salvage value, and to be depreciated on as straight-line basic. Collectibility of the rentals is reasonably predictable, and there are no important uncertainties surrounding the costs yet to be incurred by the lessor. Instructions [a] [1]From the lessee’s viewpoint. What kind of lease is the above agreement? Give reasons and supporting calculations [a] [2] From the lessor’s viewpoint. What kind of lease is the above agreement? Give reasons and supporting calculations [b] What should be the income before income taxes derived by Haden from the lease for the year ended December 31, 2004? Show supporting calculations [c] Ignoring income taxes, what should be the expenses incurred by Sandy from this lease for the year ended December 31, 2004? Show supporting calculations. [d] What journal entries should be recorded by Sandy company on January 1, 2004? [e] What journal entries should be recorded by Haden company on January 1, 2004? Attached document with assignment Ford County levies for its General Fund $2,000,000 in property taxes. Ford County levies for its General Fund $2,000,000 in property taxes. In addition, the county is responsible for collecting $4,000,000 in property taxes for the consolidated school district and $1,000,000 in property taxes for a town within the county. 2% of all taxes levied are expected to be uncollectible. When recording the levies in an agency fund, what amount would Ford County record as Taxes Receivable for Other Governments – Current and Due to Other Governments? a. $6,900,000. b. $5,000,000. c. $7,000,000. d. $4,900,000. the cost of goods manufactured during the year amounted to $665,000 the cost of goods manufactured during the year amounted to $665,000 and annual sales were $998,000, how much is the amount of gross profit for the year? The first type is 60% pure fruit juice, and the second The first type is 60% pure fruit juice, and the second type is 85% pure fruit juice. The company is attempting to produce a fruit drink that contains 74% pure fruit juice. How many pints of each of the two existing types of drink must be used to make 90 pints of a mixture that is 75% pure fruit juice? ACCT 2302 Problem 18-2A 10. Which of the following is true regarding the reporting of 10. Which of the following is true regarding the reporting of investments by state and local governmental units? A) Investments, for which a determinable fair value can be obtained, are to be reported at fair value. B) Realized and unrealized gains and losses are to be combined in the relevant operating statement (for example, the Statement of Changes in Fiduciary Net Assets). C) Both of the above. D) Neither of the above. During 2010 Sedgewick Inc. had sales on account of $132,000, cash During 2010 Sedgewick Inc. had sales on account of $132,000, cash sales of $54,000, and collections on account of $84,000. In addition, they collected $1,450 which had been written off as uncollectible in 2009. As a result of these transactions the change in the accounts receivable balance indicates a The investment category for which the investor’s “positive intent and ability The investment category for which the investor’s “positive intent and ability to hold” is important is: A. Securities reported under the equity method. B. Trading securities. C. Securities classified as held to maturity. D. Securities available for sale. 2. Which category completely excludes equity securities? A. Securities available for sale. B. Consolidating securities. C. Held-to-maturity securities. D. Trading securities. 3. In 2009, Osgood Corporation purchased $4 million in ten-year municipal bonds at face value. On December 31, 2011, the bonds had a market value of $3,600,000 and Osgood reclassified the bonds from held to maturity to trading securities. Osgood’s December 31, 2011, balance sheet and the 2011 income statement would show the following: A. Option A B. Option B C. Option C D. Option D 4. Securities that are purchased with the intent of selling them in the near future to take advantage of short-term price changes are classified as: A. Securities available for sale. B. Consolidating securities. C. Held-to-maturity securities. D. Trading securities. 5. The income statement reports changes in fair value for which type of securities? A. Securities reported under the equity method. B. Trading securities. C. Held-to-maturity securities. D. Securities available for sale. 6. On January 1, 2011, Nana Company paid $100,000 for 8,000 shares of Papa Company common stock. These securities were classified as trading securities. The ownership in Papa Company is 10%. Papa reported net income of $52,000 for the year ended December 31, 2011. The fair value of the Papa stock on that date was $45 per share. What amount will be reported in the balance sheet of Nana Company for the investment in Papa at December 31, 2011? A. $284,400. B. $300,000. C. $315,600. D. $360,000. 7. Goofy Inc. bought 15,000 shares of Crazy Co.’s stock for $150,000 on May 5, 2010, and classified the stock as available for sale. The market value of the stock declined to $118,000 by December 31, 2010. Goofy reclassified this investment as trading securities in December of 2011 when the market value had risen to $125,000. What effect on 2011 income should be reported by Goofy for the Crazy Co. shares? A. $0. B. $25,000 net loss. C. $7,000 net gain. D. $32,000 net loss. 8. All investments in debt and equity securities that don’t fit the definitions of the other reporting categories are classified as: A. Trading securities. B. Securities available for sale. C. Held-to-maturity securities. D. Consolidated securities. 9. When an equity security is appropriately carried and reported as securities available for sale, a gain should be reported in the income statement: A. When the fair value of the security increases. B. When the present value of the security increases. C. Only when the Dow Jones Industrial Average increases at least 100 points. D. Only when the security is sold. 10. Unrealized holding gains and losses on securities available for sale would have the following effects on accumulated other comprehensive income: A. Option A B. Option B C. Option C D. Option D 11. Unrealized holding gains and losses on securities available for sale would have the following effects on retained earnings: A. Option a B. Option b C. Option c D. Option d 12. On January 2, 2010, Howdy Doody Corporation purchased 12% of Ranger Corporation’s common stock for $50,000 and classified the investment as available for sale. Ranger’s net income for the years ended December 31, 2010 and 2011, were $10,000 and $50,000, respectively. During 2011, Ranger declared and paid a dividend of $60,000. There were no dividends in 2010. On December 31, 2010, the fair value of the Ranger stock owned by Howdy Doody had increased to $70,000. How much should Howdy Doody show in the 2011 income statement as income from this investment? A. $26,000. B. $7,200. C. $20,000. D. $27,200. 13. If an available-for-sale investment is sold for which there are unrealized gains in accumulated other comprehensive income (AOCI), a reclassification adjustment affects other comprehensive income (OCI) in the period of sale by A. reducing OCI for the amount of unrealized gains in AOCI. B. increasing OCI for the amount of unrealized gains in AOCI. C. no effect on OCI, as OCI only includes the effects of unrealized gains and losses. D. no effect on OCI, as the realized gain is included in AOCI. 14. Seybert Systems accounts for its investment in Wang Engineering as available for sale. Seybert’s balance in accumulated other comprehensive income with respect to the Wang investment is a credit balance of $20,000, and Seybert lists the investment at $100,000 on its balance sheet. Seybert purchased the Wang investment for (ignore taxes): A. $100,000. B. $120,000. C. $80,000. D. cannot be determined from this information. 15. When the equity method of accounting for investments is used by the investor, the investment account is increased when: A. A cash dividend is received from the investee. B. The investee reports a net income for the year. C. The investor records additional depreciation related to the investment. D. The investee reports a net loss for the year. 16. Which of the following increases the investment account under the equity method of accounting? A. Decreasing the market price of the investee’s stock B. Dividends paid by the investee that were declared in the previous year C. Net loss of the investee company D. None of the above is correct. 17. If the fair value of equity securities is not determinable and the equity method is not appropriate, the securities should be reported at: A. Amortized cost. B. Cost. C. Consolidated value. D. Net present value. 18. On July 1, 2011, Tremen Corporation acquired 40% of the shares of Delany Company. Tremen paid $3,000,000 for the investment, and that amount is exactly equal to 40% of the fair value of identifiable net assets on Delany’s balance sheet. Delany recognized net income of $1,000,000 for 2011, and paid $150,000 quarterly dividends to its shareholders. After all closing entries are made, Tremen’s “Investment in Delany Company” account would have a balance of: A. $3,200,000. B. $3,160,000. C. $3,000,000. D. $3,080,000. 19. Jack Corporation purchased a 20% interest in Jill Corporation for $1,500,000 on January 1, 2011. Jack can significantly influence Jill. On December 10, 2011, Jill declared and paid $1 million in dividends. Jill reported a net loss of $6 million for the year. What amount of loss should Jack report in its income statement for 2011 relative to its investment in Jill? A. $1 000,000. B. $1,200,000. C. $1,400,000. D. $1,500,000. 20. Sox Corporation purchased a 40% interest in Hack Corporation for $1,500,000 on Jan 1, 2011. On November 1, 2011, Hack declared and paid $1 million in dividends. On December 31, Hack reported a net loss of $6 million for the year. What amount of loss should Sox report on its income statement for 2011 relative to its investment in Hack? A. $1,100,000. B. $2,400,000. C. $1,500,000. D. $1,600,000. Nichols Company had 500 units of “Dink” in its inventory at Nichols Company had 500 units of “Dink” in its inventory at a cost of $5 each. It purchased, for $2,400, 300 more units of “Dink”. Nichols then sold 600 units at a selling price of $10 each, resulting in a gross profit of $2,100. The cost flow assumption used by Kingman I am using the following text book: Accounting (Tools for Business I am using the following text book: Accounting (Tools for Business Decision Making 2nd Edition), I need the answer to problem 18-2A… ISBN: 10-0-470-08744-7 / ISBN: 13-978-0-470-08744-2 The post SE 8. Assume that the step in SE 6 is depreciated appeared first on uniessay writers.

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professional_accounting

Revaluation Main Page: financial advisor, inventory control, finance, money, investment, business, tax advisor, accounting, Also see related: insurance, first time homebuyer, property, home financing, financing, homebuyer, homebuying, credit, home buyer, Definition of Revaluation An increase in the foreign exchange value of a currency that is pegged to other currencies or gold. Counterpart items In the balance of payments, counterpart items are analogous to unrequited transfers in the current account. They arise because the double-entry system in balance of payments accounting and refer to adjustments in reserves owing to monetization or demonetization of gold, allocation or cancellation of SDRs, and revaluation of the various components of total reserves. Cash-equivalent items Temporary investments of currently excess cash in short-term, high-quality investment media such as treasury bills and Banker's Acceptances. The parties to an interest rate swap. Counterparty Party on the other side of a trade or transaction. The risk that the other party to an agreement will default. In an options contract, the risk to the option buyer that the option writer will not buy or sell the underlying as agreed. Country economic risk Developments in a national economy that can affect the outcome of an international financial transaction. Nonrecurring Items Revenues or gains and expenses or losses that are not expected to recur on a regular basis. This term is often used interchangeably with special items. Significant credits or charges resulting from transactions or events that, in the view of management, are not representative of normal business activities of the period and that affect comparability of earnings. This term is often used interchangeably with nonrecurring Accelerated cost recovery system (ACRS) Schedule of depreciation rates allowed for tax purposes. An explanation or report in financial terms about the transactions of an organization. Account Value The sum of all the interest options in your policy, including interest. The process of satisfying stakeholders in the organization that managers have acted in the best interests of the stakeholders, a result of the stewardship function of managers, which takes place through accounting. A collection of systems and processes used to record, report and interpret business transactions. A broad, all-inclusive term that refers to the methods and procedures of financial record keeping by a business (or any entity); it also refers to the main functions and purposes of record keeping, which are to assist in the operations of the entity, to provide necessary information to managers for making decisions and exercising control, to measure profit, to comply with income and other tax laws, and to prepare financial Accounting and Auditing Enforcement Release (AAER) Administrative proceedings or litigation releases that entail an accounting or auditing-related violation of the securities laws. Accounting change An alteration in the accounting methodology or estimates used in the reporting of financial statements, usually requiring discussion in a footnote attached to the financial statements. Accounting earnings Earnings of a firm as reported on its income statement. Accounting entity A business for which a separate set of accounting records is being maintained. Accounting equation The representation of the double-entry system of accounting such that assets are equal to liabilities plus capital. The formula Assets = Liabilities + Equity. An equation that reflects the two-sided nature of a business entity, assets on the one side and the sources of assets on the other side (assets = liabilities + owners� equity). The assets of a business entity are subject to two types of claims that arise from its two basic sources of capital�liabilities and owners� equity. The accounting equation is the foundation for double-entry bookkeeping, which uses a scheme for recording changes in these basic types of accounts as either debits or credits such that the total of accounts with debit balances equals the total of accounts with credit balances. The accounting equation also serves as the framework for the statement of financial condition, or balance sheet, which is one of the three fundamental financial statements reported by a business. Accounting Errors Unintentional mistakes in financial statements. accounted for by restating the prior-year financial statements that are in error. Accounting exposure The change in the value of a firm's foreign currency denominated accounts due to a change in exchange rates. Accounting insolvency total liabilities exceed total assets. A firm with a negative net worth is insolvent on the books. Accounting Irregularities Intentional misstatements or omissions of amounts or disclosures in financial statements done to deceive financial statement users. The term is used interchangeably with fraudulent financial reporting. Accounting liquidity The ease and quickness with which assets can be converted to cash. Accounting period The period of time for which financial statements are produced � see also financial year. The principles, bases, conventions, rules and procedures adopted by management in preparing and presenting financial statements. Accounting rate of return (ARR) A method of investment appraisal that measures the profit generated as a percentage of the investment � see return on investment. the rate of earnings obtained on the average capital investment over the life of a capital project; computed as average annual profits divided by average investment; not based on cash flow A set of accounts that summarize the transactions of a business that have been recorded on source documents. �Buckets� within the ledger, part of the accounting system. Each account contains similar transactions (line items) that are used for the production of financial statements. Or commonly used as an abbreviation for financial statements. Money owed to suppliers. Amounts a company owes to creditors. Amounts owed by the company for goods and services that have been received, but have not yet been paid for. Usually accounts payable involves the receipt of an invoice from the company providing the services or goods. Short-term, non-interest-bearing liabilities of a business that arise in the course of its activities and operations from purchases on credit. A business buys many things on credit, whereby the purchase cost of goods and services are not paid for immediately. This liability account records the amounts owed for credit purchases that will be paid in the short run, which generally means about one month. Acurrent liability on the balance sheet, representing short-term obligations to pay suppliers. Amounts due to vendors for purchases on open account, that is, not evidenced by a signed note. Accounts Payable Days (A/P Days) The number of days it would take to pay the ending balance in accounts payable at the average rate of cost of goods sold per day. Calculated by dividing accounts payable by cost of goods sold per day, which is cost of goods sold divided by 365. Money owed by customers. Amounts owed to a company by customers that it sold to on credit. total accounts receivable are usually reduced by an allowance for doubtful accounts. Amounts owed to the company, generally for sales that it has made. Short-term, non-interest-bearing debts owed to a business by its customers who bought goods and services from the business on credit. Generally, these debts should be collected within a month or so. In a balance sheet, this asset is listed immediately after cash. (Actually the amount of short-term marketable investments, if the business has any, is listed after cash and before accounts receivable.) accounts receivable are viewed as a near-cash type of asset that will be turned into cash in the short run. A business may not collect all of its accounts receivable. See also bad debts. A current asset on the balance sheet, representing short-term amounts due from customers who have purchased on account. Amounts due from customers for sales on open account, not evidenced Money owed to a business for merchandise or services sold on open account. Accounts Receivable Days (A/R Days) The number of days it would take to collect the ending balance in accounts receivable at the year's average rate of revenue per day. Calculated as accounts receivable divided by revenue per day (revenue divided by 365). The ratio of net credit sales to average accounts receivable, a measure of how quickly customers pay their bills. accounts receivable turnover ratio A ratio computed by dividing annual sales revenue by the year-end balance of accounts receivable. Technically speaking, to calculate this ratio the amount of annual credit sales should be divided by the average accounts receivable balance, but this information is not readily available from external financial statements. For reporting internally to managers, this ratio should be refined and finetuned to be as accurate as possible. The recording of revenue when earned and expenses when incurred, irrespective of the dates on which the associated cash flows occur. accrual-basis accounting Well, frankly, accrual is not a good descriptive term. Perhaps the best way to begin is to mention that accrual-basis accounting is much more than cash-basis accounting. Recording only the cash receipts and cash disbursement of a business would be grossly inadequate. A business has many assets other than cash, as well as many liabilities, that must be recorded. Measuring profit for a period as the difference between cash inflows from sales and cash outflows for expenses would be wrong, and in fact is not allowed for most businesses by the income tax law. For management, income tax, and financial reporting purposes, a business needs a comprehensive record-keeping system�one that recognizes, records, and reports all the assets and liabilities of a business. This all-inclusive scope of financial record keeping is referred to as accrual-basis accounting. Accrual-basis accounting records sales revenue when sales are made (though cash is received before or after the sales) and records expenses when costs are incurred (though cash is paid before or after expenses are recorded). Established financial reporting standards require that profit for a period must be recorded using accrual-basis accounting methods. Also, these authoritative standards require that in reporting its financial condition a business must use accrual-basis accounting. Accruals accounting A method of accounting in which profit is calculated as the difference between income when it is earned and expenses when They are incurred. Cumulative gains or losses reported in shareholders' equity that arise from changes in the fair value of available-for-sale securities, from the effects of changes in foreign-currency exchange rates on consolidated foreign-currency financial statements, certain gains and losses on financial derivatives, and from adjustments for underfunded pension plans. Accumulated Value An amount of money invested plus the interest earned on that money. actual cost system a valuation method that uses actual direct material, direct labor, and overhead charges in determining the cost of Work in Process Inventory Adjustable rate preferred stock (ARPS) Publicly traded issues that may be collateralized by mortgages and MBSs. Adjusted present value (APV) The net present value analysis of an asset if financed solely by equity (present value of un-levered cash flows), plus the present value of any financing decisions (levered cash flows). In other words, the various tax shields provided by the deductibility of interest and the benefits of other investment tax credits are calculated separately. This analysis is often used for highly leveraged transactions such as a leverage buy-out. Aggressive Accounting A forceful and intentional choice and application of accounting principles done in an effort to achieve desired results, typically higher current earnings, whether the practices followed are in accordance with generally accepted accounting principles or not. Aggressive accounting practices are not alleged to be fraudulent until an administrative, civil, or criminal proceeding takes that step and alleges, in particular, that an intentional, material misstatement has taken place in an effort to deceive financial statement readers. the systematic assignment of an amount to a recipient set of categories annuity a series of equal cash flows (either positive or negative) per period The process of storing costs in one account and shifting them to other accounts, based on some relevant measure of activity. Allocation base A measure of activity or volume such as labour hours, machine hours or volume of production used to apportion overheads to products and Allowance for doubtful accounts A contra account related to accounts receivable that represents the amounts that the company expects will not be collected. An estimate of the uncollectible portion of accounts receivable that is subtracted from the gross amount of accounts receivable to arrive at the estimated collectible amount. The second-largest stock exchange in the United States. It trades mostly in small-to medium-sized companies. approximated net realizable value at split-off allocation a method of allocating joint cost to joint products using a simulated net realizable value at the split-off point; approximated value is computed as final sales price minus incremental separate costs Asian currency units (ACUs) Dollar deposits held in Singapore or other Asian centers. Asset allocation decision The decision regarding how an institution's funds should be distributed among the major classes of assets in which it may invest. Auction rate preferred stock (ARPS) Floating rate preferred stock, the dividend on which is adjusted every seven weeks through a Dutch auction. Automated storage/retrieval system A racking system using automated systems to load and unload the racks. Average accounting return The average project earnings after taxes and depreciation divided by the average book value of the investment during its life. Average age of accounts receivable The weighted-average age of all of the firm's outstanding invoices. Balance of Merchandise Trade The difference between exports and imports of goods. A statistical compilation formulated by a sovereign nation of all economic transactions between residents of that nation and residents of all other nations during a stipulated period of time, usually a calendar year. The difference between the demand for and supply of a country's currency on the foreign exchange market. Balance of Payments Accounts A statement of a country's transactions with other countries. Net flow of goods (exports minus imports) between countries. See balance of merchandise trade. Also called the statement of financial condition, it is a summary of the assets, liabilities, and owners' equity. A �snapshot� statement that freezes a company on a particular day, like the last day of the year, and shows the balances in its asset, liability, and stockholders� equity accounts. It�s governed by the formula: Assets = Liabilities + Stockholders� Equity. A financial statement showing the financial position of a business � its assets, liabilities and capital � at the end of an accounting period. One of the basic financial statements; it lists the assets, liabilities, and equity accounts of the company. The balance Sheet is prepared using the balances at the end of a specific day. A term often used instead of the more formal and correct term�statement of financial condition. This financial statement summarizes the assets, liabilities, and owners� equity sources of a business at a given moment in time. It is prepared at the end of each profit period and whenever else it is needed. It is one of the three primary financial statements of a business, the other two being the income statement and the statement of cash flows. The values reported in the balance sheet are the amounts used to determine book value per share of capital stock. Also, the book value of an asset is the amount reported in a business�s most recent balance sheet. A report that summarizes all assets, liabilities, and equity for a company for a given point in time. Financial statement that shows the value of the firm�s assets and liabilities at a particular time. A financial report showing the status of a company's assets, liabilities, and owners' equity on a given date. Balance sheet exposure See:accounting exposure. Balance sheet identity total Assets = total Liabilities + total Stockholders' Equity Balanced-Budget Multiplier The multiplier associated with a change in government spending financed by an equal change in taxes. An investment company that invests in stocks and bonds. The same as a balanced mutual fund. Balanced mutual fund This is a fund that buys common stock, preferred stock and bonds. The same as a balanced fund. A system of non-financial performance measurement that links innovation, customer and process measures to financial performance. balanced scorecard (BSC) an approach to performance measurement that weighs performance measures from four perspectives: financial performance, an internal business perspective, a customer perspective, and an innovation and learning perspective Basic balance In a balance of payments, the basic balance is the net balance of the combination of the current account and the capital account. Benefit Value The amount of cash payable on a benefit. General term for a document demanding payment. Blocked currency A currency that is not freely convertible to other currencies due to exchange controls. Bond value With respect to convertible bonds, the value the security would have if it were not convertible apart from the conversion option. Book-entry securities The Treasury and federal agencies are moving to a book-entry system in which securities are not represented by engraved pieces of paper but are maintained in computerized records at the Fed in the names of member banks, which in turn keep records of the securities They own as well as those They are holding for customers. In the case of other securities where a book-entry has developed, engraved securities do exist somewhere in quite a few cases. These securities do not move from holder to holder but are usually kept in a central clearinghouse or by another agent. A company's book value is its total assets minus intangible assets and liabilities, such as debt. A company's book value might be more or less than its market value. An asset�s cost basis minus accumulated depreciation. The value of an asset as carried on the balance sheet of a company. In reference to the value of a company, it is the net worth (equity) of the company. An asset�s original cost, less any depreciation that has been subsequently incurred. Net worth of the firm�s assets or liabilities according to the balance sheet. book value and book value per share Generally speaking, these terms refer to the balance sheet value of an asset (or less often of a liability) or the balance sheet value of owners� equity per share. Either term emphasizes that the amount recorded in the accounts or on the books of a business is the value being used. The total of the amounts reported for owners� equity in its balance sheet is divided by the number of stock shares of a corporation to determine the book value per share of its capital stock. BOOK VALUE OF COMMON STOCK The theoretical amount per share that each stockholder would receive if a company�s assets were sold on the balance sheet�s date. Book value equals: (Stockholders� equity) / (Common stock shares outstanding) The ratio of stockholder equity to the average number of common shares. Book value per share should not be thought of as an indicator of economic worth, since it reflects accounting valuation (and not necessarily market valuation). The book value of a company divided by the number of shares business intelligence (BI) system a formal process for gathering and analyzing information and producing intelligence to meet decision making needs; requires information about internal processes as well as knowledge, technologies, and competitors

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professional_accounting

Number of shares outstanding of issuer’s common stock, as of February 24, 2019, was 485,914,676. Comprehensive income attributable to Conagra Brands, Inc. The unaudited financial information reflects all adjustments, which are, in the opinion of management, necessary for a fair presentation of the results of operations, financial position, and cash flows for the periods presented. The adjustments are of a normal recurring nature, except as otherwise noted. These Condensed Consolidated Financial Statements should be read in conjunction with the Consolidated Financial Statements and related notes included in the Conagra Brands, Inc. (the "Company", "Conagra Brands", "we", "us", or "our") Annual Report on Form 10-K for the fiscal year ended May 27, 2018. The results of operations for any quarter or a partial fiscal year period are not necessarily indicative of the results to be expected for other periods or the full fiscal year. Basis of Consolidation — The Condensed Consolidated Financial Statements include the accounts of Conagra Brands and all majority-owned subsidiaries. In addition, the accounts of all variable interest entities for which we have been determined to be the primary beneficiary are included in our Condensed Consolidated Financial Statements from the date such determination is made. All significant intercompany investments, accounts, and transactions have been eliminated. Revenue Recognition — Our revenues primarily consist of the sale of food products which are sold to retailers and foodservice customers through direct sales forces, broker, and distributor arrangements. These revenue contracts generally have single performance obligations. Revenue, which includes shipping and handling charges billed to the customer, is reported net of variable consideration and consideration payable to our customers, including applicable discounts, returns, allowances, trade promotion, consumer coupon redemption, unsaleable product, and other costs. Amounts billed and due from our customers are classified as receivables and require payment on a short-term basis and, therefore, we do not have any significant financing components. We recognize revenue when (or as) performance obligations are satisfied by transferring control of the goods to customers. Control is transferred upon delivery of the goods to the customer. Shipping and/or handling costs that occur before the customer obtains control of the goods are deemed to be fulfillment activities and are accounted for as fulfillment costs. We assess the goods and services promised in our customers' purchase orders and identify a performance obligation for each promise to transfer a good or service (or bundle of goods or services) that is distinct. We offer various forms of trade promotions and the methodologies for determining these provisions are dependent on local customer pricing and promotional practices, which range from contractually fixed percentage price reductions to provisions based on actual occurrence or performance. Our promotional activities are conducted either through the retail trade or directly with consumers and include activities such as in-store displays and events, feature price discounts, consumer coupons, and loyalty programs. The costs of these activities are recognized at the time the related revenue is recorded, which normally precedes the actual cash expenditure. The recognition of these costs therefore requires management judgment regarding the volume of promotional offers that will be redeemed by either the retail trade or consumer. These estimates are made using various techniques including historical data on performance of similar promotional programs. Differences between estimated expense and actual redemptions are recognized as a change in management estimate in a subsequent period. Comprehensive Income — Comprehensive income includes net income, currency translation adjustments, certain derivative-related activity, changes in the value of available-for-sale investments (prior to the adoption of Accounting Standards Update ("ASU") 2016-01), and changes in prior service cost and net actuarial gains (losses) from pension (for amounts not in excess of the 10% corridor) and post-retirement health care plans. On foreign investments we deem to be essentially permanent in nature, we do not provide for taxes on currency translation adjustments arising from converting an investment denominated in a foreign currency to U.S. dollars. When we determine that a foreign investment, as well as undistributed earnings, are no longer permanent in nature, estimated taxes will be provided for the related deferred tax liability (asset), if any, resulting from currency translation adjustments. 1 Net of unrealized gains on available-for-sale securities of $0.6 million reclassified to retained earnings as a result of the adoption of ASU 2016-01. 1 Amounts in parentheses indicate income recognized in the Condensed Consolidated Statements of Earnings. Cash and cash equivalents — Cash and all highly liquid investments with an original maturity of three months or less at the date of acquisition, including short-term time deposits and government agency and corporate obligations, are classified as cash and cash equivalents. Reclassifications and other changes — Certain prior year amounts have been reclassified to conform with current year presentation. liabilities, revenues, and expenses as reflected in the Condensed Consolidated Financial Statements. Actual results could differ from these estimates. Accounting Changes — In May 2014, the Financial Accounting Standards Board ("FASB") issued ASU 2014-09, Revenue from Contracts with Customers ("Topic 606"), which replaces most existing revenue recognition guidance in U.S. GAAP, including industry-specific requirements. Topic 606 provides companies with a single revenue recognition model for recognizing revenue with customers; specifically requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. We utilized a comprehensive approach to evaluate and document the impact of the guidance on our current accounting policies and practices in order to identify material differences, if any, that would result from applying the new requirements to our revenue contracts. We did not identify any material differences resulting from applying the new requirements to our revenue contracts. In addition, we did not identify any significant changes to our business processes, systems, and controls to support recognition and disclosure requirements under the new guidance. We adopted the provisions of Topic 606 in fiscal 2019 utilizing the modified retrospective method. We recorded a $0.5 million cumulative effect adjustment, net of tax, to the opening balance of fiscal 2019 retained earnings, a decrease to receivables of $7.6 million, an increase to inventories of $2.8 million, an increase to prepaid expenses and other current assets of $6.9 million, an increase to other accrued liabilities of $1.4 million, and an increase to other noncurrent liabilities of $0.2 million. The adjustments primarily related to the timing of recognition of certain customer charges, trade promotional expenditures, and volume discounts. In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall: Recognition and Measurement of Financial Assets and Financial Liabilities, which addresses certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. The effective date for this standard is for fiscal years beginning after December 31, 2017. We adopted this ASU in fiscal 2019. The adoption of this guidance did not have a material impact to our consolidated financial statements. this ASU retrospectively in fiscal 2019. The adoption of this guidance did not have a material impact to our consolidated financial statements. In November 2016, the FASB issued ASU 2016-18, Statement of Cash Flows: Restricted Cash, which provides amendments to current guidance to address the classifications and presentation of changes in restricted cash in the statement of cash flows. We adopted this ASU retrospectively in fiscal 2019. The adoption of this guidance did not have a material impact to our consolidated financial statements. In January 2017, the FASB issued ASU 2017-01, Business Combinations: Clarifying the Definition of a Business, which provides a new framework for determining whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. We adopted this ASU prospectively in fiscal 2019. The adoption of this guidance did not have a material impact to our consolidated financial statements. In August 2017, the FASB issued ASU 2017-12, Derivatives and Hedging: Targeted Improvements to Accounting for Hedging Activities, which improves the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements and make certain targeted improvements to simplify the application of the hedge accounting guidance in current U.S. GAAP. The amendments in this update better align an entity's risk management activities and financial reporting for hedging relationships through changes to both the designation and measurement guidance for qualifying hedging relationships and presentation of hedge results. The effective date for the standard is for fiscal years beginning after December 15, 2018. We elected to early adopt this ASU in fiscal 2019. The adoption of this guidance did not have a material impact to our consolidated financial statements. See Note 8 for a discussion of our derivatives. Recently Issued Accounting Standards — In February 2016, the FASB issued ASU 2016-02, Leases, Topic 842, which requires lessees to reflect most leases on their balance sheet as assets and obligations. The effective date for the standard is for fiscal years beginning after December 15, 2018. Early adoption is permitted. We are evaluating the effect that this standard will have on our consolidated financial statements and related disclosures. We have identified an accounting system to support the future state lease accounting process and have begun to develop the future state process design as part of the overall system implementation. We have begun populating the accounting system with lease data and validating the completeness and accuracy of such data. We expect the adoption of this standard to have a material impact to our balance sheets; however, we are not able, at this time, to reasonably estimate the expected increase in assets and liabilities in our condensed consolidated balance sheet upon adoption. The standard can be applied using the modified retrospective method or entities may also elect the optional transition method provided under ASU 2018-11, Leases, Topic 842: Targeted Improvement, issued in July 2018, allowing for application of the standard at the adoption date, with recognition of a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption. We will adopt this ASU on the first day of our fiscal year 2020 using the optional transition method. In August 2018, the FASB issued ASU No. 2018-14, Compensation—Retirement Benefits—Defined Benefit Plans—General (Topic 715-20): Disclosure Framework—Changes to the Disclosure Requirements for Defined Benefit Plans, which modifies the disclosure requirements for defined benefit pension plans and other post-retirement plans. The effective date for this standard is for fiscal years beginning after December 15, 2020, with early adoption permitted. We do not expect ASU 2018-14 to have a material impact to our consolidated financial statements and related disclosures. for capitalizing implementation costs incurred to develop or obtain internal-use software (and hosting arrangements that include an internal-use software license). The effective date for the standard is for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. Early adoption is permitted. The amendments in this ASU should be applied either retrospectively or prospectively to all implementation costs incurred after the date of adoption. We do not expect ASU 2018-15 to have a material impact to our consolidated financial statements and related disclosures. On October 26, 2018, we acquired Pinnacle Foods Inc. ("Pinnacle"), a branded packaged foods company specializing in shelf-stable and frozen foods, which is now a wholly-owned subsidiary of the Company. Pursuant to the Agreement and Plan of Merger, dated as of June 26, 2018 (the "Merger Agreement"), among the Company, Pinnacle, and Patriot Merger Sub Inc., a wholly-owned subsidiary of the Company that ceased to exist at the effective time of the merger, each outstanding share of Pinnacle common stock was converted into the right to receive $43.11 per share in cash and 0.6494 shares of common stock, par value $5.00 per share, of the Company ("Company Shares") (together, the "Merger Consideration"), with cash payable in lieu of fractional shares of Company Shares. The total amount of consideration paid in connection with the acquisition was approximately $8.03 billion and consisted of: (1) cash of $5.17 billion ($5.12 billion net of cash acquired); (2) 77.5 million Company Shares, with an approximate value of $2.82 billion, issued out of the Company's treasury; and (3) replacement awards issued to former Pinnacle employees representing the fair value attributable to pre-combination service (see Note 9) of $51.1 million. In connection with the acquisition, we issued long-term debt of $8.33 billion (see Note 5) (which includes funding under the new term loan agreement) and received cash proceeds of $575.0 million ($555.7 million net of related fees) from the issuance of common stock in an underwritten public offering. We used such proceeds for the payment of the cash portion of the Merger Consideration, the repayment of Pinnacle debt acquired, the refinancing of certain Conagra Brands debt, and the payment of related fees and expenses. The following table summarizes our current allocation of the total purchase consideration to the estimated fair values of the assets acquired and liabilities assumed at the acquisition date. During the third quarter of fiscal 2019, we made adjustments to our initial allocations, which resulted in an increase to goodwill of $203.6 million. This goodwill increase resulted primarily from reductions in values of brands, trademarks and other intangibles of $159.9 million and, property, plant and equipment of $17.4 million, and an increase to deferred tax liabilities of $16.1 million as we refine our fair value estimates. These changes did not have a significant impact on our net income for the thirteen and thirty-nine weeks ended February 24, 2019. Goodwill represents the excess of the consideration transferred over the preliminary estimate of fair values of the assets acquired and liabilities assumed and is primarily attributable to synergies and intangible assets such as assembled workforce which are not separately recognizable. Of the total goodwill, $236.7 million is deductible for tax purposes. Amortizable brands, trademarks and other intangibles totaled $679.6 million and have a weighted average estimated useful life of 25 years. We are currently completing our fair value assessment of the acquired assets and liabilities with the assistance of third-party valuation specialists and any adjustments identified in the measurement period, which will not exceed one year from the acquisition date, will be accounted for prospectively. Until we complete our fair value assessments and further integration activities and organizational structural changes occur, our Pinnacle business is considered a separate reportable segment and all goodwill was preliminarily allocated to reporting units within this segment. The results of operations of Pinnacle are reported in the Company's condensed consolidated financial statements from the date of acquisition and include $712.3 million and $971.1 million of total net sales and $101.6 million and $130.3 million of operating profit for the third quarter and first three quarters of fiscal 2019, respectively, which are included in the Pinnacle Foods segment's financial results. The following unaudited pro forma financial information presents the combined results of operations as if the acquisition of Pinnacle had occurred on May 29, 2017, the beginning of fiscal year 2018. These unaudited pro forma results may not necessarily reflect the actual results of operations that would have been achieved, nor are they necessarily indicative of future results of operations. Pro forma net income from continuing operations attributable to Conagra Brands, Inc. Acquisition related costs incurred by the Company of $1.2 million and $62.1 million for the third quarter and first three quarters of fiscal 2019, respectively, were excluded and assumed to have been incurred at the beginning of fiscal 2018 and included in the results for the first three quarters of fiscal 2018. Acquisition related costs incurred by Pinnacle of $66.8 million for the first three quarters of fiscal 2019 were excluded from the pro forma results. Non-recurring expense of $26.9 million and $51.3 million for the third quarter and first three quarters of fiscal 2019, respectively, related to the fair value adjustment to acquisition-date inventory estimated to have been sold was removed and $52.7 million of expense was included in the results for the first three quarters of fiscal 2018. Non-recurring expense of $45.7 million for the first three quarters of fiscal 2019 related to securing bridge financing for the acquisition were excluded and assumed to have been incurred at the beginning of fiscal 2018 and included in the results for the first three quarters of fiscal 2018. In February 2018, we acquired the Sandwich Bros. of Wisconsin® business, maker of frozen breakfast and entree flatbread pocket sandwiches, for a cash purchase price of $87.3 million, net of cash acquired, including working capital adjustments. Approximately $57.8 million has been classified as goodwill, and $9.7 million and $7.1 million have been classified as non-amortizing and amortizing intangible assets, respectively. The amount allocated to goodwill is deductible for tax purposes. The business is included in the Refrigerated & Frozen segment. In October 2017, we acquired Angie's Artisan Treats, LLC, maker of Angie's® BOOMCHICKAPOP® ready-to-eat popcorn, for a cash purchase price of $249.8 million, net of cash acquired, including working capital adjustments. Approximately $156.7 million has been classified as goodwill, of which $95.4 million is deductible for income tax purposes. Approximately $73.8 million and $10.3 million of the purchase price have been allocated to non-amortizing and amortizing intangible assets, respectively. The business is primarily included in the Grocery & Snacks segment, and to a lesser extent within the International segment. The acquisitions of Sandwich Bros. of Wisconsin® and Angie's® BOOMCHICKAPOP® collectively contributed $41.6 million and $116.7 million to net sales during the third quarter and first three quarters of fiscal 2019, respectively, and $31.4 million and $41.4 million during the third quarter and first three quarters of fiscal 2018, respectively. For each of these acquisitions, the amounts allocated to goodwill were primarily attributable to anticipated synergies, product portfolios, and other intangibles that do not qualify for separate recognition. Under the acquisition method of accounting, the assets acquired and liabilities assumed in these acquisitions were recorded at their respective estimated fair values at the date of acquisition. On November 9, 2016, we completed the spinoff of our Lamb Weston business (the "Spinoff"). As of such date, we did not beneficially own any equity interest in Lamb Weston and no longer consolidated Lamb Weston into our financial results. We reflected the results of this business as discontinued operations for all periods presented. We entered into a transition services agreement in connection with the Spinoff and recognized $0.1 million and $2.2 million of income for the performance of services during the third quarter and first three quarters of fiscal 2018, respectively, classified within selling, general and administrative ("SG&A") expenses. On February 1, 2016, pursuant to the Stock Purchase Agreement, dated as of November 1, 2015, we completed the disposition of our Private Brands operations to TreeHouse Foods, Inc. In the first three quarters of fiscal 2019 and 2018, we recognized income of $0.9 million and $0.2 million, respectively, within discontinued operations. We entered into a transition services agreement with TreeHouse Foods, Inc. and recognized $2.2 million of income for the performance of services during the first three quarters of fiscal 2018 classified within SG&A expenses. During the first quarter of fiscal 2019, we completed the sale of our Del Monte® processed fruit and vegetable business in Canada, which was included in our International segment, to Bonduelle Group for combined proceeds of $42.4 million Canadian dollars, which was equivalent to approximately $32.2 million U.S. dollars at the exchange rates on the closing date of the transaction and the final settlement of the working capital adjustments. We recognized a gain on the sale of $13.2 million recognized within SG&A expenses. The assets of this business have been reclassified as assets held for sale within our Condensed Consolidated Balance Sheets for periods prior to the divestiture. On February 25, 2019, subsequent to the end of the third quarter of fiscal 2019, we completed the sale of our Wesson® oil business, for net proceeds of $167.1 million, subject to final working capital adjustments. The business is primarily included in our Grocery & Snacks segment. The Company expects to sell its Italian-based frozen pasta business, Gelit, headquartered in Doganella di Ninfa, Italy, within the next twelve months. In addition, we are actively marketing certain other assets totaling $11.6 million and $29.4 million at February 24, 2019, and May 27, 2018, respectively. These assets have been reclassified as assets held for sale within our Condensed Consolidated Balance Sheets for all periods presented. In December 2018, our Board of Directors (the "Board") approved a restructuring and integration plan related to the ongoing integration of the recently acquired operations of Pinnacle (the "Pinnacle Integration Restructuring Plan") for the purpose of achieving significant cost synergies between the companies. We expect to incur material charges for exit and disposal activities under U.S. GAAP. Although we remain unable to make good faith estimates relating to the entire Pinnacle Integration Restructuring Plan, we are reporting on actions initiated through the end of the third quarter of fiscal 2019, including the estimated amounts or range of amounts for each major type of costs expected to be incurred, and the charges that have resulted or will result in cash outflows. We expect to incur up to $360.0 million ($285.0 million of cash charges and $75.0 million of non-cash charges) in relation to operational expenditures under the Pinnacle Integration Restructuring Plan. We have incurred or expect to incur approximately $255.6 million of charges ($253.7 million of cash charges and $1.9 million of non-cash charges) for actions identified to date under the Pinnacle Integration Restructuring Plan. We expect to incur costs related to the Pinnacle Integration Restructuring Plan over a three-year period. Included in the above results are $35.9 million of charges that have resulted or will result in cash outflows and $1.0 million in non-cash charges. Included in the above results are $138.2 million of charges that have resulted or will result in cash outflows and $1.3 million in non-cash charges. In the third quarter of fiscal 2019, management initiated a new restructuring plan (the "Conagra Restructuring Plan") for costs in connection with actions taken to improve SG&A effectiveness and efficiencies and to optimize our supply chain network. We have incurred or expect to incur $4.3 million of charges ($2.4 million of cash charges and $1.9 million of non-cash charges) for actions identified to date under the Conagra Restructuring Plan. We are unable to quantify the scope of the entire Conagra Restructuring Plan at this time. In the third quarter and first three quarters of fiscal 2019, we recognized charges of $1.0 million ($0.7 million of cash charges and $0.3 million in non-cash charges) in association with the Conagra Restructuring Plan. As of February 24, 2019, we have substantially completed our restructuring activities related to our Supply Chain and Administrative Efficiency Plan (the "SCAE Plan"). In the third quarter and first three quarters of fiscal 2019, we recognized charges of $3.5 million and $8.6 million, respectively, in connection with the SCAE Plan. In the third quarter and first three quarters of fiscal 2018, we recognized charges of $14.7 million and $33.2 million, respectively, in connection with the SCAE Plan. We have recognized $468.9 million in pre-tax expenses ($103.2 million in cost of goods sold, $363.4 million in SG&A expenses, and $2.3 million in pension and postretirement non-service income) from the inception of the SCAE Plan through February 24, 2019, related to our continuing operations. Included in these results were $318.9 million of cash charges and $150.0 million of non-cash charges. Our total pre-tax expenses for the SCAE Plan related to our continuing operations are expected to be $472.7 million ($322.7 million of cash charges and $150.0 million of non-cash charges). At February 24, 2019, we had a revolving credit facility (the "Revolving Credit Facility") with a syndicate of financial institutions providing for a maximum aggregate principal amount outstanding at any one time of $1.6 billion (subject to increase to a maximum aggregate principal amount of $2.1 billion with the consent of the lenders). The Revolving Credit Facility matures on July 11, 2023 and is unsecured. The term of the Revolving Credit Facility may be extended for additional one-year or two-year periods from the then-applicable maturity date on an annual basis. As of February 24, 2019, there were no outstanding borrowings under the Revolving Credit Facility. In the first quarter of fiscal 2019, in connection with the announcement of the Pinnacle acquisition, we secured $9.0 billion in fully committed bridge financing. Prior to the acquisition, we capitalized financing costs related to the bridge financing of $45.7 million to be amortized over the commitment period. Our net interest expense included $11.9 million for the first three quarters of fiscal 2019 as a result of this amortization. The bridge facility was terminated in connection with the acquisition, and we recognized $33.8 million of expense within SG&A expenses for the remaining unamortized financing costs. Also in the first quarter of fiscal 2019, we entered a term loan agreement (the “Term Loan Agreement”) with a syndicate of financial institutions providing for term loans to the Company in an aggregate principal amount of up to $1.3 billion, as well as deal-contingent forward starting interest rate swap contracts (see Note 8) to hedge a portion of the interest rate risk related to our anticipated issuance of long-term debt to help finance the acquisition of Pinnacle. During the second quarter of fiscal 2019, to finance a portion of our acquisition of Pinnacle, we (i) issued new senior unsecured notes in an aggregate principal amount of $7.025 billion and (ii) borrowed $1.30 billion under the Term Loan Agreement. We issued the new senior unsecured notes in seven tranches: floating rate senior notes due October 22, 2020 in an aggregate principal amount of $525.0 million with interest equal to three-month LIBOR plus 0.75%, 3.8% senior notes due October 22, 2021 in an aggregate principal amount of $1.20 billion; 4.3% senior notes due May 1, 2024 in an aggregate principal amount of $1.0 billion; 4.6% senior notes due November 1, 2025 in an aggregate principal amount of $1.0 billion; 4.85% senior notes due November 1, 2028 in an aggregate principal amount of $1.30 billion; 5.3% senior notes due November 1, 2038 in an aggregate principal amount of $1.0 billion; and 5.4% senior notes due November 1, 2048 in an aggregate principal amount of $1.0 billion. Our $1.30 billion of borrowings under the Term Loan Agreement consist of a $650.0 million tranche of three-year term loans and a $650.0 million tranche of five-year term loans. The three-year tranche loans mature on October 26, 2021 and the five-year tranche loans mature on October 26, 2023. These term loans will bear interest at, at the Company's election, either (a) LIBOR plus a percentage spread (ranging from 1% to 1.625% for three-year tranche loans and 1.125% to 1.75% for five-year tranche loans) based on the Company's senior unsecured long-term indebtedness ratings or (b) the alternate base rate, described in the Term Loan Agreement as the greatest of (i) Bank of America's prime rate, (ii) the federal funds rate plus 0.50%, and (iii) one-month LIBOR plus 1.00%, plus a percentage spread (ranging from 0% to 0.625% for three-year tranche loans and 0.125% to 0.75% for five-year tranche loans) based on the Company's senior unsecured long-term indebtedness ratings. The Company may voluntarily prepay term loans under the Term Loan Agreement, in whole or in part, without penalty, subject to certain conditions. the third quarter of fiscal 2019, we repaid an additional $125.0 million of the three-year tranche loans and $125.0 million of the five-year tranche loans. In the second quarter of fiscal 2019, in connection with the Pinnacle acquisition, we prepaid in full $2.40 billion of obligations and liabilities of Pinnacle under or in respect of Pinnacle's credit agreement and other debt agreements. We also redeemed $350.0 million in aggregate principal amount of Pinnacle's outstanding 5.875% senior notes due January 15, 2024 and recognized a charge of $3.9 million as a cost of early retirement of debt. Also, in connection with the financing for the Pinnacle acquisition, we capitalized $49.6 million of debt issuance costs. Our net interest expense was reduced by $1.0 million and $1.2 million during the third quarter and first three quarters of fiscal 2019, respectively, due to the impact of the interest rate swap contracts entered into in the first quarter of fiscal 2019. During the second quarter of fiscal 2019, we terminated the interest rate swap contacts and received proceeds of $47.5 million. This gain was deferred in accumulated other comprehensive income and is being amortized as a reduction of interest expense over the lives of the related debt instruments. During the third quarter of fiscal 2018, we entered into a term loan agreement (the "Prior Term Loan Agreement") with a financial institution. The Prior Term Loan Agreement provided for term loans to the Company in an aggregate principal amount not to exceed $300.0 million, maturing on February 26, 2019. During the fourth quarter of fiscal 2018, we borrowed the full amount of the $300.0 million provided for under the Prior Term Loan Agreement. During the second quarter of fiscal 2019, we repaid in full the principal balance of all term loans outstanding under the Prior Term Loan Agreement. This did not result in a significant gain or loss. During the fourth quarter of fiscal 2018, we repaid the remaining principal balance of $70.0 million of our 2.1% senior notes on the maturity date of March 15, 2018. During the third quarter of fiscal 2018, we repaid the remaining principal balance of $119.6 million of our 1.9% senior notes on the maturity date of January 25, 2018. During the third quarter of fiscal 2018, we repaid the remaining capital lease liability balance of $28.5 million in connection with the early exit of an unfavorable lease contract. During the second quarter of fiscal 2018, we issued $500.0 million aggregate principal amount of floating rate notes due October 9, 2020. The notes bear interest at a rate equal to three-month LIBOR plus 0.50% per annum. The Revolving Credit Facility and the Term Loan Agreement generally require our ratio of earnings before interest, taxes, depreciation and amortization ("EBITDA") to interest expense not to be less than 3.0 to 1.0 and our ratio of funded debt to EBITDA not to exceed certain decreasing specified levels, ranging from 5.875 through the first quarter of fiscal 2020 to 3.75 from the second quarter of fiscal 2023 and thereafter, with each ratio to be calculated on a rolling four-quarter basis. As of February 24, 2019, we were in compliance with all financial covenants under the Revolving Credit Facility and the Term Loan Agreement. (the "lease put option") that allows the lessor to require us to purchase the building at the greater of original construction cost, or fair market value, without a lease agreement in place (the "put price") in certain limited circumstances. As a result of substantial impairment charges related to our divested private brands operations, this lease put option became exercisable. We are amortizing the difference between the put price and the estimated fair value (without a lease agreement in place) of the property over the remaining lease term within SG&A expenses. As of February 24, 2019 and May 27, 2018, the estimated amount by which the put option price exceeded the estimated fair value of the property was $8.2 million, of which we had accrued $1.5 million and $1.2 million, respectively. This lease is accounted for as an operating lease, and accordingly, there are no material assets and liabilities, other than the accrued portion of the put price, associated with this entity included in the Condensed Consolidated Balance Sheets. We have determined that we do not have the power to direct the activities that most significantly impact the economic performance of this entity. In making this determination, we have considered, among other items, the terms of the lease agreement, the expected remaining useful life of the asset leased, and the capital structure of the lessor entity. During the third quarter of fiscal 2018, we purchased two buildings that were subject to lease put options and recognized net losses totaling $48.2 million for the early exit of unfavorable lease contracts. Non-amortizing intangible assets are comprised of brands and trademarks. Amortizing intangible assets, carrying a remaining weighted average life of approximately 21 years, are principally composed of customer relationships, licensing arrangements, and acquired intellectual property. Amortization expense was $14.9 million and $34.0 million for the third quarter and first three quarters of fiscal 2019, respectively, and $8.9 million and $26.2 million for the third quarter and first three quarters of fiscal 2018, respectively. Based on amortizing assets recognized in our Condensed Consolidated Balance Sheet as of February 24, 2019, amortization expense is estimated to average $59.0 million for each of the next five years. Our operations are exposed to market risks from adverse changes in commodity prices affecting the cost of raw materials and energy, foreign currency exchange rates, and interest rates. In the normal course of business, these risks are managed through a variety of strategies, including the use of derivatives. Commodity and commodity index futures and option contracts are used from time to time to economically hedge commodity input prices on items such as natural gas, vegetable oils, proteins, packaging materials, dairy, grains, and electricity. Generally, we economically hedge a portion of our anticipated consumption of commodity inputs for periods of up to 36 months. We may enter into longer-term economic hedges on particular commodities, if deemed appropriate. As of February 24, 2019, we had economically hedged certain portions of our anticipated consumption of commodity inputs using derivative instruments with expiration dates through December 2019. settlement of foreign-denominated assets and liabilities. As of February 24, 2019, we had economically hedged certain portions of our foreign currency risk in anticipated transactions using derivative instruments with expiration dates through November 2019. From time to time, we may use derivative instruments, including interest rate swaps, to reduce risk related to changes in interest rates. This includes, but is not limited to, hedging against increasing interest rates prior to the issuance of long-term debt and hedging the fair value of our senior long-term debt. During the first quarter of fiscal 2019, we entered into deal-contingent forward starting interest rate swap contracts to hedge a portion of the interest rate risk related to our issuance of long-term debt to help finance the acquisition of Pinnacle. We settled these contracts during the second quarter of fiscal 2019 and deferred a $47.5 million gain in accumulated other comprehensive income. This gain will be amortized as a reduction of interest expense over the lives of the related debt instruments. The unamortized amount at February 24, 2019, was $46.3 million. Many of our derivatives do not qualify for, and we do not currently designate certain commodity or foreign currency derivatives to achieve, hedge accounting treatment. We reflect realized and unrealized gains and losses from derivatives used to economically hedge anticipated commodity consumption and to mitigate foreign currency cash flow risk in earnings immediately within general corporate expense (within cost of goods sold). The gains and losses are reclassified to segment operating results in the period in which the underlying item being economically hedged is recognized in cost of goods sold. In the event that management determines a particular derivative entered into as an economic hedge of a forecasted commodity purchase has ceased to function as an economic hedge, we cease recognizing further gains and losses on such derivatives in corporate expense and begin recognizing such gains and losses within segment operating results immediately. We may use options and cross currency swaps to economically hedge the fair value of certain monetary assets and liabilities (including intercompany balances) denominated in a currency other than the functional currency. These derivatives are marked-to-market with gains and losses immediately recognized in SG&A expenses. These substantially offset the foreign currency transaction gains or losses recognized as values of the monetary assets or liabilities being economically hedged change. All derivative instruments are recognized on our balance sheets at fair value (refer to Note 16 for additional information related to fair value measurements). The fair value of derivative assets is recognized within prepaid expenses and other current assets, while the fair value of derivative liabilities is recognized within other accrued liabilities. In accordance with U.S. GAAP, we offset certain derivative asset and liability balances, as well as certain amounts representing rights to reclaim cash collateral and obligations to return cash collateral, where master netting agreements provide for legal right of setoff. At February 24, 2019 and May 27, 2018, amounts representing obligations to return cash collateral of $0.2 million and $1.0 million, respectively, were included in prepaid expenses and other current assets in our Condensed Consolidated Balance Sheets. As of February 24, 2019, our open commodity contracts had a notional value (defined as notional quantity times market value per notional quantity unit) of $240.8 million and $98.5 million for purchase and sales contracts, respectively. As of May 27, 2018, our open commodity contracts had a notional value of $100.0 million and $34.2 million for purchase and sales contracts, respectively. The notional amount of our foreign currency forward contracts as of February 24, 2019 and May 27, 2018 was $81.3 million and $82.4 million, respectively. We enter into certain commodity, interest rate, and foreign exchange derivatives with a diversified group of counterparties. We continually monitor our positions and the credit ratings of the counterparties involved and limit the amount of credit exposure to any one party. These transactions may expose us to potential losses due to the risk of nonperformance by these counterparties. We have not incurred a material loss due to nonperformance in any period presented and do not expect to incur any such material loss. We also enter into futures and options transactions through various regulated exchanges. At February 24, 2019, the maximum amount of loss due to the credit risk of the counterparties, had the counterparties failed to perform according to the terms of the contracts, was $2.5 million. third quarter and first three quarters of fiscal 2019 is income of $3.5 million and expense of $16.7 million, respectively, for accelerated vesting of awards related to Pinnacle integration restructuring activities, net of the impact of marking-to-market these awards based on a lower market price of Conagra common shares. Also included in the total stock-based compensation expense for the third quarter and first three quarters of fiscal 2019 was expense of $0.1 million and $0.2 million, respectively, related to stock options granted by a subsidiary in the subsidiary's shares to the subsidiary's employees. The expense for these stock options for the third quarter and first three quarters of fiscal 2018 was income of $0.1 million and expense of $0.3 million, respectively. For the first three quarters of fiscal 2019, we granted 0.8 million restricted stock units at a weighted average grant date price of $35.94 and 0.5 million performance shares at a weighted average grant date price of $35.96. During the second quarter of fiscal 2019, the Company granted the following awards to Pinnacle employees in replacement of their unvested equity awards as of the closing date: (1) 2.0 million cash-settled restricted stock unit awards at a grant date price of $36.37 and (2) 2.3 million cash-settled stock appreciation rights with a fair value estimated at closing date using a Black-Scholes option-pricing model and a grant date price of $36.37. Approximately $51.1 million of the fair value of the replacement awards granted to Pinnacle employees was attributable to pre-combination service and was included in the purchase price and established as a liability. As of February 24, 2019, the liability of the replacement awards was $23.9 million, which includes post-combination service expense, the mark-to-market of the liability, and the impact of payouts since acquisition. Post-combination expense of approximately $6.0 million, based on the market price of Conagra common shares as of February 24, 2019, is expected to be recognized related to the replacement awards over the remaining post-combination service period, approximately two years. Performance shares are granted to selected executives and other key employees with vesting contingent upon meeting various Company-wide performance goals. The performance goal for one-third of the target number of performance shares for the three-year performance period ending in fiscal 2019 (the "2019 performance period") is based on our fiscal 2017 EBITDA return on capital, subject to certain adjustments. The fiscal 2017 EBITDA return on capital target, when set, excluded the results of Lamb Weston. The performance goal for the final two-thirds of the target number of performance shares granted for the 2019 performance period is based on our diluted earnings per share ("EPS") compound annual growth rate ("CAGR"), subject to certain adjustments, measured over the two-year period ending in fiscal 2019. In addition, for certain participants, all performance shares for the 2019 performance period are subject to an overarching EPS goal that must be met in each fiscal year of the 2019 performance period before any pay out can be made to such participants on the performance shares. The performance goals for the three-year performance periods ending in fiscal 2020 and 2021 are based on our diluted EPS CAGR, subject to certain adjustments, measured over the defined performance periods. In addition, for certain participants, all performance shares for the 2020 performance period are subject to an overarching EPS goal that must be met in each fiscal year of the 2020 performance period before any pay out can be made to such participants on the performance shares. Awards, if earned, will be paid in shares of our common stock. Subject to limited exceptions set forth in the performance share plan, any shares earned will be distributed after the end of the performance period, and only if the participant continues to be employed with the Company through the date of distribution. For awards where performance against the performance target has not been certified, the value of the performance shares is adjusted based upon the market price of our common stock and current forecasted performance against the performance targets at the end of each reporting period and amortized as compensation expense over the vesting period. Forfeitures are accounted for as they occur. Basic earnings per share is calculated on the basis of weighted average outstanding shares of common stock. Diluted earnings per share is computed on the basis of basic weighted average outstanding shares of common stock adjusted for the dilutive effect of stock options, restricted stock unit awards, and other dilutive securities. During the second quarter of fiscal 2019, we issued 77.5 million shares of our common stock out of treasury to the former shareholders of Pinnacle pursuant to the terms of the Merger Agreement. In addition, we issued 16.3 million shares of our common stock, par value $5.00 per share, in an underwritten public offering in connection with the financing of the Pinnacle acquisition, with net proceeds of $555.7 million (see Note 2). For the third quarter and first three quarters of fiscal 2019, there were 3.5 million and 1.8 million stock options outstanding, respectively, that were excluded from the computation of diluted weighted average shares because the effect was antidilutive. For the third quarter and first three quarters of fiscal 2018, there were 1.2 million and 1.3 million stock options outstanding, respectively, that were excluded from the calculation. Income tax expense from continuing operations for the third quarter of fiscal 2019 and 2018 was $67.2 million and a benefit of $91.4 million, respectively. Income tax expense from continuing operations for the first three quarters of fiscal 2019 and 2018 was $147.0 million and $138.1 million, respectively. The effective tax rate (calculated as the ratio of income tax expense to pre-tax income from continuing operations, inclusive of equity method investment earnings) from continuing operations was 21.7% and (35.5)% for the third quarter of fiscal 2019 and 2018, respectively. The effective tax rate from continuing operations was 20.9% and 16.0% for the first three quarters of fiscal 2019 and 2018, respectively. an increase to the deemed repatriation tax liability. capital gains from the planned divestiture of the Wesson® oil business, additional tax expense on non-deductible facilitative costs associated with the acquisition of Pinnacle, and additional income tax expense related to state taxes. an income tax benefit allowed upon the vesting/exercise of employee stock compensation awards by our employees, beyond that which is attributable to the original fair value of the awards upon the date of grant. The effective tax rate for the first three quarters of fiscal 2018 reflects the above-cited items, as well as additional expense related to undistributed foreign earnings for which the indefinite reinvestment assertion is no longer made. The amount of gross unrecognized tax benefits for uncertain tax positions was $49.4 million as of February 24, 2019 and $32.5 million as of May 27, 2018. Included in the balance as of February 24, 2019 was $1.0 million for tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. The May 27, 2018 balance had no tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. The gross unrecognized tax benefits excluded related liabilities for gross interest and penalties of $11.5 million and $7.7 million as of February 24, 2019 and May 27, 2018, respectively. The net amount of unrecognized tax benefits at February 24, 2019 and May 27, 2018 that, if recognized, would impact the Company's effective tax rate was $42.6 million and $27.8 million, respectively. Included in those amounts is $9.3 million and $6.7 million, respectively, that would be reported in discontinued operations. Recognition of these tax benefits would have a favorable impact on the Company's effective tax rate. We estimate that it is reasonably possible that the amount of gross unrecognized tax benefits will decrease by up to $16.6 million over the next twelve months due to various federal, state, and foreign audit settlements and the expiration of statutes of limitations. As of February 24, 2019 and May 27, 2018, we had a deferred tax asset of $721.9 million and $721.6 million, respectively, that was generated from the capital loss realized on the sale of the Private Brands operations with corresponding valuation allowances of $697.7 million and $721.6 million, respectively, to reflect the uncertainty regarding the ultimate realization of the tax asset. During the first three quarters of fiscal 2019, the valuation allowance was adjusted by $24.2 million due to expected capital gains from the planned divestiture of the Wesson® oil business. Historically, we have not provided U.S. deferred taxes on the cumulative undistributed earnings of our foreign subsidiaries. We have determined that previously undistributed earnings of certain foreign subsidiaries no longer meet the requirements for indefinite reinvestment under applicable accounting guidance and, therefore, recognized $0.5 million of income tax expense in the first three quarters of fiscal 2019. We believe our subsidiaries have invested or will invest the remaining undistributed earnings indefinitely, or the earnings will be remitted in a tax-neutral transaction. We are a party to certain litigation matters relating to our acquisition of Beatrice Company ("Beatrice") in fiscal 1991, including litigation proceedings related to businesses divested by Beatrice prior to our acquisition of the company. These proceedings include suits against a number of lead paint and pigment manufacturers, including ConAgra Grocery Products Company, LLC, a wholly owned subsidiary of the Company ("ConAgra Grocery Products") as alleged successor to W. P. Fuller & Co., a lead paint and pigment manufacturer owned and operated by a predecessor to Beatrice from 1962 until 1967. These lawsuits generally seek damages for personal injury, property damage, economic loss, and governmental expenditures allegedly caused by the use of lead-based paint, and/or injunctive relief for inspection and abatement. Although decisions favorable to us have been rendered in Rhode Island, New Jersey, Wisconsin, and Ohio, we remain a defendant in active suits in Illinois and California. ConAgra Grocery Products has denied liability in both suits, both on the merits of the claims and on the basis that we do not believe it to be the successor to any liability attributable to W. P. Fuller & Co. The California suit is discussed in the following paragraph. The Illinois suit seeks class-wide relief for reimbursement of costs associated with the testing of lead levels in blood. We do not believe it is probable that we have incurred any liability with respect to the Illinois case, nor is it possible to estimate any potential exposure. In California, a number of cities and counties joined in a consolidated action seeking abatement of an alleged public nuisance in the form of lead-based paint potentially present on the interior of residences, regardless of its condition. On September 23, 2013, a trial of the California case concluded in the Superior Court of California for the County of Santa Clara, and on January 27, 2014, the court entered a judgment (the "Judgment") against ConAgra Grocery Products and two other defendants ordering the creation of a California abatement fund in the amount of $1.15 billion. Liability is joint and several. The Company appealed the Judgment, and on November 14, 2017 the California Court of Appeal for the Sixth Appellate District reversed in part, holding that the defendants were not liable to pay for abatement of homes built after 1950, but affirmed the Judgment as to homes built before 1951. The Court of Appeal remanded the case to the trial court with directions to recalculate the amount of the abatement fund estimated to be necessary to cover the cost of remediating pre-1951 homes, and to hold an evidentiary hearing regarding appointment of a suitable receiver. ConAgra Grocery Products and the other defendants petitioned the California Supreme Court for review of the decision, which we believe to be an unprecedented expansion of current California law. On February 14, 2018, the California Supreme Court denied the petition and declined to review the merits of the case, and the case was remanded to the trial court for further proceedings. ConAgra Grocery Products and the other defendants sought further review of certain issues from the Supreme Court of the United States, but on October 15, 2018, the Supreme Court declined to review the case. In light of the decision rendered by the California Appellate Court on November 14, 2017, and the California Supreme Court's decision on February 14, 2018 not to review the Appellate Court's decision, we have concluded that the liability has become probable as contemplated by Accounting Standards Codification Topic 450. On September 4, 2018, the trial court recalculated its estimate of the amount needed to remediate pre-1951 homes in the plaintiff jurisdictions to be $409.0 million. However, uncertainties remain which make it difficult to estimate the ultimate potential liability, including (i) although liability is joint and several, it is unknown what amount each defendant may ultimately be required to pay or how allocation among the defendants (and other potentially responsible parties such as property owners who may have violated the applicable housing codes) will be determined; (ii) according to the trial court's original order, participation in the abatement program by eligible homeowners is voluntary and it is unknown what percentage of eligible homeowners will choose to participate or how such claims will be administered; (iii) the trial court's original order required that any amounts paid by the defendants into the fund that were not spent within four years would be returned to the defendants, and it is unknown whether this feature of the fund will be retained or, if it is retained, how much will be spent during that time period; and (iv) defendants will have a new right to appeal any new aspects of the judgment entered by the trial court upon remand, although it is unknown whether the court would stay execution of any new judgment while a subsequent appeal is pending. While the ultimate amount of any loss and timing of payments related thereto remain uncertain and could change as further information is obtained, we have accrued $136.0 million, within other accrued liabilities, for this matter as of February 24, 2019. The extent of insurance coverage is uncertain and the Company's carriers are on notice; however, any possible insurance recovery has not been considered for purposes of determining our liability. We cannot assure that the final resolution of these matters will not have a material adverse effect on our financial condition, results of operations, or liquidity. Court in November 2017. On September 14, 2018, the Nebraska Supreme Court affirmed the jury verdict and the rulings of the trial court. As of November 6, 2018, the Company and its insurers satisfied the judgment in full. We are party to a number of putative class action lawsuits challenging various product claims made in the Company's product labeling. These matters include Briseno v. ConAgra Foods, Inc., in which it is alleged that the labeling for Wesson® oils as 100% natural is false and misleading because the oils contain genetically modified plants and organisms. In February 2015, the U.S. District Court for the Central District of California granted class certification to permit plaintiffs to pursue state law claims. The Company appealed to the United States Court of Appeals for the Ninth Circuit, which affirmed class certification in January 2017. The Supreme Court of the United States declined to review the decision and the case has been remanded to the trial court for further proceedings. While we cannot predict with certainty the results of this or any other legal proceeding, we do not expect this matter to have a material adverse effect on our financial condition, results of operations, or business. We are party to matters challenging the Company's wage and hour practices. These matters include a number of class actions consolidated under the caption Negrete v. ConAgra Foods, Inc., et al, pending in the U.S. District Court for the Central District of California, in which the plaintiffs allege a pattern of violations of California and/or federal law at several current and former Company manufacturing facilities across the State of California. While we cannot predict with certainty the results of this or any other legal proceeding, we do not expect this matter to have a material adverse effect on our financial condition, results of operations, or business. The Company, its directors, and several of its executive officers are defendants in several class actions alleging violations of federal securities laws. The lawsuits assert that the Company's officers made material misstatements and omissions that caused the market to have an unrealistically positive assessment of the Company's financial prospects in light of the acquisition of Pinnacle, thus causing the Company's securities to be overvalued prior to the release of the Company's consolidated financial results on December 20, 2018 for the second quarter of fiscal year 2019. The first of these lawsuits, captioned West Palm Beach Firefighters' Pension Fund v. Conagra Brands, Inc., et al., with which subsequent lawsuits alleging similar facts will likely be consolidated, was filed February 22, 2019 in the U.S. District Court for the Northern District of Illinois. While we cannot predict with certainty the results of this or any other legal proceedings, we do not expect this matter to have a material adverse effect on our financial condition, results of operations, or business. Certain litigation matters were filed in connection with our acquisition of Pinnacle (see Note 2). On August 7, 2018, a purported stockholder of Pinnacle filed a complaint in a putative class action in the United States District Court for the District of New Jersey, captioned Alexander Rasmussen v. Pinnacle Foods Inc. et al., Case No. 2:18-cv-12501. On August 9, 2018, a purported stockholder of Pinnacle filed a complaint in a putative class action in the United States District Court for the District of New Jersey, captioned Robert H. Paquette v. Pinnacle Foods Inc. et al., Case No. 2:18-cv-12578. On August 9, 2018, a purported stockholder of Pinnacle filed a complaint in a putative class action in the United States District Court for the District of New Jersey, captioned Wesley Lindquist v. Pinnacle Foods Inc. et al., Case No. 2:18-cv-12610. On September 12, 2018, the Court consolidated the three New Jersey Actions (the "Consolidated Actions"), each of which alleged that Pinnacle's preliminary proxy statement, filed with the SEC on July 25, 2018, omitted material information with respect to the merger, rendering it false and misleading and thus that Pinnacle and the directors of Pinnacle violated Section 14(a) of the Exchange Act as well as Rule 14a-9 under the Exchange Act. The Consolidated Actions further alleged that the directors of Pinnacle violated Section 20(a) of the Exchange Act and sought to enjoin the transactions contemplated by the Merger Agreement unless Pinnacle disclosed the allegedly material information that was allegedly omitted from the proxy statement, an award of damages and an award of attorneys' fees and expenses. On September 27, 2018, Pinnacle filed a Form 8-K with the Securities and Exchange Commission containing supplemental disclosures that substantially mooted the claims raised in the Consolidated Actions regarding the sufficiency of the disclosures in the proxy statement. On October 4, 2018, the parties stipulated to dismissal of the Consolidated Actions. On August 15, 2018, a purported stockholder of Pinnacle filed a complaint in a putative class action in the Court of Chancery of the State of Delaware, captioned Jordan Rosenblatt v. Pinnacle Foods Inc. et al., Case No. 2018-0605 (the "Rosenblatt Action"). The Rosenblatt Action alleged that the directors of Pinnacle breached their fiduciary duty of disclosure by filing a preliminary proxy statement that contained materially incomplete and misleading information. The Rosenblatt Action further alleged that Pinnacle, Conagra, and Merger Sub aided and abetted the directors' alleged breach of fiduciary duty. The Rosenblatt Action sought, among other things, to enjoin the transactions contemplated by the merger agreement, rescission of the merger or an award of rescissory damages should the merger be consummated, an award of damages and an award of attorneys' fees and expenses. Conagra and Pinnacle maintained that the Rosenblatt Action was without merit and filed a motion to dismiss. Ultimately, the plaintiff chose not to pursue the Rosenblatt Action and filed a voluntary notice of dismissal without prejudice. On January 30, 2019, the Court dismissed the case. party at approximately 40 Superfund, proposed Superfund, or state-equivalent sites (the "Beatrice sites"). These sites involve locations previously owned or operated by predecessors of Beatrice that used or produced petroleum, pesticides, fertilizers, dyes, inks, solvents, PCBs, acids, lead, sulfur, tannery wastes, and/or other contaminants. Reserves for these Beatrice environmental proceedings have been established based on our best estimate of the undiscounted remediation liabilities, which estimates include evaluation of investigatory studies, extent of required clean-up, the known volumetric contribution of Beatrice and other potentially responsible parties, and its experience in remediating sites. The accrual for Beatrice-related environmental matters totaled $53.0 million as of February 24, 2019, a majority of which relates to the Superfund and state-equivalent sites referenced above. During the third quarter of fiscal 2017, a final Remedial Investigation/Feasibility Study was submitted for the Southwest Properties portion of the Wells G&H Superfund site, which is one of the Beatrice sites. The U.S. Environmental Protection Agency (the "EPA") issued a Record of Decision (the "ROD") for the Southwest Properties portion of the site on September 29, 2017 and has entered into negotiations with potentially responsible parties to determine final responsibility for implementing the ROD. In certain limited situations, we guarantee obligations of the Lamb Weston business pursuant to guarantee arrangements that existed prior to the Spinoff and remained in place following completion of the Spinoff until such guarantee obligations are substituted for guarantees issued by Lamb Weston. Such guarantee arrangements are described below. Pursuant to the Separation and Distribution Agreement, dated as of November 8, 2016 (the "Separation Agreement"), between us and Lamb Weston, these guarantee arrangements are deemed liabilities of Lamb Weston that were transferred to Lamb Weston as part of the Spinoff. Accordingly, in the event that we are required to make any payments as a result of these guarantee arrangements, Lamb Weston is obligated to indemnify us for any such liability, reduced by any insurance proceeds received by us, in accordance with the terms of the indemnification provisions under the Separation Agreement. Lamb Weston is a party to a warehouse services agreement with a third-party warehouse provider through July 2035. Under this agreement, Lamb Weston is required to make payments for warehouse services based on the quantity of goods stored and other service factors. Minimum payments of $1.5 million per month are required under this agreement. Prior to the Spinoff, we guaranteed the warehouse provider that we would make the payments required under the services agreement in the event that Lamb Weston failed to perform. Upon completion of the Spinoff, the guarantee remained in place, and we recognized a liability for the estimated fair value of this guarantee. During the third quarter of fiscal 2019, we entered into an Assignment and Assumption Agreement with Novation pursuant to which Lamb Weston assumed all of our obligations under the services agreement and related guarantee and we were released from all further obligations thereunder. As a result of this agreement, we reversed the applicable liability, previously recorded in other noncurrent liabilities, and recognized a benefit of $27.3 million in SG&A expenses. Lamb Weston is a party to an agricultural sublease agreement with a third party for certain farmland through 2020 (subject, at Lamb Weston's option, to extension for two additional five-year periods). Under the terms of the sublease agreement, Lamb Weston is required to make certain rental payments to the sublessor. We have guaranteed the sublessor Lamb Weston's performance and the payment of all amounts (including indemnification obligations) owed by Lamb Weston under the sublease agreement, up to a maximum of $75.0 million. We believe the farmland associated with this sublease agreement is readily marketable for lease to other area farming operators. As such, we believe that any financial exposure to the Company, in the event that we were required to perform under the guarantee, would be largely mitigated. We lease a certain office building from an entity that we have determined to be a variable interest entity. The lease agreement with this entity includes a fixed-price purchase option for the asset being leased. The lease agreement also contains a contingent put option (the "lease put option") that allows the lessor to require us to purchase the building at the greater of original construction cost, or fair market value, without a lease agreement in place (the "put price") in certain limited circumstances. As a result of substantial impairment charges related to our divested Private Brands operations, this lease put option became exercisable. We are amortizing the difference between the put price and the estimated fair value (without a lease agreement in place) of the property over the remaining lease term within SG&A expenses. As of February 24, 2019 and May 27, 2018, the estimated amount by which the put option price exceeded the estimated fair value of the property was $8.2 million, of which we had accrued $1.5 million and $1.2 million, respectively. This lease is accounted for as an operating lease, and accordingly, there are no material assets and liabilities, other than the accrued portion of the put price, associated with this entity included in the Condensed Consolidated Balance Sheets. We have determined that we do not have the power to direct the activities that most significantly impact the economic performance of this entity. In making this determination, we have considered, among other items, the terms of the lease agreement, the expected remaining useful life of the asset leased, and the capital structure of the lessor entity. During the third quarter of fiscal 2018, we purchased two buildings that were subject to lease put options and recognized net losses totaling $48.2 million for the early exit of unfavorable lease contracts. possible that a change of the estimates of any of the foregoing matters may occur in the future and, as noted, the lead paint matter could result in a material final judgment which could have a material adverse effect on our financial condition, results of operations, or liquidity. Costs of legal services associated with the foregoing matters are recognized in earnings as services are provided. We have defined benefit retirement plans ("plans") for eligible salaried and hourly employees. Benefits are based on years of credited service and average compensation or stated amounts for each year of service. We also sponsor postretirement plans which provide certain medical and dental benefits ("other postretirement benefits") to qualifying U.S. employees. In connection with the acquisition of Pinnacle, we now include the components of pension and postretirement expense associated with the Pinnacle pension plans and an other post-employment benefit plan in our Condensed Consolidated Statements of Earnings from the date of the completion of the acquisition. These plans are frozen for future benefits. A net liability of $34.8 million is included in our Condensed Consolidated Balance Sheets at February 24, 2019. The tabular disclosures presented below are inclusive of the Pinnacle plans. The Company uses a split discount rate (spot-rate approach) for the U.S. plans and certain foreign plans. The spot-rate approach applies separate discount rates for each projected benefit payment in the calculation of pension service and interest cost. The weighted-average discount rates for service and interest costs under the spot-rate approach used for pension benefit cost in fiscal 2019 were 4.21% and 3.83%. During the third quarter and first three quarters of fiscal 2019, we contributed $3.6 million and $11.5 million, respectively, to our pension plans and contributed $2.0 million and $6.3 million, respectively, to our other postretirement plans. Based upon the current funded status of the plans and the current interest rate environment, we anticipate making further contributions of approximately $3.0 million to our pension plans for the remainder of fiscal 2019. We anticipate making further contributions of approximately $9.9 million to our other postretirement plans during the remainder of fiscal 2019. These estimates are based on ERISA guidelines, current tax laws, plan asset performance, and liability assumptions, which are subject to change. During the third quarter and first three quarters of fiscal 2018, we recorded a benefit of $1.7 million and an expense of $0.4 million, respectively, related to our expected incurrence of certain multi-employer pension plan withdrawal costs. These amounts have been included in restructuring activities.

{'timestamp': '2019-04-21T06:18:05Z', 'url': 'https://q10k.com/CAG', 'language': 'en', 'source': 'c4'}

professional_accounting

TWEETER HOME ENTERTAINMENT GROUP INC TWEETER HOME EMTERTAINMENT GROUP, INC. For the fiscal year ended September 30, 2003 Tweeter Home Entertainment Group, Inc. of incorporation) (I.R.S. Employer 40 Pequot Way (Registrant’s telephone number including area code) Securities registered pursuant to section 12(g) of the Act: Common Stock, $.01 par value (Title of Class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o Indicate by check mark whether the registrant is an accelerated filer as defined in Exchange Act Rule 12b-2). Yes þ No o The aggregate market value of the common stock held by non-affiliates of the registrant, based upon the last sales price for such stock on March 31, 2003 as reported by the Nasdaq Stock Market, was approximately $95,020,470. Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date. Title of Class Outstanding at December 11, 2003 Portions of the definitive Proxy Statement for the 2004 Annual Meeting of Stockholders to be held on January 15, 2004 are incorporated by reference into Part III. Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters Item 6. Selected Financial Data (amounts in thousands, except per share and number of stores data) INDEX TO FINANCIAL STATEMENTS INDEPENDENT AUDITORS’ REPORT Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 10. Directors and Executive Officers of the Registrant Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management Item 13. Certain Relationships and Related Transactions Item 14. Principal Accountant Fees and Services Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K EX-10.8 SEVERANCE AGREEMENT (PHILO PAPPAS) EX-10.19 AMENDMENT TO CREDIT AGREEMENT EX-14 CODE OF ETHICS EX-23 CONSENT OF DELOITTE & TOUCHE LLP EX-31.1 RULE 13A-14(A)/15D-14(A) CERTIFICATION EX-32.1 SECTION 1350 CERTIFICATION In this Annual Report on Form 10-K, the “Company,” “Tweeter,” “we,” “us” and “our” mean Tweeter Home Entertainment Group, Inc. and its subsidiaries. This Annual Report on Form 10-K contains forward-looking statements regarding Tweeter’s performance, strategy, plans, objectives, expectations, beliefs and intentions. The actual outcome of the events described in these forward-looking statements could differ materially. This Report, and especially the sections entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains a discussion of some of the factors and risks that could contribute to those differences. Tweeter is a national specialty consumer electronics retailer providing audio and video solutions for the home and mobile environment. Tweeter believes it has the expertise to “explain it all, deliver it all, and install it all” so that its customers can “Just Sit Back and EnjoyTM.” We operate 174 stores in twenty-one states under the Tweeter, HiFi Buys, Sound Advice, Bang & Olufsen, Electronic Interiors, Showcase Home Entertainment and Hillcrest names in New England, the Mid-Atlantic, the Southeast, Texas, California, greater Chicago, Florida and Arizona. Tweeter operates in a single business segment of retailing audio and video consumer electronics products. The Company’s stores feature a selection of quality home and mobile audio and video products including cutting edge HDTV, plasma and LCD televisions, DVD players and recorders, surround sound systems, audio components, digital video satellite systems, satellite radios, personal video recorders and digital camcorders. We differentiate ourselves by focusing on consumers who seek audio and video products with advanced features, functionality and performance. These products tend to be more expensive within their category of products and will often have newer or more advanced technology. An example of this would be the KVH TracVision A5, satellite TV for the car. We do not offer consumer electronics products such as personal computers or home office equipment. The Company has created an inviting retail environment in each store with specially designed home theater rooms, allowing its customers to visualize the technology in a more natural home setting. The stores average 10,000 square feet and are staffed with highly trained sales and installation professionals. The Company’s goal is to ensure that each customer receives the best possible experience through their entire purchase and installation process. We believe this commitment to service, along with Tweeter’s competitive prices and Automatic Price Protection program, will continue to build customer loyalty and Tweeter brand awareness nationwide. In 1972, we opened our first store in Boston under the Tweeter name and over the next two decades grew exclusively through new store openings in New England, expanding to eighteen stores by 1995. In 1995, Tweeter adopted an aggressive growth strategy to (i) open new stores in current regional markets and relocate certain stores to more favorable sites and (ii) to selectively pursue acquisitions in new regional markets and achieve operating improvements by converting the acquired companies to our core operating model and leveraging distribution, marketing and corporate infrastructure. We completed the acquisition of Bryn Mawr Radio and Television, Inc. (“Bryn Mawr”) in May 1996, HiFi Buys Incorporated (“HiFi Buys”) in May 1997, Home Entertainment of Texas, Inc. (“Home Entertainment”) in February 1999, DOW Stereo/ Video, Inc. (“Dow”) in July 1999, United Audio Centers, Inc. (“United Audio Centers”) in April 2000, Douglas T.V. & Appliance, Inc. and Douglas Audio Video Centers, Inc. (collectively, “Douglas”) in October 2000, The Video Scene, Inc. (“Big Screen City”) in May 2001, SMK Marketing, Inc. (“Audio Video Systems”) in June 2001, Sound Advice, Inc. (“Sound Advice”) in August 2001 and Hillcrest High Fidelity, Inc. (“Hillcrest”) in March 2002. In addition, in September 2002, the Company re-launched the Tweeter Web site to market and sell consumer electronics over the Internet. The new tweeter.com site was designed to mirror the in-store experience as well as the look and feel of its brick and mortar counterparts. Tradenames. Tweeter currently operates under several tradenames. The large majority (120) of stores are operated as Tweeter, four stores in Arizona are operated as Showcase Home Entertainment (“Show- case”), two stores in Dallas are operated as Hillcrest, twenty-five stores in Florida are operated as Sound Advice and fourteen stores in metro Atlanta are operated as HiFi Buys. We continue to assess whether the HiFi Buys stores should be converted to the Tweeter brand. If the determination is made that they should be converted, we anticipate doing so in either the spring of 2004 or 2005, depending on market conditions. We will likely convert the Hillcrest stores in Texas at the same time. We are evaluating whether or not to convert the Showcase stores, and we believe it is unlikely we will convert the Sound Advice stores to the Tweeter brand. Sound Advice has a strong brand in Florida, and currently we believe that the risk of conversion outweighs the benefit that could be derived from the conversion. However, this is an area that will be continually evaluated over time. We have registered the “Tweeter etc.” service mark with the United States Patent and Trademark Office. Its registration number is 2097801 and the renewal due date is September 16, 2007. We have not registered any other tradenames. We are aware that other consumer electronics retailers use the name HiFi Buys and Sound Advice. Competition. Tweeter is a relatively small player in the national (United States) landscape of consumer electronics. The overall industry is just under $100 billion in size (data provided by Consumer Electronics Association Market Research) and we account for less than 1% of that total. Several large players, including Best Buy, Circuit City, Sears and Wal-Mart, dominate the industry and have significantly greater resources than Tweeter. Tweeter does not compete with these larger players in all categories. There is a small overlap in products that are sold by the big players and Tweeter, however. Typically, this includes the higher-end (more sophisticated, more features and options) of the larger players’ products and the lower end (more entry level, fewer features and options) of our products. One advantage we believe we have over the larger players is the ability to service our customers. The larger players often cannot compete with the customer service we can provide. Seasonality. Our business is subject to seasonal variations. Historically, we have realized a significant portion of our total revenue and net income for the year during the first and fourth fiscal quarters, with a majority of net income for such quarters realized in the first fiscal quarter. Due to the importance of the holiday shopping season, any factor negatively impacting the holiday selling season could have an adverse effect on our revenues and our ability to generate a profit. Our quarterly results of operations may also fluctuate significantly due to a number of factors, including the timing of new store openings and acquisitions, and unexpected changes in volume-related rebates or changes in cooperative advertising policies from suppliers. In addition, operating results may be negatively affected by increases in merchandise costs, price changes in response to competitive factors and unfavorable local, regional or national economic developments that result in reduced consumer spending. Purchases and Returns. Tweeter, like most of the consumer electronics retail industry, allows its customers to return products within a specified amount of time from the initial retail sale. This is typically thirty days, although this can vary for some product categories such as speakers, where we have a trade up policy available. We also offer extended payment terms and other promotional offers as an inducement to purchase. We partner with GE Capital Services to run our private label credit card; GE Capital Services bears all credit risk under the terms of this agreement. Our goal is to become the leading national specialty retailer of high quality audio and video products as well as to be known as the national leader of “In-Home Services and Education.” The key elements of our business strategy are as follows: Extensive Selection of Mid- to High-End Audio and Video Products. We concentrate on mid- to high-end audio and video consumer electronics products. This focus differentiates us from larger format superstores and mass merchandisers, who offer a broad array of consumer electronics and non-electronics products with an emphasis on products priced at introductory price levels. Our emphasis on mid- to higher-end products positions us attractively to manufacturers seeking to sell more advanced or limited distribution products as part of their distribution strategy. As a result of our mid- to higher-end product focus, a historical early adopter customer base and our extensively trained sales force, we are often among the earliest retailers to offer new product innovations on behalf of manufacturers. Tweeter has a long tradition of catering to the audio and/or video enthusiast, and over the last thirty-one years we have introduced many new technologies to the marketplace. We were among the first retailers to see the flat panel plasma and LCD televisions, the DVD player, the CD player, the camcorder and the VCR. We will often hold a market share in new technology that is out of proportion to our less than 1% share of consumer electronics retailing overall. For example, we continue to hold in excess of 13% market share in the sale of flat panel plasma televisions (data provided by the July 2003 reports distributed by NPD Group), one of the newest and most advanced technologies within the video category. Our stronghold on these new and generally expensive technologies declines as the retail prices decrease and the technology becomes more familiar to a mainstream customer. In addition, we believe that our focused product offering allows for higher gross margin opportunities, appeals to a more service-conscious consumer and results in enhanced brand awareness of our regional names to our targeted customer group. In-Home Installation Business. As consumer electronics products have become more sophisticated and complex, we have become aware of a corresponding tendency for customers to be deterred from purchasing integrated audio/video systems because of the perceived difficulty in setting the systems up properly in their homes. We have sought to address this problem, and to increase sales of such sophisticated systems, by offering home installation services in many of our markets. The majority of these services are provided by the Company’s employees, however, in some outlying markets, we have outsourced these services with a plan to eventually control 100% of our in-home services internally. Exceptional Customer Service. We believe that the quality and knowledge of our sales associates is critical to our success and represents a significant competitive advantage. Our relationship-selling model encourages sales associates to promote a comfortable, trusting, low-pressure environment. We provide new sales associates with four weeks of intensive classroom training, and all sales associates receive four to six days of ongoing training per year, both at the store and at Tweeter’s regional training centers. Our sales force receives technical product and sales training prior to our introduction of significant new products. We believe that the success of our operating model has enabled us to engender long-term customer loyalty. Dynamic, Inviting Stores. Our stores display products in a dynamic and inviting setting intended to encourage the customer to view and hear products in sound rooms architecturally and acoustically designed to simulate the customer’s home or mobile environment. The store prototype blends a colorful, comfortable lifestyle environment, with innovative and interactive product displays which enable customers to audition and compare a sample of products. Each store contains a flat panel technology showcase which displays an extensive selection of plasma, LCD and related products, and every store contains a movie theater room, which showcases our home theater products. Everyday Competitive Pricing. Except in the Florida and Arizona markets, we utilize an “everyday competitive pricing” strategy with fixed prices clearly marked on our products. Store managers regularly visit local competitors to ensure that our pricing remains competitive within the store’s local market. In addition, our patented Automatic Price Protection program backs all product sales. Under this program, if a customer purchases a consumer electronics product from one of our stores and a competitor within twenty-five miles of the store advertises a lower price within thirty days, we automatically send a check to the customer for the difference without requiring the customer to request payment. The Automatic Price Protection program is designed to remove pricing concerns from the purchase decision and, as a result, allows customers and the sales staff to focus on product functionality, performance and quality. Automatic Price Protection has not been implemented at the Sound Advice stores in Florida, the Showcase Home Entertainment stores in Arizona or the Hillcrest stores in Dallas, Texas. These stores follow a more traditional, promotional sale strategy in their general marketing effort and we will continue to evaluate whether to implement our Automatic Price Protection strategy in these markets. Our current growth strategy is to capitalize on new technologies and home installation services to drive comparable store sales. A store is included as a comparable store after it has been in operation for twelve full months from the date of opening, acquisition, or relocation. When products such as CD players, DVD players, plasma televisions, digital televisions, mobile video and satellite radio were first introduced, we were one of the first retailers to sell these products. We expect that we will continue to be among the first retailers to offer new consumer electronics products as they are developed, and continue to put considerable effort into having a knowledgeable sales team able to explain new technologies to customers. We believe that as a result we will continue to attract buyers who wish to be “early adopters” of new products. New Stores. We intend to open new stores and relocate a limited number of stores within existing markets in order to increase penetration and leverage regional advertising, distribution, and operating efficiencies. During fiscal 2003, we opened twelve stores and closed five stores in the following regions: Region New Stores Opened Closed Stores For fiscal year 2004, we intend to open three stores and to relocate one store. We believe that the ten acquisitions made since May 1996 have provided us with platforms from which to open new stores within and around their markets. Acquisition of Hillcrest. In March 2002, we completed the acquisition of Hillcrest, a two-store chain located in the greater Dallas, Texas area. Hillcrest, a specialty retailer with a significant focus on in-home installation, had annual sales of approximately $14 million and had operated in the Dallas market for fifty-three years. We implemented some key aspects of our business strategy and integrated their operations with our existing Dallas operations. Store Format and Operations As of September 30, 2003, we operated 174 stores, consisting of 120 Tweeter stores in New England, the Mid-Atlantic, the Southeast, Texas, Southern California and in the greater Chicago area; fourteen HiFi Buys stores in the Southeast; twenty-five Sound Advice stores in Florida; six Bang & Olufsen stores in Florida; two Electronic Interiors stores in Florida; four Showcase Home Entertainment stores in the Phoenix, Arizona market; one Bang & Olufsen store in Phoenix, Arizona and two Hillcrest stores in Dallas, Texas. While our stores vary in size, the current prototype is 10,000 square feet, with approximately 70% of our square footage devoted to selling space. Our store concept combines the comfort of the home environment with practical displays enabling consumers to sample and compare the features and functions of products in various combinations. The store prototype blends a colorful, comfortable lifestyle environment with innovative and interactive product displays that enable customers to audition and compare a sample of products. Unlike many of our competitors’ stores, which contain large, open spaces in which many different audio and video products are tested and sampled, our stores feature individual sound rooms. The sound rooms architecturally and acoustically resemble a home environment to enable the customer to see and hear how products will perform at home. These sound rooms allow the customer to listen to and compare various combinations of receivers, CD and DVD players and speakers. In addition, each store contains a flat panel technology showcase which displays an extensive selection of plasma, LCD and related video products, and every store contains a movie theater room, which showcases our home theater products. Other displays, such as the “big red button,” allow the customer to change, by pushing a button, mono television sound into a five-speaker or surround sound experience. Each store also features an imaging gallery that allows customers to sample different camcorders and digital still cameras, and to shoot videos of their children within the adjacent children’s play area. The majority of our stores have areas that feature state-of-the-art audio and video mobile systems, which serves to exhibit our mobile installation capabilities. Most stores provide mobile systems installation through on-premises installation bays. Stores are typically staffed with a store manager, an assistant manager, approximately twelve sales associates and mobile electronics installers. Some associates specialize in either in-home or mobile systems. We provide new sales associates with four weeks of intensive classroom training, and all sales associates receive four to six days of ongoing training per year, both at the store and at the regional training centers. The sales force receives technical product and sales training prior to the introduction of significant new products. All stores are open seven days a week. Most of our store managers are compensated through base pay, commissions and monthly bonuses based on gross margin. Store managers can earn a substantial portion of their annual compensation through such bonuses. Sales associates are compensated through a commission program that is based on the retail prices and gross margin of products sold. Our stores feature home audio systems and components, mobile audio and video systems, video products such as large screen televisions, including flat panel plasma, LCD, digital projection and digital tube televisions, digital satellite systems, digital video recorders, camcorders, DVD players and other consumer electronics products such as wireless networking devices, home audio speakers, stereo and surround sound receivers and portable audio equipment. We offer home and mobile stereo installation services and provide warranty and non-warranty repair services through all of our stores. Our in-home installation business provides design, installation and educational services in connection with new construction and home renovations, as well as for existing homes. Products provided by our in-home installation group include whole-house music systems, home theatre systems, satellite TV, Internet access systems, and touch screen controls. We also offer product replacement services, where we enter into agreements with insurance companies to provide replacement products at a discounted rate to their policyholders. Under these agreements, the insurance companies refer the policyholder to Tweeter to obtain the replacement products and we bill the insurance companies directly, rather than their policyholders, for the products. Additionally, we have a corporate sales division, which markets and sells to businesses, institutions and other organizations. Our emphasis on mid- to high-end products enables us to offer limited distribution products and to be among the earliest retailers to offer new product innovations on behalf of manufacturers. We stock products from many suppliers, including, Alpine, B&K, Bose, Boston Acoustics, Denon, Kenwood, Mirage, Martin Logan, Mitsubishi, Monster Cable, Panasonic, Philips, Pioneer, Samsung, Sharp, Sonus Faber, Sony, Velodyne and Yamaha. We seek to manage our product mix to maximize gross margin performance and inventory turns. Historically, video products have yielded lower gross margin than audio products. Total sales of video products have increased at rates faster than the increases in audio product sales during the last several years as a result of the increased customer interest in big screen televisions. Accordingly, we have enhanced our in-home installation business and adopted a “Sell Audio with Video” strategy in order to enhance our overall gross margin through increased sales of higher margin audio products and in-home services. The strategy involves a training and incentive program for sales associates to work with customers to demonstrate audio products that enhance the performance of the video products they are purchasing, so that a customer purchasing a video product is more likely to purchase an audio product as well. In addition, the sales team has developed a new “Power Rank” measurement tool that scores every store in the chain both regionally and nationally on specific company sales development goals. Some measurement examples are the attachment of accessories and performance guarantees (extended warranties), penetration of in-home labor as a percentage of sales and maintaining minimum levels of discontinued inventory. The table below sets forth the approximate percentage of revenues for each of our primary product categories for our fiscal years ended September 30, 2001, September 30, 2002 and September 30, 2003, respectively. The percentage of revenues represented by each product category may be affected by, among other factors, competition, economic conditions, consumer trends, the introduction into the market of new products, changes in our product mix, and the timing of marketing events. The percentages are also affected by our acquisitions of stores offering different mixes of products. The historical percentages set forth below may not be indicative of revenue percentages for future periods: Percentage of Retail Revenues Fiscal Years Ended Product Category 2001 2002 2003 Audio Equipment(1) Video Equipment(2) Mobile Equipment and Other(3) (1) Includes speakers, cassette decks, receivers, turntables, compact disc players, mini-disc players, amplifiers, preamplifiers, home theater in a box, and portable audio equipment. (2) Includes televisions, projection televisions, video recording devices, camcorders, DVD players, satellite dishes and video accessories. (3) Includes mobile decks, amplifiers and speakers, mobile security products, navigation equipment, wireless phones, audio and mobile accessories, installation and service labor, and extended performance guarantees. Purchasing and Inventory Our purchasing and inventory control functions are based out of our executive offices in Canton, Massachusetts. The purchasing decisions are made by our buying team, which has primary responsibility for product selection, stocking levels and pricing. Purchasing decisions are facilitated by our information systems, which analyze stocking levels and product sell-through. The purchasing group continuously reviews new and existing products with a view towards maintaining a wide range of high quality, brand-name consumer electronics products within the product mix. In order to remain current with new and developing products, we regularly host presentations by our major suppliers. In the recent years, we have traveled to the Far East to assist in product development issues surrounding product innovation for our class of products. In addition to making direct purchases, we are a member of the Progressive Retailers Organization (“PRO”) group, a volume-buying group of seventeen specialty electronics retailers across the country. This affiliation often provides us with the opportunities to obtain additional supplier rebates, product discounts and promotional products. We are not obligated to make purchases through PRO. Our President and Chief Executive Officer also serves on the Board of Directors of PRO. We source products from many suppliers, the largest of whom, Sony, accounted for 22% of fiscal 2003 purchases. We do not maintain long-term commitments or exclusive contracts with any particular supplier, but instead consider numerous factors, including price, credit terms, distribution, quality and compatibility within the existing product mix in making our purchasing decisions. We utilize an automatic replenishment system for store inventory, maintaining stock levels and minimizing total dollars invested in inventory. We believe that our relationship with our large suppliers is excellent and that our focused merchandising and high degree of customer service makes us an important distribution channel, particularly for the introduction of new products. We distribute products to stores through our regional distribution centers. The Canton, Massachusetts distribution center is 80,000 square feet and services the New England stores. The King of Prussia, Pennsylvania distribution center is 50,000 square feet and services the Mid-Atlantic stores. The Atlanta, Georgia facility is 80,000 square feet and the Charlotte, North Carolina distribution center is 15,000 square feet, both servicing the Southeast stores. The Houston, Texas distribution center is 64,000 square feet and services the Houston area stores. The Dallas, Texas distribution centers total 25,600 square feet and service the Dallas area stores. The San Diego, California facility is 57,200 square feet and services the Southern California stores. The Chicago, Illinois facility is 122,000 square feet and services the Illinois stores. The Pembroke Park, Florida distribution center and other small Florida outlet facilities total approximately 234,000 square feet and service all the Florida stores. The Phoenix, Arizona distribution facility is 14,300 square feet and services the Arizona stores. We believe that these facilities are sufficient to handle any expansion in these markets through at least the year 2004. Tweeter targets consumers seeking informed advice concerning product selection and system integration of audio and video consumer electronics products. Our marketing strategy over the last year has shifted to more of a newspaper print strategy from an electronic media or radio strategy. We will continue to supplement our print campaigns with radio, television and an extensive direct marketing effort. The specific allocation of advertising dollars among the various types of advertising media is reviewed from time to time by management and, if necessary, adjusted to reflect our assessment of advertising results and market conditions. Providing competitive product pricing is a critical component of our marketing and advertising strategy. Store managers regularly visit the local competition to ensure the store’s pricing remains competitive. At the same time, our uniquely executed Automatic Price Protection program backs our competitive prices. Under the Automatic Price Protection program, if a customer purchases a consumer electronics product from a Tweeter store and a competitor within twenty-five miles of that store advertises a lower price in the newspaper within thirty days of the customer’s purchase, we automatically send a check to the customer for the difference. Unlike other price guarantee programs in place within the industry, the refund process does not require the customer to call or return to the store of purchase and request a price match refund. The Automatic Price Protection program is intended to be hassle-free, customer friendly and viewed as a reflection of Tweeter’s commitment to customer service. In fiscal 1997, we implemented a “Wise-Buys” program. Under this program, Tweeter’s merchandise buyers identify special, reduced-priced items, often closeouts or last year’s top-of-the-line models, which are purchased from the manufacturer and offered to the consumer at a substantial discount from the original retail price. We believe that the pricing of the Wise-Buys items represents substantial value to the consumer with little or no negative impact to gross margin. Our advertisements frequently describe or refer to the Automatic Price Protection and Wise-Buys programs. Our stores average approximately 10,000 square feet and are typically located in freestanding buildings or strip shopping centers within high traffic shopping areas. New store sites are selected on the basis of several factors, including physical location, demographic characteristics of the local market, proximity to superstore competitors, access to highways or other major roadways and available lease terms. We look for co-tenants that are likely to draw customers whom we would otherwise target within the site’s relevant market and believe that the proximity of superstore competitors is, on balance, a positive factor due to increased customer traffic. We lease substantially all of our stores. The following table presents the number and location of stores we operated at the end of each of the last three fiscal years: State 2001 2002 2003 We utilize a sophisticated, fully integrated mainframe based management information system which updates after every transaction, and which is accessible on a real time basis to management, sales associates and product buyers. Extensive sales reporting and sales tracking are provided real time on screen to store managers and individual sales associates. The screen tracks category sales and benchmarks key sales data. This system enables management and store managers to review sales volume, gross margin and product mix on a per store or per sales associate basis, allows for the viewing of open orders, inventory value and mix and tracks sales by product category, by sales associate, and by store. We provide ongoing training and support in the use of this system and compensate and benchmark the store managers based upon this information. As of September 30, 2003, we had 3,621 employees, consisting of 3,511 full-time and 110 part-time employees. None of our employees are covered by collective bargaining agreements, and we believe our relations with our employees are good. Tweeter.com Web Site Our Web site address is www.tweeter.com. We make our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or Section 15(d) of the Securities Exchange Act of 1934 available on our Web site as soon as reasonably practicable after we electronically file such documents with, or furnish them to, the Securities and Exchange Commission. The value of an investment in Tweeter will be subject to the significant risks inherent in its business. Investors should consider carefully the risks and uncertainties described below. This Annual Report contains forward-looking statements regarding Tweeter’s performance, strategy, plans, objectives, expectations, beliefs and intentions. The actual outcome of the events described in these forward-looking statements could differ materially. The following is a discussion of some of the factors and risks that could contribute to those differences. We may not be able to open new stores and, even if we do open new stores, we may not be able to operate those stores profitably. While the opening of new stores has slowed considerably, we expect to continue to open new stores from time to time. The opening of additional stores in new geographical markets could present competitive and merchandising challenges different from those we currently or previously faced within our existing geographic markets. In addition, we may incur higher costs related to advertising, administration and distribution as we enter new markets. There are a number of factors that could affect our ability to open or acquire new stores. These factors also affect the ability of any newly opened or acquired stores to achieve sales and profitability levels comparable with our existing stores, or to become profitable at all. These factors include: • The identification and acquisition of suitable sites and the negotiation of acceptable leases for such sites; • The obtaining of governmental and other third-party consents, permits and licenses needed to operate such additional sites; • The hiring, training and retention of skilled personnel; • The availability of adequate management and financial resources; • The adaptation of our distribution and other operational and management systems to an expanded network of stores; • The ability and willingness of suppliers to supply products on a timely basis at competitive prices; and • Continued consumer demand for our products at levels that can support acceptable profit margins. Our success depends on our ability to increase sales in our existing stores. We may not be able to do so. Our continued growth also depends on our ability to increase sales in our existing stores. The opening of additional stores in an existing market could result in lower net sales at our existing stores in that market. Our ability to increase sales in existing stores may also be affected by: • Our success in driving customers into our stores; • Not maintaining fully staffed and trained employees; • Our inability to keep stores stocked with the correct merchandise; and • Our ability to choose the correct mix of products to sell. We have recently altered our primary marketing strategy to include an emphasis on print advertisements, where we have limited experience. Our marketing strategy has historically focused primarily on electronic media, radio and an extensive direct marketing effort. While we still rely on these channels, during the last year, we have also been using a more aggressive print advertising strategy. As we only have limited experience using print media for advertisements, we may not use print media in the most effective manner. In addition, print media may not be as effective in reaching prospective customers as other channels of advertising. As a result, fewer customers may purchase products or services. We depend on key personnel and our business may be severely disrupted if we lose the services of our key executives. Our success depends upon the active involvement of senior management personnel, particularly Samuel Bloomberg, Tweeter’s Chairman of the Board, Jeffrey Stone, Tweeter’s President and Chief Executive Officer, Joseph McGuire, Tweeter’s Senior Vice President and Chief Financial Officer, and Philo Pappas, Tweeter’s Senior Vice President and Chief Merchandising Officer. The loss of the full-time services of Messrs. Bloomberg, Stone, McGuire, Pappas, or other members of senior management, could severely disrupt our business as we may not be able to replace them. Tweeter has employment contracts with Messrs. Bloomberg, Stone, McGuire, and Pappas. Tweeter has no other employment agreements with any members of its senior management team. Tweeter currently maintains key-man life insurance on the lives of Messrs. Bloomberg and Stone in the amounts of $1,000,000 and $5,000,000, respectively. We face intense competition that could reduce our market share. Tweeter competes against a diverse group of retailers, including several national and regional large format merchandisers and superstores, such as Circuit City and Best Buy, which sell, among other products, audio and video consumer electronics products similar and often identical to those Tweeter sells. Tweeter also competes in particular markets with a substantial number of retailers that specialize in one or more types of consumer electronics products that Tweeter sells. Certain of these competitors have substantially greater financial resources than Tweeter that may increase their ability to purchase inventory at lower costs or to initiate and sustain predatory price competition. In addition, the large format stores are continuing to expand their geographic markets, and this expansion may increase price competition within those markets. Our business is subject to quarterly fluctuations and seasonality. Seasonal shopping patterns affect our business. The fourth calendar quarter, which is Tweeter’s first fiscal quarter and which includes the December holiday shopping period, has historically contributed, and is expected to continue to contribute, a significant portion of our total revenue and more than half of our operating and net income for our entire fiscal year. As a result, any factors negatively affecting Tweeter during the fourth calendar quarter of any year, including adverse weather or unfavorable economic conditions, would have a material adverse impact on our revenues for the entire year. More generally, Tweeter’s quarterly results of operations may fluctuate based upon such factors as: • The amount of net sales contributed by stores; • The mix of consumer electronics products sold in its stores; • Profitability of sales of particular products; and • Changes in volume-rebates from manufacturers. Our comparable store sales results may fluctuate significantly. “Comparable store sales” is a term we use to compare the year over year sales performance of our stores. A store is included in the comparable store sales base after it is in operation for twelve full months. An acquired store is included after twelve full months from the date of acquisition. Remodeled or relocated stores are excluded from the comparable store base until they have completed twelve full months of operation from the date the remodeling was completed or the store re-opened after relocation. A number of factors have historically affected, and will continue to affect, Tweeter’s comparable store sales results, including, among other factors: • Competition: well-established competitors with an abundance of resources may enter markets in which stores are located and provide products at lower prices. This competition may cause sales to decline from prior year sales; • General regional and national economic conditions: severe regional weather conditions such as floods, hurricanes or tornados, or regional business crises causing large layoffs or work stoppages may cause regional comparable store sales declines, while exceptional regional business success may cause comparable store sales increases. In addition, national economic crises, such as a recession, may cause comparable store sales declines while favorable economic events, such as a stock market surge, may cause comparable store sales increases; • Consumer trends: if consumer trends shift to a new product technology, we will likely see an increase in comparable store sales. However, if trends shift from a high average sale price product one year to a middle average sale price product the next, comparable store sales will likely decrease; • Changes in Tweeter’s product mix: if Tweeter changes product mix in a way that results in higher or lower average sale price, comparable store sales will tend to follow this change; • Timing of promotional events: if a promotional event held one year is not held the following year, then comparable store sales may be reduced by not having the same “promotional” sale base. Conversely, if an event which is not held one year is held the following year, then comparable store sales may be higher; and • New product introductions: new product introductions may increase comparable store sales by providing customers with an incentive to replace their existing systems. New product introductions may cause comparable store sales to decrease, however, if the product is a lower-priced item that replaces a higher priced product. Recent economic conditions make forecasting comparable store sales particularly difficult. Comparable store sales, as they did in fiscal 2002 and 2003, may decrease in the future. Changes in Tweeter’s comparable store sales results could cause the price of the common stock and profitability to fluctuate substantially. We may need additional capital and we may not be able to obtain it on acceptable terms, if at all. Financing for the opening and acquisition of new stores may be in the form of debt or equity or both and may not be available on terms acceptable to Tweeter, if at all. We estimate that the average cash investment, including pre-opening expenses for tenant fit-out and inventory (net of payables), required to open a store to be approximately $1.2 million. The actual cost of opening a store may be significantly greater than such estimates, however, and we may need to seek additional debt and/or equity financing in order to fund our continued expansion through 2004 and beyond. Tweeter estimates that it requires an average of $1.2 million cash investment to open a new store. Some stores have been opened for as little as $600,000 and some have cost as much as $2.2 million. The differences in cost result from the specific circumstances relating to the store opening. In some cases, stores are leased in an existing building and costs are incurred to “Tweeterize” the space. In other cases, Tweeter might enter into a ground lease where the site is a piece of land that has to be fully developed. In connection with some of these ground leases, Tweeter has built multi-tenant facilities in which Tweeter will only occupy one of the spaces and sublet the remaining space. Additional factors that vary depending on the region in which a new store is being opened, and can therefore cause a corresponding region-to-region variation in the cost of opening a new store, including the following: • Labor cost, regional cost of living, and the use of union or non-union labor; • Material cost (which can vary by state and region); and • General contractors fees and volume benefits (e.g. a contractor building more than one store). In addition, our ability to incur additional indebtedness or issue equity or debt securities could be limited by covenants in present and future loan agreements and debt instruments. We may not be able to anticipate and respond to changes in consumer demand, preference and patterns. Tweeter’s success depends on its ability to anticipate and respond in a timely manner to consumer demand and preferences regarding audio and video consumer electronics products and changes in consumer demand and preferences. Consumer spending patterns, particularly discretionary spending for products such as those Tweeter markets, are affected by, among other things, prevailing economic conditions. In addition, the periodic introduction and availability of new products and technologies at price levels that generate wide consumer interest stimulate the demand for audio and video consumer electronics products. Also, many products that incorporate the newest technologies, such as high-definition television, are subject to significant technological and pricing limitations and to the actions and cooperation of third parties such as television broadcasters. It is possible that these products or other new products will never achieve widespread consumer acceptance. Furthermore, the introduction or expected introduction of new products or technologies may depress sales of existing products and technologies. Significant deviations from the projected demand for products Tweeter sells would result in lost sales or lower margins due to the need to mark down excess inventory. If any of our relationships with our key suppliers are terminated, we may not be able to find suitable replacements. The success of Tweeter’s business and growth strategy depends to a significant degree upon its suppliers, particularly its brand-name suppliers of audio and video equipment such as Sony, Mitsubishi, Panasonic, Pioneer, Monster Cable, Boston Acoustics and Yamaha. Tweeter does not have any supply agreements or exclusive arrangements with any suppliers. Tweeter typically orders its inventory through the issuance of individual purchase orders to suppliers. In addition, Tweeter relies heavily on a relatively small number of suppliers. Tweeter’s two largest suppliers accounted for approximately 32% of its sales during fiscal 2003. The loss of any of these key suppliers could affect our business, as we may not be able to find suitable replacements. Suppliers may not be willing to supply products to stores at acceptable prices. It is possible that Tweeter will be unable to acquire sufficient quantities or an appropriate mix of consumer electronics products at acceptable prices, if at all. Specifically, Tweeter’s ability to establish additional stores in existing markets and to penetrate new markets depends to a significant extent on the willingness and ability of suppliers to supply those additional stores at acceptable prices, and suppliers may not be willing or able to do so. Our service marks and patents may not be effective to protect our intellectual property rights. Our “Tweeter etc.,” “Audio, Video and a Boatload of Know How,” “Slamfest” and “Picture Perfect” service marks have been registered with the United States Patent and Trademark Office. Tweeter has not registered “HiFi Buys,” “Sound Advice” and some of its other service marks. We are aware that other consumer electronics retailers use the name “HiFi Buys” and “Sound Advice.” Tweeter has submitted applications for registration of some of its other service marks, which applications are currently pending. Tweeter may be unable to successfully register such service marks. In addition our service marks, whether registered or unregistered, and patents may not be effective to protect our intellectual property rights, and infringement or invalidity claims may be asserted by third parties in the future. Tweeter has a patent on its method of Automatic Price Protection, but we do not think the patent, in and of itself, provides us with a significant benefit or advantage. Anti-takeover provisions of the Delaware General Corporation Law, our certificate of incorporation and our shareholders’ rights agreement could delay or deter a change in control. Our corporate charter and by-laws, as well as certain provisions of the Delaware General Corporation Law, contain provisions which may deter, discourage or make more difficult a change in control of Tweeter, even if such a change in control would be in the interest of a significant number of our stockholders or if a change in control would provide stockholders with a substantial premium for their shares over then current market prices. For example, our charter authorizes our Board of Directors to issue one or more classes of preferred stock, having such designations, rights and preferences as they determine. Our stockholders have no right to take action by written consent and may not call special meetings of stockholders. Any amendment of the by-laws by the stockholders or certain provisions of the charter requires the affirmative vote of at least 75% of the shares of voting stock then outstanding. Our charter also provides for the staggered election of directors to serve for one, two and three-year terms, and for successive three-year terms thereafter, subject to removal only for cause upon the vote of not less than 75% of the shares of common stock represented at a stockholders’ meeting. In addition, under the terms of our shareholders’ rights agreement, in general, if a person or group acquires more than 15% of the outstanding shares of our common stock, all other stockholders of Tweeter would have the right to purchase securities from Tweeter at a discount to such securities’ fair market value, thus causing substantial dilution to the holdings of the acquiring person or group. Our corporate offices and the New England distribution and service centers are located in two owned facilities totaling 140,000 square feet in Canton, Massachusetts. In addition, we lease over 650,000 square feet of regional operating facilities including distribution and service centers in King of Prussia, Pennsylvania, Atlanta, Georgia, Charlotte, North Carolina, Houston, Texas, Dallas, Texas, San Diego, California, Chicago, Illinois, Pembroke Park, Florida and Phoenix, Arizona. Our stores, substantially all of which are leased, include sales space, inventory storage, management offices and employee areas. The majority of the leases provide for a fixed minimum rent with scheduled escalation dates and amounts. Leases for thirty-four of the stores have a percentage rent provision ranging from 1.5% to 6% of gross sales at each location in excess of certain specified sales amounts. The initial terms of the leases range from five to twenty years and generally allow us to renew for up to three additional five-year terms. The terms of a majority of the leases, including renewal options, extend beyond the year 2023. From time to time, we are involved in litigation in the ordinary course of our business. In the opinion of management, no such litigation is likely to have a material adverse effect on our results of operations, cash flows or financial condition. Our common stock is traded on the Nasdaq National Market, under the symbol “TWTR.” Public trading in our common stock commenced on July 16, 1998. Prior to that date, there was no public market for our common stock. The following table sets forth the high, low and last sale prices for the common stock for the last eight quarters in which the Common Stock was publicly traded. Quarter Ended High Low Last $ 30.00 $ 12.02 $ 29.00 $ 15.98 $ 5.26 $ 6.90 $ 6.45 $ 3.34 $ 4.77 The last sale price of the common stock on December 11, 2003, as reported by Nasdaq, was $8.33 per share. As of December 11, 2003, there were approximately 4,600 holders of record of our common stock. We do not anticipate paying any cash dividends for the foreseeable future. Please see “Liquidity and Capital Resources” below. Recent Sales of Unregistered Securities Set forth below is selected financial and operating data for each of the five years ended September 30, 2003. The selected statement of operations and balance sheet data for each of the five years ended September 30, 2003 have been derived from our financial statements, which have been audited by our independent auditors. The information set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the notes thereto included elsewhere in this Report. 1999(3) 2000(4) 2001(5) 2002(6) 2003 Statement of Operations: $ 279,562 $ 399,926 $ 540,123 $ 796,072 $ 786,994 179,227 253,672 347,942 509,258 516,874 Selling expenses 69,225 99,645 135,766 213,663 239,263 Corporate, general and administrative expenses 1,056 1,522 2,380 1,573 680 Impairment charge — — — 194,902 — Income (loss) from operations 15,232 25,745 27,785 (164,761 ) (16,738 ) Income (loss) equity investments — 518 843 (26 ) 650 Loss on investment — — (1,162 ) — — 204 1,549 1,069 27 112 (310 ) (402 ) (377 ) (2,282 ) (2,834 ) 6,050 10,964 11,263 (1,913 ) (7,148 ) $ 9,076 $ 16,446 $ 16,895 $ (165,129 ) $ (11,662 ) Basic earnings (loss) per share: $ 0.63 $ 0.97 $ 0.87 $ (7.07 ) $ (0.49 ) Diluted earnings (loss) per share: Weighted-average shares outstanding: Diluted(1) Operating Data: Stores open at beginning of period Stores acquired 16 7 43 2 0 Stores open at end of period Remodeled/relocated stores Comparable store sales(2) 5.0 % 13.5 % 0.6 % (3.3 )% (9.9 )% $ 31,524 $ 83,540 $ 70,478 $ 89,291 $ 86,575 Long-term debt, excluding current portion 5,717 14 35,936 50,074 48,267 Stockholder’s equity 87,245 174,951 332,392 174,611 165,037 (footnotes on following page) (1) Shares outstanding include 1,587, 1,545, 786, 0 and 0 shares issuable upon exercise of stock options and warrants outstanding as of September 30, 1999, 2000, 2001, 2002 and 2003, respectively, after applying the treasury stock method. (2) Stores are included in the comparable store base after they are in operation for 12 full months. Acquired stores are included after 12 months from the date of acquisition. Remodeled or relocated stores are excluded from the comparable store base until they have completed 12 full months of operation from the date the remodeling was completed or the store re-opened after relocation. (3) The fiscal year 1999 data includes the results of the Home Entertainment acquisition from February 1, 1999 and the DOW Stereo/ Video acquisition from July 1, 1999. (4) The fiscal year 2000 data includes the results of the United Audio Centers acquisition from April 1, 2000. (5) The fiscal year 2001 data includes the results of the Douglas acquisition from October 2, 2000, the Big Screen City acquisition from May 1, 2001, the Audio Video Systems acquisition from June 1, 2001 and the Sound Advice acquisition from August 1, 2001. (6) The fiscal year 2002 data includes the results of the Hillcrest acquisition from March 1, 2002. This Annual Report contains forward-looking statements regarding Tweeter’s performance, strategy, plans, objectives, expectations, beliefs and intentions. The actual outcome of the events described in these forward-looking statements could differ materially. Therefore, this Report, and especially this section and the section entitled “Risk Factors” contains a discussion of some of the factors and risks that could contribute to those differences. Tweeter is a leading specialty retailer of mid- to high-end audio and video consumer electronics products operating under the Tweeter, HiFi Buys, Sound Advice, Bang & Olufsen, Electronic Interiors, Showcase Home Entertainment and Hillcrest names. We opened our first Tweeter store in New England in 1972. Over thirty-one years, we have refined our retail concept to meet the needs of consumers seeking brand name products with advanced features, functionality and performance which we sell through our highly trained, relationship-driven sales force. We believe that our effective merchandising and superior customer service has enabled us to generate substantial customer loyalty. In 1995, we adopted an aggressive growth strategy to: • Open new stores in current regional markets and relocate certain stores to more favorable sites; and • Selectively pursue acquisitions in new regional markets and achieve operating improvements by converting the acquired companies to our core operating model and leveraging distribution, marketing and corporate infrastructure. Between 1996 and 2002, we acquired ten companies within our industry, for a total of ninety-one storefronts, in eleven states. We funded these acquisitions through a combination of private equity investments, debt, an initial public offering and two follow-on offerings. We seek to increase sales, profitability and asset productivity at acquired companies by converting them to our standard operating model with enhanced training for sales personnel, superior customer service, improved merchandising focused on mid-to higher-end audio and video equipment and more stringent operating controls. We also have aggressively expanded our corporate infrastructure over the past several years to support our growth, including expanding our management team with the addition of senior financial, information systems, and merchandising personnel. We will continue to grow our infrastructure this year, particularly in the area of supply chain, where we have identified a variety of opportunities to pursue that we believe will improve our profitability. In the beginning of fiscal 2003, our growth plan was to build twenty new stores, and remodel four. However, we had a dramatic decline in sales in December 2002, which caused us to alter those plans. Comparable store sales for December, which is the single most important month of the year for both revenue and profits, declined by 16.3% as compared to the same month in 2001. In the early part of January 2003, we made a decision to halt as much store growth as we could, and to terminate or postpone any leases to which we were then committed. As a result, we opened twelve stores during fiscal 2003, with all of them opening in the first half of the year. We have continued with a limited growth plan for fiscal 2004 as we plan to open three new stores, with all of them being prior commitments. We have not signed a new lease, other than renewals, since our decision to halt store growth in January 2003. Our growth plans will be very limited until we feel that we are returning to more historical operating profit levels. Tweeter has operated at around a 5% operating income margin for most of the last six years, prior to fiscal 2003. Excluding our goodwill impairment charge in fiscal 2002, fiscal 2003 marks the first operating loss at Tweeter in more than ten years. We believe that this operating loss, coupled with the uncertainty surrounding the economy in general, means that limiting store growth, preserving capital, and reducing debt are the goals that management should be, and will be, pursuing in fiscal 2004. Comparable store sales have declined now for ten successive quarters. We responded to declining business trends by cutting costs, reducing our capital spending, and addressing operating inefficiencies created by the ten acquisitions of eleven businesses over the prior eight years. During the course of fiscal 2003, we worked on an initiative to move to “One Company, One Way” wherever practical. Acquiring eleven businesses over a eight-year span resulted in some disparate business processes during the acquisition periods. We created a list to meet this initiative and report that 90% of our objectives were met in 2003. We plan to complete the integration of the remaining areas during the first half of fiscal 2004. PricewaterhouseCoopers LLP was engaged to support our internal audit function in November 2002. Our goal for internal audit is to help us identify and assess internal controls. Typically, internal audit reports on internal controls with suggestions for improvement. We are implementing internal audit with both a “checks and balances” mission, as well as a mandate for education, and plan to use the function to disseminate best practices throughout Tweeter. In May 2003 we engaged RetailMasters, a consulting organization comprised mostly of former Best Buy senior executives, and created FOUNDATIONS for WINNING. FOUNDATIONS for WINNING is our overarching internal initiative to provide the Company with best practices in several areas including supply chain, sales development, and store level operating disciplines. Our goal is to become “best in class” in these foundational areas. For fiscal 2004, supply chain initiatives will be among the largest and most visible that we will be pursuing. The following table is derived from the consolidated statements of operations and sets forth, for the periods indicated, the actual amounts, in thousands, of certain income and expense items and their percentages, relative to total revenue: Fiscal Years Ended September 30, $ 540,123 100.0% $ 796,072 100.0% $ 786,994 100.0% $ 192,181 35.6% $ 286,814 36.0% $ 270,120 34.3% 135,766 25.1% 213,663 26.8% 239,263 30.4% 26,250 4.9% 41,437 5.2% 46,915 6.0% 2,380 0.4% 1,573 0.2% 680 0.1% — — 194,902 24.5% — — 27,785 5.1% (164,761 ) -20.7% (16,738 ) -2.1% Income (loss) from equity investments 843 0.2% (26 ) 0.0% 650 0.0% (1,162 ) 0.2% — 0.0% — 0.0% 1,069 0.1% 27 0.0% 112 0.0% (377 ) 0.0% (2,282 ) -0.3% (2,834 ) -0.3% 11,263 2.1% (1,913 ) -0.2% (7,148 ) -0.9% $ 16,895 3.1% $ (165,129 ) -20.8% $ (11,662 ) -1.5% Fiscal 2003 as Compared to Fiscal 2002 Total Revenue. Total revenue includes delivered merchandise, labor, net commissions on service contracts sold, completed service center work orders, insurance replacement and corporate sales. Total revenue decreased $9.1 million, or 1.1%, to $787.0 million in the year ended September 30, 2003 from $796.1 million for the year ended September 30, 2002. The decrease was primarily the result of a comparable store sales decline of $73.3 million or 9.9%, closed stores of $4.9 million offset by revenues from new and renovated stores of $69.1 million. Home installation labor revenue as a percentage of revenue increased during the year ended September 30, 2003 from 2.2% to 2.8%. Cost of Sales and Gross Profit. Cost of sales includes merchandise costs, delivery costs, distribution costs, home installation labor costs, purchase discounts, and supplier volume rebates. Cost of sales increased $7.6 million, or 1.5%, to $516.9 million in the year ended September 30, 2003 from $509.3 million in the year ended September 30, 2002. Gross profit decreased $16.7 million, or 5.8%, to $270.1 million in the year ended September 30, 2003 from $286.8 million for the year ended September 30, 2002. The gross margin for the years ended September 30, 2003 and 2002 was 34.3% and 36.0%, respectively. The decrease in gross margin is due primarily to a concerted effort to reduce open box and discontinued inventory, which required much higher levels of markdown than usual. The charge to gross margin in the fourth quarter of fiscal 2003 was approximately $8 million. Additional pressures on gross margin through the year came from a reduction in suppliers program funds, as the Company continued to miss stretch goals throughout the year, as well as the continued growth of the video category as a percent of our overall mix. Supplier program funds year over year decreased by approximately $10.2 million, excluding the $11.1 million favorable effect of the reclass related to the adoption of EITF 02-16 “Accounting by a Customer for Certain Consideration Received from a Vendor.” The video category carries lower gross margins than the Company average, so as this grows within the overall mix, it will bring the overall gross profit on product down. This is a trend that we expect to continue through fiscal 2004. The percent of video sales to total sales increased 300 basis points year over year. Selling Expenses. Selling expenses include the compensation of store personnel and store specific support functions, occupancy costs, store level depreciation, advertising, and pre-opening expenses. Selling expenses increased $25.6 million, or 12.0%, to $239.3 million for the year ended September 30, 2003 from $213.7 million for the year ended September 30, 2002. As a percentage of total revenue, selling expenses increased to 30.4% for the year ended September 30, 2003 from 26.8% in the prior year period. The percentage increase was attributable to reduced cooperative advertising support from suppliers, increased occupancy costs, additional depreciation from the new and acquired stores and higher self-insurance costs. Total cooperative advertising funds received from suppliers decreased $6.7 million year over year, excluding the effect of the EITF 02-16 reclass. The amount of reimbursement received after January 1, 2003 upon the adoption of EITF 02-16 that were treated as a reduction of cost of goods sold but which would have been recorded as a reduction of advertising expenses prior to EITF 02-16 amounted to $11.1 million for the fiscal year ended September 30, 2003. We believe that supplier cooperative advertising funds will stabilize or increase slightly in fiscal 2004. Depreciation expense increased $4 million year over year. As capital expenditures are below historical levels in 2003 and planned capital expenditures for 2004 are below historical levels, we expect depreciation expense to stabilize at current levels. Corporate, General and Administrative Expenses. Corporate, general and administrative expenses include the costs of the finance, information systems, merchandising, marketing, human resources and training departments, related support functions and executive officers. Corporate, general and administrative expenses for the year ended September 30, 2003 increased $5.5 million, or 13.2%, to $46.9 million from $41.4 million for the year ended September 30, 2002. As a percentage of total revenue, corporate, general and administrative expenses increased to 6.0% for the year ended September 30, 2003 from 5.2% for the prior year period. We expect that the corporate, general and administrative expenses will range between 5% and 6% in fiscal 2004. The increase was primarily due to increases in compensation, professional and consulting fees, and fixed asset and other write-offs. Compensation increased by more than $2.0 million due, in part, to $1.2 million of stock based compensation paid to a newly recruited executive. Professional fees were up $1.5 million due to payments to outside consultants. Fixed assets and other write-offs were approximately $2 million as compared to a gain on asset disposal of $.4 million in 2002. Amortization of Intangibles. Amortization of intangibles decreased to $680,000 for the year ended September 30, 2003 from $1.6 million for the year ended September 30, 2002. The decrease was primarily due to the write-off of goodwill and certain intangibles in fiscal 2002. Write off of Goodwill and Intangible Assets. In accordance with Statements of Financial Accounting Standards (SFAS) No. 142, “Goodwill and other Intangible Assets”, Tweeter reviews goodwill and other intangibles with indefinite useful lives on an annual basis, or more frequently if impairment indicators arise. During the fourth quarter of fiscal 2002, we performed our annual test for impairment. We performed a valuation analysis of Tweeter with the assistance of a third party valuation specialist and concluded that the fair value of the reporting unit did not exceed its carrying amount. We then measured the amount of the impairment loss by comparing the fair value of the reporting unit to the carrying amount of that goodwill. In performing a valuation of Tweeter, the third party valuation specialists estimated the value of the business enterprise using (i) the Discounted Cash Flow method of the Income Approach and (ii) the Guideline Company method of the Market Approach. The specialists gave full consideration to the trends of Tweeter’s business, the competitive environment in which it operates and its financial and operating results. As a result of their valuation we determined that the recorded goodwill and certain other intangible assets were impaired. Tweeter recorded, in the fourth quarter of fiscal 2002, an impairment charge for its entire balance of goodwill ($191.5 million) and a portion of its intangible assets ($3.4 million). Interest Income and Expense. Interest expense was $2.8 million for the year ended September 30, 2003 compared to interest expense of $2.3 million for the year ended September 30, 2002. This fluctuation is due primarily to the increased average level of borrowings on our revolving credit agreement during the year ended September 30, 2003. Interest income was $112,000 for the year ended September 30, 2003 compared to $27,000 for the year ended September 30, 2002. Income Tax Expense (Benefit). The effective tax rate (benefit) for the years ended September 30, 2003 and 2002 was (38.0%) and (1.1%), respectively. The difference in the effective tax rate (benefit) for the year ended September 30, 2003 of (38.0%) from an expected statutory rate of 40.0% primarily relates to nondeductible expenses. Excluding the impairment charge of $194.9 million and the related tax benefit of $13.1 million, the effective tax rate for the year ended September 30, 2002 would have been 40.0%. Management expects that the effective tax rate will be 40.0% in fiscal 2004. Total Revenue. Total revenue increased $255.9 million, or 47.4%, to $796.1 million in the year ended September 30, 2002 from $540.1 million for the year ended September 30, 2001. The increase was primarily comprised of revenues of $195.9 million derived from acquired stores from the date of acquisition and $69.2 million from new stores. This was offset by a comparable store sales decrease of $15.3 million or 3.3%. Home installation labor revenue as a percentage of revenue doubled during the year ended September 30, 2001 from 1.1% to 2.2%. Cost of Sales and Gross Profit. Cost of sales increased $161.3 million, or 46.4%, to $509.3 million in the year ended September 30, 2002 from $347.9 million in the year ended September 30, 2001. Gross profit increased $94.6 million, or 49.2%, to $286.8 million in the year ended September 30, 2002 from $192.2 million for the year ended September 30, 2001. The gross margin for the years ended September 30, 2002 and 2001 was 36.0% and 35.6%, respectively. The increase in gross margin is due primarily to higher product margins, as a result of a change in mix, and the reduction of inventory shrink. Selling Expenses. Selling expenses increased $77.9 million, or 57.4%, to $213.7 million for the year ended September 30, 2002 from $135.8 million for the year ended September 30, 2001. As a percentage of total revenue, selling expenses increased to 26.8% for the year ended September 30, 2002 from 25.1% in the prior year period. The percentage increase was attributable to $9.9 million more fees associated with extended credit card financing, $217.2 million increased occupancy costs, $7.2 million additional depreciation from the new and acquired stores and $3.5 million higher insurance costs. Corporate, General and Administrative Expenses. Corporate, general and administrative expenses for the year ended September 30, 2002 increased 57.9% to $41.4 million from $26.2 million for the year ended September 30, 2001. As a percentage of total revenue, corporate, general and administrative expenses increased to 5.2% for the year ended September 30, 2002 from 4.9% for the prior year period. The increase was due to higher occupancy costs relative to the acquired companies, payroll and depreciation. Amortization of Intangibles. Amortization of intangibles decreased to $1.6 million for the year ended September 30, 2002 from $2.4 million for the year ended September 30, 2001. The decrease was due to the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets.” This statement requires that amortization be recorded only on intangible assets with definitive lives and not on goodwill or intangible assets with indefinite useful lives. Impairment Charge. During fiscal 2002, a sustained reduction in the Company’s market capitalization indicated that the carrying value of goodwill and other intangibles may have been impaired. Based on this, the Company hired an independent third party to prepare a valuation analysis and the results of the valuation indicated that the goodwill recorded was fully impaired. For the fiscal year ended September 30, 2002, an impairment charge of $194.9 million was taken to write off all recorded goodwill and certain intangibles. Interest Income and Expense. Interest expense was $2.3 million for the year ended September 30, 2002 compared to interest expense of $377,000 for the year ended September 30, 2001. This fluctuation is due primarily to the borrowings on our revolving credit agreement during the year ended September 30, 2002 compared to cash investment income realized on our outstanding cash balances during the first ten months of the year ended September 30, 2001. The increase in borrowings was due to the debt acquired in the Sound Advice acquisition and the opening of new stores. Interest income was $27,000 for the year ended September 30, 2002 compared to $1.1 million for the year ended September 30, 2001, primarily due to the decrease in the cash balance. Income Tax Expense (Benefit). The effective tax rate (benefit) for the years ended September 30, 2002 and 2001 was (1.1%) and 40.0%, respectively. Excluding the impairment charge of $194.9 million and the related tax benefit of $13.1 million, the effective tax rate for the year ended September 30, 2002 would have been 40.0%. The 2002 tax benefit, in part, is attributable to the portion of goodwill impaired that was deductible for income tax purposes. Our cash needs are primarily for working capital to support our inventory requirements and capital expenditures, pre-opening expenses and beginning inventory for new stores and for remodeling or relocating older stores. Additionally, capital needs are created as acquisition opportunities are pursued. Our primary sources of financing have been net cash from operations, borrowings under our credit facility, and proceeds from the sale of equity or subordinated notes. At September 30, 2003 and 2002, our working capital was $86.6 million and $89.3 million, respectively. Cash provided by operations was $10.3 million for the year ended September 30, 2003. This was a result of an $11.7 million loss, depreciation and amortization of $21.8 million, a decrease of $25.7 million of inventory, a decrease of $23.9 million of accounts payable and accrued expenses, an increase of $4.9 million in customer deposits, a decrease of $3.8 million in accounts receivable and a $13.7 million increase in prepaid expenses and other assets, primarily related to tax assets recorded in conjunction with the write off of goodwill, as well as minor changes in other operating accounts. Net cash used in investing activities during fiscal 2003 was approximately $12.3 million. Purchase of property and equipment of $24.2 million was the primary use of cash in investing activities. Approximately $19 million was used to open twelve new stores and relocate/remodel four stores and the balance of $5 million was used for other miscellaneous capital expenditures for equipment, fixtures and leasehold improvements. In fiscal 2003, net proceeds of $12.6 million were received from the sale of two of the Company’s owned properties, which the Company now leases from the buyer. There are no other material commitments for capital expenditures other than new store openings and remodeling or relocating existing stores, which is estimated to total $10 million in the next 12 months. On April 16, 2003, the Company entered into an agreement with its lenders for a new three-year senior secured revolving credit facility in the amount of $110 million. The facility replaces a $100 million line of credit that was due to expire in 2004. Availability under the credit facility will be based on a borrowing base tied to a percentage of eligible inventory, receivables and real estate. The interest rate on the new facility ranges from 2.00% to 2.50% over LIBOR, provided the Company commits the loan balances for a period of thirty days or more, or 0% to .25% over the prime rate. The line is secured by substantially all of the assets of the Company and its subsidiaries and contains various covenants and restrictions, including that: (i) Tweeter cannot create, incur, assume or permit additional indebtedness, (ii) Tweeter cannot create, incur, assume or permit any lien on any property or asset, (iii) Tweeter cannot merge or consolidate with any other person or permit any other person to merge or consolidate with the Company, (iv) Tweeter cannot purchase, hold or acquire any investment in any other person except those specifically permitted, (v) Tweeter cannot sell, transfer, lease, or otherwise dispose of any asset except permitted exceptions, and (vi) Tweeter cannot declare or make any restricted payments. The borrowers under the credit facility will be subsidiaries of Tweeter, and Tweeter will be a guarantor of any amounts borrowed. In addition, there is a commitment fee for the unused portion of the line of .375%. Our weighted-average interest rate on outstanding borrowings (under this credit facility and our prior credit facility) for fiscal 2003 was approximately 3.4%. The credit facility has a maturity date of April 1, 2006, and there are not any required quarterly or monthly principal prepayments under the facility. As of September 30, 2003, $19,200,000 was available under the revolving credit facility. Under the credit facility as originally signed, we were required to maintain a certain fixed charge coverage ratio as of the end of each month. On August 30, 2003, we amended the agreement to eliminate this requirement, and replaced it with additional reserves in the amount of $6.0 million, used when computing the available borrowing base under the facility. The Company’s contractual obligations and due dates consist of the following at September 30, 2003: Total 2004 2005-2006 2007-2008 Thereafter $ 48,252,000 $ — $ 48,252,000 $ — $ — 262,930,000 30,194,000 54,994,000 49,658,000 128,084,000 Name in title sponsorships 22,496,000 3,267,000 6,700,000 5,950,000 6,579,000 Capital leases and other 170,000 155,000 15,000 — — $ 333,848,000 $ 33,616,000 $ 109,961,000 $ 55,608,000 $ 134,663,000 Tweeter believes that its existing cash, together with cash generated by operations and available borrowings under the credit facility, will be sufficient to finance its working capital and capital expenditure requirements for at least the next twelve months. Furthermore, due to the seasonality if its business, Tweeter’s working capital needs are significantly higher in the fiscal third and fourth quarters and there is the possibility that this could cause unforeseen capital constraints in the future. Within our credit facility, there is an option during our peak holiday season buying periods to have more availability on our credit line to meet these needs. Management does not believe that inflation has had a material adverse effect on our results of operations. However, we cannot predict accurately the effect of inflation on future operating results. Our business is subject to seasonal variations. Historically, we have realized a significant portion of our total revenue and net income for the year during the first and fourth fiscal quarters, with a majority of net income for such quarters realized in the first fiscal quarter. Due to the importance of the holiday shopping season, any factors negatively impacting the holiday selling season could have an adverse effect on our revenues and our ability to generate a profit. Our quarterly results of operations may also fluctuate significantly due to a number of factors, including the timing of new store openings and acquisitions and unexpected changes in volume-related rebates or changes in cooperative advertising policies from manufacturers. In addition, operating results may be negatively affected by increases in merchandise costs, price changes in response to competitive factors and unfavorable local, regional or national economic developments that result in reduced consumer spending. Presented below is a discussion about our application of critical accounting policies that require us to make assumptions about matters that are uncertain at the time the accounting estimate is made, and where different estimates that we reasonably could have used in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. Management has identified the following accounting estimates as critical for Tweeter, and will discuss them separately below: allowance for bad and doubtful accounts, inventory obsolescence provision, income tax accruals, self-insurance reserves, and deferred cash discounts, volume rebates and coop advertising. Management has discussed the development and selection of these critical accounting estimates with the audit committee of our Board of Directors and the audit committee has reviewed our disclosure relating to it in this MD&A. Allowance for Bad and Doubtful Accounts Most of our accounts receivable are due from our suppliers and less than 10% are due from retail customers. Our net accounts receivable balance at September 30, 2003 of $18.3 million constitutes 5.9% of our total assets, and the reserve of $1.1 million is 5.7% of gross accounts receivable. We categorize our accounts receivable by business type and estimate our bad debt reserve using four aging classifications: current, thirty-one to sixty days, sixty-one to ninety days and over ninety days. For each business type, based on the amounts in each aging category, we apply a percentage to determine the amount of the reserve to be applied to each category. If a further review of a business type shows that this methodology needs to be adjusted, the percentage of reserve is adjusted accordingly. In recent years, as a result of a combination of the factors described above, we have increased our bad debt reserve to reflect our estimated valuation of gross receivables. It is also possible that bad debt write-off could increase significantly in the future. We have historically estimated our bad and doubtful debt allowance as a percentage of the aging categories, which could differ materially if the historical trend changed. Estimating an allowance for doubtful accounts requires significant management judgment. In addition, different reserve estimates that we reasonably could have used would have had a material impact on our reported accounts receivable balance and thus would have had a material impact on the presentation of the results of operations. For those reasons, and in view of the fact that our accounts receivable balance is 5.9% of our total assets at September 30, 2003, we believe that the accounting estimate related to bad and doubtful accounts is a critical accounting estimate. Inventory Obsolescence Inventory represents a significant portion of our assets (38.1%). Our profitability and viability is highly dependent on the demand for our products. An imbalance between purchasing levels and sales could cause rapid and material obsolescence, and loss of competitive price advantage and market share. We believe that our product mix has provided sufficient diversification to mitigate this risk. At the end of each reporting period, we reduce the value by our estimate of what we believe to be obsolete, and we recognize an expense of the same amount, which is included in cost of sales in our consolidated statement of operations. In our industry, merchandise models change periodically. When they do, we reclassify the old model into a discontinued category. We also reclassify merchandise into the discontinued category when we decide we no longer want to sell the item. Generally, we attempt to sell these discontinued models at standard retail prices. In estimating our obsolescence reserve, we analyze the sales of discontinued merchandise by department and determine what profit or loss was recorded in the quarter. If product of the discontinued department is sold for below cost during the quarter, then we apply that negative percentage to the value of the inventory on hand as of the balance sheet date. In addition to this reserve we also identify the selling costs to be incurred in the sale of such discontinued inventory and add that to this obsolescence reserve. We also evaluate the obsolescence of our service parts inventory based on the aging of this inventory. We apply a percentage to each aging category in order to determine the reserve amount. As a result of a combination of the factors described above, we have reduced our net inventory value to reflect our estimated amount of inventory obsolescence. Our inventory obsolescence reserve at September 30, 2003 is $2.1 million. It is also possible that obsolescence could rapidly become a significant issue in the future. In addition, different reserve estimates that we reasonably could have used would have had a material impact on our reported net inventory and cost of sales, and thus would have had a material impact on the presentation of our results of operations. For those reasons, we believe that the accounting estimate related to inventory obsolescence is a critical accounting estimate. Our estimate of the expense or benefit and the sufficiency of the income tax accrual is somewhat dependent on our assessment of certain tax filing exposures. We provide for potential tax exposures arising from routine audits by taxing agencies. It is reasonably possible to assume that actual amounts payable as a result of such audits could be materially different from amounts accrued in the consolidated balance sheet. Our estimate of deferred tax assets is impacted by our assessment of our ability to generate sufficient taxable income to be able to realize the deferred tax asset. Based on management’s assessment of our historical performance and the current economic conditions, we have determined that no valuation allowance against our deferred tax asset is required as of September 30, 2003 as we believe that we will be sufficiently profitable as to realize all recognized deferred tax assets. Should we not generate the expected levels of taxable income, a valuation allowance could be required. Self-Insurance Reserves We are self-insured for workers’ compensation, general liability insurance and medical/dental benefits and evaluate our liability estimate on a quarterly basis based on actuarial information and past experience. Historical claims are reviewed as to when they are incurred versus when they are actually paid and an average claims lag is determined. Once the average historical lag is determined, it is applied to the current level of claims being processed. Management believes, and past experience has confirmed, the underwriting cost reductions outweigh the financial risk incurred by self-insurance of workers’ compensation, general liability and medical/dental benefits. Accounting standards require that a related loss contingency be recognized in our consolidated balance sheet. We determined that the total future liability related to claims that have already been incurred but have not been billed is $2.8 million, compared to our estimate last year of $3.0 million. We believe that the accounting estimate related to assessment of future liability for current insurance claims is a critical accounting estimate because it is highly susceptible to change from period to period due to the requirement that our management make assumptions about future costs of claims based on historical costs. Deferred Cash Discounts, Volume Rebates and Coop Advertising We receive cash discounts for timely payment of merchandise invoices and recognize these amounts in our statement of operations upon the sale of the inventory. The amount of the deferral for discounts received but not yet recognized in income is $3.4 million as of September 30, 2003, compared to $4.6 million as of September 30, 2002 and is classified as a reduction in gross inventory in the consolidated balance sheet. We also receive substantial funds from our suppliers for volume rebates and coop advertising. These funds can be earned in two ways; the first is based on levels of inventory purchases and the second is based on performance of specific advertising activities. Amounts earned based on levels of inventory purchases are recognized in the income statement based on when the inventory from each supplier is sold. Amounts earned based on performance of specific advertising activities are recognized in the income statement as these activities are performed. The amount of the deferral for amounts received related to levels of inventory purchases is $10.8 million, as of September 30, 2003, compared to $6.2 million as of September 30, 2002. No amounts were deferred as of September 30, 2003 for specific advertising activities as we did not have any unfulfilled obligations in relation to cash received prior to the year end. Many of our agreements include stretch goals where the level of funds earned is dependent upon achieving certain purchase levels. We record these program funds as a reduction of inventory costs when we determine that we are likely to achieve the goal. We believe that the accounting estimate related to deferred cash discounts, volume rebates and coop advertising is a critical accounting estimate because it is highly susceptible to change from period to period due to changes in inventory levels, the supplier mix of the inventory on hand, and the timing of performance of specific advertising activities in relation to when the cash for these activities is received. Prior to fiscal 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, amendment of FASB Statement No. 13, and Technical Corrections,” and SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The adoption of these standards in fiscal year 2003 did not have a material effect on our financial position or result of operations. In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this pronouncement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of this statement are effective for fiscal years ending after December 31, 2002. The adoption of SFAS No. 148 did not have a material effect on our consolidated financial position or results of operations as we continue to account for stock-based compensation to employees using the intrinsic method under APB 25. In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This pronouncement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The provisions of this statement are effective for transactions that are entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a material effect on our consolidated financial position or results of operations. In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which clarifies disclosure, recognition and measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition and measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The adoption of FIN 45 had no impact on our consolidated financial position and results of operations. In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” relating to consolidation of certain entities. First, FIN 46 will require identification of our participation in variable interest entities (“VIEs”), which are defined as entities with a level of invested equity that is not sufficient to fund future activities to permit them to operate on a stand alone basis, or whose equity holders lack certain characteristics of a controlling financial interest. For entities identified as VIEs, FIN 46 sets forth a model to evaluate potential consolidation based on an assessment of which party to the VIEs, if any, bears a majority of the exposure to its expected losses, or stands to gain from a majority of its expected returns. FIN 46 also sets forth certain disclosure regarding interests in VIEs that are deemed significant, even if consolidation is not required. We do not expect that the adoption of this statement will have a material impact on our consolidated financial position or results of operations. In July 2003, the EITF issued EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on the timing and method of revenue recognition for sales arrangements that include the delivery of more than one product or service. EITF No. 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF No. 00-21 did not have a material effect on our consolidated financial position or results of operations. The market risk inherent in our financial instruments and in our financial position is the potential for loss arising from adverse changes in interest rates, principally related to our borrowings. We do not enter into financial instruments for trading purposes. On July 14, 2003, we entered into an interest rate swap which fixes the interest rate on up to $35 million of libor-based borrowings under the revolving term bank loan at 1.69%, plus the applicable margin, for the period from January 1, 2004 to December 31, 2004. The interest rate swap has been designated as a cash flow hedge. The effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The remaining gain or loss on the derivative instrument in excess of the cumulative change in the present value of future cash flows of the hedged item, if any, is recognized in current earnings during the period of change. For the year ended September 30, 2003, we did not record any expense or income in the statement of operations with respect to this instrument. At September 30, 2003, we had $48.3 million of variable rate borrowings outstanding under our revolving credit facility that approximates fair value. A hypothetical 10% change in interest rates for this variable rate debt would have an approximate $164,000 annual impact on our interest expense. Tweeter Home Entertainment Group, Inc. and Subsidiaries Consolidated Balance Sheets as of September 30, 2002 and 2003. Consolidated Statements of Operations for the Years Ended September 30, 2001, 2002 and 2003. Consolidated Statements of Stockholders’ Equity for the Years Ended September 30, 2001, 2002 and 2003. Consolidated Statements of Cash Flows for the Years Ended September 30, 2001, 2002 and 2003. To the Board of Directors and Stockholders of Canton, Massachusetts We have audited the accompanying consolidated balance sheets of Tweeter Home Entertainment Group, Inc. and subsidiaries as of September 30, 2002 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended September 30, 2003. Our audits also included the financial statement schedule listed in the Index at Item 15(a)(2). These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Tweeter Home Entertainment Group, Inc. and subsidiaries as of September 30, 2002 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended September 30, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. As discussed in Note 9 to the consolidated financial statements, the Company changed its method of accounting for goodwill and other intangible assets on October 1, 2001. As discussed in Note 2 to the consolidated financial statements, during fiscal 2003, the Company changed its method of accounting for vendor consideration. September 30, September 30, Accounts receivable, net of allowance for doubtful accounts of $1,075,000 and $1,110,000 at September 30, 2002 and 2003, respectively Intangible assets, net Other assets, net 923,169 2,404,938 $ 335,878,201 $ 308,436,389 LIABILITIES AND STOCKHOLDERS’ EQUITY Customer deposits Deferred warranty 100,370,485 83,978,388 Other Long-Term Liabilities: Rent related accruals Total other long-term liabilities Commitments and Contingencies (See Note 7) Preferred stock, $.01 par value, 10,000,000 shares authorized, no shares issued Common stock, $.01 par value, 60,000,000 shares authorized; 25,378,308 shares issued at September 30, 2002 and 25,748,489 shares at September 30, 2003. Unearned equity compensation — (408,142 ) 49,280 (15,931 ) (116,305,296 ) (127,967,415 ) Less treasury stock, at cost: 1,818,503 shares at September 30, 2002 and 1,742,616 shares at September 30, 2003 See notes to consolidated financial statements. Years Ended September 30, $ 540,122,610 $ 796,072,059 $ 786,993,926 (347,941,836 ) (509,258,027 ) (516,873,746 ) — 194,902,181 — 27,784,861 (164,760,342 ) (16,738,062 ) 843,270 (25,836 ) 649,885 (1,161,969 ) — — 1,068,524 26,811 112,449 (376,713 ) (2,282,369 ) (2,834,140 ) 11,263,189 (1,912,745 ) (7,147,749 ) $ 16,894,784 $ (165,128,991 ) $ (11,662,119 ) Basic earnings (loss) per share $ 0.87 $ (7.07 ) $ (0.49 ) Diluted earnings (loss) per share Weighted average shares outstanding: CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY Common Stock Additional Other Treasury Stock Total Paid-in Accumulated Unearned Comprehensive Comprehensive Stockholder’s Shares Amount Capital Deficit Compensation Income Shares Amount Income Equity Balance, September 30, 2000 20,251,734 $ 202,517 $ 144,538,059 $ 31,928,911 $ 176,208 1,879,911 $ (1,894,893 ) $ 174,950,802 Issuance of common stock, Net 4,172,400 41,724 119,191,122 119,232,846 Issuance of shares under stock option plan including tax benefit 298,840 2,989 3,453,945 3,456,934 Estimated fair value of stock options exchanged in Sound Advice merger Issuance of treasury stock under employee stock purchase plan 324,941 (23,765 ) 16,636 341,577 16,894,784 $ 16,894,784 16,894,784 Unrealized holding gain arising during the period Less: Reclassification adjustment of a $528,331 gain included in goodwill and a loss of $396,767 in net income Net unrealized loss on investments, net of tax of $73,471 (110,290 ) (110,290 ) (110,290 ) Comprehensive income 24,722,974 $ 247,230 $ 285,132,941 $ 48,823,695 $ 65,918 1,856,146 $ (1,878,257 ) $ 332,391,527 42,886 429 998,729 999,158 (165,128,991 ) $ (165,128,991 ) (165,128,991 ) $ (165,145,629 ) 25,378,308 $ 253,783 $ 292,464,945 $ (116,305,296 ) $ 49,280 1,818,503 $ (1,851,907 ) $ 174,610,805 100,181 1,002 519,195 520,197 Issuance of restricted stock 270,000 2,700 1,627,500 (1,627,500 ) 2,700 Amortization of unearned equity compensation (11,662,119 ) $ (11,662,119 ) (11,662,119 ) Net unrealized gain on investments, net of tax of $7,301 Fair value of interest rate forward contract, net of tax of $50,774 $ (11,727,330 ) 25,748,489 $ 257,485 $ 294,969,338 $ (127,967,415 ) $ (408,142 ) $ (15,931 ) 1,742,616 $ (1,798,786 ) $ 165,036,549 — — 1,219,358 (Income) loss from joint venture (843,270 ) 25,836 — Loss on disposal of equipment — 209,132 924,542 Provision for doubtful accounts 119,256 803,448 1,014,939 Tax benefit from options exercised Deferred income tax (benefit) provision 5,735,913 (7,359,770 ) 103,586 Amortization of deferred gain on sale leaseback — — (45,233 ) Loss (gain) on investment 1,161,969 — (273,746 ) Changes in operating assets and liabilities, net of effects from acquisition of businesses: (Increase) decrease in accounts receivable (10,025,370 ) 5,936,637 3,837,537 Decrease (increase) in inventory 2,436,264 (12,145,787 ) 25,664,532 (13,248,825 ) (6,043,993 ) (13,661,145 ) Increase (decrease) in accounts payable and accrued expenses 14,669,867 (5,884,398 ) (23,897,696 ) Increase in customer deposits Increase in rent related accruals Decrease in deferred warranty Purchase of property and equipment (47,572,530 ) (54,599,895 ) (24,188,284 ) Proceeds from sale-leaseback transaction, net of fees — 13,827,121 12,551,118 Proceeds from sale of property and equipment — 25,150 59,488 (Purchase) sale of investments (2,829,222 ) 88,791 (750,000 ) Cash paid for acquisitions, net of cash acquired (24,767,020 ) (4,812,735 ) — Dividends from joint venture 600,000 3,231,951 25,052 (Decrease) increase in amount due to bank (3,752,803 ) (3,944,169 ) 2,689,382 Net proceeds (payments) of debt 36,944,944 14,120,346 (1,940,279 ) Payment of debt assumed in acquisitions (25,684,896 ) — — Proceeds from options exercised Proceeds from other equity transactions — 211,827 — 8,997,965 13,521,590 1,563,719 DECREASE IN CASH AND CASH EQUIVALENTS (31,014,586 ) (995,334 ) (432,186 ) CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 34,292,555 3,277,969 2,282,635 CASH AND CASH EQUIVALENTS, END OF YEAR $ 3,277,969 $ 2,282,635 $ 1,850,449 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid (received) during the period for: $ 233,213 $ 2,395,892 $ 2,623,688 $ 10,835,667 $ 10,151,471 $ (40,007 ) Noncash investing activities: Issuance of common stock and assumption of options for acquisitions $ 136,860,000 $ 1,000,000 $ — New capital leases $ 741,000 $ — $ — Years Ended September 30, 2001, 2002 and 2003 1. Business of the Company The Company sells audio, video, entertainment and electronics products through a chain of 174 retail stores in the New England, Mid-Atlantic, Southeast, Texas, Southern California, greater Chicago, Florida and Arizona markets. The Company operates under the names “Tweeter,” “HiFi Buys,” “Sound Advice,” “Bang & Olufsen,” “Electronic Interiors,” “Showcase Home Entertainment” and “Hillcrest High Fidelity.” The Company operates in a single business segment of retailing audio and video consumer electronics products. Basis of Presentation — The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All material intercompany transactions have been eliminated in consolidation. Cash and Cash Equivalents — The Company considers all highly liquid instruments purchased with maturities of three months or less to be cash equivalents. Inventory — Inventory, which consists primarily of goods purchased for resale, is stated at the lower of average cost or market. Property and Equipment — Property and equipment are stated at cost. Depreciation and amortization are computed by the straight-line method over the estimated useful lives of the respective assets. Amortization of improvements to leased properties is based upon the remaining terms of the leases or the estimated useful lives of such improvements, whichever is shorter. Furniture and fixtures are depreciated over three and seven years. Automobiles and trucks are depreciated over three years. Leasehold interests are amortized over the remaining lives of the leases. Buildings owned by the Company are depreciated over a period of fifteen years. Fully depreciated property and equipment are written off in the period they become fully depreciated. Long-Term Investments — Long-term investments consist of investments in marketable equity securities and an investment in a privately held company. Marketable equity securities are stated at fair value. Marketable equity securities are classified as available-for-sale. Unrealized holding gains and losses, net of the related tax effect, on available-for-sale securities are included in other comprehensive income, which is reflected in stockholders’ equity. Prior to the third quarter of fiscal 2003, the investment in a privately held company, Tivoli Audio LLC (“Tivoli”), was accounted for using the cost method. On June 30, 2003, Tweeter made an additional investment of $750,000 in Tivoli. This additional investment increased the Company’s ownership percentage to 25%, resulting in the Company accounting for this investment in 2003 using the equity method of accounting. The difference between income recorded on the cost method and the equity method in 2001 and 2002 was not material. Intangible Assets — Intangible assets consist of non-compete agreements and tradenames, which are amortized on a straight-line basis over five years. Goodwill — Prior to fiscal 2002, goodwill generated from acquisitions initiated before June 30, 2001 was amortized on a straight-line basis over twenty to twenty-five years. In fiscal 2002, amortization of goodwill generated from acquisitions initiated before June 30, 2001 ceased in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” and no amortization was charged on goodwill generated from acquisitions initiated subsequent to June 30, 2001 (Sound Advice and Hillcrest). As described in Note 9, during the three months ended September 30, 2002, all of the Company’s goodwill was determined to be fully impaired and was written off. Other Assets — Other assets include deferred financing costs that are being amortized over the term of the financing. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued) Fair Market Value of Financial Instruments — The estimated fair market values of the Company’s financial instruments, which include accounts receivable, accounts payable and other current liabilities, approximate their carrying values due to the short term nature of these instruments. The carrying value of long-term debt approximates fair value due to its variable interest rate. Financial Instruments — The Company is exposed to market risks arising from changes in interest rates on its revolving term bank loan. On July 14, 2003, the Company entered into a pay fixed, receive floating interest rate swap to change the interest rate exposure on its bank loan. On the date on which the Company entered into the derivative, the derivative was designated as a hedge of the identified exposure. The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. The Company measures effectiveness of its hedging relationships both at hedge inception and on an ongoing basis. Long-Lived Assets — When conditions indicate a need to evaluate recoverability, SFAS No. 144 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of” requires that the Company (1) recognize an impairment loss only if the carrying amount of a long-lived asset is not recoverable based on its undiscounted future cash flows and (2) measure an impairment loss as the difference between the carrying amount and fair value of the asset. Accounting for Estimates — In the process of preparing its consolidated financial statements, the Company estimates the appropriate carrying value of certain assets and liabilities that are not readily apparent from other sources. The primary estimates underlying the Company’s consolidated financial statements include allowances for potential bad debts, vendor allowances, obsolete inventory, intangible assets and goodwill, the useful lives of its long-lived assets, the recoverability of deferred tax assets and other matters. Management bases its estimates on certain assumptions, which they believe are reasonable in the circumstances, and does not believe that any change in those assumptions in the near term would have a significant effect on the consolidated financial position or results of operations. Actual results could differ from these estimates. Revenue Recognition — Revenue from merchandise sales is recognized upon shipment or delivery of goods. Service revenue is recognized when the repair service is completed. Revenue from installation labor is recognized as the labor is provided. The Company records a sales returns reserve to reflect estimated sales returns after the period. Automatic Price Protection — Under this program, if a customer purchases a consumer electronics product from one of the Company’s stores and a competitor within twenty-five miles of the store advertises a lower price within thirty days, the Company automatically sends a check to the customer for the difference. Tweeter records the cost of its Automatic Price Protection as a reduction in revenue and records a reserve, based on management’s estimate of future liability under the program. Warranty Revenue — The Company sells extended warranties for third-party providers. The Company receives a commission from the third-party provider which is recorded as revenue at the time of sale. Prior to their acquisition by Tweeter, Bryn Mawr Radio and Television Inc., HiFi Buys Incorporated, and Douglas T.V. & Appliance, Inc. and Douglas Audio Video Centers, Inc. sold extended warranty contracts beyond the normal manufacturers’ warranty period. The term of the coverage (including the manufacturers’ warranty period) is between twelve and sixty months. The fair value of the deferred revenue from the sale of the extended warranty contracts sold prior to the acquisition by Tweeter has been deferred and is being amortized on a straight-line basis over the contract period. All costs related to the contracts are charged to expense as incurred. Income Taxes — The Company provides for deferred tax liabilities or assets resulting from temporary differences between financial reporting and taxable income and for loss carry-forwards based on enacted tax laws and rates. Store Opening Costs — Costs of a non-capital nature incurred prior to store openings are expensed as incurred. Stock-Based Compensation — The Company accounts for its common stock incentive plans for employees and its employee stock purchase plan in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25). In compliance with SFAS No. 123, “Accounting for Stock-Based Compensation,” the Company has disclosed the required pro forma effect on net income (loss) below. For purposes of determining the disclosures required by SFAS No. 123, the fair value of each stock option granted in 2001, 2002 and 2003 under the Company’s stock option plan was estimated on the date of grant using the Black-Scholes option-pricing model. Key assumptions used to apply this pricing model were as follows: Risk free interest rate Expected life of option grants (years) Expected volatility of underlying stock 113.3 % 105.9 % 83.8 % Had compensation cost for stock option grants during the years ended September 30, 2001, 2002 and 2003 been determined under the provisions of SFAS No. 123, the Company’s net income (loss) and earnings (loss) per share would have been as follows: Net income (loss) as reported Stock-based employee compensation expense determined under the intrinsic method, net of related tax effects — — 756,000 Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (3,552,000 ) (5,298,000 ) (5,871,000 ) Pro forma net income (loss) Basic — as reported $ 0.87 $ (7.07 ) $ (.49 ) Basic — pro forma Diluted — as reported Diluted — pro forma The weighted-average grant date fair value of all grants issued for the years ended September 30, 2001, 2002 and 2003 was $17.36, $5.08, and $4.13, respectively. Deferred Rent and Rental Expense — Minimum rent expense is recorded using the straight-line method over the related lease term. The difference between current payments required and rent expense is reflected as deferred rent. Net gain from sale-leaseback transactions are initially deferred and then amortized over the lease term. Vendor Allowances, Allowance for Bad and Doubtful Accounts — Accounts receivable are primarily due from the suppliers from which the Company buys its products. The various types of allowances included in accounts receivable are purchase rebate allowances, cooperative advertising allowances, returned merchandise and warranty work performed by the Company’s service departments. Cash discounts earned for timely payments of merchandise invoices are recorded as a reduction of inventory and recognized in the statement of operations upon the sale of the related inventory. Purchase rebate allowances and general cooperative advertising allowances are earned based on the purchase of inventory. The carrying value of inventory is initially reduced by the amount of purchase rebates and advertising allowances earned, resulting in lower cost of goods sold when the inventory is sold. Certain supplier agreements include stretch goals where the level of funds earned is dependent upon the Company achieving certain purchase levels. These program funds are recorded as a reduction of inventory costs when it is determined that it is likely the Company will achieve the goal. Vendor allowances earned based on specific advertising activities and other activities are recognized as a reduction of the expense as these activities are performed and only to the extent that the cost of the activities equals or exceeds the amount of the allowance. When the Company returns merchandise to a supplier, typically because it is defective, the Company records a receivable for the value of the merchandise returned and reduces the inventory balance. The Company sells products that come with a manufacturer’s warranty. When the Company repairs products that are still under manufacturer’s warranty, the supplier reimburses the Company for the parts and the technician’s labor. Once the product is repaired, the Company establishes a receivable for the amounts due from the supplier and records warranty revenue. During the quarter ended March 31, 2003, Tweeter adopted EITF 02-16, “Accounting by a Customer for Certain Consideration Received from a Vendor” (“EITF 02-16”) which addresses how and when to reflect consideration received from suppliers in the consolidated financial statements. Under EITF 02-16, certain consideration received from suppliers that would have previously been recorded as a reduction to selling expenses, is now recorded as a reduction to cost of goods sold. The amount of reimbursement received after January 1, 2003 upon the adoption of EITF 02-16 that were treated as a reduction of cost of goods sold but which would have been recorded as a reduction of advertising expenses prior to EITF 02-16 amounted to $11,077,000 for the fiscal year ended September 30, 2003. Advertising — For the years ended September 30, 2001, 2002 and 2003, gross advertising expense, including electronic media, newspaper, buyer’s guides and direct mailings, which are expensed when released, was $32,621,000, $44,378,000 and $43,921,000, respectively. Cooperative advertising, for specific advertising activities received from suppliers offsetting our gross advertising expense, excluding the effect of the EITF 02-16 reclass, amounted to $27,600,000, $36,169,000 and $28,856,000 for the years ended September 30, 2001, 2002 and 2003, respectively, resulting in net advertising of $5,021,000, $8,209,000 and $15,065,000 for the three years, respectively. Comprehensive Income (Loss) — For the years ended September 30, 2001, 2002 and 2003, the Company’s comprehensive income (loss) was comprised of net income (loss), net unrealized gains or losses on investments and net change in the value of the derivative instrument. Earnings Per Share — Basic earnings per share is calculated based on the weighted-average number of common shares outstanding. Diluted earnings per share is based on the weighted-average number of common shares outstanding, and dilutive potential common shares (common stock options). The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share: Basic Earning Per Share (“EPS”): Weighted-average shares outstanding Basic EPS Diluted Earnings Per Share: Numerator Weighted-average common shares outstanding Potential common stock equivalents outstanding Diluted EPS The number of potentially dilutive shares excluded from the earnings per share calculation for fiscal 2001, 2002 and 2003 because they are anti-dilutive was 502,600, 3,596,393 and 4,330,631, respectively. Segment Information — The Company operates in one business segment. The table below sets forth the approximate percentage of revenues for each of the Company’s primary product categories for its fiscal years ended September 30, 2001, 2002 and 2003. The percentage of revenues represented by each product category may be affected by, among other factors, competition, economic conditions, consumer trends, the introduction into the market of new products, changes in the Company’s product mix, acquisitions of stores with different product mixes, and the timing of marketing events. The historical percentages set forth below may not be indicative of revenue percentages for future periods: (3) Includes car decks, amplifiers and speakers, car security products, navigation equipment, wireless phones, audio and car accessories, installation and service labor, and extended performance guarantees. Recent Accounting Pronouncements — Prior to fiscal 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 143, “Accounting for Asset Retirement Obligations,” SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, amendment of FASB Statement No. 13, and Technical Corrections,” and SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” The adoption of these standards in fiscal year 2003 did not have a material effect on the Company’s consolidated financial position or result of operations. In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation — Transition and Disclosure, an amendment of FASB Statement No. 123.” This Statement amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this pronouncement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of this statement are effective for fiscal years ending after December 31, 2002. The adoption of SFAS No. 148 did not have a material effect on the Company’s consolidated financial position or results of operations as the Company continues to account for stock-based compensation to employees using the intrinsic method under APB 25. In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This pronouncement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The provisions of this statement are effective for transactions that are entered into or modified after June 30, 2003. The adoption of SFAS No. 149 did not have a material effect on the Company’s consolidated financial position or results of operations. In November 2002, the FASB issued Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which clarifies disclosure, recognition and measurement requirements related to certain guarantees. The disclosure requirements are effective for financial statements issued after December 15, 2002 and the recognition and measurement requirements are effective on a prospective basis for guarantees issued or modified after December 31, 2002. The adoption of FIN 45 had no impact on the Company’s consolidated financial position and results of operations. In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities,” which clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” relating to consolidation of certain entities. First, FIN 46 will require identification of our participation in variable interest entities (“VIEs”), which are defined as entities with a level of invested equity that is not sufficient to fund future activities to permit them to operate on a stand alone basis, or whose equity holders lack certain characteristics of a controlling financial interest. For entities identified as VIEs, FIN 46 sets forth a model to evaluate potential consolidation based on an assessment of which party to the VIEs, if any, bears a majority of the exposure to its expected losses, or stands to gain from a majority of its expected returns. FIN 46 also sets forth certain disclosure regarding interests in VIEs that are deemed significant, even if consolidation is not required. The Company does not expect that the adoption of this statement will have a material impact on the Company’s consolidated financial position or results of operations. In July 2003, the EITF issued EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables,” which provides guidance on the timing and method of revenue recognition for sales arrangements that include the delivery of more than one product or service. EITF No. 00-21 is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of EITF No. 00-21 did not have a material effect on the Company’s consolidated financial position or results of operations. Reclassifications — Certain financial statement amounts for 2001 and 2002 have been reclassified to conform to the classifications used in the September 30, 2003 consolidated financial statements. 3. Property and Equipment Major classifications of property and equipment are summarized below: Leasehold improvements Furniture and equipment Automobiles and trucks Capitalized leases Leasehold interests Less accumulated depreciation and amortization In September 2002, the Company entered into a sale-leaseback transaction whereby the Company sold and leased back five of its owned retail properties and related equipment. These leases are treated as operating leases. The total cost of all assets sold was $14,548,609 and proceeds, net of related fees, were $13,827,121. Accumulated depreciation on assets sold as part of the sale-leaseback transaction was $1,366,125. The net gain on the sale-leaseback transaction of $644,637 is being amortized over fifteen years and is included within rent related accruals in the consolidated balance sheet. Due to the timing of the transaction, no portion of this gain was recognized in the income statement for the year ended September 30, 2002. During fiscal 2003, the Company recognized $44,766 of gain in the income statement. In June and September 2003, the Company entered into a sale-leaseback transaction whereby the Company sold and leased back two of its owned retail properties and related equipment. These leases are treated as operating leases. The total cost of all assets sold was $13,202,622 and proceeds, net of related fees, were $12,551,118. Accumulated depreciation on assets sold as part of the sale-leaseback transaction was $679,506. The net gain on the sale-leaseback transaction of $28,002 is being amortized over fifteen years and is included within rent related accruals in the consolidated balance sheet. For the year ending September 30, 2003, $467 of this gain was recognized in the statement of operations. Depreciation and amortization of property and equipment for the fiscal years ended September 30, 2001, 2002 and 2003 aggregated $8,995,868, $16,248,258 and $20,325,147, respectively. During fiscal 2003, fully depreciated assets with an original cost of $253,911 were written off. 4. Accrued Expenses Accrued expenses consist of the following: Compensation and fringe benefits Advertising related accruals Sales taxes payable Insurance reserves 5. Debt Long-term debt consists of the following: Revolving term credit facility Amounts due bank Capital leases Less current portion On June 29, 2001, the Company signed a three-year senior credit facility (the “Credit Facility”) that provided the Company the ability to borrow up to $75 million. On May 31, 2002 the Credit Facility was amended to increase the availability to $100 million. Borrowings under the Credit Facility were collateralized by the Company’s inventory and certain other assets and bore interest at the lender’s base rate (4.75% at September 30, 2002), or Eurodollar pricing plus 1.5% if the Company committed to borrow amounts for a period of at least thirty days. The Company’s weighted-average interest rate on outstanding borrowings during 2002 was approximately 3.1%. The Credit Facility contained restrictive covenants and conditions, including requirements to maintain certain minimum financial ratios and a designated net worth level as well as limits on capital expenditures. This Credit Facility also restricted the Company from paying cash dividends. The Credit Facility had a maturity date of July 31, 2004. On April 16, 2003, the Company concluded arrangements with its lenders, for a new three-year senior secured revolving Credit Facility in the amount of $110 million. The new Credit Facility replaces the $100 million line of credit that was due to expire in 2004. Availability under the Credit Facility is based on a borrowing base tied to a percentage of eligible inventory, receivables and real estate. The interest rate on the new Credit Facility ranges from 2.00% to 2.50% over LIBOR, provided the Company commits the balances for a period of thirty days or more, or 0% to .25% over the prime rate. The line is secured by substantially all of the assets of the Company and its subsidiaries and contains various covenants and restrictions, including that: (i) Tweeter cannot create, incur, assume or permit additional indebtedness, (ii) Tweeter cannot create, incur, assume or permit any lien on any property or asset, (iii) Tweeter cannot merge or consolidate with any other person or permit any other person to merge or consolidate with the Company, (iv) Tweeter cannot purchase, hold or acquire any investment in any other person except those specifically permitted, (v) Tweeter cannot sell, transfer, lease, or otherwise dispose of any asset except permitted exceptions, and (vi) Tweeter cannot declare or make any restricted payments. The borrowers under the Credit Facility will be subsidiaries of Tweeter, and Tweeter will be a guarantor of any amounts borrowed. In addition, there is a commitment fee for the unused portion of the line of .375%. Our weighted-average interest rate on outstanding borrowings (under this Credit Facility and our prior Credit Facility) for fiscal 2003 was approximately 3.4%. The Credit Facility has a maturity date of April 1, 2006, and there are no required quarterly or monthly principal prepayments under the facility. As of September 30, 2003, $19,200,000 was available under the revolving Credit Facility. On July 14, 2003, the Company entered into an interest rate swap which fixes the interest rate on up to $35 million of libor-based borrowings under the Credit Facility at 1.69%, plus the applicable margin, for the period from January 1, 2004 to December 31, 2004. The interest rate swap has been designated as a cash flow hedge. The effective portion of the gain or loss on the derivative instrument is reported as a component of accumulated other comprehensive income and reclassified into earnings in the same period or periods during which the hedged transaction affects earnings. The ineffective portion of the derivative instrument is recognized in current earnings during the period of change. For the year ended September 30, 2003, the Company has not recorded any expense or income in the statement of operations with respect to this instrument. Under the Credit Facility as originally signed, the Company was required to maintain a certain fixed charge coverage ratio as of the end of each month. On August 30, 2003, the Company amended the agreement to eliminate this requirement, and replaced it with additional reserves in the amount of $6.0 million, used when computing the available borrowing base under the facility. On the accompanying consolidated balance sheets, included in the “Current portion of long-term debt” is $4,520,513 and $7,209,895 for 2002 and 2003, respectively, which represents checks issued but not yet cleared (amounts due bank). 6. Employee Savings Plan In October 1985, the Company established an employee savings plan covering all of its employees. Under the terms of the plan, which was adopted under Section 401(k) of the Internal Revenue Code, the Company can match employee contributions. Such matching contributions cannot exceed the employer’s established annual percentage of compensation, which was a maximum of 6% for the years ended September 30, 2001 and 2002. The Company’s contribution expense was $650,000 and $750,000 for the years ended September 30, 2001 and 2002, respectively. There was no contribution expense for the year ended September 30, 2003. 7. Commitments and Contingencies The Company leases the majority of its stores, installation centers, warehouses and administrative facilities under operating leases. The lives of these leases range from five to twenty years with varying renewal options. The leases provide for base rentals, real estate taxes, common area maintenance charges and, in some instances, for the payment of percentage rents based on sales volume. Rent expense for the years ended September 30, 2001, 2002 and 2003 was $20,514,859, $31,977,705 and $37,532,687, respectively, including percentage rent expense of $318,817, $474,944 and $209,253 respectively. Future minimum rental commitments under non-cancelable operating leases as of September 30, 2003 are as follows: The Company has entered into employment agreements with certain key employees. These agreements provide for continued employment with termination of the agreement at the option of either party. Under certain circumstances, the key employees could receive an amount up to two times their annual base salary. Beginning in April 1999, the Company entered into five agreements to become the “name in title” sponsor for various performing arts centers in certain key markets throughout the country. Under these agreements, the Company will be required to pay $3,266,667 in fiscal 2004, $3,350,000 the next three fiscal years, $2,600,000 in fiscal 2008, and $6,579,166 thereafter. The Company is involved in legal proceedings and litigation arising in the ordinary course of business. In the opinion of management, the outcome of such proceedings and litigation currently pending will not materially affect the Company’s consolidated financial statements. The provision for income taxes consisted of the following: $ 4,437,899 $ 4,413,332 $ (6,950,580 ) 1,089,377 1,033,693 (300,755 ) 5,527,276 5,447,025 (7,251,335 ) $ 11,263,189 $ (1,912,745 ) $ (7,147,749 ) The tax effects of significant temporary differences comprising the Company’s current and long-term net deferred tax assets are as follows: Employee compensation and fringe Bad debt reserve Inventory related accruals Self insured health insurance accruals Net deferred tax assets — current Deferred rent Unrealized (gain)/loss on marketable equity securities (32,853 ) 10,620 State deferred taxes, net (744,044 ) 107,691 Net deferred tax assets — long-term Total net deferred tax assets The Company has determined that it is more likely than not that it will fully realize the deferred tax assets. Consequently, no valuation allowance was established as of September 30, 2002 and 2003. The Company has approximately $16 million of state net operating losses to be carried forward, which expire between 2008 and 2023. A reconciliation between the statutory and effective income tax rates is as follows: Statutory income tax rate (benefit) 35.0 % (35.0 )% (35.0 )% State income taxes, net of federal benefit 4.3 (0.1 ) (4.6 ) Non-deductible impairment charge — 33.9 — Effective income tax rate 40.0 % (1.1 )% (38.0 )% 9. Acquisitions, Intangibles and Goodwill Fiscal Year 2001 Acquisitions During fiscal year 2001, the Company acquired the following three entities for a total cost, including acquisition costs, of $15,760,000, which included the issuance of 125,905 shares of common stock valued at $3,397,000: • Douglas T.V. & Appliance Inc. and Douglas Audio Video Centers, Inc., a four-store consumer electronics retailer in the Chicago, Illinois area. • The Video Scene, Inc. (d/b/a Big Screen City), a four-store consumer electronics retailer based in the San Diego, California area. • SMK Marketing, Inc. (d/b/a Audio Video Systems), a three-store consumer electronics retailer in the Charlotte, North Carolina area. Goodwill recognized in these three transactions amounted to $15,819,000, of which $9,601,000 is expected to be tax-deductible. On August 1, 2001, the Company also acquired 100% of the outstanding common stock of Sound Advice, Inc. (“Sound Advice”). The results of Sound Advice’s operations have been included in the consolidated financial statements since that date. Sound Advice is a full service specialty retailer of consumer electronics products sold in thirty-three Florida-based stores and five Arizona-based stores. This acquisition was consummated for a number of reasons, including the compatibility of Sound Advice with Tweeter’s existing acquisition strategy, the protection of growing markets in Florida and Arizona, the strength of Sound Advice’s management team, expected efficiencies of a combined infrastructure and the timing of the acquisition (i.e., prior to the fiscal 2001 holiday selling season). All of these reasons contributed to the excess of consideration over the fair value of assets acquired and liabilities assumed. The aggregate purchase price was $149,974,000, which included the issuance of 4,046,495 shares of common stock valued at $115,838,000. Acquired intangible assets amounted to $7,505,000 for non-compete agreements and tradenames, both of which have weighted-average useful lives of five years. At the end of fiscal 2002, all acquired intangible assets were reviewed for impairment and an impairment charge of $3,425,000 was recognized. Of this total impairment charge, $3,147,000 related to the Sound Advice acquisition. The $135,944,000 of goodwill in connection with the acquisition of Sound Advice was all assigned to the Company’s one operating segment and reporting unit and was part of the impairment charge taken in fiscal 2002. None of the goodwill is expected to be deductible for income tax purposes. Fiscal Year 2002 Acquisition During fiscal year 2002, the Company acquired Hillcrest High Fidelity, Inc. a two store specialty retailer with a significant focus on in-home installation, in Dallas, Texas. The total purchase consideration, including acquisition costs, was $5,690,000, which included the issuance of 42,886 shares of common stock valued at $1,000,000. Goodwill recognized in this transaction amounted to $4,538,000, of which no tax deduction is expected. Total cash paid for acquisitions in fiscal 2002 of $4,813,000 in the statement of cash flows represents the total cash consideration of the Hillcrest transaction, net of cash acquired and amounts not paid as of September 30, 2002, as well as cash paid for acquisitions made in the prior fiscal year which had been accrued as of September 30, 2001. Acquired Intangible Assets For the fiscal years ended September 30, 2001, 2002 and 2003, the amortization expense of tradenames and non-compete agreements was $250,168, $1,572,794 and $680,000, respectively. During fiscal 2002 the Company, as part of the impairment charge, wrote down the value of certain intangible assets by $3,425,372. The accumulated amortization of intangible assets that were impaired was $1,029,629. For each of the fiscal years 2004 and 2005, the amortization expense is estimated to be $680,000 and for the fiscal year 2006 the amortization is estimated to be $567,000. On October 1, 2001, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” which required that goodwill be reviewed for impairment periodically. Upon adopting SFAS No. 142, the carrying value of goodwill was evaluated in accordance with the standard and determined not to be impaired. Subsequently, as part of the annual impairment test required under SFAS No. 142, a sustained reduction in the Company’s market capitalization indicated that the carrying value of goodwill may be impaired. Based on this, the Company hired an independent third party to prepare a valuation analysis and the results of the valuation indicated that the goodwill recorded was fully impaired. For the fiscal year ended September 30, 2002, an impairment charge of $191,477,000 was taken to write off all recorded goodwill. Had the non-amortization provisions of SFAS No. 142 been effective for fiscal 2001, the Company’s net income and earnings per share would have been as follows for fiscal year 2001: Fiscal Year Ended Reported net income Add back goodwill amortization, net of tax Basic Earnings Per Share: 10. Stockholders’ Equity Common Stock — Holders of common stock are entitled to dividends if declared by the Board of Directors, and each share carries one vote. The common stock has no cumulative voting, redemption or preemptive rights. Common Stock Incentive Plans — In November of 1995, the Company implemented a stock option plan, under which incentive and nonqualified stock options may be granted to management, key employees and outside directors to purchase shares of the Company’s common stock. The exercise price for incentive stock options for employees and nonqualified options for outside directors range from $0.31 to $32.13 per share. Options are generally exercisable over a period from one to ten years from the date of the grant and are dependent on the vesting schedule associated with the grant. Options for 350,460 and 324,134 shares were exercisable under the 1995 Stock Option Plan at September 30, 2002 and 2003, respectively. On June 1, 1998, the Company terminated the 1995 Stock Option Plan and adopted the 1998 Stock Option and Incentive Plan (the “1998 Plan”) to provide incentives to attract and retain executive officers, directors, key employees and consultants. On July 30, 2001, at a special meeting of the Tweeter stockholders, an amendment to the 1998 Stock Option and Incentive Plan was approved to increase the number of shares available for issuance by 1,200,000. The aggregate number of shares of common stock issuable under the 1998 Plan is 4,281,084 shares as of September 30, 2003. In addition, the number of shares of common stock issuable under the 1998 Plan will increase, on each anniversary date of the adoption of the 1998 Plan, by a number of shares not to exceed 300,000 shares. As options granted under the 1998 Plan are exercised, the number of shares represented by such previously outstanding options will again become available for issuance under the 1998 Plan up to a maximum of 100,000 shares of common stock annually. There were 1,587,107 and 2,591,834 shares exercisable under the 1998 Stock Option Plan at September 30, 2002 and 2003, respectively. There were 1,054,003 shares available for future grants at September 30, 2003. The 1998 Plan is administered by the Compensation Committee of the Board of Directors and will allow the Company to issue one or more of the following: stock options (incentive stock options and non-qualified options), restricted stock awards, stock appreciation rights, common stock in lieu of certain cash compensation, dividend equivalent rights, performance shares and performance units (collectively, “Plan Awards”). The 1998 Plan was to expire five years following its adoption. However, during fiscal 2003, the Board of Directors voted to extend the 1998 Plan for one additional year making the expiration date June 1, 2004. Awards made thereunder and outstanding at the expiration of the 1998 Plan will survive in accordance with their terms. Other than stock options, no Plan Awards were granted during 2001, 2002 and 2003. In any plan year no more than 25% of the shares reserved for issuance under the 1998 Plan may be used for Plan Awards consisting of restricted stock. All grants of restricted stock under the 1998 Plan will be subject to vesting over seven years, subject, however, at the administrator’s discretion, to acceleration of vesting upon the achievement of specified performance goals. The 1998 Plan also provides for the grant or issuance of Plan Awards to directors of the Company who are not employees of the Company. These options are 100% vested at the time of grant. The Board of Directors authorized grants of options for a total of 14,000, 40,000 and 110,400 shares of common stock for the years ended September 30, 2001, 2002 and 2003, respectively. The following summarizes transactions under the stock option plans: Weighted- Number of Per Share Option Exercise Shares Price Price 1,927,060 $0.31 to $32.13 $ 12.29 1,495,300 $1.69 to $29.13 $ 9.80 (298,840 ) $0.31 to $23.88 $ 3.83 32,665 $3.62 to $32.13 $ 21.32 7,880 $12.97 to $32.13 $ 21.80 1,253,000 $3.80 to $7.45 $ 5.33 (100,181 ) $0.31 to $8.50 $ 4.00 418,581 $3.62 to $32.13 $ 14.61 Number of Average Options Exercisable Exercisable Price Exercisable 2,915,968 $ 10.46 1,774,850 $ 8.58 The following summarizes information about all stock options outstanding at September 30, 2003: Weighted- Number of Shares Average Options Outstanding at Remaining Exercisable at September 30, Contractual September 30, Range of Exercise Prices 2003 Life (Years) 2003 163,080 2.2 163,080 2,127,829 7.2 1,092,936 16,700 3.4 9,900 3,000 9.0 1,800 60,000 3.7 46,800 Issuance of Restricted Stock — On April 21, 2003, the Company granted 270,000 shares of restricted common stock in conjunction with the employment of its new Senior Vice President and Chief Merchandising Officer. Of these shares 162,000 vested upon grant, 54,000 shares vest on February 1, 2004 and the remaining 54,000 shares vest on February 1, 2005. Employee Stock Purchase Plan — During fiscal 1999, the Company adopted an Employee Stock Purchase Plan (the “ESPP”). The ESPP was effective upon approval by the stockholders of the Company and will continue in effect for a term of twenty years, unless terminated sooner. The Company has the right to terminate the ESPP at any time. The ESPP is intended to be an Employee Stock Purchase Plan under Section 423 of the Internal Revenue Code of 1986, as amended. Subject to adjustment pursuant to the ESPP, the aggregate number of shares of common stock that may be sold under the ESPP is 1,000,000. In the fiscal years ended September 30, 2001, 2002 and 2003, the Company issued 23,765, 37,643 and 75,887 shares of common stock, respectively, under this plan. At September 30, 2003, there were 847,986 shares available for future sales. 11. Related-Party Transactions On November 9, 2001, Cyberian Outpost, Inc. was sold to FCOP Acquisition, Inc., a wholly-owned subsidiary of Fry’s Electronics, a private company operating in the state of California, for $.25 per share. Tweeter owned 285,423 shares of Cyberian Outpost, Inc. prior to this sale. The Company’s joint venture with Cyberian Outpost, Inc. ceased operations on December 31, 2001. On February 9, 2002, the joint venture and all related agreements with Cyberian Outpost, Inc. were terminated. In connection with the Tweeter.Outpost.com joint venture formed with Cyberian Outpost, Inc., the Company was responsible for paying its suppliers for the inventory purchased by the joint venture and billing the joint venture. For the years ended September 30, 2001 and 2002, the Company billed the joint venture $10,759,000 and $720,000, respectively, for inventory purchases. At September 30, 2002 no money was owed to the Company by the joint venture. The Company had made equity investments in the common stock of Cyberian Outpost, Inc. totaling $1,233,000. During fiscal 2001, the Company wrote down the value of these investments, taking a charge of $1,162,000. In fiscal 2002, the investment was sold and the Company received $71,000 in cash. Prior to the third quarter of fiscal 2003, the Company invested cash of approximately $1,021,000 in Tivoli. On June 30, 2003, Tweeter made an additional investment of $750,000 in Tivoli. This additional investment increased the Company’s ownership percentage to 25%. Tivoli is a manufacturer of consumer electronics products from which the Company purchases product for resale. The Company accounts for its investment in Tivoli under the equity method of accounting, recognizing the Company’s share of Tivoli’s income or loss in the Company’s statement of operations. During fiscal 2001, 2002 and 2003, the Company purchased $601,597, $2,225,392 and $3,363,724 of merchandise from Tivoli. Dividends received from Tivoli amounted to $25,097, $92,355 and $507,932 in fiscal years 2001, 2002, and 2003, respectively. Amounts payable to Tivoli were $76,469 and $46,053 at September 30, 2002 and 2003 respectively. 12. Investments The Company’s investments consist of the following: Available-for-sale equity securities Equity investment in Tivoli On October 4, 1999, the Company formed a joint venture with Cyberian Outpost, Inc. (Nasdaq: COOL), organized as Tweeter.Outpost.com, LLC, to jointly market and sell consumer electronics over the Internet. The Tweeter.Outpost.com site was launched on October 19, 1999, with a primary URL of Tweeter.Outpost.com. Each party capitalized the joint venture with a $2,500,000 investment and each party maintained a 50% interest. On November 9, 2001, Cyberian Outpost, Inc. was sold to FCOP Acquisition, Inc., a wholly owned subsidiary of Fry’s Electronics, a private company operating in the state of California, for $.25 per share. Tweeter owned 285,423 shares of Cyberian Outpost, Inc. prior to this sale. The joint venture ceased operations on December 31, 2001. On February 9, 2002, the joint venture and all related agreements with Cyberian Outpost, Inc. were terminated. During each period, the Company recorded its 50% of the net income (loss) on the statement of operations in the line “income (loss) from equity investment.” For the years ended September 30, 2001 and 2002, the amounts were income of $843,000 and a loss of $26,000, respectively. The Company was also responsible for paying its suppliers for the inventory purchased by the joint venture and billing the joint venture. At September 30, 2002, no amounts were due from the joint venture. The Company also made an equity investment of $1.2 million dollars in the common stock of Cyberian Outpost, Inc. and as of September 30, 2001, the investment was written down to $71,000 to reflect the sale of Cyberian Outpost, Inc. to FCOP Acquisition, Inc. At September 30, 2001, this investment was classified as held for trading and during fiscal 2002 it was sold for $71,000. For the fiscal years ended September 30, 2001 and 2002, the joint venture had revenues of $15,013,000 and $1,432,000, respectively, and had net income in 2001 of $1,687,000 and a net loss of $52,000 in 2002. At September 30, 2001, the joint venture had assets of $6,737,000 and liabilities of $213,000. At the time the joint venture was terminated, the Company wrote off $139,935 of start-up costs which it had been amortizing over five years. At September 30, 2001, 2002 and 2003, the unrealized gain, before income tax effect, on securities of $110,000, $82,000 and $100,000, respectively was included in accumulated other comprehensive income reflected in stockholders’ equity. During fiscal year 2001, the Company recorded a $1.1 million loss on its investment in Cyberian Outpost, Inc. and reclassified that investment to “trading.” This reclassification resulted in an adjustment to other comprehensive income of approximately $0.6 million. Also, on August 1, 2001, the Company eliminated its investment in Sound Advice, Inc. in connection with the acquisition described in Note 9, resulting in a reclassification adjustment of approximately $4.2 million in other comprehensive income. 13. Quarterly Results of Operations (Unaudited) The following is a tabulation of the quarterly results of operations for the fiscal years ended September 30, 2002 and 2003. The Company recorded an impairment charge in the fourth quarter of 2002 for its entire goodwill ($191,477,000) and a portion of its intangible assets ($3,425,000) as discussed in Note 9: December 31, March 31, June 30, September 30, 13,503 2,592 103 (181,327 ) 0.59 0.11 0.00 (7.71 ) 5,204 (2,461 ) (4,124 ) (10,281 ) 0.22 (0.10 ) (0.17 ) (.43 ) Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual Report (the “Evaluation Date”), have concluded that as of the Evaluation Date our disclosure controls and procedures were effective and designed to ensure that material information relating to Tweeter would be made known to them by others within the Company. During the period covered by this Annual Report, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. The information required by this Item is included in the definitive Proxy Statement for the Company’s 2004 Annual Meeting of Stockholders, to be filed with the Commission on or about December 19, 2003 (the “2004 Proxy Statement”), under “Election of Directors” and is incorporated herein by reference. The information required by this Item is included in the 2004 Proxy Statement under “Executive Compensation” and is incorporated herein by reference. The information required by this Item, other than the table included below, is included in the 2004 Proxy Statement under “Security Ownership of Certain Beneficial Owners and Management” and is incorporated herein by reference. securities remaining Number of available for future securities to be issuance under issued upon exercise Weighted-average equity compensation of outstanding exercise price of plans (excluding options, warrants outstanding options, securities reflected and rights warrants and rights in column(a)) Equity compensation plans approved by security holders: 1998 Stock Option and Incentive Plan 2,591,834 $ 11.44 1,054,003 (1) 1995 Stock Option Plan 324,134 2.63 — 152,014 9.96 847,986 3,067,982 $ 10.44 1,901,989 (1) The number of shares of common stock issuable under the plan increases each year by a number of shares not to exceed 300,000 shares. Also, as options granted under the plan are exercised, the number of shares represented by such previously outstanding options will become re-available for issuance under the plan up to a maximum of 100,000 shares of common stock annually. The information required by this Item is included in the 2004 Proxy Statement under “Employment/ Severance Agreements” and is incorporated herein by reference. The information required by this Item is included in the 2004 Proxy Statement under “Principal Accountant Fees and Services” and is incorporated herein by reference. (a)(1) Financial Statements. The financial statements required to be filed by Item 15 of this Annual Report on Form 10-K, and filed herewith, are as follows: Consolidated Balance Sheets as of September 30, 2002 and 2003 Consolidated Statements of Operations for the Years Ended September 30, 2001, 2002 and 2003 Consolidated Statements of Stockholders’ Equity for the Years Ended September 30, 2001, 2002 and 2003 Consolidated Statements of Cash Flows for the Years Ended September 30, 2001, 2002 and 2003 (a)(2) Financial Statement Schedules. Schedule II attached (a)(3) Exhibits. See the Exhibit Index included immediately preceding the Exhibits to this Form 10-K. (b) Reports on Form 8-K. On July 7, 2003, Tweeter filed with the Securities and Exchange Commission a Current Report on Form 8-K to announce its sales results for the quarter ended June 30, 2003. On July 24, 2003, Tweeter filed with the Securities and Exchange Commission a Current Report on Form 8-K to announce its Results of Operations and Financial Condition for the quarter ended June 30, 2003. In addition, Tweeter filed a transcript of its quarterly earnings conference call held on July 24, 2003. VALUATION AND QUALIFYING ACCOUNTS Balance at Charged to Charged to Deductions Balance at Beginning Costs and Other Net of End of Description of Period Expenses Accounts Write-Offs Period $ 1,075 $ 1,483 $ — $ 1,448 $ 1,110 850 803 — 578 1,075 800 119 3 72 850 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: /s/ JEFFREY STONE Jeffrey Stone By: /s/ JOSEPH MCGUIRE Senior Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature Title Date /s/ SAMUEL BLOOMBERG Samuel Bloomberg Chairman of the Board December 11, 2003 Jeffrey Stone Director, President and Chief Executive Officer December 11, 2003 By: /s/ MICHAEL CRONIN Michael Cronin Director December 11, 2003 By: /s/ JEFFREY BLOOMBERG Jeffrey Bloomberg Director December 11, 2003 By: /s/ MATTHEW BRONFMAN Matthew Bronfman Director December 11, 2003 By: /s/ STEVEN FISCHMAN Steven Fischman Director December 11, 2003 By: /s/ PETER BESHOURI Peter Beshouri Director December 11, 2003 (a) Exhibit: 3.1 (9) — Amended and Restated Certificate of Incorporation of the Company. 3.2 (9) — Amendment to Amended and Restated Certificate of Incorporation of the Company. 3.3 (9) — Amended and Restated By-Laws of the Company, as amended. 4.1 (9) — Specimen Certificate representing the Company’s common stock. 4.2 (9) — Shareholder’s Rights Agreement. 10.1 (1) — 1995 Stock Option Plan. 10.2 (6) — 1998 Stock Option and Incentive Plan, as amended. 10.3 (10) — Employment Agreement between the Company and Samuel Bloomberg. 10.4 (10) — Employment Agreement between the Company and Jeffrey Stone. 10.5 (1) — Employment Agreement between the Company and Joseph McGuire. 10.6 (6) — Employment Agreement between the Company and Peter Beshouri. 10.7 (6) — Employment Agreement between the Company and Michael Blumberg. 10.8 (10) — Severance Agreement between the Company and Philo Pappas. 10.9 (1) — Progressive Retailers Organization, Inc. Policy and Procedures Manual. 10.10 (2) — Employee Stock Purchase Plan. 10.11 (3) — Tweeter Home Entertainment Group Deferred Compensation Plan. 10.12 (3) — Tweeter Home Entertainment Group Deferred Compensation Plan Adoption Agreement. 10.13 (4) — Credit Agreement dated as of June 29, 2001 among the Company, Fleet National Bank and the other parties thereto. 10.14 (5) — Third Amendment to Credit Agreement, dated as of May 31, 2002, among the Company, Fleet National Bank and the other parties thereto. 10.15 (6) — Fourth Amendment to Credit Agreement dated as of September 27, 2002 among the Company, Fleet National Bank and the other parties thereto. 10.16 (7) — Fifth Amendment to Credit Agreement dated as of January 29, 2003 among the Company, Fleet National Bank and the other parties thereto. 10.17 (8) — Credit Agreement dated as of April 16, 2003, among the Company, Fleet National Bank and other parties thereto. 10.18 (8) — Guarantee dated as of April 16, 2003, among the Company, Fleet National Bank and other parties thereto. 10.19 (10) — Third Amendment to Credit Agreement, dated as of August 30, 2003, among the Company, Fleet National Bank and other parties thereto. 14 (10) — Code of Ethics. 21 (6) — Subsidiaries of the Company. 23 (10) — Consent of Deloitte & Touche LLP. 31.1 (10) — Rule 13a-14(a)/15d-14(a) Certification. 32.1 (10) — Section 1350 Certification. (1) Filed as an exhibit to the Company’s Registration Statement on Form S-1 (Registration Number 333-51015) or amendments thereto and incorporated herein by reference. (3) Filed as an exhibit to the Company’s Annual Report on Form 10-K for the year ended September 30, 2000 and incorporated herein by reference. (5) Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2002 and incorporated herein by reference. (7) Filed as an exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter ended December 31, 2002 and incorporated herein by reference. (8) Filed as an exhibit to the Company’s Current Report on Form 8-K filed April 23, 2003 and incorporated herein by reference. (10) Filed herewith.

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PLUG POWER INC x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2007 ¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO Commission File Number: 0-27527 968 ALBANY-SHAKER ROAD, LATHAM, NEW YORK 12110 (Address of registrant’s principal executive office) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act). Large Accelerated Filer ¨ Accelerated Filer x Non-Accelerated Filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b 2 of the Exchange Act). Yes ¨ No x The number of shares of common stock, par value of $.01 per share, outstanding as of May 1, 2007 was 86,895,433 INDEX to FORM 10-Q Item 1 – Financial Statements (Unaudited) Condensed Consolidated Balance Sheets - March 31, 2007 and December 31, 2006 Condensed Consolidated Statements of Operations - Three month periods ended March 31, 2007 and March 31, 2006 and Cumulative Amounts from Inception Condensed Consolidated Statements of Cash Flows - Three month periods ended March 31, 2007 and March 31, 2006 and Cumulative Amounts from Inception Notes to Condensed Consolidated Financial Statements Item 2 – Management’s Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3 – Quantitative and Qualitative Disclosures About Market Risk Item 4 – Controls and Procedures Item 1A – Risk Factors Item 2 – Unregistered Sales of Equity Securities and Use of Proceeds Item 6 – Exhibits Plug Power Inc. and Subsidiaries (A Development Stage Enterprise) March 31, 2007 December 31, $ 72,954,388 $ 26,899,866 Available-for-sale securities 178,416,212 242,223,202 Accounts receivable, less allowance of $35,670 at March 31, 2007 and Property, plant and equipment, net 17,831,695 18,048,254 $ 294,332,205 $ 307,919,912 Due to broker for security purchase $ — $ 5,000,000 Accrued expenses 8,439,583 12,279,293 Class B Capital stock, a class of preferred stock, $0.01 par value per share; 5,000,000 shares authorized; 395,000 shares issued and outstanding at March 31, 2007 and December 31, 2006 Common stock, $0.01 par value per share; 245,000,000 shares authorized; 86,844,706 shares issued and outstanding at March 31, 2007 and 86,794,915 shares issued and outstanding at December 31, 2006 Deficit accumulated during the development stage (468,574,552 ) (457,391,545 ) Total liabilities and stockholders’ equity The accompanying notes are an integral part of the unaudited condensed consolidated financial statements. March 31, Cumulative Amounts from Product and service revenue $ 462,034 $ 856,730 $ 32,821,959 Research and development contract revenue 2,168,143 1,418,978 64,446,709 Cost of revenue and expenses Cost of product and service revenue Cost of research and development contract revenue In-process research and development — — 12,026,640 Research and development expense: Noncash stock-based compensation 876,369 663,360 12,501,913 Other research and development 8,422,026 8,321,400 343,198,686 General and administrative expense: Other general and administrative Operating loss (15,056,630 ) (12,899,613 ) (482,541,940 ) Interest income and net realized gains/losses from the sale of available-for-sale securities 3,873,623 822,605 33,893,273 — (48,911 ) (1,348,135 ) Loss before equity in losses of affiliates Equity in losses of affiliates — — (18,577,750 ) $ (11,183,007 ) $ (12,125,919 ) $ (468,574,552 ) Loss per share: Basic and diluted $ (0.13 ) $ (0.14 ) Weighted average number of common shares outstanding Noncash prepaid development costs Amortization of deferred grant revenue — — (1,000,000 ) Allowance for bad debts — — 35,670 Loss on disposal of property, plant and equipment In-kind services — — 1,340,000 Amortization and write-off of deferred rent Changes in assets and liabilities, net of effects of acquired companies: (1,310,695 ) 250,938 (2,019,665 ) (1,216,819 ) (536,089 ) (6,420,956 ) (381,206 ) 229,578 (5,165,774 ) Accounts payable and accrued expenses (29,835 ) (1,310,949 ) 2,795,905 1,164,501 102,031 4,856,821 Proceeds from acquisition, net Increase in notes receivable (1,500,000 ) — (2,500,000 ) Purchase of property, plant and equipment (542,417 ) (332,461 ) (34,521,592 ) Proceeds from disposal of property, plant and equipment — — 315,666 Purchase of intangible asset Investment in affiliate Proceeds from maturities and sales of available-for-sale securities 192,186,063 53,916,313 1,964,970,773 Purchases of available-for-sale securities (133,321,754 ) (45,743,215 ) (2,143,400,147 ) 56,821,892 7,840,637 (196,794,059 ) Proceeds from issuance of common and preferred stock — — 428,529,602 Proceeds from public offerings, net Proceeds from shares issued for stock option exercises and employee stock purchase plan — 3,591 10,761,696 Principal payments on long-term debt and capital lease obligations — (43,677 ) 628,868,289 Increase (decrease) in cash and cash equivalents 46,054,522 (3,270,672 ) 72,954,388 Cash and cash equivalents, beginning of period 26,899,866 21,877,726 — $ 72,954,388 $ 18,607,054 $ 72,954,388 1. Nature of Operations Plug Power Inc. and subsidiaries (Company) was originally formed as a joint venture between Edison Development Corporation (EDC) and Mechanical Technology Incorporated (MTI) in the State of Delaware on June 27, 1997 and succeeded by merger to all of the assets, liabilities and equity of Plug Power, L.L.C. on November 3, 1999. The Company is a development stage enterprise involved in the design, development and manufacture of on-site energy systems for energy consumers worldwide. The Company’s focus is on a platform-based systems architecture, which includes proton exchange membrane (PEM) fuel cell and fuel processing technologies, from which multiple products are being offered or are under development. A fuel cell is an electrochemical device that combines hydrogen and oxygen to produce electric power without combustion. Hydrogen is derived from hydrocarbon fuels such as natural gas, propane, methanol or gasoline and can also be obtained from the electrolysis of water, stored hydrogen or a hydrogen pipeline. The Company is currently offering its GenCore® product for commercial sale. The GenCore® product is a back-up power product initially targeted for telecommunications, broadband, utility and industrial uninterruptible power supply (UPS) applications. We are developing additional products known as GenSys® for continuous run power applications, with optional combined heat and power capability for remote small commercial and remote residential applications. We are also pursuing development and commercialization of fuel cell power units known as GenDrive™ that provide power for electric lift trucks and other mobile industrial equipment for which lead-acid batteries are the incumbent technology. The Company’s cash requirements depend on numerous factors, including completion of our product development activities, ability to commercialize our on-site energy products, market acceptance of our systems and other factors. The Company expects to continue to devote substantial capital resources to continue its development programs directed at commercializing on-site energy products for worldwide use, hiring and training production staff, developing and expanding manufacturing capacity, and continuing expansion of production and research and development activities. The Company will pursue the expansion of its operations through internal growth and strategic acquisitions and expects that such activities will be funded from existing cash and cash equivalents and available-for-sale securities and to a lesser extent, issuance of additional equity or debt securities or additional borrowings subject to market and other conditions. The failure to raise the funds necessary to finance future cash requirements or consummate future acquisitions could adversely affect the Company’s ability to pursue its strategy and could negatively affect its operations in future periods. The Company anticipates incurring additional losses over at least the next several years and believes that its current cash, cash equivalents and available-for-sale securities balances will provide sufficient liquidity to fund operations for at least the next twelve months. At March 31, 2007, the Company had unrestricted cash, cash equivalents and available-for-sale securities in the amount of $251.4 million and working capital of $257.5 million. 2. Basis of Presentation Principles of Consolidation: The accompanying unaudited condensed interim consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated in consolidation. Interim Financial Statements: The unaudited condensed interim consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, all adjustments, which consist solely of normal recurring adjustments, necessary to present fairly, in accordance with U.S. generally accepted accounting principles, the financial position, results of operations and cash flows for all periods presented, have been made. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for the full year. Certain information and footnote disclosures normally included in annual consolidated financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These unaudited condensed consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K filed for the fiscal year ended December 31, 2006. The information presented in the accompanying condensed consolidated balance sheet as of December 31, 2006 has been derived from the Company’s December 31, 2006 audited consolidated financial statements. All other information has been derived from the Company’s unaudited consolidated financial statements for the periods as of and ending March 31, 2007 and 2006. Cash Equivalents: Cash equivalents consist of money market accounts, overnight repurchase agreements and certificates of deposit with an initial term of less than three months. For purposes of the condensed consolidated statements of cash flows, the Company considers all highly liquid debt instruments with original maturities of three months or less to be cash equivalents. Available-for-Sale Securities: Management determines the appropriate classification of its investments in available-for-sale securities at the time of purchase and reevaluates such determinations at each balance sheet date. Available-for-sale securities include debt obligations and mortgage-backed securities, which are carried at estimated fair value. These investments are considered available-for-sale, and the difference between the amortized cost and the estimated fair value of these securities is reflected in accumulated other comprehensive income (loss) as a separate component of stockholders’ equity. The Company has had no investments that qualify as trading or held-to-maturity. The cost of securities sold is based on the specific identification method. Security transactions are recognized on a trade date basis. Premiums and discounts on securities are amortized and accreted over the term of the security using the interest method. When a decline in market value of a security is considered other-than-temporary, the cost basis of the individual security is written down to estimated fair value as the new cost basis and the loss is charged to interest income and net realized gains (losses) from the sale of available-for-sale securities in the consolidated statement of operations. At March 31, 2007, the difference between the amortized cost and the fair value of these securities result in an unrealized loss in the amount of $13,161. At March 31, 2007, the Company held available-for-sale securities with maturities not to exceed thirty months. Inventory: Inventory is stated at the lower of average cost or market and generally consists primarily of raw materials. At March 31, 2007, inventory included 15 completed units shipped on a consignment basis, valued at approximately $223,000. At December 31, 2006, inventory included 43 completed units shipped on a consignment basis, valued at approximately $573,000. Goodwill: Goodwill acquired in a purchase business combination and determined to have an indefinite useful life is not amortized, but instead tested for impairment at least annually or upon the occurrence of triggering events in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets”. Goodwill represents the excess of costs over fair value of H Power Corp. net assets acquired during 2003. Impairment of Long-Lived Assets: Long-lived assets, such as property, plant, and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to estimated undiscounted future cash flows expected to be generated by the asset. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset. Assets to be disposed of would be separately presented in the balance sheet and reported at the lower of the carrying amount or fair value less costs to sell, and are no longer depreciated. The assets and liabilities of a disposal group classified as held for sale would be presented separately in the appropriate asset and liability sections of the balance sheet. Product and Service Revenue: The Company applies the guidance within SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (SAB 104) in the evaluation of its contracts to determine when to properly recognize revenue. Under SAB 104, revenue is recognized when title and risk of loss have passed to the customer, there is persuasive evidence of an arrangement, delivery has occurred or services have been rendered, the sales price is determinable, and collectibility is reasonably assured. The Company’s initial sales of GenSys® and GenCore® 5T products contain multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support. While contract terms require payment shortly after delivery or installation of the fuel cell system and are not contingent on the achievement of specific milestones or other substantive performance, the multiple obligations within contractual arrangements are not accounted for separately based on the Company’s limited commercial experience and available evidence of fair value of the different components. As a result, the Company defers recognition of product and service revenue and recognizes revenue on a straight-line basis over the stated contractual term, or over the expected term if it is probable that the contractual term will be extended, as the continued service, maintenance and other support obligations expire, which are generally for periods of twelve to thirty months. Cost of product and service revenue includes the direct material cost incurred in the manufacture of the products we sell, which are generally recognized when units are shipped, as well as the labor and material costs incurred for product maintenance, replacement parts and service under our contractual obligations, which are recognized as incurred. At March 31, 2007 and December 31, 2006, the Company had deferred product and service revenue in the amount of $2.8 million and $2.2 million, respectively. As the Company gains commercial experience, including field experience relative to service and warranty based on the sales of initial products, the fair values for the multiple elements within future contracts may become determinable, and the Company may, in future periods, recognize revenue upon shipment of the product or may continue to defer recognition, based on application of appropriate guidance within Emerging Issues Task Force (EITF) Issue No. 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables”. Research and Development Contract Revenue: Research and development contract revenue primarily relates to cost reimbursement research and development contracts associated with the development of PEM fuel cell technology. The Company generally shares in the cost of these programs with cost sharing percentages between 20% and 51%. Revenue from “time and material” contracts is recognized on the basis of hours utilized, plus other reimbursable contract costs incurred during the period. At March 31, 2007 and December 31, 2006, the Company had deferred contract revenue of $1.1 million and $461,000, respectively. Income Taxes: Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is recorded to reduce the carrying amounts of deferred tax assets if it is more likely than not that such assets will not be realized. We did not report a benefit for federal and state income taxes in the consolidated financial statements as the deferred tax asset generated from our net operating loss has been offset by a full valuation allowance because it is more likely than not that the tax benefits of the net operating loss carryforward will not be realized. Stock Based Compensation: Under Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R), the Company is required to recognize, as compensation expense, the estimated fair value of all share-based payments to employees on a straight-line basis (net of estimated forfeitures) over the requisite service period for all share-based payments to employees and directors based on the grant date estimate of fair value for those awards. The Company estimates the fair value of stock-based awards using a Black-Scholes valuation model. Stock-based compensation expense is recorded in “Research and development expense—Noncash stock-based compensation” and “General and administrative expense—Noncash stock-based compensation” in the consolidated statements of operations based on the employees’ respective function or an estimated allocation between functions for certain employees. The Company records deferred tax assets for awards that result in deductions on the Company’s income tax returns, unless the Company cannot recognize the deduction (i.e. the Company is in a net operating loss (NOL) position), based on the amount of compensation cost recognized and the Company’s statutory tax rate. Differences between the deferred tax assets recognized for financial reporting purposes and the actual tax deduction reported on the Company’s income tax return are recorded in additional paid-in capital if the tax deduction exceeds the deferred tax asset or in the consolidated statements of operations if the deferred tax asset exceeds the tax deduction and no additional paid-in capital exists from previous awards. No tax benefit or expense for stock-based compensation has been recorded during three months ended March 31, 2007 and 2006, since the Company remains in a NOL position. The Company continues to record the fair market value of stock options granted to non-employees and non-directors in exchange for services in accordance with EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services”, in the consolidated statements of operations. For the three months ended March 31, 2007 and 2006, the Company recorded expense of approximately $1.4 million and $858,000, respectively, in connection with its share-based payment awards. Use of Estimates: The unaudited condensed consolidated financial statements of the Company have been prepared in conformity with U.S. generally accepted accounting principles, which require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 3. Loss Per Share Loss per share for the Company is calculated as follows: Numerator: $ (11,183,007 ) $ (12,125,919 ) Denominator: Weighted average number of common shares No options, warrants, securities convertible into common stock (such as the Company’s preferred stock), or unvested restricted stock outstanding were included in the calculation of diluted loss per share because their impact would have been anti-dilutive. These dilutive potential common shares for the three month periods ended March 31, 2007 and 2006 are summarized as follows: Unvested restricted stock Preferred stock(1) 46,570,993 6,431,776 The preferred stock amount represents the dilutive potential common shares of the 395,000 shares of Class B capital stock issued on June 29, 2006. 4. Stockholders’ Equity Changes in stockholders’ equity for the three months ended March 31, 2007 are as follows: During the $ 3,950 $ 867,952 $ 751,118,315 $ (70,480 ) $ (457,391,545 ) $ 294,528,192 (11,183,007 ) (11,183,007 ) $ (11,183,007 ) Net change in unrealized loss on available-for-sale securities 498 1,362,808 1,363,306 $ 3,950 $ 868,450 $ 752,481,123 $ (13,161 ) $ (468,574,552 ) $ 284,765,810 $ (11,125,688 ) Common stock issued during the three months ended March 31, 2007 consisted of approximately 50,000 shares issued as stock-based compensation for employee benefit plans. 5. Supplemental Disclosures of Cash Flows Information The following represents required supplemental disclosures of cash flows information and noncash financing and investing activities which occurred during the three months ended March 31, 2007 and 2006: $ — $ 42,733 Stock-based compensation accrual impact — 660,095 Change in unrealized gain/loss on available-for-sale securities Reduction of due to broker for security purchase (5,000,000 ) — 6. Recent Accounting Pronouncements In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in tax positions. This Interpretation requires that the Company recognize in its financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. This Interpretation is effective for fiscal years beginning after December 15, 2006, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company adopted this statement on January 1, 2007. No adjustment of opening balances was required and the adoption of this Interpretation did not have a material impact on the Company’s consolidated financial statements. In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). This new standard establishes a framework for measuring the fair value of assets and liabilities. This framework is intended to provide increased consistency in how fair value determinations are made under various existing accounting standards which permit, or in some cases require, estimates of fair market value. SFAS No. 157 also expands financial statement disclosure requirements about a company’s use of fair value measurements, including the effect of such measures on earnings. This standard is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. While the Company is currently evaluating the provisions of SFAS No. 157, the Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities Including an Amendment of SFAS No. 115” (SFAS No. 159). This new standard permits entities to choose to measure many financial instruments and certain warranty and insurance contracts at fair value on a contract-by-contract basis. This standard is effective for fiscal years beginning after November 15, 2007. While the Company is currently evaluating the provisions of SFAS No. 159, the Company does not expect the adoption of this statement to have a material impact on its consolidated financial statements. On April 3, 2007 Plug closed its previously announced acquisition of Cellex Power Products, Inc., or Cellex. The Company purchased all of the outstanding capital stock of Cellex from its equity holders for an aggregate cash purchase price of $45.0 million. On May 7, 2007, the Company announced the acquisition of General Hydrogen Corporation, or General Hydrogen. The Company paid approximately $10.0 million, consisting of approximately $7.0 million in cash and the settlement of $3.0 million in senior secured loans previously made by the Company to General Hydrogen, for all of the outstanding capital stock of General Hydrogen. In addition, the shareholders of General Hydrogen received warrants to purchase up to 571,429 shares of the Company’s Common Stock. The warrants become exercisable when the Company’s Common Stock trades at a volume weighted average price of $7.00 or more for 10 consecutive trading days. The warrants carry an exercise price of $.01 per share and expire four years from the date of issuance. Coincident with the acquisition of General Hydrogen, Plug Power entered into a two-year agreement with Ballard Power Systems Inc. for the purchase of fuel cell stacks for Plug Power’s commercial needs with respect to electric lift truck applications, replacing the previous agreement between General Hydrogen and Ballard. The General Hydrogen and Cellex Power products were designed around the Ballard stack and have generated tens of thousands of operating hours to validate reliability and performance. Under the new agreement, Plug Power and Ballard will work together to drive reliable, low-cost solutions that are expected to significantly improve the outlook for fuel cell commercialization of material handling applications. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our accompanying unaudited condensed consolidated financial statements and notes thereto included within this report, and our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2006. In addition to historical information, this Form 10-Q and following discussion contain statements that are not historical facts and are considered forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements contain projections of our future results of operations or of our financial position or state other forward-looking information. In some cases you can identify these statements by forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will” and “would” or similar words. We believe that it is important to communicate our future expectations to our investors. However, there may be events in the future that we are not able to accurately predict or control and that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements. Investors are cautioned not to rely on forward-looking statements because they involve risks and uncertainties, and actual results may differ materially from those discussed as a result of various factors, including, but not limited to: the risk that the anticipated synergies of the Cellex Power Products, Inc. and General Hydrogen Corporation acquisitions are not realized; the risk that possible strategic benefits of the investment by Smart Hydrogen do not materialize, that orders will not ship, be installed and/or convert to revenue; our ability to develop commercially viable on-site energy products; the cost and timing of developing our on-site energy products; market acceptance of our on-site energy products; our ability to manufacture on-site energy products on a large-scale commercial basis; competitive factors, such as price competition and competition from other traditional and alternative energy companies; the cost and availability of components and parts for our on-site energy products; the ability to raise and provide the necessary capital to develop, manufacture and market our on-site energy products; our ability to establish relationships with third parties with respect to product development, manufacturing, distribution and servicing and the supply of key product components; our ability to protect our intellectual property; our ability to lower the cost of our on-site energy products and demonstrate their reliability; the cost of complying with current and future governmental regulations; the impact of deregulation and restructuring of the electric utility industry on demand for our on-site energy products; fluctuations in the trading price and volume of our common stock and other risks and uncertainties discussed, but are not limited to, those set forth under the caption “Factors Affecting Future Results” in our Annual Report on Form 10-K filed for the fiscal year ended December 31, 2006 as updated by Part II, Item 1A of this Form 10-Q. These forward-looking statements speak only as of the date on which the statements were made and are not guarantees of future performance. Except as may be required by applicable law, we do not undertake or intend to update any forward-looking statements after the date of this Form 10-Q. We design and develop on-site energy systems based on proton exchange membrane fuel cell technology for commercial and residential energy consumers worldwide. We are focused on platform-based systems, which include proton exchange membrane, or PEM, fuel cell and fuel processing technologies, from which we are offering or developing multiple products. We are currently offering our GenCore® product for commercial sale. Our GenCore® product is a back-up power product for telecommunications, broadband, utility and industrial uninterruptible power supply, or UPS, applications. We are developing additional products known as GenSys® for continuous run power applications, with optional combined heat and power capability for remote small commercial and remote residential applications. We are also developing products known as GenDrive™ targeted at the materials handling application. We are a development stage enterprise in the early period of field-testing and marketing our initial commercial products to a limited number of customers, including telecommunications companies, utilities, government entities and our distribution partners. Our initial commercial product, the GenCore® 5T, is designed to provide direct-current backup power for the targeted application described above. See “Product Development and Commercialization.” The GenCore® 5T is fueled by hydrogen and does not require a fuel processor. Our sales and marketing strategy is to build a network of leading distributors who have established relationships, and sub-distributor networks, that can distribute and service our products in targeted geographic and/or market segments. We have distribution agreements in place with 17 distributors including Tyco Electronics Power Systems, Inc., or Tyco, our largest North American distribution partner and IST Holdings Ltd., or IST, our distribution partner in South Africa with whom we jointly received a $3 million customer buy-down grant from the International Finance Corporation in 2005. We also form relationships with customers and enter into development and demonstration programs with telecommunications companies, electric utilities, government agencies and other energy providers. Many of our initial sales of GenSys® and GenCore® 5T are contract-specific arrangements containing multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support. The multiple obligations within our contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence of fair value. As a result, we defer recognition of product and service revenue and recognize revenue on a straight-line basis over the contractual terms as the continued service, maintenance and other support obligations expire, which are generally for periods of twelve to thirty months. However, if the warranty or service period is expected to exceed the contractual warranty/service period the deferred revenue would be recognized over that expected longer warranty/service period and may not begin until units are installed. See “Basis of Presentation—Product and Service Revenue.” As we gain commercial experience, including field experience relative to service and warranty of our initial products, the fair values for the multiple elements within our future contracts may become determinable and we may, in future periods, recognize product revenue upon delivery or installation of the product, or we may continue to defer recognition, based on application of appropriate guidance within EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” or changes in the manner in which we structure contractual agreements, including our agreements with distribution partners. Our cash requirements depend on numerous factors, including completion of our product development activities, ability to commercialize our fuel cell systems, market acceptance of our systems and other factors. We expect to pursue the expansion of our operations through internal growth and strategic acquisitions. As of March 31, 2007, we had cash and cash equivalents and available-for-sale securities totaling $251.4 million and working capital of $257.5 million. During the three months ended March 31, 2007, cash used by operating activities was $10.8 million, consisting primarily of a net loss of $11.2 million offset, in part, by non-cash expenses in the amount of $2.2 million, including $0.8 million for depreciation and amortization and $1.4 million for stock based compensation. Cash provided by investing activities for the three months ended March 31, 2007 was $56.8 million, consisting of $58.8 million of net proceeds from available-for-sale securities to accommodate the acquisition of Cellex Power Products, Inc., or Cellex offset by $542,000 used to purchase property, plant and equipment and an additional $1.5 million in notes receivable. Investment Transactions On April 3, 2007, the Company completed its previously announced transaction with Cellex. The Company paid $45 million in cash for all of Cellex’s outstanding shares. Cellex has been developing PEM fuel cell power units for electric lift trucks and is targeting the estimated $1.5 billion industrial motive battery market. In November 2006, Cellex successfully completed beta testing of its zero-emission, hydrogen fuel cell power units in pallet trucks at two Ohio-based Wal-Mart distribution centers. Cellex has focused its initial product initiatives on class 3 electric lift trucks, often referred to as “pallet trucks,” that are the predominant equipment used to transport goods within large distribution centers. Cellex’s product strategy is to develop a full product portfolio addressing all three classes of electric lift trucks, enabling complete conversion of distribution centers and maximizing customer benefit. Cellex’s product delivers value to the customer via increased productivity and reduced fueling time, as well as the elimination of cost, environmental and safety issues associated with traditional lead acid batteries. On May 7, 2007, the Company announced the acquisition of General Hydrogen Corporation, or General Hydrogen, a leader in the development and commercialization of fuel cell power units that provide motive power for electric lift trucks and other mobile industrial equipment. The Company paid approximately $10.0 million, consisting of approximately $7.0 million in cash and the settlement of $3.0 million in senior secured loans previously made by the Company to General Hydrogen, for all of the outstanding capital stock of General Hydrogen. In addition, the shareholders of General Hydrogen received warrants to purchase up to 571,429 shares of the Company’s Common Stock. The warrants become exercisable when the Company’s Common Stock trades at a volume weighted average price of $7.00 or more for 10 consecutive trading days. The warrants carry an exercise price of $.01 per share and expire four years from the date of issuance. Product Development and Commercialization We are focused on a fuel cell technology platform from which we believe we can offer multiple products. We currently have one commercial product line, GenCore®, which we continue to enhance and broaden: GenCore®—Back-up Power for Telecommunication, Broadband, Utility and UPS Applications—We currently offer the GenCore® product line which is focused on providing direct-current backup power for telecom, broadband, utility and industrial UPS market applications. Our GenCore® products are fueled by hydrogen and do not require a fuel processor. See “Distribution, Marketing and Strategic Relationships” for additional information regarding product development and commercialization. Additionally, we continue to advance the development of our other technology platforms: GenSys®—Remote Continuous Power for Light Commercial and Residential Applications—We plan to continue to develop GenSys® into a platform that is expected to support a number of products, including systems fueled by liquefied petroleum gas, or LPG, for remote applications and, eventually, both grid independent and grid-connected light commercial and residential applications fueled by LPG or natural gas. In connection with the development of our GenSys® platform, we are developing combined heat and power fuel cell systems for light commercial and residential applications that provide supplemental heat as electricity is produced. We began field-testing of the next generation GenSys®, our continuous run product, in the third quarter of 2005. See “Distribution, Marketing and Strategic Relationships” for additional information regarding product development and commercialization. Home Energy Station—We have been developing technology in support of the automotive fuel cell market under a series of agreements with Honda R&D Co Ltd. of Japan (Honda), a subsidiary of Honda Motor Co., Ltd., under which we have developed, on a joint and exclusive basis, and tested three phases of prototype fuel cell systems that provide electricity and heat to a home or business, while also providing hydrogen fuel for a fuel cell vehicle (named the Home Energy Station). Since 2003, we have successfully demonstrated three successive prototype generations of the Home Energy Station at Honda R&D Americas’ facility in Torrance, California and at Plug Power’s facility in Latham, NY. The companies are currently collaborating on the fourth generation prototype Home Energy Station pursuant to the latest agreement signed in early 2006. Across each generation of the Home Energy Station, we have significantly reduced size and weight, as well as improved performance. See “Distribution, Marketing and Strategic Relationships” for additional information regarding product development and commercialization. GenDrive™— Through our recent acquisitions of Cellex and General Hydrogen, we are pursuing development and commercialization of fuel cell motive power units that provide power for electric lift trucks and other mobile industrial equipment for which lead-acid batteries are the incumbent technology. Our fuel cell motive power units allow users to increase productivity and reduce operating costs through a quick hydrogen refueling process that eliminates the need to change batteries repeatedly throughout the day. They also eliminate the environmental and safety issues traditionally associated with lead-acid batteries. Distribution, Marketing and Strategic Relationships We have developed an extended enterprise by forming strategic relationships with well-established companies in key areas including distribution, marketing, supply, technology development and product development. As part of our sales and marketing strategy, we have built a network of leading distributors who have established relationships and sub-distributor networks that can distribute and service our products in specific geographic or market segments. We have 17 distribution agreements in place, including agreements with Tyco, our largest North American distribution partner, and IST, our distribution partner in South Africa with whom we jointly received a $3 million grant from the International Finance Corporation in 2005. We have continuing strategic partnerships and have established strong supply-chain relationships with several companies some of which described in greater detail below. Telecommunications Consultants India Ltd. (TCIL): In April 2007, the Company announced a non-exclusive agreement with TCIL to market, distribute and service Plug Power’s GenCore® product line to government entities in India and specific TCIL projects outside of India. Consistent with the Company’s sales and marketing strategy, TCIL will seek opportunities for the GenCore product line to support existing projects it is developing globally as well as government-owned telecommunications providers in India, where the need for reliable, extended-run backup power is critical. The telecommunications market in India is growing at a rate of four million subscribers per month due largely to the rapid expansion of wireless networks. The growth of the market, combined with a relatively fragile utility grid, creates strong opportunities for Plug Power’s clean, reliable backup and primary-power fuel cells to support the nation’s telecommunications infrastructure. General Electric Company (GE) Entities: In March 2006, the Company, GE MicroGen, Inc. (“GE MicroGen”) a wholly-owned subsidiary of General Electric Company (“GE”), and GE restructured their service and equity relationships by terminating the joint venture, GE Fuel Cell Systems (“GEFCS”), and the associated distributor and other agreements, and entering into a new development collaboration agreement. Under the new agreement, the Company and GE (through its Global Research unit) have agreed to collaborate on programs including, but not limited to, development of tools, materials and components that can be applied to various types of fuel cell products. The specific programs to be undertaken under the agreement, and the detailed terms and conditions thereof, remain subject to agreement by both parties. It is anticipated that such programs could also include collaboration on sales and marketing opportunities for the Company’s products. Under the terms of the new development collaboration agreement, the Company is obligated to purchase $1 million of services from GE prior to December 31, 2008. The development collaboration agreement is scheduled to terminate on the earlier of (i) December 31, 2014 or (ii) upon completion of a certain level of program activity. Tyco: In September 2004, we completed an agreement with Tyco to market, promote and sell our GenCore® 5T fuel cell systems for telecommunication backup applications under both the Tyco Electronics and Plug Power brands through its direct sales force. The Company is party to a nationwide service and installation agreement for GenCore® with Tyco Electronics Installation Services Inc. Honda: We have an agreement with Honda to exclusively and jointly develop and test the Home Energy Station. We expect our current contract with Honda to continue into mid-2007 to fund our joint development of the fourth generation Home Energy Station. We also have an agreement with Honda to fund joint research and development of technology that may be utilized in future systems; we have completed our work under this agreement and are in the process of preparing a final report for Honda. BASF: Our joint development agreement with BASF to develop, on an exclusive basis for certain applications, a high temperature membrane electrode unit, or MEU, for stationary fuel cell systems expired on June 30, 2006. We continue to work with BASF on a nonexclusive basis under a project funded by the European Commission. We also have an agreement with BASF for the development and supply of advanced catalysts to increase the overall performance and efficiency of our fuel processor. The supply agreement with BASF specifies the rights and obligations for BASF to supply products to us until 2013. Vaillant: We are working with Vaillant GmbH, a major supplier of residential heating equipment in Europe, as part of a consortium to develop a residential combined heat and power system incorporating the high-temperature MEU from BASF. DTE Energy: We have an exclusive distribution agreement with DTE Energy for the states of Michigan, Ohio, Illinois, and Indiana. Under the agreement, we can sell directly or negotiate nonexclusive distribution rights to third parties for our GenCore® backup power product line. We have agreed to pay a 5% commission for sales of GenCore® based on sales price of units shipped to third parties in the above noted states. The distribution agreement expires on December 31, 2014. Comparison of the Three Months Ended March 31, 2007 and March 31, 2006. Product and service revenue. Product and service revenue decreased to $462,000 for the three months ended March 31, 2007, from $857,000 for the three months ended March 31, 2006, primarily due to the timing of revenue recognition for certain previously shipped systems where revenue became fully recognized prior to the three months ended March 31, 2007 and for units shipped and installed during the first quarter of 2007. We defer recognition of product and service revenue at the time of delivery and recognize revenue as the continued service, maintenance and other support obligations expire. However, if the warranty or service period is expected to exceed the contractual warranty/service period the deferred revenue would be recognized over that expected longer warranty/service period and may not begin until units are installed. Many of our initial sales of GenSys® and GenCore® 5T products contain multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support. While contract terms generally require payment shortly after delivery or installation (with respect to certain consignment sales) of the fuel cell system and are not contingent on the achievement of specific milestones or other substantive performance, the multiple obligations within our contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence of fair value of the different components. As a result, we defer recognition of product and service revenue and recognize revenue on a straight-line basis as the continued service, maintenance and other support obligations expire, which are generally for periods of twelve to thirty months. However, if the warranty or service period is expected to exceed the contractual warranty/service period the deferred revenue would be recognized over that expected longer warranty/service period and recognition of revenue may not begin until units are installed. During the three months ended March 31, 2007, we shipped 41 GenCore® systems and released from consignment 28 of a total of 43 units on consignment at December 31, 2006, and began recognizing product and service revenue for this current year activity in the amount of $68,000. We also recognized $394,000 of revenue deferred at December 31, 2006. This compares to 15 GenCore® systems shipped for the three months ended March 31, 2006, during which we recognized $143,000 of product and service revenue against 2006 deliveries and $714,000 of revenue deferred at December 31, 2005. During the three months ended March 31, 2007 and 2006, we invoiced $1.1 million and $449,000, respectively, for the delivery of fuel cell systems and the release of units that were on consignment and recognized revenue of $462,000 and $857,000, respectively. Any differences between the amounts invoiced and the recognized revenue is a result of deferred revenue recognized in accordance with our revenue recognition policy as described above. Research and development contract revenue. Research and development contract revenue increased to $2.2 million for the three months ended March 31, 2007 compared to $1.4 million during the same period last year. The net change is the result of spending levels increasing for material purchases and subcontractor activity as the U.S. Department of Energy, the U.S. Department of Defense, the New York State Energy Research and Development Authority, and NASA have begun new programs and there is decreased activity under our contracts with the National Institute of Standards and Technology and with Honda R&D Co., Ltd. of Japan. Research and development contract revenue primarily relates to cost reimbursement research and development contracts associated with the development of PEM fuel cell technology. We generally share in the cost of these programs, with our cost-sharing percentages being between 20% and 51% of total project costs. We also have fixed fee contracts in 2007. Revenue from “time and material” contracts is recognized on the basis of hours expended plus other reimbursable contract costs incurred during the period. We expect to continue certain research and development contract work that is directly related to our current product development efforts. Cost of product and service revenue. Cost of product and service revenue increased to $1.7 million for the three months ended March 31, 2007 from $1.2 million for the three months ended March 31, 2006. Cost of product and service revenue includes the direct material cost incurred in the manufacture of the products we sell, which costs are recognized when units are shipped, as well as the labor and material costs incurred for product maintenance, replacement parts and service under our contractual obligations, which are recognized as incurred. These costs consist primarily of production materials and fees paid to outside suppliers for subcontracted components and services. The increase is primarily due to the increase in shipments and installations and increased direct material costs during the quarter ended March 31, 2007 compared to the same quarter last year. For the three months ended March 31, 2007 we installed 63 units compared with 28 units for the three months ended March 31, 2006. Cost of research and development contract revenue. Cost of research and development contract revenue increased to $2.7 million for the three months ended March 31, 2007 from $2.5 million for the three months ended March 31, 2006 as a result of the new contracts for 2007 offset by decreased work under existing agreements as described above. Cost of research and development contract revenue includes costs associated with research and development contracts including compensation and benefits for engineering and related support staff, fees paid to outside suppliers for subcontracted components and services, fees paid to consultants for services provided, materials and supplies used and other directly allocable general overhead costs allocated to specific research and development contracts. Noncash research and development expense. Noncash research and development expense for the three months ended March 31, 2007, increased to $876,000 from $663,000 during the same period last year. Noncash research and development expense represents the recognition of the fair value of stock grants to employees, consultants and others in exchange for services provided over the applicable vesting periods. Other research and development expense. Other research and development expenses were $8.4 million for the three months ended March 31, 2007 compared to $8.3 million for the three months ended March 31, 2006. These costs are associated with our efforts to advance the development of our next generation continuous run product combined with continued research and development activities related to future product initiatives. Other research and development expense includes materials to build development and prototype units, cash compensation and benefits for the engineering and related staff, expenses for contract engineers, fees paid to outside suppliers for subcontracted components and services, fees paid to consultants for services provided, materials and supplies consumed, facility related costs such as computer and network services and other general overhead costs. Noncash general and administrative expense. Noncash general and administrative expenses for the three months ended March 31, 2007 increased to $513,000 from $195,000 for the three months ended March 31, 2006. Noncash general and administrative expense represents the recognition of the fair value of stock grants to employees, consultants and others in exchange for services provided over the applicable vesting periods. Other general and administrative expense. Other general and administrative expense increased to $3.5 million for the three months ended March 31, 2007 from $2.2 million for the three months ended March 31, 2006 primarily as a result of increased sales activities and costs related to the corporate reorganization announced in February 2007. Other general and administrative expense includes cash compensation, benefits and related costs in support of our general corporate functions, including general management, finance and accounting, human resources, marketing, information technology and legal services. Interest income and net realized gains/(losses) from available-for-sale securities. Interest income and net realized gains/losses from the sale of available-for-sale securities, consisting primarily of interest earned on our cash, cash equivalents and available-for-sale securities, increased to $3.9 million for the three months ended March 31, 2007 from $823,000 for the three months ended March 31, 2006. The increase was the result of higher cash and marketable securities balances as a result of the sale of our Class B capital stock to Smart Hydrogen Inc. in June of 2006. Total net realized gains from available-for-sale securities was approximately $54,000 and $12,000 for the three months ended March 31, 2007 and 2006, respectively. Interest expense. Interest expense was $49,000 for the three months ended March 31, 2006. Interest expense consisted of interest on our long-term obligation related to the purchase of real estate and interest paid on capital lease obligations. As of December 31, 2006, all of the Company’s debt and capital lease obligations were paid in full. Income taxes. We did not report a benefit for federal and state income taxes in the consolidated financial statements as the deferred tax asset generated from our net operating loss has been offset by a full valuation allowance because it is more likely than not that the tax benefits of the net operating loss carryforward will not be realized. Critical Accounting Policies and Estimates The preparation of financial statements in conformity with generally accepted accounting principles and related disclosure requires management to make estimates and assumptions that affect: the amounts reported for assets and liabilities; the disclosure of contingent assets and liabilities at the date of the financial statements; and the amounts reported for revenues and expenses during the reporting period. Specifically, we must use estimates in determining the economic useful lives of assets, including identifiable intangibles, and various other recorded or disclosed amounts. Therefore, our financial statements and related disclosure are necessarily affected by these estimates. We evaluate these estimates on an ongoing basis, utilizing historical experience and other methods considered reasonable in the particular circumstances. Nevertheless, actual results may differ significantly from estimates. To the extent that actual outcomes differ from estimates, or additional facts and circumstances cause management to revise estimates, our financial position or results of operations as reflected in our financial statements will be affected. Any effects on business, financial position or results of operations resulting from revisions to these estimates are recorded in the period in which the facts that give rise to the revision become known. We believe that the following are our most critical accounting policies affected by the estimates and assumptions the Company must make in the preparation of its financial statements and related disclosure: Revenue recognition: We are a development stage enterprise in the stages of performing field testing and marketing our initial commercial product to a limited number of customers, including telecom, utilities, government entities and our distribution partners. This product is a limited edition fuel cell system that is intended to offer complementary, quality power while demonstrating the market value of fuel cells as a preferred form of alternative distributed power generation. Subsequent enhancements to our initial product are expected to expand the market opportunity for fuel cells by lowering the installed cost, decreasing operating and maintenance costs, increasing efficiency, improving reliability, and adding features such as grid independence and co-generation and UPS applications. We apply the guidance within Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (SAB 104) to our initial sales contracts to determine when to properly recognize revenue. Our initial sales of GenSys® and GenCore® 5T products contain multiple obligations that may include a combination of fuel cell systems, continued service, maintenance and other support. While contract terms generally require payment shortly after delivery or installation of the fuel cell system and are not contingent on the achievement of specific milestones or other substantive performance, the multiple obligations within our contractual arrangements are not accounted for separately based on our limited commercial experience and available evidence of fair value. As a result, we defer recognition of product and service revenue and recognize revenue on a straight-line basis over the contractual service period, which is generally for periods of twelve to thirty months, or over the anticipated service period if expected to exceed the contractual service period. In these instances when it is anticipated that the actual service period will exceed the contractual service period, the accretion of the deferred product and service revenue may not begin until the installation of the unit and will continue through the expected service period. As we gain commercial experience, including field experience relative to service and warranty based on the sales of our initial products, the fair values for the multiple elements within our future contracts may become determinable and we may, in future periods, recognize revenue upon delivery of the product or we may continue to defer recognition, based on application of appropriate guidance within EITF 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” or changes in the manner in which we structure contractual agreements, including our agreements with distribution partners. Valuation of long-lived assets: We assess the impairment of long-lived assets and goodwill, if any, whenever events or changes in circumstances indicate that the carrying value may not be recoverable and, for goodwill, at least annually. Factors we consider important which could trigger an impairment review include, but are not limited to, the following: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of our use of the acquired assets or the strategy for our overall business; significant negative industry or economic trends; significant decline in our stock price for a sustained period; and our market capitalization relative to net book value. When we determine that the carrying value of intangible, long-lived assets and goodwill, if any, may not be recoverable based upon the existence of one or more of the above indicators of impairment, we would measure any impairment based upon the provisions of Statement of Financial Accounting Standards (SFAS) No. 142, “Goodwill and Other Intangible Assets” and SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, as appropriate. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations. Accounting for income taxes: As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves the estimation of our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. Included in this assessment is the determination of the net operating loss carryforward that has resulted from our cumulative net operating loss since inception. These differences, primarily net operating loss carryforwards, result in a net deferred tax asset. We must assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent that we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense or forego a benefit within income taxes in the consolidated statement of operations. Under Section 382 of the Internal Revenue Code (IRC), the use of loss carryforwards may be limited if a change in ownership of a company, as defined by the IRC, occurs. The Company has determined that due to transactions involving the Company’s shares by significant shareholders, a change of ownership has occurred under the provisions of IRC Section 382. As a result of this change of ownership, the usage of a portion, which may be substantial, of the net operating loss amounts, has become limited. The Company is in the process of determining the impact of this limitation. Once determined, the deferred tax asset related to the net operating loss and an equivalent amount of valuation allowance will be adjusted accordingly. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance of $211.7 million as of December 31, 2006 due to uncertainties related to our ability to utilize the net deferred tax assets, primarily consisting of net operating losses and credits which may be carried forward, before they expire. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to adjust the recorded valuation allowance, which could materially impact our financial position and results of operations. At March 31, 2007 and 2006, our net deferred tax assets have been offset in full by a valuation allowance. As a result, the net provision for income taxes is zero for the three month periods ended March 31, 2007 and 2006. The Company adopted the Financial Accounting Standards Board (FASB) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (FIN 48), which clarifies the accounting for uncertainty in tax positions on January 1, 2007. No adjustment of opening balances was required and the adoption of this Interpretation did not have a material impact on the Company’s consolidated financial statements. Stock Based Compensation: Our adoption of SFAS No. 123 (revised 2004), “Share-Based Payment”, or SFAS 123(R), in the first quarter of 2006 required that we recognize stock-based compensation expense associated with the vesting of share based instruments in the statement of operations. Determining the amount of stock-based compensation to be recorded requires us to develop estimates to be used in calculating the grant-date fair value of stock options. We calculate the grant-date fair values using the Black-Scholes valuation model. The Black-Scholes model requires us to make estimates of the following assumptions: Expected volatility—The estimated stock price volatility was derived based upon a blend of implied volatility (i.e. management’s expectation of volatility) and the Company’s actual historical stock prices over the expected life of the options, which represents the Company’s best estimate of expected volatility. Expected option life—The Company’s estimate of an expected option life was calculated in accordance with the Staff Accounting Bulletin No. 107 (“SAB 107”) simplified method for calculating the expected term assumption. The simplified method is a calculation based on the contractual life of the associated options. The Company will be required to utilize actual historical data to determine the expected option life beginning in 2008. Risk-free interest rate—We used the yield on zero-coupon U.S. Treasury securities for a period that is commensurate with the expected life assumption as the risk-free interest rate. The amount of stock-based compensation recognized during a period is based on the value of the portion of the awards that are ultimately expected to vest. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. The term “forfeitures” is distinct from “cancellations” or “expirations” and represents only the unvested portion of the surrendered option. We reviewed historical forfeiture data and determined the appropriate forfeiture rate based on that data. We will re-evaluate this analysis periodically and adjust the forfeiture rate as necessary. Ultimately, we will recognize the actual expense over the vesting period only for the shares that vest. Recent Accounting Pronouncements Our cash requirements depend on numerous factors, including completion of our product development activities, ability to commercialize our on-site energy products, market acceptance of our systems and other factors. We expect to devote substantial capital resources to continue our development programs directed at commercializing our on-site energy products for worldwide use, hiring and training our production staff, develop and expand our manufacturing capacity and continue expanding our production and our research and development activities. We expect to pursue the expansion of our operations through internal growth and strategic acquisitions and expect that such activities will be funded from existing cash and cash equivalents, issuance of additional equity or debt securities or additional borrowings subject to market and other conditions. The failure to raise the funds necessary to finance our future cash requirements or consummate future acquisitions could adversely affect our ability to pursue our strategy and could negatively affect our operations in future periods. We anticipate incurring substantial additional losses over at least the next several years and believe that our current cash, cash equivalents and available-for-sale securities balances will provide sufficient liquidity to fund operations for at least the next twelve months. Several key indicators of liquidity are summarized in the following table: Year ended Unrestricted cash, cash equivalents and available-for-sale securities at end of period $ 251,371 $ 86,266 $ 269,123 Working capital at end of period 257,470 85,527 267,002 542 332 1,275 During the three months ended March 31, 2007, cash used by operating activities was $10.8 million, consisting primarily of a net loss of $11.2 million offset, in part, by noncash expenses in the amount of $2.2 million, including $0.8 million for depreciation and amortization and $1.4 million for stock-based compensation awards. Cash provided by investing activities for the three months ended March 31, 2007 was $56.8 million, consisting of $58.8 million in net proceeds from available-for-sale securities to accommodate the acquisition of Cellex offset by $542,000 used to purchase property, plant and equipment and $1.5 million in notes receivable. We have financed our operations through March 31, 2007 primarily from the sale of equity, which has provided cash in the amount of $635.7 million. Since inception, net cash used in operating activities has been $359.1 million, and cash used in investing activities has been $196.8 million, including our purchase of property, plant and equipment of $34.5 million and our investments in available-for-sale securities in the amount of $178.4 million offset, in part, by net proceeds from acquisition of $29.5 million. On April 3, 2007 Plug closed its previously announced acquisition of Cellex. The Company purchased all of the outstanding capital stock of Cellex from its equity holders for an aggregate cash purchase price of $45.0 million. On May 7, 2007, the Company announced the acquisition of General Hydrogen. The Company paid approximately $10.0 million, consisting of approximately $7.0 million in cash and the settlement of $3.0 million in senior secured loans previously made by the Company to General Hydrogen, for all of the outstanding capital stock of General Hydrogen. In addition, the shareholders of General Hydrogen received warrants to purchase up to 571,429 shares of the Company’s Common Stock. The warrants become exercisable when the Company’s Common Stock trades at a volume weighted average price of $7.00 or more for 10 consecutive trading days. The warrants carry an exercise price of $.01 per share and expire four years from the date of issuance. From inception through March 31, 2007, we have incurred losses of $468.6 million and expect to continue to incur losses as we continue our product development and commercialization programs and expand our manufacturing capacity. We expect that losses will fluctuate from quarter to quarter and that such fluctuations may be substantial as a result of, among other factors, the number of systems we produce, deliver, and install, the cost and sales price of such systems, the related service requirements necessary to maintain those systems and potential design changes required as a result of field testing. ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We invest our excess cash in government, government-backed and interest-bearing investment-grade securities that we generally hold for the duration of the term of the respective instrument. We do not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, we believe that, while the investment-grade securities we hold are subject to changes in the financial standing of the issuer of such securities, we are not subject to any material risks arising from changes in interest rates, foreign currency exchange rates, commodity prices, equity prices or other market changes that affect market risk-sensitive instruments. ITEM 4—CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures As required by Rule 13a-15(b) under the Securities and Exchange Act of 1934, our management, including the Chief Executive Officer and Interim Chief Financial Officer, conducted an evaluation as of the end of the period covered by this report, of the effectiveness of the Company’s disclosure controls and procedures as defined in Exchange Act Rule 13a-15(e). Based on that evaluation, the Chief Executive Officer and Interim Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. (b) Changes in internal controls over financial reporting As required by Rule 13a-15(d) under the Securities Exchange Act of 1934, our management, including the Chief Executive Officer and Interim Chief Financial Officer, also conducted an evaluation of the Company’s internal control over financial reporting to determine whether any changes occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. Based on that evaluation, there has been no such change during the period covered by this report. ITEM 1A—RISK FACTORS The following risk factors are in addition to those included in our Annual Report on Form 10-K filed for the year ended December 31, 2006: We may not successfully integrate our acquisitions of Cellex Power Products, Inc. and General Hydrogen Corporation. We must be able to successfully manage and integrate our acquisitions of Cellex Power Products, Inc. and General Hydrogen Corporation. Specifically, we must be able to integrate these acquisitions without any significant disruption to our ability to manage and execute our business plan. In addition, our financial results could be adversely impacted if we are not able to deliver the expected cost and growth synergies associated with these acquisitions. ITEM 2—UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS During the three months ended March 31, 2007, we issued 70,825 shares of our common stock in connection with matching contributions under our 401(k) Savings & Retirement Plan. The issuance of these shares is exempt from registration under Section 3(a)(2) of the Securities Act of 1933, as amended. ITEM 6—EXHIBITS Amended and Restated Certificate of Incorporation of Plug Power Inc. (1) Certificate of Designations of Class B Capital Stock, a series of preferred stock, of Plug Power Inc. (2) Amended and restated By-laws of Plug Power Inc. (2) Certificate of Amendment of the Amended and Restated Certificate of Incorporation of Plug Power Inc. (3) Plug Power Executive Incentive Plan (4) 31.1 and 31.2 Certifications pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (5) Certifications pursuant to 18 U.S.C. Section 1350, adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (5) (1) Incorporated by reference to the Company’s Form 10-K for the period ending December 31, 1999 (2) Incorporated by reference to the Company’s current Report on Form 8-K dated June 29, 2006 (4) Incorporated by reference to the Company’s current Report on Form 8-K dated February 23, 2007 (5) Furnished herewith Pursuant to requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: May 10, 2007 by: /s/ Roger B. Saillant Roger B. Saillant /s/ Robert P. Powers Robert P. Powers Corporate Controller

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professional_accounting

CAPITAL GOLD CORP Form 10QSB FORM 10-QSB |X| QUARTERLY REPORT UNDER SECTION 13 OR 15(d) For the quarterly period ended April 30, 2004 |_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) For the transition period from to Commission File Number: 0-13078 CAPITAL GOLD CORPORATION (Exact name of small business issuer as specified in its charter) NEVADA 13-3180530 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 76 Beaver Street, 26TH floor, New York, NY 10005 Issuer's telephone number: (212) 344-2785 (Former name, former address and former fiscal year, if changed since last report) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| Indicate the number of shares outstanding of each of the issuer's classes of common equity as of the latest practicable date. Class Outstanding at June 15, 2004 ---------------------- ---------------------------- Common Stock, par value $.001 per share 58,188,423 Transitional Small Business Format (check one); Yes |_| No |X| PART I. FINANCIAL INFORMATION Item 1. Financial Statements The accompanying financial statements are unaudited for the interim periods, but include all adjustments (consisting only of normal recurring accruals), which we consider necessary for the fair presentation of results for the three and nine months ended April 30, 2004. Moreover, these financial statements do not purport to contain complete disclosure in conformity with generally accepted accounting principles and should be read in conjunction with our audited financial statements at, and for the fiscal year ended July 31, 2003. The results reflected for the three and nine months ended April 30, 2004 are not necessarily indicative of the results for the entire fiscal year. (A DEVELOPMENT STAGE ENTERPRISE) CONDENSED CONSOLIDATED BALANCE SHEET Cash and Cash Equivalents $ 387,359 Loans Receivable - Related Party 23,787 Loans Receivable - Others 17,390 Other Current Assets 12,703 Prepaid Expenses 11,364 Marketable Securities 35,000 Total Current Assets 487,603 Mining, Milling and Other Property and Equipment (Net of Accumulated Depreciation of $358,230) 344,780 Other Investments 23,466 Mining Reclamation Bonds 35,550 Security Deposits 9,599 Total Other Assets 68,615 Total Assets $ 900,998 LIABILITIES AND STOCKHOLDERS' EQUITY Accounts Payable $ 11,368 Accrued Expenses 71,925 Total Current Liabilities 83,293 Stockholders' Equity: Common Stock, Par Value $.001 Per Share; Authorized 150,000,000 Shares; Issued and Outstanding 56,279,061 Shares 56,279 Additional Paid-In Capital 24,183,165 Deficit Accumulated in the Development Stage (23,424,660) Accumulated Other Comprehensive Income (Loss) 2,921 Total Stockholders' Equity 817,705 Total Liabilities and Stockholders' Equity $ 900,998 The accompanying notes are an integral part of the financial statements. CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS For The Period Three Months Ended Nine Months Ended September 17,1982 April 30, April 30, (Inception) ---------------------------- ---------------------------- To 2004 2003 2004 2003 April 30, 2004 ------------ ------------ ------------ ------------ -------------- Interest Income $ 2,254 $ 1,325 $ 3,134 $ 28,319 $ 752,575 Miscellaneous -- -- 6,905 7,701 39,582 ------------ ------------ ------------ ------------ ------------ Total Revenues 2,254 1,325 10,039 36,020 792,157 Costs and Expenses: Mine Expenses 85,100 379,172 369,242 828,152 6,508,726 Write-Down of Mining, Milling and Other Property and Equipment -- -- -- -- 999,445 Selling, General and Administrative Expenses 158,294 195,561 491,822 499,772 8,662,029 Stock Based Compensation 900 132,201 34,934 207,554 8,877,904 Loss on Joint Venture 800,000 -- 800,000 -- 901,700 Depreciation -- -- -- -- 367,726 Total Costs and Expenses 1,044,294 706,934 1,695,998 1,535,478 26,317,530 Loss Before Other Income (Expense) (1,042,040) (705,609) (1,685,959) (1,499,458) (25,525,373) Other Income (Expense): Gain on Sale of Property and Equipment -- -- -- -- 46,116 Gain on Sale of Subsidiary -- -- -- -- 1,907,903 Option Payment -- -- -- -- 70,688 Loss on Write-Off of Investment -- -- -- -- (10,000) Loss on Option -- -- -- -- (50,000) Loss on Write-Off of Minority Interest (150,382) -- (150,382) -- (150,382) Total Other Income (Expense) (150,382) -- (150,382) -- 1,814,325 Loss Before Minority Interest (1,192,422) (705,609) (1,836,341) (1,499,458) (23,711,048) Minority Interest in Net Loss of Subsidiary -- 20,119 51,220 78,464 286,388 Net Loss $ (1,192,422) $ (685,490) $ (1,785,121) $ (1,420,994) $(23,424,660) ============ ============ ============ ============ ============ Net Loss Per Common Share - Basic and Diluted $ (0.02) $ (0.02) $ (0.04) $ (0.03) ============ ============ ============ ============ Weighted Average Common Shares Outstanding 54,914,470 40,837,405 50,019,933 41,311,671 CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS For The Nine For The Period Months Ended September 17, 1982 April 30, (Inception) ----------------------------- To 2004 2003 April 30, 2004 ------------ ------------ -------------- Cash Flow From Operating Activities: Net Loss $ (1,785,121) $ (1,420,994) $(23,424,660) Adjustments to Reconcile Net Loss to Net Cash (Used) By Operating Activities: Depreciation -- -- 367,726 Gain on Sale of Subsidiary -- -- (1,907,903) Minority Interest in Net Loss of Subsidiary (51,220) (78,464) (286,388) Write-Down of Impaired Mining, Milling and Other Property and Equipment -- -- 999,445 Gain on Sale of Property and Equipment -- -- (46,116) Loss on Write-Off of Investment -- -- 10,000 Loss From Joint Venture 800,000 -- 901,700 Write Off of Minority Interest 150,382 -- 150,382 Value of Common Stock Issued for Services 900 -- 2,813,893 Stock Based Compensation 34,034 207,554 8,877,004 (Increase) Decrease in Other Current Assets 2,275 (58,038) (12,703) (Increase) in Security Deposits (1,164) -- (9,599) (Increase) in Prepaid Expenses (1,337) -- (11,364) Increase (Decrease) in Accounts Payable (120,649) (2,799) 3,561 (Decrease) in Accrued Expenses (55,596) (18,095) (55,868) ------------ ------------ ------------ Net Cash (Used) By Operating Activities (1,027,496) (1,370,836) (11,630,890) Cash Flow From Investing Activities: Purchase of Mining, Milling and Other Property and Equipment -- -- (1,705,650) Proceeds on Sale of Mining, Milling and Other Property and Equipment -- -- 83,638 Proceeds From Sale of Subsidiary -- 1,492,131 2,131,616 Expenses of Sale of Subsidiary -- -- (101,159) Advance Payments - Joint Venture -- -- 98,922 Investment in Joint Venture -- -- (101,700) Investment in Privately Held Company -- -- (10,000) Net Assets of Business Acquired (Net of Cash) -- -- (42,130) Purchase of Marketable Securities -- (50,000) (50,000) Purchase of Other Investments (10,584) (12,882) (23,466) Net Cash Provided (Used) By Investing Activities (10,584) 1,379,249 280,071 For the Six For The Period Months Ended September 17, 1982 ----------------------------- To 2004 2003 April 30, 2004 ------------ ------------ -------------- Cash Flow From Financing Activities: (Increase) in Loans Receivable - Related Party $ (3,607) $ -- $ (23,787) (Increase) Decrease in Loans Receivable - Others 975 (41,465) (17,390) Increase in Loans Payable - Officers -- -- 18,673 Repayment of Loans Payable - Officers -- -- (18,673) Increase in Note Payable -- -- 11,218 Payments of Note Payable -- -- (11,218) Proceeds From Issuance of Common Stock 1,067,448 30,800 11,850,549 Commissions on Sale of Common Stock -- -- (5,250) Expenses of Initial Public Offering -- -- (408,763) Capital Contributions - Joint Venture Subsidiary 100,156 80,340 304,564 Purchase of Certificate of Deposit - Restricted -- -- (5,000) Purchase of Mining Reclamation Bond -- -- (30,550) ------------ ------------ ------------ Net Cash Provided By Financing Activities 1,164,972 69,675 11,664,373 Effect of Exchange Rate Changes 14,057 31,769 73,805 Increase (Decrease) In Cash and Cash Equivalents 140,949 109,857 387,359 Cash and Cash Equivalents - Beginning 246,410 149,433 -- Cash and Cash Equivalents - Ending $ 387,359 $ 259,290 $ 387,359 ============ ============ ============ Cash Paid For Interest $ -- $ -- -- Cash Paid For Income Taxes $ -- $ -- $ -- Non-Cash Financing Activities: Issuances of Common Stock as Commissions on Sales of Common Stock $ -- $ -- $ 440,495 Issuance of Common Stock as Payment for Mining, Milling and Other Property and Equipment $ -- $ -- $ 4,500 Transfer of Joint Venture Advance Payments into Joint Venture Capital $ -- $ 98,922 $ 98,922 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 - Basis of Presentation The accompanying unaudited condensed consolidated financial statements include the accounts of Capital Gold Corporation and its subsidiaries, which are wholly and majority owned. All significant inter-company accounts and transactions have been eliminated in consolidation. have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with instructions to Form 10-QSB. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of the Company's management, the accompanying consolidated financial statements reflect all adjustments (which include only normal recurring adjustments) necessary to present fairly the consolidated financial position and results of operations and cash flows for the periods presented. Results of operations for interim periods are not necessarily indicative of the results of operations for a full year. The condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company is a development stage enterprise and has recurring losses from operations and operating cash constraints that raise substantial doubt about the Company's ability to continue as a going concern. NOTE 2 - Marketable Securities The Company accounts for its investments in marketable securities in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Management determines the appropriate classification of all securities at the time of purchase and re-evaluates such designation as of each balance sheet date. The Company has classified its marketable equity securities as available for sale securities and has recorded such securities at fair value. The Company uses the specific identification method to determine realized gains and losses. Unrealized holding gains and losses are excluded from earnings and, until realized, are reported in a separate component of stockholders' equity. Marketable securities are classified as current assets and are summarized Marketable equity securities, at cost $ 50,000 Marketable equity securities, at fair value $ 35,000 NOTE 3 - Other Comprehensive Income (Loss) - Supplemental Non-Cash Investing Other comprehensive income (loss) consists of accumulated foreign translation gains and losses and net unrealized gain on available-for-sale securities and is summarized as follows: Balance - July 31, 2003 $ 53,633 Equity Adjustments from Foreign Currency Translation (15,712) Unrealized Loss on Available-for- Sale Securities (35,000) Balance - April 30, 2004 $ 2,921 NOTE 4 - Other Events - Termination of Joint Venture Agreement On April 6 and 8, 2004, effective March 31, 2004, Minera Santa Rita S. de R.L. de C.V. ("MSR"), one of our wholly-owned Mexican affiliates, and Grupo Minero FG S.A. de C.V. ("FG") executed an agreement (the "Termination Agreement") terminating their joint venture agreement (the "JV Agreement") with regard to the El Chanate project in Mexico. Pursuant to the Termination Agreement, the parties have terminated amicably the JV Agreement and have released each other from all obligations under the JV Agreement. In consideration of FG's contributions to the venture of $457,455, we issued to FG 2,000,000 restricted shares of our common stock valued at $800,000 and MSR issued to FG a participation certificate entitling FG to receive five percent of the MSR's annual dividends, when declared. In connection with the issuance of these 2,000,000 shares, the Company recognized a charge to operations of $800,000. Additionally, the Company has recognized a loss of $150,382 on the write off of the joint venture minority interest. The participation certificate also gives FG the right to participate, but not to vote, in the meetings of MSR's Board of Managers, Technical Committee and Partners. MSR also received a right of first refusal to carry out the works and render construction services required to effectuate the El Chanate project. This right of first refusal is not applicable where a funding source for the project determines that others should render such works or services. FG has agreed to assign or otherwise transfer to MSR all permits, licenses, consents and authorizations (collectively, "authorizations") for which FG had obtained in its name in connection with the development of the El Chanate project to the extent that the authorizations are assignable. If the authorizations are not assignable or other wise transferable, FG has given its consent for the authorizations to be cancelled so that they can be re-issued ore re-granted in MSR's name. The foregoing is in the process of being completed. NOTE 5 - Financing Term Sheet The Company had executed a royalty financing term sheet with Royal Gold, Inc., of Denver, Colorado to supply $13.8 million. Consummation of this funding was subject to due diligence, execution of a definitive agreement, the satisfaction of conditions to be contained therein, and approval by both parties' Directors. During April 2004 the Company and Royal Gold agreed not to proceed because the parties could not agree on final terms. NOTE 6 - Stockholders' Equity During the nine months ended April 30, 2004, the Company sold 10,506,300 shares of common stock to unrelated third party investors for gross proceeds of $1,821,098. Also, during the nine months ended April 30, 2004 the Company issued 572,727 shares of common stock for gross proceeds of $20,600 to related parties upon exercise of options and 515,000 shares of common stock for gross proceeds of $25,750 to an unrelated party upon exercise of options. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Cautionary Statement on Forward-Looking Statements Some information contained in or incorporated by reference into this report on Form 10-QSB may contain "forward-looking statements," as defined in Section 21E of the Securities and Exchange Act of 1934. These statements include comments regarding exploration and mine development and construction plans, costs, grade, production and recovery rates, permitting, financing needs, the availability of financing on acceptable terms or other sources of funding, and the timing of additional tests, feasibility studies and environmental permitting. The use of any of the words "anticipate," "continue," "estimate," "expect," "may," "will," "project," "should," "believe" and similar expressions are intended to identify uncertainties. We believe the expectations reflected in those forward-looking statements are reasonable. However, we cannot assure you that these expectations will prove to be correct. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of the risk factors set forth below and other factors set forth in, including the section "Issues and Uncertainties" below, or incorporated by reference into, this report: o worldwide economic and political events affecting the supply of and demand for gold; o volatility in market prices for gold and other metals; o financial market conditions, and the availability of debt or equity financing on terms acceptable to us; o uncertainties as to whether additional drilling, testing and feasibility studies will establish reserves at any of our properties; o uncertainties associated with developing a new mine, including potential cost overruns and the unreliability of estimates in early states of mine development; o uncertainties as to title to our properties and the availability of sufficient properties to allow for planned activities at El Chanate in Mexico and at Leadville in Colorado. o variations in ore grade and other characteristics affecting mining, crushing, milling and smelting operations and mineral recoveries; o geological, metallurgical, technical, permitting, mining and processing problems; o the availability and timing of acceptable arrangements for power, transportation, mine construction, contract mining, water and smelting; the availability, terms conditions and timing of required government approvals; o uncertainties regarding future changes in tax and foreign-investment legislation or implementation of existing tax and foreign-investment legislation; o the availability of experienced employees; and o political instability, violence and other risks associated with operating in a country like Mexico with a developing economy. Many of those factors are beyond our ability to control or predict. You should not unduly rely on these forward-looking statements. These statements speak only as of the date of this report on Form 10-QSB. Except as required by law, we are not obligated to publicly release any revisions to these forward-looking statements to reflect future events or developments. All subsequent written and oral forward-looking statements attributable to us and persons acting on our behalf are qualified in their entirety by the cautionary statements contained in this section and elsewhere in this report on Form 10-QSB. Results of Operation Sonora, Mexico During the quarter ended April 30, 2004, we continued to analyze the El Chanate concessions in Mexico. Our property holdings there consist of 14 contiguous, high priority concessions totaling approximately 3,497 hectares (8,642 acres or 13.5 square miles). Further exploration and development of the El Chanate project, assuming it is economically feasible, will mostly occur on these concessions owned by us. We also own outright 466 hectares (1,151 acres or 1.8 square miles) of surface rights at El Chanate and no third party ownership or leases exist on this fee land or the El Chanate concessions. In August 2003, M3 Engineering of Tucson, Arizona completed a feasibility study (the "Study") on the El Chanate concessions. Based on 253 drill holes and more than 22,000 gold assays, the study provides details for an open pit gold mine. The Study indicates that the initial open pit project contains proven and probable reserves of 358,000 ounces of gold within 13.5 million metric tonnes of ore with an average grade of 0.827 grams/tonne. It estimated that the mine could recover approximately 48,000 - 50,000 ounces of gold per year over a five year mine life. The study assumes a production rate of 2.6 million tonnes of ore per year or 7,500 tonnes per day, operating at 345 days per year. The processing plan for this open pit heap leach gold project calls for crushing the ore to 100% minus 3/8 inch. Carbon columns will be used to recover the gold. If financing for the project is obtained and if the necessary plant, equipment and facilities are acquired, an adequate water supply is secured, and power lines to the mine are constructed, we anticipate, but cannot assure, that the mine will commence commercial production in 2005. Based on the current reserve calculations, the mine life is estimated to be 62 months. The study forecasts initial capital costs of $13.8 million, which includes $2.1 million of working capital. Average initial annual production is planned at approximately 50,000 ounces per year at an average operating cash cost of $229 per ounce. This cash cost may decrease as the production rate increases. Total costs will vary depending upon the price of gold (due to the nature of underlying payment obligations to the original owner of the property); they are estimated to range between $292 per ounce at a gold price of $310/ounce and $299 per ounce at a gold price of $370 per ounce. We will be working on measures to attempt to reduce costs going forward. Reserves and production rates are based on a gold price of $325 per ounce, which is the Base Case of the Management believes that the capital costs to establish a surface, heap leach mining operation at El Chanate will be approximately $13.8 million. Financing is being sought through bank loans, equity and/or royalty arrangements. In this regard, we had executed a royalty financing term sheet with Royal Gold, Inc., of Denver, Colorado to supply the $13.8 million, as specified in the Study. However, in April 2004, we and Royal Gold mutually agreed not to proceed because the parties could not agree on final terms. We believe that equity financing may provide certain attractive alternative sources of project funding and we are exploring those possibilities. Unless and until we obtain adequate financing on acceptable terms, we will not be able to move forward with full-scale construction of the mine. There can be no assurance that adequate equity or debt financing can be attained. Management believes the project will benefit substantially from rising gold prices, which are currently in the $390 per ounce range. Mineralized material previously below operating cut-off gold grades, could possibly become economic if future engineering studies support lowering the cutoff grade due to gold prices substantially above the $325 per ounce used in the feasibility study to define the proven and probable reserves mentioned above. We are currently looking at equipment and processing techniques that may be capable of supporting higher production rates. In this regard, Metcon Research Inc. of Tucson, Arizona is completing studies of gold recoveries on existing samples at fine grind sizes of 100 mesh, 150 mesh and 200 mesh and will prepare a report of its findings. These studies have been undertaken to determine whether extraction by fine grinding is economical given the elevated price of gold. Generally, fine grinding, while more expensive, can achieve higher gold recoveries than the heap leach method recommended in the feasibility study. However, M3, who conducted the feasibility study for us, recently informed us that heap leaching remains the most economical method of extraction at current gold prices. In addition, we recently completed further core drilling (three holes for 657 meters) to validate the reverse circulation drilling in the deeper levels of the deposit. We are expecting assays from this core drilling program. If the results are sufficiently positive, we plan on having our feasibility study updated. Should the results be positive, no assurance can be given that additional reserves will be identified. In January 2004, we received the permits from the Mexican Department of Environmental Affairs and Natural Resources necessary to begin construction of the El Chanate gold mining project. These permits also cover the operation of a heap-leach gold recovery system. Effective March 31, 2004, by mutual agreement, Minera Santa Rita S. de R.L. de C.V. ("MSR"), one of our wholly-owned Mexican affiliates, and FG terminated their joint venture agreement. For information, please see "Liquidity and Capital Resources; Plan of Operations" below. Leadville, Colorado During the nine months ended April 30, 2004, as during the prior fiscal year ended July 31, 2003, activity at our Leadville, Colorado properties consisted principally of mine maintenance. Primarily as a result of our focus on El Chanate, we temporarily reduced to a minimum activity in Leadville, Colorado. Between November 1, 2002 and December 1, 2003, we conditionally acquired 61 properties in Leadville, Colorado having a gross acreage of approximately 623 acres. Some of the properties are classified as residential and others are classified as mining. All were purchased at the Lake County, Colorado, tax sale for the back taxes due on the properties. We paid an aggregate of approximately $19,400 for the properties. Of these properties, we let 9 lapse and, with regard to 8 of these properties, we were paid off by the property owners and we received back our payments for these properties, plus interest at 10%. If a property owner does not pay his property taxes the county treasurer has the right to put the property up for auction at an advertised county tax sale. Sometimes, the property owner will ask the treasurer to postpone the auction of the property for a year with the promise to pay soon. If taxes are still not paid, the auction bidder will be required to pay two years of taxes. If we pay the 'back taxes' and then 'current year' taxes for four consecutive years our ownership of a given property purchased at tax sale is final, and the deed is transferred to us. If the property owner can pay the back taxes, he is required to pay us the back taxes plus interest. The current back tax interest rate is 12% in Lake County. We acquired these properties, especially the residential properties, as an investment. We are not required to commit to any work or maintenance on any of the properties at this time. Management believes that these are good investments. The mining properties are located in the general area of our other mining properties. There is a possibility that at some future date the zoning for the mining claims will be changed to allow residential development. Management believes that, at such time, these properties will most likely become more valuable due to their scenic location. In the time prior to any zoning change, these properties may have mineral value; however, we have no current plans to explore these mining properties. We generated no revenues from mining operations during the three or nine months ended April 30, 2004 and 2003. There were de minimis non-operating revenues during the three months ended April 30, 2004 and 2003 of approximately $2,254 and $1,325, respectively. There were de minimis non-operating revenues during the nine months ended April 30, 2004 and 2003 of approximately $10,039 and $36,000, respectively. These non-operating revenues primarily represent interest Costs and Expenses Over all costs and expenses during the three months ended April 30, 2004 ($1,044,294) increased by $337,360 (approximately 48%) from the three months ended April 30, 2003 ($706,934). Over all costs and expenses during the nine months ended April 30, 2004 ($1,695,998) increased by $160,520 (approximately 10%) from the nine months ended April 30, 2003 ($1,535,478). The primary reason for the increase in overall costs and expenses during the three months ended April 30, 2004 was the loss incurred on our joint venture with FG, offset by significantly reduced mine expenses and stock based As discussed above in Note 4 to our Condensed Consolidated Financial Statements, effective March 31, 2004, the joint venture agreement with FG was terminated. In consideration of FG's contributions to the venture of $457,455, we issued to FG 2,000,000 restricted shares of our common stock valued at $800,000 and MSR issued to FG a participation certificate entitling FG to receive five percent of the MSR's annual dividends, when declared. In connection with the issuance of these 2,000,000 shares, the Company recognized a one-time charge to operations of $800,000. This charge represents the cost of acquiring FG's interest in the joint venture. Mine expenses during the three months ended April 30, 2004 ($85,100) decreased by $294,072 (approximately 78%) from the three months ended April 30, 2003 ($379,172). Mine expenses during the nine months ended April 30, 2004 ($369,242) decreased by $458,910 (approximately 55%) from the nine months ended April 30, 2003 ($828,152). We believe that the decrease in mine expenses resulted primarily from less physical activity on the property due to our major efforts being directed at locating development funding to fully develop the project less available capital and termination of our joint venture agreement. Selling, general and administrative expenses during the three months ended April 30, 2004 ($158,294) decreased by $37,267 (approximately 19%) from the three months ended April 30, 2003 ($195,561). Selling, general and administrative expenses during the nine months ended April 30, 2004 ($491,822) decreased by $7,950 (approximately 2%) from the nine months ended April 30, 2003 ($499,772). We believe that the decrease in selling, general and administration expenses resulted primarily from less activity due to less available capital during the three months ended April 30, 2004. Stock based compensation during the three months ended April 30, 2004 was $900 compared to $132,201 for the three months ended April 30, 2003. Stock based compensation during the nine months ended April 30, 2004 was $34,934 compared to $207,554 for the nine months ended April 30, 2003. As a result of the termination of the joint venture discussed above, the Company recognized a loss of $150,382 on the write off of the joint venture minority interest during the quarter ended April 30, 2004. As a result, our net loss for the three months ended April 30, 2004 was $1,192,422, which was $506,932 greater than our $685,490 net loss for the three months ended April 30, 2003. As a result, our net loss for the nine months ended April 30, 2004 was $1,785,121, which was $364,127 greater than our $1,420,994 net loss for the nine months ended April 30, 2003. Loss from Changes in Foreign Exchange Rates During the three months ended April 30, 2004, we recorded equity adjustments from foreign currency translations of approximately $5,630. These translation adjustments are related to changes in the rates of exchange between the Mexican Peso and the US dollar. Liquidity and Capital Resources; Plan of Operations As of April 30, 2004, we had working capital of $404,310. Our plans over the next 12 months primarily include the cost of construction of the El Chanate open-pit gold mine in Mexico, administration and holding costs in Colorado and general administrative costs in New York. Our primary source of funds used during the quarter ended April 30, 2004 was from the sale and issuance of common stock for gross proceeds of $120,000. On April 6 and 8, 2004, effective March 31, 2004, MSR, one of our wholly-owned Mexican affiliates, and FG executed an agreement (the "Termination Agreement") terminating the joint venture agreement (the "JV Agreement") with regard to the El Chanate project in Mexico. Pursuant to the Termination Agreement, the parties have terminated amicably the JV Agreement and have released each other from all obligations under the JV Agreement. In consideration of FG's contributions to the venture of $457,455, we issued 2,000,000 restricted shares (valued at $800,000) of our common stock and MSR issue to FG a participation certificate entitling FG to receive five percent of MSR's annual dividends, when declares. The participation certificate also gives FG the right to participate, but not to vote, in the meetings of MSR's Board of Managers, Technical Committee and Partners. FG also received a right of first refusal to carry out the works and render construction services required to effectuate the El Chanate project. This right of first refusal is not applicable where a funding source for the project determines that others should render such works or FG has agreed to assign or otherwise transfer to MSR all permits, licenses, consents and authorizations (collectively, "authorizations") for which FG had obtained in its name in connection with the development of the El Chanate authorizations are not assignable or otherwise transferable, FG has given its consent for the authorizations to be cancelled so that they can be re-issued or We solicited and received bids from three experienced and qualified contactors for mining El Chanate ores. These bids were higher than anticipated and were rejected. We are reviewing certain ways to optimize blasting, hauling and the amounts of pre-production mine stripping to reduce the mining costs. We believe, but cannot guarantee, that there are certain cost savings to be made which, if implemented, will improve the economic returns at El Chanate. We are actively looking for financing for construction of the El Chanate open-pit gold mine in Sonora, Mexico. We had a term sheet for funding from Royal Gold. However, in April 2004, we and Royal Gold mutually agreed not to proceed because the parties could not agree on final terms. We believe that equity financing may provide certain attractive alternative sources of project funding and we are exploring those possibilities. Unless and until we obtain adequate financing on acceptable terms, we will not be able to move forward with full-scale construction of the mine. There can be no assurance that adequate equity or debt financing can be attained. As explained in our annual report on form 10-KSB, historically, we have not generated any material revenues from operations and have been in a precarious financial condition. No assurance whatsoever can be given that we will be able to obtain any significant funds in the near future or that we will be able to continue as a going concern or that any of our plans with respect to our gold properties will, to a material degree, come to fruition. In order to continue our program we will need to obtain substantial financing. There is no assurance that we will be successful. Our condensed consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. We are a development stage enterprise and have recurring losses from operations and operating cash constraints that raise substantial doubt about our ability to continue as a going concern. Management does not expect that environmental issues will have an adverse material effect on our liquidity or earnings. Before any additional exploration or any development or mining or construction of milling facilities could begin at our Leadville properties, it would be necessary to meet all environmental requirements and to satisfy the regulatory agencies in Colorado that our proposed procedures fell within the boundaries of sound environmental practice. We currently are bonded to insure reclamation of any areas disturbed by our past activities. The current amount of this bond is $35,550. In Mexico, we are not aware of any significant environmental concerns or existing reclamation requirements at the El Chanate properties. We received the required Mexican government permits for construction, mining and processing the El Chanate ores in January 2004. Part of the Leadville Mining District has been declared a federal Superfund site under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, and the Superfund Amendments and Reauthorization Act of 1986. Several mining companies and one individual were declared defendants in a possible lawsuit. We were not named a defendant or Possible Responsible Party. We did respond in full detail to a lengthy questionnaire prepared by the Environmental Protection Agency ("EPA") regarding our proposed procedures and past activities in November 1990. To our knowledge, the EPA has initiated no further comments or We do include in all our internal revenue and cost projections a certain amount for environmental and reclamation costs on an ongoing basis. This amount is determined at a fixed amount of $0.05 per metric tonne of material to be milled on a continual, ongoing basis to provide primarily for reclaiming tailing disposal sites and other reclamation requirements. At this time, there do not appear to be any environmental costs to be incurred by us beyond those already addressed above. No assurance can be given that environmental regulations will not be changed in a manner that would adversely affect our planned operations. Off-Balance Sheet Transactions We do not have any transactions, agreements or other contractual arrangements that constitute off-balance sheet arrangements. Application Of Critical Accounting Policies Our financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management's application of accounting policies. Critical accounting policies for us include impairment of long-lived assets, accounting for stock-based compensation and environmental remediation costs. In accordance with SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of," we review our long-lived assets for impairments. Impairment losses on long-lived assets are recognized when events or changes in circumstances indicate that the undiscounted cash flows estimated to be generated by such assets are less than their carrying value and, accordingly, all or a portion of such carrying value may not be recoverable. Impairment losses then are measured by comparing the fair value of assets to their carrying amounts. During the year ended July 31, 2002, we performed a review of our Colorado mine and mill improvements and determined that an impairment loss should be recognized. Accordingly, at July 31, 2002, we reduced by $999,445 the net carrying value of certain assets relating to our Leadville, Colorado facility to $300,000, which approximates management's estimate of fair value. We recognized no additional impairment loss during the quarter ended We account for stock-based compensation to our employees using the intrinsic value method in accordance with provisions of the Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations which requires the recognition of compensation expense over the vesting period of the option when the exercise price of the stock option granted is less than the fair value of the underlying common stock. Additionally, we comply with the disclosure provisions of Statement of Financial Accounting Standards No. 123 "Accounting for Stock Based Compensation" ("SFAS 123") and provide pro forma disclosure of net loss and loss per share as if the fair value method has been applied in measuring compensation expense for stock options granted. Stock-based compensation related to options granted to non-employees is recognized using the fair value method in accordance with SFAS 123. Environmental remediation costs are accrued based on estimates of known environmental remediation exposure. Such accruals are recorded even if significant uncertainties exist over the ultimate cost of the remediation. It is reasonably possible that our estimates of reclamation liabilities, if any, could change as a result of changes in regulations, extent of environmental remediation required, means of reclamation or cost estimates. Ongoing environmental compliance costs, including maintenance and monitoring costs, are expensed as incurred. There were no environmental remediation costs accrued at Issues And Uncertainties The following issues and uncertainties, among others, should be considered in evaluating our financial outlook. We have not generated any operating revenues. If we are unable to commercially develop our mineral properties, we will not be able to generate profits and our business may fail. To date, we have no producing properties. As a result, we have no current source of operating revenue and we have historically operated and continue to operate at a loss. Our ultimate success will depend on our ability to generate profits from our properties. Our viability is largely dependent on the successful commercial development of the El Chanate project. We lack operating cash flow and rely on external funding sources. If we are unable to continue to obtain needed capital from outside sources, we will be forced to reduce or curtail our operations. We do not generate any positive cash flow from operations and we do not anticipate that any positive cash flow will be generated for some time. We have limited financial resources. Leases and licenses that we hold impose financial obligations on us. As a result we need to obtain additional capital from outside sources to continue operations and effect our business plan. We cannot assure that adequate additional funding will be available. We believe that equity financing may provide certain attractive sources of project funding and we are exploring those possibilities. If we are unable to continue to obtain needed capital from outside sources, we will be forced to reduce or curtain our operations. Mining costs quotes were recently received from selected qualified mining contractors and these bids range from 13% to 45% above feasibility study costs. We are exploring ways to reduce these mining costs as quoted by the potential contractors. Further exploration and development of the mineral properties in which we hold interests depends upon our ability to obtain financing through o bank or other debt financing, o equity financing, or o other means. Failure to obtain additional financing on a timely basis could cause us to forfeit all or parts of our interests in some or all of (i) the El Chanate concessions, and (ii) our Leadville properties, and reduce or terminate our Our year end audited financial statements contain a "going concern" explanatory paragraph. Our inability to continue as a going concern would require a restatement of assets and liabilities on a liquidation basis, which would differ materially and adversely from the going concern basis on which our financial statements included in this quarterly report have been prepared. Our financial statements for the year ended July 31, 2003 included in our form 10-KSB for the year ended as of that date, and the financial statements for the quarter ended April 30, 2004 contained in this quarterly report on form 10-QSB, and filed with the Commission, have been prepared on the basis of accounting principles applicable to a going concern. Our auditors' report on the financial statements contained in our Form 10-KSB includes an additional explanatory paragraph following the opinion paragraph on our ability to continue as a going concern. A note to these financial statements describes the reasons why there is substantial doubt about our ability to continue as a going concern and our plans to address this issue. Neither our July 31, 2003 financial statements nor our April 30, 2004 quarterly unaudited financial statements include any adjustments that might result from the outcome of this uncertainty. Our inability to continue as a going concern would require a restatement of assets and liabilities on a liquidation basis, which would differ materially and adversely from the going concern basis on which our financial statements have been Our ability on a going forward basis to discover viable and economic mineral reserves is subject to numerous factors, most of which are beyond our control and are not predictable. Exploration for gold is speculative in nature, involves many risks and is frequently unsuccessful. Any gold exploration program entails risks relating to o the location of economic ore bodies, o development of appropriate metallurgical processes, o receipt of necessary governmental approvals and o construction of mining and processing facilities at any site chosen for mining. The commercial viability of a mineral deposit is dependent on a number of factors including: o the price of gold, o exchange rates, o the particular attributes of the deposit, such as its o size, o grade and o proximity to infrastructure, o financing costs, o taxation, o royalties, o land tenure, o land use, o water use, o power use, o importing and exporting gold and o environmental protection. The effect of these factors cannot be accurately predicted. Aside from our El Chanate concessions, the mineral properties in which we have an interest or right are in the exploration stages and are without reserves of gold or other minerals. We cannot assure that current or proposed exploration or development on our other properties in which we have an interest will result in the discovery of gold mineralization reserves or will result in a profitable commercial mining operation. We have a limited number of prospects. As a result, our chances of commencing viable mining operations are dependent upon the success of one project. Our only current properties are the El Chanate concessions and our Leadville properties. At present, we are not doing any substantive work at our Leadville properties. Our El Chanate concessions are owned by one of our wholly-owned subsidiaries, Oro de Altar. MSR, another of our Mexican subsidiaries, leases the land and claims at El Chanate from Oro de Altar. FG, our former joint venture partner, has the right to receive five percent of MSR's annual dividends, when declared. We currently do not have operations on either of our properties, and we must commence such operations to receive revenues. Accordingly, we are dependent upon the success of the El Chanate concessions. If we are unable to obtain a crushing system and other equipment for our Mexican concessions at an acceptable cost, our ability to obtain requisite funding for our planned mining operations and our anticipated results of operations from mining at these concessions, once mining commences, may be adversely affected. In March 2003, we obtained exclusive options to purchase an ore crusher and related assets (spare parts for the crusher and certain transportable building structures). The options expired and the owner of these assets sold his interest to a third party. We currently are in discussions with others for the acquisition of equipment for use at our Mexican concessions. We are optimistic about being able to acquire additional equipment at favorable costs; however, there can be no assurance that we will be successful in acquiring these assets. Moreover, our ability to acquire such equipment is subject to our ability to obtain adequate necessary funding. If we are unable to obtain this equipment at an acceptable cost, our ability to obtain requisite funding for our planned mining operations and our anticipated results of operations from mining at these concessions, once mining commences, may be adversely affected. Gold prices can fluctuate on a material and frequent basis due to numerous factors beyond our control. If and when we commence production, our ability to generate profits from operations could be materially and adversely affected by such fluctuating prices. The profitability of any gold mining operations in which we have an interest will be significantly affected by changes in the market price of gold. Gold prices fluctuate on a daily basis and are affected by numerous factors beyond our control, including: o the level of interest rates, o the rate of inflation, o central bank sales, o world supply of gold and o stability of exchange rates. Each of these factors can cause significant fluctuations in gold prices. Such external factors are in turn influenced by changes in international investment patterns and monetary systems and political developments. The price of gold has historically fluctuated widely and, depending on the price of gold, revenues from mining operations may not be sufficient to offset the costs of such Changes in regulatory or political policy could adversely affect our exploration and future production activities. Any changes in government policy may result in changes to laws affecting: o ownership of assets, o mining policies, o monetary policies, o rates of exchange, o environmental regulations, o labor relations, o repatriation of income and o return of capital. Any such changes may affect our ability to undertake exploration and development activities in respect of present and future properties in the manner currently contemplated, as well as our ability to continue to explore, develop and operate those properties in which we have an interest or in respect of which we have obtained exploration and development rights to date. The possibility, particularly in Mexico, that future governments may adopt substantially different policies, which might extend to expropriation of assets, cannot be ruled out. Compliance with environmental regulations could adversely affect our With respect to environmental regulation, environmental legislation generally is evolving in a manner which will require: o stricter standards and enforcement, o increased fines and penalties for non-compliance, o more stringent environmental assessments of proposed projects o a heightened degree of responsibility for companies and their officers, directors and employees. There can be no assurance that future changes to environmental legislation and related regulations, if any, will not adversely affect our operations. We could be held liable for environmental hazards that exist on the properties in which we hold interests, whether caused by previous or existing owners or operators of the properties. Any such liability could adversely affect our business and financial condition. Mining Risks and Potential Inadequacy of Insurance Coverage could adversely affect us If and when we commence mining operations at any of our properties, such operations will involve a number of risks and hazards, including: o environmental hazards, o industrial accidents, o labor disputes, o metallurgical and other processing, o unusual and unexpected rock formations, o ground or slope failures, o cave-ins, o acts of God, o mechanical equipment and facility performance problems and o the availability of materials and equipment. Such risks could result in: o damage to, or destruction of, mineral properties or production facilities, o personal injury or death, o environmental damage, o delays in mining, o monetary losses and o possible legal liability. Industrial accidents could have a material adverse effect on our future business and operations. Although as we move forward in the development of any of our properties we plan to maintain insurance within ranges of coverage consistent with industry practice, we cannot be certain that this insurance will cover the risks associated with mining or that we will be able to maintain insurance to cover these risks at economically feasible premiums. We also might become subject to liability for pollution or other hazards which we cannot insure against or which we may elect not to insure against because of premium costs or other reasons. Losses from such events could have a material adverse effect on Calculation of reserves and metal recovery dedicated to future production is not exact, might not be accurate and might not accurately reflect the economic viability of our properties. Reserve estimates may not be accurate. There is a degree of uncertainty attributable to the calculation of reserves, resources and corresponding grades being dedicated to future production. Until reserves or resources are actually mined and processed, the quantity of reserves or resources and grades must be considered as estimates only. In addition, the quantity of reserves or resources may vary depending on metal prices. Any material change in the quantity of reserves, resource grade or stripping ratio may affect the economic viability of our properties. In addition, there can be no assurance that mineral recoveries in small scale laboratory tests will be duplicated in large tests under on-site conditions or during production. We are dependent on the efforts of certain key personnel and contractors, the loss of whose services could have a materially adverse effect on our We are dependent on a relatively small number of key personnel, the loss of any one of whom could have an adverse effect on us. In addition, while certain of our officers and directors have experience in the exploration and operation of gold producing properties, we will remain highly dependent upon contractors and third parties in the performance of our exploration and development activities. As such there can be no guarantee that such contractors and third parties will be available to carry out such activities on our behalf or be available upon commercially acceptable terms. There are uncertainties as to title matters in the mining industry. We believe that we have good title to our properties; however, defects in such title could have a material adverse effect on us. We have investigated our rights to explore, exploit and develop our various properties in manners consistent with industry practice and, to the best of our knowledge, those rights are in good standing. However, we cannot assure that the title to or our rights of ownership of either the El Chanate concessions or our Leadville properties will not be challenged or impugned by third parties or governmental agencies. In addition, there can be no assurance that the properties in which we have an interest are not subject to prior unregistered agreements, transfers or claims and title may be affected by undetected defects. Any such defects could have a material adverse effect on us. Should we successfully commence mining operations in the future, our ability to remain profitable, should we become profitable, will be dependent on our ability to find, explore and develop additional properties. Our ability to acquire such additional properties will be hindered by competition. Gold properties are wasting assets. They eventually become depleted or uneconomical to continue mining. The acquisition of gold properties and their exploration and development are subject to intense competition. Companies with greater financial resources, larger staffs, more experience and more equipment for exploration and development may be in a better position than us to compete for such mineral properties. Our property interests in Mexico are subject to the risks of doing business in foreign countries. We face risks normally associated with any conduct of business in foreign countries with respect to our El Chanate project in Sonora, Mexico, including various levels of political and economic risk. The occurrence of one or more of these events could have a material adverse impact on our efforts or future operations which, in turn, could have a material adverse impact on our future cash flows, earnings, results of operations and financial condition. These risks o invalidity of governmental orders, o uncertain or unpredictable political, legal and economic environments, o war and civil disturbances, o changes in laws or policies, o delays in obtaining or the inability to obtain necessary governmental permits, o governmental seizure of land or mining claims, o limitations on ownership, o limitations on the repatriation of earnings, o increased financial costs, o import and export regulations, including restrictions on the export of gold, and o foreign exchange controls. These risks may limit or disrupt the project, restrict the movement of funds or impair contract rights or result in the taking of property by nationalization or expropriation without fair compensation. Gold is sold in the world market in U.S. dollars; however, we may incur a significant amount of our expenses in Mexican pesos. If and when we sell gold, if applicable currency exchange rates fluctuate our revenues and results of operations may be materially and adversely affected. If and when we commence sales of gold, such sales will be made in the world market in U.S. dollars. We may incur a significant amount of our expenses in Mexican pesos. As a result, our financial performance would be affected by fluctuations in the value of the Mexican peso to the U.S. dollar. At the present time, we have no plan or policy to utilize forward contracts or currency options to minimize this exposure, and even if these measures are implemented there can be no assurance that such arrangements will be available, be cost effective or be able to fully offset such future currency risks. Item 3. Controls and Procedures. Gifford A Dieterle, our Chief Executive Officer and our Chief Financial Officer, has evaluated, as of the end of the period covered by this report, the effectiveness of the design and operation of our disclosure controls and procedures with respect to the information generated for use in this report. Based upon that evaluation, taking into account our limited resources and current business operations, he concluded that the disclosure controls and procedures were effective to provide reasonable assurances that information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. There have been no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION Item 2. Changes in Securities and Small Business Issuer Purchases of Equity Securities. During the quarter ended April 30, 2004, we issued the following shares of our Common Stock pursuant to the exemption from registration provided by Section 4(2) of the Securities Act of 1933: We sold 729,605 shares for $90,100 to 16 persons. Also, during the three months ended April 30, 2004, we issued 200,000 shares of common stock and received gross proceeds of $4,000 from the exercise of options by one of our officers and directors, and we issued 515,000 shares of common stock for gross proceeds of $25,750 to an unrelated party upon exercise of options. Item 3. Defaults Upon Senior Securities Item 4 Submission of Matters to a Vote of Security Holders Item 5. Other Information Item 6. Exhibits and Reports on Form 8-K Exhibits: 31.1 Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 from the Company's Chief Executive Officer 2002 from the Company's Chief Financial Officer Reports on Form 8-K: Report filed on April 12, 2004. Item 5. Other Events and Regulation FD Disclosure. Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. By: /s/ Gifford A. Dieterle Gifford A. Dieterle President/Treasurer

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For the Fiscal Year Ended February 3, 2018 Commission file number 000-51217, 001-36693 SEARS HOLDINGS CORPORATION (State of Incorporation) (I.R.S. Employer Identification No.) 3333 Beverly Road, Hoffman Estates, Illinois (Address of principal executive offices) (Zip Code) Registrant’s Telephone Number, Including Area Code: (847) 286-2500 Common Stock, par value $0.01 per share The NASDAQ Stock Market Warrants to Purchase Common Stock Securities registered pursuant to Section 12(g) of the Act: Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such response) and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405) is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large accelerated filer ¨ Accelerated filer x Non-accelerated filer (Do not check if a smaller reporting company) ¨ Smaller reporting company ¨ Emerging growth company ¨ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x On March 16, 2018, the registrant had 107,957,410 shares of common stock outstanding. The aggregate market value (based on the closing price of the Registrant's common stock for stocks quoted on the NASDAQ Global Select Market) of shares of the Registrant's common stock owned by non-affiliates as of the last business day of the Registrant's most recently completed second fiscal quarter, was approximately $200 million. Part III of this Form 10-K incorporates by reference certain information from the Registrant’s definitive proxy statement relating to our Annual Meeting of Stockholders to be held on May 9, 2018 (the "2018 Proxy Statement"), which will be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year to which this Form 10-K relates. Sears Holdings Corporation ("Holdings") is the parent company of Kmart Holding Corporation ("Kmart") and Sears, Roebuck and Co. ("Sears"). Holdings (together with its subsidiaries, "we," "us," "our," or the "Company") was formed as a Delaware corporation in 2004 in connection with the merger of Kmart and Sears (the "Merger") on March 24, 2005. We are an integrated retailer with significant physical and intangible assets, as well as virtual capabilities enabled through technology. At February 3, 2018, we operated a national network of stores with 1,002 full-line and specialty retail stores in the United States operating through Kmart and Sears. Further, we operate a number of websites under the sears.com and kmart.com banners which offer millions of products and provide the capability for our members and customers to engage in cross-channel transactions such as free store pickup; buy in store/ship to home; and buy online, return in store. We are also the home of Shop Your Way®, a free membership program that connects its members to personalized products, programs and partners that help them save time and money every day. Through an extensive network of national and local partners, members can shop thousands of their favorite brands, dine out and access an array of exclusive partners like Uber® and fuboTV® to earn CASHBACK in points to redeem for savings on future purchases at Sears, Kmart, Lands' End and at ShopYourWay.com. The Sears MasterCard with Shop Your Way® features an industry-leading 5-3-2-1 rewards offer, where members can earn rewards points on all purchases everywhere they shop. The Company is a leading home appliance retailer, as well as a leader in tools, lawn and garden, fitness equipment, automotive repair and maintenance, and is a significant player in the rapidly emerging connected solutions market. We offer key proprietary brands including Kenmore® and DieHard®, as well as Craftsman® branded product offerings. Our Kenmore and DieHard brands are also now available on Amazon.com. We also maintain a broad apparel and home offering including such well-known labels as Jaclyn Smith®, Joe Boxer®, Route 66®, Cannon®, Adam Levine® and Levi's® and also offer Lands' End® merchandise in some of our Full-line stores. We are the nation's No. 1 provider of appliance and product repair services, with over five million service calls made annually. The retail industry is changing rapidly. The progression of the Internet, mobile technology, social networking and social media is fundamentally reshaping the way we interact with our core customers and members. As a result, we are transitioning to a member-centric company. Our focus continues to be on our core customers, our members, and finding ways to provide them value and convenience through Integrated Retail and our Shop Your Way membership platform. We have invested significantly in our membership program, our online ecommerce platforms and the technology needed to support these initiatives. We operate in two reportable segments, Kmart and Sears Domestic. Financial information, including revenues, operating loss, total assets and capital expenditures for each of these business segments is contained in Note 17 of Notes to Consolidated Financial Statements. Information regarding the components of revenue for Holdings is included in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations as well as Note 17 of Notes to Consolidated Financial Statements. At February 3, 2018, the Company operated a total of 432 Kmart stores across 47 states, Guam, Puerto Rico and the U.S. Virgin Islands. This store count consists of 431 discount stores, averaging 94,000 square feet, and one Super Center, approximately 185,000 square feet. Most Kmart stores are one-floor, free-standing units that carry a wide array of products across many merchandise categories, including consumer electronics, seasonal merchandise, outdoor living, toys, lawn and garden equipment, food and consumables and apparel, including products sold under such well-known labels as Craftsman, Jaclyn Smith, Adam Levine, Joe Boxer, Basic Editions and certain proprietary Sears branded products (such as Kenmore and DieHard) and services. We also offer an assortment of major appliances, including Kenmore-branded products, in all of our locations. There are 183 Kmart stores that also operate in-store pharmacies. The Super Center combines a full-service grocery along with the merchandise selection of a discount store. There are also three Sears Auto Centers operating in Kmart stores, offering a variety of professional automotive repair and maintenance services, as well as a full assortment of automotive accessories. Kmart offers a layaway program, which allows members and customers to cost-effectively finance their purchases both in-store and online. In addition, our members and customers have the ability to buy online and pick up in store via mygofer.com, kmart.com or shopyourway.com. Kmart also sells its products through its kmart.com website and provides members and customers enhanced cross-channel options such as buying through a mobile app or online and picking up merchandise in one of our Kmart or Sears Full-line stores. Sears Domestic At February 3, 2018, Sears Domestic operations consisted of the following: Full-line Stores—547 stores located across 49 states and Puerto Rico, primarily mall-based locations averaging 159,000 square feet. Full-line stores offer a wide array of products and service offerings across many merchandise categories, including appliances, consumer electronics/connected solutions, tools, sporting goods, outdoor living, lawn and garden equipment, certain automotive services and products, such as tires and batteries, home fashion products, as well as apparel, footwear, jewelry and accessories for the whole family. Our product offerings include our proprietary Kenmore, DieHard, WallyHome, Bongo, Covington, Simply Styled, Everlast, Metaphor, Roebuck & Co., Outdoor Life and Structure brand merchandise, and other brand merchandise such as Craftsman, Roadhandler and Levi's. Lands' End, Inc. continues to operate 151 "store within a store" departments inside Sears Domestic Full-line locations. We also have 423 Sears Auto Centers operating in association with Full-line stores. In addition, there are 19 free-standing Auto Centers that operate independently of Full-line stores. Sears extends the availability of its product selection through the use of its sears.com and shopyourway.com websites, which offer an assortment of home, apparel and accessory merchandise and provide members and customers the option of buying through a mobile app or online and picking up their merchandise in one of our Sears Full-line or Kmart stores. Specialty Stores—23 specialty stores (primarily consisting of the 19 free-standing Auto Centers noted above) located in free-standing, off-mall locations or high-traffic neighborhood shopping centers, including three DieHard Auto Centers - two in Detroit and one in San Antonio. Specialty stores also include Sears Appliances and Mattresses stores in Ft. Collins, Colorado, Camp Hill, Pennsylvania, Pharr, Texas and Honolulu, Hawaii. Commercial Sales—We sell Kenmore appliances to home builders and property managers through Kenmore Direct, the business-to-business sales organization of KCD Brands. Kenmore Direct operates using a number of sales channels including an Amazon Business sales account. We also sell a wide assortment of appliance brands including luxury brands, parts and services to builders, developers, designers, among other commercial and residential customers through Monark Premium Appliance Co., which includes California Builder Appliances, Inc. (d/b/a Monark Premium Appliance Co. of California), Florida Builder Appliances, Inc. (d/b/a Monark Premium Appliance Co.) and Starwest, LLC. (d/b/a Monark Premium Appliance Co. of Arizona). Home Services—Product Repair Services, the nation's No. 1 provider of appliance and product repair services, is a key element in our active relationship with nearly 30 million households. With approximately 5,200 service technicians making over five million service calls annually, this business delivers a broad range of retail-related residential and commercial services across all 50 states, Puerto Rico, Guam and the Virgin Islands under either the Sears Parts & Repair Services or A&E Factory Service trade names. Commercial and residential customers can obtain parts and repair services for all major brands of products within the appliances, lawn and garden equipment, consumer electronics, floor care products, and heating and cooling systems categories. We also provide repair parts with supporting instructions for "do-it-yourself" members and customers through our searspartsdirect.com website. This business also offers protection agreements, home warranties and Kenmore and Carrier brand residential heating and cooling systems. Home Services also includes home improvement services (primarily siding, windows, cabinet refacing, kitchen remodeling, roofing, carpet and upholstery cleaning, air duct cleaning, and garage door installation and repair) provided through Sears Home Improvement and Sears Home & Business Franchises. Delivery and Installation—Provides both home delivery and retail installation services for Holdings' retail operations with over three million deliveries and installation calls made annually. Also includes Innovel Solutions, which provides delivery services for third party customers. In the normal course of business, we consider opportunities to purchase leased operating properties, as well as offers to sell owned, or assign leased, operating and non-operating properties. These transactions may, individually or in the aggregate, result in material proceeds or outlays of cash. In addition, we review leases that will expire in the short term in order to determine the appropriate action to take. Further information concerning our real estate transactions is contained in Note 11 of Notes to Consolidated Financial Statements. The KMART® and SEARS® trade names, service marks and trademarks, used by us both in the United States and internationally, are material to our retail and other related businesses. We sell proprietary branded merchandise under a number of brand names that are important to our operations. Our KENMORE® and DIEHARD® brands are among the most recognized proprietary brands in retailing. These marks are the subject of numerous United States and foreign trademark registrations. Other well recognized Company trademarks and service marks include ATHLETECH®, BLUELIGHT®, COVINGTON®, ROEBUCK & CO.®, SHOP YOUR WAY®, SMART SENSE®, STRUCTURE®, THOM MCAN®, and WALLY®, which also are registered or are the subject of pending registration applications in the United States. Generally, our rights in our trade names and marks continue so long as we use them. The retail business is seasonal in nature, and we generate a high proportion of our revenues, operating income and operating cash flows during the fourth quarter of our year, which includes the holiday season. As a result, our overall profitability is heavily impacted by our fourth quarter operating results. Additionally, in preparation for the fourth quarter holiday season, we significantly increase our merchandise inventory levels, which are financed from operating cash flows, credit terms received from vendors and borrowings under our domestic credit agreement (described in the "Uses and Sources of Liquidity" section below). Fourth quarter reported revenues accounted for approximately 26% of total reported revenues in 2017, 27% of total reported revenues in 2016 and 29% of total reported revenues in 2015. See Note 19 of Notes to Consolidated Financial Statements for further information on revenues earned by quarter in 2017 and 2016. Our business is subject to highly competitive conditions. We compete with a wide variety of retailers, including other department stores, discounters, home improvement stores, consumer electronics dealers, auto service providers, specialty retailers, wholesale clubs, as well as many other retailers operating on a national, regional or local level in the United States. Online and catalog businesses, which handle similar lines of merchandise, also compete with us. Walmart, Target, Kohl's, J.C. Penney, Macy's, The Home Depot, Lowe's, Best Buy and Amazon are some of the national retailers and businesses with which we compete. The Home Depot and Lowe's are major competitors in relation to our home appliance business, which accounted for approximately 16% of our 2017, 15% of our 2016 and 15% of our 2015 reported revenues. Success in these competitive marketplaces is based on factors such as price, product assortment and quality, service and convenience, including availability of retail-related services such as access to credit, product delivery, repair and installation. Additionally, we are influenced by a number of factors, including, but not limited to, the cost of goods, consumer debt availability and buying patterns, economic conditions, customer preferences, inflation, currency exchange fluctuations, weather patterns, and catastrophic events. Item 1A in this Annual Report on Form 10-K contains further information regarding risks to our business. At February 3, 2018, subsidiaries of Holdings had approximately 89,000 employees in the United States and U.S. territories. This employee count includes part-time employees. Our Website; Availability of SEC Reports and Other Information Our corporate website is located at searsholdings.com. Our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these reports are available, free of charge, through the "SEC Filings" portion of the Investors Home section of our website as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission ("SEC"). The Corporate Governance Guidelines of our Board of Directors, the charters of the Audit, Compensation and Nominating and Corporate Governance Committees of the Board of Directors, our Code of Conduct and the Board of Directors Code of Conduct are available in the "Corporate Governance" portion of the Investors Home section of searsholdings.com. References to our website address do not constitute incorporation by reference of the information contained on such website, and the information contained on the website is not part of this document. Our operations and financial results are subject to various risks and uncertainties, including those described below, which could adversely affect our business, results of operations and financial condition. We cannot predict whether our plans to enhance our financial flexibility and liquidity to fund our transformation will be successful. We are continuing to pursue a transformation strategy and to explore potential initiatives to enhance our financial flexibility and liquidity. We have incurred significant losses and experienced negative operating cash flows for the past several years, and accordingly we have taken a number of actions to fund our continued transformation and meet our obligations, including: the amendment and extension of our revolving credit facility; the extension of our first lien term loan facility from June 2018 to January 2019 (with a right on our part to further extend such maturity, subject to the satisfaction of certain conditions, to July 2019); the entrance into the first lien term loan facility due 2020, the second lien term loan facility due 2020 and the second lien line of credit loan facility due 2020, the amendment of the senior secured letter of credit facility; the extension of our real estate term loan facility from July 2017 to July 2018; the entrance into the real estate term loan facility due 2020, the incremental real estate term loan facility due 2018 and the intellectual property/ground lease term loan facility due 2020; the private exchange offers relating to our senior secured notes and senior unsecured notes, the negotiated exchanges of other indebtedness; the entrance into the REMIC real estate term loan facility due December 2018 and the REMIC mezzanine loan facility due 2020; the sale of the Craftsman brand; the rights offering and sale-leaseback transaction with Seritage Growth Properties; the separation of our Lands' End subsidiary; the Sears Canada rights offering; the rights offering for senior unsecured notes with warrants; and various real estate transactions. As a result, we are, and we expect to continue to be, highly leveraged. We expect to pursue other near-term actions to bolster liquidity. If we continue to incur losses, additional actions may be required to further enhance our financial flexibility and liquidity. The success of our initiatives is subject to risks and uncertainties with respect to market conditions and other factors that may cause our actual results, performance or achievements to differ materially from our plans. We cannot assure that cash flows and other internal and external sources of liquidity will at all times be sufficient for our cash requirements. If necessary, we may need to consider further actions and steps to improve our cash position, mitigate any potential liquidity shortfall, pursue additional sources of liquidity, and reduce costs. There can be no assurance that these actions would be successful. Any refinancing of our debt could be at higher interest rates and may require us to comply with more onerous covenants, which could further restrict our business operations. In addition, there can be no assurance that the evaluation and/or completion of any potential transactions will not have a negative impact on our other businesses. We cannot predict the outcome of any actions to generate liquidity, whether such actions would generate the expected liquidity as currently planned, or the availability of additional debt financing. The specific actions taken or assets involved, the timing, and the overall amount will depend on a variety of factors, including market conditions, interest in specific assets, valuations of those assets and our underlying operating performance. If we continue to experience operating losses and we are not able to generate additional liquidity through the mechanisms described above or through some combination of other actions, including real estate or other asset sales, while not expected, then our liquidity needs may exceed availability under our Amended Domestic Credit Agreement, our second lien line of credit loan facility and our other existing facilities, and we might need to secure additional sources of funds, which may or may not be available to us. If we are unable to secure such additional funds, we may not be able to meet our obligations as they become due. Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. Certain factors, including changes in market conditions and our credit ratings, may continue to limit our access to capital markets and other financing sources and materially increase our borrowing costs. In addition to credit terms from vendors, our liquidity needs are funded by our operating cash flows and borrowings under our credit agreements and commercial paper program, asset sales and access to capital markets. The availability of financing depends on numerous factors, including economic and market conditions, our operating performance, our credit ratings, and lenders' assessments of our prospects and the prospects of the retail industry in general. Changes in these factors may affect our cost of financing, liquidity and our ability to access financing sources, including our commercial paper program and possible second lien indebtedness that is permitted under the domestic revolving credit facility, with respect to each of which we have no lender commitments. Rating agencies revise their ratings for the companies that they follow from time to time. Several ratings agencies have previously downgraded the credit rating on certain of our outstanding debt instruments and may further downgrade or otherwise revise such ratings in the future. In addition, our ratings may be withdrawn in their entirety at any time. The Company's domestic credit facility currently provides up to $2.5 billion of lender commitments, $1.5 billion of which are revolving commitments. Our ability to borrow funds under this facility is limited by a borrowing base determined by the value, from time to time, of eligible inventory and certain accounts receivable. The value of these eligible assets has not always been sufficient to support borrowings of up to the full amount of the commitments under this facility, and we have not always had full access to the facility, but rather have had access to a lesser amount determined by the borrowing base. A decline in the value of eligible assets has also resulted in our inability to borrow up to the full amount of second lien indebtedness permitted by the domestic credit facility as our second-lien borrowings are limited by a borrowing base requirement under the indenture that governs our senior secured notes due 2018. The domestic revolving credit facility imposes various other requirements, which take effect if availability falls below designated thresholds, including a cash dominion requirement. The domestic credit facility also effectively limits full access to the facility if our fixed charge ratio at the last day of any fiscal month is less than 1.0 to 1.0. As of February 3, 2018, our fixed charge ratio continues to be less than 1.0 to 1.0. If availability under the domestic revolving credit facility were to fall below 10%, the Company would be required to test the fixed charge coverage ratio, and would not comply with the facility, and the lenders under the facility could demand immediate payment in full of all amounts outstanding and terminate their obligations under the facility. In addition, the domestic credit facility provides that in the event we make certain prepayments of indebtedness, for a period of one year thereafter we must maintain availability under the facility of at least 12.5%, and it prohibits certain other prepayments of indebtedness. Moreover, if the borrowing base (as calculated pursuant to the indenture relating to our 6 5/8% senior secured notes due 2019, which were issued in March 2018 (the "New Senior Secured Notes")) falls below the principal amount of the New Senior Secured Notes plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for the New Senior Secured Notes on the last day of any two consecutive quarters beginning with the second quarter of our 2018 fiscal year, it could trigger an obligation to offer to repurchase all outstanding New Senior Secured Notes at a purchase price equal to 101% of the principal amount, plus accrued and unpaid interest. The lenders under our various credit facilities may not be able to meet their commitments if they experience shortages of capital and liquidity. Disruptions or turmoil in the financial markets could reduce our ability to meet our capital requirements. There can be no assurance that our ability to otherwise access the credit markets will not be adversely affected by changes in the financial markets and the global economy. Our business results and ability to fund our transformation depend on our ability to achieve cost savings initiatives and complete our previously announced restructuring program. In 2017, we initiated a restructuring program targeted to deliver at least $1.25 billion in annualized cost savings. Under the restructuring program, we reduced our corporate overhead, more closely integrated our Sears and Kmart operations and improved our merchandising, supply chain and inventory management. The savings also included cost reductions resulting from the closure of 303 Kmart and 132 Sears stores. In January 2018, we identified an additional $200 million of cost savings, unrelated to store closings. However, if we are unable to deliver the additional cost reductions, while continuing to invest in business growth, our financial results could be adversely impacted. Our ability to successfully manage and execute these initiatives and realize expected savings and benefits in the amounts and at the times anticipated is important to our business success, and any failure to do so, which could result from our inability to successfully execute plans, changes in global or regional economic conditions, competition, changes in the industries in which we compete, unanticipated costs or charges and other factors described herein, could adversely affect our business, financial condition and results of operations. As part of our overhead reduction, we have reduced our corporate and operations headcount, including management level, distribution and field employees. These reductions, as well as employee attrition, could result in the potential loss of specific knowledge relating to our company, operations and industry that could be difficult to replace. Also, we now operate with fewer employees, who have assumed additional duties and responsibilities. The restructuring program and workforce changes may negatively impact communication, morale, management cohesiveness and effective decision-making, which could have an adverse impact on our business operations, customer experience, sales and results of operations. The lack of willingness of our vendors to do business with us or to provide acceptable payment terms could negatively impact our liquidity and/or reduce the availability of products or services we seek to procure. We depend on our vendors to provide us with financing on our purchases of inventory and services. From time to time, certain of our vendors have sought to limit the availability of vendor credit to us or to modify the other terms under which they sell to us, or both, which has negatively impacted our liquidity. In addition, the inability of vendors to access liquidity, or the insolvency of vendors, could lead to their failure to deliver inventory or other services. Certain of our vendors finance their operations and/or reduce the risk associated with collecting accounts receivable from us by selling or "factoring" the receivables or by purchasing credit insurance or other forms of protection from loss associated with our credit risks. The ability of our vendors to do so is subject to the perceived credit quality of the Company. Such vendors could be limited in their ability to factor receivables or obtain credit protection in the future because of our perceived financial position and creditworthiness, which could reduce the availability of products or services we seek to procure, increase the cost to us of those products and services, or both. We have ongoing discussions concerning our liquidity and financial position with the vendor community and third parties that offer various credit protection services to our vendors. The topics discussed have included such areas as pricing, payment terms and ongoing business arrangements. As of the date of this report, we have not experienced any significant disruption in our access to merchandise or our operations due to vendors slowing or ceasing merchandise shipments or requiring or conditioning the sale or shipment of merchandise on new payment terms or other assurances. However, there can be no assurances that there will not be a future disruption, and such circumstances could have a negative effect on our business, financial condition and results of operations. If we are unable to compete effectively in the highly competitive retail industry, our business and results of operations could be materially adversely affected. The retail industry is highly competitive with few barriers to entry. We compete with a wide variety of retailers, including other department stores, discounters, home improvement stores, appliances and consumer electronics retailers, auto service providers, specialty retailers, wholesale clubs, online and catalog retailers and many other competitors operating on a national, regional or local level. Some of our competitors are actively engaged in new store expansion or increasing their online presence. Online and catalog businesses, which handle similar lines of merchandise, and some of which are not required to collect sales taxes on purchases made by their customers, also compete with us. Competition may intensify as competitors enter into business combinations or alliances. We also experience significant competition from promotional activities of our competitors, and some competitors may be able to devote greater resources to sourcing, promoting and selling their products. In this competitive marketplace, success is based on factors such as price, advertising, product assortment, quality, service, reputation and convenience. Our success depends on our ability to differentiate ourselves from our competitors with respect to shopping convenience, a quality assortment of available merchandise, functionality of digital channels, and superior customer service and experience. We must also successfully respond to our members' and customers' changing tastes and expectations. The performance of our competitors, as well as changes in their pricing policies, marketing activities, new store openings, online presence, use of purchasing data and other business strategies, could have a material adverse effect on our business, financial condition and results of operations. If we fail to offer merchandise and services that our members and customers want, our sales may be limited, which would reduce our revenues and profits. In order for our business to be successful, we must identify, obtain supplies of, and offer to our members and customers, attractive, innovative and high-quality merchandise. Our products and services must satisfy the desires of our members and customers, whose preferences may change in the future. Our sales and operating results depend in part on our ability to predict consumer demand for products and services we sell, availability of merchandise, product trends, and our members' and customers' purchasing habits, tastes and preferences. If we misjudge these predictions, our relationship with our members and customers may be negatively impacted, and we may be faced with excess inventories of some products, which may impact our sales or require us to sell the merchandise we have obtained at lower prices, and missed opportunities for products and services we chose not to offer. In addition, merchandise misjudgments may adversely impact the perception or reputation of our company, which could result in declines in member and customer loyalty and vendor relationships. These factors could have a negative effect on our business, financial condition and results of operations. If our integrated retail strategy to transform into a member-centric retailer is not successful, our business and results of operations could be adversely affected. We are seeking to transform into a member-centric retailer through our integrated retail strategy, which is based on a number of initiatives, including our Shop Your Way program, that depend on, among other things, our ability to respond quickly to ongoing technology developments and implement new ways to understand and rely on the data to interact with our members and customers and our ability to provide attractive, convenient and consistent online and mobile experiences for our members. We must anticipate and meet our members' and customers' evolving expectations, while counteracting developments by our competitors and striving to deliver a seamless experience across all of our sales channels. We may need to adjust our strategic initiatives depending on our members' and customers' reactions to and level of engagement with our initiatives. Failure to execute these initiatives or provide our members with positive experiences may result in a loss of active members, failure to attract new members and lower than anticipated sales. There is no assurance that our initiatives and strategies will improve our operating results. If we do not successfully manage our inventory levels, our operating results will be adversely affected. We must maintain sufficient inventory levels to operate our business successfully. However, we also must guard against accumulating excess inventory as we seek to minimize out-of-stock levels across all product categories and to maintain in-stock levels. We obtain a significant portion of our inventory from vendors located outside the United States. Some of these vendors require lengthy advance notice of our requirements in order to be able to supply products in the quantities we request. This usually requires us to order merchandise, and enter into purchase order contracts for the purchase and manufacture of such merchandise, well in advance of the time these products will be offered for sale. As a result, we may experience difficulty in responding quickly to a changing retail environment, which makes us vulnerable to changes in price and demand. If we do not accurately anticipate the future demand for a particular product or the time it will take to obtain new inventory, our inventory levels will not be appropriate and our results of operations may be negatively impacted. Our business has been and will continue to be affected by worldwide economic conditions; an economic downturn, a renewed decline in consumer-spending levels and other conditions, including inflation and changing prices of energy, could lead to reduced revenues and gross margins, and negatively impact our liquidity. Many economic and other factors are outside of our control, including consumer and commercial credit availability, consumer confidence and spending levels, as well as the impact of payroll tax and medical cost increases on U.S. consumers, recession, inflation, deflation, employment levels, housing sales and remodels, interest rates, tax rates, rates of economic growth, fiscal and monetary government policies, consumer debt levels, consumer debt payment behaviors, fuel costs and other challenges currently affecting the global economy, the full impact of which on our business, results of operations and financial condition cannot be predicted with certainty. These economic conditions adversely affect the disposable income levels of, and the credit available to, our members and customers, which could lead to reduced demand for our merchandise. Increases in fuel and energy costs may have a significant impact on our operations. We require significant quantities of fuel for the vehicles used by technicians in our home services business, and we are exposed to the risk associated with variations in the market price for petroleum products. We could experience a disruption in energy supplies, including our supply of gasoline, as a result of factors that are beyond our control, which could have an adverse effect on our business. Certain of our vendors also could experience increases in the cost of various raw materials, such as cotton, oil-related materials, steel and rubber, which could result in increases in the prices that we pay for merchandise, particularly apparel, appliances and tires. Domestic and international political events also affect consumer confidence. The threat, outbreak or escalation of terrorism, civil unrest, military conflicts or other hostilities could lead to a decrease in consumer spending. Any of these events and conditions could inhibit sales or cause us to increase inventory markdowns and promotional expenses, thereby reducing our gross margins. Failure to execute effective advertising efforts may adversely impact our financial performance. Effective advertising and marketing efforts play a crucial role in maintaining high customer traffic both in store and online. We are focused on developing new marketing initiatives and maintaining effective promotional strategies that target further growth in our business. Failure to execute effective advertising efforts to attract new customers or retain existing customers may adversely impact our financial performance. Our business results may be negatively impacted as a result of the recapture rights included in the Master Leases in connection with the Seritage transaction and JV transactions. In 2015, we entered into various sale-lease back transactions with respect to certain of our real properties with Seritage Growth Properties ("Seritage") and certain joint ventures we formed with affiliates of Simon Property Group, Inc., General Growth Properties, Inc. and the Macerich Company (collectively, the "JVs"). In connection with the Seritage transaction and JV transactions, Holdings entered into agreements with Seritage and the JVs pursuant to which Holdings leased 255 of the properties (the "Master Leases"). The Master Leases include recapture provisions that allow Seritage or the JVs, as applicable, to reclaim approximately 50% of the space within these properties (subject to certain exceptions, including reclamation rights as to 100% of the space at 21 properties, and further subject to a lease termination payment by Seritage), in addition to all of the automotive care centers which are free-standing or attached as "appendages," and all outparcels or outlots, as well as certain portions of parking areas and common areas. While we believe these provisions are generally beneficial for Holdings as they facilitate the transformation of our physical stores, potentially enable us to rationalize our footprint by reducing the space we occupy in a given location, and provide us with substantial flexibility in how we manage our store network moving forward, if we are unable to successfully manage and execute our plans to operate our stores in the smaller footprint, our business, financial condition and results of operations could be adversely impacted. Additionally, the recapture rights are within the control of Seritage and the JVs and we cannot predict the timing on which the recapture rights may be exercised, if at all, or whether the timing of any such exercise of these rights will align well with the timing of our transformation, which could create disruptions in our operations. Potential liabilities in connection with the separations of Sears Hometown and Outlet Stores and Lands' End or other asset transactions may arise under fraudulent conveyance and transfer laws and legal capital requirements. With respect to the separations of our Sears Hometown and Outlet Stores and Lands' End, Inc. subsidiaries, the sale of real estate assets to real estate investment trusts and other third parties, the sale of the Craftsman brand, and any future dispositions of other similar assets, if the Company, Lands' End, or any asset purchaser subsequently fails to pay its creditors or enters insolvency proceedings, the transaction may be challenged under U.S. federal, U.S. state and foreign fraudulent conveyance and transfer laws, as well as legal capital requirements governing distributions and similar transactions. If a court were to determine under these laws that, (a) at the time of the transaction, the entity in question: (1) was insolvent; (2) was rendered insolvent by reason of the transaction; (3) had remaining assets constituting unreasonably small capital; (4) intended to incur, or believed it would incur, debts beyond its ability to pay these debts as they matured; or (b) the transaction in question failed to satisfy applicable legal capital requirements, the court could determine that the transaction was voidable, in whole or in part. Subject to various defenses, the court could then require the Company, Lands' End, the respective purchaser, or other recipients of value in connection with any such transaction, as the case may be, to turn over value to other entities involved in the transaction and contemplated transactions for the benefit of unpaid creditors. The measure of insolvency and applicable legal capital requirements will vary depending upon the jurisdiction whose law is being applied. Certain dividend payments received by us from Sears Canada Inc., and other transactions involving Sears Canada Inc., may be subject to challenge. In 2012 and 2013, we received dividend payments from our former subsidiary, Sears Canada Inc. ("Sears Canada") in the aggregate amount of $295 million. The payments of these dividends by Sears Canada, as well as "the surrender by Sears Canada of its exclusive right to use the Craftsman trademark in Canada in connection with the sale by Holdings of the Craftsman business to Stanley Black & Decker in March 2017," have been identified by the court-appointed monitor for Sears Canada in connection with its bankruptcy liquidation as potential "transactions of interest" subject to review. In addition, the Canadian bankruptcy court has appointed a litigation advisor to investigate and potentially recommend claims relating to dividend payments made by Sears Canada. In the event that a court of competent jurisdiction were to determine that any dividend payments made by, or other transactions involving, Sears Canada were subject to recapture, we could suffer financial liability, which could have a materially adverse impact on our liquidity or financial condition. We rely extensively on computer systems to implement our integrated retail strategy, process transactions, summarize results and otherwise manage our business. Disruptions in these systems could harm our ability to run our business. Given the significance of our online and mobile capabilities, our collection and use of data to create personalized experiences, and the number of individual transactions we have each year, including in our stores, it is critical that we maintain uninterrupted operation of our computer and communications hardware and software systems, some of which are based on end-of-life or legacy technology, operate with minimal or no vendor support and are otherwise difficult to maintain. Our systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, worms, other malicious computer programs, denial-of-service attacks, security breaches, catastrophic events such as fires, tornadoes, hurricanes, acts of terrorism and usage errors by our employees. If our systems are damaged, breached or cease to function properly, we may have to make a significant investment to repair or replace them, and we may suffer loss of critical data and interruptions or delays in our operations. Operating legacy systems subjects us to inherent costs and risks associated with maintaining, upgrading and replacing these systems and retaining sufficiently skilled personnel to maintain and operate the systems, demands on management time, and other risks and costs. Any material interruption in our computer operations may have a material adverse effect on our business or results of operations, including on our Shop Your Way program and participation in or engagement with that program. We are pursuing initiatives to transform our information technology processes and systems. These initiatives are highly complex and include replacing legacy systems, upgrading existing systems, and acquiring new systems and hardware with updated functionality. The risk of disruption is increased in periods when such complex and significant systems changes are undertaken. If we do not maintain the security of our member and customer, associate or company information, we could damage our reputation, incur substantial additional costs and become subject to litigation. The protection of member, customer, employee, and company data is critical to the Company. We have systems and processes in place that are designed to protect information and protect against security and data breaches as well as fraudulent transactions and other activities. Nevertheless, cyber-security risks such as malicious software and attempts to gain unauthorized access to data are rapidly evolving and becoming increasingly sophisticated. Techniques or software used to gain unauthorized access, and/or disable, degrade or harm our systems may be difficult to detect or scope for prolonged periods of time, and we may be unable to anticipate these techniques or put in place protective or preventive measures. These attempts to gain unauthorized access could lead to disruptions in our systems, unauthorized release of confidential or otherwise protected information or corruption of data. If individuals are successful in infiltrating, breaking into, disrupting, damaging or otherwise stealing from the computer systems of the Company or its third-party providers we may have to make a significant investment to fix or replace them, we may suffer interruptions in our operations in the interim, we may face costly litigation, government investigations, government enforcement actions, fines and/or lawsuits, the ability for our members to earn or redeem points in our Shop Your Way program may be impacted or halted, and our reputation with our members and customers may be significantly harmed. There is no guarantee that the procedures that we have implemented to protect against unauthorized access to secured data are adequate to safeguard against all data security breaches. A data security breach or any failure by us to comply with applicable privacy and information security laws and regulations could result in a loss of customer or member confidence and negatively impact our business, including our Shop Your Way program, and our results of operations. Moreover, a data security breach could require us to devote significant management resources to address the problems created by the breach and to expend significant additional resources to upgrade further the security measures that we employ to guard against such breaches, which could disrupt our business, operations and financial condition. We are subject to payment-related risks that could increase our operating costs, expose us to fraud or theft, subject us to potential liability and potentially disrupt our business operations. As a retailer that accepts payments using a variety of methods, including credit and debit cards, PayPal, and gift cards, the Company is subject to rules, regulations, contractual obligations and compliance requirements, including payment network rules and operating guidelines, data security standards and certification requirements, and rules governing electronic funds transfers. The regulatory environment related to information security and privacy is increasingly rigorous, with new and constantly changing requirements applicable to our business, and compliance with those requirements could result in additional costs or accelerate these costs. For certain payment methods, including credit and debit cards, we pay interchange and other fees, which could increase over time and raise our operating costs. We rely on third parties to provide payment processing services, including the processing of credit cards, debit cards, and other forms of electronic payment. If these companies become unable to provide these services to us, or if their systems are compromised, it could disrupt our business. The Payment Card Industry ("PCI") has established standards for securing payment card data through the PCI Data Security Standards ("DSS"). The Company is required to conduct an annual assessment with a PCI Qualified Security Assessor to assess compliance with the PCI DSS. Based on the 2016 assessment, the Company was determined to be non-compliant with PCI DSS. For 2017, we delivered 6 out of 7 compliant reports for PCI. The only outstanding report for automotive is to be delivered in the first quarter of 2018 as has been agreed upon with the relevant processor and card brands. While the Company took corrective actions which allowed it to regain compliance with PCI DSS, there can be no assurance that the Company will achieve compliance in the future. A failure to achieve compliance with PCI DSS could result in the incurrence of fines, penalties or other liabilities by the Company. Due to the seasonality of our business, our annual operating results would be adversely affected to a heightened degree if our business performs poorly in the fourth quarter. Due to the seasonality of our business, our operating results vary considerably from quarter to quarter. We generate a high proportion of revenues, operating income and operating cash flows during the fourth quarter of our year, which includes the holiday season. In addition, our Company incurs significant additional expenses for inventory, advertising and employees in the period leading up to the months of November and December in anticipation of higher sales volume in the fourth quarter. As a result, our fourth quarter operating results significantly impact our annual operating results. Our fourth quarter operating results may fluctuate significantly, based on many factors, including holiday spending patterns and weather conditions. Our sales may fluctuate for a variety of reasons, which could adversely affect our results of operations. Our business is sensitive to customers' spending patterns, which in turn are subject to prevailing economic conditions. Our sales and results of operations have fluctuated in the past, and we expect them to continue to fluctuate in the future. A variety of other factors affect our sales and financial performance, including: actions by our competitors, including opening of new stores in our existing markets or changes to the way these competitors go to market online; our ability to integrate and deliver an attractive online retail experience; seasonal fluctuations due to weather conditions; changes in our merchandise strategy and mix; changes in population and other demographics; and timing of our promotional events. Accordingly, our results for any one quarter are not necessarily indicative of the results to be expected for any other quarter, and comparable store sales for any particular future period may increase or decrease. For more information on our results of operations, see Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 of this Annual Report on Form 10-K. We rely on foreign sources for significant amounts of our merchandise, and our business may therefore be negatively affected by the risks associated with international trade. We depend on a large number of products produced in foreign markets. We face risks, including reputational risks, associated with sourcing, purchasing, and the delivery of merchandise originating outside the United States, including: potential economic and political instability in countries where our suppliers are located; increases in shipping costs; manufacturing and transportation delays and interruptions, including without limitation, delays and interruptions resulting from labor slowdowns, strikes, or other disruptions at any port where merchandise we purchase enters the U.S.; the availability of raw materials to suppliers; supplier financial instability; supplier compliance with applicable laws, including labor and environmental laws, and with our global compliance program for suppliers and factories; merchandise safety and quality issues, adverse fluctuations in currency exchange rates; and changes in U.S. and foreign laws affecting the importation and taxation of goods, including duties, tariffs and quotas, or changes in the enforcement of those laws. U.S. foreign trade policies, trade restrictions, other impositions on imported goods, trade sanctions imposed on certain countries, the limitation on the importation of certain types of goods or of goods containing certain materials from other countries, and other factors relating to foreign trade are beyond our control. These and other factors affecting our suppliers and our access to products could adversely affect our results of operations. We rely on third parties to provide us with services in connection with the administration of certain aspects of our business. We have entered into agreements with third-party service providers (both domestic and overseas) to provide processing and administrative functions over a broad range of areas, and we may continue to do so in the future. These areas include finance and accounting, information technology, including IT development, call center, human resources and procurement functions. Services provided by third parties could be interrupted as a result of many factors, such as acts of God or contract disputes, and any failure by third parties to provide us with these services on a timely basis or within our service level expectations and performance standards could result in a disruption of our business. In addition, to the extent we are unable to maintain our outsourcing arrangements, we could incur substantial costs, including costs associated with hiring new employees or finding an alternative outsourced solution. Moreover, the Company cannot make any assurances that it would be able to arrange for alternate or replacement outsourcing arrangements on terms as favorable as the Company’s existing agreements, if at all. Any inability on the part of the Company to do so could negatively affect our results of operations. These outsourcing arrangements also carry the risk that the Company will fail to adequately retain the significant internal historical knowledge of our business and systems that is transferred to the service providers as the employment of the Company's personnel who possess such knowledge ends. We could incur charges due to impairment of goodwill, intangible and long-lived assets. At February 3, 2018, we had goodwill and intangible asset balances of $1.4 billion, which are subject to periodic testing for impairment. Our long-lived assets, primarily stores, also are subject to periodic testing for impairment. A significant amount of judgment is involved in the periodic testing. Failure to achieve sufficient levels of cash flow within our reporting unit, or sales of our branded products or cash flow generated from operations at individual store locations could result in impairment charges for goodwill and intangible assets or fixed asset impairment for long-lived assets, which could have a material adverse effect on our reported results of operations. Impairment charges, if any, resulting from the periodic testing are non-cash. A significant decline in the property fair values could result in long-lived asset impairment charges. See Notes 12 and 13 of Notes to Consolidated Financial Statements for further information. Our failure to attract or retain employees, including key personnel, may disrupt our business and adversely affect our financial results. Our business is dependent on our ability to attract, develop, and retain qualified employees, many of whom are entry-level or part-time positions with historically high turnover rates. Our ability to meet our labor needs and control labor costs is subject to external factors such as unemployment levels, prevailing wage rates, collective bargaining efforts, health care and other benefit costs, changing demographics, and our reputation within the labor market. If we are unable to attract and retain adequate numbers and an appropriate mix of qualified employees, the quality of service we provide to our customers may decrease and our financial performance may be adversely affected. Further, we depend on the contributions of key personnel, including Edward S. Lampert, our Chairman and Chief Executive Officer, and other key employees, for our future success. Over the past several years, the departures of a number of our executive officers have caused disruptions to, and uncertainty in, our business and operations. Future changes in our senior management team or the departures of other key employees may further disrupt our business and materially adversely affect our results of operations. Affiliates of our Chairman and Chief Executive Officer, whose interests may be different than your interests, exert substantial influence over our Company. Affiliates of Edward S. Lampert, our Chairman and Chief Executive Officer, collectively own approximately 49% of the outstanding shares of our common stock at February 3, 2018. These affiliates are controlled, directly or indirectly, by Mr. Lampert. Accordingly, these affiliates, and thus Mr. Lampert, have substantial influence over many, if not all, actions to be taken or approved by our stockholders, including the election of directors and any transactions involving a change of control. The interests of these affiliates, which have investments in other companies, including Seritage and our former subsidiaries, Sears Hometown and Outlet Stores, Inc., Lands' End, Inc. and Sears Canada, may from time to time diverge from the interests of our other stockholders, particularly with regard to new investment opportunities. This substantial influence may also have the effect of discouraging offers to acquire our Company because the consummation of any such acquisition would likely require the consent of these affiliates. In addition, as of February 3, 2018, these affiliates collectively hold approximately $1.8 billion of our outstanding indebtedness. As long as these affiliates continue to hold significant amounts of our indebtedness, such affiliates’ interests may be different than those of our other stockholders and debtholders. We may be unable to protect or preserve the image of our brands and our intellectual property rights, which could have a negative impact on our business. We regard our copyrights, service marks, trademarks, trade dress, trade secrets, patents and similar intellectual property as critical to our success, particularly those that relate to our private branded merchandise. As such, we rely on trademark and copyright law, patent law, trade secret protection and confidentiality agreements with our associates, consultants, vendors, and others to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets, patents or other proprietary rights for any reason, or if we fail to maintain the image of our brands due to merchandise and service quality issues, actual or perceived, adverse publicity, governmental investigations or litigation, or other reasons, our brands and reputation could be damaged and we could lose members and customers. Our sales and operating results could be adversely affected by product safety concerns or claims concerning the services we offer. If our merchandise offerings do not meet applicable safety standards or consumer expectations regarding safety, we could experience decreased sales, increased costs, and exposure to reputational risk and personal injury, death, or property damage claims related to such merchandise. Such matters may require us to take actions such as product recalls and could give rise to government enforcement actions. We also provide various services to our members and customers, which could also give rise to such claims and government actions. Although we maintain liability insurance, we cannot be certain that our coverage will be adequate for liabilities actually incurred or that insurance will continue to be available to us on economically reasonable terms, or at all. Reputational damage caused by, and claims arising from, real or perceived product safety concerns or from the services we offer could negatively affect our business and results of operations. We may be subject to periodic litigation and other regulatory proceedings. These proceedings may be affected by changes in laws and government regulations or changes in the enforcement thereof. From time to time, we may be involved in lawsuits and regulatory actions relating to our business, certain of which may be in jurisdictions with reputations for aggressive application of laws and procedures against corporate defendants. Some of these actions have the potential for significant statutory penalties, and compensatory, treble or punitive damages. Our pharmacy, home services and grocery businesses, in particular, are subject to numerous federal, state and local regulations, and a significant change in, or noncompliance with, these regulations could have a material adverse effect on our compliance costs and results of operations. We are impacted by trends in litigation, including class-action allegations brought under various consumer protection and employment laws, including wage and hour laws, patent infringement claims, and investigations and actions that are based on allegations of untimely compliance or noncompliance with applicable regulations or statutes. Due to the inherent uncertainties of litigation and regulatory proceedings, we cannot accurately predict the ultimate outcome of any such proceedings. An unfavorable outcome could have a material adverse impact on our business, financial condition, and results of operations. In addition, regardless of the outcome of any litigation or regulatory proceedings, these proceedings could result in substantial costs and may require that we devote substantial resources to defend our Company. Further, changes in governmental regulations both in the United States and in the other countries where we operate could have adverse effects on our business and subject us to additional regulatory actions. For a description of current legal proceedings, see Item 3, Legal Proceedings, as well as Note 18 of Notes to Consolidated Financial Statements in this Annual Report on Form 10-K. Our pension and postretirement benefit plan obligations are currently underfunded, and we may have to make significant cash payments to some or all of these plans, which would reduce the cash available for our businesses. We have unfunded obligations under our domestic pension and postretirement benefit plans. The funded status of our pension plans is dependent upon many factors, including returns on invested assets, the level of certain market interest rates and the discount rate used to determine pension obligations. Unfavorable returns on the plan assets or unfavorable changes in applicable laws or regulations could materially change the timing and amount of required plan funding, which would reduce the cash available for our businesses. In addition, a decrease in the discount rate used to determine pension obligations could result in an increase in the valuation of pension obligations, which could affect the reported funding status of our pension plans and future contributions, as well as the periodic pension cost in subsequent years. Moreover, unfavorable regulatory action could materially change the timing and amount of required plan funding and negatively impact our business operations and impair our business strategy. On March 18, 2016, we entered into a five-year pension plan protection and forbearance agreement (the “PPPFA”) with the Pension Benefit Guaranty Corporation ("PBGC"), pursuant to which the Company has agreed to continue to protect, or "ring-fence," pursuant to customary covenants, the assets of certain special purpose subsidiaries (the "Relevant Subsidiaries") holding real estate and/or intellectual property assets. Also under the agreement, the Relevant Subsidiaries granted PBGC a springing lien on the ring-fenced assets, which lien will be triggered only by (a) failure to make required contributions to the Company's pension plans (the "Plans"), (b) prohibited transfers of ownership interests in the Relevant Subsidiaries, (c) termination events with respect to the Plans, or (d) bankruptcy events with respect to the Company or certain of its material subsidiaries. In connection with the closing of our sale of the Craftsman brand, we agreed to grant the PBGC a lien on, and subsequently contribute to the Plans, the value of the $250 million cash payment payable to the Company on the third anniversary of the Craftsman closing. We subsequently sold the right to receive such payment to a third-party purchaser and deposited the proceeds from such sale into an escrow for the benefit of the Plans. We also granted a lien to the PBGC on the 15-year income stream relating to new Stanley Black & Decker sales of Craftsman products, and agreed to contribute the payments from Stanley Black & Decker under such income stream to the Plans. We also agreed to grant the PBGC a lien on $100 million of real estate assets to secure the Company's minimum pension funding obligations through the end of 2019, and agreed to certain other amendments to the PPPFA. In November 2017, we entered into an amendment to the PPPFA that allowed the Company to pursue the monetization of 138 of our properties that were subject to a ring-fence arrangement created under the PPPFA. In March 2018, the Company closed on the Secured Loan and the Mezzanine Loan, which transactions released the properties from the ring-fence arrangement. The Company contributed approximately $282 million of the proceeds of such loans to our pension plans, and deposited $125 million into an escrow for the benefit of the Plans. Under our agreement with the PBGC, the escrowed amount will also be contributed to the Plans and, when so contributed, will be fully credited against the Company’s minimum pension funding obligations in 2018 and 2019. Following such transactions, the Company has been relieved of contributions to the Plans for approximately two years (other than the contributions from escrow described above and a $20 million supplemental payment due in the second quarter of 2018). The ultimate amount of pension contributions could be affected by factors such as changes in applicable laws, as well as financial market and investment performance and demographic changes. The Company will continue to make required contributions to the Plans, the scheduled amounts of which are not, other than as described above, affected by the arrangement. Under the PPPFA, the PBGC has agreed to forbear from initiating an involuntary termination of the Plans, except upon the occurrence of specified conditions, one of which is based on the aggregate market value of the Company’s issued and outstanding stock. As of the date of this report, the Company’s stock price is such that the PBGC would be permitted to cease forbearance. The PBGC has been given notice in accordance with the terms of the PPPFA and has not communicated any intention to cease its forbearance; however, if the PBGC were to initiate an involuntary termination of the Plans, our financial condition could be materially and adversely affected. We may not realize the full anticipated benefits of the Craftsman sale transaction. We may not realize the full anticipated benefits of the Craftsman sale transaction (the "Craftsman Sale"), in which case our business, financial results or operations could be adversely affected. Under the terms of our Acquired IP License Agreement with Stanley Black & Decker, we have the right to continue to use the Licensed IP (as defined in such agreement) and sell Craftsman-branded products in certain distribution channels. If the license is terminated, or if the terms of the license agreement are otherwise modified, we may not be able to continue to market, procure or sell Craftsman-branded products on favorable terms or at all, and our business may be adversely affected. Our failure to comply with federal, state, local and international laws, or changes in these laws could adversely affect our results of operations. Our business is subject to a wide array of laws and regulations. If we fail to comply with applicable laws and regulations, we could be subject to legal risk, including government enforcement action and class action civil litigation that could increase our cost of doing business. Changes in the regulatory environment regarding topics such as privacy and information security, product safety, environmental protection, payment methods and related fees, responsible sourcing, supply chain transparency, wage and hour laws, health care mandates and other applicable laws and regulations could also cause our compliance costs to increase and adversely affect our results of operations. Our performance could further be impacted by changes in legislation, trade policies and agreements, energy and environmental standards, and tax laws and regulations. The current U.S. Administration has signaled that it may alter trade agreements and terms with foreign countries, and recently limited trade by announcing upcoming tariffs on imported steel and aluminum and imposing tariffs and quotas on imports of residential washers from certain foreign countries. These restrictions and tariffs, as well as future additional tariffs and/or quotas, on products that we import may require that we raise our prices, which could result in decreased sales. Further, changes in environmental and energy efficiency standards and regulations applicable to products that we develop and/or sell, and potential changes in the size and availability of tax incentives applicable to such products, may impact the types, characteristics, and consumer interest in such products, which may negatively impact our results of operations. Moreover, future legislation or regulations, including environmental matters, product certification, product liability, tariffs, duties, taxes, tax incentives and other matters, may impact our results. Major developments in tax policy or trade relations, such as the imposition of unilateral tariffs on imported products, could have a material adverse effect on our business, results of operations and liquidity. Weather conditions and natural disasters may impact consumer shopping patterns and could adversely affect our results of operations. Significant weather conditions where our stores are located could negatively affect the Company's business and results of operations. Heavy snowfall, ice storms, rainstorms or other extreme weather conditions over a prolonged period could make it difficult for our members and customers to travel to our stores, thus leading to decreased sales. Our business is also susceptible to unseasonable weather conditions, such as unseasonably warm temperatures during the winter season or cool weather during the summer season, which could reduce demand for certain inventory and compromise our efforts to predict and manage inventory levels effectively. In addition, extreme weather conditions could result in disruption or delay of production and delivery of materials and products in our supply chain. In addition, natural disasters such as hurricanes, tornadoes and earthquakes, or a combination of these or other factors, could damage or destroy our facilities or make it difficult for members and customers to travel to our stores, thereby negatively affecting our business and results of operations as well as causing us to incur significant expenses to repair or replace such facilities. Our stock price has been and may continue to be volatile. The market price of our common stock has fluctuated substantially and may continue to fluctuate significantly. Future announcements or disclosures concerning us or any of our competitors, our strategic initiatives, our sales and profitability, any quarterly variations in actual or anticipated operating results or comparable sales, any failure to meet analysts' expectations and sales of large blocks of our common stock, among other factors, could cause the market price of our common stock to fluctuate substantially. Increases in employee wages and the cost of employee benefits could impact our financial results and cash flow. Our expenses relating to employee health benefits are significant. Increases in minimum wages or unfavorable changes in the cost of such benefits could negatively affect our financial results and cash flow. Healthcare costs have risen significantly in recent years, and various legislative and private sector initiatives regarding healthcare reform have resulted, and could continue to result, in significant changes to the U.S. healthcare system. Due to the breadth and complexity of the healthcare reform legislation, and the potential for change in this regard under the current U.S. Administration, we are unable at this time to fully determine the impact that further healthcare reform will have on our employee health benefit plans. The following table summarizes the locations of our Kmart and Sears Domestic stores at February 3, 2018: State / Territory Full-line Stores In addition, at February 3, 2018, we had 30 domestic supply chain distribution centers, of which 10 were owned and 20 were leased with remaining lease terms ranging up to 10 years. Of the total, six primarily support Kmart stores, 20 primarily support Sears stores and four support both Sears and Kmart stores. We also had 400 domestic store warehouses, customer call centers and service facilities (including 20 facilities related to our Monark Premium Appliance Co. of California, Monark Premium Appliance Co., and Monark Premium Appliance Co. of Arizona businesses), most of which are leased for terms ranging from one to six years or are part of other facilities included in the above table. Many of our facilities are also used to support our online channels. Our principal executive offices are located on a 200-acre site owned by us at the Prairie Stone office park in Hoffman Estates, Illinois. The complex consists of six interconnected office buildings totaling approximately two million gross square feet of office space. We also own an 86,000 square foot office building in Troy, Michigan. We operate numerous buying offices throughout the world that procure product internationally, as well as an information technology center in Pune, India. A description of our leasing arrangements and commitments appears in Note 14 of Notes to Consolidated Financial Statements. See Part II, Item 8, Financial Statements—Notes to Consolidated Financial Statements, Note 18—Legal Proceedings, for additional information regarding legal proceedings, which information is incorporated herein by this reference. EXECUTIVE OFFICERS OF THE REGISTRANT The following table and information sets forth the names of our executive officers, their current positions and offices with the Company, the date they first became executive officers of the Company, their current ages, and their principal employment during the past five years. Date First Became an Executive Officer Edward S. Lampert Chairman of the Board and Chief Executive Officer Robert A. Riecker Julie Ainsworth J. Mitchell Bowling Chief Executive Officer, Sears Home Services Leena Munjal Chief Digital Officer Robert (B.J.) Naedele Chief Commercial Officer, Shop Your Way Perry (Dean) Schwartz President, Hardlines Stephen L. Sitley General Counsel and Chief Compliance Officer Mr. Lampert has served as Chairman of the Company's Board of Directors since 2004 and as our Chief Executive Officer since February 2013. He also is the Chairman and Chief Executive Officer of ESL Investments, Inc., which he founded in April 1988. Mr. Riecker was appointed to his current position in April 2017, and had served as Controller and Head of Capital Markets Activities since October 2016. He joined the Company as Assistant Controller in October 2005 and served as Vice President and Assistant Controller from May 2007 to October 2011. From October 2011 until his election as Vice President, Controller and Chief Accounting Officer in January 2012, he served as the Company's Vice President, Internal Audit. Ms. Ainsworth joined the Company in March 2017 as Chief People Officer. Prior to joining the Company, she was Chief Executive Officer of celectiv LLC, a recruiting platform for technology-based companies, which she co-founded in 2014. From 2010 until 2013 she served as President of Warranty Division and Chief Marketing Officer of North American Services Division of Centrica plc, an energy and services company. Mr. Bowling joined the Company in November 2017 as Chief Executive Officer, Sears Home Services. Prior to joining the Company, he served as Senior Vice President and Chief Operating Officer of Apollo Education Group, a leading provider of higher education for working adults, from December 2013 until April 2017, and prior to that, served as Senior Vice President and General Manager of New Businesses at Comcast, a global telecommunications provider, from 2009 until 2013. Ms. Munjal was appointed to her current position in January 2018. She previously served as Senior Vice President, Customer Experience and Integrated Retail, since October 2012. She was appointed as Divisional Vice President, Integrated Retail and Member Experience, in July 2011 and was promoted to Vice President in June 2012. From October 2009 to June 2011, she served as Divisional Vice President, and Chief of Staff, Office of the Chairman, and served as Chief of Staff, Office of the CEO, from November 2007 to November 2009. Ms. Munjal joined Sears as Director, Information Technology, in March 2003. Mr. Naedele joined the Company in March 2017. Prior to joining the Company, he served in a variety of roles with Nike, Inc., a company engaged in the design, development, marketing and sales of athletic gear and apparel, which he joined in July 2008, most recently as Vice President, Strategic Growth Initiatives from March 2016 until February 2017, and prior to that as Vice President, Global Brand Marketing from July 2014 until March 2016 and Global Business General Manager from July 2012 until July 2014. Mr. Schwartz was appointed to his current position in April 2017. He previously served as President, Tools, Lawn & Garden, Fitness, Sporting Goods and Children's Entertainment from January 2017 until April 2017, as Vice President, Tools and Lawn & Garden from August 2016 until January 2017, as Vice President, Tools from May 2013 until August 2016, and as Vice President, Lawn & Garden from March 2009 until May 2013. Mr. Sitley was appointed General Counsel in November 2017 and became Chief Compliance Officer in December 2017. From June 2016 until November 2017, he served as Vice President, Human Resources Operations, Compliance and Associate Relations, and prior to that, was Deputy General Counsel, Litigation and Employment from June 2011 until June 2016. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Holdings' common stock is quoted on The NASDAQ Stock Market under the ticker symbol SHLD. There were 9,502 shareholders of record at March 16, 2018. The quarterly high and low sales prices for Holdings' common stock are set forth below. Common stock price Holdings has not paid cash dividends over the two most recent fiscal years and does not expect to pay cash dividends in the foreseeable future. Equity Compensation Plan Information The following table reflects information about securities authorized for issuance under our equity compensation plans at February 3, 2018. Plan Category to be issued upon exercise of outstanding options, warrants and Weighted-average exercise price of options, remaining available for future issuance under equity compensation plans* Equity compensation plans approved by security holders Equity compensation plans not approved by security holders Represents shares of common stock that may be issued pursuant to our 2013 Stock Plan. Awards under the 2013 Stock Plan may be restricted stock, stock unit awards, incentive stock options, nonqualified stock options, stock appreciation rights, or certain other stock-based awards. The 2013 Stock Plan also allows common stock of Holdings to be awarded in settlement of an incentive award under the Sears Holdings Corporation Umbrella Incentive Program (and any incentive program established thereunder). The shares shown exclude shares covered by an outstanding plan award that, subsequent to February 3, 2018, ultimately are not delivered on an unrestricted basis (for example, because the award is forfeited, canceled, settled in cash or used to satisfy tax withholding obligations). Comparison of Five-Year Cumulative Stockholder Return The following graph compares the cumulative total return to stockholders on Holdings' common stock from February 1, 2013 through February 2, 2018, the last trading day before the end of fiscal year 2017, based on the market prices at the last trading day before the end of each fiscal year through and including fiscal year 2017, with the return on the S&P 500 Index, the S&P 500 Retailing Index and the S&P 500 Department Stores Index for the same period. The graph assumes an initial investment of $100 on February 1, 2013 in each of our common stock, the S&P 500 Index, the S&P Retailing Index and the S&P 500 Department Stores Index. The graph further assumes reinvestment of the value of: (i) subscription rights to purchase shares of common stock of Sears Hometown and Outlet Stores, Inc. on September 13, 2012, the ex-distribution date of the distribution of such rights to Holdings’ shareholders; (ii) common shares of Sears Canada on November 13, 2012, the distribution date of such shares to Holdings’ shareholders; (iii) shares of Lands' End on April 7, 2014, the ex-distribution date of the distribution of such shares to Holdings' shareholders; (iv) subscription rights to purchase shares of common stock of Sears Canada on October 17, 2014, the ex-distribution date of the distribution of such rights to Holdings' shareholders; (v) subscription rights to purchase up to $625 million in aggregate principal amount of 8% senior unsecured notes due 2019 and warrants to purchase shares of Holdings' common stock on November 3, 2014, the ex-distribution date of the distribution of such rights to Holdings' shareholders; and (vi) subscription rights to purchase shares of common stock of Seritage Growth Properties on June 12, 2015, the distribution date of such rights to Holdings’ shareholders. The S&P 500 Retailing Index consists of companies included in the S&P 500 Index in the broadly defined retail sector, which includes competing retailers of softlines (apparel and domestics) and hardlines (appliances, electronics and home improvement products), as well as food and drug retailers. The S&P 500 Department Stores Index consists primarily of department stores that compete with our full-line stores. S&P 500 Retailing Index S&P 500 Department Stores Index Purchase of Equity Securities During the quarter ended February 3, 2018, we did not repurchase any shares of our common stock under our common share repurchase program. At February 3, 2018, we had approximately $504 million of remaining authorization under the program. Purchased(1) per Share Total Number of Shares Purchased as Part of Publicly Approximate Dollar Value of Shares that May Yet Be Purchased October 29, 2017 to November 25, 2017 November 26, 2017 to December 30, 2017 December 31, 2017 to February 3, 2018 Consists entirely of 0 shares acquired from associates to meet withholding tax requirements from the vesting of restricted stock. Our common share repurchase program was initially announced on September 14, 2005 and has a total authorization since inception of the program of $6.5 billion, including the authorizations to purchase up to an additional $500 million of common stock on each of December 17, 2009 and May 2, 2011. The program has no stated expiration date. The Amended Domestic Credit Agreement (described in Management's Discussion and Analysis of Financial Condition and Results of Operations - Uses and Sources of Liquidity section below) limits our ability to make restricted payments, including dividends and share repurchases, subject to specified exceptions that are available if, in each case, no event of default under the credit facility exists immediately before or after giving effect to the restricted payment. These include exceptions that require that projected availability under the credit facility, as defined, is at least 15%, exceptions that may be subject to certain maximum amounts and an exception that requires that the restricted payment is funded from cash on hand and not from borrowings under the credit facility. Further, the Amended Domestic Credit Agreement includes customary covenants that restrict our ability to make dispositions, prepay debt and make investments, subject, in each case, to various exceptions. The Amended Domestic Credit Agreement also imposes various other requirements, which take effect if availability falls below designated thresholds, including a cash dominion requirement and a requirement that the fixed charge ratio at the last day of any quarter be not less than 1.0 to 1.0. The table below summarizes our recent financial information. The data set forth below should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and our Consolidated Financial Statements and notes thereto in Item 8. dollars in millions, except per share data Summary of Operations Revenues(1) Domestic comparable store sales % (13.5 )% (7.4 Net loss from continuing operations attributable to Holdings' shareholders Per Common Share (3.57 (20.78 Diluted: Holdings' book value per common share Long-term debt Long-term capital lease obligations Adjusted EBITDA(2) Number of stores We follow a retail-based financial reporting calendar. Accordingly, the fiscal year ended February 3, 2018 contained 53 weeks, while all other years presented contained 52 weeks. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" in Item 7 for a reconciliation of this measure to GAAP and a discussion of management’s reasoning for using such measure. The periods presented were impacted by certain significant items, which affected the comparability of amounts reflected in the above selected financial data. For 2017, 2016 and 2015, these significant items are discussed within Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations." 2014 results include the impact of domestic pension expense of $89 million, store closings and severance of $224 million, other expenses of $50 million and the results of Lands' End and Sears Canada that were included in the results of operations prior to the separations of $(10) million and $71 million, respectively. 2013 results include the impact of domestic pension expense of $162 million, domestic store closings and severance of $130 million, and the results of Lands' End and Sears Canada that were included in the results of our operations prior to the separations of $(150) million and $(3) million, respectively. Both 2014 and 2013 also included charges related to impairments, as well as gains on sales of assets. Management's Discussion and Analysis of Financial Condition and Results of Operations We have divided our Management's Discussion and Analysis of Financial Condition and Results of Operations into the following six sections: Overview of Holdings Results of Operations: Holdings' Consolidated Results Business Segment Results Analysis of Consolidated Financial Condition Contractual Obligations and Off-Balance Sheet Arrangements Application of Critical Accounting Policies and Estimates Cautionary Statement Regarding Forward-Looking Information The discussion that follows should be read in conjunction with the Consolidated Financial Statements and notes thereto included in Item 8. Holdings, the parent company of Kmart and Sears, was formed in connection with the March 24, 2005 merger of these two companies. We are an integrated retailer with significant physical and intangible assets, as well as virtual capabilities enabled through technology. We operate a national network of stores, with 1,002 full-line and specialty retail stores in the United States, operating as Kmart and Sears. Further, we operate a number of websites under the sears.com and kmart.com banners which offer millions of products and provide the capability for our members and customers to engage in cross-channel transactions such as free store pickup; buy in store/ship to home; and buy online, return in store. We are also the home of Shop Your Way®, a free membership program that connects its members to personalized products, programs and partners that help them save time and money every day. Through an extensive network of national and local partners, members can shop thousands of their favorite brands, dine out and access an array of exclusive partners to earn points to redeem for savings on future purchases at Sears, Kmart, Lands' End and at ShopYourWay.com. We conduct our operations in two business segments: Kmart and Sears Domestic. The nature of operations conducted within each of these segments is discussed within the Business Segments section of Item 1 in this Annual Report on Form 10-K. Our business segments have been determined in accordance with accounting standards regarding the determination, and reporting, of business segments. Our fiscal year end is the Saturday closest to January 31 each year. Fiscal year 2017 consisted of 53 weeks. Fiscal years 2016 and 2015 consisted of 52 weeks. Unless otherwise stated, references to years in this report relate to fiscal years rather than to calendar years. Holdings' consolidated results of operations for 2017, 2016 and 2015 are summarized as follows: Merchandise sales Services and other Cost of sales, buying and occupancy - merchandise sales Gross margin dollars - merchandise sales Gross margin rate - merchandise sales Cost of sales and occupancy - services and other Gross margin dollars - services and other Gross margin rate - services and other Total cost of sales, buying and occupancy Total gross margin dollars Total gross margin rate Selling and administrative Selling and administrative expense as a percentage of total revenues Depreciation and amortization Impairment charges Gain on sales of assets Operating loss Interest and investment loss Income tax benefit Income attributable to noncontrolling interests NET LOSS ATTRIBUTABLE TO HOLDINGS’ SHAREHOLDERS NET LOSS PER COMMON SHARE ATTRIBUTABLE TO HOLDINGS’ SHAREHOLDERS Diluted loss per share Diluted weighted average common shares outstanding References to comparable store sales amounts within the following discussion include sales for all stores operating for a period of at least 12 full months, including remodeled and expanded stores, but excluding store relocations and stores that have undergone format changes. Comparable store sales amounts include sales from sears.com and kmart.com shipped directly to customers. These online sales resulted in a negative impact to our comparable store sales results of approximately 70 basis points and 20 basis points for 2017 and 2016, respectively. In addition, comparable store sales have been adjusted for the change in the unshipped sales reserves recorded at the end of each reporting period, which resulted in a benefit of 30 basis points in 2017 and did not have any impact in 2016. Comparable store sales results for 2017 were calculated based on the 52-week period ended January 27, 2018 as compared to the comparable 52-week period in the prior year, while comparable store sales results for 2016 were calculated based on the 52-week period ended January 28, 2017 as compared to the comparable 52-week period in the prior year. 2017 Compared to 2016 Net Loss Attributable to Holdings' Shareholders We recorded a net loss attributable to Holdings' shareholders of $383 million ($3.57 loss per diluted share) and $2.2 billion ($20.78 loss per diluted share) for 2017 and 2016, respectively. The decrease in net loss for the year primarily reflected an increase in gain on sales of assets, a decrease in selling and administrative expenses and an increase in income tax benefit, partially offset by a decline in gross margin, which was primarily driven by the decline in revenues. Our results for 2017 and 2016 were affected by a number of significant items. In addition to our net loss attributable to Holdings' shareholders determined in accordance with Generally Accepted Accounting Principles ("GAAP"), for purposes of evaluating operating performance, we use Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA"). Adjusted EBITDA was determined as follows: Net loss attributable to Holdings per statement of operations Before excluded items Closed store reserve and severance Pension expense Amortization of deferred Seritage gain (1) Consisted of items associated with legal matters, expenses associated with natural disasters, transaction costs associated with strategic initiatives, one-time credits from vendors and other expenses. Adjusted EBITDA for our segments was as follows: Operating income (loss) per statement of operations % to revenues The following tables set forth the impact each excluded item used in calculating Adjusted EBITDA had on specific income and expense amounts reported in our Consolidated Statements of Operations during the years 2017, 2016 and 2015. Year Ended February 3, 2018 Other Excluded Items: Gross margin impact Selling and administrative impact Year Ended January 28, 2017 Adjusted EBITDA is computed as net loss attributable to Sears Holdings Corporation appearing on the Statements of Operations excluding income attributable to noncontrolling interests, income tax benefit, interest expense, interest and investment loss, other income, depreciation and amortization, gain on sales of assets and impairment charges. In addition, it is adjusted to exclude certain significant items as set forth below. Our management uses Adjusted EBITDA to evaluate the operating performance of our businesses, as well as executive compensation metrics, for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items. While Adjusted EBITDA is a non-GAAP measurement, management believes that it is an important indicator of ongoing operating performance, and useful to investors, because: EBITDA excludes the effects of financings and investing activities by eliminating the effects of interest and depreciation costs; Management considers gains/(losses) on the sale of assets to result from investing decisions rather than ongoing operations; and Other significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results. We have adjusted our results for these items to make our statements more comparable and therefore more useful to investors as the items are not representative of our ongoing operations and reflect past investment decisions. These other significant items included in Adjusted EBITDA are further explained as follows: Closed store reserve and severance – We are transforming our Company to a less asset-intensive business model. Throughout this transformation, we continue to make choices related to our stores, which could result in sales, closures, lease terminations or a variety of other decisions. Pension expense – Contributions to our pension plans remain a significant use of our cash on an annual basis. Cash contributions to our pension and postretirement plans are separately disclosed on the cash flow statement. While the Company's pension plan is frozen, and thus associates do not currently earn pension benefits, we have a legacy pension obligation for past service performed by Kmart and Sears associates. The annual pension expense included in our statement of operations related to these legacy domestic pension plans was relatively minimal in years prior to 2009. However, due to the severe decline in the capital markets that occurred in the latter part of 2008, and the resulting abnormally low interest rates, which continue to persist, our domestic pension expense was $656 million in 2017, $288 million in 2016 and $229 million in 2015. Pension expense is comprised of interest cost, expected return on plan assets and recognized net loss and other. This adjustment eliminates the entire pension expense from the statement of operations to improve comparability. Pension expense is included in the determination of net loss. As further described in Note 7 of Notes to Consolidated Financial Statements, settlement charges also impacted pension expense in 2017. In conjunction with executing two separate agreements to purchase group annuity contracts in May 2017 and August 2017, the Company recorded non-cash charges of $200 million and $203 million, respectively, during the second and third quarters of 2017 for losses previously accumulated in other comprehensive income (loss), which were recognized through the statement of operations upon settlement. In addition, in conjunction with a lump sum offer completed in 2017, the Company recorded a non-cash charge of $76 million for losses previously accumulated in other comprehensive income (loss), which was recognized through the statement of operations immediately upon settlement during the fourth quarter of 2017. The components of the adjustments to EBITDA related to pension expense were as follows: Components of net periodic expense: Interest cost Expected return on plan assets Recognized net loss and other Net periodic expense In accordance with GAAP, we recognize on the balance sheet actuarial gains and losses for defined benefit pension plans annually in the fourth quarter of each fiscal year and whenever a plan is determined to qualify for a remeasurement during a fiscal year. For income statement purposes, these actuarial gains and losses are recognized throughout the year through an amortization process. The Company recognizes in its results of operations, as a corridor adjustment, any unrecognized actuarial net gains or losses that exceed 10% of the larger of projected benefit obligations or plan assets. Accumulated gains/losses that are inside the 10% corridor are not recognized, while accumulated actuarial gains/losses that are outside the 10% corridor are amortized over the "average future service" of the population and are included in the recognized net loss and other line item above. Actuarial gains and losses occur when actual experience differs from the estimates used to allocate the change in value of pension plans to expense throughout the year or when assumptions change, as they may each year. Significant factors that can contribute to the recognition of actuarial gains and losses include changes in discount rates used to remeasure pension obligations on an annual basis or upon a qualifying remeasurement, differences between actual and expected returns on plan assets and other changes in actuarial assumptions. Management believes these actuarial gains and losses are primarily financing activities that are more reflective of changes in current conditions in global financial markets (and in particular interest rates) that are not directly related to the underlying business and that do not have an immediate, corresponding impact on the benefits provided to eligible retirees. For further information on the actuarial assumptions and plan assets referenced above, see Management's Discussion and Analysis of Financial Condition and Results of Operations - Application of Critical Accounting Policies and Estimates - Defined Benefit Pension Plans, and Note 7 of Notes to Consolidated Financial Statements. Other – Consisted of items associated with legal matters, expenses associated with natural disasters, transaction costs associated with strategic initiatives, one-time credits from vendors and other expenses. Amortization of deferred Seritage gain – A portion of the gain on the Seritage transaction and certain other sale-leaseback transactions were deferred and will be recognized in proportion to the related rent expense, which is a component of cost of sales, buying and occupancy in the Consolidated Statements of Operations, over the lease terms. Management considers the amortization of the deferred Seritage gain to result from investing decisions rather than ongoing operations. Revenues and Comparable Store Sales Total revenues decreased $5.4 billion, or 24.6%, to $16.7 billion in 2017 compared to 2016 primarily driven by the decline in merchandise sales of $4.8 billion. The decline in merchandise sales included a decrease of approximately $3.2 billion as a result of having fewer Kmart and Sears Full-line stores in operation. For the full year, comparable store sales declined 13.5%, which contributed to $1.9 billion of the revenue decline relative to the prior year. The Company recognized approximately $189 million of revenues during the 53rd week of 2017. Services and other revenues declined $609 million during 2017 as compared to 2016, primarily driven by a decline in service-related revenues of approximately $295 million, as well as a decline in revenues from Sears Hometown and Outlet Stores, Inc. ("SHO") of approximately $208 million during 2017 as compared to 2016. Kmart comparable store sales declined 11.4% for the full year primarily driven by declines in the pharmacy, grocery & household, home, drugstore, consumer electronics and apparel categories. Sears Domestic comparable store sales for the year declined 15.2% primarily driven by decreases in the home appliances, apparel, consumer electronics and lawn & garden categories. Total gross margin declined $1.2 billion to $3.5 billion in 2017 as compared to the prior year primarily as a result of the above noted decline in sales, as well as a slight decline in gross margin rate, as the decline in gross margin rate for merchandise sales was partially offset by an improvement in gross margin rate for services and other. Gross margin for 2017 and 2016 included charges of $227 million and $226 million, respectively, related to store closures. Gross margin for 2017 and 2016 also included credits of $78 million and $88 million, respectively, related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction, while 2016 also included one-time vendor credits of $33 million. As compared to the prior year, Kmart's gross margin rate for 2017 increased 10 basis points, while Sears Domestic's gross margin rate decreased 60 basis points. Gross margin for Kmart and Sears Domestic were negatively impacted by expenses associated with store closures. Excluding the impact of significant items as noted in the Adjusted EBITDA tables, Kmart's gross margin rate would have improved 60 basis points in 2017 as compared to the prior year, while Sears Domestic's gross margin rate would have been flat to the prior year. The improvement in Kmart's gross margin rate was primarily driven by margin rate improvement in the apparel, home and drugstore categories, partially offset by a decline in the pharmacy category. Sears Domestic's gross margin rate for 2017 reflects improvement in the apparel category, which was offset by declines in the home appliances and tools categories. Kmart experienced lower clearance markdowns and Shop Your Way points expense, partially offset by an increase in promotional markdowns, while Sears Domestic experienced lower clearance markdowns, offset by an increase in both promotional markdowns and Shop Your Way points expense. In addition, as a result of the Seritage and JV transactions, 2017 and 2016 included additional rent expense of approximately $169 million and $197 million, respectively. Due to the structure of the leases, we expect that our cash rent obligations to Seritage and the joint venture partners will decline, over time, as space in these stores is recaptured. From the inception of the Seritage transaction to date, we have received recapture notices on 55 properties and we also exercised our right to terminate the lease on 56 properties. Selling and Administrative Expenses Selling and administrative expenses decreased $978 million to $5.1 billion in 2017 from $6.1 billion in 2016 and included significant items, as noted in the Adjusted EBITDA tables, which aggregated to an expense of $893 million and $510 million for 2017 and 2016, respectively. Excluding these items, selling and administrative expenses declined $1.4 billion, primarily due to a decrease in payroll expense. In addition, advertising expense also declined as we continued to shift away from traditional advertising to use of Shop Your Way points expense, which is included within gross margin. Selling and administrative expenses as a percentage of total revenues ("selling and administrative expense rate") were 30.7% and 27.6% for 2017 and 2016, respectively, as the decreases in overall selling and administrative expenses were more than offset by the above noted decline in revenues. Depreciation and amortization expense decreased by $43 million during 2017 to $332 million, as compared to 2016, primarily due to having fewer assets to depreciate. We recorded impairment charges of $142 million in 2017, which consisted of impairment of $72 million related to the Sears trade name, as well as $70 million related to the impairment of long-lived assets. We recorded impairment charges of $427 million in 2016, which consisted of impairment of $381 million related to the Sears trade name, as well as $46 million related to the impairment of long-lived assets. Impairment charges recorded in both years are described further in Notes 1 and 13 of Notes to Consolidated Financial Statements. We recorded total gains on sales of assets of $1.6 billion in 2017 and $247 million in 2016, which were primarily attributable to several significant real estate transactions. The gains recorded during 2017 included gains of $708 million recognized on the sale or amendment and lease terminations of 95 locations, $492 million recognized on the Craftsman Sale, $253 million as a result of recapture and lease termination activity and two stores that qualified for sales recognition and sale-leaseback accounting and $79 million related to other asset sales. Gains on sales of assets are described further in Note 11 of Notes to Consolidated Financial Statements. We recorded an operating loss of $430 million and $2.0 billion in 2017 and 2016, respectively. The operating loss for 2017 included significant items, as noted in the Adjusted EBITDA tables, which totaled $1.0 billion, while operating loss for 2016 included significant items which totaled $615 million. Both 2017 and 2016 also included charges related to impairments, as well as gains on sales of assets. Taking these significant items into consideration, the decrease in operating loss in 2017 was primarily driven by the decrease in selling and administrative expenses, partially offset by the decline in gross margin noted above. We incurred $539 million and $404 million in interest expense during 2017 and 2016, respectively. The increase is due to an increase in average outstanding borrowings in 2017, as well as an increase in the annual weighted-average interest rate for our borrowings. We recorded interest and investment loss of $12 million during 2017 compared to $26 million during 2016. Interest and investment loss is described further in Note 6 of Notes to Consolidated Financial Statements. We recorded an income tax benefit of $598 million in 2017 compared with an income tax benefit of $174 million in 2016. Our effective tax rate for 2017 was a benefit of 61.0% compared to a benefit of 7.3% for 2016. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the "Tax Act"). The Tax Act makes broad and complex changes to the U.S. tax code that affected our fiscal year ended February 3, 2018, including, but not limited to, (1) reducing the U.S. federal corporate tax rate to 21%, (2) requiring a one-time transition tax on certain unrepatriated earnings of foreign subsidiaries that is payable over eight years and (3) various other miscellaneous changes that are effective in fiscal 2017. With the lower U.S. federal corporate rate effective beginning January 1, 2018, our U.S. federal corporate tax rate for fiscal 2017 is a blended rate of 33.717%. The income tax benefit for the period ended February 3, 2018 included a tax benefit of approximately $470 million related to the impacts of the Tax Act. In addition to the impact of the Tax Act, the Company also realized a significant tax benefit during 2017 on the reversal of deferred taxes mainly related to the Craftsman Sale, but also related to indefinite-life assets associated with property sold. Our tax rate in 2017 continues to reflect the effect of not recognizing the benefit of current period losses in certain domestic and foreign jurisdictions where it is more likely than not that such benefits would be realized. In addition, 2017 was negatively impacted by foreign branch taxes and state income taxes. During 2016, the Company realized a significant tax benefit on the deferred taxes related to the partial impairment of the Sears trade name. In addition, the Company recorded a tax benefit related to the net gain on pension and other postretirement benefits in continuing operations and a corresponding tax expense of the same amount in other comprehensive income. Also, the application of the requirements for accounting for income taxes, after consideration of our valuation allowance, caused a significant variation in the typical relationship between income tax expense and pretax income. Our tax rate in 2016 reflected the effect of not recognizing the benefit of current period losses in certain domestic and foreign jurisdictions where it was not more likely than not that such benefits would be realized. In addition, 2016 was negatively impacted by foreign branch taxes and state income taxes. We recorded a net loss attributable to Holdings' shareholders of $2.2 billion ($20.78 loss per diluted share) and $1.1 billion ($10.59 loss per diluted share) for 2016 and 2015, respectively. The increase in net loss for the year primarily reflected a decline in gross margin, which was driven by a decline in both revenues and gross margin rate, partially offset by a decrease in selling and administrative expenses. Total revenues decreased $3.0 billion, or 12.0%, to $22.1 billion in 2016, as compared to revenues of $25.1 billion in 2015, primarily driven by the decline in merchandise sales of $2.7 billion. The decline in merchandise sales included a decrease of $1.3 billion as a result of having fewer Kmart and Sears Full-line stores in operation. For the full year, comparable store sales declined 7.4%, which contributed to $1.4 billion of the revenue decline relative to the prior year. Services and other revenues declined $308 million during 2016 as compared to 2015, primarily driven by a decline in service-related revenues of approximately $30 million, as well as a decline in revenues from SHO of approximately $238 million during 2016 as compared to 2015. Kmart comparable store sales declined 5.3% for the full year primarily driven by declines in the grocery & household, consumer electronics and pharmacy categories. Sears Domestic comparable store sales for the year declined 9.3% primarily driven by decreases in the home appliances, apparel and consumer electronics categories. Total gross margin declined $1.1 billion to $4.7 billion in 2016 from $5.8 billion in 2015 as a result of the above noted decline in sales, as well as a decline in gross margin rate, as the decline in gross margin rate for merchandise sales was partially offset by an improvement in gross margin rate for services and other. Gross margin for 2016 included one-time vendor credits of $33 million, as well as a credit of $88 million related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction, while 2015 included one-time vendor credits of $146 million, as well as a credit of $52 million related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction. Gross margin for 2016 and 2015 also included charges of $226 million and $44 million, respectively, related to store closures. As compared to the prior year, Kmart's gross margin rate for 2016 declined 310 basis points. Excluding significant items primarily related to store closures as noted in the Adjusted EBITDA tables, Kmart's gross margin rate would have declined 130 basis points with margin rate declines experienced across most categories, most notably in the apparel, grocery & household, drugstore, home and pharmacy categories. Sears Domestic's gross margin rate for 2016 decreased 130 basis points. Excluding the impact of significant items in both years primarily related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction, one-time vendor credits and store closures, Sears Domestic's gross margin rate declined 60 basis points, with the most notable decreases experienced in the apparel, home appliances and footwear categories. The decline in margin rate experienced in both Kmart and Sears Domestic is primarily attributable to increased markdowns, including an increase in Shop Your Way points expense. In addition, as a result of the Seritage and JV transactions, 2016 and 2015 included additional rent expense and assigned sub-tenant rental income of approximately $197 million and $133 million, respectively. Selling and administrative expenses decreased $748 million to $6.1 billion in 2016 from $6.9 billion in 2015 and included significant items, as noted in the Adjusted EBITDA tables, which aggregated to an expense of $510 million and $365 million for 2016 and 2015, respectively. Excluding these items, selling and administrative expenses declined $893 million, primarily due to a decrease in payroll expense. In addition, advertising expense also declined as we continued to shift away from traditional advertising to use of Shop Your Way points expense, which is included within gross margin. We recorded impairment charges of $427 million in 2016, which consisted of impairment of $381 million related to the Sears trade name, as well as $46 million related to the impairment of long-lived assets. We recorded impairment charges of $274 million in 2015, which consisted of impairment of $180 million related to the Sears trade name, as well as $94 million related to the impairment of long-lived assets. Impairment charges recorded in both years are described further in Notes 1 and 13 of Notes to Consolidated Financial Statements. We recorded total gains on sales of assets of $247 million in 2016 and $743 million in 2015, which were primarily attributable to several significant real estate transactions. The gains recorded in 2015 included $508 million recognized in connection with the joint venture transactions and the sale-leaseback transaction with Seritage. Gains on sales of assets recorded in both years are described further in Note 11 of Notes to Consolidated Financial Statements. We recorded an operating loss of $2.0 billion and $1.0 billion in 2016 and 2015, respectively. The operating loss for 2016 included significant items, as noted in the Adjusted EBITDA tables, which totaled $615 million, while operating loss for 2015 included significant items which totaled $211 million. Both 2016 and 2015 also included charges related to impairments, as well as gains on sales of assets. Taking these significant items into consideration, the decrease in operating loss in 2016 was primarily driven by the decrease in selling and administrative expenses, partially offset by the decline in gross margin noted above. We incurred $404 million and $323 million in interest expense during 2016 and 2015, respectively. The increase is due to an increase in average outstanding borrowings in 2016. We recorded interest and investment loss of $26 million during 2016 compared to interest and investment loss of $62 million during 2015. Interest and investment income loss is described further in Note 6 of Notes to Consolidated Financial Statements. We recorded an income tax benefit of $174 million in 2016 compared with an income tax benefit of $257 million in 2015. Our effective tax rate for 2016 was a benefit of 7.3% compared to a benefit of 18.6% for 2015. During 2016, the Company realized a significant tax benefit on the deferred taxes related to the partial impairment of the Sears trade name. In addition, the Company recorded a tax benefit related to the net gain on pension and other postretirement benefits in continuing operations and a corresponding tax expense of the same amount in other comprehensive income. Also, the application of the requirements for accounting for income taxes, after consideration of our valuation allowance, caused a significant variation in the typical relationship between income tax expense and pretax income. Our tax rate in 2016 reflected the effect of not recognizing the benefit of current period losses in certain domestic and foreign jurisdictions where it was not more likely than not that such benefits would be realized. In addition, 2016 was negatively impacted by foreign branch taxes and state income taxes. The 2015 rate was favorably impacted by the significant tax benefit realized on the deferred taxes related to indefinite-life assets associated with the property sold in the transaction with Seritage and the tax benefit realized on the deferred taxes related to the partial impairment of the Sears trade name. These items were partially offset by foreign branch taxes and state income taxes. Kmart results and key statistics were as follows: dollars in millions Comparable store sales % Cost of sales, buying and occupancy Gross margin dollars Gross margin rate Operating income (loss) Total Kmart stores Kmart’s revenues decreased by $3.0 billion to $5.6 billion in 2017, primarily due to the effect of having fewer stores in operation, which accounted for approximately $2.4 billion of the decline. Revenues were also impacted by a decrease in comparable store sales of 11.4%, which accounted for approximately $689 million of the decline. The Company recognized approximately $64 million of revenues during the 53rd week of 2017. The decline in comparable store sales was primarily driven by declines in the pharmacy, grocery & household, home, drugstore, consumer electronics and apparel categories. Kmart generated $1.0 billion in gross margin in 2017 compared to $1.6 billion in 2016. The decrease in Kmart’s gross margin is due to the above noted decrease in sales, partially offset by an increase in gross margin rate. Gross margin included charges related to store closures of $154 million and $187 million in 2017 and 2016, respectively, as well as credits of $11 million and $17 million in 2017 and 2016, respectively, related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction. Kmart's gross margin rate increased 10 basis points to 18.1% in 2017 from 18.0% in 2016. Excluding the impact of significant items, as noted in the Adjusted EBITDA tables, Kmart's gross margin rate would have improved 60 basis points in 2017 as compared to the prior year, primarily driven by margin rate improvement in the apparel, home and drugstore categories, partially offset by a decline in the pharmacy category. Kmart experienced lower clearance markdowns and Shop Your Way points expense, partially offset by an increase in promotional markdowns. In addition, as a result of the Seritage and JV transactions, 2017 and 2016 included additional rent expense of approximately $21 million and $35 million, respectively. Kmart's selling and administrative expenses decreased $720 million in 2017. Selling and administrative expenses included significant items, as noted in the Adjusted EBITDA tables, which aggregated to expense of $104 million and $146 million for 2017 and 2016, respectively. Excluding these items, selling and administrative expenses decreased $678 million primarily due to decreases in payroll and advertising expenses. Kmart's selling and administrative expense rate was 25.9% in 2017 and 25.1% in 2016 and increased primarily as a result of lower expense leverage due to the sales decline noted above. Kmart recorded impairment charges of $16 million and $22 million in 2017 and 2016, respectively, related to the impairment of long-lived assets. Impairment charges recorded during 2017 and 2016 are further described in Note 13 of Notes to Consolidated Financial Statements. Kmart recorded total gains on sales of assets of $881 million and $181 million in 2017 and 2016, respectively. The gains recorded during 2017 included gains of $492 million recognized on the Craftsman Sale, $164 million recognized on the sale or amendment and lease terminations of 43 locations, $43 million as a result of recapture and lease termination activity and $79 million related to other asset sales. Gains on sales of assets are described further in Note 11 of Notes to Consolidated Financial Statements. Kmart recorded operating income of $367 million in 2017 as compared to an operating loss of $530 million in 2016. Operating income for 2017 included significant items, as noted in the Adjusted EBITDA tables, which totaled $247 million, while operating loss for 2016 included significant items which totaled $316 million. Both 2017 and 2016 also included gains on sales of assets, as well as charges related to impairments. Taking these significant items into consideration, the decrease in Kmart's operating loss was primarily driven by the decrease in selling and administrative expenses, partially offset by a decline in gross margin noted above. Kmart’s revenues decreased by $1.5 billion to $8.7 billion in 2016, primarily due to the effect of having fewer stores in operation, which accounted for approximately $1.0 billion of the decline. Revenues were also impacted by a decrease in comparable store sales of 5.3%, which accounted for approximately $477 million of the decline. The decline in comparable store sales was primarily driven by declines in the grocery & household, consumer electronics and pharmacy categories. Kmart generated $1.6 billion in gross margin in 2016 compared to $2.1 billion in 2015. The decrease in Kmart’s gross margin is due to the above noted decrease in sales, as well as a decline in gross margin rate. Gross margin included significant items which aggregated to expense of $170 million and $28 million for 2016 and 2015, respectively. Kmart's gross margin rate declined 310 basis points to 18.0% in 2016 from 21.1% in 2015. Excluding the impact of significant items primarily related to store closures, as noted in the Adjusted EBITDA tables, Kmart's gross margin rate would have declined 130 basis points due to margin rate declines experienced across most categories, most notably in the apparel, grocery & household, drugstore, home and pharmacy categories driven by increased markdowns, including an increase in Shop Your Way points expense. In addition, as a result of the Seritage and JV transactions, 2016 and 2015 included additional rent expense and assigned sub-tenant rental income of approximately $35 million and $25 million, respectively. Kmart's selling and administrative expenses decreased $362 million in 2016. Selling and administrative expenses included significant items, as noted in the Adjusted EBITDA tables, which aggregated to expense of $146 million and $90 million for 2016 and 2015, respectively. Excluding these items, selling and administrative expenses decreased $418 million primarily due to decreases in payroll and advertising expenses. Kmart recorded total gains on sales of assets of $181 million and $185 million in 2016 and 2015, respectively. Gains on sales of assets recorded in both years are described further in Note 11 of Notes to Consolidated Financial Statements. Kmart recorded an operating loss of $530 million in 2016 as compared to $292 million in 2015. Operating loss for 2016 included significant items, as noted in the Adjusted EBITDA tables, which totaled $316 million, while operating loss for 2015 included significant items which totaled $118 million. Both 2016 and 2015 also included gains on sales of assets, as well as charges related to impairments. Taking these significant items into consideration, the decrease in Kmart's operating loss was primarily driven by the decrease in selling and administrative expenses, partially offset by a decline in gross margin. Sears Domestic results and key statistics were as follows: Number of: Total Sears Stores Sears Domestic's revenues decreased by $2.4 billion to $11.1 billion in 2017 as compared to 2016. This decline in revenues was primarily driven by a decrease in comparable store sales of 15.2%, which accounted for $1.2 billion of the decline, and the effect of having fewer Full-line stores in operation, which accounted for $760 million of the decline. The decline in Sears Domestic comparable store sales was primarily driven by decreases in the home appliances, apparel, consumer electronics and lawn & garden categories. The Company recognized approximately $125 million of revenues during the 53rd week of 2017. In addition, we also experienced a decline in revenues from SHO of approximately $208 million during 2017 as compared to 2016. Sears Domestic generated gross margin of $2.5 billion and $3.1 billion in 2017 and 2016, respectively, which included charges related to store closures of $73 million and $39 million in 2017 and 2016, respectively. Gross margin also included credits of $67 million and $71 million in 2017 and 2016, respectively, related to the amortization of the deferred gain on sale of assets associated with the Seritage transaction, while 2016 also included one-time vendor credits of $33 million. Sears Domestic's gross margin rate for the year declined 60 basis points to 22.6% in 2017 from 23.2% in 2016. Excluding the impact of significant items in both years primarily related to store closures, the amortization of the deferred gain on sales of assets associated with the Seritage transaction and one-time vendor credits, Sears Domestic's gross margin rate in 2017 would have been flat to the prior year, which reflects improvement in the apparel category, which was offset by declines in the home appliances and tools categories. Sears Domestic experienced lower clearance markdowns, offset by an increase in both promotional markdowns and Shop Your Way points expense. In addition, as a result of the Seritage and JV transactions, 2017 and 2016 included additional rent expense of approximately $148 million and $162 million, respectively. Sears Domestic’s selling and administrative expenses decreased $258 million in 2017 as compared to 2016 and included significant items, as noted in the Adjusted EBITDA tables, which aggregated to $789 million and $364 million for 2017 and 2016, respectively. Excluding these items, selling and administrative expenses decreased $683 million, primarily due to decreases in payroll and advertising expenses. Sears Domestic's selling and administrative expense rate was 33.2% in 2017 and 29.2% in 2016 and increased as the above noted expense reduction was more than offset by the decline in sales noted above. Sears Domestic recorded impairment charges of $126 million in 2017 which consisted of impairment of $72 million related to the Sears trade name, as well as $54 million related to the impairment of long-lived assets. We recorded impairment charges of $405 million in 2016 which consisted of impairment of $381 million related to the Sears trade name, as well as $24 million related to the impairment of long-lived assets. Impairment charges recorded in both years are described further in Notes 1 and 13 of Notes to Consolidated Financial Statements. Sears Domestic recorded total gains on sales of assets of $767 million and $66 million in 2017 and 2016, respectively. The gains recorded during 2017 included gains of $544 million recognized on the sale or amendment and lease terminations of 52 locations and $210 million as a result of recapture and lease termination activity and two stores that qualified for sales recognition and sale-leaseback accounting. Gains on sales of assets are described further in Note 11 of Notes to Consolidated Financial Statements. Sears Domestic reported an operating loss of $797 million in 2017 compared to $1.4 billion in 2016. Sears Domestic's operating loss in 2017 included significant items, as noted in the Adjusted EBITDA tables, which totaled $795 million, while operating loss for 2016 included significant items which totaled $299 million. Both 2017 and 2016 also included charges related to impairments, as well as gains on sales of assets. Taking these significant items into consideration, the decrease in Sears Domestic's operating loss in 2017 was driven by the decrease in selling and administrative expenses, partially offset by the decline in gross margin noted above. Sears Domestic's revenues decreased by $1.5 billion to $13.5 billion in 2016 as compared to 2015. This decline in revenues was primarily driven by a decrease in comparable store sales of 9.3%, which accounted for $890 million of the decline, and the effect of having fewer Full-line stores in operation, which accounted for $241 million of the decline. The decline in Sears Domestic comparable store sales was primarily driven by decreases in the home appliances, apparel and consumer electronics categories. In addition, we also experienced a decline in revenues from SHO of approximately $238 million during 2016 as compared to 2015. Sears Domestic generated gross margin of $3.1 billion and $3.7 billion in 2016 and 2015, respectively, which included significant items which aggregated to additional gross margin of $65 million and $182 million for 2016 and 2015, respectively. Sears Domestic's gross margin rate for the year declined 130 basis points to 23.2% in 2016 from 24.5% in 2015. Excluding the impact of significant items in both years primarily related to the amortization of the deferred gain on sales of assets associated with the Seritage transaction, one-time vendor credits and store closures, s noted in the Adjusted EBITDA tables, Sears Domestic's gross margin rate declined 60 basis points, with the most notable decreases experienced in the apparel, home appliances and footwear categories driven by increased markdowns, including an increase in Shop Your Way points expense. Sears Domestic recorded impairment charges of $405 million in 2016 which consisted of impairment of $381 million related to the Sears trade name, as well as $24 million related to the impairment of long-lived assets. We recorded impairment charges of $260 million in 2015 which consisted of impairment of $180 million related to the Sears trade name, as well as $80 million related to the impairment of long-lived assets. Impairment charges recorded in both years are described further in Notes 1 and 13 of Notes to Consolidated Financial Statements. Sears Domestic recorded total gains on sales of assets of $66 million and $558 million in 2016 and 2015, respectively. The gains recorded in 2015 included $371 million recognized in connection with the joint venture transactions and the sale-leaseback transaction with Seritage. Gains on sales of assets recorded in both years are described further in Note 11 of Notes to Consolidated Financial Statements. Sears Domestic reported an operating loss of $1.4 billion in 2016 compared to $708 million in 2015. Sears Domestic's operating loss in 2016 included significant items, as noted in the Adjusted EBITDA tables, which totaled $299 million, while operating loss for 2015 included significant items which totaled $93 million. Both 2016 and 2015 also included charges related to impairments, as well as gains on sales of assets. Taking these significant items into consideration, the decrease in Sears Domestic's operating loss in 2016 was driven by the decrease in selling and administrative expenses, partially offset by the above noted decline in gross margin. Cash Balances Our cash and cash equivalents include all highly liquid investments with original maturities of three months or less at the date of purchase. Our cash balances as of February 3, 2018 and January 28, 2017 are detailed in the following table. February 3, January 28, Cash and equivalents Cash posted as collateral Credit card deposits in transit Total cash and cash equivalents Restricted cash Total cash balances We had total cash balances of $336 million and $286 million at February 3, 2018 and January 28, 2017, respectively. At various times, we have posted cash collateral for certain outstanding letters of credit and self-insurance programs. Such cash collateral is classified within cash and cash equivalents given we have the ability to substitute letters of credit at any time for this cash collateral and it is therefore readily available to us. Our invested cash may include, from time to time, investments in, but not limited to, commercial paper, federal, state and municipal government securities, floating-rate notes, repurchase agreements and money market funds. Cash amounts held in these short-term investments are readily available to us. Credit card deposits in transit include deposits in transit from banks for payments related to third-party credit card and debit card transactions. The Company classifies cash balances that are legally restricted pursuant to contractual arrangements as restricted cash. The restricted cash balance relates to amounts deposited into an escrow for the benefit of our pension plans. We classify outstanding checks in excess of funds on deposit within other current liabilities and reduce cash balances when these checks clear the bank on which they were drawn. Outstanding checks in excess of funds on deposit were $74 million and $29 million as of February 3, 2018 and January 28, 2017, respectively. Operating Activities The Company used $1.8 billion of cash in its operations during 2017, $1.4 billion during 2016 and $2.2 billion during 2015. Our primary source of operating cash flows is the sale of goods and services to customers, while the primary use of cash in operations is the purchase of merchandise inventories and the payment of operating expenses. We used more cash in operations in 2017 compared to 2016 primarily due to declines in merchandise payables and other liabilities, partially offset by a decline in merchandise inventories. We used less cash in operations in 2016 compared to 2015 primarily due to a decrease in our net inventory. Merchandise inventories were $2.8 billion and $4.0 billion, respectively, at February 3, 2018 and January 28, 2017, while merchandise payables were approximately $0.6 billion and $1.0 billion, respectively, at February 3, 2018 and January 28, 2017. Our inventory balances decreased approximately $1.2 billion primarily due to both store closures and improved productivity. Sears Domestic inventory decreased in virtually all categories, with the most notable decreases in the apparel, tools and home appliances categories. Kmart inventory decreased in all categories with the most notable decreases in the apparel, home, drugstore and grocery & household categories. Investing Activities We generated net cash flows from investing activities of $1.9 billion in 2017, $244 million in 2016 and $2.5 billion in 2015. For 2017, net cash flows from investing activities consisted of cash proceeds from the sale of properties and investments of $1.1 billion, proceeds from the Craftsman Sale of $572 million and proceeds from the sale of receivables of $293 million, partially offset by cash used for capital expenditures of $80 million. For 2016, net cash flows from investing activities primarily consisted of cash proceeds from the sale of properties and investments of $386 million, partially offset by cash used for capital expenditures of $142 million. For 2015, net cash flows from investing activities primarily consisted of cash proceeds from the sale of properties and investments of $2.7 billion, partially offset by cash used for capital expenditures of $211 million. Proceeds from the sales of properties and investments in 2015 included approximately $2.6 billion of net proceeds from the Seritage transaction. We spent $80 million, $142 million and $211 million during 2017, 2016 and 2015, respectively, for capital expenditures. Capital expenditures during all three years primarily included investments in online and mobile shopping capabilities, enhancements to the Shop Your Way platform, information technology infrastructure and store maintenance. We anticipate 2018 capital expenditure levels to be similar to 2017 levels. In the normal course of business, we consider opportunities to purchase leased operating properties, as well as offers to sell owned, or assign leased, operating and non-operating properties. These transactions may, individually or in the aggregate, result in material proceeds or outlays of cash and cause our capital expenditure levels to vary from period to period. In addition, we review leases that will expire in the short term in order to determine the appropriate action to take with respect to them. Financing Activities During 2017, the Company used net cash flows in financing activities of $2 million, which consisted of debt repayments of $1.4 billion and the payment of debt issuance costs of $43 million, offset by proceeds from debt issuances of $1.0 billion, an increase in short-term borrowings of $271 million and $106 million of net cash proceeds received from sale-leaseback financing transactions. During 2016, we generated net cash flows from financing activities of $1.2 billion, which consisted of proceeds from debt issuances of $2.0 billion and $71 million of net cash proceeds received from a sale-leaseback financing transaction for five Sears Full-line stores and two Sears Auto Centers that have continuing involvement, partially offset by a decrease in short-term borrowings of $797 million, debt repayments of $66 million and the payment of debt issuance costs of $51 million. During 2015, the Company used net cash flows in financing activities of $364 million, which consisted of debt repayments of $1.4 billion, of which $927 million was the purchase of Senior Secured Notes pursuant to the tender offer and $400 million was the repayment of the secured short-term loan, the payment of debt issuance costs of $50 million related to the amendment and extension of our Domestic Credit Facility and fees related to the tender offer related to our Senior Secured Notes. These uses of cash were partially offset by an increase in short-term borrowings of $583 million and $508 million of net cash proceeds from sale-leaseback financing, which consisted of $426 million of proceeds from the JV transactions received during 2015 and $82 million of proceeds received in 2015 related to four joint venture properties that have continuing involvement. During 2017, 2016 and 2015, we did not repurchase any of our common shares under our share repurchase program. The common share repurchase program was initially announced in 2005 and had a total authorization since inception of the program of $6.5 billion. At February 3, 2018, we had approximately $504 million of remaining authorization under the program. The common share repurchase program has no stated expiration date and share repurchases may be implemented using a variety of methods, which may include open market purchases, privately negotiated transactions, block trades, accelerated share repurchase transactions, the purchase of call options, the sale of put options or otherwise, or by any combination of such methods. Uses and Sources of Liquidity Our primary need for liquidity is to fund working capital requirements of our businesses, capital expenditures and for general corporate purposes, including debt repayments and pension plan contributions. The Company has taken a number of actions to support its ongoing transformation efforts, while continuing to support its operations and meet its obligations in light of the incurred losses and negative cash flows experienced over the past several years. These actions included: The completion of various secured and unsecured financing transactions, the extension of the maturity of certain of our indebtedness, and the amendment to other terms of certain of our indebtedness to increase our overall financial flexibility, including: a $750 million Senior Secured Term Loan (the "2016 Term Loan") under its domestic credit facility maturing in July 2020; a $500 million real estate loan facility in April 2016 (the "2016 Secured Loan Facility"), initially maturing in July 2017, initially extended to January 2018, subsequently extended to April 2018, and then further extended to July 2018, subject to the payment of an extension fee; an additional $500 million real estate loan facility in January 2017 (the "2017 Secured Loan Facility"), maturing in July 2020; a Second Lien Credit Agreement in September 2016, pursuant to which the Company borrowed $300 million under a term loan (the "Second Lien Term Loan"), maturing in July 2020; an amendment in July 2017 to the Second Lien Credit Agreement to provide for the creation of a $500 million uncommitted second-lien line of credit loan facility under which the Company may borrow line of credit loans (the "Line of Credit Loans"), and a subsequent amendment to that facility to extend the maximum duration of the Line of Credit Loans from 180 days to 270 days and permit total borrowings of up to $600 million; a Letter of Credit and Reimbursement Agreement in December 2016, originally providing for up to a $500 million secured standby letter of credit facility (the "LC Facility") from certain affiliates of ESL Investments, Inc. ("ESL"); a $200 million real estate loan facility (the "Incremental Loans") in October 2017, with the Incremental Loans maturing in April 2018, with the option to extend to July 2018, subject to the extension of the 2016 Secured Loan Facility; the extension of the maturity date of the initial $1.0 billion term loan (the "Term Loan") under our Amended Domestic Credit Agreement from June 2018 to January 2019 (with a right of the borrowers thereunder to further extend such maturity, subject to the satisfaction of certain conditions, to July 2019); amendments to our Amended Domestic Credit Agreement and certain other indebtedness which reduced the aggregate revolver commitments from $1.971 billion to $1.5 billion, but also implemented other modifications to covenants and reserves against the domestic credit facility borrowing base that improved net liquidity, and increased the maximum permissible short-term borrowings of the Company from $750 million to $1.25 billion; a Term Loan Credit Agreement in January 2018 providing for a secured term loan facility (the "Term Loan Facility"), secured by substantially all of the unencumbered intellectual property of the Company and its subsidiaries, other than intellectual property relating to the Kenmore and DieHard brands, as well as by certain real property interests, in each case subject to certain exclusions. An aggregate principal amount of $250 million was borrowed with the ability to borrow an additional $50 million against the same collateral; an amendment to the indenture governing our 6 5/8% Senior Secured Notes due 2018 to increase the maximum permissible borrowings secured by inventory to 75% of book value of such inventory from 65% and defer the collateral coverage test for purposes of the repurchase offer covenant in the indenture to restart it with the second quarter of 2018 (such that no collateral coverage event can occur until the end of the third quarter of 2018); an amendment to the March 2016 Pension Plan Protection and Forbearance Agreement (the "PPPFA") with the Pension Benefit Guaranty Corporation (the "PBGC") providing for the release of 138 of our properties from a ring-fence arrangement created under our five-year PPPFA in exchange for the payment of approximately $407 million into the Sears pension plans. This agreement provides the Company with financial flexibility through the ability to monetize properties, and, in addition, provides funding relief from contributions to the pension plans for the next two years; and various commercial paper issuances to meet short-term liquidity needs, with the maximum amount outstanding during fiscal 2017 of $160 million. Achievement of $1.25 billion in annualized cost savings in 2017 as part of the restructuring program announced earlier this year. Actions taken to realize the annualized cost savings have included simplification of the organizational structure of Holdings, streamlining of operations, reducing unprofitable categories and the closure of under-performing stores. In 2017, we closed approximately 435 stores, and an additional 103 stores previously announced for closure are expected to be closed by the end of the first quarter of 2018. As a result of these actions, the Company has begun to see improvement in the operations in fiscal 2017, as the restructuring program actions, including the closing of unprofitable stores, have begun to take effect. The sale of the Craftsman brand to Stanley Black & Decker for consideration consisting of cash payments and a royalty. Sales of properties and investments for proceeds of $1.1 billion and $386 million in 2017 and 2016, respectively. On March 8, 2018, the Company secured an additional $100 million incremental real estate loan (the "Second Incremental Loan"), pursuant to an amendment to the Second Amended and Restated Loan Agreement, dated as of October 18, 2017, with JPP, LLC and JPP II, LLC, entities affiliated with ESL Investments, Inc. The Second Incremental Loan is secured by the same real estate properties as the 2017 Secured Loan Facility, and certain properties under the previous Incremental Loans outstanding, and matures in July 2020. The Company used the proceeds from the Incremental Loan for general corporate purposes. In March 2018, the Company also closed on the $200 million Secured Loan and the $240 million Mezzanine Loan, both as defined in Note 3 of Notes to Consolidated Financial Statements, in connection with the release of 138 of our properties from the ring-fence arrangement with the PBGC as described above. The properties, which have an aggregate appraised value of nearly $980 million, serve as collateral for the Secured Loan, and the Mezzanine Loan is secured by pledge of the equity interests in the direct parent company of the entities that own such properties. The Company contributed approximately $282 million of the proceeds of such loans to our pension plans, and deposited $125 million into an escrow for the benefit of our pension plans. The Mezzanine Loan Agreement, as defined in Note 3 of Notes to Consolidated Financial Statements, contains an uncommitted accordion feature pursuant to which we may incur additional loans of not more than $200 million in aggregate, subject to certain conditions, including that such additional loans not exceed an amount equal to the principal amount of the Secured Loan repaid. The Company expects to pay down the Secured Loan over the next three to six months using proceeds generated from the sale of the underlying properties. In February 2018, the Company commenced private exchange offers for its outstanding 8% Senior Unsecured Notes Due 2019 and 6 5/8% Senior Secured Notes Due 2018 (the "Exchange Offers"), pursuant to which it offered to (1) issue in exchange for its outstanding 8% Senior Unsecured Notes Due 2019 (the "Old Senior Unsecured Notes") new 8% Senior Unsecured Notes Due 2019, of a like principal amount, convertible into common stock of the Company, with interest on such notes to be payable in kind at the Company's option (the "New Senior Unsecured Notes"), and (2) issue in exchange for its outstanding 6 5/8% Senior Secured Notes Due 2018 (the "Old Senior Secured Notes") new 6 5/8% Senior Secured Notes Due 2019, of a like principal amount, convertible into common stock of the Company, with interest on such notes to be payable in kind at the Company's option (the "New Senior Secured Notes"). The Exchange Offers expired on March 15, 2018. Approximately $214 million aggregate principal amount of the Old Senior Unsecured Notes and approximately $170 million aggregate principal amount of the Old Senior Secured Notes were validly tendered, accepted and canceled in the Exchange Offers, and the Company issued a like principal amount of New Senior Unsecured Notes and New Senior Secured Notes. The New Senior Unsecured Notes and New Senior Secured Notes are optionally convertible by the holders thereof into shares of the Company’s common stock at conversion prices of $8.33 and $5.00, respectively, per share of common stock, and are mandatorily convertible at the Company's option if the volume weighted average trading price of the common stock on the NASDAQ exceeds $10.00 for a prescribed period. In connection with the closing of the Exchange Offers, the Company also obtained the requisite consent of holders of Old Senior Secured Notes to adopt amendments to the indenture governing those notes to eliminate substantially all of the restrictive covenants and certain events of default in the indenture, and make the liens securing senior second lien obligations, including the new Senior Secured Notes and the Second Lien Term Loan described below, effectively senior to the liens securing junior second lien obligations, including the Old Senior Secured Notes. Also in connection with the closing of the Exchange Offers, the Company entered into an amendment to its Second Lien Credit Agreement. The amendment provides the Company with the option to pay interest on its outstanding $300 million principal amount Second Lien Term Loan in kind, and also provides that the Company's obligation under the Second Lien Term Loan is convertible into common stock of the Company, on the same conversion terms as the New Senior Secured Notes. Also in connection with the closing of the Exchange Offers, the Company’s subsidiary, Sears Roebuck Acceptance Corp. ("SRAC"), consummated a private exchange with certain third parties of approximately $100 million in principal amount of senior unsecured notes issued by SRAC maturing between 2027 and 2043 and bearing interest at rates between 6.50% and 7.50% per annum, pursuant to which SRAC issued a like principal amount of new unsecured notes (the "SRAC Exchange Notes"). The SRAC Exchange Notes mature in March 2028 and bear interest at a rate of 7.0% per annum, and provide the Company with the option to pay such interest in kind at an interest rate of 12.0% per annum. The SRAC Exchange Notes are also guaranteed by the same subsidiaries of the Company that guarantee the New Senior Secured Notes. On March 21, 2018, we obtained a $125 million FILO term loan (the "FILO Loan") from JPP, LLC and JPP II, LLC, entities affiliated with ESL, and Benefit Street 2018 LLC, an entity affiliated with Thomas J. Tisch, under our Amended Domestic Credit Agreement. The Company received approximately $122 million in net proceeds from the FILO Loan, which proceeds were using to reduce outstanding borrowings under our revolving credit facility. The FILO Loan has a maturity date of July 20, 2020, which is the same maturity date as the Company's revolving credit facility commitments, and does not amortize. In addition to pursuing several transactions to adjust our capital structure in order to enhance our liquidity and financial position, the Company is also taking incremental actions to further streamline operations to drive profitability, including cost reductions of $200 million on an annualized basis in 2018 unrelated to store closures. In addition to the actions taken above, the Company has other resources available to support its operations. Our domestic credit facility permits us up to $2.0 billion of second lien loan capacity (of which $1.1 billion was utilized at February 3, 2018) outside the credit agreement, all depending on the applicable and available borrowing base as defined in our applicable debt agreements, as well as our ability to secure commitments from lenders. We also have the ability to obtain longer-term secured financing maturing outside of the domestic credit facility maturity date which would not be subject to borrowing base limitations (see Note 3 of Notes to Consolidated Financial Statements). Other options available to us, which we will evaluate and execute as appropriate, include refinancing existing debt, borrowing against facilities in place with availability and additional real estate loans against unencumbered properties, which we have successfully executed in the past. We also continue to explore ways to unlock value across a range of assets, including entering into or renegotiating commercial arrangements, and exploring ways to maximize the value of our Home Services, Innovel and Sears Auto Centers businesses, as well as our Kenmore and DieHard brands, through partnerships, sales or other means of externalization that could expand distribution of our brands and service offerings to realize significant growth. We expect to continue to right-size, redeploy and highlight the value of our assets, including monetizing our real estate portfolio and exploring potential asset sales, in our transition from an asset intensive, historically "store-only" based retailer to a more asset light, integrated membership-focused company. We expect to continue to face a challenging competitive environment. While we continue to focus on our overall profitability, including managing expenses, we reported a loss in 2017, and were required to fund cash used in operating activities with cash from investing and financing activities. If we continue to experience operating losses, and we are not able to generate additional liquidity through the actions described below or through some combination of other actions, including real estate or other asset sales, while not expected, then our liquidity needs may exceed availability under our Amended Domestic Credit Agreement, our second lien line of credit loan facility and our other existing facilities, and we might need to secure additional sources of funds, which may or may not be available to us. A failure to secure such additional funds could cause us to be in default under the Amended Domestic Credit Agreement. Moreover, if the borrowing base (as calculated pursuant to our outstanding second lien debt) falls below the principal amount of such second lien debt plus the principal amount of any other indebtedness for borrowed money that is secured by liens on the collateral for such debt on the last day of any two consecutive quarters, it could trigger an obligation to repurchase our New Senior Secured Notes in an amount equal to such deficiency. As of February 3, 2018, we are in a deferral period of the collateral coverage test and the calculation restarts in the second quarter of 2018 (such that no collateral coverage event can occur until the end of the third quarter of 2018). Additionally, a failure to generate additional liquidity could negatively impact our access to inventory or services that are important to the operation of our business. We believe the following actions, some of which we expect, subject to our governance processes, to include related party participation and funding, are probable of occurring and will be sufficient to satisfy our liquidity needs for the next twelve months from the issuance of the financial statements: Sales of the properties securing the $200 million Secured Loan to fund the repayment of such Secured Loan; Additional borrowings under the Mezzanine Loan Agreement and the Term Loan Facility; Renegotiation of certain commercial arrangements; Monetization of the Kenmore brand; Extension of maturities beyond March 2019 of Line of Credit Loans under the Second Lien Credit Agreement, the 2016 Secured Loan Facility, the Incremental Secured Loan Facility and the LC Facility and the Term Loan under the Amended Domestic Credit Agreement; Additional borrowings secured by real estate assets or borrowings under the short-term basket; and Further restructurings to help manage expenses and improve profitability. The PPPFA contains certain limitations on our ability to sell assets, which could impact our ability to complete asset sale transactions or our ability to use proceeds from those transactions to fund our operations. Therefore, the analysis of liquidity needs includes consideration of the applicable restrictions under the PPPFA. We expect that the actions outlined above will further enhance our liquidity and financial flexibility and we expect that these actions will be executed in alignment with the anticipated timing of our liquidity needs. Our outstanding borrowings at February 3, 2018 and January 28, 2017 were as follows: Short-term borrowings: Unsecured commercial paper Secured borrowings Line of credit loans Incremental loans Long-term debt, including current portion: Notes, term loan and debentures outstanding Capitalized lease obligations Total borrowings We fund our peak sales season working capital needs through our domestic revolving credit facility and commercial paper markets and secured short-term debt. Secured borrowings: Maximum daily amount outstanding during the period Average amount outstanding during the period Amount outstanding at period-end Weighted average interest rate Unsecured commercial paper: Line of credit loans: Information about our Domestic Credit Agreement, Letter of Credit Facility, Secured Loan and Mezzanine Loan, Term Loan Facility, 2017 Secured Loan Facility, 2016 Secured Loan Facility, Second Lien Credit Agreement, Old Senior Secured Notes and New Senior Secured Notes, Old Senior Unsecured Notes and New Senior Unsecured Notes, Unsecured Commercial Paper, Secured Short-Term Loan and Wholly-owned Insurance Subsidiary and Intercompany Securities is included in Note 3 of Notes to Consolidated Financial Statements. Domestic Pension Plans Funding Contributions to our pension plans remain a significant use of our cash on an annual basis. While the Company's pension plans are frozen, and thus associates do not currently earn pension benefits, the Company has a legacy pension obligation for past service performed by Kmart and Sears associates. During 2017, we contributed $295 million to our domestic pension plans, including amounts contributed from the escrow created pursuant to the PPPFA. We estimate that our minimum pension funding obligations will be approximately $280 million in 2018 (excluding the $20 million supplemental payment described below) and approximately $276 million in 2019. As previously noted, the Company agreed to grant the PBGC a lien on, and subsequently contribute to the Company's pension plans, the value of the $250 million cash payment payable to the Company on the third anniversary of the Craftsman closing (the "Craftsman Receivable"). During the 13 weeks ended July 29, 2017, we sold the Craftsman Receivable to a third-party purchaser, and deposited the proceeds into an escrow for the benefit of our pension plans. We subsequently contributed a portion of the proceeds received from the sale of the Craftsman Receivable to our pension plans, which contribution was credited against the Company's minimum pension funding obligations in 2017. Under our agreement with the PBGC, the remaining proceeds will also be contributed to our pension plans, and when so contributed, will be fully credited against the Company's minimum pension funding obligations in 2018 and 2019. The Company also agreed to grant a lien to the PBGC on the 15-year income stream relating to new Stanley Black & Decker sales of Craftsman products, and agreed to contribute the payments from Stanley Black & Decker under such income stream to the Company's pension plans, with such payments to be credited against the Company's minimum pension funding obligations starting no later than five years from the closing date. The Company also agreed to grant the PBGC a lien on $100 million of real estate assets to secure the Company's minimum pension obligations through the end of 2019. In November 2017, the Company announced an amendment to the PPPFA that allowed the Company to pursue the monetization of 138 of our properties that were subject to a ring-fence arrangement created under the PPPFA. In March 2018, the Company closed on the Secured Loan and the Mezzanine Loan, which transactions released the properties from the ring-fence arrangement. The Company contributed approximately $282 million of the proceeds of such loans to our pension plans, and deposited $125 million into an escrow for the benefit of our pension plans. Under our agreement with the PBGC, the escrowed amount will also be contributed to our pension plans and, when so contributed, will be fully credited against the Company’s minimum pension funding obligations in 2018 and 2019 described above. Following such transactions, the Company has been relieved of contributions to our pension plans for approximately two years (other than the contributions from escrow described above and a $20 million supplemental payment due in the second quarter of 2018). The ultimate amount of pension contributions could be affected by factors such as changes in applicable laws, as well as financial market and investment performance and demographic changes. Information concerning our obligations and commitments to make future payments under contracts such as debt and lease agreements, and under contingent commitments, is aggregated in the following table. Payments Due by Period Contractual Obligations After 5 Years Short-term borrowings Capital lease obligations Royalty license fees(1) Pension funding obligations(2) Long-term debt including current portion and interest Liability and interest related to uncertain tax positions(3)

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FORM 10-K/A (AMENDMENT NO. 4*) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 2002 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 1-12317 NATIONAL-OILWELL, INC. DELAWARE 76-0475815 - --------------------------------- ------------------- (State or other jurisdiction (IRS Employer of incorporation or organization) Identification No.) 10000 RICHMOND AVENUE (Registrant's telephone number, including area code) COMMON STOCK, PAR VALUE $.01 NEW YORK STOCK EXCHANGE ---------------------------- ------------------------------ (Title of Class) (Exchange on which registered) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO ----- ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K/A or any amendment to this Form 10-K/A. [ X ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [ X ] No [ ] As of March 3, 2003, 84,224,527 common shares were outstanding. Based upon the closing price of these shares on the New York Stock Exchange and, excluding solely for purposes of this calculation 4,140,609 shares beneficially owned by directors and executive officers, the aggregate market value of the common shares of National-Oilwell, Inc. held by non-affiliates was approximately $1.8 Portions of the Proxy Statement in connection with the 2003 Annual Meeting of Stockholders are incorporated in Part III of this report. *This amendment is filed for the sole purpose of including Exhibits 99.1 and 99.2 with this Form 10-K/A. National Oilwell designs, manufactures and sells comprehensive systems, components, and products used in oil and gas drilling and production, as well as distributes products and provides services to the exploration and production segment of the oil and gas industry. Our Products and Technology segment designs and manufactures complete land drilling and workover rigs, as well as drilling related systems on offshore rigs. Technology has increased the desirability of one vendor assuming responsibility for the entire suite of components used in the drilling process, as mechanical and hydraulic components are replaced by or augmented with integrated computerized systems. In addition to traditional components such as drawworks (the hoisting winch used to raise and lower drill pipe), mud pumps (used to circulate drilling fluids), top drives (used to turn drill pipe) derricks, cranes, jacking and mooring systems (used to raise, lower and anchor offshore jackup drilling rigs), and other structural components, we provide automated pipehandling, control and electrical power systems. We have also developed new technology for drawworks and mud pumps applicable to the highly demanding offshore markets. Non-capital products produced by our Products and Technology segment include drilling motors and specialized downhole tools that are sold or rented, spare parts and service on the large installed base of our equipment, expendable parts for mud pumps and other equipment, and smaller downhole, progressive cavity and transfer pumps. Our Distribution Services segment provides maintenance, repair and operating supplies and spare parts to drill site and production locations throughout North America and to offshore contractors worldwide. Increasingly, this business also is expanding to locations outside North America, including the Middle East, Southeast Asia, and South America. Using our information technology platforms and processes, we can provide complete procurement, inventory management, and logistics services to our customers. National Oilwell's business strategy is to enhance its market positions and operating performance in the upstream oil and gas business by: Leveraging our Capital Equipment Installed Base We believe our market position and comprehensive product offering present substantial opportunities to capture a significant portion of expenditures for the construction of new drilling rigs and equipment as well as the upgrade and refurbishment of existing drilling rigs and equipment. Over the next few years, the advanced age of the existing fleet of drilling rigs, coupled with drilling activity involving greater depths and extended reach, is expected to generate demand for new equipment. National Oilwell's automation and control systems offer the potential to improve the performance of new and existing drilling rigs. The large installed base of our equipment also provides recurring demand for spare parts and expendable products necessary for proper and efficient operation. Expanding our Non-Capital Products Business Our non-capital equipment revenues continue to represent over half of our products and technology business. We rent and sell high-performance drilling motors and downhole tools and in the manufacture of certain expendable products and spare parts needed in the drilling and production process. We believe additional expansion in the non-capital upstream oil and gas industry would be beneficial to our business and our customers. Furthering our Information Technology and Process Improvement Strategy National Oilwell has developed an integrated information technology and process improvement strategy to enhance procurement, inventory management and logistics activities. As a result of the need to improve industry efficiency, oil and gas companies and drilling contractors are frequently seeking alliances with suppliers, manufacturers and service providers to achieve cost and capital improvements. We believe we are well positioned to provide these services as a result of our: - large and geographically diverse network of distribution service centers in major oil and gas producing areas; - strong relationship with a large community of industry suppliers; - knowledge of customers procurement processes, suppliers capabilities and products performance; and - information systems that offer customers and suppliers enhanced capabilities. In addition, the integration of our distribution expertise, extensive network and growing base of customer alliances provides an increased opportunity for cost-effective marketing of our manufactured parts and equipment. Continuing our Acquisitions Strategy We believe the oilfield service and equipment industry will continue to experience consolidation as businesses seek to align themselves with other market participants in order to gain access to broader markets and integrated product offerings. From 1997 through January 2003, National Oilwell has made a total of thirty-two acquisitions and plans to continue to participate in this trend. While none of our individual acquisitions have materially affected the development of our current business or the results of our operations, the aggregate effect has positively impacted our ability to provide complete drilling equipment systems to our customers. National Oilwell designs, manufactures and sells drilling systems and components for both land and offshore drilling rigs as well as complete land drilling and well servicing rigs. Mechanical components include drawworks, mud pumps, top drives, solids control equipment (used to remove particulates from drilling fluids), traveling equipment (hooks and blocks used to hoist and lower drill pipe) and rotary tables (used to rotate drill pipe). These components are essential to pump fluids and hoist, support and rotate the drill string. Many of these components are designed specifically for applications in offshore, extended reach and deep land drilling. This equipment is installed on new rigs and often replaced during the upgrade and refurbishment of existing rigs. We design and manufacture masts, derricks and substructures for use on land rigs and on fixed and mobile offshore platforms suitable for drilling applications to depths of up to 30,000 feet or more. Other products include cranes, jacking and mooring systems, reciprocating and centrifugal pumps and fluid end expendables for all major manufacturers' pumps. Our business includes the sale of replacement parts for our own manufactured machinery and equipment. We also design and manufacture electrical systems and control and data acquisition systems for drilling related operations and automated and remotely controlled machinery for drilling rigs. Our control systems can control and monitor many simultaneous operations on a drilling rig and often form the basis for our state-of-the-art driller's cabin. Our automated pipe handling system provides an efficient and cost effective method of joining lengths of drill pipe or casing as does our iron roughneck. These and similar technologically advanced products can greatly improve the safety on rigs, often by reducing the number of persons working on the drilling floor. While offering a complete line of conventional rigs, National Oilwell has extensive experience in providing rig designs to satisfy requirements for harsh or specialized environments. Such products include drilling and well servicing rigs designed for the Arctic, highly mobile drilling and well servicing rigs for jungle and desert use, modular well servicing rigs for offshore platforms and modular drilling facilities for North Sea platforms. We also design and produce fully integrated drilling equipment packages for offshore rigs. National Oilwell designs and manufactures drilling motors, drilling jars and specialized drilling tools for rent and sale. We also design and manufacture a complete line of fishing tools used to remove objects stuck in the wellbore. National Oilwell provides distribution services through its network of approximately 150 distribution service centers. National Oilwell's distribution service centers are located throughout the oil and gas producing regions of North America, with 105 in the United States, 40 in Canada, and the remainder in various international locations. These distribution service centers stock and sell a variety of expendable items for oilfield applications and spare parts for our proprietary equipment. As oil and gas companies and drilling contractors have refocused on their core competencies and emphasized efficiency initiatives to reduce costs and capital requirements, our distribution services have expanded to offer outsourcing and alliance arrangements that include comprehensive procurement, inventory management and logistics support. In addition, we believe we have a competitive advantage in the distribution services business by distributing products manufactured by us and from the association of this business with our Products and Technology segment. The supplies and equipment stocked by our distribution service centers vary by location. Each distribution point generally offers a large line of oilfield products including valves, fittings, flanges, spare parts for oilfield equipment and miscellaneous expendable items. Most drilling contractors and oil and gas companies typically buy supplies and equipment pursuant to non-exclusive contracts, which normally specify a discount from list price for each product or product category. Our goal is to create strategic alliances with our customers whereby we become the customer's primary supplier of those items. In certain cases, we assume responsibility for procurement, inventory management and product delivery for the customer, occasionally by working directly out of the customer's facilities. We believe e-commerce brings a significant advantage to larger companies that are technologically proficient. During the last few years, we have invested over $20 million to improve our information technology systems. Our e-commerce system can interface directly with customers' systems to maximize efficiencies for us and for our customers. We believe we have an advantage in this effort due to our investment in technology, geographic size, knowledge of the industry and customers, existing relationships with vendors and existing means of product delivery. Substantially all of our capital equipment and spare parts sales, and a large portion of our smaller pumps and parts sales, are made through our direct sales force and distribution service centers. Sales to foreign state-owned oil companies are typically made in conjunction with agent or representative arrangements. Our downhole products are generally rented and sold worldwide through our own sales force and through commissioned representatives. Distribution sales are made through our network of distribution service centers. Customers for our products and services include drilling and other service contractors, exploration and production companies, supply companies and nationally owned or controlled drilling and production companies. The oilfield services and equipment industry is highly competitive and our revenues and earnings can be affected by price changes, introduction of new technologies and products and improved availability and delivery. National Oilwell's Products and Technology business segment competes with several companies in North America that have drilling products that compete directly with certain of our products. National Oilwell's Distribution Services business segment faces competition from various smaller regional competitors who leverage geographic strength in a particular market area, as well as other multinational distribution companies utilizing pricing power to compete. None of these competing companies dominate in any of the business segments in which we operate. Manufacturing and Backlog National Oilwell has manufacturing facilities located in the United States, Canada, Norway and China. The manufacture of parts or purchase of components is sometimes outsourced to qualified subcontractors. The manufacturing operations require a variety of components, parts and raw materials which we purchase from multiple commercial sources. We have not experienced and do not expect any significant delays in obtaining deliveries of materials. Sales of products are made on the basis of written orders and oral commitments. Our backlog for equipment at recent year-ends has been: December 31, 2002 $364 million (includes $170 million from the Hydralift ASA acquisition) December 31, 2001 385 million Distribution Suppliers National Oilwell obtains products sold by its Distribution Services business from a number of suppliers, including our own Products and Technology segment. No single supplier of products is significant to our operations. We have not experienced and do not expect a shortage of products that we sell. National Oilwell maintains a staff of engineers and technicians to: - design and test new products, components and systems for use in drilling and pumping applications; - enhance the capabilities of existing products; and - assist our sales organization and customers with special Our product engineering efforts focus on developing technology to improve the economics and safety of drilling and production processes, and to emphasize technology and complete drilling solutions. National Oilwell owns or has a license to use a number of patents covering a variety of products. Although in the aggregate these patents are of importance, we do not consider any single patent to be of a critical or essential nature. In general, our business has historically relied upon technological capabilities, quality products and application of expertise rather than patented technology. As of December 31, 2002, we had a total of 6,900 employees, 4,300 of whom were salaried and 2,600 of whom were paid on an hourly basis. Of this workforce, 1,300 employees are employed in Canada, 850 in Norway and 675 in other locations outside the United States. Available Information Regarding our SEC Filings Our corporate offices are located at 10000 Richmond Avenue, Houston, Texas 77042-4200. Our phone number at that location is (713) 346-7500 and our Internet address is www.natoil.com. Information we make public about our company, including all SEC required filings, is available to you, free of charge, at our Internet address. You should carefully consider the risks described below, in addition to other information contained or incorporated by reference herein. Realization of any of the following risks could have a material adverse effect on our business, financial condition, cash flows and results of operations. Demand for Our Products is Dependent Upon the Price of Oil and Gas and the Willingness to Explore and Produce Oil and Gas. National Oilwell is dependent upon the oil and gas industry and its willingness to explore for and produce oil and gas. The industry's willingness to explore and produce depends upon the prevailing view of future product prices. Many factors affect the supply and demand for oil and gas and therefore influence product prices, including: o level of production from known reserves; o cost of producing oil and gas; o level of drilling activity; o worldwide economic activity; o national government political requirements; o development of alternate energy sources; and o environmental regulations. If there is a significant reduction in demand for drilling services, in cash flows of drilling contractors or production companies or in drilling or well servicing rig utilization rates, then demand for our products will decline. Volatile Oil and Gas Prices Affect Demand for Our Products. Oil and gas prices have been volatile since 1990, ranging from $10 - $40 per barrel. Over the last three years, oil prices have generally ranged within $20-$30 per barrel. Spot gas prices have also been volatile since 1990, ranging from less than $1.00 per mmbtu of gas to above $10.00. Gas prices were moderate in 1998 and 1999, generally ranging from $1.80 - $2.50 per mmbtu. Gas prices in 2000 generally ranged from $4-$8 per mmbtu. In the second quarter of 2001, gas prices came under pressure, generally ranging between $2.20 to $3.00 per mmbtu through the first quarter of 2002. Gas prices have generally ranged between $3.00 - $5.00 per mmbtu since that time. Expectations for future oil and gas prices cause many shifts in the strategies and expenditure levels of oil and gas companies and drilling contractors, particularly with respect to decisions to purchase major capital equipment of the type we manufacture. Industry activity and our revenues have not responded to the higher commodity prices that have existed since the second quarter of 2002, presumably due to concerns that these prices will not continue in the current range. The oil and gas prices which are determined by the marketplace may be above or below a range that is acceptable to our customers, which could reduce demand for our products. Competition in our Industry Could Ultimately Lead to Lower Revenues and Earnings. The oilfield products and services industry is highly competitive. The following competitive actions can each affect our revenues and earnings: o price changes; o new product and technology introductions; and o improvements in availability and delivery. National Oilwell's Products and Technology business segment competes with several companies in North America that have drilling products that compete directly with certain of our products. National Oilwell's Distribution Services business segment faces competition from various smaller regional competitors who leverage geographic strength in a particular market area, as well as other multinational distribution companies utilizing pricing power to compete. Competition in our industry could lead to lower revenues and earnings. Because Some of Our Products are Used in Potentially Hazardous Activities, We Face Potential Product Liability and Warranty Claims. Customers use some of our products in potentially hazardous drilling, completion and production applications that can cause: o injury or loss of life; o damage to property, equipment or the environment; and o suspension of operations. National Oilwell may be named as a defendant in product liability or other lawsuits asserting potentially large claims if an accident occurs at a location where our equipment and services have been used. We are currently party to various legal and administrative proceedings. The outcome of any such legal or administrative proceedings could have an adverse effect on our financial The Location of Some of our Customers in Foreign Markets that may have Unstable Economies or Governments Could Have a Negative Impact on Our Revenues and Operating Results. Some of our revenues depend upon customers in the Middle East, Africa, Southeast Asia, South America and other international markets. These revenues are subject to risks of instability of foreign economies and governments. Laws and regulations limiting exports to particular countries can affect our sales, and sometimes export laws and regulations of one jurisdiction contradict those of another. National-Oilwell Sells Products and Services Outside the United States. Changes in Foreign Currency Exchange Rates Could Have a Negative Impact on our Revenues and Operating Results. National Oilwell is exposed to the risks of changes in exchange rates between the U.S. dollar and foreign currencies. Our Norwegian companies enter into foreign exchange forward contracts, primarily between the Norwegian kroner and the US dollar, to hedge cash flows on certain significant contracts. Our decisions regarding the need for hedging foreign currencies in Norway and other countries can adversely affect our operating results. Our Growth Could Cause Difficulties Integrating Operations that We Acquire. National Oilwell has acquired 32 companies since April 1997, including nine in 2001 and four in 2002. In addition, we acquired two other companies in January 2003. We do not know whether suitable acquisition candidates will be available on reasonable terms or if we will have access to adequate funds to complete any desired acquisition. In addition, we may not be able to successfully integrate the operations of the acquired companies. Combining organizations could interrupt the activities of some or all of our businesses and have a negative impact on operations. Our Indebtedness Could Limit Our Ability to Borrow Additional Funds and/or Make Us Vulnerable to General Adverse Economic and Industry Conditions. In 1998, National Oilwell issued $150 million of 6 7/8% unsecured senior notes due July 1, 2005. In 2001, we issued an additional $150 million of 6 1/2% unsecured senior notes due March 15, 2011. In 2002, we issued $200 million of 5.65% unsecured senior notes due November 15, 2012. We also have a $175 million revolving line of credit and approximately $200 million in availability under various borrowing arrangements of our wholly-owned foreign subsidiaries. Our leverage requires us to use some of our cash flow from operations for payment of interest on our debt. Our leverage may also make it more difficult to obtain additional financing in the future. Further, our leverage could make us more vulnerable to economic downturns and competitive pressures. National Oilwell owned or leased approximately 235 facilities worldwide as of December 31, 2002, including the following principal manufacturing and administrative facilities: BUILDING SPACE LOCATION (SQUARE FOOT) DESCRIPTION STATUS - -------- -------------- ----------- ------ Pampa, Texas 548,000 Manufactures drilling machinery and equipment Owned Houston, Texas 540,000 Manufactures downhole tools and mobile rigs Owned Houston, Texas 260,000 Manufactures drilling machinery and equipment Leased Carquefou, France 213,000 Manufactures offshore and marine handling Owned Sugarland, Texas 190,000 Manufactures braking systems and generators Owned Galena Park, Texas 188,000 Manufactures drilling components and rigs Owned Houston, Texas 178,000 Manufactures electrical power systems Owned Edmonton, Alberta, Canada 162,000 Manufactures downhole tools Owned Kristiansand, Norway 157,000 Manufactures drilling and offshore equipment Owned Tulsa, Oklahoma 140,000 Manufactures pumps and expendable parts Owned McAlester, Oklahoma 117,000 Manufactures pumps and expendable parts Owned Houston, Texas 115,000 Administrative offices Leased Stavanger, Norway 87,000 Manufactures drilling components and systems Leased Calgary, Alberta, Canada 76,000 Manufactures coiled tubing units and wireline trucks Owned Molde, Norway 68,000 Manufactures marine handling equipment Owned Marble Falls, Texas 65,000 Manufactures drilling expendable parts Owned Stavanger, Norway 62,000 Manufactures drilling components and systems Owned Nisku, Alberta, Canada 59,000 Manufactures drilling machinery and equipment Owned Edmonton, Alberta, Canada 57,000 Manufactures drilling machinery and equipment Owned We own or lease 65 satellite repair and manufacturing facilities that refurbish and manufacture new equipment and parts and approximately 150 distribution service centers worldwide. We believe the capacity of our facilities is adequate to meet demand currently anticipated for 2003. National Oilwell has various claims, lawsuits and administrative proceedings that are pending or threatened, all arising in the ordinary course of business, with respect to commercial, product liability and employee matters. Although no assurance can be given with respect to the outcome of these or any other pending legal and administrative proceedings and the effect such outcomes may have, we believe any ultimate liability resulting from the outcome of such proceedings will not have a material adverse effect on our consolidated financial ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the quarter ended ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS National Oilwell common stock is listed on the New York Stock Exchange (ticker symbol: NOI). The following table sets forth the stock price range during the past three years: 2002 2001 2000 ------------------------ ----------------------- ------------------------ Quarter High Low High Low High Low - ------- ------- ------- ------- ------- ------- ------- First $ 26.25 $ 16.43 $ 40.50 $ 33.65 $ 31.38 $ 14.25 Second 28.81 20.91 39.55 26.80 32.89 22.94 Third 21.29 15.19 25.74 12.91 37.50 27.25 Fourth 23.31 17.69 20.86 13.85 39.19 28.25 As of March 3, 2003, there were 537 holders of record of National Oilwell common stock. Many stockholders choose to own shares through brokerage accounts and other intermediaries rather than as holders of record so the actual number is unknown but significantly higher. National Oilwell has never paid cash dividends, and none are anticipated during 2003. Data for periods prior to 2000 shown below is restated to combine IRI International and Dupre' results pursuant to pooling-of-interests accounting. 2002 2001 2000 1999 1998 ------------ ------------ ------------ ------------ ------------ (IN THOUSANDS OF U.S. DOLLARS, EXCEPT PER SHARE AMOUNTS) OPERATING DATA: Revenues $ 1,521,946 $ 1,747,455 $ 1,149,920 $ 839,648 $ 1,449,248 Operating income (1) 134,323 189,277 48,456 1,325 139,815 Income (loss) before taxes 112,465 168,017 27,037 (14,859) 125,021 Net income (loss) (2) 73,069 104,063 13,136 (9,385) 81,336 Net income (loss) per share Basic (2) 0.90 1.29 0.17 (0.13) 1.19 Diluted (2) 0.89 1.27 0.16 (0.13) 1.19 OTHER DATA: Depreciation and amortization 25,048 38,873 35,034 25,541 20,518 Capital expenditures 24,805 27,358 24,561 17,547 39,246 BALANCE SHEET DATA: Working capital 768,852 631,257 480,321 452,015 529,937 Total assets 1,968,662 1,471,696 1,278,894 1,005,715 1,091,028 Long-term debt, less current maturities 594,637 300,000 222,477 196,053 222,209 Stockholders' equity 933,364 867,540 767,206 596,375 603,568 (1) In connection with the IRI International Corporation merger in 2000, we recorded charges of $14.1 million related to direct merger costs, personnel reductions, and facility closures and inventory write-offs of $15.7 million due to product line rationalization. In 1998, a $17.0 million charge was recorded related to personnel reductions and facility closures and a $5.6 million charge related to the write-down of certain tubular inventories. (2) We adopted Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" (SFAS 142), effective January 1, 2002. The effects of not amortizing goodwill and other intangible assets in periods prior to the adoption of SFAS 142 would have resulted in net income (loss) of $115.0 million, $23.1 million, $(4.0) million and $84.8 million for the years ended December 31, 2001, 2000, 1999,and 1998, respectively; basic earnings per common share of $1.42, $0.29, $(0.06) and $1.24 for the years ending December 31, 2001, 2000, 1999 and 1998, respectively; and diluted earnings per common share of $1.41, $0.29, $(0.06) and $1.24 for the years ending December 31, 2001, 2000, 1999 and 1998, respectively. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS We design, manufacture and sell drilling systems, drilling equipment and downhole products as well as distribute maintenance, repair and operating products to the oil and gas industry. Our revenues and operating results are directly related to the level of worldwide oil and gas drilling and production activities and the profitability and cash flow of oil and gas companies and drilling contractors, which in turn are affected by current and anticipated prices of oil and gas. Oil and gas prices have been and are likely to continue to be volatile. See "Risk Factors". We conduct our operations through the following segments: drilling and workover rigs, and drilling related systems for offshore rigs. Technology has increased the desirability of one vendor assuming responsibility for the entire suite of components used in the drilling process, as mechanical and hydraulic components are replaced by or augmented with integrated computerized systems. In addition to traditional components such as drawworks, mud pumps, top drives, derricks, cranes, jacking and mooring systems, and other structural components, we provide automated pipehandling, control and electrical power systems. We have also developed new technology for drawworks and mud pumps applicable to the highly demanding offshore markets. supplies and spare parts from our network of distribution service centers to drill site and production locations throughout North America and to offshore contractors worldwide. Increasingly, this business also is expanding to locations outside North America, including the Middle East, Southeast Asia, and South America. Using our information technology platforms and processes, we can provide complete procurement, inventory management, and logistics services to our customers. Products are purchased from numerous manufacturers and vendors, including our Products and Technology segment. Operating results by segment, which have been restated to reflect a business combination accounted for under the pooling-of-interests method during 2000, are as follows (in millions): 2002 2001 2000 ---------- ---------- ---------- Products and Technology $ 917.3 $ 1,120.9 $ 683.5 Distribution Services 686.2 707.8 521.3 Eliminations (81.5) (81.3) (54.8) Total $ 1,522.0 $ 1,747.4 $ 1,150.0 ========== ========== ========== Products and Technology $ 127.0 $ 171.0 $ 61.0 ? Distribution Services 18.1 28.5 12.9 Corporate (10.8) (10.2) (11.3) 134.3 189.3 62.6 Special Charge -- -- 14.1 Total $ 134.3 $ 189.3 $ 48.5 Products and Technology revenues in 2002 were $203.6 million (18%) lower than the previous year as moderate oil and gas prices failed to sustain the 2001 levels of market activity in all product areas. Capital equipment revenues were down $72 million while related spare parts and expendable parts were lower than 2001 by $38 million. Sales and rentals of downhole motors and fishing tools decreased by approximately $74 million, impacted by its strong dependence on the North American market. Operating income fell $44 million in 2002 when compared to the prior year, impacted by the margin reduction due to the significantly lower volume. Changes in sales price did not have any significant effect on revenues compared to the prior year. The absence of amortization of goodwill in 2002, as required per the new accounting guidance, favorably impacted operating income by $10.4 million. Reductions in compensation expense also contributed approximately $11.0 million in operating income when compared to the prior year. Revenues from the mid-December 2002 acquisition of Hydralift ASA, and the consolidation of our Chinese joint venture, each contributed $8.0 million in revenues and $0.3 million and $2.2 million in operating income, respectively. Revenues for the Products and Technology segment in 2001 increased by $437.4 million (64 %) from 2000 as virtually all products experienced significant revenue growth. Capital equipment revenues were up $285 million, drilling spares up $35 million, expendable pumps and parts were higher by $47 million and downhole tools increased $75 million. As a result of this robust growth in the volume of product sales, operating income in 2001 increased by $110.0 million from the prior year. Changes in sales price did not have any significant effect on revenues compared to the prior year. Revenues from acquisitions completed in 2001 under the purchase method of accounting contributed $34 million in incremental revenues. Backlog of the Products and Technology capital products was $364 million at December 31, 2002, $385 million at December 31, 2001 and $282 million at December 31, 2000. Backlog at December 31, 2002 includes $170 million acquired in late December through the purchase of Hydralift ASA. Substantially all of the current backlog is expected to be shipped by mid-year 2004. Distribution Services revenues fell $21.6 million, or 3%, from the 2001 level as this segment's strategy to create strategic alliances and expand its international presence made significant market penetration during a difficult market. North American revenues fell approximately 16% due to the lower activity level while shipments in the international market almost doubled. Sales of our own-make products increased almost 12% while maintenance, repair and operating ("MRO") supplies fell almost 5%. Changes in sales price did not have any significant effect on revenues compared to the prior year. Operating income in 2002 was $10.4 million lower than the prior year. Margin reduction, due to the lower volume and project bidding pressures, contributed to approximately 80% of the operating income shortfall with the remainder due to significant infrastructure growth. Distribution Services revenues in 2001 increased $186.5 million from the 2000 level with all areas and products participating in the upswing that lasted until the middle of the 4th quarter 2001. U.S. revenues of MRO supplies were up 44% while Canadian revenues were 13% higher than the prior year. Changes in sales price did not have any significant effect on revenues compared to the prior year. Operating income in 2001 increased by $15.6 million from the prior year due to the higher revenue volume and cost efficiencies linked to the new global operating system. Revenues from acquisitions completed in 2001 under the purchase method of accounting contributed $24 million in incremental revenues. Corporate charges represent the unallocated portion of centralized and executive management costs. Year 2002 costs of $10.8 million reflect certain corporate-led marketing initiatives and general overhead incurred to support a larger company. Year 2001 costs of $10.2 million represents a 10% reduction from the prior year as various e-strategy and e-commerce initiatives became operational. Year 2003 corporate charges are expected to approximate $12 million due to recent acquisitions. Special Charge During 2000, we recorded a special charge, net of a $0.4 million credit from previous special charges, of $14.1 million ($11.0 million after tax, or $0.14 per share) related to the merger with IRI International. Components of the charge were (in millions): Direct transaction costs $ 6.6 Severance 6.4 Facility closures 1.5 Prior year reversal (0.4) $ 14.1 The cash and non-cash elements of the charge approximated $13 million and $1.1 million, respectively. All direct cash outlays have been spent. Facility closure costs consisted of lease cancellation costs and impairment of a closed manufacturing facility that is classified with "Property held for sale" on our balance sheet. All of this charge is applicable to the Products and Technology business segment. Interest expense in 2002 totaled $24.1 million, an increase of $1.3 million from the prior year. All of this increase is a direct result of our mid-November 2002 sale of $200 million of 5.65% unsecured senior notes. Our average borrowing cost during 2002 of 6.4% remained the same as 2001. We expect our interest expense in 2003 to increase by at least $10 million as a result of our higher senior debt Despite continual borrowing rate declines during 2001, interest expense increased approximately $5.5 million over 2000 due to our higher debt level to support the working capital associated with the robust business climate. In March 2001, we sold $150 million of 6 1/2% unsecured senior notes which increased our total senior debt to $300 million. Year 2001 average monthly debt, including the senior notes, was $334 million or $118 million (54%) greater than the 2000 level. National Oilwell is subject to U.S. federal, state and foreign taxes and recorded a combined tax rate of 35% in 2002, 38% in 2001 and 51% in 2000. The 2000 effective tax rate was impacted by certain transaction costs associated with the IRI merger and the inclusion of pre-merger IRI capital losses due to pooling-of-interests accounting that may not be deductible. Excluding the impact of merger-related costs and capital losses, our combined effective tax rate for 2000 was 36%. We expect our tax rate in 2003 to approximate 34%. We have net operating loss carryforwards in the United States that could reduce future tax expense by up to $4.2 million. They expire at various dates through 2017. Additional loss carryforwards in Europe could reduce future tax expense by $10.3 million and reduce goodwill $9.4 million if realized in the future. Due to the uncertainty of future utilization of these loss carryforwards, $2.8 million of the potential benefits in the U.S. and $9.6 million in Europe have been fully At December 31, 2002, National Oilwell had working capital of $768.9 million, an increase of $137.6 million from December 31, 2001. The addition of Hydralift ASA and consolidation of the Chinese joint venture accounted for $123.3 million of this increase, including $78 million of the increase in cash. After considering the Halco acquisition in January 2002 and the change in current deferred taxes, the rest of the company reduced our need for working capital during 2002. Due to a new revolving three-year credit facility put in place during July 2002, all of our debt is of a long-term nature. Total capital expenditures were $24.8 million during 2002, $27.4 million in 2001 and $24.6 million in 2000. Additions and enhancements to the downhole rental tool fleet and information management and inventory control systems represent the majority of these capital expenditures. Capital expenditures are expected to approximate $35 million in 2003, which should also approximate depreciation expense in that year, with continued emphasis on rental tools and information technology. We believe we have sufficient existing manufacturing capacity to meet currently anticipated demand through 2003 for our products and services. In November 2002, we sold $200 million of 5.65 % unsecured senior notes due November 15, 2012. Proceeds were used to acquire Hydralift ASA. Interest is payable on May 15 and November 15 of each year. In March 2001, we sold $150 million of 6.50 % unsecured senior notes due March 15, 2011, with interest payable on March 15 and September 15 of each year. In June 1998, we sold $150 million of 6.875 % unsecured senior notes due July 1, 2005, with interest payments due annually on January 1 and July 1. On July 30, 2002, we replaced the existing credit facility with a new three-year unsecured $175 million revolving credit facility. This facility is available for acquisitions and general corporate purposes and provides up to $50 million for letters of credit, of which $22.0 million were outstanding at December 31, 2002. Interest is based upon prime or Libor plus 0.5% subject to a ratings based grid. In securing this new credit facility, we incurred approximately $0.9 million in fees which will be amortized to expense over the term of the facility. The senior notes contain reporting covenants and the credit facility contains financial covenants and ratios regarding maximum debt to capital and minimum interest coverage. We were in compliance with all covenants governing these facilities at December 31, 2002. We also have additional credit facilities totaling $223 million that are used primarily for acquisitions, general corporate purposes and letters of credit. Recently acquired Hydralift ASA represents $152 million of these facilities. These multi-currency Hydralift committed facilities are secured by a guarantee, contain financial covenants and expire in 2006. Borrowings against these additional credit facilities totaled $93 million at December 31, 2002 and an additional $39 million had been used for letters of credit and guarantees. We believe cash generated from operations and amounts available under our credit facilities and from other sources of debt will be sufficient to fund operations, working capital needs, capital expenditure requirements and financing obligations. We also believe any significant increase in capital expenditures caused by any need to increase manufacturing capacity can be funded from operations or through debt financing. We have not entered into any transactions, arrangements, or relationships with unconsolidated entities or other persons which would materially affect liquidity, or the availability of or requirements for capital resources. A summary of our outstanding contractual obligations and other commercial commitments at December 31, 2002 is as follows (in thousands): CONTRACTUAL OBLIGATIONS TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS --------------------------------------- ---------- ------------ ---------- ---------- ------------- Long Term Debt $ 594,637 $ -- $ 244,637 $ -- $ 350,000 Operating Leases 63,625 17,658 30,450 6,943 8,574 ---------- ---------- ---------- ---------- ---------- Total contractual obligations $ 658,262 $ 17,658 $ 275,087 $ 6,943 $ 358,574 ========== ========== ========== ========== ========== AMOUNT OF COMMITMENT EXPIRATION PER PERIOD COMMERCIAL COMMITMENTS TOTAL YEAR 1-3 YEARS 4-5 YEARS AFTER 5 YEARS Line of Credit $ 326,698 $ -- $ 326,698 $ -- $ -- Standby Letters of Credit 61,432 41,635 19,797 -- -- Total commercial commitments $ 388,130 $ 41,635 $ 346,495 $ -- $ -- We intend to pursue additional acquisition candidates, but the timing, size or success of any acquisition effort and the related potential capital commitments cannot be predicted. We expect to fund future cash acquisitions primarily with cash flow from operations and borrowings, including the unborrowed portion of the credit facility or new debt issuances, but may also issue additional equity either directly or in connection with acquisitions. There can be no assurance that acquisition funds will be available at terms acceptable to us. Inflation has not had a significant impact on National Oilwell's operating results or financial condition in recent years. MARKET RISK DISCLOSURE We are exposed to changes in foreign currency exchange rates and interest rates. Additional information concerning each of these matters follows: Foreign Currency Exchange Rates We have operations in foreign countries, including Canada, Norway and the United Kingdom, as well as operations in Latin America, China and other European countries. The net assets and liabilities of these operations are exposed to changes in foreign currency exchange rates, although such fluctuations generally do not affect income since their functional currency is the local currency. For operations where our functional currency is not the local currency, such as Singapore and Venezuela, the net asset or liability position is insignificant and, therefore, changes in foreign currency exchange rates are not expected to have a material impact on earnings. Some of our revenues in foreign countries are denominated in US dollars, and therefore, changes in foreign currency exchange rates impact our earnings to the extent that costs associated with those US dollar revenues are denominated in the local currency. In order to mitigate that risk, we may utilize foreign currency forward contracts to better match the currency of our revenues and associated costs. We do not use foreign currency forward contracts for trading or speculative purposes. The counterparties to these contracts are major financial institutions, which minimizes counterparty credit risk. The impact of foreign currency exchange rates has not materially affected our results of operations in any of the last three years. We do not believe that a hypothetical 10% movement in these foreign currencies would have a material impact on our earnings. Our long term borrowings consist of $150 million in 6.875% senior notes, $150 million in 6.5% senior notes and $200 million in 5.65% senior notes. We also have borrowings under our other facilities totaling $94.6 million at December 31, 2002. A portion of the borrowings are denominated in multiple currencies which could expose us to market risk with exchange rate movements. These instruments carry interest at a pre-agreed upon percentage point spread from either the prime interest rate, LIBOR or NIBOR. Under our credit facilities, we may, at our option, fix the interest rate for certain borrowings based on a spread over LIBOR or NIBOR for 30 days to 6 months. Based upon our December 31, 2002 borrowings under our variable rate facilities of $94.6 million, an immediate change of one percent in the interest rate would cause a change in annual interest expense of approximately $0.9 million. Our objective in maintaining a portion of our debt in variable rate borrowings is the flexibility obtained regarding early repayment without penalties and lower overall cost as compared with fixed-rate borrowings. The preparation of our financial statements requires us to make certain estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Our estimation process generally relates to potential bad debts, obsolete and slow moving inventory, value of intangible assets, and deferred income tax accounting. Note 1 to the consolidated financial statements contains the accounting policies governing each of these matters. Our estimates are based on historical experience and on our future expectations that we believe to be reasonable under the circumstances. The combination of these factors result in the amounts shown as carrying values of assets and liabilities in the financial statements and accompanying notes. Actual results could differ from our current estimates and those differences may be material. We believe the following accounting policies are the most critical in the preparation of our consolidated financial statements: We maintain an allowance for doubtful accounts for accounts receivables by providing for specifically identified accounts where collectibility is doubtful and a general allowance based on the aging of the receivables compared to past experience and current trends. A majority of our revenues come from drilling contractors, independent oil companies, international oil companies and government-owned or government-controlled oil companies, and we have receivables, some denominated in local currency, in many foreign countries. If, due to changes in worldwide oil and gas drilling activity or changes in economic conditions in certain foreign countries, our customers were unable to repay these receivables, additional allowances would be required. Allowances for inventory obsolescence are determined based on our historical usage of inventory on-hand as well as our future expectations related to our substantial installed base and the development of new products. The amount reserved is the recorded cost of the inventory minus its estimated realizable value. Changes in worldwide oil and gas drilling activity and the development of new technologies associated with the drilling industry could require additional allowances to reduce the value of inventory to the lower of its cost or net realizable value. We account for our defined benefit pension plans in accordance with Statement of Financial Accounting Standards No. 87, Employers' Accounting for Pensions (FAS 87), which requires that amounts recognized in the financial statements be determined on an actuarial basis. Significant elements in determining our pension income or expense in accordance with FAS 87 is the discount rate assumption and the expected return on plan assets. The discount rate used approximates the weighted average rate of return on high-quality fixed income investments whose maturities match the expected payouts. The expected return on plan assets is based upon the geometric mean of historical returns of a number of different equities, including stocks, bonds and U.S. treasury bills. The assumed long-term rate of return on assets is applied to a calculated value of plan assets, which results in an estimated return on plan assets that is included in current year pension income or expense. The difference between this expected return and the actual return on plan assets is deferred and amortized against future pension income or expense. A substantial portion of our pension amounts relate to its defined benefit plans in the United States and the United Kingdom. During 2000, 2001 and 2002, we assumed that the expected long-term rate of return on plan assets for these plans would be between 6.3% and 8.0%. Prior to 2001, our actual cumulative long-term rate of return on the pension assets of these plans was in excess of these amounts; however, these plans' assets have recently earned substantially less than the assumed rates of return. The impact of our pension plans on our 2002 results of operations, cash flow and liquidity has been immaterial but recent actual returns of the plan assets may effect future contributions to the plans and our earnings. The amount of unrecognized losses on pension assets is $31.8 million. For 2003, we have lowered the assumed rates of return to between 6.0% and 7.0%, depending on the plan. As a result of this and other factors, we believe there will be an increase in pension expense of approximately $0.5-$1.0 million for 2003. Business acquisitions are accounted for using the purchase method of accounting. The cost of the acquired company is allocated to identifiable tangible and intangible assets based on estimated fair value, with the excess allocated to goodwill. On at least an annual basis, we assess whether goodwill is impaired. Our annual impairment tests are performed at the beginning of the 4th quarter of each year. If we determine that goodwill is impaired, we measure that impairment based on the amount by which the book value of goodwill exceeds its implied fair value. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit's identifiable assets and liabilities from the fair value of that reporting unit as a whole. Additional impairment assessments may be performed on an interim basis if we encounter events or changes in circumstances that would indicate that, more likely than not, the carrying amount of goodwill has been impaired. The fair value of the reporting units is determined based on internal management estimates that considers multiple valuation techniques. Our net deferred tax assets and liabilities are recorded at the amount that is more likely than not to be realized or paid. Should we determine that we would not be able to realize all or part of the net deferred tax asset in the future, an adjustment to the deferred tax assets would be charged to income in the period of such determination. SUBSEQUENT EVENTS On January 2, 2003, we acquired LSI, a Houston, Texas based distributor of specialty electrical products, for approximately $13 million. This transaction generated approximately $6 million in goodwill and is complementary to our distribution services business. On January 16, 2003, we acquired the Mono pumping products business from Halliburton Energy Services for approximately $89 million, consisting of $22.7 million in cash and 3.2 million shares of our common stock. This transaction, which consisted of purchasing all the outstanding stock of Monoflo, Inc. in the United States and Mono Group in the United Kingdom, generated approximately $46 million in goodwill and will add to the non-capital product lines within our Products and Technology segment. RECENTLY ISSUED ACCOUNTING STANDARDS The Financial Accounting Standards Board issued Statement on Financial Accounting Standards (SFAS) No. 143, "Accounting for Asset Retirement Obligations", which sets forth the accounting and reporting to be followed for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs and SFAS No. 146, "Accounting for Costs Associated with Exit or Disposal Activities", addresses disposal activities and termination costs in exiting an activity. These pronouncements are generally effective January 1, 2003. The Company believes the adoption of these new accounting pronouncements will not have a significant impact on its results of operations or financial position. Some of the information in this document contains, or has incorporated by reference, forward-looking statements. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. Forward-looking statements typically are identified by use of terms such as "may," "will," "expect," "anticipate," "estimate," and similar words, although some forward-looking statements are expressed differently. You should be aware that our actual results could differ materially from results anticipated in the forward-looking statements due to a number of factors, including but not limited to changes in oil and gas prices, customer demand for our products and worldwide economic activity. You should also consider carefully the statements under "Risk Factors" which address additional factors that could cause our actual results to differ from those set forth in the forward-looking statements. Given these uncertainties, current or prospective investors are cautioned not to place undue reliance on any such forward-looking statements. We undertake no obligation to update any such factors or forward-looking statements to reflect future events or developments. Incorporated by reference to Item 7 above, "Market Risk Disclosure." ITEM 8. FINANCIAL STATEMENT AND SUPPLEMENTARY DATA Attached hereto and a part of this report are financial statements and supplementary data listed in Item 15. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Incorporated by reference to the definitive Proxy Statement for the 2003 Annual Meeting of Stockholders. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The following table sets forth information as of our fiscal year ended December 31, 2002, with respect to compensation plans under which our common stock may be REMAINING AVAILABLE FOR NUMBER OF SECURITIES TO FUTURE ISSUANCE UNDER BE ISSUED UPON WEIGHTED-AVERAGE EQUITY COMPENSATION EXERCISE OF EXERCISE PRICE OF PLANS (EXCLUDING OUTSTANDING OPTIONS, OUTSTANDING OPTIONS, SECURITIES REFLECTED IN WARRANTS AND RIGHTS WARRANTS AND RIGHTS COLUMN (A)) PLAN CATEGORY (a) (b) (c) (1) - ----------------------- ------------------------ -------------------- ----------------------- Equity compensation plans approved by security holders 3,790,496 $ 21.99 4,219,162 plans not approved by security holders 0 0 0 ----------- -------- ----------- Total 3,790,496 $ 21.99 4,219,162 =========== ======== =========== (1) Shares could be issued other than upon the exercise of stock options, warrants or rights; however, none are anticipated during 2003. On February 14, 2003, we issued 977,500 stock options at an exercise price of $20.14. Security Ownership of Certain Beneficial Owners and Management ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Incorporated by reference to the definitive Proxy Statement for the 2003 Annual Meeting of Stockholders. ITEM 14. CONTROLS AND PROCEDURES (a) Evaluation of disclosure controls and procedures Our chief executive officer and chief financial officer, based on their evaluation of our disclosure controls and procedures (as defined in Exchange Act Rule 13a-14(c)) as of a date within 90 days prior to the filing of this annual report on Form 10-K, have concluded that our disclosure controls and procedures are adequate and effective for the information required to be disclosed by us in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and that this information is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. (b) Changes in internal control There were no significant changes in our internal controls or in other factors that could significantly affect our internal controls subsequent to the date of their evaluation described ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 10-K a) Financial Statements and Exhibits 1. Financial Statements The following financial statements are presented in response to Part II, Item 8: Page(s) in Consolidated Balance Sheets.........................................................26 Consolidated Statements of Operations...............................................27 Consolidated Statements of Cash Flows...............................................28 Consolidated Statements of Stockholders' Equity.....................................29 Notes to Consolidated Financial Statements..........................................30 2. Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts.....................................51 All schedules, other than Schedule II, are omitted because they are not applicable, not required or the information is included in the financial statements or notes thereto. 3. Exhibits 2.1 Combination Agreement between National-Oilwell, Inc. and Hydralift ASA regarding the transaction announced October 11, 2002 (Exhibit 2.1) (5). 3.1 Amended and Restated Certificate of Incorporation of National-Oilwell, Inc. (Exhibit 3.1) (1). 3.2 By-laws of National-Oilwell, Inc. Filed as an exhibit to the Annual Report on Form 10-K, filed March 7, 2003. 10.1 Employment Agreement dated as of January 1, 2002 between Merrill A. Miller, Jr. and National Oilwell, with a similar agreement with Steven W. Krablin (Exhibit 10.1) (2). Dwight W. Rettig and National Oilwell, with similar agreements with Robert L. Bloom, Kevin Neveu, Mark A. Reese and Robert R. Workman (Exhibit 10.2) (2). 10.3 Employment Agreement dated as of June 28, 2000 between Gary W. Stratulate and IRI International, Inc., which has now merged into National Oilwell (Exhibit 10.3) (2). 10.4 Amended and Restated Stock Award and Long-Term Incentive Plan (Exhibit 10.1) (3)*. 10.5 Loan Agreement dated July 30, 2002 (Exhibit 10.2) (3). 10.6 Employment Agreement dated as of March 1, 2000 between Jon Gjedebo and a National Oilwell subsidiary (Exhibit 10.8) (4). 10.7 Non-competition Agreement dated as of June 28, 2000 between Hushang Ansary and National Oilwell (Exhibit 10.9) (4). 21.1 Subsidiaries of the Company. Filed as an exhibit to the Annual Report on Form 10-K, filed March 7, 2003. 23.1 Consent of Ernst & Young LLP 24.1 Power of Attorney (included on signature page hereto). Filed as an exhibit to the Annual Report on Form 10-K, filed March 7, 2003. 99.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. b) Reports on Form 8-K A report on Form 8 - K was filed on October 16, 2002 regarding a press release announcing the signing of a Combination Agreement to acquire Hydralift ASA for NOK 55, approximately U.S. $7.33, per share. A report on Form 8 - K was filed on November 14, 2002 which contained the Combination Agreement of the previously announced transaction with Hydralift ASA. A report on Form 8 - K was filed on February 12, 2003 regarding a press release announcing our financial results for the fourth quarter and full year ended December 31,2002. - ---------- * Compensatory plan or arrangement for management or others (1) Filed as an Exhibit to our Quarterly Report on Form 10-Q filed on (2) Filed as an Exhibit to our Annual Report on Form 10-K filed on March (4) Filed as an Exhibit to our Annual Report on Form 10-K filed on March 1, (5) Filed as an Exhibit to our Current Report on Form 8-K filed on November Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange Act of 1934, the registrant has duly caused this amendment to its Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized. DATE: JUNE 26, 2003 BY: /S/ STEVEN W. KRABLIN STEVEN W. KRABLIN VICE PRESIDENT AND I, Merrill A. Miller, Jr., certify that: 1. I have reviewed this annual report on Form 10-K/A of National-Oilwell, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. DATE: JUNE 26, 2003 BY: /s/ MERRILL A. MILLER, JR. MERRILL A. MILLER, JR. I, Steven W. Krablin, certify that: DATE: JUNE 26, 2003 BY: /s/ STEVEN W. KRABLIN REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders We have audited the accompanying consolidated balance sheets of National-Oilwell, Inc., as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of National-Oilwell, Inc., at December 31, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States. As discussed in Note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill and other intangible assets. /s/ ERNST & YOUNG LLP December 31, December 31, 2002 2001 ------------- ------------- Cash and cash equivalents $ 118,338 $ 43,220 Receivables, net 428,116 382,153 Inventories 470,088 455,934 Costs in excess of billings 53,805 -- Deferred income taxes 26,783 16,825 Prepaid and other current assets 17,938 10,434 Total current assets 1,115,068 908,566 Property, plant and equipment, net 208,420 168,951 Deferred income taxes 36,864 16,663 Goodwill, net 581,576 352,094 Property held for sale 7,389 12,144 Other assets 19,345 13,278 $ 1,968,662 $ 1,471,696 ============= ============= Current portion of long-term debt -- 10,213 Accounts payable 168,548 161,277 Customer prepayments 9,533 9,843 Accrued compensation 5,087 23,661 Billings in excess of costs 61,738 -- Other accrued liabilities 101,310 72,315 Total current liabilities 346,216 277,309 Long-term debt 594,637 300,000 Other liabilities 30,229 6,467 Total liabilities 1,025,694 604,156 Commitments and contingencies Minority interest 9,604 -- Stockholders' equity: Common stock - par value $.01; 81,014,713 and 80,902,882 shares issued and outstanding at December 31, 2002 and December 31, 2001 810 809 Additional paid-in capital 594,849 592,507 Accumulated other comprehensive loss (44,461) (34,873) Retained earnings 382,166 309,097 933,364 867,540 The accompanying notes are an integral part of these statements. 2002 2001 2000 ------------- ------------- ------------- Revenues $ 1,521,946 $ 1,747,455 $ 1,149,920 Cost of products and services sold 1,160,082 1,319,621 884,774 Merger related inventory write-offs -- -- 15,684 Gross profit 361,864 427,834 249,462 Selling, general, and administrative 227,541 238,557 186,924 Special charge -- -- 14,082 Operating income 134,323 189,277 48,456 Interest and financial costs (27,279) (24,929) (19,069) Interest income 2,638 1,775 2,908 Other income (expense), net 3,656 1,894 (5,258) Income before income taxes and minority interest 113,338 168,017 27,037 Provision for income taxes 39,396 63,954 13,901 Income before minority interest 73,942 104,063 13,136 Minority interest in income of consolidated subsidiaries (873) -- -- Net income $ 73,069 $ 104,063 $ 13,136 ============= ============= ============= Net income per share: Basic $ 0.90 $ 1.29 $ 0.17 Diluted $ 0.89 $ 1.27 $ 0.16 Weighted average shares outstanding: Basic 80,974 80,813 79,325 Diluted 81,709 81,733 80,760 2002 2001 2000 Cash flow from operating activities: Net income $ 73,069 $ 104,063 $ 13,136 Adjustments to reconcile net income to net cash provided (used) by operating activities: Depreciation and amortization 25,048 38,873 35,034 Provision for losses on receivables 3,606 3,897 1,589 Provision for deferred income taxes 11,446 7,847 (5,881) Gain on sale of assets (4,551) (2,878) (3,522) Foreign currency transaction (gain) loss 307 573 (1,397) Tax benefit from exercise of nonqualified stock options 328 2,348 4,901 Special charge -- -- 14,082 Merger related inventory write-offs -- -- 15,684 Changes in assets and liabilities, net of acquisitions: Marketable securities -- -- 14,686 Receivables 58,953 (74,700) (65,619) Inventories 25,189 (71,906) (27,219) Income taxes receivable -- -- 12,888 Prepaid and other current assets (2,960) 2,411 (4,802) Accounts payable (32,031) (23,357) 47,345 Other assets/liabilities, net (54,363) (22,547) (24,292) Net cash provided (used) by operating activities 104,041 (35,376) 26,613 Cash flow from investing activities: Purchases of property, plant and equipment (24,805) (27,358) (24,561) Proceeds from sale of assets 12,534 7,927 8,227 Businesses acquired and investments in joint ventures, net of cash (213,052) (38,517) (48,208) Net cash used by investing activities (225,323) (57,948) (64,542) Cash flow from financing activities: Borrowings against lines of credit 303,220 294,084 273,376 Payments against lines of credit (311,018) (354,310) (254,202) Net proceeds from issuance of long-term debt 199,070 146,631 -- Proceeds from stock options exercised 2,343 9,286 14,247 Other 1,363 -- (662) Net cash provided by financing activities 194,978 95,691 32,759 Effect of exchange rate losses on cash 1,422 (1,606) (462) Increase (decrease) in cash and equivalents 75,118 761 (5,632) Cash and cash equivalents, beginning of year 43,220 42,459 48,091 Cash and cash equivalents, end of year $ 118,338 $ 43,220 $ 42,459 Supplemental disclosures of cash flow information: Cash payments during the period for: Interest $ 21,579 $ 20,772 $ 16,807 Income taxes 45,615 26,775 7,333 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY ACCUMULATED ADDITIONAL OTHER COMMON PAID-IN COMPREHENSIVE RETAINED STOCK CAPITAL LOSS EARNINGS TOTAL ------------ ------------ ------------- ------------ ------------ Balance at December 31, 1999 $ 717 $ 415,701 $ (11,923) $ 191,880 $ 596,375 ------------ ------------ ------------ ------------ ------------ Net income 13,136 13,136 Other comprehensive income Currency translation adjustments (10,684) (10,684) Marketable securities valuation adjustment 749 749 Comprehensive income 3,201 Stock issued for acquisition 79 153,948 154,027 Stock options exercised 9 8,580 8,589 Tax benefit of options exercised 4,901 4,901 Other 95 18 113 Net income 104,063 104,063 Marketable securities valuation adjustment (1,446) (1,446) Comprehensive income 91,048 ============ ============ ============ ============ ============ Currency translation adjustments 2,474 2,474 Interest rate contract 886 886 Minimum liability of defined benefit plans (12,948) (12,948) Comprehensive income 63,481 Tax benefit of options exercised 328 328 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION AND BASIS OF PRESENTATION We design, manufacture and sell comprehensive systems, components, and products used in oil and gas drilling and production, as well as distribute products and provide supply chain integration services to the upstream oil and gas industry. Our revenues and operating results are directly related to the level of worldwide oil and gas drilling and production activities and the profitability and cash flow of oil and gas companies and drilling contractors, which in turn are affected by current and anticipated prices of oil and gas. Oil and gas prices have been and are likely to continue to be volatile. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Consolidation The accompanying consolidated financial statements include the accounts of National-Oilwell, Inc. and its majority-owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. Investments that are not wholly-owned, but where we exercise control, are fully consolidated with the equity held by minority owners reflected as minority interest in the accompanying balance sheet and their portion of net income (loss) is included in other income (expense) in the accompanying statement of operations. Investments in unconsolidated affiliates, over which we exercise significant influence, but not control, are accounted for by the equity method. Investments in which we exercise no control or significant influence would be accounted for under the cost method. Fair Value of Financial Instruments The carrying amounts of financial instruments including cash and cash equivalents, receivables, and payables approximated fair value because of the relatively short maturity of these instruments. Cash equivalents include only those investments having a maturity date of three months or less at the time of purchase. The carrying values of other financial instruments approximate their respective fair values. Derivative Financial Instruments We record all derivative financial instruments at their fair value in our consolidated balance sheet. All derivative financial instruments we hold are designated as cash flow hedges and are highly effective in offsetting movements in the underlying risks. Accordingly, gains and losses from changes in the fair value of derivative financial instruments are deferred and recognized in earnings as the underlying transactions occur. Because our derivative financial instruments are so closely related to the underlying transactions, hedge ineffectiveness is insignificant. We use foreign currency forward contracts to mitigate our exposure to changes in foreign currency exchange rates on firm sale commitments to better match the local currency cost components of our fixed US dollar contracts. Such arrangements typically have terms between three months and one year, depending upon the customer's purchase order. We also use, from time to time, interest rate contracts to mitigate our exposure to changes in interest rates on anticipated long-term debt issuances. These contracts are typically short term in nature. We do not use derivative financial instruments for trading or speculative purposes. Inventories consist of oilfield products, manufactured equipment, manufactured specialized drilling products and downhole motors and spare parts for manufactured equipment and drilling products. Inventories are stated at the lower of cost or market using the first-in, first-out or average cost methods. Allowances for excess and obsolete inventories are determined based on our historical usage of inventory on-hand as well as our future expectations related to our substantial installed base and the development of new products. The amount reserved, which totaled $49.4 million and $49.1 million at December 31, 2002 and 2001, respectively, is the recorded cost of the inventory minus its estimated realizable value. Provisions for excess and obsolete inventories have been immaterial in recent years. Property, plant and equipment are recorded at cost. Expenditures for major improvements that extend the lives of property and equipment are capitalized while minor replacements, maintenance and repairs are charged to operations as incurred. Disposals are removed at cost less accumulated depreciation with any resulting gain or loss reflected in operations. Depreciation is provided using the straight-line method or declining balance method over the estimated useful lives of individual items. Depreciation expense was $25.0 million, $27.1 million and $24.7 million for the years ending December 31, 2002, 2001 and 2000. Long-lived Assets Effective January 1, 2002, we adopted SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". SFAS 144 superceded SFAS 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of". The adoption of SFAS 144 had no effect on our results of operations. We record impairment losses on long-lived assets used in operations when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amount of those assets. The net carrying value of assets not recoverable is reduced to fair value if lower than carrying value. In determining the fair market value of the assets, we consider market trends and recent transactions involving sales of similar assets, or when not available, discounted cash flow analysis. Impairments of our equity investments would be recognized when declines in market values below carrying amounts were considered other than temporary. Assets Held for Sale In the course of integrating acquisitions and streamlining operations, we have closed certain manufacturing facilities. Facilities where we have a formal plan to sell the facility are classified as held for sale. We expect these facilities to be sold within one year but market conditions may impact our ability to sell the facilities. When we designate an asset as held for sale, we record its carrying value at the lower of its current carrying amount or the estimated fair value less costs to sell and stop recording depreciation expense. Carrying values are adjusted to reflect any subsequent deterioration in fair value. Deferred financing costs are amortized on a straight-line basis over the life of the related debt security. Beginning in 2002, we adopted FAS 142 "Accounting for Goodwill and Other Intangible Assets" and accordingly stopped amortizing goodwill that arose from acquisitions before June 30, 2001. We also performed an impairment test as of the beginning of 2002 that indicated no impairment of goodwill or other intangibles. The effect of not amortizing goodwill and other intangibles in periods prior to adoption follows (in thousands): 2002 2001 2000 ---------- ---------- ---------- Reported net income $ 73,069 $ 104,063 $ 13,136 Add back: Goodwill amortization, net of tax -- 10,959 9,930 Adjusted net income $ 73,069 $ 115,022 $ 23,066 Adjusted net income per share: Basic $ 0.90 $ 1.42 $ 0.29 Diluted $ 0.89 $ 1.41 $ 0.29 Basic 80,974 80,813 79,325 Diluted 81,709 81,733 80,760 On at least an annual basis, we assess whether goodwill is impaired. Our annual impairment tests are performed at the beginning of the 4th quarter of each year. Our annual impairment test indicated no impairment. If we determine that goodwill is impaired, we measure that impairment based on the amount by which the book value of goodwill exceeds its implied fair value. The implied fair value of goodwill is determined by deducting the fair value of a reporting unit's identifiable assets and liabilities from the fair value of that reporting unit as a whole. Additional impairment assessments may be performed on an interim basis if we encounter events or changes in circumstances that would indicate that, more likely than not, the carrying amount of goodwill has been impaired. Fair value of the reporting units is determined based on internal management estimates. The functional currency for our Canadian, United Kingdom, Norwegian, German, Netherlands and Australian operations is the local currency. The cumulative effects of translating the balance sheet accounts from the functional currency into the U.S. dollar at current exchange rates are included in accumulated other comprehensive income. Revenues and expenses are translated at average exchange rates in effect during the period. The U.S. dollar is used as the functional currency for the Singapore and Venezuelan operations. Accordingly, financial statements of these foreign subsidiaries are remeasured to U.S. dollars for consolidation purposes using current rates of exchange for monetary assets and liabilities and historical rates of exchange for nonmonetary assets and related elements of expense. Revenue and other expense elements are remeasured at rates that approximate the rates in effect on the transaction dates. For all operations, gains or losses from remeasuring foreign currency transactions into the functional currency are included in income. Foreign currency transactions losses/(gains) were $0.3 million, $0.6 million and $(1.4) million for the years ending December 31, 2002, December 31, 2001 and December 31, 2000, respectively. Our products and services are generally sold based upon purchase orders or contracts with the customer that include fixed or determinable prices and that do not include right of return or other similar provisions or other significant post delivery obligations. Except for the construction of large rig packages, we record revenue at the time delivery has occurred, the customer has been provided with all proper inspection and other required documentation, title and risk of loss has passed to the customer and collectibility is reasonably assured. Customer advances or deposits are deferred and recognized as revenue when we have completed all of our performance obligations related to the sale. We also recognize revenue as services are performed and as rental charges are incurred. The amounts billed for shipping and handling costs are included in revenue and related costs are included in costs of sales. Revenues for the construction of large rig packages are reported on the percentage of completion method of accounting. Revenues and gross profit are recognized as work is performed based upon the relationship between actual costs incurred and total expected costs at completion. All known or anticipated losses on contracts are provided for immediately in earnings. The liability method is used to account for income taxes. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to amounts which are more likely than not to be realized. Concentration of Credit Risk We grant credit to our customers, which operate primarily in the oil and gas industry. We perform periodic credit evaluations of our customers' financial condition and generally do not require collateral, but may require letters of credit for certain international sales. We maintain an allowance for doubtful accounts for accounts receivables by providing for specifically identified accounts where collectibility is doubtful and an additional allowance based on the aging of the receivables compared to past experience and current trends. Accounts receivable are net of allowances for doubtful accounts of approximately $12.6 million and $9.1 million at December 31, 2002 and December 31, 2001, We use the intrinsic value method in accounting for our stock-based employee compensation plans. Environmental Liabilities When environmental assessments or remediations are probable and the costs can be reasonably estimated, remediation liabilities are recorded on an undiscounted basis and are adjusted as further information develops or circumstances change. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect reported and contingent amounts of assets and liabilities as of the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Net Income Per Share The following table sets forth the computation of weighted average basic and diluted shares outstanding (in thousands): ------ ------ ------ Denominator for basic earnings per share - weighted average 80,974 80,813 79,325 Effect of dilutive securities: Employee stock options 735 920 1,435 Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions 81,709 81,733 80,760 ====== ====== ====== 2. ACQUISITIONS On December 18, 2002, we completed a cash tender offer for 92% of the common shares of Hydralift ASA, a Norwegian based company specializing in the offshore drilling equipment industry. By December 31, 2002, we had substantially completed the acquisition of the remaining shares for a total purchase price, including the assumption of debt, of approximately $300 million. The results of Hydralift's operations have been included in our income statement since the acquisition date. As a result of this acquisition, we strengthened our position in the offshore drilling market and gained access to new product lines that complement our existing product offerings. The combination of our product offerings will open new markets to us, particularly within the FPSO (floating production storage and offloading) market. The purchase price will be allocated to the assets acquired and liabilities assumed based on their relative fair values. A preliminary allocation of the purchase price follows (in thousands): Assets acquired: Cash $ 47,387 Other current assets 138,709 Fixed assets 28,626 Other 24,920 Goodwill and other intangible assets 221,073 Liabilities assumed: Current liabilities 95,223 Debt obligations 93,101 Net assets acquired $245,001 The final allocation of the purchase price will be based upon independent appraisals and other valuations and may reflect other actions including product line rationalizations or other actions. All of the goodwill from this acquisition will be allocated to the Products and Technology segment and will be fully deductible for tax purposes. The following unaudited pro forma information assumes the acquisition of Hydralift had occurred as of the beginning of each year shown (in thousands): 2002 2001 ---------- ---------- Revenues $1,862,372 $2,003,995 Net income 87,148 116,718 Per diluted share $ 1.07 $ 1.43 Adjustments made to derive the pro forma data relate principally to acquisition financing. These results are not necessarily indicative of what actually would have occurred if the acquisition had happened as of the beginning of 2002 or 2001 nor are they indicative of future results. The estimated effects of cost reductions arising from the acquisition of Hydralift have been excluded. In January 2002, we also completed the acquisition of the assets and business of HAL Oilfield Pump & Equipment Company for approximately $16 million. This business, which designs, manufactures and distributes centrifugal pumps, pump packages and expendable parts, is complementary to our Mission pump product line. Goodwill related to this acquisition was approximately $10 million and is During 2002 we also acquired two other businesses for approximately $1.2 million in cash. In 2001, we acquired nine companies for an aggregate of $51 million in cash. Individual purchase prices ranged from $0.6 million to $16.5 million. Each of these acquisitions enhanced or expanded our market position within each of our segments. Five of these acquisitions related to our Products and Technology segment, including Integrated Power Systems, Maritime Hydraulics (Canada) Ltd., Tech Power Controls Company, Houston Scientific International, Inc. and Rigquip UK business and related assets. The remaining acquisitions, including Demij (a Netherlands distribution company), Rye Supply Company, Inc., Texas Oil Works Supply, Inc. and Well-Serv, Inc. related to our Distribution segment. Aggregate goodwill relating to these acquisitions was $30 million and approximately half of this amount is deductible for tax purposes. In February 2000, the merger with Hitec ASA was completed for approximately $158 million as we issued 7.9 million shares of common stock. This transaction was accounted for as a purchase effective February 1, 2000 and generated goodwill of approximately $150 million. In June 2000, IRI International Corporation was merged with the Company and accounted for as a pooling-of-interests. We issued 13.5 million shares of common stock valued at approximately $447 million. During 2000 we also acquired four other businesses for approximately $48 million in cash. The purchase method of accounting was used to account for these acquisitions and generated approximately $9 million in goodwill. On January 16, 2003 we acquired the Mono pumping products business from million in goodwill. 3. INVENTORIES Inventories consist of (in thousands): DECEMBER 31, DECEMBER 31, 2002 2001 ------------ ------------ Raw materials and supplies $ 60,699 $ 39,272 Work in process 109,924 101,376 Finished goods and purchased products 299,465 315,286 -------- -------- Total $470,088 $455,934 ======== ======== 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of (in thousands): ESTIMATED DECEMBER 31, DECEMBER 31, USEFUL LIVES 2002 2001 ------------ ------------ ------------ Land and improvements 2-20 Years $ 11,927 $ 9,557 Buildings and improvements 5-31 Years 74,610 53,268 Machinery and equipment 5-12 Years 111,652 89,268 Computer and office equipment 3-10 Years 92,794 73,322 Rental equipment 1-7 Years 77,328 63,971 --------- --------- 368,311 289,386 Less accumulated depreciation (159,891) (120,435) $ 208,420 $ 168,951 ========= ========= 5. LONG-TERM DEBT Long-term debt consists of (in thousands): Credit facilities $ 94,637 $ 10,213 6.875% senior notes 150,000 150,000 6.50% senior notes 150,000 150,000 5.65% senior notes 200,000 -- 594,637 310,213 Less current portion -- 10,213 $594,637 $300,000 Recently acquired Hydralift ASA represents $152 million of these facilities. These multi-currency Hydralift committed facilities are secured by a guarantee, contain financial covenants and expire in 2006. These instruments carry interest at a pre-agreed upon percentage point spread from either the prime interest rate or NIBOR. Borrowings against these additional credit facilities totaled $93 million at December 31, 2002 and an additional $39 million had been used for letters of credit and guarantees. 6. PENSION PLANS National Oilwell and its consolidated subsidiaries have pension plans covering substantially all of its employees. Defined-contribution pension plans cover most of the U.S. and Canadian employees and are based on years of service, a percentage of current earnings and matching of employee contributions. For the years ended December 31, 2002, 2001 and 2000, pension expense for defined-contribution plans was $9.1 million, $6.0 million and $4.2 million, and all funding is current. Certain retired or terminated employees of predecessor or acquired companies also participate in defined benefit plans in the United States which have been retained by National Oilwell subsidiaries but which no longer accrue benefits. Active employees are ineligible to participate in any of these defined benefit plans. Our subsidiaries in the United Kingdom have a defined benefit pension plan whose participants are primarily retired and terminated employees who are no longer accruing benefits. In addition, approximately 160 U.S. retirees and spouses participate in defined benefit health care plans of predecessor or acquired companies that provide postretirement medical and life insurance benefits. Pension assets are principally invested in a fixed income bond fund, equity securities, United Kingdom government securities and cash deposits. The change in benefit obligation, plan assets and the funded status of the defined pension plans in the United States and the United Kingdom, and defined postretirement plans in the United States, follows: Pension benefits Postretirement benefits ---------------------- ----------------------- At year end 2002 2001 2002 2001 -------------- -------- -------- -------- --------- Benefit obligation at beginning of year $ 49,605 $ 46,511 $ 7,416 $ 3,107 Service cost 274 173 40 21 Interest cost 3,336 3,457 552 506 Actuarial (gain) loss 10,973 1,272 1,094 4,079 Benefits paid (2,996) (2,186) (645) (503) Retiree contributions 161 99 32 -- Other 3,357 279 -- 206 -------- -------- -------- -------- BENEFIT OBLIGATION AT END OF YEAR $ 64,710 $ 49,605 $ 8,489 $ 7,416 Fair value of plan assets at beginning of year $ 51,211 $ 60,062 $ -- $ -- Actual return (9,335) (7,715) -- -- Contributions 1,621 450 645 503 Other 4,174 600 -- -- FAIR VALUE OF PLAN ASSETS AT END OF YEAR $ 44,675 $ 51,211 -- -- Funded status $(20,035) $ 1,606 (8,489) (7,416) Unrecognized actuarial net loss/ (gain) 31,815 7,662 4,270 3,389 Prior service costs not yet recognized 281 303 213 257 Minimum pension liability (19,698) -- -- -- Other (10,543) (9,223) PREPAID (ACCRUED) BENEFIT COST $(18,180) $ 348 (4,006) (3,770) Significant assumptions used for the plans follow: Pension benefits Postretirement benefits ------------------------ ----------------------- For the year 2002 2001 2000 2002 2001 2000 ------------ ---- ---- ---- ---- ---- ----- Weighted average assumptions: Discount rate 5.8% 6.5% 7.5% 6.5% 6.9% 7.6% Expected long-term rate of return 6.3% 7.0% 8.0% n/a n/a n/a Rate of compensation increase 4.0% 4.25% 5.0% n/a n/a n/a A 17% annual rate of increase in the per capita cost of covered health care benefits was assumed for 2003, decreasing by approximately 3% points per year to 5.5% in 2007, with 5.5% increases per year thereafter. Net periodic benefit cost (credit): Pension benefits Postretirement benefits ----------------------------------- --------------------------------- For the year 2002 2001 2000 2002 2001 2000 -------------- ------- ------- ------- ------- ------- ------- Service cost - benefits earned during the period $ 422 $ -- $ 108 $ 40 $ 21 $ 16 Interest cost on projected benefit obligation 3,313 1,194 1,186 552 506 232 Expected return on plan assets (3,886) (1,183) (1,280) -- -- -- Net amortization and deferral 74 46 (8) 257 178 (13) ------- ------- ------- ------- ------- ------- NET PERIODIC BENEFIT COST (CREDIT) $ (77) $ 57 $ 6 $ 849 $ 705 $ 235 ======= ======= ======= ======= ======= ======= Assumed health care cost trend rates have a significant effect on the amounts reported for the postretirement benefits. A one percentage point change in assumed health care cost trend rates would have the following effects: 1% Point Increase 1% Point Decrease ----------------- ----------------- Effect on total of service and interest cost components in 2002 $ 47 $ (40) Effect on postretirement benefit obligation at year-end 2002 $ 770 $(655) In addition, our subsidiaries in Norway have defined benefit pension plans. The pension plan assets are invested primarily in equity securities, overseas bonds, real estate and cash deposits. At December 31, 2002, the plan assets at fair market value and the projected benefit obligation were approximately $12.0 million. 7. ACCUMULATED OTHER COMPREHENSIVE INCOME / (LOSS) The components of other comprehensive loss are as follows (in thousands): Cumulative Cumulative Change in Currency Marketable Minimum Translation Interest Securities Pension Liability Adjustment Rate Contract Valuation Adj. TOTAL ----------------- ----------- ------------- -------------- --------- Balance at December 31, 1999 $ -- $ (12,639) $ -- $ 716 $ (11,923) Current period activity (10,684) 1,136 (9,548) Tax effect (387) (387) --------- --------- --------- --------- --------- Balance at December 31, 2000 -- (23,323) -- 1,465 (21,858) Current period activity (11,569) (2,191) (13,760) Tax effect 745 745 Balance at December 31, 2001 -- (34,892) -- 19 (34,873) Current period activity (19,698) 2,474 1,363 (15,861) Tax effect 6,750 (477) 6,273 Balance at December 31, 2002 $ (12,948) $ (32,418) $ 886 $ 19 $ (44,461) ========= ========= ========= ========= ========= 8. COMMITMENTS AND CONTINGENCIES We lease land, buildings, storage facilities, vehicles, data processing equipment and software under operating leases expiring in various years through 2012. Rent expense for the years ended December 31, 2002, 2001 and 2000 was $21.2 million, $19.0 million and $12.6 million. Our minimum rental commitments for operating leases at December 31, 2002 were as follows: 2003 - $17.7 million; 2004 - $13.8 million; 2005 - $9.9 million; 2006 - $6.8 million; 2007 - $5.8 million and subsequent to 2007 - $9.7 million. We are involved in various claims, regulatory agency audits and pending or threatened legal actions involving a variety of matters. The total liability on these matters at December 31, 2002 cannot be determined; however, in our opinion, any ultimate liability, to the extent not otherwise provided for, should not materially affect our financial position, liquidity or results of Our business is affected both directly and indirectly by governmental laws and regulations relating to the oilfield service industry in general, as well as by environmental and safety regulations that specifically apply to our business. Although we have not incurred material costs in connection with our compliance with such laws, there can be no assurance that other developments, such as stricter environmental laws, regulations and enforcement policies thereunder could not result in additional, presently unquantifiable costs or liabilities to 9. COMMON STOCK National Oilwell has authorized 150 million shares of $.01 par value common stock. We also have authorized 10 million shares of $.01 par value preferred stock, none of which is issued or outstanding. Under the terms of National Oilwell's Stock Award and Long-Term Incentive Plan, as amended, 8.4 million shares of common stock are authorized for the grant of options to officers, key employees, non-employee directors and other persons. Options granted under our stock option plan generally vest over a three-year period starting one year from the date of grant and expire five or ten years from the date of grant. The purchase price of options granted may not be less than the market price of National Oilwell common stock on the date of grant. At December 31, 2002, approximately 4.2 million shares were available for future grants. We also have inactive stock option plans that were acquired in connection with the acquisitions of Dreco Energy Services, Ltd. in 1997, and of Hitec ASA and IRI International Corporation in 2000. We converted the outstanding stock options under these plans to options to acquire our common stock and no further options are being issued under these plans. Stock option information summarized below includes amounts for the National Oilwell Stock Award and Long-Term Incentive Plan and stock plans of acquired companies. Options outstanding at December 31, 2002 under the stock option plans have exercise prices between $5.62 and $40.50 per share, and expire at various dates from February 19, 2003 to August 15, 2012. The following summarizes options activity: YEARS ENDED DECEMBER 31, 2002 2001 2000 ---------------------------- ---------------------------- ---------------------------- AVERAGE AVERAGE AVERAGE NUMBER OF EXERCISE NUMBER OF EXERCISE NUMBER OF EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE ---------- ---------- ---------- ---------- ---------- ---------- Shares under option at 3,094,160 $ 22.95 2,792,585 $ 16.50 2,041,204 $ 14.59 Granted 977,500 18.53 911,626 40.50 758,961 23.56 Options from acquisitions -- -- -- -- 1,006,342 10.52 Cancelled (133,465) 28.54 (218,086) 25.47 (86,425) 14.10 Exercised (147,699) 13.52 (391,965) 16.39 (927,497) 11.80 Exercisable at end of year 2,119,692 $ 18.71 1,474,833 $ 15.68 1,097,327 $ 13.73 ========== ========== ========== ========== ========== ========== The following summarizes information about stock options outstanding as of OPTIONS OUTSTANDING OPTIONS EXERCISABLE WEIGHTED-AVG. ----------------------------- ------------------------------- RANGE OF REMAINING WEIGHTED-AVG. WEIGHTED-AVG. EXERCISE PRICE CONTRACTUAL LIFE SHARES EXERCISE PRICE SHARES EXERCISE PRICE -------------- ---------------- --------- -------------- --------- -------------- $ 5.62 to $10.52 2.98 1,131,451 $ 10.21 1,131,451 $ 10.21 $11.45 to $21.70 8.57 1,049,425 18.21 111,925 15.56 ---- --------- ------- --------- ------- Totals 6.04 3,790,496 $ 21.99 2,119,692 $ 18.71 ==== ========= ======= ========= ======= The weighted average fair value of options granted during 2002, 2001 and 2000 was approximately $8.95, $22.04, and $15.70 per share, respectively, as determined using the Black-Scholes option-pricing model. Assuming that we had accounted for our stock-based compensation using the alternative fair value method of accounting under FAS No. 123 and amortized the fair value to expense over the option's vesting period, our net income and net income per share would have been (in thousands, except per share data): 2002 2001 2000 ----------- ----------- ----------- Net income: As reported $ 73,069 $ 104,063 $ 13,136 Pro forma $ 63,926 $ 94,227 $ 5,584 Basic net income per share: As reported $ 0.90 $ 1.29 $ 0.17 Pro forma 0.79 1.17 0.07 Diluted net income per share: These pro forma results may not be indicative of future effects. The assumptions used in the Black-Scholes option-pricing model were: ASSUMPTIONS 2002 2001 2000 - ---------------------------- ---- ---- ---- Risk-free interest rate 2.4% 6.3% 4.7% Expected dividend -- -- -- Expected option life (years) 5 5 4 Expected volatility 54% 55% 94% The Company evaluates annually the grant of options to eligible participants and in February 2003, 977,500 options to purchase shares of common stock were granted at an exercise price of $20.14, the fair value of the common stock at the date of grant. 10. INCOME TAXES The domestic and foreign components of income before income taxes were as follows (in thousands): DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000 ----------------- ----------------- ----------------- Domestic $ 45,716 $101,700 $(10,555) Foreign 66,749 66,317 37,592 -------- -------- -------- $112,465 $168,017 $ 27,037 ======== ======== ======== The components of the provision (benefit) for income taxes consisted of (in thousands): DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000 ----------------- ----------------- ----------------- Federal $ 11,315 $ 32,222 $ 5,401 State 909 581 123 Foreign 15,726 23,304 14,258 -------- -------- -------- 27,950 56,107 19,782 Deferred: Federal 4,888 4,925 (6,757) State 1,144 391 (507) Foreign 5,414 2,531 1,383 11,446 7,847 (5,881) $ 39,396 $ 63,954 $ 13,901 ======== ======== ======== The difference between the effective tax rate reflected in the provision for income taxes and the U.S. federal statutory rate was as follows (in DECEMBER 31, 2002 DECEMBER 31, 2001 DECEMBER 31, 2000 ----------------- ----------------- ----------------- Federal income tax at statutory rate $ 39,363 $ 58,806 $ 9,462 Foreign income tax rate differential (2,990) 1,405 781 State income tax, net of federal benefit 556 299 336 Tax benefit of foreign sales income (1,580) (1,575) (1,492) Nondeductible expenses 1,053 2,423 4,626 Foreign dividends net of FTCs 1,176 (1,967) (1,046) Net operating loss carryforwards -- 2,948 1,744 Change in deferred tax valuation allowance 400 1,223 (606) Prior year taxes 1,126 -- -- Other 292 392 96 -------- -------- -------- $ 39,396 $ 63,954 $ 13,901 ======== ======== ======== Significant components of National Oilwell's deferred tax assets and liabilities were as follows (in thousands): DECEMBER 31, DECEMBER 31, 2002 2001 ------------ ------------ Deferred tax assets: Allowances and operating liabilities $ 29,047 $ 9,408 Net operating loss carryforwards 23,891 16,107 Foreign tax credit carryforwards 15,082 13,580 Capital loss carryforward 3,527 3,527 Other 22,012 20,378 -------- -------- Total deferred tax assets 93,559 63,000 Valuation allowance for deferred tax assets (29,912) (29,512) 63,647 33,488 Deferred tax liabilities: Tax over book depreciation 14,168 10,366 Operating and other assets 31,688 -- Other 8,756 10,014 Total deferred tax liabilities 54,612 20,380 Net deferred tax assets $ 9,035 $ 13,108 ======== ======== In the United States, the Company has $12.0 million of net operating loss carryforwards as of December 31, 2002, which expire at various dates through 2017. These operating losses were acquired primarily in the combination with Dreco Energy Services, Ltd. and are associated with Dreco's US subsidiary. As a result of share exchanges occurring since the date of the combination resulting in a more than 50% aggregate change in the beneficial ownership of Dreco, the availability of these loss carryforwards to reduce future United States federal taxable income may have become subject to various limitations under Section 382 of the Internal Revenue Code of 1986, as amended. In addition, these net operating losses can only be used to offset separate company taxable income of Dreco's US subsidiary. Since the ultimate realization of these net operating losses is uncertain, the related potential benefit of $4.2 million has been recorded with a $2.8 million valuation allowance. Future income tax expense will be reduced if the Company ultimately realizes the benefit of these net operating losses. Also in the United States, the Company has $9.1 million of capital loss 2005. The related potential benefit of $3.5 million has been recorded with a valuation allowance of $3.5 million. These capital losses are not available to reduce future operating income but are expected to be realized as deductions against future capital gains. The Company has $ 15.1 million of excess foreign tax credits as of December 31, 2002, which expire at various dates through 2006. These credits have been allotted a valuation allowance of $ 14.1 million and would be realized as a reduction of future income tax expense. Outside the United States, the company has $67.5 million of net operating loss carryforwards as of December 31, 2002. Of this amount, $65.3 million will expire at various dates through 2012 and $2.2 million is available indefinitely. The related potential benefit available of $19.7 million has been recorded with a valuation allowance of $9.6 million. If the Company ultimately realizes the benefit of these net operating losses, $9.4 million would reduce goodwill and other intangible assets and $10.3 million would reduce income tax expense. The deferred tax valuation allowance increased $0.4 million for the period ending December 31, 2002 and $1.2 million for the period ending December 31, 2001. These increases resulted primarily from the recognition of additional excess foreign tax credits that may not be realized in the future. National-Oilwell's deferred tax assets are expected to be realized principally through future earnings. Undistributed earnings of the Company's foreign subsidiaries amounted to $193.4 million and $149.2 million at December 31, 2002 and December 31, 2001, respectively. Those earnings are considered to be permanently reinvested and no provision for U.S. federal and state income taxes has been made. Distribution of these earnings in the form of dividends or otherwise could result in either U.S. federal taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable in various foreign countries. Determination of the amount of unrecognized deferred U.S. income tax liability is not practical; however, unrecognized foreign tax credit carryforwards would be available to reduce some portion of the U.S. liability. Withholding taxes of approximately $23.4 million would be payable upon remittance of all previously unremitted earnings at 11. SPECIAL CHARGE Direct transaction costs $ 6.6 Severance 6.4 Facility closures 1.5 Prior year reversal (0.4) 12. BUSINESS SEGMENTS AND GEOGRAPHIC AREAS National Oilwell's operations consist of two segments: Products and Technology and Distribution Services. The Products and Technology segment designs and manufactures a variety of oilfield equipment for use in oil and gas drilling, completion and production activities. The Distribution Services segment distributes an extensive line of oilfield supplies and equipment. Intersegment sales and transfers are accounted for at commercial prices and are eliminated in consolidation. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies of the Company. The Company evaluates performance of each reportable segment based upon its operating income, excluding non-recurring items. No single customer accounted for 10% or more of consolidated revenues during the three years ended December 31, 2002. Summarized financial information is as follows (in thousands): PRODUCTS AND DISTRIBUTION CORPORATE/ TECHNOLOGY SERVICES ELIMINATIONS TOTAL ------------ ------------ ------------ ---------- Revenues from: Unaffiliated customers $ 837,750 $ 684,196 $ -- $1,521,946 Intersegment sales 79,500 1,978 (81,478) -- ---------- ---------- ---------- ---------- Total revenues 917,250 686,174 (81,478) 1,521,946 Operating income (loss) 127,011 18,083 (10,771) 134,323 Capital expenditures 19,849 3,612 1,344 24,805 Depreciation and amortization 19,340 4,883 825 25,048 Goodwill 560,235 16,457 4,884 581,576 Identifiable assets 1,640,171 266,663 61,828 1,968,662 Unaffiliated customers $1,041,614 $ 705,817 $ 24 $1,747,455 Total revenues 1,120,919 707,818 (81,282) 1,747,455 Unaffiliated customers $ 629,967 $ 519,911 $ 42 $1,149,920 Operating income (loss) 60,992(2) 12,884 (25,420)(1) 48,456(1)(2) (1) Includes a special charge of $14,082 for 2000 related to the merger with IRI. (2) Includes $15,684 of inventory write-offs related to the merger with IRI. Geographic Areas: UNITED UNITED STATES CANADA NORWAY KINGDOM OTHER ELIMINATIONS TOTAL ---------- ---------- ---------- ---------- ---------- ------------ ---------- Unaffiliated customers $1,054,956 $ 254,361 $ 86,169 $ 44,733 $ 81,727 $ -- $1,521,946 Interarea sales 108,191 59,370 18,561 7,393 1,199 (194,714) -- ---------- ---------- ---------- ---------- ---------- ---------- ---------- Total revenues 1,163,147 313,731 104,730 52,126 82,926 (194,714) 1,521,946 Long-lived assets 618,501 423,029 787,505 48,525 91,102 -- 1,968,662 Interarea sales 129,525 45,890 11,591 7,421 445 (194,872) -- Total revenues 1,410,123 383,337 49,762 50,399 48,706 (194,872) 1,747,455 Unaffiliated customers $ 799,415 $ 239,940 $ 31,961 $ 48,050 $ 30,554 $ -- $1,149,920 Interarea sales 43,521 28,302 3,786 4,796 737 (81,142) -- Total revenues 842,936 268,242 35,747 52,846 31,291 (81,142) 1,149,920 13. QUARTERLY FINANCIAL DATA (UNAUDITED) Summarized quarterly results were as follows (in thousands, except per share data): 1ST QUARTER 2ND QUARTER 3RD QUARTER 4TH QUARTER TOTAL ----------- ----------- ----------- ----------- ---------- YEAR ENDED DECEMBER 31, 2002 Revenues $ 388,986 $ 372,390 $ 366,929 $ 393,641 $1,521,946 Gross Profit 93,045 87,404 88,533 92,882 361,864(1) Income before taxes 33,102 26,501 27,743 25,119 112,465 Net income 21,185 16,961 17,756 17,167 73,069 Net income per basic share 0.26 0.21 0.22 0.21 0.90 Net income per diluted share 0.26 0.21 0.22 0.21 0.89 Gross Profit 91,173 103,494 119,905 113,262 427,834(1) Net income 21,478 25,299 28,938 28,348 104,063 We have audited the consolidated financial statements of National-Oilwell, Inc. as of December 31, 2002 and 2001, and for each of the three years in the period ended December 31, 2002, and have issued our report thereon dated February 18, 2003 (included elsewhere in this Form 10-K/A). Our audits also included the financial statement schedule listed in the index at item 15a of this Form 10-K/A. This schedule is the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 2002, 2001 AND 2000 (DEDUCTIONS) BALANCE CHARGED TO CHARGE BALANCE BEGINNING COSTS AND OFFS AND END OF OF YEAR EXPENSES OTHER YEAR --------- ------------ -------- -------- Allowance for doubtful accounts: 2002 $ 9,094 $ 3,606 $ (124) $ 12,576 2001 5,885 3,897 (688) 9,094 2000 8,986 1,589 (4,690) 5,885 Allowance for excess and obsolete inventory reserves: 2002 $ 49,084 $ 1,672 $ (1,364) $ 49,392 2001 53,283 807 (5,006) 49,084 2000 39,355 16,814 (2,886) 53,283 Valuation allowance for deferred tax assets: 2002 $ 29,512 $ 400 $ -- $ 29,912 2001 28,289 1,223 -- 29,512 2000 19,228 (606) 9,667 28,289 INDEX TO EXHIBITS NUMBER DESCRIPTION - ------- ----------- 2.1 Combination Agreement between National-Oilwell, Inc. and Hydralift ASA regarding the transaction announced October 11, 2002 (Exhibit 2.1) (5). 3.1 Amended and Restated Certificate of Incorporation of 3.2 By-laws of National-Oilwell, Inc. Filed as an exhibit to the 10.1 Employment Agreement dated as of January 1, 2002 between Merrill A. Miller, Jr. and National Oilwell, with a similar agreement with Steven W. Krablin (Exhibit 10.1) (2). 10.2 Employment Agreement dated as of January 1, 2002 between Dwight W. Rettig and National Oilwell, with similar agreements with Robert L. Bloom, Kevin Neveu, Mark A. Reese and Robert R. Workman (Exhibit 10.2) (2). 10.3 Employment Agreement dated as of June 28, 2000 between Gary W. Stratulate and IRI International, Inc., which has now merged into National Oilwell (Exhibit 10.3) (2). 10.4 Amended and Restated Stock Award and Long-Term Incentive Plan 10.5 Loan Agreement dated July 30, 2002 (Exhibit 10.2) (3). 10.6 Employment Agreement dated as of March 1, 2000 between Jon Gjedebo and a National Oilwell subsidiary (Exhibit 10.8) (4). 10.7 Non-competition Agreement dated as of June 28, 2000 between 21.1 Subsidiaries of the Company. Filed as an exhibit to the Annual 23.1 Consent of Ernst & Young LLP 24.1 Power of Attorney (included on signature page hereto). Filed as an exhibit to the Annual Report on Form 10-K, filed March 7, 2003. 99.1 Certification pursuant to Section 906 of the Sarbanes-Oxley Act of CONSENT OF INDEPENDENT AUDITORS We consent to the use of our report dated February 18, 2003, included in the Annual Report on Form 10-K of National-Oilwell, Inc. for the year ended December 31, 2002, with respect to the consolidated financial statements, as amended, included in this Form 10-K/A. We consent to the incorporation by reference in the following Registration Statements of National-Oilwell, Inc. and in the related Prospectuses of our reports dated February 18, 2003, with respect to the consolidated financial statements, as amended, and schedule of National-Oilwell, Inc. included in this Annual Report (Form 10-K/A) for the year ended December 31, 2002. Form Description S-8 Stock Award and Long Term Incentive Plan, Value Appreciation and Incentive Plan A and Value Appreciation and Incentive Plan B (No. 333-15859) S-8 National-Oilwell Retirement and Thrift Plan (No. 333-36359) S-8 Post Effective Amendment No. 3 to the Registration Statement on Form S-4 filed on Form S-8 pertaining to the Dreco Energy Services Ltd. Amended and Restated 1989 Employee Incentive Stock Option Plan, as amended, and Employment and Compensation Arrangements Pursuant to Private Stock Option Agreements (No. 333-21191) S-8 Post Effective Amendment No. 1 on Form S-8 to Registration Statement on Form S-4 pertaining to the IRI International Corporation Equity Incentive Plan (No. 333-36644) S-3 Registration Statement on Form S-3 pertaining to the issuance of 3,200,000 shares to Halliburton Energy Services, Inc. (No. 333-102665) I, Merrill A. Miller, Jr., Chairman, President and Chief Executive Officer of National-Oilwell, Inc., certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) the Annual Report on Form 10-K/A for the year ended December 31, 2002 (the "Periodic Report') which this statement accompanies fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78m) and (2) information contained in the Periodic Report fairly presents, in all material respects, the financial condition and results of operations of National-Oilwell, Inc. Dated: June 26, 2003 /s/ Merrill A. Miller, Jr. A signed original of this written statement required by Section 906 has been provided to National-Oilwell, Inc. and will be retained by National-Oilwell, Inc. and furnished to the Securities and Exchange Commission or its staff upon I, Steven W. Krablin, Chief Financial Officer of National-Oilwell, Inc., certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: /s/ Steven W. Krablin

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professional_accounting

EXXON MOBIL CORP ☑ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF For the transition period from __________to________ Commission File Number 1-2256 Identification Number) 5959 LAS COLINAS BOULEVARD, IRVING, TEXAS 75039-2298 (Registrant's telephone number, including area code) Trading Symbol Name of Each Exchange on Which Registered Common Stock, without par value Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☑ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ☑ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and “emerging growth company” in Rule 12b-2 of the Exchange Act. ☑ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☑ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Outstanding as of March 31, 2019 Three months ended March 31, 2019 and 2018 Condensed Consolidated Statement of Comprehensive Income As of March 31, 2019 and December 31, 2018 Condensed Consolidated Statement of Changes in Equity Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Index to Exhibits (millions of dollars) Revenues and other income Sales and other operating revenue Income from equity affiliates Total revenues and other income Costs and other deductions Crude oil and product purchases Production and manufacturing expenses Exploration expenses, including dry holes Non-service pension and postretirement benefit expense Other taxes and duties Total costs and other deductions Net income including noncontrolling interests Net income attributable to noncontrolling interests Net income attributable to ExxonMobil Earnings per common share (dollars) Earnings per common share - assuming dilution (dollars) The information in the Notes to Condensed Consolidated Financial Statements is an integral part of these statements. Other comprehensive income (net of income taxes) Foreign exchange translation adjustment Adjustment for foreign exchange translation (gain)/loss included in net income Postretirement benefits reserves adjustment (excluding amortization) Amortization and settlement of postretirement benefits reserves adjustment included in net periodic benefit costs Comprehensive income including noncontrolling interests Comprehensive income attributable to noncontrolling interests Comprehensive income attributable to ExxonMobil Mar. 31, Dec. 31, Notes and accounts receivable – net Crude oil, products and merchandise Investments, advances and long-term receivables Property, plant and equipment – net Other assets, including intangibles – net Notes and loans payable Postretirement benefits reserves Deferred income tax liabilities Long-term obligations to equity companies Other long-term obligations Common stock without par value (9,000 million shares authorized, 8,019 million shares issued) Earnings reinvested Common stock held in treasury (3,788 million shares at March 31, 2019 and 3,782 million shares at December 31, 2018) ExxonMobil share of equity Cash flows from operating activities Changes in operational working capital, excluding cash and debt All other items – net Cash flows from investing activities Additions to property, plant and equipment Proceeds associated with sales of subsidiaries, property, plant and equipment, and sales and returns of investments Additional investments and advances Other investing activities including collection of advances Cash flows from financing activities Reductions in short-term debt Additions/(reductions) in commercial paper, and debt with three months or less maturity (1) Cash dividends to ExxonMobil shareholders Cash dividends to noncontrolling interests Changes in noncontrolling interests Common stock acquired Effects of exchange rate changes on cash Increase/(decrease) in cash and cash equivalents Supplemental Disclosures Income taxes paid Cash interest paid Included in cash flows from operating activities Capitalized, included in cash flows from investing activities Total cash interest paid (1) Includes a net addition of commercial paper with a maturity of over three months of $5.3 billion in 2019 and a net reduction of $0.3 billion in 2018. The gross amount of commercial paper with a maturity of over three months issued was $6.4 billion in 2019 and $0.4 billion in 2018, while the gross amount repaid was $1.1 billion in 2019 and $0.7 billion in 2018. Share of Balance as of December 31, 2017 Amortization of stock-based awards Net income for the period Dividends - common shares Cumulative effect of accounting Acquisitions, at cost Balance as of March 31, 2018 Common Stock Share Activity (millions of shares) Balance as of December 31 Balance as of March 31 1. Basis of Financial Statement Preparation These unaudited condensed consolidated financial statements should be read in the context of the consolidated financial statements and notes thereto filed with the Securities and Exchange Commission in the Corporation's 2018 Annual Report on Form 10-K. In the opinion of the Corporation, the information furnished herein reflects all known accruals and adjustments necessary for a fair statement of the results for the periods reported herein. All such adjustments are of a normal recurring nature. Prior data has been reclassified in certain cases to conform to the current presentation basis. The Corporation's exploration and production activities are accounted for under the "successful efforts" method. 2. Accounting Changes Effective January 1, 2019, the Corporation adopted the Financial Accounting Standards Board’s Standard, Leases (Topic 842), as amended. The standard requires all leases to be recorded on the balance sheet as a right of use asset and a lease liability. The Corporation used a transition method that applies the new lease standard at January 1, 2019. The Corporation applied a policy election to exclude short-term leases from balance sheet recognition and also elected certain practical expedients at adoption. As permitted, the Corporation did not reassess whether existing contracts are or contain leases, the lease classification for any existing leases, initial direct costs for any existing lease and whether existing land easements and rights of way, which were not previously accounted for as leases, are or contain a lease. At adoption on January 1, 2019, an operating lease liability of $3.3 billion was recorded and the operating lease right of use asset was $4.3 billion, including $1.0 billion of previously recorded prepaid leases. There was no cumulative earnings effect adjustment. Effective January 1, 2020, ExxonMobil will adopt the Financial Accounting Standards Board’s update, Financial Instruments – Credit Losses (Topic 326), as amended. The standard requires a valuation allowance for credit losses be recognized for certain financial assets that reflects the current expected credit loss over the asset’s contractual life. The valuation allowance considers the risk of loss, even if remote, and considers past events, current conditions and expectations of the future. The Corporation is evaluating the standard and its effect on the Corporation’s financial statements. 3. Litigation and Other Contingencies A variety of claims have been made against ExxonMobil and certain of its consolidated subsidiaries in a number of pending lawsuits. Management has regular litigation reviews, including updates from corporate and outside counsel, to assess the need for accounting recognition or disclosure of these contingencies. The Corporation accrues an undiscounted liability for those contingencies where the incurrence of a loss is probable and the amount can be reasonably estimated. If a range of amounts can be reasonably estimated and no amount within the range is a better estimate than any other amount, then the minimum of the range is accrued. The Corporation does not record liabilities when the likelihood that the liability has been incurred is probable but the amount cannot be reasonably estimated or when the liability is believed to be only reasonably possible or remote. For contingencies where an unfavorable outcome is reasonably possible and which are significant, the Corporation discloses the nature of the contingency and, where feasible, an estimate of the possible loss. For purposes of our contingency disclosures, “significant” includes material matters, as well as other matters which management believes should be disclosed. ExxonMobil will continue to defend itself vigorously in these matters. Based on a consideration of all relevant facts and circumstances, the Corporation does not believe the ultimate outcome of any currently pending lawsuit against ExxonMobil will have a material adverse effect upon the Corporation's operations, financial condition, or financial statements taken as a whole. The Corporation and certain of its consolidated subsidiaries were contingently liable at March 31, 2019, for guarantees relating to notes, loans and performance under contracts. Where guarantees for environmental remediation and other similar matters do not include a stated cap, the amounts reflect management’s estimate of the maximum potential exposure. These guarantees are not reasonably likely to have a material effect on the Corporation’s financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. As of March 31, 2019 Debt-related ExxonMobil share Additionally, the Corporation and its affiliates have numerous long-term sales and purchase commitments in their various business activities, all of which are expected to be fulfilled with no adverse consequences material to the Corporation’s operations or financial condition. The operations and earnings of the Corporation and its affiliates throughout the world have been, and may in the future be, affected from time to time in varying degree by political developments and laws and regulations, such as forced divestiture of assets; restrictions on production, imports and exports; price controls; tax increases and retroactive tax claims; expropriation of property; cancellation of contract rights and environmental regulations. Both the likelihood of such occurrences and their overall effect upon the Corporation vary greatly from country to country and are not predictable. In accordance with a Venezuelan nationalization decree issued in February 2007, a subsidiary of the Venezuelan National Oil Company (PdVSA) assumed the operatorship of the Cerro Negro Heavy Oil Project. The decree also required conversion of the Cerro Negro Project into a “mixed enterprise” and an increase in PdVSA’s or one of its affiliate’s ownership interest in the Project. ExxonMobil refused to accede to the terms proffered by the government, and on June 27, 2007, the government expropriated ExxonMobil’s 41.67 percent interest in the Cerro Negro Project. ExxonMobil collected awards of $908 million in an arbitration against PdVSA under the rules of the International Chamber of Commerce in respect of an indemnity related to the Cerro Negro Project and $260 million in an arbitration for compensation due for the La Ceiba Project and for export curtailments at the Cerro Negro Project under rules of International Centre for Settlement of Investment Disputes (ICSID). An ICSID arbitration award relating to the Cerro Negro Project’s expropriation ($1.4 billion) was annulled based on a determination that a prior Tribunal failed to adequately explain why the cap on damages in the indemnity owed by PdVSA did not affect or limit the amount owed for the expropriation of the Cerro Negro Project. ExxonMobil filed a new claim seeking to restore the original award of damages for the Cerro Negro Project with ICSID on September 26, 2018. The net impact of this matter on the Corporation’s consolidated financial results cannot be reasonably estimated. Regardless, the Corporation does not expect the resolution to have a material effect upon the Corporation’s operations or financial condition. An affiliate of ExxonMobil is one of the Contractors under a Production Sharing Contract (PSC) with the Nigerian National Petroleum Corporation (NNPC) covering the Erha block located in the offshore waters of Nigeria. ExxonMobil's affiliate is the operator of the block and owns a 56.25 percent interest under the PSC. The Contractors are in dispute with NNPC regarding NNPC's lifting of crude oil in excess of its entitlement under the terms of the PSC. In accordance with the terms of the PSC, the Contractors initiated arbitration in Abuja, Nigeria, under the Nigerian Arbitration and Conciliation Act. On October 24, 2011, a three-member arbitral Tribunal issued an award upholding the Contractors' position in all material respects and awarding damages to the Contractors jointly in an amount of approximately $1.8 billion plus $234 million in accrued interest. The Contractors petitioned a Nigerian federal court for enforcement of the award, and NNPC petitioned the same court to have the award set aside. On May 22, 2012, the court set aside the award. The Contractors appealed that judgment to the Court of Appeal, Abuja Judicial Division. On July 22, 2016, the Court of Appeal upheld the decision of the lower court setting aside the award. On October 21, 2016, the Contractors appealed the decision to the Supreme Court of Nigeria. In June 2013, the Contractors filed a lawsuit against NNPC in the Nigerian federal high court in order to preserve their ability to seek enforcement of the PSC in the courts if necessary. Following dismissal by this court, the Contractors appealed to the Nigerian Court of Appeal in June 2016. In October 2014, the Contractors filed suit in the United States District Court for the Southern District of New York to enforce, if necessary, the arbitration award against NNPC assets residing within that jurisdiction. NNPC has moved to dismiss the lawsuit. At this time, the net impact of this matter on the Corporation's consolidated financial results cannot be reasonably estimated. However, regardless of the outcome of enforcement proceedings, the Corporation does not expect the proceedings to have a material effect upon the Corporation's operations or financial condition. 4. Other Comprehensive Income Information ExxonMobil Share of Accumulated Other Current period change excluding amounts reclassified from accumulated other comprehensive income Amounts reclassified from accumulated other Total change in accumulated other comprehensive income Amounts Reclassified Out of Accumulated Other Comprehensive Income - Before-tax Income/(Expense) Foreign exchange translation gain/(loss) included in net income (Statement of Income line: Other income) Amortization and settlement of postretirement benefits reserves adjustment included in net periodic benefit costs (Statement of Income line: Non-service pension and postretirement benefit expense) Income Tax (Expense)/Credit For Components of Other Comprehensive Income Earnings per common share Net income attributable to ExxonMobil (millions of dollars) Weighted average number of common shares outstanding (millions of shares) Earnings per common share (dollars) (1) Dividends paid per common share (dollars) (1) The calculation of earnings per common share and earnings per common share – assuming dilution are the same in each period shown. 6. Pension and Other Postretirement Benefits Components of net benefit cost Pension Benefits - U.S. Amortization of actuarial loss/(gain) and prior service cost Net pension enhancement and curtailment/settlement cost Net benefit cost Pension Benefits - Non-U.S. Other Postretirement Benefits 7. Financial Instruments and Derivatives Financial Instruments. The estimated fair value of financial instruments at March 31, 2019 and December 31, 2018, and the related hierarchy level for the fair value measurement is as follows: Total Gross Assets Effect of Counterparty Netting Effect of Collateral Netting Difference in Carrying Value and Fair Value Net Carrying Value Derivative assets (1) Advances to/receivables from equity companies (2)(7) Other long-term financial assets (3) Derivative liabilities (4) Long-term debt (5) Long-term obligations to equity companies (7) financial liabilities (6)

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professional_accounting

Filing menu Free signup for more Track your favorite companies Receive email alerts for new filings Personalized dashboard of news and more Access all data and search results Filing files 10-Q Quarterly report 31.1 Management certification of annual or quarterly disclosure Download Excel data file View Excel data file Share this filing Associated FOX transcripts Earnings call transcript Related press release 6 May 20 Fox Reports Third Quarter Fiscal 2020 Filing tables Export all tables to Excel Constraining Litigous H.S. senior Bad New words: Aid, aimed, Auto, Bowl, Car, carryback, charge, cybersecurity, decline, declined, deferral, disease, disposition, Divestiture, Divisional, doubled, downturn, driven, environment, evolving, exposed, fourth, indefinite, large, LIV, local, macroeconomic, magnitude, medium, Miami, NASCAR, negatively, pandemic, payroll, plant, playoff, pose, posed, postponed, postponement, Racing, recession, refundable, Relief, remotely, retransmission, shelter, simplify, Simplifying, situation, slowdown, sporting, spread, streaming, strong, Super, supply, Supreme, test, travel, Tubi, weak, workforce, working Removed: Baseball, certificate, Cup, de, FIFA, Internationale, MLB, occur, preferred, sell, World FOX similar filings 2021 Q3 Quarterly report Filing view Full width Fixed width Default size S M L Default font Times Arial Search this filing Tables only Footnotes only Pre-defined: FOX Dashboard 10-Q Filing FOX Dashboard Financials Data Institutional Insider News Filings Transcripts Reddit ESG Shorts Patents 10-Q Filing FOX Fox 10-Q2020 Q3 Quarterly report Filed: 6 May 20, 8:00pm (Mark One) Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the quarterly period ended March 31, 2020 Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from to of Incorporation or Organization) 1211 Avenue of the Americas, New York, New York Registrant’s telephone number, including area code (212) 852-7000 Trading Symbols Name of Each Exchange on Which Registered Class A Common Stock, par value $0.01 per share The Nasdaq Global Select Market Class B Common Stock, par value $0.01 per share Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer Accelerated filer Non-accelerated filer Smaller reporting company Emerging growth company As of May 4, 2020, 342,642,286 shares of Class A Common Stock, par value $0.01 per share, and 261,078,355 shares of Class B Common Stock, par value $0.01 per share, were outstanding. Part I. Financial Information Unaudited Consolidated Statements of Operations for the three and nine months ended March 31, 2020 and 2019 Unaudited Consolidated Statements of Comprehensive Income for the three and nine months ended March 31, 2020 and 2019 Consolidated Balance Sheets as of March 31, 2020 (unaudited) and June 30, 2019 (audited) Unaudited Consolidated Statements of Cash Flows for the nine months ended March 31, 2020 and 2019 Unaudited Consolidated Statements of Equity for the three and nine months ended March 31, 2020 and 2019 Notes to the Unaudited Consolidated Financial Statements Part II. Other Information Unregistered Sales of Equity Securities and Use of Proceeds Defaults Upon Senior Securities UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS (IN MILLIONS, EXCEPT PER SHARE AMOUNTS) For the three months ended For the nine months ended Impairment and restructuring charges Income before income tax expense Less: Net income attributable to noncontrolling interests Net income attributable to Fox Corporation stockholders EARNINGS PER SHARE DATA Weighted average shares Net income attributable to Fox Corporation stockholders per share The accompanying notes are an integral part of these Unaudited Consolidated Financial Statements. UNAUDITED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Other comprehensive income, net of tax Benefit plan adjustments Less: Net income attributable to noncontrolling interests(a) Comprehensive income attributable to Fox Corporation stockholders Net income attributable to noncontrolling interests includes $4 million and $6 million for the three months ended March 31, 2020 and 2019, respectively, and $16 million and $27 million for the nine months ended March 31, 2020 and 2019, respectively, relating to redeemable noncontrolling interests. (IN MILLIONS, EXCEPT SHARE AND PER SHARE AMOUNTS) (audited) Receivables, net Inventories, net Non-current assets Property, plant and equipment, net Intangible assets, net Deferred tax assets Other non-current assets Accounts payable, accrued expenses and other current liabilities Non-current liabilities Borrowings Other liabilities Redeemable noncontrolling interests Class A common stock(a) Class B common stock(b) Total Fox Corporation stockholders' equity Class A common stock, $0.01 par value per share, 2,000,000,000 shares authorized, 342,640,682 shares and 354,422,419 shares issued and outstanding at par as of March 31, 2020 and June 30, 2019, respectively. Class B common stock, $0.01 par value per share, 1,000,000,000 shares authorized, 261,078,355 shares and 266,173,651 shares issued and outstanding at par as of March 31, 2020 and June 30, 2019, respectively. UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS Adjustments to reconcile net income to cash provided by operating activities Amortization of cable distribution investments Equity-based compensation Deferred income taxes Change in operating assets and liabilities, net of acquisitions and dispositions Receivables and other assets Inventories net of program rights payable Accounts payable and other liabilities Net cash provided by operating activities INVESTING ACTIVITIES Acquisitions, net of cash acquired Sale of investments Purchase of investments Other investing activities, net Net cash used in investing activities FINANCING ACTIVITIES Net transfers to Twenty-First Century Fox, Inc. Net dividend paid to Twenty-First Century Fox, Inc. Repurchase of shares Dividends paid and distributions Other financing activities, net Net cash used in financing activities Net (decrease) increase in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of period UNAUDITED CONSOLIDATED STATEMENTS OF EQUITY Accumulated Other Total Fox Corporation Fox, Inc. Retained Noncontrolling (Loss) Income Interests(a) Balance, December 31, 2019 Other comprehensive income Dividends declared Shares repurchased Balance, March 31, 2020 Net decrease in Twenty-First Century Fox, Inc. investment Conversion of Twenty-First Century Fox, Inc. investment Balance, June 30, 2019 Adoption of new accounting standards(c) Excludes Redeemable noncontrolling interests which are reflected in temporary equity (See Note 4—Fair Value under the heading “Redeemable Noncontrolling Interests”). Represents accumulated other comprehensive loss transferred from Twenty-First Century Fox, Inc. investment related to the pension and postretirement benefit assets and liabilities of the Shared Plans (See Note 14—Pension and Other Postretirement Benefits in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019 as filed with the Securities and Exchange Commission on August 9, 2019). Reflects the adoption of ASU 2016-01 and ASU 2018-02 as defined in Note 2—Summary of Significant Accounting Policies in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019 as filed with the Securities and Exchange Commission on August 9, 2019 under the heading “Recently Adopted and Recently Issued Accounting Guidance and U.S. Tax Reform.” NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION Fox Corporation, a Delaware corporation (“FOX” or the “Company”), is a news, sports and entertainment company, which manages and reports its businesses in the following segments: Cable Network Programming, Television and Other, Corporate and Eliminations. The Distribution On March 19, 2019, the Company became a standalone publicly traded company through the pro rata distribution by Twenty-First Century Fox, Inc. (now known as TFCF Corporation) (“21CF”) of all of the issued and outstanding common stock of FOX to 21CF stockholders (other than holders that were subsidiaries of 21CF) (the “Distribution”) in accordance with the Amended and Restated Distribution Agreement and Plan of Merger, dated as of June 20, 2018, by and between 21CF and 21CF Distribution Merger Sub, Inc. Following the Distribution, 354 million and 266 million shares of the Company’s Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Class B Common Stock, par value $0.01 per share (the “Class B Common Stock” and, together with the Class A Common Stock, the “Common Stock”), respectively, began trading independently on The Nasdaq Global Select Market (“Nasdaq”). In connection with the Distribution, the Company entered into the Separation and Distribution Agreement, dated as of March 19, 2019 (the “Separation Agreement”), with 21CF, which effected the internal restructuring (the “Separation”) whereby 21CF transferred to FOX a portfolio of 21CF’s news, sports and broadcast businesses, including FOX News Media (consisting of FOX News and FOX Business), FOX Entertainment, FOX Sports, FOX Television Stations, and sports cable networks FS1, FS2, FOX Deportes and Big Ten Network, and certain other assets, and FOX assumed from 21CF the liabilities associated with such businesses and certain other liabilities. The Separation and the Distribution were effected as part of a series of transactions contemplated by the Amended and Restated Merger Agreement and Plan of Merger, dated as of June 20, 2018, by and among 21CF, The Walt Disney Company (“Disney”) and certain subsidiaries of Disney, pursuant to which, among other things, 21CF became a wholly-owned subsidiary of Disney. In connection with the Separation, the Company entered into several agreements that govern certain aspects of the Company’s relationship with 21CF and Disney following the Separation. These include the Separation Agreement, a tax matters agreement, a transition services agreement, as well as agreements relating to intellectual property licenses, employee matters, commercial arrangements and a studio lot lease (See Note 1—Description of Business and Basis of Presentation in the 2019 Form 10-K, as defined below, for further discussion). The Unaudited Consolidated Financial Statements of FOX have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. In the opinion of management, all adjustments consisting only of normal recurring adjustments necessary for a fair presentation have been reflected in these Unaudited Consolidated Financial Statements. Operating results for the interim periods presented are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2020, due to, among other things, the impact of coronavirus disease 2019 (“COVID-19”) on the Company’s business. The impact of COVID-19 and measures to prevent its spread are affecting the macroeconomic environment, as well as the business of the Company, in a number of ways. For example, while the Company’s national news ratings remain strong, sporting events for which the Company has broadcast rights have been cancelled or postponed, the production of certain entertainment content the Company acquires has been suspended and demand in local advertising markets has declined. The magnitude of the impacts will depend on the duration and extent of COVID-19 and the effect of governmental actions, consumer behavior and actions taken by the Company’s business partners in response to the pandemic and such governmental actions. The evolving and uncertain nature of this situation makes it challenging for the Company to estimate the future performance of its businesses, particularly over the near to medium term, including the supply and demand for its services, its cash flows and its current and future advertising revenue. However, the impact of COVID-19 could have a material adverse effect on the Company’s business, financial condition or results of operations over the near to medium term. The preparation of the Company’s Unaudited Consolidated Financial Statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts that are reported in the Unaudited Consolidated Financial Statements and accompanying disclosures. Although these estimates are based on management’s best knowledge of current events and actions that the Company may undertake in the future, actual results may differ from those estimates. A significant decline in estimated advertising revenue or the expected popularity of the Company’s programming could lead to a downward revision in the fair value of, among other things, the Company’s reporting units, indefinite-lived intangible assets and long-lived assets and result in an impairment and a non-cash charge that is material to the Company’s reported net earnings. An impairment did not exist as of March 31, 2020. The Company will perform its annual impairment review during the fourth quarter of fiscal 2020. In addition, the recoverability of national sports contracts is based on the Company’s best estimates at March 31, 2020 of attributable revenues and costs; such estimates may change in the future and such changes may be significant. Should revenues decline materially from estimates applied at March 31, 2020, amortization of rights may be accelerated. These interim Unaudited Consolidated Financial Statements and notes thereto should be read in conjunction with the audited consolidated and combined financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019 as filed with the Securities and Exchange Commission on August 9, 2019 (the “2019 Form 10-K”). The Company’s financial statements for the three and nine months ended March 31, 2020 and 2019 and as of March 31, 2020 and June 30, 2019 are presented on a consolidated basis. The Company’s unaudited consolidated financial statements for the three and nine months ended March 31, 2020 reflect the Company’s results of operations and cash flows as a standalone company, and the Company’s Consolidated Balance Sheets as of March 31, 2020 and June 30, 2019 consist of the Company’s consolidated balances. Prior to the Distribution, which occurred on March 19, 2019, the Company’s combined financial statements were derived from the unaudited consolidated financial statements and accounting records of 21CF. The Unaudited Consolidated Statements of Operations for the three and nine months ended March 31, 2019 include, for the periods prior to March 19, 2019, allocations for certain support functions that were provided on a centralized basis within 21CF prior to the Distribution and not recorded at the business unit level, such as certain expenses related to finance, legal, insurance, information technology, compliance and human resources management activities, among others. 21CF did not routinely allocate these costs to any of its business units. These expenses were allocated to FOX on the basis of direct usage when identifiable, with the remainder allocated on a pro rata basis of combined revenues, headcount or other relevant measures. Management believes the assumptions underlying the Unaudited Consolidated Financial Statements, including the assumptions regarding allocating general corporate expenses from 21CF, are reasonable. Nevertheless, the Unaudited Consolidated Financial Statements may not include all of the actual expenses that would have been incurred by FOX and may not reflect FOX’s consolidated results of operations and cash flows had it been a standalone company during the entirety of the periods presented. Actual costs that would have been incurred if FOX had been a standalone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. For purposes of the Company’s financial statements for the period prior to the Distribution, the income tax provision in the Unaudited Consolidated Statements of Operations was calculated as if FOX filed a separate tax return and was operating as a standalone business. Therefore, cash tax payments and items of current and deferred taxes may not be reflective of FOX’s actual tax balances prior to or subsequent to the Distribution. Prior to the Distribution, the Company’s operating results were included in 21CF’s consolidated U.S. federal and state income tax returns. Intercompany transactions with 21CF or its affiliates and the Company are reflected in the historical Unaudited Consolidated Financial Statements for the period prior to the Distribution. All significant intracompany transactions and accounts within the Company’s consolidated businesses have been eliminated. Investments in and advances to entities or joint ventures in which the Company has significant influence, but less than a controlling financial interest, are accounted for using the equity method. Significant influence generally exists when the Company owns an interest between 20% and 50%. In accordance with Accounting Standards Codification (“ASC”) 321 “Investments—Equity Securities” (“ASC 321”), equity securities in which the Company has no significant influence (generally less than a 20% ownership interest) with readily determinable fair values are accounted for at fair value based on quoted market prices. Equity securities without readily determinable fair values are accounted for either at fair value or using the measurement alternative which is at cost minus impairment, if any, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. All gains and losses on investments in equity securities are recognized in the Unaudited Consolidated Statements of Operations. The Company’s fiscal year ends on June 30 of each year. Certain fiscal 2019 amounts have been reclassified to conform to the fiscal 2020 presentation. The unaudited and audited consolidated financial statements are referred to as the “Financial Statements” herein. The unaudited consolidated statements of operations are referred to as the “Statements of Operations” herein. The unaudited and audited consolidated balance sheets are referred to as the “Balance Sheets” herein. The unaudited consolidated statements of cash flows are referred to as the “Statements of Cash Flows” herein. Recently Adopted and Recently Issued Accounting Guidance and the CARES Act In February 2016, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) 2016-02, “Leases (Topic 842)” (“Topic 842”), as amended. Topic 842 requires recognition of lease liabilities and right-of-use (“ROU”) assets on the balance sheet and disclosure of key information about leasing arrangements. On July 1, 2019, the Company adopted Topic 842 on a modified retrospective basis and recorded operating lease liabilities and ROU assets of approximately $635 million and $585 million, respectively, at the date of adoption (See Note 7—Leases). The difference between the Company’s initial recognition of operating lease liabilities and ROU assets, at the date of adoption, was primarily a result of the reclassification of the deferred rent liability. The adoption of Topic 842 did not have a significant impact on the Statements of Operations. In accordance with the guidance in Topic 842, the Company elected not to reassess (i) whether any existing contracts are or contain leases, (ii) lease classification for existing leases or (iii) capitalization of initial direct costs for existing leases. During the third quarter of fiscal 2020, the Company early adopted ASU 2017-04, “Intangibles—Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). The objective of ASU 2017-04 is to simplify how an entity is required to test goodwill for impairment. Under previous GAAP, entities were required to test goodwill for impairment using a two-step approach. Under the amendments in ASU 2017-04, an entity performs its goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. The adoption of ASU 2017-04 did not have an effect on the Company’s Financial Statements. In March 2020, the U.S. government enacted the Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”). The CARES Act includes provisions relating to refundable payroll tax credits, deferral of the employer portion of certain payroll taxes, net operating loss carryback periods, modifications to net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. The Company does not expect the impact of these changes on the Company’s financial statements will be material. NOTE 2. ACQUISITIONS, DISPOSALS AND OTHER TRANSACTIONS The transactions described below support the Company’s strategy to strengthen its core brands and leverage its sports broadcasting rights and expand their reach beyond their traditional linear businesses. Acquisitions and Disposals Tubi Acquisition In April 2020, the Company acquired Tubi, Inc. (“Tubi”), a leading free ad-supported streaming service, for approximately $445 million in net cash consideration at closing (the “Tubi Acquisition”). Potential additional consideration in the form of deferred consideration and unvested options totaling approximately $45 million may be due over a three-year period following the closing of the transaction. The Company financed the Tubi Acquisition principally with the net proceeds from the sale of its investment in Roku, Inc. (“Roku”) discussed below. Television Stations Acquisition and Divestiture In March 2020, the Company acquired 3 television stations (FOX-affiliate KCPQ and MyNetworkTV-affiliate KZJO located in Seattle, Washington and FOX-affiliate WITI located in Milwaukee, Wisconsin) for approximately $350 million in cash from Nexstar Media Group, Inc. (“Nexstar”). As part of this transaction, the Company sold Nexstar 2 television stations (FOX-affiliate WJZY and MyNetworkTV-affiliate WMYT located in Charlotte, North Carolina) for approximately $45 million in cash. The consideration transferred of approximately $350 million for the stations the Company acquired has been preliminarily allocated, based on a provisional valuation, as follows: approximately $210 million to intangible assets, of which approximately $110 million has been allocated to Federal Communications Commission (“FCC”) licenses with indefinite lives and approximately $100 million to amortizable intangible assets, primarily retransmission agreements with useful lives of approximately eight years; approximately $30 million to property, plant and equipment; and the balance to the goodwill on the transaction. The estimated goodwill, which is tax deductible, reflects the increased synergies and market penetration expected from combining the operations of the 3 television stations with those of the Company. Credible Acquisition In October 2019, the Company acquired 67% of the equity in Credible Labs Inc. (“Credible”), a U.S. consumer finance marketplace, for approximately A$390 million (approximately $260 million) in cash (the “Credible Acquisition”), net of cash acquired. The remaining 33% of Credible not owned by the Company has been recorded at fair value on the acquisition date based on the Company’s valuation of Credible’s business using a market approach (a Level 3 measurement as defined in Note 4—Fair Value). The consideration transferred of approximately $260 million has been preliminarily allocated, based on a provisional valuation of 100% of Credible, as follows: approximately $70 million to intangible assets with useful lives ranging from five to 10 years; approximately $285 million representing goodwill on the transaction; approximately $(110) million to redeemable noncontrolling interests and the remainder to other net assets. The estimated goodwill, which is not tax deductible, reflects the increased market penetration and synergies expected from combining the operations of Credible and the Company. In addition, the Company has agreed to contribute up to $75 million of capital to Credible over approximately two years following the closing of the Credible Acquisition. Other Transactions In March 2020, the Company sold its investment in Roku for approximately $340 million. The Company recorded losses of approximately $470 million and $210 million for the three and nine months ended March 31, 2020, respectively, related to changes in the fair value of its investment in Roku prior to disposition, which were recorded in Other, net in the Statements of Operations (See Note 14—Additional Financial Information). The Stars Group In May 2019, the Company and The Stars Group Inc. (“The Stars Group”) announced plans to launch FOX Bet, a national media and sports wagering partnership in the U.S., which was launched in the first quarter of fiscal 2020. FOX Sports and The Stars Group have entered into a long-term commercial arrangement through which FOX Sports provides The Stars Group with an exclusive license to use certain FOX Sports trademarks. Prior to the tenth anniversary of the commercial agreement, and subject to certain conditions and applicable gaming regulatory approvals, FOX Sports has an option to acquire up to 50% of the equity in The Stars Group’s U.S. business. In addition, the Company invested $236 million to acquire a 4.99% equity interest in The Stars Group. The common shares issued to the Company are subject to certain transfer restrictions for a period ending in May 2021, subject to customary exceptions. The Company accounts for the investment in The Stars Group at fair value (See Note 4—Fair Value). In October 2019, Flutter Entertainment plc (“Flutter”) and The Stars Group announced that they had reached agreement on the terms of a recommended all-share combination to create a global leader in sports betting and gaming (the “Combination”) and, in early May 2020, the Combination was completed. As part of the agreement, FOX Sports received the right to acquire an approximately 18.5% equity interest in FanDuel Group, a majority-owned subsidiary of Flutter, at its market value in 2021 (structured as a 10-year option from 2021, subject to a carrying value adjustment). Caffeine and Caffeine Studios In fiscal 2019, the Company invested, in the aggregate, approximately $100 million in cash for a minority equity interest in Caffeine, Inc. (“Caffeine”), a social broadcasting platform for gaming, entertainment and other creative content, and Caffeine Studio, LLC (“Caffeine Studios”), a newly formed venture that is jointly owned by the Company and Caffeine. The Company accounts for the investments in Caffeine using the measurement alternative in accordance with ASC 321 and Caffeine Studios using the equity method. NOTE 3. INVENTORIES, NET The Company’s inventories were comprised of the following: Sports programming rights Entertainment programming rights Total inventories, net Less: current portion of inventories, net Total non-current inventories, net NOTE 4. FAIR VALUE In accordance with ASC 820, “Fair Value Measurement,” fair value measurements are required to be disclosed using a three-tiered fair value hierarchy which distinguishes market participant assumptions into the following categories: (i) inputs that are quoted prices in active markets (“Level 1”); (ii) inputs other than quoted prices included within Level 1 that are observable, including quoted prices for similar assets or liabilities (“Level 2”); and (iii) inputs that require the entity to use its own assumptions about market participant assumptions (“Level 3”). The following tables present information about financial assets and liabilities carried at fair value on a recurring basis: As of March 31, 2020 Investments in equity securities As of June 30, 2019 The investment categorized as Level 2 represents an investment in equity securities of The Stars Group estimated using the quoted market price of The Stars Group common stock less a discount due to a lack of marketability (“DLOM”). The DLOM was derived based on the remaining term of the lock up period and the volatility of The Stars Group common stock (See Note 2—Acquisitions, Disposals and Other Transactions under the heading “The Stars Group” for further discussion). The Company utilizes the market approach valuation technique for its Level 3 fair value measures. Inputs to such measures could include observable market data obtained from independent sources such as broker quotes and recent market transactions for similar assets. It is the Company’s policy to maximize the use of observable inputs in the measurement of its Level 3 fair value measurements. To the extent observable inputs are not available, the Company utilizes unobservable inputs based upon the assumptions market participants would use in valuing the liability. Examples of utilized unobservable inputs are future cash flows and long-term growth rates. The investment categorized as Level 1 represents an investment in equity securities of Roku with a readily determinable fair value, which was sold in March 2020 (See Note 2—Acquisitions, Disposals and Other Transactions under the heading “Roku” for further discussion). The Company accounts for redeemable noncontrolling interests in accordance with ASC 480-10-S99-3A, “Distinguishing Liabilities from Equity,” because their exercise is outside the control of the Company. The redeemable noncontrolling interests recorded at fair value are put rights held by minority shareholders in a majority-owned sports network and Credible. The changes in redeemable noncontrolling interests classified as Level 3 measurements were as follows: Beginning of period Acquisitions(a) Accretion and other End of period See Note 2—Acquisitions, Disposals and Other Transactions under the heading “Credible Acquisition.” As a result of the expiration of a portion of the put rights held by the sports network minority shareholder during the nine months ended March 31, 2020 and 2019, approximately $120 million and $200 million, respectively, was reclassified into equity. Another portion of the put rights held by the sports network minority shareholder will become exercisable in July 2020 and the remaining portion will become exercisable in July 2021. The put right held by the Credible minority shareholder will become exercisable in fiscal year 2025. The carrying value of the Company’s financial instruments, such as cash and cash equivalents, receivables, payables and investments accounted for using the measurement alternative in accordance with ASC 321, approximates fair value. Carrying value Fair value is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market (a Level 1 measurement). Concentrations of Credit Risk Cash and cash equivalents are maintained with several financial institutions. The Company has deposits held with banks that exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and are maintained with financial institutions of reputable credit and, therefore, bear minimal credit risk. Generally, the Company does not require collateral to secure receivables. As of March 31, 2020 and June 30, 2019, the Company had 0 individual customers that accounted for 10% or more of the Company’s receivables. NOTE 5. GOODWILL AND INTANGIBLE ASSETS, NET The changes in the carrying values of the Company’s intangible assets and related accumulated amortization were as follows: Intangible assets not subject to amortization Amortizable assets, net(a) Acquisitions(b) Disposals(b) Net of accumulated amortization of $150 million and $129 million as of March 31, 2020 and June 30, 2019, respectively. The average useful life of amortizable intangible assets ranges from five to 20 years. See Note 2—Acquisitions, Disposals and Other Transactions under the heading “Acquisitions and Disposals.” The changes in the carrying value of goodwill, by segment, are as follows: Other, Disposals(a) NOTE 6. BORROWINGS Senior Notes Issued In April 2020, the Company issued $600 million of 3.05% senior notes due 2025 and $600 million of 3.50% senior notes due 2030. In January 2019, the Company issued $6.8 billion of senior notes (See Note 9—Borrowings in the 2019 Form 10-K under the heading “Senior Notes Issued Under the January 2019 Indenture”). Revolving Credit Agreement The Company is party to a credit agreement providing a $1.0 billion unsecured revolving credit facility with a sub-limit of $150 million available for the issuance of letters of credit and a maturity date of March 2024 (See Note 9—Borrowings in the 2019 Form 10-K under the heading “Revolving Credit Agreement”). In April 2020, the Company entered into an amendment to the credit agreement, which, among other things, deducts cash in excess of $500 million from indebtedness for purposes of calculating the operating income leverage ratio under the agreement. As of March 31, 2020, there were 0 borrowings outstanding under the revolving credit agreement. NOTE 7. LEASES Lessee Arrangements The Company has lease agreements primarily for office facilities, transponder agreements and other equipment leases. At contract inception, the Company determines if a contract is or contains a lease and whether it is an operating or finance lease. The Company does not separate lease components from nonlease components for real estate leases. For operating leases that have a lease term of greater than one year, the Company initially recognizes operating lease liabilities and ROU assets at the lease commencement date, which is the date that the lessor makes an underlying asset available for use by the Company. ROU assets represent the Company’s right to use an underlying asset for the lease term and lease liabilities represent the present value of the Company’s obligation to make lease payments, primarily escalating fixed payments, over the lease term. The discount rate used to determine the present value of the lease payments is generally the Company’s incremental borrowing rate because the rate implicit in the lease is generally not readily determinable. The incremental borrowing rate for the lease term is determined by adjusting the Company’s unsecured borrowing rate for a similar term to approximate a collateralized borrowing rate. The Company's lease terms for each of its leases represents the noncancelable period for which the Company has the right to use an underlying asset, together with all of the following: (i) periods covered by an option to extend the lease if the Company is reasonably certain to exercise that option; (ii) periods covered by an option to terminate the lease if the Company is reasonably certain not to exercise that option; and (iii) periods covered by an option to extend (or not to terminate) the lease in which exercise of the option is controlled by the lessor. The Company recognizes lease payments as lease expense on a straight-line basis over the lease term. The Company’s operating ROU assets are included in Other non-current assets and the Company’s current and non-current operating lease liabilities are included in Accounts payable, accrued expenses and other current liabilities and Other liabilities, respectively, in the Company’s Balance Sheet (See Note 14—Additional Financial Information). The following amounts were recorded in the Company’s Balance Sheet relating to its operating leases and other supplemental information: ROU assets Lease liabilities Current lease liabilities Non-current lease liabilities Total lease liabilities Other supplemental information Weighted average remaining lease term Weighted average discount rate The following table presents information about the Company’s lease costs and supplemental cash flows information for leases: For the nine months ended March 31, 2020 Lease costs Total lease costs(a) Supplemental cash flows information Operating cash flows from operating leases ROU assets obtained in exchange for operating lease liabilities(b) Total lease costs of $34 million and $95 million for the three and nine months ended March 31, 2020, respectively, are net of sublease income of approximately $15 million and $40 million, respectively. Primarily related to leases obtained through the Company’s acquisitions (See Note 2—Acquisitions, Disposals and Other Transactions under the heading “Acquisitions and Disposals”). The following table presents the lease payments relating to the Company’s operating leases: Total lease payments(a) Less: imputed interest Present value of operating lease liabilities In addition to the total lease payments presented above, the Company has a lease for an office facility with total lease payments of approximately $55 million that has not yet commenced as of March 31, 2020. Lessor Arrangements The Company’s lessor arrangements primarily relate to its owned production and office facilities at the FOX Studios lot, which is located in Los Angeles, California. The Company is responsible for the management of the FOX Studios lot, which includes managing and providing facilities, studio operations, and production services, which until 2026 will predominantly be utilized by Disney productions. The Company leases production and office space on the FOX Studios lot to 21CF for an initial term of seven years, subject to 2 five-year renewal options exercisable by 21CF. The Company will receive approximately $50 million annually in lease payments over the lease term. The Company recorded total lease income of approximately $15 million and $40 million for the three and nine months ended March 31, 2020, respectively, which is included in Revenues in the Statements of Operations. The Company recognizes lease payments for operating leases as revenue on a straight-line basis over the lease term and variable lease payments as revenue in the period incurred. NOTE 8. STOCKHOLDERS’ EQUITY Stock Repurchase Program On November 6, 2019, the Company announced that its Board of Directors (the “Board”) had authorized a stock repurchase program providing for the repurchase of $2 billion of the Company’s Common Stock. The program has no time limit and may be modified, suspended or discontinued at any time. The Company also announced that it had entered into an accelerated share repurchase (“ASR”) agreement to repurchase $350 million of Class A Common Stock and announced its intention to promptly repurchase $150 million of Class B Common Stock. In accordance with the ASR agreement in November 2019, the Company paid a third-party financial institution $350 million and received an initial delivery of approximately 8 million shares of Class A Common Stock, representing 80% of the shares expected to be repurchased under the ASR agreement, at a price of $34.99 per share, which was the Nasdaq closing share price of the Class A Common Stock on November 11, 2019. Upon settlement of the ASR agreement in January 2020, the Company received a final delivery of approximately 2 million shares of Class A Common Stock. The final number of shares purchased under the ASR agreement was determined using a price of $36.05 per share (the volume-weighted average market price of the Class A Common Stock during the term of the ASR agreement less a discount). The Company accounted for the ASR agreement as two separate transactions. The initial delivery of Class A Common Stock was accounted for as a treasury stock transaction recorded on the acquisition date. The final settlement of Class A Common Stock was accounted for as a forward contract indexed to the Class A Common Stock and qualified as an equity transaction. During the nine months ended March 31, 2020, the Company repurchased approximately 2 million and 5 million shares of Class A Common Stock and Class B Common Stock, respectively, for $72 million and $178 million, respectively, in the open market. In total, the Company repurchased approximately 17 million shares of Common Stock for $600 million during the nine months ended March 31, 2020. Repurchased shares are retired and reduce the number of shares issued and outstanding. The Company allocates the amount of the repurchase price over par value between additional paid-in capital and retained earnings. As of March 31, 2020, the Company’s remaining stock repurchase authorization was approximately $1.4 billion. Stockholders Agreement The Company also announced on November 6, 2019 that it had entered into a stockholders agreement with the Murdoch Family Trust pursuant to which the Company and the Murdoch Family Trust have agreed not to take actions that would result in the Murdoch Family Trust and Murdoch family members together owning more than 44% of the outstanding voting power of the shares of Class B Common Stock or would increase the Murdoch Family Trust’s voting power by more than 1.75% in any rolling twelve-month period. The Murdoch Family Trust would forfeit votes to the extent necessary to ensure that the Murdoch Family Trust and the Murdoch family collectively do not exceed 44% of the outstanding voting power of the Class B shares, except where a Murdoch family member votes their own shares differently from the Murdoch Family Trust on any matter. Temporary Stockholder Rights Plan In connection with the Distribution, the Board approved the adoption of a Temporary Stockholder Rights Agreement (as amended, the “Rights Agreement”), effective March 19, 2019 (See Note 10—Stockholders’ Equity in the 2019 Form 10-K under the heading “Temporary Stockholder Rights Plan”). In November 2019, the rights issued pursuant to the Rights Agreement expired in accordance with the terms of the agreement. The following table summarizes the dividends declared per share on both the Company’s Class A Common Stock and Class B Common Stock: For the three months ended March 31, For the nine months ended March 31, Cash dividend per share The Company declared a semi-annual dividend of $0.23 per share on both the Class A Common Stock and the Class B Common Stock during the three months ended March 31, 2020, which was paid in April 2020 to stockholders of record on March 4, 2020. NOTE 9. EQUITY-BASED COMPENSATION In connection with the Distribution, the Company adopted the Fox Corporation 2019 Shareholder Alignment Plan (the “SAP”), under which equity-based compensation, including stock options, stock appreciation rights, restricted and unrestricted stock, restricted stock units (“RSUs”), performance stock units (“PSUs”) and other types of FOX equity awards may be granted. The Company’s officers, directors and employees are eligible to participate in the SAP. Performance Stock Units PSUs are fair valued on the date of grant and expensed over the service period using a straight-line method as the awards cliff vest at the end of the three-year performance period. The Company also estimates the number of shares expected to vest which is based on management’s determination of the probable outcome of the performance conditions, which requires considerable judgment. The Company records a cumulative adjustment in periods that the Company’s estimate of the number of shares expected to vest changes. Additionally, the Company ultimately adjusts the expense recognized to reflect the actual vested shares following the resolution of the performance conditions. The number of shares that will be issued upon vesting of PSUs can range from 0% to 200% of the target award, based on (i) the Company’s average annual adjusted earnings per share growth, (ii) the Company’s average annual adjusted free cash flow growth and (iii) the Company’s three-year total shareholder return (“TSR”) as measured against the three-year TSR of the companies that comprise the Standard and Poor’s 500 Index. The fair value of the TSR condition is determined using a Monte Carlo simulation model. During the nine months ended March 31, 2020, approximately 1.4 million PSUs were granted, which have a three-year performance measurement period beginning in July 2019. The awards are subject to the achievement of three pre-established objective performance measures determined by the Compensation Committee of the Board (the “Compensation Committee”). The awards issued will be settled in shares of Class A Common Stock upon vesting and are subject to the participants’ continued employment with the Company. Any person who holds PSUs shall have no ownership interest in the shares of Class A Common Stock to which such PSUs relate until and unless shares of Class A Common Stock are delivered to the holder. All shares of Class A Common Stock awards that are cancelled or forfeited become available for future grants. Certain of these awards have a graded vesting provision and the expense recognition is accelerated. Restricted Stock Units During the nine months ended March 31, 2020, approximately 1.1 million RSUs were granted, which vest in equal annual installments over a three-year period subject to the participants’ continued employment with the Company. In March 2019, in connection with the Distribution, the Compensation Committee granted approximately 2.4 million RSUs under the SAP, which will primarily vest in 2 tranches. Approximately 50% of the RSUs will vest on June 15, 2020 and the remaining RSUs will vest on June 15, 2021, in each case, subject to a service requirement through the vesting dates. During the nine months ended March 31, 2020, approximately 3.8 million stock options were granted, which generally have a term of seven years and vest in equal annual installments over a three-year period subject to the participants’ continued employment with the Company. In March 2019, in connection with the Distribution, the Compensation Committee granted approximately 3.1 million stock options under the SAP. The stock options will vest 50% on June 15, 2020 and 50% on June 15, 2021, in each case, subject to a service requirement through the vesting dates. As of March 31, 2020, the Company had approximately 7 million stock options outstanding. For the three and nine months ended March 31, 2020, the computation of diluted earnings per share did not include most of the stock options outstanding during these periods, because their inclusion would have been antidilutive. The following table summarizes the Company’s equity-based compensation: Equity-based compensation(a) Intrinsic value of all settled equity-based awards Prior to the Distribution, equity-based compensation included allocated expense for both executive directors and corporate executives of 21CF, allocated using a proportional allocation driver, which management deemed to be reasonable. The Company’s stock based awards are settled in Class A Common Stock. As of March 31, 2020, the Company’s total estimated compensation cost, not yet recognized, related to non-vested equity awards held by the Company’s employees was approximately $165 million and is expected to be recognized over a weighted average period between one and two years. NOTE 10. RELATED PARTY TRANSACTIONS AND TWENTY-FIRST CENTURY FOX, INC. INVESTMENT In the ordinary course of business, the Company enters into transactions with related parties, which prior to the Distribution included subsidiaries and equity affiliates of 21CF. The following table sets forth the net revenue from related parties included in the Statements of Operations for the three and nine months ended March 31, 2019: Related party revenue Related party expense Related party revenue, net of expense For the three and nine months ended March 31, 2020, the related party revenue and expense were not material. Corporate Allocations and Twenty-First Century Fox, Inc. Investment Prior to the Distribution, 21CF provided services to and funded certain expenses for the Company such as: global real estate and occupancy costs and employee benefits (“Direct Corporate Expenses”). In addition, the Company’s Financial Statements include, for the periods prior to March 19, 2019, general corporate expenses of 21CF which were not historically allocated to the Company for certain support functions that were provided on a centralized basis within 21CF prior to the Distribution and not recorded at the business unit level, such as certain expenses related to finance, legal, insurance, information technology, compliance and human resources management activities, among others (“General Corporate Expenses”). For purposes of the Financial Statements for the three and nine months ended March 31, 2019, the General Corporate Expenses were allocated to the Company. The General Corporate Expenses were included in the Statements of Operations in Selling, general and administrative expenses and Other, net, as appropriate. These expenses were allocated to the Company on the basis of direct usage when identifiable, with the remainder allocated on a pro rata basis of combined revenues, headcount or other relevant measures of the Company. Management believes the assumptions underlying the Financial Statements, including the assumptions regarding allocating General Corporate Expenses from 21CF are reasonable. Nevertheless, the Financial Statements may not include all of the actual expenses that would have been incurred by FOX and may not reflect the Company’s consolidated results of operations and cash flows had it been a standalone company prior to the Distribution. Actual costs that would have been incurred if the Company had been a standalone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure. For the purposes of the Statements of Operations, the Company recorded approximately $100 million and $270 million of General Corporate Expenses within Selling, general and administrative expenses for the three and nine months ended March 31, 2019, respectively, and the remaining balance of the Corporate allocations presented in the table below within Other, net for the three and nine months ended March 31, 2019. Intercompany transactions with 21CF or its affiliates and the Company are reflected in the historical Financial Statements for the period prior to the Distribution. All significant intercompany balances between 21CF and the Company for the period prior to the Distribution have been reflected in the Statement of Cash Flows as a financing activity. The following table summarizes the components of the net decrease in the Twenty-First Century Fox, Inc. investment for the three and nine months ended March 31, 2019: Cash pooling, general financing activities and other(a) Corporate allocations Taxes payable(b) Deferred taxes on step-up(c) Other deferred taxes(c) The nature of activities included in the line item ‘Cash pooling, general financing activities and other’ includes financing activities, capital transfers, cash sweeps, other treasury services and Direct Corporate Expenses. For purposes of the Company’s financial statements for the periods prior to the Distribution, the income tax expense in the Statements of Operations has been calculated as if FOX filed a separate tax return and was operating as a standalone business. This amount represents the difference between the separate tax return methodology and the actual tax liabilities attributed to the Company, in accordance with applicable tax law, as of the date of the Distribution. As a result of the Separation and the Distribution, FOX obtained an additional tax basis in its assets equal to their respective fair market values. These amounts represent the additional estimated deferred tax asset recorded as a result of the increased tax basis (See Note 1—Description of Business and Basis of Presentation in the 2019 Form 10-K under the heading “Basis of Presentation”) and other deferred tax adjustments recorded as of the date of the Distribution. NOTE 11. COMMITMENTS AND CONTINGENCIES The Company has commitments under certain firm contractual arrangements (“firm commitments”) to make future payments. These firm commitments secure the future rights to various assets and services to be used in the normal course of operations. The total firm commitments and future debt payments as of March 31, 2020 and June 30, 2019 were approximately $37 billion and $41 billion, respectively. The decrease from June 30, 2019 was primarily due to sports programming rights payments. Profits Participants Litigation In November 2015, Wark Entertainment, Inc., Temperance Brennan, L.P., Snooker Doodle Productions, Inc., and Bertha Blue, Inc. filed lawsuits against 21CF, Fox Entertainment Group, Twentieth Century Fox Film Corporation, Twentieth Century Fox Television (“TCFTV”), and Fox Broadcasting Corporation in the Superior Court of Los Angeles. The plaintiffs were profits participants in the Bones television series and alleged that TCFTV, which produced the show, breached its contracts with the plaintiffs and committed fraud concerning certain of those contracts, and that 21CF, Fox Entertainment Group, and Fox Broadcasting Corporation induced TCFTV’s breach of contract and intentionally interfered with the plaintiffs’ contracts with TCFTV. During the quarter ended September 30, 2019, the parties amicably resolved the lawsuits, and the Company contributed $34 million pursuant to a settlement agreement with the plaintiffs and Disney as successor to 21CF, Fox Entertainment Group, Twentieth Century Fox Film Corporation, and TCFTV. During the quarter ended March 31, 2020, Disney reached an amicable settlement with an additional profits participant who came forward. The Company’s portion of this settlement is approximately $20 million. Profits participation litigation is subject to uncertainty and it is possible that there could be adverse developments in pending or future cases that could involve a FOX subsidiary. As of March 31, 2020, the Company does not believe that it has incurred a probable material loss for any other activities. The Company and certain of its current and former employees have been subject to allegations of sexual harassment and discrimination and racial discrimination relating to alleged misconduct at the Company’s FOX News business. The Company has resolved many of these claims and is contesting other claims in litigation. The Company has also received regulatory and investigative inquiries relating to these matters. To date, none of the amounts paid in settlements or reserved for pending or future claims, is individually or in the aggregate, material to the Company. The amount of liability, if any, that may result from these or related matters cannot be estimated at this time. However, the Company does not currently anticipate that the ultimate resolution of any such pending matters will have a material adverse effect on its business, financial condition, results of operations or cash flows. U.K. Newspaper Matters Indemnity In connection with the separation of 21CF and News Corporation in June 2013, 21CF agreed to indemnify News Corporation, on an after-tax basis, for payments made after the separation arising out of civil claims and investigations relating to phone hacking, illegal data access and inappropriate payments to public officials that occurred at subsidiaries of News Corporation, as well as legal and professional fees and expenses paid in connection with the related criminal matters, other than fees, expenses and costs relating to employees who are not (i) directors, officers or certain designated employees or (ii) with respect to civil matters, co-defendants with News Corporation (the “U.K. Newspaper Matters Indemnity”). In accordance with the Separation Agreement, certain costs and liabilities related to the U.K. Newspaper Matters Indemnity were assumed by the Company. The liability recorded in the Balance Sheets related to the indemnity was approximately $65 million and $50 million as of March 31, 2020 and June 30, 2019, respectively. The Company establishes an accrued liability for legal claims and indemnification claims when the Company determines that a loss is both probable and the amount of the loss can be reasonably estimated. Once established, accruals are adjusted from time to time, as appropriate, in light of additional information. The amount of any loss ultimately incurred in relation to matters for which an accrual has been established may be higher or lower than the amounts accrued for such matters. Any fees, expenses, fines, penalties, judgments or settlements which might be incurred by the Company in connection with the various proceedings could affect the Company’s results of operations and financial condition. For the contingencies disclosed above for which there is at least a reasonable possibility that a loss may be incurred, other than the accrual provided, the Company was unable to estimate the amount of loss or range of loss. The Company’s operations are subject to tax in various domestic jurisdictions and as a matter of course, the Company is regularly audited by federal and state tax authorities. The Company believes it has appropriately accrued for the expected outcome of all pending tax matters and does not currently anticipate that the ultimate resolution of pending tax matters will have a material adverse effect on its consolidated financial condition, future results of operations or liquidity. Each member of the 21CF consolidated group, which includes 21CF, the Company (prior to the Distribution) and 21CF’s other subsidiaries, is jointly and severally liable for the U.S. federal income and, in certain jurisdictions, state tax liabilities of each other member of the consolidated group. Consequently, the Company could be liable in the event any such liability is incurred, and not discharged, by any other member of the 21CF consolidated group. The tax matters agreement requires 21CF and/or Disney to indemnify the Company for any such liability. Disputes or assessments could arise during future audits by the Internal Revenue Service in amounts that the Company cannot quantify. NOTE 12. PENSION AND OTHER POSTRETIREMENT BENEFITS The Company participates in and/or sponsors various pension, savings and postretirement benefit plans. Pension plans and postretirement benefit plans are closed to new participants with the exception of a small group covered by collective bargaining agreements. The net periodic benefit cost was $14 million and $13 million for the three months ended March 31, 2020 and 2019, respectively, and $41 million and $40 million for the nine months ended March 31, 2020 and 2019, respectively. NOTE 13. SEGMENT INFORMATION The Company is a news, sports and entertainment company, which manages and reports its businesses in the following segments: Cable Network Programming, which principally consists of the production and licensing of news and sports content distributed primarily through traditional cable television systems, direct broadcast satellite operators and telecommunication companies (“traditional MVPDs”), and online multi-channel video programming distributors (“digital MVPDs”), primarily in the U.S. Television, which principally consists of the acquisition, marketing and distribution of broadcast network programming nationally under the FOX brand and the operation of 29 full power broadcast television stations, including 11 duopolies, in the U.S. Of these stations, 18 are affiliated with the FOX Network, 10 are affiliated with MyNetworkTV and 1 is an independent station. Other, Corporate and Eliminations, which principally consists of corporate overhead costs, intracompany eliminations, the FOX Studios lot and Credible. The FOX Studios lot, located in Los Angeles, California, provides television and film production services along with office space, studio operation services and includes all operations of the facility. Credible is a U.S. consumer finance marketplace. The Company’s operating segments have been determined in accordance with the Company’s internal management structure, which is organized based on operating activities. The Company evaluates performance based upon several factors, of which the primary financial measure is segment operating income before depreciation and amortization, or Segment EBITDA. Due to the integrated nature of these operating segments, estimates and judgments are made in allocating certain assets, revenues and expenses. Beginning with the announcement of the Company’s financial results for the third quarter of fiscal 2019, the Company has renamed as “Segment EBITDA” the measure that it previously referred to as “Segment OIBDA.” The definition of this measure has not changed: Segment EBITDA is defined as Revenues less Operating expenses and Selling, general and administrative expenses. Segment EBITDA does not include: Amortization of cable distribution investments, Depreciation and amortization, Impairment and restructuring charges, Interest expense, Interest income, Other, net and Income tax expense. Management believes that Segment EBITDA is an appropriate measure for evaluating the operating performance of the Company’s business segments because it is the primary measure used by the Company’s chief operating decision maker to evaluate the performance of and allocate resources to the Company’s businesses. The following tables set forth the Company’s Revenues and Segment EBITDA for the three and nine months ended March 31, 2020 and 2019: Cable Network Programming Other, Corporate and Eliminations Segment EBITDA Revenues by Segment by Component Affiliate fee Total Cable Network Programming revenues Total Television revenues Future Performance Obligations As of March 31, 2020, approximately $5.3 billion of revenues are expected to be recognized primarily over the next one to three years. The Company’s most significant remaining performance obligations relate to affiliate contracts and content licensing contracts with fixed fees. The amount disclosed does not include (i) revenues related to performance obligations that are part of a contract whose original expected duration is one year or less, (ii) revenues that are in the form of sales- or usage-based royalties and (iii) revenues related to performance obligations for which the Company elects to recognize revenue in the amount it has a right to invoice. Total depreciation and amortization Goodwill and intangible assets, net Total goodwill and intangible assets, net NOTE 14. ADDITIONAL FINANCIAL INFORMATION The following table sets forth the components of Other, net included in the Statements of Operations: Net (losses) gains on investments in equity securities(a) Transaction costs(b) U.K. Newspaper Matters Indemnity(c) Total other, net Net (losses) gains on investments in equity securities for the three and nine months ended March 31, 2020 included the losses related to changes in fair value of the Company’s investment in Roku which was sold in March 2020 (See Note 2—Acquisitions, Disposals and Other Transactions under the heading “Roku”). The transaction costs for the three and nine months ended March 31, 2020 and 2019 are primarily related to the Separation and the Distribution and include retention related costs and for the three and nine months ended March 31, 2020 also include costs associated with the profits participants litigation (See Note 11—Commitments and Contingencies under the heading “Profits Participants Litigation”). The transaction costs for the nine months ended March 31, 2020 were offset by an adjustment to the receivables from Disney pursuant to the Separation and Distribution Agreement. See Note 11—Commitments and Contingencies under the heading “U.K. Newspaper Matters Indemnity.” The following table sets forth the components of Other non-current assets included in the Balance Sheets: Operating lease ROU assets Investments(a) Other(b) Total other non-current assets Includes investments accounted for at fair value on a recurring basis of $256 million and $761 million as of March 31, 2020 and June 30, 2019, respectively (See Note 4—Fair Value). Includes $223 million and $249 million of assets in the Grantor Trust (as defined in Note 14—Pension and Other Postretirement Benefits in the 2019 Form 10-K) as of March 31, 2020 and June 30, 2019, respectively. The following table sets forth the components of Accounts payable, accrued expenses and other current liabilities included in the Balance Sheets: Accrued expenses Program rights payable Deferred revenue Operating lease liabilities Total accounts payable, accrued expenses and other current liabilities The following table sets forth the components of Other liabilities included in the Balance Sheets: Accrued non-current pension/postretirement liabilities Non-current operating lease liabilities Other non-current liabilities Total other liabilities Cash paid for interest Cash paid for income taxes Supplemental information on acquisitions Fair value of assets acquired, excluding cash Cash acquired Liabilities assumed Cash paid Fair value of equity instruments consideration Readers should carefully review this document and the other documents filed by Fox Corporation with the Securities and Exchange Commission (the “SEC”). This section should be read together with the unaudited interim consolidated financial statements and related notes appearing elsewhere in this Quarterly Report on Form 10-Q and the Annual Report on Form 10-K for the fiscal year ended June 30, 2019 as filed with the SEC on August 9, 2019 (the “2019 Form 10-K”). On March 19, 2019, Fox Corporation (“FOX” or the “Company”) became a standalone publicly traded company through the pro rata distribution by Twenty-First Century Fox, Inc. (now known as TFCF Corporation) (“21CF”) of all of the issued and outstanding common stock of FOX to 21CF stockholders (other than holders that were subsidiaries of 21CF) (the “Distribution”) in accordance with the Amended and Restated Distribution Agreement and Plan of Merger, dated as of June 20, 2018, by and between 21CF and 21CF Distribution Merger Sub, Inc. Following the Distribution, 354 million and 266 million shares of the Company’s Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Class B Common Stock, par value $0.01 per share (the “Class B Common Stock” and, together with the Class A Common Stock, the “Common Stock”), respectively, began trading independently on The Nasdaq Global Select Market. In connection with the Distribution, the Company entered into the Separation and Distribution Agreement, dated as of March 19, 2019 (the “Separation Agreement”), with 21CF, which effected the internal restructuring (the “Separation”) whereby 21CF transferred to FOX a portfolio of 21CF’s news, sports and broadcast businesses, including FOX News Media (consisting of FOX News and FOX Business), FOX Entertainment, FOX Sports, FOX Television Stations, and sports cable networks FS1, FS2, FOX Deportes and Big Ten Network, and certain other assets, and FOX assumed from 21CF the liabilities associated with such businesses and certain other liabilities. The Separation and the Distribution were effected as part of a series of transactions contemplated by the Amended and Restated Merger Agreement and Plan of Merger, dated as of June 20, 2018, by and among 21CF, The Walt Disney Company (“Disney”) and certain subsidiaries of Disney, pursuant to which, among other things, 21CF became a wholly-owned subsidiary of Disney. In connection with the Separation, the Company entered into several agreements that govern certain aspects of the Company’s relationship with 21CF and Disney following the Separation. These include the Separation Agreement, a tax matters agreement, a transition services agreement, as well as agreements relating to intellectual property licenses, employee matters, commercial arrangements and a studio lot lease (See Note 1—Description of Business and Basis of Presentation in the 2019 Form 10-K for additional information). Management’s discussion and analysis of financial condition and results of operations is intended to help provide an understanding of the Company’s financial condition, changes in financial condition and results of operations. This discussion is organized as follows: Overview of the Company’s Business—This section provides a general description of the Company’s businesses, as well as developments that occurred during the three and nine months ended March 31, 2020 and 2019 that the Company believes are important in understanding its results of operations and financial condition or to disclose known trends. Results of Operations—This section provides an analysis of the Company’s results of operations for the three and nine months ended March 31, 2020 and 2019. This analysis is presented on both a consolidated and a segment basis. In addition, a brief description is provided of significant transactions and events that impact the comparability of the results being analyzed. Liquidity and Capital Resources—This section provides an analysis of the Company’s cash flows for the nine months ended March 31, 2020 and 2019, as well as a discussion of the Company’s outstanding debt and commitments that existed as of March 31, 2020. Included in the discussion of outstanding debt is a discussion of the amount of financial capacity available to fund the Company’s future commitments and obligations, as well as a discussion of other financing arrangements. Caution Concerning Forward-Looking Statements—This section provides a description of the use of forward-looking information appearing in this Quarterly Report on Form 10-Q, including in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Such information is based on management’s current expectations about future events which are subject to change and to inherent risks and uncertainties. Refer to Part I., Item 1A, “Risk Factors” in the 2019 Form 10-K and Part II. and to Item 1A. “Risk Factors” in the Quarterly Report on Form 10-Q for the quarter ended September 30, 2019, as filed with the SEC on November 6, 2019 (the “Q1 2020 Form 10-Q”) and this Quarterly Report on Form 10-Q for a discussion of the risk factors applicable to the Company. OVERVIEW OF THE COMPANY’S BUSINESS Television, which principally consists of the acquisition, marketing and distribution of broadcast network programming nationally under the FOX brand and the operation of 29 full power broadcast television stations, including 11 duopolies, in the U.S. Of these stations, 18 are affiliated with the FOX Network, 10 are affiliated with MyNetworkTV and one is an independent station. Other, Corporate and Eliminations, which principally consists of corporate overhead costs, intracompany eliminations, the FOX Studios lot and Credible Labs Inc. (“Credible”). The FOX Studios lot, located in Los Angeles, California, provides television and film production services along with office space, studio operation services and includes all operations of the facility. Credible is a U.S. consumer finance marketplace. Other Business Developments The impact of coronavirus disease 2019 (“COVID-19”) and measures to prevent its spread are affecting the macroeconomic environment, as well as the business of the Company, in a number of ways. For example, while the Company’s national news ratings remain strong, sporting events for which the Company has broadcast rights have been cancelled or postponed, the production of certain entertainment content the Company acquires has been suspended and demand in local advertising markets has declined. The magnitude of the impacts will depend on the duration and extent of COVID-19 and the effect of governmental actions, consumer behavior and actions taken by the Company’s business partners in response to the pandemic and such governmental actions. The evolving and uncertain nature of this situation makes it challenging for the Company to estimate the future performance of its businesses, particularly over the near to medium term, including the supply and demand for its services, its cash flows and its current and future advertising revenue. However, the impact of COVID-19 could have a material adverse effect on the Company’s business, financial condition or results of operations over the near to medium term. If current trends in advertising demand continue for the entire fourth quarter of fiscal 2020 at FOX Television Stations, FOX News Media and FOX Entertainment, the Company would expect advertising revenue to decrease approximately $200 million to $240 million or 25% to 30%, as compared to the corresponding period of fiscal 2019, which includes a reduction in advertising revenue of approximately 50% at FOX Television Stations. These estimated impacts to fourth quarter advertising revenue exclude the impact of advertising revenue related to sporting events due to the uncertainty around the scheduling of such events. Partially offsetting these decreases in revenues may be the benefit of lower programming and production expenses due to originally scheduled content not airing on our networks. A significant decline in estimated advertising revenue or the expected popularity of the Company’s programming could lead to a downward revision in the fair value of, among other things, the Company’s reporting units, indefinite-lived intangible assets and long-lived assets and result in an impairment and a non-cash charge that is material to the Company’s reported net earnings. An impairment did not exist as of March 31, 2020. The Company will perform its annual impairment review during the fourth quarter of fiscal 2020. In addition, the recoverability of national sports contracts is based on the Company’s best estimates at March 31, 2020 of attributable revenues and costs; such estimates may change in the future and such changes may be significant. Should revenues decline materially from estimates applied at March 31, 2020, amortization of rights may be accelerated. In April 2020, the Company acquired Tubi, Inc. (“Tubi”), a leading free ad-supported streaming service, for approximately $445 million in net cash consideration at closing (the “Tubi Acquisition”). Potential additional consideration in the form of deferred consideration and unvested options totaling approximately $45 million may be due over a three-year period following the closing of the transaction. The Company financed the Tubi Acquisition principally with the net proceeds from the sale of its investment in Roku, Inc. (“Roku”), which was sold for approximately $340 million in March 2020 (See Note 2—Acquisitions, Disposals and Other Transactions to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Roku” for further discussion). In March 2020, the Company acquired three television stations (FOX-affiliate KCPQ and MyNetworkTV-affiliate KZJO located in Seattle, Washington and FOX-affiliate WITI located in Milwaukee, Wisconsin) for approximately $350 million in cash from Nexstar Media Group, Inc. (“Nexstar”). As part of this transaction, the Company sold Nexstar two television stations (FOX-affiliate WJZY and MyNetworkTV-affiliate WMYT located in Charlotte, North Carolina) for approximately $45 million in cash (See Note 2—Acquisitions, Disposals and Other Transactions to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Television Stations Acquisition and Divestiture” for further discussion). On November 6, 2019, the Company announced that its Board of Directors had authorized a stock repurchase program providing for the repurchase of $2 billion of the Company’s Common Stock. The program has no time limit and may be modified, suspended or discontinued at any time. The Company also announced that it had entered into an accelerated share repurchase agreement to repurchase $350 million of Class A Common Stock and announced its intention to promptly repurchase $150 million of Class B Common Stock. At the same time, the Company announced that it had entered into a stockholders agreement with the Murdoch Family Trust (See Note 8—Stockholders’ Equity to the accompanying Unaudited Consolidated Financial Statements of FOX under the headings “Stock Repurchase Program” and “Stockholders Agreement” for further discussion). In October 2019, the Company acquired 67% of the equity in Credible for approximately A$390 million (approximately $260 million) in cash (the “Credible Acquisition”), net of cash acquired. In addition, the Company has agreed to contribute up to $75 million of capital to Credible over approximately two years following the closing of the Credible Acquisition (See Note 2—Acquisitions, Disposals and Other Transactions to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Credible Acquisition” for further discussion). In October 2019, Flutter Entertainment plc (“Flutter”) and The Stars Group Inc. announced that they had reached agreement on the terms of a recommended all-share combination to create a global leader in sports betting and gaming (the “Combination”) and, in early May 2020, the Combination was completed. As part of the agreement, FOX Sports received the right to acquire an approximately 18.5% equity interest in FanDuel Group, a majority-owned subsidiary of Flutter, at its market value in 2021 (structured as a 10-year option from 2021, subject to a carrying value adjustment). The United States Court of Appeals for the Third Circuit issued its decision in Prometheus Radio Project v. FCC in the Fall of 2019, which reinstated the Federal Communications Commission’s (“FCC”) newspaper/broadcast cross-ownership rule prohibiting common ownership of broadcast stations and daily newspapers in the same designated market area (“DMA”). The FCC implemented the reinstatement on December 20, 2019. The Company owns two television stations in the New York DMA and an attributable interest in The New York Post due to the Murdoch Family Trust’s ownership interests in both the Company and News Corporation. The FCC filed a petition for review with the U.S. Supreme Court in April 2020, and the Company also filed a petition for review with other intervenors. For more information, see “Part I. Item 1. Business - Government Regulation” in the 2019 Form 10-K. RESULTS OF OPERATIONS Results of Operations—For the three and nine months ended March 31, 2020 versus the three and nine months ended March 31, 2019 The following table sets forth the Company’s operating results for the three and nine months ended March 31, 2020, as compared to the three and nine months ended March 31, 2019: (in millions, except %) not meaningful Overview—The Company’s revenues increased 25% and 11% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019. The increase in affiliate fee revenue was primarily due to higher average rates per subscriber and higher fees received from television stations that are affiliated with the FOX Network, partially offset by the impact of a lower average number of subscribers. The increase in advertising revenue was primarily due to the broadcast of the National Football League’s (“NFL”) Super Bowl LIV and higher digital advertising revenue, partially offset by the broadcast of one less NFL Divisional playoff game, a decline in the local advertising market in March 2020 and fewer broadcasts of sporting events as a result of COVID-19 and, for the nine months ended March 31, 2020, lower political advertising revenue at the FOX Television Stations due to the U.S. midterm elections in November 2018. The increase in other revenues was primarily due to revenues generated from the operation of the FOX Studios lot for third parties and the impact of the consolidation of Bento Box Entertainment, LLC (“Bento Box”) and Credible in fiscal 2020. Operating expenses increased 24% and 11% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019, primarily due to higher sports programming rights amortization and production costs, including Super Bowl LIV costs and contractual rate increases, the impact of the consolidation of Bento Box and Credible and higher broadcast costs related to operating as a standalone public company. Partially offsetting the increase in operating expenses was one less NFL Divisional playoff game and the broadcast of fewer sporting events as a result of COVID-19, including the postponement of National Association of Stock Car Auto Racing (“NASCAR”) races. Selling, general and administrative expenses increased 38% and 29% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019, primarily due to higher costs in fiscal 2020 related to operating as a standalone public company as compared to allocated costs in fiscal 2019 (See Note 1—Description of Business and Basis of Presentation to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Basis of Presentation” for additional information). In addition, the three and nine months ended March 31, 2020 include equity-based compensation costs of approximately $10 million and $40 million, respectively, related to the grant of restricted stock units and stock options, in connection with the Distribution, under the Fox Corporation 2019 Shareholder Alignment Plan (See Note 11—Equity-Based Compensation in the 2019 Form 10-K for additional information). Interest expense—Interest expense increased $8 million and $157 million for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019, primarily due to the issuance of $6.8 billion of senior notes in January 2019 (See Note 9—Borrowings in the 2019 Form 10-K under the heading “Senior Notes Issued Under the January 2019 Indenture” for additional information). Other, net—See Note 14—Additional Financial Information to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Other, net.” Income tax expense—The Company’s tax provision and related effective tax rate of 38% and 27% for the three and nine months ended March 31, 2020, respectively, were higher than the statutory rate of 21% primarily due to state taxes, a valuation allowance recorded against net capital losses and other permanent items. The Company’s tax provision and related effective tax rate of 24% and 25% for the three and nine months ended March 31, 2019, respectively, were higher than the statutory rate of 21% primarily due to state taxes and other permanent items. Net income—Net income decreased $449 million and $261 million for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019, primarily due to losses related to changes in fair value of the Company’s investment in Roku, which was sold in March 2020, as compared to unrealized gains in fiscal 2019 (See Note 14—Additional Financial Information to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Other, net”) and higher costs in fiscal 2020 related to operating as a standalone public company. Partially offsetting the decrease in net income was higher Segment EBITDA at the Cable Network Programming and Television segments, which were impacted by costs related to operating as a standalone public company, and lower income tax expense. Segment Analysis The following tables set forth the Company’s Revenues and Segment EBITDA for the three and nine months ended March 31, 2020, as compared to the three and nine months ended March 31, 2019: Adjusted EBITDA(a) For a discussion of Adjusted EBITDA and a reconciliation of Net income to Adjusted EBITDA, see “Non-GAAP Financial Measures” below. Cable Network Programming (43% and 46% of the Company’s revenues for the first nine months of fiscal 2020 and 2019, respectively) Revenues at the Cable Network Programming segment increased 6% and 3% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019. The increase in affiliate fee revenue was primarily attributable to higher average rates per subscriber, led by contractual rate increases on existing affiliate agreements and from affiliate agreement renewals, partially offset by the impact of a lower average number of subscribers. The decrease in the average number of subscribers was due to a reduction in subscribers to traditional MVPDs, partially offset by an increase in digital MVPD subscribers. The increase in advertising revenue was primarily due to higher ratings and digital advertising revenue at FOX News Media, partially offset by the effect of higher preemptions associated with breaking news coverage and the broadcast of fewer sporting events and studio shows as a result of COVID-19. The increase in other revenues was primarily attributable to higher sports sublicensing revenue and, for the nine months ended March 31, 2020, higher revenues generated from Premier Boxing Champions (“PBC”) pay-per-view events. Cable Network Programming Segment EBITDA increased 7% for the three and nine months ended March 31, 2020, as compared to the corresponding periods of fiscal 2019, primarily due to the revenue increases noted above, partially offset by, for the three months ended March 31, 2020, higher expenses. Operating expenses increased for the three months ended March 31, 2020 primarily due to higher production costs relating to on-location studio shows in Miami leading up to Super Bowl LIV and, at FOX News Media, increased costs incurred in connection with FOX Nation and increased political coverage, partially offset by lower sports programming rights amortization, driven by the postponement of NASCAR races as a result of COVID-19. Operating expenses decreased for the nine months ended March 31, 2020 primarily due to lower sports programming rights amortization, driven by the absence of Ultimate Fighting Championship (“UFC”) content, partially offset by higher costs at FOX News Media, including talent costs. Television (56% and 54% of the Company’s revenues for the first nine months of fiscal 2020 and 2019, respectively) Revenues at the Television segment increased 41% and 16% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019. The increase in advertising revenue was primarily due to revenues resulting from the broadcast of Super Bowl LIV in February 2020 of approximately $500 million, including the post-game broadcast of The Masked Singer, higher pricing at the FOX Network and, for the three months ended March 31, 2020, higher political advertising revenue at the FOX Television Stations. Partially offsetting the increase in advertising revenue was lower ratings at the FOX Network, one less NFL Divisional playoff game, a decline in the local advertising market in March 2020 and fewer broadcasts of sporting events as a result of COVID-19 and, for the nine months ended March 31, 2020, lower political advertising revenue at the FOX Television Stations due to the U.S. midterm elections in November 2018. The increase in affiliate fee revenue was primarily due to higher fees received from television stations that are affiliated with the FOX Network and higher average rates per subscriber at the Company’s owned and operated television stations, partially offset by a lower average number of subscribers at the Company’s owned and operated television stations. The increase in other revenues was primarily due to the impact of the consolidation of Bento Box, partially offset by lower digital content licensing revenue at the FOX Network. Television Segment EBITDA more than doubled and increased 2% for the three and nine months ended March 31, 2020, respectively, as compared to the corresponding periods of fiscal 2019, primarily due to the revenue increases noted above, partially offset by higher expenses. Operating expenses increased primarily due to the broadcast of Super Bowl LIV, the impact of the consolidation of Bento Box and higher costs related to investments in original scripted programming and co-production arrangements with third party studios, partially offset by the absence of one NFL Divisional playoff game and the absence of a write-down of approximately $55 million related to entertainment and syndicated programming rights in the third quarter of fiscal 2019. Also contributing to the increase in operating expenses for the nine months ended March 31, 2020 was contractual sports rights rate increases. Selling, general and administrative expenses increased primarily due to higher costs related to operating as a standalone public company. Other, Corporate and Eliminations (1% of the Company’s revenues for the first nine months of fiscal 2020) Revenues at the Other, Corporate and Eliminations segment for the three and nine months ended March 31, 2020 included revenues generated from the operation of the FOX Studios lot for third parties and the consolidation of Credible. Operating expenses for the three and nine months ended March 31, 2020 included the consolidation of Credible and the costs of operating the FOX Studios lot for third parties. Selling, general and administrative expenses increased due to higher costs related to operating as a standalone public company, the costs of operating the FOX Studios lot for third parties and the consolidation of Credible. Beginning with the announcement of the Company’s financial results for the first quarter of fiscal 2020, the Company has renamed as “Adjusted EBITDA” the measure that it had previously referred to as “Total Segment EBITDA” and, prior to the announcement of the Company’s financial results for the third quarter of fiscal 2019, as “Total Segment OIBDA.” The definition of this measure has not changed: Adjusted EBITDA is defined as Revenues less Operating expenses and Selling, general and administrative expenses. Adjusted EBITDA does not include: Amortization of cable distribution investments, Depreciation and amortization, Impairment and restructuring charges, Interest expense, Interest income, Other, net and Income tax expense. Management believes that information about Adjusted EBITDA assists all users of the Company’s Unaudited Consolidated Financial Statements by allowing them to evaluate changes in the operating results of the Company’s portfolio of businesses separate from non-operational factors that affect Net income, thus providing insight into both operations and the other factors that affect reported results. Adjusted EBITDA provides management, investors and equity analysts a measure to analyze the operating performance of the Company’s business and its enterprise value against historical data and competitors’ data, although historical results, including Adjusted EBITDA, may not be indicative of future results (as operating performance is highly contingent on many factors, including customer tastes and preferences). Adjusted EBITDA is considered a non-GAAP financial measure and should be considered in addition to, not as a substitute for, net income, cash flow and other measures of financial performance reported in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition, this measure does not reflect cash available to fund requirements and excludes items, such as depreciation and amortization and impairment charges, which are significant components in assessing the Company’s financial performance. Adjusted EBITDA may not be comparable to similarly titled measures reported by other companies. The following table reconciles Net income to Adjusted EBITDA for the three and nine months ended March 31, 2020, as compared to the three and nine months ended March 31, 2019: Adjusted EBITDA The following table sets forth the computation of Adjusted EBITDA for the three and nine months ended March 31, 2020, as compared to the three and nine months ended March 31, 2019: Current Financial Condition The Company’s principal source of liquidity is internally generated funds which are highly dependent upon the continuation of affiliate agreements and the state of the advertising markets, the latter of which is being negatively impacted by COVID-19 in the near term. The magnitude of the impact will depend on the duration and extent of COVID-19 and the effect of governmental actions, consumer behavior and actions taken by the Company’s business partners in response to the pandemic and such governmental actions. As part of actions the Company is taking to address COVID-19 and the resulting impact on its business, operations and employees, in April 2020, the Company implemented short-term cost reductions, including reducing executive compensation and suspending compensation increases. The Company has approximately $3.2 billion of cash and cash equivalents as of March 31, 2020 and an unused five-year $1.0 billion unsecured revolving credit facility. In addition, the Company issued $1.2 billion of senior notes in April 2020 and has access to the worldwide capital markets, subject to market conditions which could be impacted by COVID-19. See Note 6—Borrowings to the accompanying Unaudited Consolidated Financial Statements of FOX. As of March 31, 2020, the Company was in compliance with all of the covenants under the revolving credit facility, and it does not anticipate any noncompliance with such covenants. The principal uses of cash that affect the Company’s liquidity position include the following: the acquisition of rights and related payments for entertainment and sports programming; operational expenditures including production costs; marketing and promotional expenses; expenses related to broadcasting the Company’s programming along with investing approximately $150 million to $200 million in establishing standalone technical facilities over the two years following the Distribution; employee and facility costs; capital expenditures; acquisitions; interest and dividend payments; debt repayments; and stock repurchases. In addition to the acquisitions, sales and possible acquisitions disclosed elsewhere, the Company has evaluated, and expects to continue to evaluate, possible acquisitions and dispositions of certain businesses and assets. Such transactions may be material and may involve cash, the Company’s securities or the assumption of additional indebtedness. See Note 2—Acquisitions, Disposals and Other Transactions to the accompanying Unaudited Consolidated Financial Statements of FOX. Sources and Uses of Cash Net cash provided by operating activities for the nine months ended March 31, 2020 and 2019 was as follows (in millions): The decrease in net cash provided by operating activities during the nine months ended March 31, 2020, as compared to the corresponding period of fiscal 2019, was primarily due to higher cash paid for interest as a result of the senior notes issued in January 2019 and cash paid for income taxes, partially offset by higher Cable Network Programming Segment EBITDA. Net cash used in investing activities for the nine months ended March 31, 2020 and 2019 was as follows (in millions): The increase in net cash used in investing activities during the nine months ended March 31, 2020, as compared to the corresponding period of fiscal 2019, was primarily due to the acquisition of three television stations and the Credible Acquisition, partially offset by the cash proceeds from the sale of the Company’s investment in Roku during the nine months ended March 31, 2020 as compared to the investments in Caffeine, Inc. and Caffeine Studio, LLC (See Note 2—Acquisitions, Disposals and Other Transactions to the accompanying Unaudited Consolidated Financial Statements of FOX). Net cash used in financing activities for the nine months ended March 31, 2020 and 2019 was as follows (in millions): The decrease in net cash used in financing activities during the nine months ended March 31, 2020, as compared to the corresponding period of fiscal 2019, was primarily due to repurchases of shares of the Company’s Common Stock and dividends paid to the Company’s stockholders during the nine months ended March 31, 2020 as compared to the net transfers to Twenty-First Century Fox, Inc. of $1.2 billion, the dividend of $8.5 billion paid to 21CF net of the $2 billion cash payment received from Disney, partially offset by the proceeds from the issuance of $6.8 billion of senior notes in January 2019 during the nine months ended March 31, 2019. The nature of activities included in net transfers to Twenty-First Century Fox, Inc. includes financing activities, capital transfers, cash sweeps, other treasury services and corporate expenses. See Note 8—Stockholders’ Equity to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Stock Repurchase Program.” Debt Instruments Borrowings include senior notes (See Note 6—Borrowings to the accompanying Unaudited Consolidated Financial Statements of FOX). Ratings of the senior notes The following table summarizes the Company’s credit ratings as of March 31, 2020: Rating Agency Senior Debt Moody's Baa2 Standard & Poor's The Company has an unused five-year $1.0 billion unsecured revolving credit facility (See Note 6—Borrowings to the accompanying Unaudited Consolidated Financial Statements of FOX). See Note 11—Commitments and Contingencies to the accompanying Unaudited Consolidated Financial Statements of FOX. See Note 1—Description of Business and Basis of Presentation to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Recently Adopted and Recently Issued Accounting Guidance and the CARES Act.” This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical or current fact are “forward-looking statements” for purposes of federal and state securities laws, including any statements regarding (i) future earnings, revenues or other measures of the Company’s financial performance; (ii) the Company’s plans, strategies and objectives for future operations; (iii) proposed new programming or other offerings; (iv) future economic conditions or performance; (v) estimated annual recurring costs relating to FOX operating as a standalone, publicly traded company; and (vi) assumptions underlying any of the foregoing. Forward-looking statements may include, among others, the words “may,” “will,” “should,” “likely,” “anticipates,” “expects,” “intends,” “plans,” “projects,” “believes,” “estimates,” “outlook” or any other similar words. Although the Company’s management believes that the expectations reflected in any of the Company’s forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any forward-looking statements. The Company’s future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed or incorporated by reference in our filings with the SEC. Important factors that could cause the Company’s actual results, performance and achievements to differ materially from those estimates or projections contained in the Company’s forward-looking statements include, but are not limited to, government regulation, economic, strategic, political and social conditions and the following factors: the COVID-19 pandemic, governmental actions to contain it and the related economic downturn and market volatility; recent and future changes in technology, including alternative methods for the delivery and storage of digital content, and in consumer behavior, including changes in when, where and how they consume content; changes in the Company’s strategies and initiatives and the acceptance thereof by consumers, distributors of the Company’s content, affiliates, advertisers and other parties with which the Company does business; the highly competitive nature of the industry in which the Company’s businesses operate; declines in advertising expenditures due to various factors such as the economic prospects of advertisers or the economy in general, technological developments and changes in consumer behavior, and shifts in advertisers’ spending toward digital and mobile offerings and away from more traditional media; the loss of affiliation or carriage agreements or arrangements where the Company makes its content available for viewing through online video platforms; the popularity of the Company’s content, including special sports events, and the continued popularity of the sports franchises, leagues and teams for which the Company has acquired programming rights; the Company’s ability to renew programming rights, particularly sports programming rights, on sufficiently favorable terms; damage to the Company’s brands or reputation; the inability to realize the anticipated benefits of the Company’s strategic investments and acquisitions; a degradation, failure or misuse of the Company’s network and information systems and other technology relied on by the Company that causes a disruption of services or improper disclosure of personal data or other confidential information; content piracy and signal theft and the Company’s ability to protect its intellectual property rights; the loss of key personnel; the effect of labor disputes, including labor disputes involving professional sports leagues whose games or events the Company has the right to broadcast; changes in tax, federal communications or other laws, regulations, practices or the interpretations thereof; the impact of any investigations or fines from governmental authorities, including FCC rules and policies and FCC decisions regarding revocation, renewal or grant of station licenses, waivers and other matters; the failure or destruction of satellites or transmitter facilities the Company depends on to distribute its programming; lower than expected valuations associated with one of the Company’s reporting units, indefinite-lived intangible assets, investments or long-lived assets; changes in GAAP or other applicable accounting standards and policies; the Company’s very limited operating history as a standalone, publicly traded company and the risk that the Company is unable to make, on a timely or cost-effective basis, the changes necessary to operate effectively as a standalone, publicly traded company; increased costs in connection with the Company operating as a standalone, publicly traded company following the Distribution and the loss of synergies the Company enjoyed from operating as part of 21CF; the Company’s reliance on 21CF to provide the Company various services during a transition period under the transition services agreement including broadcast operations, sports production, information and technology, and other services, and the risks that 21CF does not properly provide the services under this agreement or that the Company is unable to provide or obtain such services following the transition period (or during the transition period, if 21CF does not properly provide them in a timely and cost effective manner); the Company’s ability to secure additional capital on acceptable terms; the impact of any payments the Company is required to make or liabilities it is required to assume under the Separation Agreement and the indemnification arrangements entered into in connection with the Separation and the Distribution; and the other risks and uncertainties detailed in Part I., Item 1A. “Risk Factors” in the 2019 Form 10-K and in Part II., Item 1A. “Risk Factors” in the Q1 2020 Form 10-Q and this Quarterly Report on Form 10-Q. Forward-looking statements in this Quarterly Report on Form 10-Q speak only as of the date hereof, and forward-looking statements in documents that are incorporated by reference hereto speak only as of the date of those documents. The Company does not undertake any obligation to update or release any revisions to any forward-looking statement made herein or to report any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or to conform such statements to actual results or changes in our expectations, except as required by law. There have been no material changes in the market risks reported in the 2019 Form 10-K except for the decrease in the Company’s exposure to stock price risk as a result of the sale of the Company’s investment in Roku. In April 2020, the Company issued $600 million of 3.05% senior notes due 2025 and $600 million of 3.50% senior notes due 2030. Disclosure Controls and Procedures The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this quarterly report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures were effective in recording, processing, summarizing and reporting on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act and were effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. Changes in Internal Control over Financial Reporting There were no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the Company’s third quarter of fiscal 2020 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. The following information supplements and amends the disclosure set forth in the section titled “Legal Proceedings” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019, as filed with the Securities and Exchange Commission on August 9, 2019 (the “2019 Form 10-K”), and the Company’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2019, as filed with the Securities and Exchange Commission on November 6, 2019 (the “Q1 2020 Form 10-Q”). Reference is made to the lawsuits filed in the Superior Court of Los Angeles in November 2015 by Wark Entertainment, Inc., Temperance Brennan, L.P., Snooker Doodle Productions, Inc., and Bertha Blue, Inc. described on page 78 of the Form 10-K and page 32 of the Q1 2020 Form 10-Q. During the quarter ended March 31, 2020, The Walt Disney Company reached an amicable settlement with an additional profits participant who came forward. The Company’s portion of this settlement is approximately $20 million. There have been no material changes to the risk factors described in the section titled “Risk Factors” in the 2019 Form 10-K and the Q1 2020 Form 10-Q, except as set forth below. The COVID-19 pandemic could materially adversely affect the Company’s business, financial condition or results of operations. The impact of coronavirus disease 2019 (“COVID-19”) and measures to contain it are negatively affecting the macroeconomic environment and the Company’s business in a number of ways. For example, sports events for which the Company has broadcast rights have been cancelled or postponed and the production of certain entertainment content the Company acquires has been suspended, and there may be additional cancellations and postponements or production suspensions in the future. The Company’s business depends on the volume and popularity of the content it distributes, particularly sports content. Depending on the duration and severity of these content disruptions, they could materially adversely affect the Company’s advertising revenues and, over a longer period of time, its affiliate revenues. A significant decline in estimated advertising revenues or the expected popularity of the Company’s programming could also lead to a downward revision in the value of, among other things, the Company’s reporting units, indefinite-lived intangible assets and long-lived assets and result in an impairment and a non-cash charge that is material to the Company’s reported net earnings. The COVID-19 pandemic has also significantly increased economic uncertainty and market volatility. It is likely that the pandemic will cause an economic slowdown of potentially extended duration, and it is possible that it could cause a global recession. Weak economic conditions and increased volatility and disruption in the financial markets pose risks to the Company and its business partners, including advertisers whose expenditures tend to reflect overall economic conditions. The COVID-19 pandemic has caused some of the Company’s advertisers (including, in particular, local market advertisers) to reduce their spending, and future declines in the economic prospects of advertisers or the economy in general could negatively impact their advertising expenditures further in the future. For more information about these risks, see the risk factors titled “The Company is exposed to risks associated with weak economic conditions and increased volatility and disruption in the financial markets.” and “A decline in advertising expenditures could cause the Company’s revenues and operating results to decline significantly in any given period or in specific markets.” in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2019. Depending on the duration and severity of the economic downturn, it could lead to changes in consumer behavior that adversely affect the Company’s advertising or affiliate revenues. Other risks posed by the COVID-19 pandemic include those related to measures aimed at preventing the spread of the virus, such as shelter in place orders, business shutdowns, quarantines and travel bans and restrictions. These measures have affected and may further affect the Company’s workforce and operations, as well as those of its business partners. In addition, risks relating to cybersecurity incidents involving the Company or its business partners may be increased as large numbers of employees are working remotely. The magnitude of the impact of the COVID-19 pandemic on the Company will depend on the duration and extent of the pandemic, the effect of governmental actions to contain it and the duration and severity of the resulting economic slowdown. The COVID-19 pandemic could have a material adverse effect on the Company’s business, financial condition or results of operations. Below is a summary of the Company’s repurchases of its Class A Common Stock, par value $0.01 per share (the “Class A Common Stock”), and Class B Common Stock, par value $0.01 per share (the “Class B Common Stock” and, together with the Class A Common Stock, the “Common Stock”), during the three months ended March 31, 2020: of shares purchased(a) paid per share(b) Approximate dollar value of shares that may yet be purchased under the program(b)(c) January 1, 2020 – January 31, 2020 Class A common stock(d) February 1, 2020 – February 29, 2020 March 1, 2020 – March 31, 2020 The Company has not made any purchases of Common Stock other than in connection with the publicly announced stock repurchase program described below. These amounts exclude any fees, commissions or other costs associated with the share repurchases. On November 6, 2019, the Company announced that its Board of Directors had authorized a stock repurchase program providing for the repurchase of $2 billion of the Company’s Common Stock. The program has no time limit and may be modified, suspended or discontinued at any time. In connection with the stock repurchase program, the Company entered into an accelerated share repurchase (“ASR”) agreement to repurchase $350 million of Class A Common Stock in November 2019. In accordance with the ASR agreement, in November 2019, the Company paid a third-party financial institution $350 million and received an initial delivery of approximately eight million shares of Class A Common Stock, representing 80% of the shares expected to be repurchased under the ASR agreement, at a price of $34.99 per share. Upon settlement of the ASR agreement in January 2020, the Company received a final delivery of shares of Class A Common Stock. The final number of shares purchased under the ASR agreement was determined using a price of $36.05 per share (the volume-weighted average market price of the Class A Common Stock during the term of the ASR agreement less a discount) (See Note 8—Stockholders’ Equity to the accompanying Unaudited Consolidated Financial Statements of FOX under the heading “Stock Repurchase Program” for more information). Exhibits. Chief Executive Officer Certification required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended.* Chief Financial Officer Certification required by Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as amended.* Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of Sarbanes Oxley Act of 2002.** The following financial information from the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2020 formatted in Inline XBRL (eXtensible Business Reporting Language): (i) Unaudited Consolidated Statements of Operations for the three and nine months ended March 31, 2020 and 2019; (ii) Unaudited Consolidated Statements of Comprehensive Income for the three and nine months ended March 31, 2020 and 2019; (iii) Consolidated Balance Sheets as of March 31, 2020 (unaudited) and June 30, 2019 (audited); (iv) Unaudited Consolidated Statements of Cash Flows for the nine months ended March 31, 2020 and 2019; (v) Unaudited Consolidated Statements of Equity for the three and nine months ended March 31, 2020 and 2019; and (vi) Notes to the Unaudited Consolidated Financial Statements.* Cover Page Interactive Data File (formatted in Inline XBRL and contained in Exhibit 101). Filed herewith. Furnished herewith. Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. (Registrant) /s/ Steven Tomsic Steven Tomsic

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FLUIDIGM CORP - FORM 10-Q - May 11, 2015 EXCEL - IDEA: XBRL DOCUMENT - FLUIDIGM CORP Financial_Report.xls EX-31.1 - EXHIBIT 31.1 - FLUIDIGM CORP ex-311xq12015form10xq.htm 7000 Shoreline Court, Suite 100 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No ý Financial Statements (Unaudited) Condensed Consolidated Balance Sheets - March 31, 2015 and December 31, 2014 Condensed Consolidated Statements of Operations for the three months ended March 31, 2015 and 2014 Condensed Consolidated Statements of Comprehensive Loss for the three months ended March 31, 2015 and 2014 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2015 and 2014 Notes to Condensed Consolidated Financial Statements EXHIBIT LIST PART I. FINANCIAL INFORMATION (Note 2) Accounts receivable (net of allowances of $76 at March 31, 2015 and $120 at December 31, 2014) Long-term investments Other non-current assets Developed technology, net Accrued compensation and related benefits Other accrued liabilities Deferred revenue, current portion Convertible notes, net Deferred revenue, net of current portion Other non-current liabilities Preferred stock, $0.001 par value, 10,000 shares authorized, no shares issued and outstanding at March 31, 2015 and December 31, 2014 Common stock, $0.001 par value, 200,000 shares authorized at March 31, 2015 and December 31, 2014; 28,715 and 28,341 shares issued and outstanding as of March 31, 2015 and December 31, 2014, respectively Accumulated other comprehensive loss Accumulated deficit (326,108 See accompanying notes. License revenue Grant revenue Cost of product revenue Selling, general and administrative Acquisition-related expenses Loss from operations Other (expense) income, net Loss before income taxes Benefit from income taxes Net loss Net loss per share, basic and diluted Shares used in computing net loss per share, basic and diluted CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS Other comprehensive (loss) income, net of tax Unrealized gain on available-for-sale securities Foreign currency translation adjustment Other comprehensive income (loss), net of tax Total comprehensive loss CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS Operating activities Adjustments to reconcile net loss to net cash used in operating activities: Stock-based compensation expense Acquisition-related share-based awards acceleration expense Amortization of developed technology Non-cash charges for sale of inventory revalued at the date of acquisition Changes in assets and liabilities: Accounts receivable, net Net cash used in operating activities Acquisition, net of cash acquired Purchases of investments Proceeds from sales and maturities of investments Net cash provided by (used in) investing activities Financing activities Proceeds from issuance of convertible notes, net Proceeds from exercise of stock options Effect of foreign exchange rate fluctuations on cash and cash equivalents Net increase in cash and cash equivalents Issuance of common stock and options related to acquisition 1. Description of Business Fluidigm Corporation (we, our, or us) was incorporated in the State of California in May 1999 to commercialize microfluidic technology initially developed at the California Institute of Technology. In July 2007, we were reincorporated in Delaware. Our headquarters are located in South San Francisco, California. We create, manufacture, and market innovative technologies and life-science tools focused on the exploration and analysis of single cells, as well as the industrial application of genomics, based upon our core microfluidics and mass cytometry technologies. We sell instruments and consumables, including integrated fluidic circuits (IFCs), assays, and reagents, to academic institutions, clinical laboratories, and pharmaceutical, biotechnology, and agricultural biotechnology (Ag-Bio) companies. 2. Summary of Significant Accounting Policies The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP) and following the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. GAAP have been condensed or omitted, and accordingly the balance sheet as of December 31, 2014 has been derived from audited consolidated financial statements at that date but does not include all of the information required by U.S. GAAP for complete financial statements. These financial statements have been prepared on the same basis as our annual financial statements and, in the opinion of management, reflect all adjustments (consisting only of normal recurring adjustments) that are necessary for a fair presentation of our financial information. The results of operations for the three months ended March 31, 2015 are not necessarily indicative of the results to be expected for the year ending December 31, 2015 or for any other interim period or for any other future year. All intercompany accounts and transactions have been eliminated upon consolidation. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue, expenses, and related disclosures. On an ongoing basis, we evaluate our estimates, including critical accounting policies or estimates related to revenue recognition, income tax provisions, stock-based compensation, inventory valuation, allowances for doubtful accounts, and useful lives of long-lived assets. We base our estimates on historical experience and on various relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates. The accompanying condensed consolidated financial statements and related financial information should be read in conjunction with the audited consolidated financial statements and the related notes thereto for the year ended December 31, 2014 included in our Annual Report on Form 10-K filed with the SEC. Our basic and diluted net loss per share is calculated by dividing net loss by the weighted-average number of shares of common stock outstanding for the period. Restricted stock units and options to purchase common stock are considered to be potentially dilutive common shares but have been excluded from the calculation of diluted net loss per share as their effect is anti-dilutive for all periods presented. The following potentially dilutive common shares were excluded from the computation of diluted net loss per share for the interim periods presented because including them would have been anti-dilutive (in thousands): Stock options, restricted stock units and restricted stock awards NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued) The components of accumulated other comprehensive loss, net of tax, for the three months ended March 31, 2015 are summarized as follows (in thousands): Net Unrealized Gain (Loss) on Marketable Securities Balance at December 31, 2014 Other comprehensive income Balance at March 31, 2015 Business Combinations Assets acquired and liabilities assumed as part of a business acquisition are generally recorded at their fair value at the date of acquisition. The excess of purchase price over the fair value of assets acquired and liabilities assumed is recorded as goodwill. Determining fair value of identifiable assets, particularly intangibles, and liabilities acquired also requires management to make estimates, which are based on all available information and in some cases assumptions with respect to the timing and amount of future revenues and expenses associated with an asset. Accounting for business acquisitions requires management to make judgments as to whether a purchase transaction is a multiple element contract, meaning that it includes other transaction components such as a settlement of a preexisting relationship. This judgment and determination affects the amount of consideration paid that is allocable to assets and liabilities acquired in the business purchase transaction (See Note 4). Long-lived Assets, including Goodwill Goodwill and intangible assets with indefinite lives are not subject to amortization, but are tested for impairment on an annual basis during the fourth quarter or whenever events or changes in circumstances indicate the carrying amount of these assets may not be recoverable. We first conduct an assessment of qualitative factors to determine whether it is more likely than not that the fair value of our reporting unit is less than its carrying amount. If we determine that it is more likely than not that the fair value of our reporting unit is less than its carrying amount, we then conduct a two-step test for impairment of goodwill. In the first step, we compare the fair value of our reporting unit to its carrying value. If the fair value of our reporting unit exceeds its carrying value, goodwill is not considered impaired and no further analysis is required. If the carrying value of the reporting unit exceeds its fair value, then the second step of the impairment test must be performed in order to determine the implied fair value of the goodwill. If the carrying value of the goodwill exceeds its implied fair value, then an impairment loss equal to the difference would be recorded. We evaluate our finite lived intangible assets for indicators of possible impairment when events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. If any indicator of impairment exists, we assess the recoverability of the affected intangible assets by determining whether the carrying value of the asset can be recovered through undiscounted future operating cash flows. If impairment is indicated, we estimate the asset’s fair value using future discounted cash flows associated with the use of the asset, and adjust the carrying value of the asset accordingly. In April 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. This guidance is intended to simplify the presentation of debt issuance costs. These amendments require that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. It will be effective for our interim and annual financial statements beginning in the first quarter of 2016 and early adoption is permitted. We will apply the guidance in ASU 2015-03 in our financial statements commencing in the first quarter of 2016, which will result in a reclassification of approximately $1.0 million from Other assets to Convertible notes, net. 3. Convertible Notes On February 4, 2014, we closed an underwritten public offering of $201.3 million aggregate principal amount of our 2.75% Senior Convertible Notes due 2034 (Notes) pursuant to an underwriting agreement, dated January 29, 2014. The Notes accrue interest at a rate of 2.75% per year, payable semi-annually in arrears on February 1 and August 1 of each year, commencing August 1, 2014. The Notes will mature on February 1, 2034, unless earlier converted, redeemed, or repurchased in accordance with the terms of the Notes. The initial conversion rate of the Notes is 17.8750 shares of our common stock, par value $0.001 per share, per $1,000 principal amount of Notes (which is equivalent to an initial conversion price of approximately $55.94 per share). The conversion rate will be subject to adjustment upon the occurrence of certain specified events. Holders may surrender their Notes for conversion at any time prior to the stated maturity date. On or after February 6, 2018 and prior to February 6, 2021, we may redeem any or all of the Notes in cash if the closing price of our common stock exceeds 130% of the conversion price for a specified number of days, and on or after February 6, 2021, we may redeem any or all of the Notes in cash without any such condition. The redemption price of the Notes will equal 100% of the principal amount of the Notes plus accrued and unpaid interest. Holders may require us to repurchase all or a portion of their Notes on each of February 6, 2021, February 6, 2024, and February 6, 2029 at a repurchase price in cash equal to 100% of the principal amount of the Notes plus accrued and unpaid interest. If we undergo a fundamental change, as defined in the terms of the Notes, holders may require us to repurchase the Notes in whole or in part for cash at a repurchase price equal to 100% of the principal amount of the Notes plus accrued and unpaid interest. In February 2014, we received $195.2 million, net of underwriting discounts, from the issuance of the Notes and incurred approximately $1.1 million in offering-related expenses. We used $113.2 million of the net proceeds to fund the cash portion of the consideration payable by us in connection with our acquisition of DVS Sciences, Inc. (now Fluidigm Sciences Inc.) (DVS) (See Note 4). Interest expense related to the Notes was approximately $1.5 million and $1.0 million for the three months ended March 31, 2015 and 2014, respectively. Approximately $2.8 million of accrued interest under the Notes became due and was paid during the three months ended March 31, 2015. 4. Acquisition On February 13, 2014 (Acquisition Date), we acquired DVS primarily to broaden our addressable single-cell biology market opportunity and complement our existing product offerings. DVS develops, manufactures, markets, and sells high-parameter single-cell protein analysis systems and related reagents and data analysis tools. DVS’s principal market is the life sciences research market consisting of drug development companies, government research centers, and universities worldwide. The contractual price for the acquisition was $207.5 million, subject to certain adjustments as specified in the merger agreement. The aggregate purchase price was determined to be $199.9 million, as detailed in the table below (in thousands): Estimated Fair Value Issued 1,759,007 shares of Fluidigm common stock Acquisition consideration paid at Acquisition Date Accelerated stock compensation (1) Estimated fair value of vested Fluidigm equivalent stock options (2) Working capital adjustment Aggregate purchase price As a part of the acquisition, we accelerated vesting of certain DVS stock options and shares of restricted stock, and incurred a $6.7 million expense, based upon the per share consideration paid to holders of shares of DVS common stock as of February 13, 2014. This expense is accounted for as a separate transaction and reflected in the acquisition-related expenses line of the condensed consolidated statements of operations. In conjunction with the acquisition, we assumed all outstanding DVS stock options and unvested shares of restricted stock and converted, as of the Acquisition Date, the unvested stock options outstanding under the DVS stock option plan into unvested stock options to purchase approximately 143,000 shares of Fluidigm common stock and the unvested DVS restricted stock into approximately 186,000 shares of restricted Fluidigm common stock, retaining the original vesting schedules. The fair value of all converted share-based awards was $14.6 million, of which $4.0 million was attributed to the pre-combination service period and was included in the calculation of the purchase price. The remaining fair value will be recognized over the awards’ remaining vesting periods subsequent to the acquisition. The fair value of the Fluidigm equivalent share-based awards as of the Acquisition Date was estimated using the Black-Scholes valuation model. Approximately 885,000 shares of Fluidigm common stock, with a fair value of $38.6 million as of the Acquisition Date, representing 50.3030% of the shares otherwise payable to the former stockholders of DVS, were deposited into escrow. These shares comprise a portion of the merger consideration and are being held in escrow to secure indemnification obligations under the merger agreement, if any, for a period of 13 to 18 months following the Acquisition Date, subject to any then pending indemnification claims. Under the terms of the merger agreement, fifty percent (50.0%) of the aggregate shares subject to the indemnification escrow were eligible for release on March 13, 2015 (Initial Release Date), and the balance of the shares would become eligible for release on August 13, 2015, provided that in each case shares will continue to be held in escrow in amounts that we may reasonably determine in good faith to be necessary to satisfy any claims for which we have delivered a notice of claim which has not been fully resolved between us and the representative of the former stockholders of DVS (Stockholder Representative). Prior to the Initial Release Date, we submitted escrow claim notices under the terms of the merger agreement. On April 9, 2015, the Stockholder Representative provided notices objecting to our claims. We are currently in discussions with the Stockholder Representative regarding the claims. Pursuant to the terms of the merger agreement, if the parties do not reach an agreement by May 9, 2015, either party may seek to resolve the dispute by filing an action with the Court of Chancery of the State of Delaware. As of the date of this filing, no shares have been released from the escrow, and we cannot predict whether the dispute will result in litigation, whether we would prevail in any such litigation, and whether and to what extent we will be able to recover shares from the escrow. Net Assets Acquired The transaction has been accounted for using the acquisition method of accounting which requires that assets acquired and liabilities assumed be recognized at their fair values as of the Acquisition Date. The following table summarizes the assets acquired and liabilities assumed as of the Acquisition Date (in thousands): Allocation of purchase price Developed technology Total assets acquired Tax payable The following table provides details of intangible assets acquired in connection with the DVS acquisition as of March 31, 2015 (in thousands, except years): Accumulated Useful Life We recognized $2.8 million and $1.4 million in intangible asset amortization expense during the three months ended March 31, 2015 and 2014, respectively. The $104.1 million of goodwill recognized as part of the transaction is attributable primarily to expected synergies and other benefits from the acquisition, including expansion of our addressable market from the single-cell genomics market to the larger single-cell biology market and the ability to leverage our larger global commercial sales organization and infrastructure to expand awareness of DVS's products and technology. Goodwill is not expected to be deductible for income tax purposes. There were no changes in goodwill between December 31, 2014 and March 31, 2015. Acquisition Costs Acquisition-related expenses were $10.7 million for the three months ended March 31, 2014 and primarily included accelerated vesting of certain DVS restricted stock and options, and consulting, legal, and investment banking fees. These costs are included within the acquisition-related expenses line of the condensed consolidated statements of operations. 5. Balance Sheet Details Inventories consist of the following (in thousands): Work-in-process Property and equipment, net consisted of the following (in thousands): Laboratory and manufacturing equipment Leasehold improvements Office furniture and fixtures Less accumulated depreciation and amortization Construction-in-progress The total intangible assets, which includes developed technology as a result of the DVS acquisition and other intangible assets included in Other non-current assets, was $101.1 million as of March 31, 2015. The estimated future amortization expense of intangible assets as of March 31, 2015 is as follows (in thousands): 2015 (remainder of year) 6. Fair Value of Financial Instruments As a basis for considering fair value, we follow a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows: Level I: observable inputs such as quoted prices in active markets; Level II: inputs other than quoted prices in active markets that are observable either directly or indirectly; and Level III: unobservable inputs in which there is little or no market data, which requires us to develop our own assumptions. Our cash equivalents, which include money market funds, are classified as Level I because they are valued using quoted market prices. Our investments are generally classified as Level II because their value is based on valuations using significant inputs derived from or corroborated by observable market data. Depending on the security, the income and market approaches are used in the model driven valuations. Inputs of these models include recently executed transaction prices in securities of the issuer or comparable issuers and yield curves. The following table sets forth our financial instruments that were measured at fair value by level within the fair value hierarchy (in thousands): U.S. government and agency securities Total assets measured at fair value There were no transfers in and out of Level I and Level II fair value measurement categories during the three months ended March 31, 2015 and 2014, and there were no changes in the valuation techniques used. The following is a summary of investments at March 31, 2015 and December 31, 2014 (in thousands): Amortized Fair Value The contractual maturity dates of $79.5 million of our investments are within one year from March 31, 2015. The contractual maturity dates of our remaining securities are less than eighteen months from March 31, 2015. Based on an evaluation of securities that were in a loss position, we did not recognize any other-than-temporary impairment charges for the three months ended March 31, 2015 and 2014. None of these investments have been in a continuous loss position for more than 12 months. Our conclusion that these losses are not “other-than-temporary” is based on the high credit quality of the securities, their short remaining maturity periods, and our intent and ability to hold such securities until the date of recovery of their respective market values or maturity. The estimated fair value of the Notes is based on a market approach. The estimated fair value was approximately $213.8 million (par value $201.3 million) as of March 31, 2015 and represents a Level II valuation. When determining the estimated fair value of our long-term debt, we used a commonly accepted valuation methodology and market-based risk measurements that are indirectly observable, such as credit risk. The following is a summary of our cash and cash equivalents (in thousands): Operating Leases On April 9, 2013, we entered into an amendment (the 2013 Amendment) to the lease agreement dated September 14, 2010 (as amended, the Lease) relating to the lease of office and laboratory space at our corporate headquarters located in South San Francisco, California. The 2013 Amendment provided for an expansion of the premises covered under the Lease, effective April 1, 2014; an extension of the term of the Lease to April 30, 2020 with an option to renew for an additional five years; payment of base rent with rent escalation; and payment of certain operating expenses during the term of the Lease. The 2013 Amendment also provided for an allowance of approximately $0.7 million for tenant improvements, $0.2 million of which was unused by March 31, 2015 and will be used to offset base rent obligations, and an additional allowance of approximately $0.5 million for tenant improvements, which, if used, will be repaid in equal monthly payments with interest at a rate of 9% per annum over the remaining term of the Lease. On June 4, 2014, we entered into an additional amendment to the Lease (the June 2014 Amendment), which provided for an expansion of the premises covered under the Lease by approximately 13,000 square feet, effective October 1, 2014; payment of base rent with rent escalation; and payment of certain operating expenses during the term of the Lease. The June 2014 Amendment also provided for an allowance of approximately $0.2 million for tenant improvements, which was fully utilized by March 31, 2015, and an additional allowance of approximately $0.1 million for tenant improvements, which, if used, will be repaid in equal monthly payments with interest at a rate of 9% per annum over the remaining term of the Lease. The total future minimum lease payments for the additional space, which will be paid through April 2020, are approximately $2.3 million as of March 31, 2015. On September 15, 2014, we entered into an additional amendment to the Lease (the September 2014 Amendment), which provided for an expansion of the premises covered under the Lease by approximately 9,000 square feet, effective October 1, 2014; payment of base rent with rent escalation; and payment of certain operating expenses during the term of the Lease. The September 2014 Amendment also provided for an allowance of approximately $0.2 million for tenant improvements. The total future minimum lease payments for the additional space, which will be paid through April 2020, are approximately $1.6 million as of March 31, 2015. On October 14, 2013, Fluidigm Singapore Pte. Ltd., our wholly-owned subsidiary (Fluidigm Singapore), accepted an offer of tenancy (Singapore Lease) from HSBC Institutional Trust Services (Singapore) Limited, as trustee of Ascendas Real Estate Investment Trust (Landlord), relating to the lease of a new facility located in Singapore. Pursuant to the terms of the Singapore Lease, Fluidigm Singapore took possession of the facility commencing on March 3, 2014 for a term of 99 months, and the Singapore Lease and rental obligations thereunder commenced on June 3, 2014. The Singapore Lease also provides Fluidigm Singapore with an option to renew the Singapore Lease for an additional 60 months at the then prevailing market rent, and on similar terms as the existing Singapore Lease. In June 2014, Fluidigm Singapore leased additional space of approximately 2,400 square feet in the same building as the new facility on the same terms as the Singapore Lease (the June 2014 Singapore Lease). We completed the consolidation of our Singapore manufacturing operations in the new space in July 2014 and the site qualification was completed in August 2014. The leases relating to our prior manufacturing facility in Singapore terminated on August 31, 2014. In April 2015, Fluidigm Singapore leased additional space of approximately 10,000 square feet in the same building on the same terms as the Singapore Lease (the April 2015 Singapore Lease). In connection with the April 2015 Singapore Lease, Fluidigm Singapore will terminate the June 2014 Singapore Lease on June 30, 2015. The total future minimum lease payments which will be paid through June 2022, are approximately $4.5 million as of March 31, 2015. In connection with our acquisition of DVS (See Note 4), we acquired the operating leases for facilities in Sunnyvale, California and Markham, Ontario, Canada, which expire in July 2016 and January 2016, respectively. The Canada lease includes an option to renew the lease for an additional five years at the then prevailing market rent, and on similar terms as the existing lease. We recognize rent expense on a straight-line basis over the non-cancelable lease term. The total future minimum lease payments for the operating leases in Sunnyvale, California and Markham, Ontario, Canada are approximately $368,000 as of March 31, 2015. We accrue for estimated warranty obligations at the time of product shipment. Management periodically reviews the estimated fair value of its warranty liability and records adjustments based on the terms of warranties provided to customers, historical and anticipated warranty claim experience. Activity for our warranty accrual for the three months ended March 31, 2015 and 2014, which is included in other accrued liabilities, is summarized below (in thousands): Beginning balance Warranty accrual, net Ending balance From time to time, we may be subject to various legal proceedings and claims arising in the ordinary course of business. We assess contingencies to determine the degree of probability and range of possible loss for potential accrual in our financial statements. An estimated loss contingency is accrued in the financial statements if it is probable that a liability has been incurred and the amount of the loss can be reasonably estimated. Pursuant to the terms of a patent cross license agreement with Applied Biosystems, LLC (a subsidiary of Life Technologies Corporation, or Life, and now part of Thermo Fisher Scientific), we were obligated to make a $1.0 million payment to Life upon satisfaction of certain conditions. We do not believe that the conditions triggering the payment obligation have been met; however, on October 16, 2013, Life provided notice that the $1.0 million payment was due and payable under the license agreement. We accrued a loss contingency of $1.0 million on September 30, 2013 and on January 30, 2014, we paid Life the amount due while reserving our rights with respect to such matter. Among other reasons, we made the payment to avoid what would have been, in our view, an improper termination of our license to certain Life patent filings under the agreement, which could have subjected our relevant product lines to risks associated with patent infringement litigation. 8. Stock-Based Compensation During the three months ended March 31, 2015 and 2014, we granted certain employees options to purchase 276,000 and 352,000 shares of common stock, respectively. The options granted during the three months ended March 31, 2015 had exercise prices ranging from $38.53 to $44.20 and a total grant date fair value of $5.5 million. The options granted during the three months ended March 31, 2014 had exercise prices ranging from $44.07 to $47.55 and a total grant date fair value of $9.2 million. During the three months ended March 31, 2015 and 2014, we granted certain employees 349,000 and 285,000 restricted stock units, respectively. The restricted stock units granted during the three months ended March 31, 2015 had fair market values ranging from $37.45 to $44.20 and a total grant date fair value of $14.3 million. The restricted stock units granted during the three months ended March 31, 2014 had fair market values ranging from $42.43 to $47.55 and a total grant date fair value of $13.2 million. The fair value of restricted stock units is determined based on the value of the underlying common stock on the date of grant. The expenses relating to these options and restricted stock units will be recognized over their respective four-year vesting periods. We recognized stock-based compensation expense of $4.1 million and $3.4 million during the three months ended March 31, 2015 and 2014, respectively. As of March 31, 2015, we had $18.0 million and $24.2 million of unrecognized stock-based compensation costs related to stock options and restricted stock units, respectively, which are expected to be recognized over a weighted average period of 2.6 years and 3.5 years, respectively. In conjunction with the DVS acquisition, we assumed all outstanding DVS stock options and unvested shares of restricted stock (See Note 4). As of March 31, 2015, we had $0.8 million and $0.02 million of unrecognized stock-based compensation costs related to the assumed stock options and restricted stock, respectively, which are expected to be recognized over a remaining weighted average period of 1.5 years and 0.1 years, respectively. Income taxes are primarily comprised of state and foreign income taxes. The provision or benefit for income taxes for the periods presented differs from the 34% U.S. Federal statutory rate primarily due to maintaining a valuation allowance for U.S. losses and tax assets, which we do not consider to be realizable. Income tax expense primarily consists of amounts payable in foreign jurisdictions. 10. Information about Geographic Areas We operate in one reporting segment, which is the development, manufacturing, and commercialization of life science analytical and preparatory systems consisting of instruments and consumables for academic institutions, clinical laboratories, and pharmaceutical, biotechnology, and Ag-Bio companies in growth markets, such as single-cell biology and production genomics. The following table presents our product revenue by geography based on the billing address of our customers for each period presented (in thousands): Our license and grant revenues are primarily generated in the United States. No individual customer represented more than 10% of our revenues for the three month periods ended March 31, 2015 and 2014. Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations. The following discussion and analysis should be read together with our condensed consolidated financial statements and the notes to those statements included elsewhere in this Form 10-Q. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, or Securities Act, and Section 21E of the Securities Exchange Act of 1934, as amended, or Exchange Act, that are based on our management’s beliefs and assumptions and on information currently available to our management. The forward-looking statements are contained principally in the section entitled “Risk Factors” and this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Forward-looking statements include information concerning our possible or assumed future cash flow, revenue, sources of revenue and results of operations, operating and other expenses, unit sales, business strategies, financing plans, expansion of our business, competitive position, industry environment, potential growth opportunities, and the effects of competition. Forward-looking statements include statements that are not historical facts and can be identified by terms such as “anticipates,” “believes,” “could,” “seeks,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “projects,” “should,” “will,” “would,” or similar expressions and the negatives of those terms. Forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause our actual results, performance, or achievements to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements. We discuss these risks in greater detail in Part II, Item 1A, “Risk Factors,” elsewhere in this Form 10-Q, and in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our management’s beliefs and assumptions only as of the date of this Form 10-Q. Except as required by law, we assume no obligation to update these forward-looking statements, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future. You should read this Form 10-Q completely and with the understanding that our actual future results may be materially different from what we expect. “Fluidigm,” the Fluidigm logo, “Access Array,” “Biomark,” “C1,” “CyTOF,” “Delta Gene,” “EP1,” “Juno,” and “SNP Type,” are trademarks or registered trademarks of Fluidigm Corporation. Other service marks, trademarks, and trade names referred to in this Form 10-Q are the property of their respective owners. In this Form 10-Q, “we,” “us,” and “our” refer to Fluidigm Corporation and its subsidiaries. We create, manufacture, and market innovative technologies and life-science tools focused on the exploration and analysis of single cells, as well as the industrial application of genomics, based upon our core microfluidics and mass cytometry technologies. We sell instruments and consumables, including integrated fluidic circuits, or IFCs, assays, and reagents, to academic institutions, clinical laboratories, and pharmaceutical, biotechnology, and agricultural biotechnology, or Ag-Bio, companies. We distribute our systems through our direct sales force and support organizations located in North America, Europe, and Asia-Pacific, and through distributors or sales agents in several European, Latin American, Middle Eastern, and Asia-Pacific countries. Our manufacturing operations are primarily located in Singapore and Canada. Our facility in Singapore manufactures our genomics instruments, several of which are assembled at facilities of our contract manufacturers in Singapore, with testing and calibration of the assembled products performed at our Singapore facility. All of our IFCs for commercial sale and some IFCs for our research and development purposes are also fabricated at our Singapore facility. Our proteomics analytical instruments are manufactured at our facility in Canada. We also manufacture IFCs for research and development, assays, and reagents at our facilities in South San Francisco, California. Our total revenue grew from $71.2 million in 2013 to $116.5 million in 2014 (including $20.7 million in revenue from the sales of CyTOF 2 systems and related consumables following our acquisition of DVS in February 2014), and for the three months ended March 31, 2015, our total revenue was $26.7 million. We have incurred significant net losses since our inception in 1999 and, as of March 31, 2015, our accumulated deficit was $326.1 million. Critical Accounting Policies, Significant Judgments and Estimates Our condensed consolidated financial statements and the related notes included elsewhere in this Form 10-Q are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs, and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Changes in accounting estimates may occur from period to period. Accordingly, actual results could differ significantly from the estimates made by our management. We evaluate our estimates and assumptions on an ongoing basis. To the extent there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations, and cash flows will be affected. Except as otherwise disclosed, there have been no material changes in our critical accounting policies and estimates in the preparation of our condensed consolidated financial statements during the three months ended March 31, 2015 compared to those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2014, as filed with the SEC on February 26, 2015. The following table presents our historical condensed consolidated statements of operations data for the three months ended March 31, 2015 and 2014, and as a percentage of total revenue for the respective periods ($ in thousands): We generate revenue from sales of our products, license agreements, and government grants. Our product revenue consists of sales of instruments and related services, and consumables, including IFCs, assays, and other reagents. We have entered into license agreements and have received government grants to conduct research and development activities. The following table presents our revenue by source for each period presented (in thousands): The following table presents our product revenue by geography and as a percentage of total product revenue by geography based on the billing address of our customers for each period presented ($ in thousands): Our customers include academic research institutions, clinical laboratories, and pharmaceutical, biotechnology, and Ag-Bio companies worldwide. Total revenue from our five largest customers in each of the periods presented comprised 11% and 19% of our total revenue in the three months ended March 31, 2015 and 2014, respectively. Comparison of the Three Months Ended March 31, 2015 and March 31, 2014 Total revenue increased by $1.0 million, or 4%, to $26.7 million for the three months ended March 31, 2015, compared to $25.7 million for the three months ended March 31, 2014. Product revenue increased by $1.2 million, or 5%, to $26.6 million for the three months ended March 31, 2015, compared to $25.4 million for the three months ended March 31, 2014. Instrument revenue increased by $0.7 million, or 5%, primarily driven by higher unit sales of our preparatory systems, including the C1 system and the recently introduced Juno system; increased revenue from service offerings; higher unit sales of the EP1 system; and to a lesser extent, increased unit sales of the CyTOF 2 system and contributions from our other new products. The revenue increase was partially offset by a significant decrease in unit sales of Biomark HD systems and negative effects of foreign currency of $0.8 million. Consumables revenue increased by $0.5 million, or 5%, primarily due to growth in C1 IFC unit sales volume, higher antibody consumable sales, and to a lesser extent, higher sales of reagents. The revenue increase was partially offset by a decrease in analytical IFC unit volume and assay sales and negative effects of foreign currency of $0.7 million. Annualized IFC pull-through for our genomics analytical systems was below our historical range of $40,000 to $50,000 per system due to volatility based on timing of large production genomics customer purchases, within our expected range of $15,000 to $25,000 per system for our genomics preparatory systems, and within the historical range of $50,000 to $70,000 per system for our proteomics analytical systems. IFC pull-through is determined by dividing the applicable IFC revenue for a specific period by the number of genomics analytical or preparatory systems, as applicable, in our installed base at the beginning of the period. Similarly, consumables pull-through for proteomics analytical systems is determined by dividing the related consumables revenue for a specific period by the number of proteomics analytical systems in our installed base at the beginning of the period. The IFC and consumables pull-through amounts are annualized by multiplying the pull-through amounts by a ratio, the numerator of which equals 12 and the denominator of which equals the number of months in the specific period. We expect total unit sales of both instruments and consumables to increase over time as we continue our efforts to grow our customer base, expand our geographic market coverage, and launch new products. However, we expect the average selling prices of our products to fluctuate over time based on market conditions, product mix, and currency fluctuations. Grant revenue consists of a grant from California Institute for Regenerative Medicine, or CIRM. Our CIRM grant was awarded in 2011 in the amount of $1.9 million to be earned over a three-year period which ended in April 2014. The CIRM grant revenue is recognized as the related research and development services are performed and costs associated with the grants are recognized as research and development expense during the period incurred. We did not receive any grant revenue for the three months ended March 31, 2015. Grant revenue was $0.2 million for the three months ended March 31, 2014. The following table presents our cost of product revenue and product margin for each period presented ($ in thousands): Product margin Cost of product revenue includes manufacturing costs incurred in the production process, including component materials, labor and overhead, installation, packaging, and delivery costs. In addition, cost of product revenue includes amortization of developed technology, royalty costs for licensed technologies included in our products, warranty, service, provisions for slow-moving and obsolete inventory, and stock-based compensation expense. Costs related to license and grant revenue are included in research and development expense. Cost of product revenue increased by $1.9 million, or 22%, to $10.6 million for the three months ended March 31, 2015 from $8.7 million for the three months ended March 31, 2014. Cost of product revenue for the three months ended March 31, 2015 includes $2.8 million of amortization of acquired intangible assets resulting from our acquisition of DVS Sciences, Inc., or DVS, an increase of $1.4 million when compared to the comparable period in 2014, partially offset by charges from inventory step-up expensed during 2014 related to the acquisition of approximately $0.5 million. Overall cost of product revenue as a percentage of related revenue was 40% and 34%, including 10.5 and 7.5 percentage points related to these charges, for the three months ended March 31, 2015 and 2014, respectively. Product margin declined 6 percentage points for the three months ended March 31, 2015 compared to the corresponding period in 2014 primarily because of the net increase in acquisition-related charges described above, net negative effects of foreign currency exchange rate changes on revenues and production costs, higher consumables manufacturing costs, and higher stock based compensation expenses; partially offset by higher service revenue margin, and lower instrument warranty and royalty costs. The following table presents our operating expenses for each period presented (in thousands): Research and development expense consists primarily of personnel and independent contractor costs, prototype and material expenses, and other allocated facilities and information technology expenses. We have made substantial investments in research and development since our inception. Our research and development efforts have focused primarily on enhancing our technologies and supporting development and commercialization of new and existing products and services. Research and development expense increased $2.3 million, or 31%, to $10.0 million for the three months ended March 31, 2015, compared to $7.6 million for the three months ended March 31, 2014, primarily because of higher headcount and compensation-related costs of $1.2 million, increases in lab supplies and equipment costs of $0.7 million, and other expenses of $0.4 million. These increases resulted from additional expenses to support the growth of our business and the development of our products and services, including additional expenses relating to the acquired DVS operations for the full quarter in 2015 compared to a partial quarter in the prior year. We believe that our continued investment in research and development is essential to our long-term competitive position and these expenses may increase in future periods. Selling, general and administrative expense consists primarily of personnel costs for our sales and marketing, business development, finance, legal, human resources, and general management, as well as professional services, such as legal and accounting services. Selling, general and administrative expense for the three months ended March 31, 2015 increased $4.8 million, or 32%, to $20.1 million, compared to $15.3 million for the three months ended March 31, 2014, primarily driven by higher headcount and compensation-related costs of $3.5 million, increases in legal, accounting and other outside services costs of $0.7 million, increases in facilities leasing costs of $0.6 million, and increases in travel and related costs of $0.2 million, partly offset by integration-related costs of $0.3 million incurred in the prior year. These increases resulted from additional expenses to expand our worldwide commercial capabilities and support our growth, including additional expenses relating to the acquired DVS operations for the full quarter in 2015 compared to a partial quarter in the prior year. We expect selling, general and administrative expense to increase in future periods as we continue to grow our sales, technical support, marketing, and administrative headcount, support increased product sales, broaden our customer base, and incur additional costs to support our expanding global footprint and the overall growth in our business. Acquisition-related expenses of $10.7 million incurred during the three months ended March 31, 2014 primarily included accelerated vesting of certain DVS restricted stock and stock options, and consulting, legal, and investment banking fees relating to our acquisition of DVS. Interest Expense and Other Income and Expense, Net We have incurred interest expense and amortization of debt discount related to our long-term debt. The following table presents interest expense and other (expense) income, net for each period presented (in thousands): On February 4, 2014, we closed an underwritten public offering of $201.3 million aggregate principal amount of our 2.75% Senior Convertible Notes due 2034, or the Notes. The Notes accrue interest at a rate of 2.75% per year, payable semi-annually in arrears on February 1 and August 1 of each year, commencing August 1, 2014. The Notes will mature on February 1, 2034, unless earlier converted, redeemed, or repurchased in accordance with the terms of the Notes. Interest expense for the three months ended March 31, 2015 increased by $0.4 million compared to the three months ended March 31, 2014 due to accrual of interest under the terms of the Notes for a full quarter in 2015, as compared to a partial quarter in 2014. Other expense for the three months ended March 31, 2015 increased by $1.1 million compared to the three months ended March 31, 2014 primarily due to $1.3 million of losses from revaluation of certain foreign currency denominated assets and liabilities due to strengthening of the U.S. dollar during the first quarter of 2015 compared to 2014. Sources of Liquidity As of March 31, 2015, our principal sources of liquidity consisted of $37.0 million of cash and cash equivalents and $97.9 million of investments. As of March 31, 2015, our working capital excluding deferred revenue totaled $137.7 million. The following table presents our cash flow summary for each period presented (in thousands): Cash flow summary We derive cash flows from operations primarily from cash collected from the sale of our products, license agreements, and grants from certain government entities. Our cash flows from operating activities are also significantly influenced by our use of cash for operating expenses to support the growth of our business. We have historically experienced negative cash flows from operating activities as we have expanded our business and built our infrastructure domestically and internationally, and this may continue in the future. Net cash used in operating activities was $9.8 million for the three months ended March 31, 2015, compared to $10.5 million for the three months ended March 31, 2014, a decrease of $0.7 million. The cash used in operating activities in the first three months of 2015 resulted from a net loss of $15.9 million, adjusted for $8.2 million in non-cash charges and a $2.1 million net increase in working capital. The significant non-cash charges included stock-based compensation expense, amortization of intangible assets, and depreciation and amortization. The net increase in working capital was driven primarily by a net decrease in other liabilities and accounts payable, and increased inventory balances, partially offset by a decrease in accounts receivable, prepaid and other assets, and an increase in deferred revenue. Our net loss, adjusted for non-cash and non-operating items, and deferred revenue increased by $1.4 million for the three months ended March 31, 2015 compared to the same period in 2014, which included $10.7 million of acquisition related charges. This was primarily due to increased operating expenses, including a full quarter impact of the acquired DVS operations in 2015, as compared to a partial quarter impact in 2014. Our primary investing activities consist of purchases, sales, and maturities of our short-term and long-term investments, and capital expenditures for manufacturing, laboratory, and computer equipment and software to support our expanding infrastructure and work force. We expect to continue to expand our manufacturing capability, including improvements in manufacturing productivity, and expect to incur additional costs for capital expenditures related to these efforts in future periods. In addition, we expect to continue to incur costs for capital expenditures for demonstration units and loaner equipment to support our sales and service efforts, and computer equipment and software to support our growth. Net cash provided by investing activities was $10.1 million during the three months ended March 31, 2015. Net cash provided by investing activities primarily consisted of $11.1 million of proceeds from sales and maturities of investments, partially offset by capital expenditures of $0.9 million and purchase of intangible assets $0.1 million primarily to support growth in our employee base worldwide and our growth in manufacturing operations. Net cash provided by financing activities was $3.7 million during the three months ended March 31, 2015 and consists of proceeds received in connection with the exercise of options for our common stock. At March 31, 2015, our working capital excluding deferred revenue was $137.7 million, including cash, cash equivalents, and short-term investments of $116.4 million. We believe our existing cash, cash equivalents, and investments will be sufficient to meet our working capital and capital expenditure needs for at least the next 18 months. However, we may experience lower than expected cash generated from operating activities or greater than expected capital expenditures, cost of revenue, or operating expenses, and we may need to raise additional capital to expand the commercialization of our products, expand and fund our operations, further our research and development activities, or acquire or invest in a business. Our future funding requirements will depend on many factors, including market acceptance of our products, the cost of our research and development activities, the cost of filing and prosecuting patent applications, the cost associated with litigation or disputes relating to intellectual property rights or otherwise, the cost and timing of regulatory clearances or approvals, if any, the cost and timing of establishing additional sales, marketing, and distribution capabilities, the cost and timing of establishing additional technical support capabilities, and the effect of competing technological and market developments. In the future, we may acquire businesses or technologies from third parties, and we may decide to raise additional capital through debt or equity financing to the extent we believe this is necessary to successfully complete these acquisitions. We currently have no material commitments or agreements relating to any such acquisitions. If we require additional funds in the future, we may not be able to obtain such funds on acceptable terms, or at all. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. Any debt or additional equity financing that we raise may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or grant licenses on terms that are not favorable to us. If we are unable to raise adequate funds, we may have to liquidate some or all of our assets, or delay, reduce the scope of or eliminate some or all of our development programs. If we do not have, or are not able to obtain, sufficient funds, we may have to delay development or commercialization of our products or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize. We also may have to reduce marketing, customer support, research and development, or other resources devoted to our products or cease operations. As of March 31, 2015, we did not have any off-balance sheet arrangements as defined in Item 303(a)(4) of Regulation S-K promulgated under the Exchange Act. Contractual Obligations and Commitments On October 14, 2013, Fluidigm Singapore Pte. Ltd., our wholly-owned subsidiary (Fluidigm Singapore), accepted an offer of tenancy (Singapore Lease) from HSBC Institutional Trust Services (Singapore) Limited, as trustee of Ascendas Real Estate Investment Trust (Landlord), relating to the lease of a new facility located in Singapore. Pursuant to the terms of the Singapore Lease, Fluidigm Singapore took possession of the facility commencing on March 3, 2014 for a term of 99 months, and the Singapore Lease and rental obligations thereunder commenced on June 3, 2014. The Singapore Lease also provides Fluidigm Singapore with an option to renew the Singapore Lease for an additional 60 months at the then prevailing market rent, and on similar terms as the existing Singapore Lease. In June 2014, Fluidigm Singapore leased additional space of approximately 2,400 square feet in the same building as the new facility on the same terms as the Singapore Lease (the June 2014 Singapore Lease). We completed the consolidation of our Singapore manufacturing operations in the new space in July 2014 and the site qualification was completed in August 2014. The leases relating to our prior manufacturing facility in Singapore terminated on August 31, 2014. In April 2015, Fluidigm Singapore leased additional space of approximately 10,000 square feet in the same building on the same terms as the Singapore Lease (the April 2015 Singapore Lease). In connection with the April 2015 Singapore Lease, Fluidigm Singapore will terminate the June 2014 Singapore Lease on June 30, 2015. The total future minimum lease payments, which will be paid through June 2022, are approximately $4.5 million as of March 31, 2015. In connection with our acquisition of DVS (as discussed in Note 4 of our notes to the condensed consolidated financial statements), we acquired the operating leases for facilities in Sunnyvale, California and Markham, Ontario, Canada, which expire in July 2016 and January 2016, respectively. The Canada lease includes an option to renew the lease for an additional five years at the then prevailing market rent, and on similar terms as the existing lease. We recognize rent expense on a straight-line basis over the non-cancelable lease term. The total future minimum lease payments for the operating leases in Sunnyvale, California and Markham, Ontario, Canada are approximately $368,000 as of March 31, 2015. Market risk represents the risk of loss that may impact our financial position due to adverse changes in financial market prices and rates. Our market risk exposure is primarily a result of fluctuations in foreign currency exchange rates and interest rates. We do not hold or issue financial instruments for trading purposes. Foreign Currency Exchange Risk As we expand internationally, our results of operations and cash flows will become increasingly subject to fluctuations due to changes in foreign currency exchange rates. Our revenue is generally denominated in the local currency of the contracting party. Historically, the majority of our revenue has been denominated in U.S. dollars. Our expenses are generally denominated in the currencies in which our operations are located, which is primarily in the United States, with a portion of expenses incurred in Singapore and Canada where our manufacturing facilities are located. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates. The volatility of exchange rates depends on many factors that we cannot forecast with reliable accuracy. We have experienced and will continue to experience fluctuations in our net income or loss as a result of transaction gains or losses related to revaluing certain current asset and current liability balances that are denominated in currencies other than the functional currency of the entities in which they are recorded. We experienced foreign currency losses of $1.3 million for the three months ended March 31, 2015 primarily due to the strengthening of the U.S. dollar, whereas the impact of foreign currency fluctuations in the three months ended March 31, 2014 was not material. To date, we have not entered into any foreign currency hedging contracts although we may do so in the future. As our international operations grow, we will continue to reassess our approach to manage our risk relating to fluctuations in currency rates. Interest Rate Sensitivity We had cash and cash equivalents of $37.0 million at March 31, 2015. These amounts were held primarily in cash on deposit with banks and cash equivalents. We had $97.9 million in investments at March 31, 2015 held primarily in U.S. government and agency securities. The contractual maturity dates of $79.5 million of our U.S. government and agency securities are within one year from March 31, 2015. The contractual maturity dates of our remaining U.S. government and agency securities are less than eighteen months from March 31, 2015. Cash and cash equivalents and investments are held for working capital purposes. Due to the short-term nature of these investments, we believe that we do not have any material exposure to changes in the fair value of our investment portfolio as a result of changes in interest rates. Declines in interest rates, however, will reduce future investment income. If overall interest rates had decreased by 10% during the periods presented, our interest income would not have been materially affected. Fair Value of Financial Instruments We do not have material exposure to market risk with respect to investments. We do not use derivative financial instruments for speculative or trading purposes. However, we may adopt specific hedging strategies in the future. Evaluation of Disclosure Controls and Procedures Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2015. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of March 31, 2015, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level. There were no changes in our internal control over financial reporting that occurred during the three months ended March 31, 2015 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Limitations on the Effectiveness of Controls Control systems, no matter how well conceived and operated, are designed to provide a reasonable, but not an absolute, level of assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. Because of the inherent limitations in any control system, misstatements due to error or fraud may occur and not be detected. PART II. OTHER INFORMATION Item 1. Legal Proceedings. We are not currently engaged in any material legal proceedings. Item 1A. Risk Factors. We operate in a rapidly changing environment that involves numerous uncertainties and risks. The following risks and uncertainties may have a material and adverse effect on our business, financial condition, or results of operations. You should consider these risks and uncertainties carefully, together with all of the other information included or incorporated by reference in this Form 10-Q. If any of the risks or uncertainties we face were to occur, the trading price of our securities could decline, and you may lose all or part of your investment. Risks Related to Fluidigm’s Business and Strategy Market opportunities may not develop as quickly as we expect, limiting our ability to successfully sell our products, or our product development and strategic plans may change and our entry into certain markets may be delayed, if it occurs at all. The application of our technologies to single-cell biology (across genomics and proteomics) and production genomics applications are emerging market opportunities. We believe these opportunities will take several years to develop or mature and we cannot be certain that these market opportunities will develop as we expect. The future growth of the single-cell biology market and the success of our products depend on many factors beyond our control, including recognition and acceptance by the scientific community, and the growth, prevalence, and costs of competing methods of genetic and protein analysis. If the market for single-cell biology and production genomics do not develop as we expect, our business may be adversely affected. Additionally, our success in these markets may depend to a large extent on our ability to successfully sell products using our technologies. If we are not able to successfully market and sell our products, or to achieve the revenue or margins we expect, our operating results may be harmed and we may not recover our product development and marketing expenditures. In addition, our product development and strategic plans may change, which could delay or impede our entry into these markets. Our financial results and revenue growth rates have varied significantly from quarter-to-quarter and year-to-year due to a number of factors, and a significant variance in our operating results or rates of growth, if any, could lead to substantial volatility in our stock price. Our revenue, results of operations and revenue growth rates have varied in the past and may continue to vary significantly from quarter-to-quarter or year-to-year. For example, in 2011, 2012, and 2014, we experienced higher sales in the fourth quarter than in the first quarter of the next fiscal year. Although this was not the case in the fourth quarter of 2013 compared to the first quarter of 2014, this historical trend resumed in 2015, and we expect it to continue. Additionally, for the quarter ended March 31, 2015, we experienced a year-over-year revenue growth rate that was substantially lower than revenue growth rates experienced in other periods since our initial public offering. We may experience substantial variability in our product mix from period-to-period as revenue from sales of our instruments relative to sales of our consumables may fluctuate or deviate significantly from expectations. Variability in our quarterly or annual results of operations, mix of product revenue, or rates of revenue growth, if any, may lead to volatility in our stock price as research analysts and investors respond to these fluctuations. These fluctuations are due to numerous factors that are difficult to forecast, including: fluctuations in demand for our products; changes in customer budget cycles and capital spending; seasonal variations in customer operations; tendencies among some customers to defer purchase decisions to the end of the quarter; the large unit value of our systems; changes in our pricing and sales policies or the pricing and sales policies of our competitors; our ability to design, manufacture, market, sell, and deliver products to our customers in a timely and cost-effective manner; quality control or yield problems in our manufacturing operations; our ability to timely obtain adequate quantities of the materials or components used in our products, which in certain cases are purchased through sole and single source suppliers; new product introductions and enhancements by us and our competitors; unanticipated increases in costs or expenses; our complex, variable and, at times, lengthy sales cycle; global economic conditions; and fluctuations in foreign currency exchange rates. Additionally, we have certain customers who have historically placed large orders in multiple quarters during a calendar year. A significant reduction in orders from one or more of these customers could adversely affect our revenue and operating results, and if these customers defer or cancel purchases or otherwise alter their purchasing patterns, our financial results and actual results of operations could be significantly impacted. Other unknown or unpredictable factors also could harm our results. The foregoing factors, as well as other factors, could materially and adversely affect our quarterly and annual results of operations and rates of revenue growth, if any. Since our initial public offering, we have experienced significant revenue growth, and we may not achieve similar growth rates in future periods. You should not rely on our operating results for any prior quarterly or annual period as an indication of our future operating performance. If we are unable to maintain adequate revenue growth, our operating results could suffer and our stock price could decline. In addition, a significant amount of our operating expenses are relatively fixed due to our manufacturing, research and development, and sales and general administrative efforts. Any failure to adjust spending quickly enough to compensate for a shortfall relative to our anticipated revenue could magnify the adverse impact of such shortfalls on our results of operations. We expect that our sales will continue to fluctuate on an annual and quarterly basis and that our financial results for some periods may be below those projected by securities analysts, which could significantly decrease the price of our common stock. We have incurred losses since inception, and we may continue to incur substantial losses for the foreseeable future. We have a limited operating history and have incurred significant losses in each fiscal year since our inception, including net losses of $15.9 million, $52.8 million, and $16.5 million during the three months ended March 31, 2015 and years 2014 and 2013, respectively. As of March 31, 2015, we had an accumulated deficit of $326.1 million. These losses have resulted principally from costs incurred in our research and development programs, and from our manufacturing costs and selling, general, and administrative expenses. We believe that our continued investment in research and development, sales, and marketing is essential to our long-term competitive position and future growth, and we expect these expenses will increase in future periods. We also expect that our selling, general, and administrative expenses will continue to increase due to the additional operational costs associated with the growth of our business. Until we are able to generate additional revenue to support our level of operating expenses, we will continue to incur operating and net losses and negative cash flow from operations. Because of the numerous risks and uncertainties associated with our commercialization efforts and future product development, we are unable to predict when we will become profitable, and we may never become profitable. Even if we do achieve profitability, we may not be able to sustain or increase our profitability. The carrying value of long-lived and intangible assets may become impaired and result in an impairment charge. As of March 31, 2015, we had approximately $205.2 million of intangible assets, net of amortization, and goodwill. In addition, if in the future we acquire additional complementary businesses or technologies, a substantial portion of the value of such assets may be recorded as intangible assets or goodwill. The carrying amounts of intangible assets and goodwill are affected whenever events or changes in circumstances indicate that the carrying amount of any asset may not be recoverable. Such events or changes might include a significant decline in market share, a significant decline in revenues, a significant increase in losses or decrease in profits, rapid changes in technology, failure to achieve the benefits of capacity increases and utilization, significant litigation arising out of an acquisition, or other matters. Adverse events or changes in circumstances may affect the estimated undiscounted future operating cash flows expected to be derived from intangible assets and goodwill. If at any time we determine that an impairment has occurred, we will be required to reflect the impaired value as a charge, resulting in a reduction in earnings in the quarter such impairment is identified and a corresponding reduction in our net asset value. The potential recognition of impairment in the carrying value, if any, could have a material and adverse effect on our financial condition and results of operations. If our research and product development efforts do not result in commercially viable products within anticipated timelines, if at all, our business and results of operations will be adversely affected. Our business is dependent on the improvement of our existing products, our development of new products to serve existing markets, and our development of new products to create new markets and applications that were previously not practical with existing systems. We intend to devote significant personnel and financial resources to research and development activities designed to advance the capabilities of our technology. We have developed design rules for the implementation of our technology that are frequently revised to reflect new insights we have gained about the technology. In addition, we have discovered that biological or chemical reactions sometimes behave differently when implemented on our systems rather than in a standard laboratory environment. Furthermore, many such reactions take place within the confines of single cells, which have also demonstrated unexpected behavior when grown and manipulated within microfluidic environments. As a result, research and development efforts may be required to transfer certain reactions and cell handling techniques to our systems. In the past, product development projects have been significantly delayed when we encountered unanticipated difficulties in implementing a process on our systems. We may have similar delays in the future, and we may not obtain any benefits from our research and development activities. Any delay or failure by us to develop and release new products or product enhancements would have a substantial adverse effect on our business and results of operations. If one or more of our manufacturing facilities become unavailable or inoperable, we will be unable to continue manufacturing our instruments, IFCs, assays, and/or reagents and, as a result, our business will be harmed until we are able to secure a new facility. We manufacture all of our genomics analytical and preparatory instruments and integrated fluidic circuits, or IFCs, for commercial sale at our facility in Singapore, our proteomics analytical instruments for commercial sale at our facility in Canada, and our assays and reagents for commercial sale at our facility in South San Francisco. No other manufacturing facilities are currently available to us, particularly facilities of the size and scope required by our Singapore and Canada operations. Our facilities and the equipment we use to manufacture our instruments, IFCs, assays, and reagents would be costly to replace and could require substantial lead time to repair or replace. Our facilities may be harmed or rendered inoperable by natural or man-made disasters, which may render it difficult or impossible for us to manufacture our products for some period of time. If any of our facilities become unavailable to us, we cannot provide assurances that we will be able to secure a new manufacturing facility on acceptable terms, if at all. The inability to manufacture our products, combined with our limited inventory of manufactured supplies, may result in the loss of customers or harm our reputation, and we may be unable to reestablish relationships with those customers in the future. Although we possess insurance for damage to our property and the disruption of our business, this insurance may not be sufficient to cover all of our potential losses and may not continue to be available to us on acceptable terms, or at all. If our manufacturing capabilities are impaired, we may not be able to manufacture and ship our products in a timely manner, which would adversely impact our business. We may experience development or manufacturing problems or delays that could limit the growth of our revenue or increase our losses. We may encounter unforeseen situations in the manufacturing and assembly of our products that would result in delays or shortfalls in our production. For example, our production processes and assembly methods may have to change to accommodate any significant future expansion of our manufacturing capacity, which may increase our manufacturing costs, delay production of our products, reduce our product margin, and adversely impact our business. Additionally, all of our IFCs for commercial sale are manufactured at our facility in Singapore. Production of the elastomeric block that is at the core of our IFCs is a complex process requiring advanced clean rooms, sophisticated equipment, and strict adherence to procedures. Any contamination of the clean room, equipment malfunction, or failure to strictly follow procedures can significantly reduce our yield in one or more batches. We have in the past experienced variations in yields due to such factors. A drop in yield can increase our cost to manufacture our IFCs or, in more severe cases, require us to halt the manufacture of our IFCs until the problem is resolved. Identifying and resolving the cause of a drop in yield can require substantial time and resources. Furthermore, developing an IFC for a new application may require developing a specific production process for that type of IFC. While all of our IFCs are produced using the same basic processes, significant variations may be required to ensure adequate yield of any particular type of IFC. Developing such a process can be very time consuming, and any unexpected difficulty in doing so can delay the introduction of a product. If our manufacturing activities are adversely impacted, or if we are otherwise unable to keep up with demand for our products by successfully manufacturing, assembling, testing, and shipping our products in a timely manner, our revenue could be impaired, market acceptance for our products could be adversely affected and our customers might instead purchase our competitors’ products. We are dependent on single and sole source suppliers for some of the components and materials used in our products, and the loss of any of these suppliers could harm our business. We rely on single and sole source suppliers for certain components and materials used in our products. Additionally, several of our instruments are assembled at the facilities of contract manufacturers in Singapore. We do not have long term contracts with our suppliers of these components and materials or our assembly service providers. The loss of a single or sole source supplier of any of the following components and/or materials would require significant time and effort to locate and qualify an alternative source of supply, if at all: The IFCs used in our microfluidic systems are fabricated using a specialized polymer, and other specialized materials, that are available from a limited number of sources. In the past, we have encountered quality issues that have reduced our manufacturing yield or required the use of additional manufacturing processes. Specialized pneumatic and electronic components for our C1 system are available from a limited number of sources. The electron multiplier detector included in the CyTOF system and certain metal isotopes used with the CyTOF system are purchased from sole source suppliers. The nickel sampler cone used with the CyTOF system is purchased from single source suppliers and is available from a limited number of sources. The raw materials for our Delta Gene and SNP Type assays and Access Array target-specific primers are available from a limited number of sources. Our reliance on single and sole source suppliers and assembly service providers also subjects us to other risks that could harm our business, including the following: we may be subject to increased component or assembly costs; we may not be able to obtain adequate supply or services in a timely manner or on commercially reasonable terms; our suppliers or service providers may make errors in manufacturing or assembly of components that could negatively affect the efficacy of our products or cause delays in shipment of our products; and our suppliers or service providers may encounter capacity constraints or financial hardships unrelated to our demand for components or services, which could inhibit their ability to fulfill our orders and meet our requirements. We have in the past experienced quality control and supply problems with some of our suppliers, such as manufacturing errors, and may again experience problems in the future. We may not be able to quickly establish additional or replacement suppliers, particularly for our single source components, or assembly service providers. Any interruption or delay in the supply of components or materials or assembly of our instruments, or our inability to obtain components, materials, or assembly services from alternate sources at acceptable prices in a timely manner, could impair our ability to meet the demand of our customers and cause them to cancel orders or switch to competitive products. If our products fail to achieve and sustain sufficient market acceptance, our revenue will be adversely affected. Our success depends, in part, on our ability to develop and market products that are recognized and accepted as reliable, enabling and cost-effective. Most of our potential customers already use expensive research systems in their laboratories and may be reluctant to replace those systems. Market acceptance of our systems will depend on many factors, including our ability to convince potential customers that our systems are an attractive alternative to existing technologies. Compared to some competing technologies, our technology is relatively new, and most potential customers have limited knowledge of, or experience with, our products. Prior to adopting our systems, some potential customers may need to devote time and effort to testing and validating our systems. Any failure of our systems to meet these customer benchmarks could result in customers choosing to retain their existing systems or to purchase systems other than ours. In addition, it is important that our systems be perceived as accurate and reliable by the scientific and medical research community as a whole. Historically, a significant part of our sales and marketing efforts has been directed at convincing industry leaders of the advantages of our systems and encouraging such leaders to publish or present the results of their evaluation of our system. If we are unable to continue to induce leading researchers to use our systems, or if such researchers are unable to achieve and publish or present significant experimental results using our systems, acceptance and adoption of our systems will be slowed and our ability to increase our revenue would be adversely affected. Our future success is dependent upon our ability to expand our customer base and introduce new applications. Our customer base is primarily composed of academic institutions, clinical laboratories that use our technology to develop tests, and pharmaceutical, biotechnology, and agricultural biotechnology, or Ag-Bio, companies that perform analyses for research and commercial purposes. Our success will depend, in part, upon our ability to increase our market share among these customers, attract additional customers outside of these markets, and market new applications to existing and new customers as we develop such applications. Attracting new customers and introducing new applications require substantial time and expense. For example, it may be difficult to identify, engage, and market to customers who are unfamiliar with the current applications of our systems. Any failure to expand our existing customer base or launch new applications would adversely affect our ability to increase our revenue. The life science research and applied markets are highly competitive and subject to rapid technological change, and we may not be able to successfully compete. The markets for our products are characterized by rapidly changing technology, evolving industry standards, changes in customer needs, emerging competition, new product introductions, and strong price competition. We compete with both established and development stage life science research companies that design, manufacture, and market instruments and consumables for gene expression analysis, single-cell targeted gene expression or protein expression analysis, single nucleotide polymorphism genotyping, or SNP genotyping, polymerase chain reaction, or PCR, digital PCR, other nucleic acid detection, flow cytometry, cell imaging, and additional applications using well established laboratory techniques, as well as newer technologies such as bead encoded arrays, microfluidics, nanotechnology, high-throughput DNA sequencing, microdroplets, and photolithographic arrays. Most of our current competitors have significantly greater name recognition, greater financial and human resources, broader product lines and product packages, larger sales forces, larger existing installed bases, larger intellectual property portfolios, and greater experience and scale in research and development, manufacturing, and marketing than we do. For example, companies such as Affymetrix, Inc., Agena Bioscience, Inc., Agilent Technologies, Inc., Becton, Dickinson and Company, Bio-Rad Laboratories, Inc., Danaher Corporation, Illumina, Inc., Life Technologies Corporation (now part of Thermo Fisher Scientific Inc.), LGC Limited, Luminex Corporation, Millipore Corporation, NanoString Technologies, Inc., PerkinElmer, Inc. (through its acquisition of Caliper Life Sciences, Inc.), RainDance Technologies, Inc., Roche Diagnostics Corporation, Sony Corporation, Thermo Fisher Scientific Inc., and WaferGen Bio-systems, Inc. have products that compete in certain segments of the market in which we sell our products. Competitors may be able to respond more quickly and effectively than we can to new or changing opportunities, technologies, standards, or customer requirements. In light of these advantages, even if our technology is more effective than the product or service offerings of our competitors, current or potential customers might accept competitive products and services in lieu of purchasing our technology. We anticipate that we will face increased competition in the future as existing companies and competitors develop new or improved products and as new companies enter the market with new technologies. Increased competition is likely to result in pricing pressures, which could reduce our profit margins and increase our sales and marketing expenses. In addition, mergers, consolidations, or other strategic transactions between two or more of our competitors, or between our competitor and one of our key customers, could change the competitive landscape and weaken our competitive position, adversely affecting our business. Our business depends on research and development spending levels of academic, clinical, and governmental research institutions, and pharmaceutical, biotechnology, and Ag-Bio companies, a reduction in which could limit our ability to sell our products and adversely affect our business. We expect that our revenue in the foreseeable future will be derived primarily from sales of our systems and IFCs to academic institutions, clinical laboratories that use our technology to develop tests, and pharmaceutical, biotechnology, and Ag-Bio companies worldwide. Our success will depend upon their demand for and use of our products. Accordingly, the spending policies of these customers could have a significant effect on the demand for our technology. These policies may be based on a wide variety of factors, including concerns regarding any future federal government budget sequestrations, the availability of resources to make purchases, the spending priorities among various types of equipment, policies regarding spending during recessionary periods, and changes in the political climate. In addition, academic, governmental, and other research institutions that fund research and development activities may be subject to stringent budgetary constraints that could result in spending reductions, reduced allocations, or budget cutbacks, which could jeopardize the ability of these customers to purchase our products. Our operating results may fluctuate substantially due to reductions and delays in research and development expenditures by these customers. For example, reductions in capital and operating expenditures by these customers may result in lower than expected sales of our systems and IFCs. These reductions and delays may result from factors that are not within our control, such as: natural disasters; changes in government programs that provide funding to research institutions and companies; changes in the regulatory environment affecting life science and Ag-Bio companies engaged in research and commercial activities; differences in budget cycles across various geographies and industries; market-driven pressures on companies to consolidate operations and reduce costs; mergers and acquisitions in the life science and Ag-Bio industries; and other factors affecting research and development spending. Any decrease in our customers’ budgets or expenditures, or in the size, scope, or frequency of capital or operating expenditures, could materially and adversely affect our operations or financial condition. We may not be able to develop new products or enhance the capabilities of our existing systems to keep pace with rapidly changing technology and customer requirements, which could have a material adverse effect on our business, revenue, financial condition, and operating results. Our success depends on our ability to develop new products and applications for our technology in existing and new markets, while improving the performance and cost-effectiveness of our systems. New technologies, techniques, or products could emerge that might offer better combinations of price and performance than our current or future product lines and systems. Existing markets for our products, including single-cell biology and production genomics, as well as potential markets for our products such as high-throughput DNA sequencing and molecular diagnostics applications, are characterized by rapid technological change and innovation. It is critical to our success for us to anticipate changes in technology and customer requirements and to successfully introduce new, enhanced, and competitive technology to meet our customers’ and prospective customers’ needs on a timely and cost-effective basis. Developing and implementing new technologies will require us to incur substantial development costs and we may not have adequate resources available to be able to successfully introduce new applications of, or enhancements to, our systems. We cannot guarantee that we will be able to maintain technological advantages over emerging technologies in the future. While we typically plan improvements to our systems, we may not be able to successfully implement these improvements. If we fail to keep pace with emerging technologies, demand for our systems will not grow and may decline, and our business, revenue, financial condition, and operating results could suffer materially. In addition, if we introduce enhanced systems but fail to manage product transitions effectively, customers may delay or forgo purchases of our systems and our operating results may be adversely affected by product obsolescence and excess inventory. Even if we successfully implement some or all of these planned improvements, we cannot guarantee that our current and potential customers will find our enhanced systems to be an attractive alternative to existing technologies, including our current products. Being a medical device manufacturer and seeking approval and/or clearance for our products by the U.S. Food and Drug Administration, or FDA, and foreign regulatory authorities will take significant time and expense and may not result in FDA clearance or approval for the intended uses we believe are commercially attractive. If our products are successfully approved and/or cleared, we will be subject to ongoing and extensive regulatory requirements, which would increase our costs and divert resources away from other projects. If we fail to comply with these requirements, our business and financial condition could be adversely impacted. Our products are currently labeled, promoted and sold to academic institutions, life sciences laboratories, and pharmaceutical, biotechnology, and Ag-Bio companies for research purposes only, or RUO, and cannot be used for diagnostic tests or as medical devices as currently marketed. Before we can begin to label and market our products for use as, or in the performance of, clinical diagnostics in the United States, thereby subjecting them to FDA regulation as medical devices, we would be required to obtain premarket 510(k) clearance or pre-market approval from the FDA, unless an exception applies. We recently announced our plan to register with the FDA as a medical device manufacturer and list some of our products with the FDA pursuant to an FDA Class I listing for general purpose laboratory equipment within the next 12 months. While this regulatory classification is exempt from certain FDA requirements, such as the need to submit a premarket notification commonly known as a 510(k), and most of the requirements of the FDA’s Quality System Regulations, or QSRs, we will be subject to ongoing FDA “general controls,” which include compliance with FDA regulations for labeling, inspections by the FDA, complaint evaluation, corrections and removals reporting, promotional restrictions, reporting adverse events or malfunctions for our products, and general prohibitions against misbranding and adulteration. In addition, we plan to submit 510(k) premarket notifications to the FDA to obtain FDA clearance of certain of our products on a selected basis. Although we plan to submit 510(k)s, it is possible that the FDA will take the position that a more burdensome premarket application, such as a premarket approval application or a de novo application is required for some of our products. If such applications are required, greater time and investment would be required to obtain FDA approval. Even if the FDA agrees that a 510(k) is appropriate, FDA clearance can be expensive and time consuming. It generally takes a significant amount of time to prepare a 510(k), including conducting appropriate testing on our products, and several months to years for the FDA to review a submission. Notwithstanding the effort and expense, FDA clearance or approval may be denied for some or all of our products. Even if we were to obtain regulatory approval or clearance, it may not be for the uses we believe are important or commercially attractive. If we receive regulatory clearance or approval for our products, we will be subject to ongoing FDA obligations and continued regulatory oversight and review, including the general controls listed above and the FDA’s QSRs for our manufacturing operations. In addition, we may be required to obtain a new 510(k) clearance before we can introduce subsequent modifications or improvements to our products. We may also be subject to additional FDA post-marketing obligations, any or all of which would increase our costs and divert resources away from other projects. If we are not able to maintain regulatory compliance with applicable laws, we may be prohibited from marketing our products for use as, or in the performance of, clinical diagnostics and/or may be subject to fines, injunctions, and civil penalties; recall or seizure of products; operating restrictions; and criminal prosecution. We intend to seek similar regulatory clearance or approval for our products in countries outside of the United States. Sales of our products outside the United States will be subject to foreign regulatory requirements, which vary greatly from country to country. As a result, the time required to obtain clearances or approvals outside the United States may differ from that required to obtain FDA clearance or approval and we may not be able to obtain foreign regulatory approvals on a timely basis or at all. Clearance or approval by the FDA does not ensure approval by regulatory authorities in other countries, and approval by one foreign regulatory authority does not ensure approval by regulatory authorities in other countries or by the FDA. In addition, the FDA regulates exports of medical devices. Failure to comply with these regulatory requirements or obtain required approvals could impair our ability to commercialize our products for diagnostic use outside of the United States. Our products could become subject to regulation as medical devices by the FDA or other regulatory agencies, before we have obtained regulatory clearance or approval to market our products for diagnostic purposes, which would adversely impact our ability to market and sell our products and harm our business. As products that are currently labeled, promoted and intended for RUO, our products are not currently subject to regulation as medical devices by the FDA or comparable agencies of other countries. However, the FDA or comparable agencies of other countries could disagree with our conclusion that our products are currently intended for research use only or deem our current marketing and promotional efforts as being inconsistent with research use only products. For example, our customers may elect to use our research use only labeled products in their own laboratory developed tests, or LDTs, for clinical diagnostic use. The FDA has historically exercised enforcement discretion in not enforcing the medical device regulations against laboratories offering LDTs. However, on October 3, 2014, the FDA issued two draft guidance documents that set forth the FDA’s proposed risk-based framework for regulating LDTs, which are designed, manufactured, and used within a single laboratory. The draft guidance documents provide the anticipated details through which the FDA would propose to establish an LDT oversight framework, including premarket review for higher-risk LDTs, such as those that have the same intended use as FDA-approved or cleared companion diagnostics currently on the market. The FDA held a public workshop and accepted comments on the two draft guidance documents and is currently assessing next steps for the regulation of LDTs. At the same time, various legislative proposals have been floated that would take differing approaches to the regulation of LDTs. It is also possible that companies or associations will attempt to bring litigation against the FDA arguing that the FDA lacks legal authority over LDTs. We cannot predict how these various efforts will be resolved, how FDA will regulate LDTs in the future, or how that regulatory system will impact our business. Additionally, on November 25, 2013, the FDA issued Final Guidance “Distribution of In Vitro Diagnostic Products Labeled for Research Use Only.” The guidance emphasizes that the FDA will review the totality of the circumstances when it comes to evaluating whether equipment and testing components are properly labeled as RUO. The final guidance states that merely including a labeling statement that the product is for research purposes only will not necessarily render the device exempt from the FDA’s clearance, approval, and other regulatory requirements if the circumstances surrounding the distribution of the product indicate that the manufacturer knows its product is, or intends for its product to be, offered for clinical diagnostic uses. These circumstances may include written or verbal marketing claims or links to articles regarding a product’s performance in clinical applications and a manufacturer’s provision of technical support for clinical applications. If the FDA modifies its approach to our products labeled and intended for RUO, or otherwise determines our products or related applications should be subject to additional regulation as in vitro diagnostic devices based upon our customers’ use of our products for clinical diagnostic or therapeutic purposes, before we have obtained regulatory clearance or approval to market our products for diagnostic purposes, our ability to market and sell our products could be impeded and our business, prospects, results of operations and financial condition may be adversely affected. In addition, if the FDA determines that our products labeled for RUO were intended, based on a review of the totality of circumstances, for use in clinical investigation or diagnosis, those products could be considered misbranded or adulterated under the Federal Food, Drug, and Cosmetic Act and subject to recall or other enforcement action. Compliance or the failure to comply with current and future regulations, such as environmental regulations enacted in the European Union, could cause us significant expense and adversely impact our business. We are subject to many federal, state, local, and foreign regulations relating to various aspects of our business operations. Governmental entities at all levels are continuously enacting new regulations, and it is difficult to identify all applicable regulations and anticipate how such regulations will be implemented and enforced. We continue to evaluate the necessary steps for compliance with applicable regulations. To comply with applicable regulations, we have and will continue to incur significant expense and allocate valuable internal resources to manage compliance-related issues. In addition, such regulations could restrict our ability to expand or equip our facilities, or could require us to acquire costly equipment or to incur other significant expenses to comply with the regulations. For example, the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive, or RoHS, and the Waste Electrical and Electronic Equipment Directive, or WEEE, enacted in the European Union, regulate the use of certain hazardous substances in, and require the collection, reuse, and recycling of waste from, products we manufacture. Certain of our products sold in these countries may become subject to RoHS and WEEE requirements. These and similar regulations that have been or are in the process of being enacted in other countries may require us to redesign our products, use different types of materials in certain components, or source alternative components to ensure compliance with applicable standards, and may reduce the availability of parts and components used in our products by negatively impacting our suppliers’ ability to source parts and components in a timely and cost-effective manner. Any such redesigns, required use of alternative materials, or limited availability of parts and components used in our products may detrimentally impact the performance of our products, add greater testing lead times for product introductions, reduce our product margins, or limit the markets for our products, and if we fail to comply with any present and future regulations, we could be subject to future fines, penalties, and restrictions, such as the suspension of manufacturing of our products or a prohibition on the sale of products we manufacture. Any of the foregoing could adversely affect our business, financial condition, or results of operations. If we are unable to recruit and retain key executives, scientists, and technical support personnel, we may be unable to achieve our goals. We may have difficulty attracting, motivating, and retaining executives and other key employees in light of our recent acquisition. Our performance is substantially dependent on the performance of our senior management, particularly Gajus V. Worthington, our president and chief executive officer. Additionally, to expand our research and product development efforts, we need key scientists skilled in areas such as molecular and cellular biology, assay development, and manufacturing. We also need highly trained technical support personnel with the necessary scientific background and ability to understand our systems at a technical level to effectively support potential new customers and the expanding needs of current customers. Competition for these people is intense. Because of the complex and technical nature of our systems and the dynamic market in which we compete, any failure to attract and retain a sufficient number of qualified employees could materially harm our ability to develop and commercialize our technology. The loss of the services of any member of our senior management or our scientific or technical support staff might significantly delay or prevent the development of our products or achievement of other business objectives by diverting management’s attention to transition matters and identification of suitable replacements, if any, and could have a material adverse effect on our business. In addition, our research and product development efforts could be delayed or curtailed if we are unable to attract, train, and retain highly skilled employees, particularly, senior scientists and engineers. We do not maintain fixed term employment contracts or significant key man life insurance with any of our employees. Additionally, as a result of our acquisition of DVS Sciences Inc. (now Fluidigm Sciences Inc.), key Fluidigm Sciences employees became entitled to receive a portion of the acquisition consideration, the payment of which could provide sufficient financial incentive for certain officers and employees to no longer pursue employment with the combined business. In particular, we have identified several key Fluidigm Sciences employees, including key scientific and technical employees, who have been important to the development of Fluidigm Sciences’ products and technologies, and we have implemented employment compensation arrangements in connection with the acquisition to ensure these individuals’ continued employment with us. We cannot provide assurances that these arrangements will sufficiently incentivize these key employees to remain with us. If these key employees depart, we may incur significant costs in identifying, hiring, and retaining replacements for departing employees, which could substantially reduce or delay our ability to realize the anticipated benefits of the acquisition. If we are unable to integrate future acquisitions successfully, our operating results and prospects could be harmed. In addition to our recent acquisition, we may make additional acquisitions to improve our product offerings or expand into new markets. Our future acquisition strategy will depend on our ability to identify, negotiate, complete, and integrate acquisitions and, if necessary, to obtain satisfactory debt or equity financing to fund those acquisitions. Mergers and acquisitions are inherently risky, and any transaction we complete may not be successful. Our acquisition of DVS was our first acquisition of another company. Any merger or acquisition we may pursue would involve numerous risks, including but not limited to the following: difficulties in integrating and managing the operations, technologies, and products of the companies we acquire; diversion of our management’s attention from normal daily operation of our business; our inability to maintain the key business relationships and the reputations of the businesses we acquire; our inability to retain key personnel of the acquired company; uncertainty of entry into markets in which we have limited or no prior experience and in which competitors have stronger market positions; our dependence on unfamiliar affiliates and customers of the companies we acquire; insufficient revenue to offset our increased expenses associated with acquisitions; our responsibility for the liabilities of the businesses we acquire, including those which we may not anticipate; and our inability to maintain internal standards, controls, procedures, and policies. We may be unable to secure the equity or debt funding necessary to finance future acquisitions on terms that are acceptable to us. If we finance acquisitions by issuing equity or convertible debt securities, our existing stockholders will likely experience dilution, and if we finance future acquisitions with debt funding, we will incur interest expense and may have to comply with financial covenants and secure that debt obligation with our assets. Adverse conditions in the global economy and disruption of financial markets may significantly harm our revenue, profitability, and results of operations. The global credit and financial markets have in recent years experienced volatility and disruptions, including diminished liquidity and credit availability, increased concerns about inflation and deflation, and the downgrade of U.S. debt and exposure risks on other sovereign debts, decreased consumer confidence, lower economic growth, volatile energy costs, increased unemployment rates, and uncertainty about economic stability. Volatility and disruption of financial markets could limit our customers’ ability to obtain adequate financing or credit to purchase and pay for our products in a timely manner or to maintain operations, which could result in a decrease in sales volume that could harm our results of operations. General concerns about the fundamental soundness of domestic and international economies may also cause our customers to reduce their purchases. Changes in governmental banking, monetary, and fiscal policies to address liquidity and increase credit availability may not be effective. Significant government investment and allocation of resources to assist the economic recovery of sectors which do not include our customers may reduce the resources available for government grants and related funding for life science, Ag-Bio, and clinical research and development. Continuation or further deterioration of these financial and macroeconomic conditions could significantly harm our sales, profitability, and results of operations. We generate a substantial portion of our revenue internationally and are subject to various risks relating to such international activities, which could adversely affect our sales and operating performance. In addition, any disruption or delay in the shipping or off-loading of our products, whether domestically or internationally, may have an adverse effect on our financial condition and results of operations. During the three months ended March 31, 2015 and years 2014 and 2013, approximately 49%, 49%, and 48% , respectively, of our product revenue was generated from sales to customers located outside of the United States. We believe that a significant percentage of our future revenue will come from international sources as we expand our international operations and develop opportunities in other countries. Engaging in international business inherently involves a number of difficulties and risks, including: required compliance with existing and changing foreign regulatory requirements and laws, such as the RoHS and WEEE directives, which regulate the use of certain hazardous substances in, and require the collection, reuse, and recycling of waste from, products we manufacture; required compliance with anti-bribery laws, such as the U.S. Foreign Corrupt Practices Act and U.K. Bribery Act, data privacy requirements, labor laws, and anti-competition regulations; export or import restrictions; laws and business practices favoring local companies; longer payment cycles and difficulties in enforcing agreements and collecting receivables through certain foreign legal systems; unstable economic, political, and regulatory conditions; potentially adverse tax consequences, tariffs, customs charges, bureaucratic requirements, and other trade barriers; difficulties and costs of staffing and managing foreign operations; and difficulties protecting or procuring intellectual property rights. If one or more of these risks occurs, it could require us to dedicate significant resources to remedy, and if we are unsuccessful in finding a solution, our financial results will suffer. In addition, a majority of our product sales are currently denominated in U.S. dollars and fluctuations in the value of the U.S. dollar relative to foreign currencies could decrease demand for our products and adversely impact our financial performance. For example, if the value of the U.S. dollar increases relative to foreign currencies, our products could become more costly to the international consumer and therefore less competitive in international markets, or if the value of the U.S. dollar decreases relative to the Singapore dollar or the Canadian dollar, it would become more costly in U.S. dollars for us to manufacture our products in Singapore and/or in Canada. Additionally, our expenses are generally denominated in the currencies of the countries in which our operations are located, which is primarily in the United States, with a portion of expenses incurred in Singapore and Canada where a significant portion of our manufacturing operations are located. Our results of operations and cash flows are, therefore, subject to fluctuations due to changes in foreign currency exchange rates. The volatility of exchange rates depends on many factors that we cannot forecast with reliable accuracy. We have experienced and will continue to experience fluctuations in our net income or loss as a result of transaction gains or losses related to revaluing certain current asset and current liability balances that are denominated in currencies other than the functional currency of the entities in which they are recorded. For example, experienced foreign currency losses of $1.3 million, $1.1 million, and $0.5 million for the three months ended March 31, 2015 and years ended December 31, 2014 and 2013, respectively. Fluctuations in currency exchange rates could have an adverse impact on our financial results in the future. We rely on shipping providers to deliver products to our customers globally. Labor, tariff, or World Trade Organization-related disputes, piracy, physical damage to shipping facilities or equipment caused by severe weather or terrorist incidents, congestion at shipping facilities, inadequate equipment to load, dock, and offload our products, energy-related tie-ups, or other factors could disrupt or delay shipping or off-loading of our products domestically and internationally. Such disruptions or delays may have an adverse effect on our financial condition and results of operations. We are subject to risks related to taxation in multiple jurisdictions and if taxing authorities disagree with our interpretations of existing tax laws or regulations, our effective income tax rate could be adversely affected and we could have additional tax liability. We are subject to income taxes in both the United States and certain foreign jurisdictions. Significant judgments based on interpretations of existing tax laws or regulations are required in determining the provision for income taxes. For example, we have made certain interpretations of existing tax laws or regulations based upon the operations of our business internationally and we have implemented intercompany agreements based upon these interpretations and related transfer pricing analyses. If the U.S. Internal Revenue Service or other taxing authorities disagree with the positions, our effective income tax rate could be adversely affected and we could have additional tax liability, including interest and penalties. We are currently reviewing our corporate structure and tax positions and such review may result in a change in how we structure our international business operations, which may have an adverse effect on our income tax liability. Our effective income tax rate could also be adversely affected by changes in the mix of earnings in tax jurisdictions with different statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in existing tax laws or tax rates, changes in the level of non-deductible expenses (including share-based compensation), changes in our future levels of research and development spending, mergers and acquisitions, or the result of examinations by various tax authorities. Payment of additional amounts upon final adjudication of any disputes could have a material impact on our results of operations and financial position. If we are unable to manage our anticipated growth effectively, our business could be harmed. The rapid growth of our business has placed a significant strain on our managerial, operational, and financial resources and systems. To execute our anticipated growth successfully, we must continue to attract and retain qualified personnel and manage and train them effectively. We must also upgrade our internal business processes and capabilities to create the scalability that a growing business demands. We believe our facilities located in Singapore, Canada, and California, are sufficient to meet our short-term manufacturing needs. The current lease for our manufacturing facility in Singapore expires in June 2022. In the event that we need to add to our existing manufacturing space in Singapore or move our manufacturing facility to a new location in Singapore, such a move will involve significant expense and efforts in connection with the establishment of new clean rooms and the recommissioning of key manufacturing equipment, and we cannot assure you that such a move would not delay or otherwise adversely affect our manufacturing activities. We cannot provide assurances that we will be able to secure a lease on a different manufacturing facility on acceptable terms and on a timely basis, if at all, to meet our future manufacturing needs. Further, our anticipated growth will place additional strain on our suppliers and manufacturing facilities, resulting in an increased need for us to carefully monitor quality assurance. Any failure by us to manage our growth effectively could have an adverse effect on our ability to achieve our development and commercialization goals. Our products could have unknown defects or errors, which may give rise to claims against us, adversely affect market adoption of our systems, and adversely affect our business, financial condition, and results of operations. Our systems utilize novel and complex technology and such systems may develop or contain undetected defects or errors. We cannot assure you that material performance problems, defects, or errors will not arise, and as we increase the density and integration of our systems, these risks may increase. We generally provide warranties that our systems will meet performance expectations and will be free from defects. We also provide warranties relating to other parts of our systems. The costs incurred in correcting any defects or errors may be substantial and could adversely affect our operating margins. In manufacturing our products, including our systems, IFCs, and assays, we depend upon third parties for the supply of various components, many of which require a significant degree of technical expertise to produce. In addition, we purchase certain products from third-party suppliers for resale. If our suppliers fail to produce components to specification or provide defective products to us for resale and our quality control tests and procedures fail to detect such errors or defects, or if we or our suppliers use defective materials or workmanship in the manufacturing process, the reliability and performance of our products will be compromised. If our products contain defects, we may experience: a failure to achieve market acceptance or expansion of our product sales; loss of customer orders and delay in order fulfillment; damage to our brand reputation; increased cost of our warranty program due to product repair or replacement; product recalls or replacements; inability to attract new customers; diversion of resources from our manufacturing and research and development departments into our service department; and legal claims against us, including product liability claims, which could be costly and time consuming to defend and result in substantial damages. In addition, certain of our products are marketed for use with products sold by third parties. For example, our Access Array system is marketed as compatible with all major next-generation DNA sequencing instruments. If such third-party products are not produced to specification, are produced in accordance with modified specifications, or are defective, they may not be compatible with our products. In such case, the reliability and performance of our products may be compromised. The occurrence of any one or more of the foregoing could negatively affect our business, financial condition, and results of operations. To use our products, our Biomark and CyTOF systems in particular, customers typically need to purchase specialized reagents. Any interruption in the availability of these reagents for use in our products could limit our ability to market our products. Our products, our Biomark and CyTOF systems in particular, must be used in conjunction with one or more reagents designed to produce or facilitate the particular biological or chemical reaction desired by the user. Many of these reagents are highly specialized and available to the user only from a single supplier or a limited number of suppliers. Although we sell reagents for use with certain of our products, our customers may purchase these reagents directly from third-party suppliers, and we have no control over the supply of those materials. In addition, our products are designed to work with these reagents as they are currently formulated. We have no control over the formulation of reagents sold by third-party suppliers, and the performance of our products might be adversely affected if the formulation of these reagents is changed. If one or more of these reagents were to become unavailable or were reformulated, our ability to market and sell our products could be materially and adversely affected. In addition, the use of a reagent for a particular process may be covered by one or more patents relating to the reagent itself, the use of the reagent for the particular process, the performance of that process, or the equipment required to perform the process. Typically, reagent suppliers, who are either the patent holders or their authorized licensees, sell the reagents along with a license or covenant not to sue with respect to such patents. The license accompanying the sale of a reagent often purports to restrict the purposes for which the reagent may be used. If a patent holder or authorized licensee were to assert against us or our customers that the license or covenant relating to a reagent precluded its use with our systems, our ability to sell and market our products could be materially and adversely affected. For example, our Biomark system involves real-time quantitative PCR, or qPCR. Leading suppliers of reagents for real-time qPCR reactions include Life Technologies Corporation (now part of Thermo Fisher Scientific) and Roche Diagnostics Corporation, who are our direct competitors, and their licensees. These real-time qPCR reagents are typically sold pursuant to limited licenses or covenants not to sue with respect to patents held by these companies. We do not have any contractual supply agreements for these real-time qPCR reagents, and we cannot assure you that these reagents will continue to be available to our customers for use with our systems, or that these patent holders will not seek to enforce their patents against us, our customers, or suppliers. If we are unable to expand our direct sales and marketing force or distribution capabilities to adequately address our customers’ needs, our business may be adversely affected. We may not be able to market, sell, and distribute our products effectively enough to support our planned growth. We sell our products primarily through our own sales force and through distributors in certain territories. Our future sales will depend in large part on our ability to develop and substantially expand our direct sales force and to increase the scope of our marketing efforts. Our products are technically complex and used for highly specialized applications. As a result, we believe it is necessary to develop a direct sales force that includes people with specific scientific backgrounds and expertise, and a marketing group with technical sophistication. Competition for such employees is intense. We may not be able to attract and retain personnel or be able to build an efficient and effective sales and marketing force, which could negatively impact sales of our products and reduce our revenue and profitability. In addition, we may continue to enlist one or more sales representatives and distributors to assist with sales, distribution, and customer support globally or in certain regions of the world. If we do seek to enter into such arrangements, we may not be successful in attracting desirable sales representatives and distributors, or we may not be able to enter into such arrangements on favorable terms. If our sales and marketing efforts, or those of any third-party sales representatives and distributors, are not successful, our technologies and products may not gain market acceptance, which would materially and adversely impact our business operations. If we fail to maintain effective internal control over financial reporting in the future, the accuracy and timing of our financial reporting may be impaired, which could adversely affect our business and our stock price. The Sarbanes-Oxley Act requires, among other things, that we maintain effective internal control over financial reporting and disclosure controls and procedures. In particular, we must perform system and process evaluation and testing of our internal control over financial reporting to allow management to report on the effectiveness of our internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act. Our testing may reveal deficiencies in our internal control over financial reporting that are deemed to be material weaknesses. Our compliance with Section 404 requires that we incur substantial accounting expense and expend significant management time on compliance-related issues. We currently do not have an internal audit group, and we continue to evaluate our need for additional accounting and financial staff with appropriate public company experience and technical accounting knowledge. Moreover, if we do not comply with the requirements of Section 404, or if we or our independent registered public accounting firm identify deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock could decline and we could be subject to sanctions or investigations by the NASDAQ Global Select Market, or NASDAQ, the SEC or other regulatory authorities, which would require additional financial and management resources. Risks associated with a company-wide implementation of an enterprise resource planning, or ERP, system may adversely affect our business and results of operations or the effectiveness of internal control over financial reporting. We have been implementing a company-wide ERP system to handle the business and financial processes within our operations and corporate functions. ERP implementations are complex and time-consuming projects that involve substantial expenditures on system software and implementation activities that can continue for several years. ERP implementations also require transformation of business and financial processes in order to reap the benefits of the ERP system. Our business and results of operations may be adversely affected if we experience operating problems and/or cost overruns during the ERP implementation process, or if the ERP system and the associated process changes do not give rise to the benefits that we expect. If we do not effectively implement the ERP system as planned or if the system does not operate as intended, our business, results of operations, and internal controls over financial reporting may be adversely affected. Our future capital needs are uncertain and we may need to raise additional funds in the future, which may cause dilution to stockholders or may be upon terms that are not favorable to us. We believe that our existing cash and cash equivalents will be sufficient to meet our anticipated cash requirements for at least the next 18 months. However, we may need to raise substantial additional capital for various purposes, including: expanding the commercialization of our products; funding our operations; furthering our research and development; and acquiring other businesses or assets and licensing technologies. Our future funding requirements will depend on many factors, including: market acceptance of our products; the cost of our research and development activities; the cost of filing and prosecuting patent applications; the cost of defending, in litigation or otherwise, any claims that we infringe third-party patents or violate other intellectual property rights; the cost and timing of regulatory clearances or approvals, if any; the cost and timing of establishing additional sales, marketing, and distribution capabilities; the cost and timing of establishing additional technical support capabilities; the effect of competing technological and market developments; and the extent to which we acquire or invest in businesses, products, and technologies, although we currently have no commitments or agreements relating to any of these types of transactions. We cannot assure you that we will be able to obtain additional funds on acceptable terms, or at all. If we raise additional funds by issuing equity securities, our stockholders may experience dilution. Debt financing, if available, may involve covenants restricting our operations or our ability to incur additional debt. Any debt or additional equity financing that we raise may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or grant licenses on terms that are not favorable to us. If we are unable to raise adequate funds, we may have to liquidate some or all of our assets, delay development or commercialization of our products, or license to third parties the rights to commercialize products or technologies that we would otherwise seek to commercialize. We also may have to reduce marketing, customer support, or other resources devoted to our products, or cease operations. Any of these factors could harm our operating results. Our ability to use net operating losses to offset future taxable income may be subject to certain limitations. In general, under Section 382 of the Internal Revenue Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to utilize its pre-change net operating losses, or NOLs, to offset future taxable income. If we undergo one or more ownership changes, our ability to utilize NOLs could be limited by Section 382 of the Internal Revenue Code. Future changes in our stock ownership, some of which are outside of our control, could result in an ownership change under Section 382 of the Internal Revenue Code. Risks Related to Intellectual Property Our ability to protect our intellectual property and proprietary technology through patents and other means is uncertain. Our commercial success depends in part on our ability to protect our intellectual property and proprietary technologies. We rely on patent protection, where appropriate and available, as well as a combination of copyright, trade secret, and trademark laws, and nondisclosure, confidentiality, and other contractual restrictions to protect our proprietary technology. However, these legal means afford only limited protection and may not adequately protect our rights or permit us to gain or keep any competitive advantage. We apply for patents covering our products and technologies and uses thereof, as we deem appropriate. However, we may fail to apply for patents on important products and technologies in a timely fashion or at all. Our pending U.S. and foreign patent applications may not issue as patents or may not issue in a form that will be sufficient to protect our proprietary technology and gain or keep our competitive advantage. Any patents we have obtained or do obtain may be subject to re-examination, reissue, opposition, or other administrative proceeding, or may be challenged in litigation, and such challenges could result in a determination that the patent is invalid or unenforceable. In addition, competitors may be able to design alternative methods or devices that avoid infringement of our patents. Both the patent application process and the process of managing patent disputes can be time consuming and expensive. Furthermore, the laws of some foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States, and many companies have encountered significant problems in protecting and defending such rights in foreign jurisdictions. Proceedings to enforce our patent rights in foreign jurisdictions could result in substantial cost and divert our efforts and attention from other aspects of our business. Changes in either the patent laws or in interpretations of patent laws in the United States or other countries may diminish the value of our intellectual property. We cannot predict the breadth of claims that may be allowed or enforced in our patents or in third-party patents. For example: We might not have been the first to make the inventions covered by each of our pending patent applications; We might not have been the first to file patent applications for these inventions; The patents of others may have an adverse effect on our business; and Others may independently develop similar or alternative products and technologies or duplicate any of our products and technologies. To the extent our intellectual property, including licensed intellectual property, offers inadequate protection, or is found to be invalid or unenforceable, our competitive position and our business could be adversely affected. We may be involved in lawsuits to protect or enforce our patents and proprietary rights, to determine the scope, coverage and validity of others’ proprietary rights, or to defend against third party claims of intellectual property infringement, any of which could be time-intensive and costly and may adversely impact our business or stock price. Litigation may be necessary for us to enforce our patent and proprietary rights, determine the scope, coverage, and validity of others’ proprietary rights, and/or defend against third party claims of intellectual property infringement against us as well as against our suppliers, distributors, customers, and other entities with whom we do business. Litigation could result in substantial legal fees and could adversely affect the scope of our patent protection. The outcome of any litigation or other proceeding is inherently uncertain and might not be favorable to us, and we might not be able to obtain licenses to technology that we require. Even if such licenses are obtainable, they may not be available at a reasonable cost. We could therefore incur substantial costs related to royalty payments for licenses obtained from third parties, which could negatively affect our product margins or financial position. Further, we could encounter delays in product introductions, or interruptions in product sales, as we develop alternative methods or products. As we move into new markets and applications for our products, incumbent participants in such markets may assert their patents and other proprietary rights against us as a means of impeding our entry into such markets or as a means to extract substantial license and royalty payments from us. Our commercial success may depend in part on our non-infringement of the patents or proprietary rights of third parties. Numerous significant intellectual property issues have been litigated, and will likely continue to be litigated, between existing and new participants in our existing and targeted markets. For example, some of our products provide for the testing and analysis of genetic material, and patent rights relating to genetic materials remain a developing area of patent law. A recent U.S. Supreme Court decision held, among other things, that claims to isolated genomic DNA occurring in nature are not patent eligible, while claims relating to synthetic DNA may be patent eligible. We expect the ruling will result in additional litigation in our industry. In addition, third parties may assert that we are employing their proprietary technology without authorization. For example, on June 4, 2008 we received a letter from Applied Biosystems, Inc., a wholly-owned subsidiary of Life Technologies Corporation (now part of Thermo Fisher Scientific Inc. and collectively referred to as Life), asserting that our Biomark system for gene expression analysis infringes upon U.S. Patent No. 6,814,934, or the ‘934 patent, and its foreign counterparts in Europe and Canada. In June 2011, we resolved this dispute by entering into license agreements with Life which, among other matters, granted us a non-exclusive license to the ‘934 patent and its foreign counterparts. Our customers have been sued for various claims of intellectual property infringement in the past, and we expect that our customers will be involved in additional litigation in the future. In particular, our customers may become subject to lawsuits claiming that their use of our products infringes third-party patent rights, and we could become subject to claims that we contributed to or induced our customer’s infringement. In addition, our agreements with some of our suppliers, distributors, customers, and other entities with whom we do business may require us to defend or indemnify these parties to the extent they become involved in infringement claims against us, including the claims described above. We could also voluntarily agree to defend or indemnify third parties in instances where we are not obligated to do so if we determine it would be important to our business relationships. If we are required or agree to defend or indemnify any of these third parties in connection with any infringement claims, we could incur significant costs and expenses that could adversely affect our business, operating results, or financial condition. We depend on certain technologies that are licensed to us. We do not control these technologies and any loss of our rights to them could prevent us from selling our products, which would have an adverse effect on our business. We rely on licenses in order to be able to use various proprietary technologies that are material to our business, including our core IFC, multi-layer soft lithography, and mass cytometry technologies. In some cases, we do not control the prosecution, maintenance, or filing of the patents to which we hold licenses, or the enforcement of these patents against third parties. Our rights to use the technology we license are subject to the negotiation and continuation of those licenses. Certain of our licenses contain provisions that allow the licensor to terminate the license upon specific conditions. Our rights under the licenses are subject to our continued compliance with the terms of the license, including the payment of royalties due under the license. Because of the complexity of our products and the patents we have licensed, determining the scope of the license and related royalty obligation can be difficult and can lead to disputes between us and the licensor. An unfavorable resolution of such a dispute could lead to an increase in the royalties payable pursuant to the license. If a licensor believed we were not paying the royalties due under the license or were otherwise not in compliance with the terms of the license, the licensor might attempt to revoke the license. If such an attempt were successful and the license is terminated, we might be barred from marketing, producing, and selling some or all of our products, which would have an adverse effect on our business. For example, pursuant to the terms of a license agreement entered into with Life in June 2011, we were obligated to make a $1.0 million payment to Life upon satisfaction of certain conditions. On October 16, 2013, Life provided notice that the $1.0 million payment was due and payable under the license agreement. We believe that at least one of the conditions of the milestone payment remains unmet; however, we paid Life the amount due while reserving our rights with respect to such matter to, among other reasons, avoid what would have been, in our view, an improper termination of our license to certain Life patent filings under the agreement, which could have subjected our relevant product lines to risks associated with patent infringement litigation. We license certain intellectual property rights covering our mass cytometry products under agreements with several third parties. Termination of or disputes relating to any of these license agreements would have a material adverse effect on our business, operating results, and financial condition and could result in our inability to sell our mass cytometry products. The intellectual property rights covering our mass cytometry products depend in substantial part on license agreements with third parties, in particular MDS, Inc., or MDS, and also with other third parties such as Nodality, Inc., or Nodality. The licensed intellectual property rights of MDS as well as MDS’s rights and obligations under the license agreement between Fluidigm Canada Inc., or Fluidigm Canada, an Ontario corporation and wholly-owned subsidiary of Fluidigm Sciences, and MDS were subsequently assigned to and are now held by PerkinElmer Health Sciences, Inc., or PerkinElmer. Under the PerkinElmer license agreement, Fluidigm Canada received an exclusive, royalty bearing, worldwide license to certain patents that are now owned by PerkinElmer in the field of ICP-based mass cytometry, including the analysis of elemental tagged materials in connection therewith, and a non-exclusive license for reagents outside the field of ICP-based mass cytometry. Fluidigm Canada was also party to an interim license agreement, now expired, under which Nodality granted Fluidigm Canada a worldwide, non-exclusive, research use only, royalty bearing license to certain cytometric reagents, instruments, and other products. Fluidigm Canada and Nodality are currently in negotiations with respect to reinstating the license agreement and we cannot provide assurances that we will be able to reinstate or secure a new license agreement on acceptable terms, if at all. In addition, we are party to additional in-license agreements with parties such as Stanford University that relate to significant intellectual property rights, and our business and product development plans anticipate and will substantially depend on future in-license agreements with additional third parties, some of which are currently in the early discussion phase. In-licensed intellectual property rights that are fundamental to the business being operated present numerous risks relating to ownership and enforcement of intellectual property rights. For example, under the PerkinElmer license, Fluidigm Canada is not granted any right, and we do not have any right to bring enforcement actions with respect to the patents licensed from PerkinElmer, which could materially impair our ability to preclude competitors and other third parties from activities that we consider to infringe on our exclusively licensed rights. In other cases such as with Nodality, all or a portion of the license rights granted may be limited for research use only, and in the event we attempt to expand into diagnostic applications, we would be required to negotiate additional rights, which may not be available to us on commercially reasonable terms, if at all. In addition, Fluidigm Sciences’ licensors may generally terminate the applicable license agreement for uncured material breaches or if Fluidigm Sciences becomes insolvent, makes an assignment for the benefit of creditors, or has a petition in bankruptcy filed against it. Termination of material license agreements for any reason, including as a result of failure to obtain a required consent to assignment or as a result of an inability to negotiate a new or extended license where required, would result in a material loss of rights by us and would be expected to have a material adverse effect on our business, operating results, and financial condition. In particular, any such termination could prevent us from manufacturing and selling our products unless we can negotiate new license terms or develop or acquire alternative intellectual property rights that cover or enable similar functionality. While we do not believe that any existing material in-license agreements require the consent of the licensor in order for us to rely on these licenses, the question is not free from doubt, and one or more of our licensors could contend that the failure to obtain their consent constituted a breach or default under the applicable license agreement or require the negotiation of a new license. In particular, in May 2014, we received a written notice of PerkinElmer’s position that the license agreement between Fluidigm Canada and PerkinElmer requires, as a result of the acquisition, that PerkinElmer consent to negotiate a commercially reasonable license to Fluidigm. We continue to disagree with PerkinElmer's position concerning the impact of the acquisition on the license agreement and are currently in negotiations with PerkinElmer in an attempt to resolve this matter. In addition, we are evaluating alternative strategies and potential actions relating to our interests in the licensed intellectual property. In the case of a dispute over these or other terms of the applicable license agreements, including with respect to the license with PerkinElmer, we cannot provide assurances that we will be able to negotiate a new or amended license on commercially reasonable terms, if at all. Our potential dispute with PerkinElmer as well as any other disputes between us and one of Fluidigm Sciences’ existing licensors concerning the terms or conditions of the applicable license agreement could result, among other risks, in substantial management distraction; increased expenses associated with litigation or efforts to resolve disputes; substantial customer uncertainty concerning the direction of our proteomics product line; potential infringement claims against us and/or our customers, which could include efforts by a licensor to enjoin sales of our products; customer requests for indemnification by Fluidigm; and, in the event of an adverse determination, our inability to operate our business as currently operated. Any of these factors would be expected to have a material adverse effect on our business, operating results, and financial condition and could result in a substantial decline in our stock price. We are subject to certain manufacturing restrictions related to licensed technologies that were developed with the financial assistance of U.S. governmental grants. We are subject to certain U.S. government regulations because we have licensed technologies that were developed with U.S. government grants. In accordance with these regulations, these licenses provide that products embodying the technologies are subject to domestic manufacturing requirements. If this domestic manufacturing requirement is not met, the government agency that funded the relevant grant is entitled to exercise specified rights, referred to as “march-in rights,” which if exercised would allow the government agency to require the licensors or us to grant a non-exclusive, partially exclusive, or exclusive license in any field of use to a third party designated by such agency. All of our microfluidic systems revenue is dependent upon the availability of our IFCs, which incorporate technology developed with U.S. government grants. All of our instruments, including microfluidic systems, and IFCs for commercial sale are manufactured at our facility in Singapore. The federal regulations allow the funding government agency to grant, at the request of the licensors of such technology, a waiver of the domestic manufacturing requirement. Waivers may be requested prior to any government notification. We have assisted the licensors of these technologies with the analysis of the domestic manufacturing requirement, and, in December 2008, the sole licensor subject to the requirement applied for a waiver of the domestic manufacturing requirement with respect to the relevant patents licensed to us by this licensor. In July 2009, the funding government agency granted the requested waiver of the domestic manufacturing requirement for a three-year period commencing in July 2009. In June 2012, the licensor requested a continued waiver of the domestic manufacturing requirement with respect to the relevant patents, but the government agency has not yet taken any action in response to this request. If the government agency does not grant the requested waiver or the government fails to grant additional waivers of such requirement that may be sought in the future, then the U.S. government could exercise its march-in rights with respect to the relevant patents licensed to us. In addition, the license agreement under which the relevant patents are licensed to us contains provisions that obligate us to comply with this domestic manufacturing requirement. We are not currently manufacturing instruments and IFCs in the United States that incorporate the relevant licensed technology. If our lack of compliance with this provision constituted a material breach of the license agreement, the license of the relevant patents could be terminated or we could be compelled to relocate our manufacturing of microfluidic systems and IFCs to the United States to avoid or cure a material breach of the license agreement. Any of the exercise of march-in rights, the termination of our license of the relevant patents or the relocation of our manufacturing of microfluidic systems and IFCs to the United States could materially adversely affect our business, operations and financial condition. We are subject to certain obligations and restrictions relating to technologies developed in cooperation with Canadian government agencies. Some of our Canadian research and development is funded in part through government grants and by government agencies. The intellectual property developed through these projects is subject to rights and restrictions in favor of government agencies and Canadians generally. In most cases the government agency retains the right to use intellectual property developed through the project for non-commercial purposes and to publish the results of research conducted in connection with the project. This may increase the risk of public disclosure of information relating to our intellectual property, including confidential information, and may reduce its competitive advantage in commercializing intellectual property developed through these projects. In certain projects, we have also agreed to use commercially reasonable efforts to commercialize intellectual property in Canada, or more specifically in the province of Ontario, for the economic benefit of Canada and the province of Ontario. These restrictions will limit our choice of business and manufacturing locations, business partners and corporate structure and may, in certain circumstances, restrict our ability to achieve maximum profitability and cost efficiency from the intellectual property generated by these projects. In one instance, a dispute with the applicable government funded entity may require mediation, which could lead to unanticipated delays in our commercialization efforts to that project. One of our Canadian government funded projects is also subject to certain limited “march-in” rights in favor of the government of the Province of Ontario, under which we may be required to grant a license to our intellectual property, including background intellectual property developed outside the scope of the project, to a responsible applicant on reasonable terms in circumstances where the government determines that such a license is necessary in order to alleviate emergency or extraordinary health or safety needs or for public use. In addition, we must provide reasonable assistance to the government in obtaining similar licenses from third parties required in connection with the use of its intellectual property. Instances in which the government of the Province of Ontario has exercised similar “march-in” rights are rare; however, the exercise of such rights could materially adversely affect our business, operations and financial condition. We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of our employees’ former employers or other institutions or third parties with whom such employees may have been previously affiliated. Many of our employees were previously employed at universities or other life science or Ag-Bio companies, including our competitors or potential competitors. Although no claims against us are currently pending, we have in the past received notices from third parties alleging potential disclosures of confidential information. We may become subject to claims that our employees or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers or other third parties or institutions with whom our employees may have been previously affiliated. Litigation may be necessary to defend against these claims. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights. A loss of key research personnel work product could hamper or prevent our ability to commercialize certain potential products, which could severely harm our business. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management. Risks Related to Our Common Stock Our stock price may fluctuate significantly, particularly if holders of substantial amounts of our stock attempt to sell, and holders may have difficulty selling their shares based on current trading volumes of our stock. In addition, numerous other factors could result in substantial volatility in the trading price of our stock. Our stock is currently traded on NASDAQ, but we can provide no assurance that we will be able to maintain an active trading market on NASDAQ or any other exchange in the future. The trading volume of our stock tends to be low relative to our total outstanding shares, and we have several stockholders, including affiliated stockholders, who hold substantial blocks of our stock. As of March 31, 2015, we had 28,715,358 shares of common stock outstanding, and stockholders holding at least 5% of our stock, individually or with affiliated persons or entities, collectively beneficially owned or controlled approximately 62% of such shares. Sales of large numbers of shares by any of our large stockholders could adversely affect our trading price, particularly given our relatively small historic trading volumes. If stockholders holding shares of our common stock sell, indicate an intention to sell, or if it is perceived that they will sell, substantial amounts of their common stock in the public market, the trading price of our common stock could decline. Moreover, if there is no active trading market or if the volume of trading is limited, holders of our common stock may have difficulty selling their shares. In addition, the trading price of our common stock may be highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. These factors include: actual or anticipated quarterly variation in our results of operations or the results of our competitors; announcements or communications by us or our competitors relating to, among other things, new commercial products, technological advances, significant contracts, commercial relationships, capital commitments, acquisitions or sales of businesses, and/or misperceptions in or speculation by the market regarding such announcements or communications; issuance of new or changed securities analysts’ reports or recommendations for our stock; developments or disputes concerning our intellectual property or other proprietary rights; commencement of, or our involvement in, litigation; market conditions in the life science, Ag-Bio, and clinical research sectors; failure to complete significant sales; manufacturing disruptions that could occur if we were unable to successfully expand our production in our current or an alternative facility; any future sales of our common stock or other securities in connection with raising additional capital or otherwise; any major change to the composition of our board of directors or management; and general economic conditions and slow or negative growth of our markets. The stock market in general, and market prices for the securities of technology-based companies like ours in particular, have from time to time experienced volatility that often has been unrelated to the operating performance of the underlying companies. These broad market and industry fluctuations may adversely affect the market price of our common stock regardless of our operating performance. In several recent situations where the market price of a stock has been volatile, holders of that stock have instituted securities class action litigation against the company that issued the stock. If any of our stockholders were to bring a lawsuit against us, the defense and disposition of the lawsuit could be costly and divert the time and attention of our management and harm our operating results. If securities or industry analysts publish unfavorable research about our business or cease to cover our business, our stock price and/or trading volume could decline. The trading market for our common stock may rely, in part, on the research and reports that equity research analysts publish about us and our business. We do not have any control of the analysts or the content and opinions included in their reports. The price of our stock could decline if one or more equity research analysts downgrade our stock or issue other unfavorable commentary or research. If one or more equity research analysts ceases coverage of our company or fails to publish reports on us regularly, demand for our stock could decrease, which in turn could cause our stock price or trading volume to decline. Our directors, executive officers, and large stockholders have substantial control over and could limit your ability to influence the outcome of key transactions, including changes of control. As of March 31, 2015, our current executive officers, directors, stockholders holding at least 5% of our outstanding stock, and their respective affiliates, collectively beneficially owned or controlled approximately 63% of the outstanding shares of our common stock. Accordingly, these executive officers, directors, large stockholders, and their respective affiliates, acting as a group, can have substantial influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets, or any other significant corporate transactions. These stockholders may also delay or prevent a change of control of us, even if such a change of control would benefit our other stockholders. The significant concentration of stock ownership may adversely affect the trading price of our common stock due to investors’ perception that conflicts of interest may exist or arise. Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us, which may be beneficial to our stockholders, more difficult and may prevent attempts by our stockholders to replace or remove our current management and limit the market price of our common stock. Provisions in our certificate of incorporation and bylaws may have the effect of delaying or preventing a change of control or changes in our management, including provisions that: specify that special meetings of our stockholders can be called only by our board of directors, the chairman of the board, the chief executive officer or the president; establish an advance notice procedure for stockholder approvals to be brought before an annual meeting of our stockholders, including proposed nominations of persons for election to our board of directors; establish that our board of directors is divided into three classes, Class I, Class II, and Class III, with each class serving staggered three year terms; provide that our directors may be removed only for cause; provide that vacancies on our board of directors may be filled only by a majority of directors then in office, even though less than a quorum; specify that no stockholder is permitted to cumulate votes at any election of directors; and require a super-majority of votes to amend certain of the above-mentioned provisions. These provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management. In addition, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which limits the ability of stockholders owning in excess of 15% of our outstanding voting stock to merge or combine with us. We have never paid dividends on our capital stock, and we do not anticipate paying any cash dividends in the foreseeable future. We have paid no cash dividends on any of our classes of capital stock to date, have contractual restrictions against paying cash dividends, and currently intend to retain our future earnings to fund the development and growth of our business. As a result, capital appreciation, if any, of our common stock will be stockholders’ sole source of gain for the foreseeable future. Risks Related to Our Outstanding 2.75% Senior Convertible Notes due 2034 Our outstanding 2.75% senior convertible notes due 2034 are effectively subordinated to our secured debt and any liabilities of our subsidiaries. Our outstanding 2.75% senior convertible notes due 2034, which we refer to as our “notes”, rank: senior in right of payment to any of our indebtedness that is expressly subordinated in right of payment to the notes; equal in right of payment to all of our liabilities that are not so subordinated; effectively junior in right of payment to any of our secured indebtedness to the extent of the value of the assets securing such indebtedness; and structurally junior to all indebtedness and other liabilities (including trade payables) of our subsidiaries. In February 2014, we completed our offering of notes with an aggregate outstanding principal amount of $201.3 million. In the event of our bankruptcy, liquidation, reorganization, or other winding up, our assets that secure debt ranking senior in right of payment to the notes will be available to pay obligations on the notes only after the secured debt has been repaid in full from these assets, and the assets of our subsidiaries will be available to pay obligations on the notes only after all claims senior to the notes have been repaid in full. There may not be sufficient assets remaining to pay amounts due on any or all of the notes then outstanding. The indenture governing the notes does not prohibit us from incurring additional senior debt or secured debt, nor does it prohibit our subsidiaries from incurring additional liabilities. The notes are our obligations only and some of our operations are conducted through, and a portion of our consolidated assets are held by, our subsidiaries. The notes are our obligations exclusively and are not guaranteed by any of our operating subsidiaries. A portion of our consolidated assets is held by our subsidiaries. Accordingly, our ability to service our debt, including the notes, depends in part on the results of operations of our subsidiaries and upon the ability of such subsidiaries to provide us with cash, whether in the form of dividends, loans, or otherwise, to pay amounts due on our obligations, including the notes. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to make payments on the notes or to make any funds available for that purpose. In addition, dividends, loans, or other distributions to us from such subsidiaries may be subject to contractual and other restrictions and are subject to other business and tax considerations. Recent and future regulatory actions and other events may adversely affect the trading price and liquidity of the notes. We expect that many investors in, and potential purchasers of, the notes will employ, or seek to employ, a convertible arbitrage strategy with respect to the notes. Investors would typically implement such a strategy by selling short the common stock underlying the notes and dynamically adjusting their short position while continuing to hold the notes. Investors may also implement this type of strategy by entering into swaps on our common stock in lieu of or in addition to short selling the common stock. As a result, any specific rules regulating equity swaps or short selling of securities or other governmental action that interferes with the ability of market participants to effect short sales or equity swaps with respect to our common stock could adversely affect the ability of investors in, or potential purchasers of, the notes to conduct the convertible arbitrage strategy that we believe they will employ, or seek to employ, with respect to the notes. This could, in turn, adversely affect the trading price and liquidity of the notes. The SEC and other regulatory and self-regulatory authorities have implemented various rules and taken certain actions, and may in the future adopt additional rules and take other actions, that may impact those engaging in short selling activity involving equity securities (including our common stock). Such rules and actions include Rule 201 of SEC Regulation SHO, the adoption by the Financial Industry Regulatory Authority, Inc. and the national securities exchanges of a “Limit Up-Limit Down” program, the imposition of market-wide circuit breakers that halt trading of securities for certain periods following specific market declines, and the implementation of certain regulatory reforms required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Although the direction and magnitude of the effect that Regulation SHO, FINRA, securities exchange rule changes, and implementation of the Dodd-Frank Act may have on the trading price and the liquidity of the notes will depend on a variety of factors, many of which cannot be determined at the date of this report, past regulatory actions (such as certain emergency orders issued by the SEC in 2008 prohibiting short sales of stock of certain financial services companies) have had a significant impact on the trading prices and liquidity of convertible debt instruments. Any governmental or regulatory action that restricts the ability of investors in, or potential purchasers of, the notes to effect short sales of our common stock, borrow our common stock, or enter into swaps on our common stock or increases the costs of implementing an arbitrage strategy could adversely affect the trading price and the liquidity of the notes. Volatility in the market price and trading volume of our common stock could adversely impact the trading price of the notes. The stock market in recent years has experienced significant price and volume fluctuations that have often been unrelated to the operating performance of companies. The market price of our common stock could fluctuate significantly for many reasons, including in response to the risks described in this report, or for reasons unrelated to our operations, such as reports by industry analysts, investor perceptions or negative announcements by our customers, competitors or suppliers regarding their own performance, as well as industry conditions and general financial, economic and political instability. The market price of our common stock could also decline as a result of sales of a large number of shares of our common stock in the market, particularly sales by our directors, executive officers, employees, and significant stockholders, and the perception that these sales could occur may also depress the market price of our common stock. A decrease in the market price of our common stock would likely adversely impact the trading price of the notes. The market price of our common stock could also be affected by possible sales of our common stock by investors who view the notes as a more attractive means of equity participation in us and by hedging or arbitrage trading activity that we expect to develop involving our common stock. This trading activity could, in turn, affect the trading price of the notes. We may still incur substantially more debt or take other actions which would intensify the risks discussed above. We are not restricted under the terms of the indenture governing the notes from incurring additional debt, securing existing or future debt, recapitalizing our debt, or taking a number of other actions that are not limited by the terms of the indenture governing the notes that could have the effect of diminishing our ability to make payments on the notes when due. Any failure by us or any of our significant subsidiaries to make any payment at maturity of indebtedness for borrowed money in excess of $15 million or the acceleration of any such indebtedness in excess of $15 million would, subject to the terms of the indenture governing the notes, constitute a default under the indenture. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the notes when required. We may not have the ability to raise the funds necessary to repurchase the notes upon specified dates or upon a fundamental change, and our future debt may contain limitations on our ability to repurchase the notes. Holders of the notes have the right to require us to repurchase all or a portion of their notes on certain dates or upon the occurrence of a fundamental change at a repurchase price equal to 100% of the principal amount of the notes to be repurchased, plus accrued and unpaid interest, if any. We may not have enough available cash or be able to obtain financing at the time we are required to make repurchases of notes surrendered therefor. In addition, our ability to repurchase the notes may be limited by law, regulatory authority, or agreements governing our future indebtedness. Our failure to repurchase notes at a time when the repurchase is required by the indenture would constitute a default under the indenture. A default under the indenture or the fundamental change itself could also lead to a default under agreements governing our future indebtedness. If the repayment of the related indebtedness were to be accelerated after any applicable notice or grace periods, we may not have sufficient funds to repay the indebtedness and repurchase the notes when required. Holders of notes are not entitled to any rights with respect to our common stock, but they are subject to all changes made with respect to them to the extent our conversion obligation includes shares of our common stock. Holders of notes are not entitled to any rights with respect to our common stock (including, without limitation, voting rights and rights to receive any dividends or other distributions on our common stock) prior to the conversion date with respect to any notes they surrender for conversion, but they are subject to all changes affecting our common stock. For example, if an amendment is proposed to our certificate of incorporation or bylaws requiring stockholder approval and the record date for determining the stockholders of record entitled to vote on the amendment occurs prior to the conversion date with respect to any notes surrendered for conversion, then the holder surrendering such notes will not be entitled to vote on the amendment, although such holder will nevertheless be subject to any changes affecting our common stock. We have made only limited covenants in the indenture governing the notes, and these limited covenants may not protect a noteholder's investment. The indenture governing the notes does not: require us to maintain any financial ratios or specific levels of net worth, revenues, income, cash flows, or liquidity and, accordingly, does not protect holders of the notes in the event that we experience adverse changes in our financial condition or results of operations; limit our subsidiaries’ ability to guarantee or incur indebtedness that would rank structurally senior to the notes; limit our ability to incur additional indebtedness, including secured indebtedness; restrict our subsidiaries’ ability to issue securities that would be senior to our equity interests in our subsidiaries and therefore would be structurally senior to the notes; restrict our ability to repurchase our securities; restrict our ability to pledge our assets or those of our subsidiaries; or restrict our ability to make investments or pay dividends or make other payments in respect of our common stock or our other indebtedness. Furthermore, the indenture governing the notes contains only limited protections in the event of a change of control. We could engage in many types of transactions, such as acquisitions, refinancings, or certain recapitalizations, that could substantially affect our capital structure and the value of the notes and our common stock but may not constitute a “fundamental change” that permits holders to require us to repurchase their notes or a “make-whole fundamental change” that permits holders to convert their notes at an increased conversion rate. For these reasons, the limited covenants in the indenture governing the notes may not protect a noteholder's investment in the notes. The increase in the conversion rate for notes converted in connection with a make-whole fundamental change or provisional redemption may not adequately compensate noteholders for any lost value of the notes as a result of such transaction or redemption. If a make-whole fundamental change occurs prior to February 6, 2021 or upon our issuance of a notice of provisional redemption, under certain circumstances, we will increase the conversion rate by a number of additional shares of our common stock for notes converted in connection with such events. The increase in the conversion rate for notes converted in connection with such events may not adequately compensate noteholders for any lost value of the notes as a result of such transaction or redemption. In addition, if the price of our common stock in the transaction is greater than $180.00 per share or less than $39.96 per share (in each case, subject to adjustment), no additional shares will be added to the conversion rate. Moreover, in no event will the conversion rate per $1,000 principal amount of notes as a result of this adjustment exceed 25.0250 shares of common stock, subject to adjustment. Our obligation to increase the conversion rate for notes converted in connection with such events could be considered a penalty, in which case the enforceability thereof would be subject to general principles of reasonableness and equitable remedies. The conversion rate of the notes may not be adjusted for all dilutive events. The conversion rate of the notes is subject to adjustment for certain events, including, but not limited to, the issuance of certain stock dividends on our common stock, the issuance of certain rights or warrants, subdivisions, combinations, distributions of capital stock, indebtedness, or assets, cash dividends and certain issuer tender or exchange offers. However, the conversion rate will not be adjusted for other events, such as a third-party tender or exchange offer or an issuance of common stock for cash, that may adversely affect the trading price of the notes or our common stock. An event that adversely affects the value of the notes may occur, and that event may not result in an adjustment to the conversion rate. Some significant restructuring transactions may not constitute a fundamental change, in which case we would not be obligated to offer to repurchase the notes. Upon the occurrence of a fundamental change, a holder of notes has the right to require us to repurchase the notes. However, the fundamental change provisions will not afford protection to holders of notes in the event of other transactions that could adversely affect the notes. For example, transactions such as leveraged recapitalizations, refinancings, restructurings, or acquisitions initiated by us may not constitute a fundamental change requiring us to repurchase the notes. In the event of any such transaction, the holders would not have the right to require us to repurchase the notes, even though each of these transactions could increase the amount of our indebtedness, or otherwise adversely affect our capital structure or any credit ratings, thereby adversely affecting the holders of notes. In addition, absent the occurrence of a fundamental change or a make-whole fundamental change as described under changes in the composition of our board of directors will not provide holders with the right to require us to repurchase the notes or to an increase in the conversion rate upon conversion. We cannot assure noteholders that an active trading market will develop or be maintained for the notes. We do not intend to apply to list our outstanding convertible notes on any securities exchange or to arrange for quotation on any automated dealer quotation system. In addition, the liquidity of the trading market in the notes and the market price quoted for the notes may be adversely affected by changes in the overall market for this type of security and by changes in our financial performance or prospects or in the prospects for companies in our industry generally. As a result, we cannot assure noteholders that an active trading market will develop or be maintained for the notes. If an active trading market does not develop or is not maintained, the market price and liquidity of the notes may be adversely affected. In that case, noteholders may not be able to sell the notes at a particular time or at a favorable price. Any adverse rating of the notes may cause their trading price to fall. We do not intend to seek a rating on the notes. However, if a rating service were to rate the notes and if such rating service were to lower its rating on the notes below the rating initially assigned to the notes or otherwise announces its intention to put the notes on credit watch, the trading price of the notes could decline. Holders of notes may be subject to tax if we make or fail to make certain adjustments to the conversion rate of the notes even though they do not receive a corresponding cash distribution. The conversion rate of the notes is subject to adjustment in certain circumstances, including the payment of cash dividends. If the conversion rate is adjusted as a result of a distribution that is taxable to our common stockholders, such as a cash dividend, a noteholder may be deemed to have received a dividend subject to U.S. federal income tax without the receipt of any cash. In addition, a failure to adjust (or to adjust adequately) the conversion rate after an event that increases a noteholder's proportionate interest in us could be treated as a deemed taxable dividend to you. If a make-whole fundamental change occurs prior to February 6, 2021 or we provide notice of a provisional redemption, under some circumstances, we will increase the conversion rate for notes converted in connection with the make-whole fundamental change or provisional redemption. Such increase may also be treated as a distribution subject to U.S. federal income tax as a dividend. For a non-U.S. holder, any deemed dividend would be subject to U.S. federal withholding tax at a 30% rate, or such lower rate as may be specified by an applicable treaty, which may be set off against subsequent payments on the notes. Any conversions of the notes will dilute the ownership interest of our existing stockholders, including holders who had previously converted their notes. Any conversion of some or all of the notes will dilute the ownership interests of our existing stockholders. Any sales in the public market of our common stock issuable upon such conversion could adversely affect prevailing market prices of our common stock. In addition, the existence of the notes may encourage short selling by market participants because the conversion of the notes could depress the price of our common stock. After 15 years of service as our general counsel and more recently also as our executive vice president, legal affairs, William M. Smith has agreed with the company to increase his responsibility for operational and business development matters at Fluidigm. As previously disclosed, from February 2014 through October 2014, Mr. Smith led the operational and administrative aspects of integration of DVS Sciences, Inc. following its acquisition, and our chief executive officer has recently assigned him additional business development responsibility for our proteomics business. In connection with these new responsibilities, we anticipate that Mr. Smith will step down as our executive vice president, legal affairs and general counsel. Although no timeline has been established for Mr. Smith to relinquish his responsibility as our general counsel, we anticipate that his job function will increasingly focus on non-legal matters over time. Incorporated by Reference From by Reference Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of President and Chief Executive Officer Filed herewith Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Chief Financial Officer Furnished herewith XBRL Taxonomy Extension Schema Document XBRL Taxonomy Extension Definition Document In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 33-8238 and 34-47986, Final Rule: Management’s Reports on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed “filed” for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filings under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference. Dated: May 11, 2015 /s/ Gajus V. Worthington Gajus V. Worthington /s/ Vikram Jog Vikram Jog Quote for FLDM/ FLUIDIGM CORP Page FLUIDIGM CORP Reports Bankunited, inc. - 8-k, submission of matters to a vote of security holders

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professional_accounting

Document Type 10-Q Document Period End Date Sep. 30, 2015 Document Fiscal Period Focus Q1 Accounts receivable 6,812 5,088 Unbilled revenue 899 714 Inventory 1,246 2,935 Current portion of deferred financing costs 1,136 1,159 Deferred financing costs, net of current portion 4,147 4,415 Other accrued liabilities 9,631 10,441 Current portion of liability related to the sale of future royalties 11,862 7,906 Current portion of deferred revenue 858 333 Liability related to the sale of future royalties, net of current portion 186,967 191,756 Commitments and contingencies (Note E) Preferred stock, $0.01 par value; authorized 5,000 shares; no shares issued and outstanding Common stock, $0.01 par value; authorized 150,000 shares; issued and outstanding 86,981 and 86,579 shares as of September 30, 2015 and June 30, 2015, respectively 870 866 Total shareholders' equity 11,609 35,104 The carrying amount of consideration received or receivable from sale of future royalties as of the balance sheet date on potential earnings that were not recognized as revenue in conformity with GAAP, and which are expected to be recognized as such within one year or the normal operating cycle, if longer Name: imgn_LiabilityRelatedToSaleOfFutureRoyaltiesCurrent The noncurrent portion of deferred revenue related to sale of future royalties as of balance sheet date Name: imgn_LiabilityRelatedToSaleOfFutureRoyaltiesNoncurrent Net amount of current deferred finance costs capitalized at the end of the reporting period. Name: us-gaap_DeferredFinanceCostsCurrentNet Net amount of long-term deferred finance costs capitalized at the end of the reporting period. Name: us-gaap_DeferredFinanceCostsNoncurrentNet Amount after valuation and LIFO reserves of inventory expected to be sold, or consumed within one year or operating cycle, if longer. Amount of liabilities and equity items, including the portion of equity attributable to noncontrolling interests, if any. Amount of asset related to consideration paid in advance for costs that provide economic benefits in future periods, and amount of other assets that are expected to be realized or consumed within one year or the normal operating cycle, if longer. Amount after accumulated depreciation, depletion and amortization of physical assets used in the normal conduct of business to produce goods and services and not intended for resale. Examples include, but are not limited to, land, buildings, machinery and equipment, office equipment, and furniture and fixtures. Face amount or stated value per share of common stock. Face amount or stated value per share of preferred stock nonredeemable or redeemable solely at the option of the issuer. CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (USD $) License and milestone fees $ 6,070 $ 6,234 Royalty revenue 4,166 Non-cash royalty revenue related to the sale of future royalties 5,684 Research and development support 772 776 Clinical materials revenue 2,325 2,027 Total revenues 14,851 13,203 Research and development 35,132 28,018 Total operating expenses 43,461 35,113 Loss from operations (28,610) (21,910) Investment income, net 51 8 Non-cash interest expense on liability related to the sale of future royalties (5,143) Other expense, net (38) (380) Net loss (33,740) (22,282) Basic and diluted net loss per common share (in dollars per share) $ (0.39) $ (0.26) Basic and diluted weighted average common shares outstanding (in shares) 86,838 85,872 Total comprehensive loss $ (33,740) $ (22,282) Amount of the cost of borrowed funds accounted for as interest expense on liability related to the sale of future royalties. Name: imgn_NonCashInterestExpenseFromSaleOfFutureRoyalties Revenue earned from sale of future royalties during the period from the leasing or otherwise lending to a third party the entity's rights or title to certain property Name: imgn_NonCashRoyaltyRevenueRelatedToSaleOfFutureRoyalties Amount after tax of increase (decrease) in equity from transactions and other events and circumstances from net income and other comprehensive income, attributable to parent entity. Excludes changes in equity resulting from investments by owners and distributions to owners. Amount after accretion (amortization) of discount (premium), and investment expense, of interest income and dividend income on nonoperating securities. Amount of revenue recognized from goods sold, services rendered, insurance premiums, or other activities that constitute an earning process. Includes, but is not limited to, investment and interest income before deduction of interest expense when recognized as a component of revenue, and sales and trading gain (loss). Revenue earned during the period from the leasing or otherwise lending to a third party the entity's rights or title to certain property. Royalty revenue is derived from a percentage or stated amount of sales proceeds or revenue generated by the third party using the entity's property. Examples of property from which royalties may be derived include patents and oil and mineral rights. -Subparagraph (SX 210.5-03.1(e)) Name: us-gaap_RoyaltyRevenue Net loss $ (33,740) $ (22,282) Non-cash royalty revenue related to sale of future royalties (5,684) Non-cash interest expense on liability related to sale of future royalties 5,143 Gain on sale/disposal of fixed assets (6) Stock and deferred share unit compensation 5,783 5,410 Deferred rent 29 92 Accounts receivable (1,724) 58 Unbilled revenue (185) 545 Prepaid and other current assets 95 525 Other assets 62 105 Accounts payable 1,551 138 Accrued compensation (5,084) (3,153) Other accrued liabilities (871) 29 Deferred revenue 464 (2,983) Proceeds from landlord for tenant improvements 393 Net cash used for operating activities (31,351) (18,899) Purchases of property and equipment (3,377) (1,708) Net cash used for investing activities (3,377) (1,708) Proceeds from stock options exercised 4,462 144 Net cash provided by financing activities 4,462 144 Net change in cash and cash equivalents (30,266) (20,463) Cash and cash equivalents, beginning balance 278,109 142,261 Cash and cash equivalents, ending balance $ 247,843 $ 121,798 Amount of gain (loss) on sale or disposal of property, plant and equipment assets, including oil and gas property and timber property. Amount of cash inflow (outflow) of financing activities, excluding discontinued operations. Financing activity cash flows include obtaining resources from owners and providing them with a return on, and a return of, their investment; borrowing money and repaying amounts borrowed, or settling the obligation; and obtaining and paying for other resources obtained from creditors on long-term credit. Amount of cash inflow (outflow) of investing activities, excluding discontinued operations. Investing activity cash flows include making and collecting loans and acquiring and disposing of debt or equity instruments and property, plant, and equipment and other productive assets. Amount of cash inflow (outflow) from operating activities, excluding discontinued operations. Operating activity cash flows include transactions, adjustments, and changes in value not defined as investing or financing activities. Net cash outflow or inflow from monetary allowance granted by the landlord to a tenant to entice tenant to move into landlords building which will enable the tenant to prepare the leased premises for tenants occupancy. Name: us-gaap_PaymentsForProceedsFromTenantAllowance A.Summary of Significant Accounting Policies The accompanying unaudited consolidated financial statements at September 30, 2015 and June 30, 2015 and for the three months ended September 30, 2015 and 2014 include the accounts of ImmunoGen, Inc., or the Company, and its wholly owned subsidiaries, ImmunoGen Securities Corp., ImmunoGen Europe Limited and Hurricane, LLC. The consolidated financial statements include all of the adjustments, consisting only of normal recurring adjustments, which management considers necessary for a fair presentation of the Company’s financial position in accordance with accounting principles generally accepted in the U.S. for interim financial information. The June 30, 2015 condensed consolidated balance sheet data presented for comparative purposes was derived from our audited financial statements but certain information and footnote disclosures normally included in the Company’s annual financial statements have been condensed or omitted. The preparation of interim financial statements requires the use of management’s estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the interim financial statements and the reported amounts of revenues and expenditures during the reported periods. The results of the interim periods are not necessarily indicative of the results for the entire year. Accordingly, the interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended June 30, 2015. The Company has evaluated all events or transactions that occurred after September 30, 2015 up through the date the Company issued these financial statements. In October 2015, Sanofi initiated Phase I, first-in-human clinical testing of its ADC product candidate, SAR428926, triggering a $2 million development milestone payment to the Company. The Company did not have any other material recognizable or unrecognizable subsequent events during this period. The Company enters into licensing and development agreements with collaborative partners for the development of monoclonal antibody-based anticancer therapeutics. The terms of these agreements contain multiple deliverables which may include (i) licenses, or options to obtain licenses, to the Company’s antibody-drug conjugate, or ADC, technology, (ii) rights to future technological improvements, (iii) research activities to be performed on behalf of the collaborative partner, (iv) delivery of cytotoxic agents and (v) the manufacture of preclinical or clinical materials for the collaborative partner. Payments to the Company under these agreements may include upfront fees, option fees, exercise fees, payments for research activities, payments for the manufacture of preclinical or clinical materials, payments based upon the achievement of certain milestones and royalties on product sales. The Company follows the provisions of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 605-25, “Revenue Recognition—Multiple-Element Arrangements,” and ASC Topic 605-28, “Revenue Recognition-Milestone Method,” in accounting for these agreements. In order to account for these agreements, the Company must identify the deliverables included within the agreement and evaluate which deliverables represent separate units of accounting based on if certain criteria are met, including whether the delivered element has stand-alone value to the collaborator. The consideration received is allocated among the separate units of accounting, and the applicable revenue recognition criteria are applied to each of the separate units. At September 30, 2015, the Company had the following two types of agreements with the parties identified below: Development and commercialization licenses, which provide the party with the right to use the Company’s ADC technology and/or certain other intellectual property to develop compounds to a specified antigen target: Amgen (four exclusive single-target licenses(1)) Bayer HealthCare (one exclusive single-target license) Biotest (one exclusive single-target license) Lilly (three exclusive single-target licenses) Amgen has sublicensed one of its exclusive single-target licenses to Oxford BioTherapeutics Ltd. Novartis (five exclusive single-target licenses and one license to two related targets: one target on an exclusive basis and the second target on a non-exclusive basis) Roche, through its Genentech unit (five exclusive single-target licenses) Sanofi (one exclusive single-target license and one exclusive license to multiple individual targets) Research license/option agreement for a defined period of time to secure development and commercialization licenses to use the Company’s ADC technology to develop anticancer compounds to specified targets on established terms (referred to herein as right-to-test agreements): CytomX Takeda, through its wholly owned subsidiary, Millennium Pharmaceuticals, Inc. Development and Commercialization Licenses The deliverables under a development and commercialization license agreement generally include the license to the Company’s ADC technology with respect to a specified antigen target, and may also include deliverables related to rights to future technological improvements, research activities to be performed on behalf of the collaborative partner and the manufacture of preclinical or clinical materials for the collaborative partner. Generally, development and commercialization licenses contain non-refundable terms for payments and, depending on the terms of the agreement, provide that the Company will (i) at the collaborator’s request, provide research services at negotiated prices which are generally consistent with what other third parties would charge, (ii) at the collaborator’s request, manufacture and provide to it preclinical and clinical materials or deliver cytotoxic agents at negotiated prices which are generally consistent with what other third parties would charge, (iii) earn payments upon the achievement of certain milestones and (iv) earn royalty payments, generally until the later of the last applicable patent expiration or 10 to 12 years after product launch. In the case of Kadcyla, however, the minimum royalty term is 10 years and the maximum royalty term is 12 years on a country by country basis, regardless of patent protection. Royalty rates may vary over the royalty term depending on the Company’s intellectual property rights and/or the presence of comparable competing products. The Company may provide technical assistance and share any technology improvements with its collaborators during the term of the collaboration agreements. The Company does not directly control when or whether any collaborator will request research or manufacturing services, achieve milestones or become liable for royalty payments. As a result, the Company cannot predict when or if it will recognize revenues in connection with any of the foregoing. In determining the units of accounting, management evaluates whether the license has stand-alone value from the undelivered elements to the collaborative partner based on the consideration of the relevant facts and circumstances for each arrangement. Factors considered in this determination include the research capabilities of the partner and the availability of ADC technology research expertise in the general marketplace. If the Company concludes that the license has stand-alone value and therefore will be accounted for as a separate unit of accounting, the Company then determines the estimated selling prices of the license and all other units of accounting based on market conditions, similar arrangements entered into by third parties, and entity-specific factors such as the terms of the Company’s previous collaborative agreements, recent preclinical and clinical testing results of therapeutic products that use the Company’s ADC technology, the Company’s pricing practices and pricing objectives, the likelihood that technological improvements will be made, and, if made, will be used by the Company’s collaborators and the nature of the research services to be performed on behalf of its collaborators and market rates for similar services. Upfront payments on development and commercialization licenses are deferred if facts and circumstances dictate that the license does not have stand-alone value. Prior to the adoption of Accounting Standards Update (ASU) No. 2009-13, “Revenue Arrangements with Multiple Deliverables” on July 1, 2010, the Company determined that its licenses lacked stand-alone value and were combined with other elements of the arrangement and any amounts associated with the license were deferred and amortized over a certain period, which the Company refers to as the Company’s period of substantial involvement. The determination of the length of the period over which to defer revenue is subject to judgment and estimation and can have an impact on the amount of revenue recognized in a given period. Historically the Company’s involvement with the development of a collaborator’s product candidate has been significant at the early stages of development, and lessens as it progresses into clinical trials. Also, as a drug candidate gets closer to commencing pivotal testing the Company’s collaborators have sought an alternative site to manufacture their products, as the Company’s facility does not produce pivotal or commercial drug product. Accordingly, the Company generally estimates this period of substantial involvement to begin at the inception of the collaboration agreement and conclude at the end of non-pivotal Phase II testing. The Company believes this period of substantial involvement is, depending on the nature of the license, on average six and one-half years. Quarterly, the Company reassesses its periods of substantial involvement over which the Company amortizes its upfront license fees and makes adjustments as appropriate. In the event a collaborator elects to discontinue development of a specific product candidate under a development and commercialization license, but retains its right to use the Company’s technology to develop an alternative product candidate to the same target or a target substitute, the Company would cease amortization of any remaining portion of the upfront fee until there is substantial preclinical activity on another product candidate and its remaining period of substantial involvement can be estimated. In the event that a development and commercialization license were to be terminated, the Company would recognize as revenue any portion of the upfront fee that had not previously been recorded as revenue, but was classified as deferred revenue, at the date of such termination. Upfront payments on development and commercialization licenses may be recognized upon delivery of the license if facts and circumstances dictate that the license has stand-alone value from the undelivered elements, which generally include rights to future technological improvements, research services, delivery of cytotoxic agents and the manufacture of preclinical and clinical materials. The Company may also provide cytotoxic agents to its collaborators or produce preclinical and clinical materials at negotiated prices which are generally consistent with what other third parties would charge. The Company recognizes revenue on cytotoxic agents and on preclinical and clinical materials when the materials have passed all quality testing required for collaborator acceptance and title and risk of loss have transferred to the collaborator. Arrangement consideration allocated to the manufacture of preclinical and clinical materials in a multiple-deliverable arrangement is below the Company’s full cost, and the Company’s full cost is not expected to ever be below its contract selling prices for its existing collaborations. During the three months ended September 30, 2015 and 2014, the difference between the Company’s full cost to manufacture preclinical and clinical materials on behalf of its collaborators as compared to total amounts received from collaborators for the manufacture of preclinical and clinical materials was $7.0 million and $3.1 million, respectively. The majority of the Company’s costs to produce these preclinical and clinical materials are fixed and then allocated to each batch based on the number of batches produced during the period. Therefore, the Company’s costs to produce these materials are significantly impacted by the number of batches produced during the period. The volume of preclinical and clinical materials the Company produces is directly related to the number of clinical trials the Company and its collaborators are preparing for or currently have underway, the speed of enrollment in those trials, the dosage schedule of each clinical trial and the time period such trials last. Accordingly, the volume of preclinical and clinical materials produced, and therefore the Company’s per-batch costs to manufacture these preclinical and clinical materials, may vary significantly from period to period. The Company may also produce research material for potential collaborators under material transfer agreements. Additionally, the Company performs research activities, including developing antibody specific conjugation processes, on behalf of its collaborators and potential collaborators during the early evaluation and preclinical testing stages of drug development. The Company records amounts received for research materials produced or services performed as a component of research and development support revenue. The Company also develops conjugation processes for materials for later-stage testing and commercialization for certain collaborators. The Company is compensated at negotiated rates and may receive milestone payments for developing these processes which are recorded as a component of research and development support revenue. The Company’s development and commercialization license agreements have milestone payments which for reporting purposes are aggregated into three categories: (i) development milestones, (ii) regulatory milestones, and (iii) sales milestones. Development milestones are typically payable when a product candidate initiates or advances into different clinical trial phases. Regulatory milestones are typically payable upon submission for marketing approval with the U.S. Food and Drug Administration, or FDA, or other countries’ regulatory authorities or on receipt of actual marketing approvals for the compound or for additional indications. Sales milestones are typically payable when annual sales reach certain levels. At the inception of each agreement that includes milestone payments, the Company evaluates whether each milestone is substantive and at risk to both parties on the basis of the contingent nature of the milestone. This evaluation includes an assessment of whether (a) the consideration is commensurate with either (1) the entity’s performance to achieve the milestone, or (2) the enhancement of the value of the delivered item(s) as a result of a specific outcome resulting from the entity’s performance to achieve the milestone, (b) the consideration relates solely to past performance and (c) the consideration is reasonable relative to all of the deliverables and payment terms within the arrangement. The Company evaluates factors such as the scientific, regulatory, commercial and other risks that must be overcome to achieve the respective milestone, the level of effort and investment required to achieve the respective milestone and whether the milestone consideration is reasonable relative to all deliverables and payment terms in the arrangement in making this assessment. Non-refundable development and regulatory milestones that are expected to be achieved as a result of the Company’s efforts during the period of substantial involvement are considered substantive and are recognized as revenue upon the achievement of the milestone, assuming all other revenue recognition criteria are met. Milestones that are not considered substantive because the Company does not contribute effort to the achievement of such milestones are generally achieved after the period of substantial involvement and are recognized as revenue upon achievement of the milestone, as there are no undelivered elements remaining and no continuing performance obligations, assuming all other revenue recognition criteria are met. Under the Company’s development and commercialization license agreements, the Company receives royalty payments based upon its licensees’ net sales of covered products. Generally, under these agreements the Company is to receive royalty reports and payments from its licensees approximately one quarter in arrears, that is, generally in the third month of the quarter after the licensee has sold the royalty-bearing product or products. The Company recognizes royalty revenues when it can reliably estimate such amounts and collectability is reasonably assured. As such, the Company generally recognizes royalty revenues in the quarter reported to the Company by its licensees, or one quarter following the quarter in which sales by the Company’s licensees occurred. The Company’s right-to-test agreements provide collaborators the right to (a) test the Company’s ADC technology for a defined period of time through a research, or right-to-test, license, (b) take options, for a defined period of time, to specified targets and (c) upon exercise of those options, secure or “take” licenses to develop and commercialize products for the specified targets on established terms. Under these agreements, fees may be due to the Company (i) at the inception of the arrangement (referred to as “upfront” fees or payments), (ii) upon taking an option with respect to a specific target (referred to as option fees or payments earned, if any, when the option is “taken”), (iii) upon the exercise of a previously taken option to acquire a development and commercialization license(s) (referred to as exercise fees or payments earned, if any, when the development and commercialization license is “taken”), or (iv) some combination of all of these fees. For right-to-test agreements where the options to secure development and commercialization licenses to the Company’s ADC technology are considered substantive, the Company does not consider the development and commercialization licenses to be a deliverable at the inception of the agreement. For those right-to-test agreements entered into prior to the adoption of ASU No. 2009-13 where the options to secure development and commercialization licenses are considered substantive, the Company has deferred the upfront payments received and recognizes this revenue over the period during which the collaborator could elect to take options for development and commercialization licenses. These periods are specific to each collaboration agreement. If a collaborator takes an option to acquire a development and commercialization license under these agreements, any substantive option fee is deferred and recognized over the life of the option, generally 12 to 18 months. If a collaborator exercises an option and takes a development and commercialization license to a specific target, the Company attributes the exercise fee to the development and commercialization license. Upon exercise of an option to acquire a development and commercialization license, the Company would also attribute any remaining deferred option fee to the development and commercialization license and apply the multiple-element revenue recognition criteria to the development and commercialization license and any other deliverables to determine the appropriate revenue recognition, which will be consistent with the Company’s accounting policy for upfront payments on single-target licenses. In the event a right-to-test agreement were to be terminated, the Company would recognize as revenue any portion of the upfront fee that had not previously been recorded as revenue, but was classified as deferred revenue, at the date of such termination. None of the Company’s right-to-test agreements entered into subsequent to the adoption of ASU No. 2009-13 has been determined to contain substantive options. For right-to-test agreements where the options to secure development and commercialization licenses to the Company’s ADC technology are not considered substantive, the Company considers the development and commercialization licenses to be a deliverable at the inception of the agreement and applies the multiple-element revenue recognition criteria to determine the appropriate revenue recognition. None of the Company’s right-to-test agreements entered into prior to the adoption of ASU No. 2009-13 has been determined to contain non-substantive options. The Company does not directly control when or if any collaborator will exercise its options for development and commercialization licenses. As a result, the Company cannot predict when or if it will recognize revenues in connection with any of the foregoing. Cash and cash equivalents are primarily maintained with three financial institutions in the U.S. Deposits with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and, therefore, bear minimal risk. The Company’s cash equivalents consist of money market funds with underlying investments primarily being U.S. Government issued securities and high quality, short term commercial paper. Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents and marketable securities. The Company held no marketable securities as of September 30, 2015 and June 30, 2015. The Company’s investment policy, approved by the Board of Directors, limits the amount it may invest in any one type of investment, thereby reducing credit risk concentrations. All highly liquid financial instruments with maturities of three months or less when purchased are considered cash equivalents. As of September 30, 2015 and June 30, 2015, the Company held $247.8 million and $278.1 million, respectively, in cash and money market funds consisting principally of U.S. Government-issued securities and high quality, short-term commercial paper which were classified as cash and cash equivalents. Fair value is defined under ASC Topic 820, “Fair Value Measurements and Disclosures,” as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy to measure fair value which is based on three levels of inputs, of which the first two are considered observable and the last unobservable, as follows: Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. As of September 30, 2015, the Company held certain assets that are required to be measured at fair value on a recurring basis. The following table represents the fair value hierarchy for the Company’s financial assets measured at fair value on a recurring basis as of September 30, 2015 (in thousands): Fair Value Measurements at September 30, 2015 Using As of June 30, 2015, the Company held certain assets that are required to be measured at fair value on a recurring basis. The following table represents the fair value hierarchy for the Company’s financial assets measured at fair value on a recurring basis as of June 30, 2015 (in thousands): The fair value of the Company’s cash equivalents is based primarily on quoted prices from active markets. The majority of the Company’s unbilled revenue at September 30, 2015 and June 30, 2015 represents research funding earned prior to those dates based on actual resources utilized under the Company’s agreements with various collaborators. Inventory costs relate to clinical trial materials being manufactured for sale to the Company’s collaborators. Inventory is stated at the lower of cost or market as determined on a first-in, first-out (FIFO) basis. Inventory at September 30, 2015 and June 30, 2015 is summarized below (in thousands): Raw materials inventory consists entirely of DM1 and DM4, proprietary cell-killing agents the Company developed as part of its ADC technology. The Company considers more than a twelve month supply of raw materials that is not supported by firm, fixed orders and/or projections from its collaborators to be excess and establishes a reserve to reduce to zero the value of any such excess raw material inventory with a corresponding charge to research and development expense. In accordance with this policy, the Company recorded no expense related to excess inventory during the three-month period ended September 30, 2015 and $337,000 of expense during the three months ended September 30, 2014. Work in process inventory consists of conjugate manufactured for sale to the Company’s collaborators to be used in preclinical and clinical studies. All conjugate is made to order at the request of the collaborators and subject to the terms and conditions of respective supply agreements. As such, no reserve for work in process inventory is required. Basic and diluted net loss per share is calculated based upon the weighted average number of common shares outstanding during the period. During periods of income, participating securities are allocated a proportional share of income determined by dividing total weighted average participating securities by the sum of the total weighted average common shares and participating securities (the “two-class method”). Shares of the Company’s restricted stock participate in any dividends declared by the Company and are therefore considered to be participating securities. Participating securities have the effect of diluting both basic and diluted earnings per share during periods of income. During periods of loss, no loss is allocated to participating securities since they have no contractual obligation to share in the losses of the Company. Diluted (loss) income per share is computed after giving consideration to the dilutive effect of stock options and restricted stock that are outstanding during the period, except where such non-participating securities would be anti-dilutive. Options outstanding to purchase common stock and unvested restricted stock (in thousands) The Company’s common stock equivalents have not been included in any net loss per share calculation because their effect is anti-dilutive due to the Company’s net loss position. As of September 30, 2015, the Company is authorized to grant future awards under one employee share-based compensation plan, which is the ImmunoGen, Inc. 2006 Employee, Director and Consultant Equity Incentive Plan, or the 2006 Plan. At the annual meeting of shareholders on November 11, 2014, an amendment to the 2006 Plan was approved and an additional 5,500,000 shares were authorized for issuance under this plan. As amended, the 2006 Plan provides for the issuance of Stock Grants, the grant of Options and the grant of Stock-Based Awards for up to 17,500,000 shares of the Company’s common stock, as well as 1,676,599 shares of common stock which represent awards granted under the previous stock option plan, the ImmunoGen, Inc. Restated Stock Option Plan, or the Former Plan, that were forfeited, expired or were cancelled without delivery of shares of common stock or which resulted in the forfeiture of shares of common stock back to the Company between November 11, 2006 and June 30, 2014. Option awards are granted with an exercise price equal to the market price of the Company’s stock at the date of grant. Options vest at various periods of up to four years and may be exercised within ten years of the date of grant. The stock-based awards are accounted for under ASC Topic 718, “Compensation—Stock Compensation.” Pursuant to Topic 718, the estimated grant date fair value of awards is charged to the statement of operations and comprehensive loss over the requisite service period, which is the vesting period. Such amounts have been reduced by an estimate of forfeitures of all unvested awards. The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the assumptions noted in the following table. As the Company has not paid dividends since inception, nor does it expect to pay any dividends for the foreseeable future, the expected dividend yield assumption is zero. Expected volatility is based exclusively on historical volatility data of the Company’s stock. The expected term of stock options granted is based exclusively on historical data and represents the period of time that stock options granted are expected to be outstanding. The expected term is calculated for and applied to one group of stock options as the Company does not expect substantially different exercise or post-vesting termination behavior among its option recipients. The risk-free rate of the stock options is based on the U.S. Treasury rate in effect at the time of grant for the expected term of the stock options. Using the Black-Scholes option-pricing model, the weighted average grant date fair values of options granted during the three months ended September 30, 2015 and 2014 were $10.31 and $6.27 per share, respectively. Stock compensation expense related to stock options and restricted stock awards granted under the 2006 Plan was $5.7 million and $5.3 million during the three months ended September 30, 2015 and 2014, respectively. As of September 30, 2015, the estimated fair value of unvested employee awards was $35 million, net of estimated forfeitures. The weighted-average remaining vesting period for these awards is approximately two and a half years. During the three months ended September 30, 2015, holders of options issued under the Company’s equity plans exercised their rights to acquire an aggregate of approximately 402,000 shares of common stock at prices ranging from $3.19 to $17.00 per share. The total proceeds to the Company from these option exercises were approximately $4.5 million. During the three months ended September 30, 2015, the Company continued to operate in one operating segment which is the business of discovery of monoclonal antibody-based anticancer therapeutics. The percentages of revenues recognized from significant customers of the Company in the three months ended September 30, 2015 and 2014 are included in the following table: There were no other customers of the Company with significant revenues in the three months ended September 30, 2015 and 2014. In May 2014, the FASB issued Accounting Standards Update 2014-9, Revenue from Contracts with Customers (Topic 606) (“ASU 2014-09”), to clarify the principles for recognizing revenue. This update provides a comprehensive new revenue recognition model that requires revenue to be recognized in a manner to depict the transfer of goods or services to a customer at an amount that reflects the consideration expected to be received in exchange for those goods or services. The original effective date would have required the Company to adopt beginning in its first quarter of fiscal 2018. In July 2015, the FASB voted to amend ASU 2014-09 by approving a one-year deferral of the effective date as well as providing the option to early adopt the standard on the original effective date. Accordingly, the Company may adopt the standard in either its first quarter of fiscal 2018 or 2019. The new revenue standard allows for either full retrospective or modified retrospective application. The Company is currently evaluating the timing of its adoption, the transition method to apply and the impact that this guidance will have on its consolidated financial statements and related disclosures. In August 2014, the FASB issued Accounting Standards Update 2014-15, Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. This new standard gives a company’s management the final responsibilities to decide whether there’s substantial doubt about the company’s ability to continue as a going concern and to provide related footnote disclosures. The standard provides guidance to management, with principles and definitions that are intended to reduce diversity in the timing and content of disclosures that companies commonly provide in their footnotes. Under the new standard, management must decide whether there are conditions or events, considered in the aggregate, that raise substantial doubt about the company’s ability to continue as a going concern within one year after the date that the financial statements are issued, or within one year after the date that the financial statements are available to be issued when applicable. This guidance is effective for annual reporting beginning after December 15, 2016, including interim periods within the year of adoption, with early application permitted. Accordingly, the standard is effective for the Company on July 1, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements. In April 2015, the FASB issued Accounting Standards Update 2015-03, Interest-Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. To simplify presentation of debt issuance costs, this new standard requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected by this update. This guidance is effective for annual reporting beginning after December 15, 2015, including interim periods within the year of adoption, and calls for retrospective application, with early application permitted. Accordingly, the standard is effective for the Company on July 1, 2016. The Company’s consolidated balance sheet as of September 30, 2015 includes in assets $5.3 million of debt issuance costs classified as deferred financing costs. In July 2015, the FASB issued Accounting Standards Update 2015-11, Simplifying the Measurement of Inventory (Topic 330). To simplify the principles for subsequent measurement of inventory, this new standard requires inventory measured using any method other than LIFO or the retail method shall be measured at the lower of cost and net realizable value, rather than lower of cost or market. This guidance is effective for annual reporting beginning after December 15, 2016, including interim periods within the year of adoption, and calls for prospective application, with early application permitted. Accordingly, the standard is effective for the Company on July 1, 2017. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements. Collaborative Agreements B.Collaborative Agreements Eli Lilly and Company (Lilly) had the right to take three exclusive development and commercialization licenses under a right-to-test agreement established in December 2011, and took these licenses prior to the expiration of the agreement in December 2014. The Company received a $20 million upfront payment in connection with the execution of the right-to-test agreement in 2011. Under the terms of this right-to-test agreement, the first license had no associated exercise fee, and the second and third licenses each had a $2 million exercise fee. The first development and commercialization license was taken in August 2013 and the agreement was amended in December 2013 to provide Lilly with an extension provision and retrospectively include a $2 million exercise fee for the first license in lieu of the fee due for either the second or third license. The second and third licenses were taken in December 2014, with one including the $2 million exercise fee and the other not. Under the two licenses with the $2 million exercise fee, the Company is entitled to receive up to a total of $199 million in milestone payments, plus royalties on the commercial sales of any resulting products. Under the license taken in December 2014 without the exercise fee, the Company is entitled to receive up to a total of $200.5 million in milestone payments, plus royalties on the commercial sales of any resulting products. The total milestones are categorized as follows: development milestones—$29 million for the two development and commercialization licenses with the $2 million exercise fee, and $30.5 million for the one development and commercialization license with no exercise fee; regulatory milestones—$70 million in all cases; and sales milestones—$100 million in all cases. In September 2015, Lilly initiated Phase I, first-in-human clinical testing of its ADC product candidate, LY3076226, triggering a $5 million milestone payment to the Company which is included in license and milestone fee revenue for the three months ended September 30, 2015. The next payment the Company could receive would be either a $9 million milestone for commencement of a Phase II clinical trial under this license or a $5 million development milestone payment with the commencement of a Phase I clinical trial under either of its other two licenses. At the time of execution of this agreement, there was significant uncertainty as to whether these milestones would be achieved. In consideration of this, as well as the Company’s expected involvement in the research and manufacturing of these product candidates, these milestones were deemed substantive. The Company also is entitled to receive payments for delivery of cytotoxic agents to Lilly and research and development activities performed on behalf of Lilly. Lilly is responsible for the manufacturing, product development and marketing of any products resulting from this collaboration. Under a now-expired right-to-test agreement, in September 2009, November 2009 and December 2012, Amgen took three exclusive development and commercialization licenses, for which the Company received an exercise fee of $1 million for each license taken. In May 2013, Amgen took one non-exclusive development and commercialization license, for which the Company received an exercise fee of $500,000. In October 2013, the non-exclusive license was amended and converted to an exclusive license, for which Amgen paid an additional $500,000 fee to the Company. Amgen has sublicensed its rights under this license to Oxford BioTherapeutics Ltd. For each development and commercialization license taken, the Company is entitled to receive up to a total of $34 million in milestone payments, plus royalties on the commercial sales of any resulting products. The total milestones per license are categorized as follows: development milestones—$9 million; regulatory milestones—$20 million; and sales milestones—$5 million. Amgen (or its sublicensee(s)) is responsible for the manufacturing, product development and marketing of any products resulting from these development and commercialization licenses. In September 2015, the IND application for its third ADC product candidate became effective, triggering a $1 million milestone payment to the Company which is included in license and milestone fee revenue for the three months ended September 30, 2015. In November 2011, the IND applications to the FDA for its product candidates AMG 595 and AMG 172 became effective, which triggered two $1 million milestone payments to the Company. The next potential milestone the Company will be entitled to receive under these three licenses will be a development milestone for the first dosing of a patient in a Phase II clinical trial, which will result in a $3 million payment being due. The next potential milestone the Company will be entitled to receive under the May 2013 license will be a $1 million development milestone for an IND becoming effective. At the time of execution of each of these development and commercialization licenses, there was significant uncertainty as to whether these milestones would be achieved. In consideration of this, as well as the Company’s past involvement in the research and manufacturing of these product candidates, these milestones were deemed substantive. In July 2003, the Company entered into a broad collaboration agreement with Sanofi (formerly Aventis) to discover, develop and commercialize antibody-based products. The collaboration agreement provides Sanofi with worldwide development and commercialization rights to new antibody-based products directed to targets that are included in the collaboration, including the exclusive right to use the Company’s maytansinoid ADC technology in the creation of products developed to these targets. The product candidates (targets) as of September 30, 2015 in the collaboration include SAR650984 (CD38), SAR566658 (CA6), SAR408701 (CEACAM5) and one earlier-stage compound that has yet to be disclosed. We are entitled to receive milestone payments potentially totaling $21.5 million, per target, plus royalties on the commercial sales of any resulting products. The total milestones are categorized as follows: development milestones—$7.5 million; and regulatory milestones—$14 million. Through September 30, 2015, the Company has received and recognized an aggregate of $20.5 million in milestone payments for compounds covered under this agreement now or in the past, including a $3 million development milestone related to initiation of a Phase IIb clinical trial (as defined in the agreement) for SAR650984 and a $1 million development milestone related to initiation of a Phase I clinical trial for SAR408701 which are included in license and milestone fee revenue for the three months ended September 30, 2014. In December 2006, we entered into a right-to-test agreement with Sanofi. The agreement provides Sanofi with the right to (a) test the Company’s maytansinoid ADC technology with Sanofi’s antibodies to targets under a right-to-test, or research, license, (b) take exclusive options, with certain restrictions, to specified targets for specified option periods and (c) upon exercise of those options, take exclusive licenses to use the Company’s maytansinoid ADC technology to develop and commercialize products directed to the specified targets on terms agreed upon at the inception of the right-to-test agreement. Sanofi no longer has the right to take additional options under the agreement, although multiple outstanding options remain in effect for the remainder of their respective option periods. For each development and commercialization license taken, the Company is entitled to receive an exercise fee of $2 million and up to a total of $30 million in milestone payments, plus royalties on the commercial sales of any resulting products. The total milestones are categorized as follows: development milestones—$10 million; and regulatory milestones—$20 million. In December 2013, Sanofi took its first exclusive development and commercialization license under the right-to-test agreement, for which the Company received an exercise fee of $2 million and was recognizing this amount as revenue ratably over the Company’s estimated period of its substantial involvement. The Company had previously estimated this development period would conclude at the end of non-pivotal Phase II testing. During the first quarter of fiscal 2015, the Company determined it will not be substantially involved in the development and commercialization of the product based on Sanofi’s current plans to develop and manufacture the product without the Company’s assistance. As a result of this determination, we recognized the balance of the upfront exercise fee during the prior period. This change in estimate resulted in an increase to license and milestone fees of $1.7 million for the three months ended September 30, 2014 compared to amounts that would have been recognized pursuant to the Company’s previous estimate. Pursuant to the license agreement noted above, in October 2015, Sanofi initiated Phase I, first-in-human clinical testing of its ADC product candidate, SAR428926, triggering a $2 million development milestone payment to the Company. The next milestone payment the Company could receive would be a $4 million development milestone for commencement of a Phase IIb clinical trial (as defined in the agreement) under this license. At the time of execution of this agreement, there was significant uncertainty as to whether these milestones would be achieved. In consideration of this, as well as the Company’s past involvement in the research and manufacturing of Sanofi’s product candidates, these milestones were deemed substantive. For additional information related to these agreements, as well as the Company’s other significant collaborative agreements, please read Note C, Agreements to our consolidated financial statements included within the Company’s 2015 Form 10-K. Liability Related to Sale of Future Royalties Liabilities Related to Sale of Future Royalties C. Liability Related to Sale of Future Royalties In April 2015, Immunity Royalty Holdings, L.P. (IRH) purchased the right to receive 100% of the royalty payments on commercial sales of Kadcyla arising under the Company’s development and commercialization license with Genentech, until IRH has received aggregate royalties equal to $235 million or $260 million, depending on when the aggregate royalties received by IRH reach a specified milestone. Once the applicable threshold is met, if ever, the Company will thereafter receive 85% and IRH will receive 15% of the Kadcyla royalties for the remaining royalty term. At consummation of the transaction in April 2015, the Company received cash proceeds of $200 million. As part of this sale, the Company incurred $5.9 million of transaction costs, which are presented in the accompanying consolidated balance sheet as deferred financing costs and will be amortized to interest expense over the estimated life of the royalty purchase agreement. Although the Company sold its rights to receive royalties from the sales of Kadcyla, as a result of its ongoing involvement in the cash flows related to these royalties, the Company will continue to account for these royalties as revenue and recorded the $200 million in proceeds from this transaction as a liability related to sale of future royalties (Royalty Obligation) that will be amortized using the interest method over the estimated life of the royalty purchase agreement. The following table shows the activity within the liability account during the three-month period ended September 30, 2015 (in thousands): Period from June 30, 2015 to Liability related to sale of future royalties — beginning balance Non-cash Kadcyla royalty revenue Non-cash interest expense recognized Liability related to sale of future royalties — ending balance As royalties are remitted to IRH, the balance of the Royalty Obligation will be effectively repaid over the life of the agreement. In order to determine the amortization of the Royalty Obligation, the Company is required to estimate the total amount of future royalty payments to be received and remitted to IRH as noted above over the life of the agreement. The sum of these amounts less the $200 million proceeds the Company received will be recorded as interest expense over the life of the Royalty Obligation. Since inception, the Company’s estimate of this total interest expense resulted in an effective annual interest rate of 9.8%. The Company periodically assesses the estimated royalty payments to IRH and to the extent such payments are greater or less than its initial estimates, or the timing of such payments is materially different than its original estimates, the Company will prospectively adjust the amortization of the Royalty Obligation. There are a number of factors that could materially affect the amount and timing of royalty payments from Genentech, most of which are not within the Company’s control. Such factors include, but are not limited to, changing standards of care, the introduction of competing products, manufacturing or other delays, biosimilar competition, patent protection, adverse events that result in governmental health authority imposed restrictions on the use of the drug products, significant changes in foreign exchange rates as the royalties remitted to IRH are made in U.S. dollars (USD) while significant portions of the underlying sales of Kadcyla are made in currencies other than USD, and other events or circumstances that could result in reduced royalty payments from Kadcyla, all of which would result in a reduction of non-cash royalty revenues and the non-cash interest expense over the life of the Royalty Obligation. Conversely, if sales of Kadcyla are more than expected, the non-cash royalty revenues and the non-cash interest expense recorded by the Company would be greater over the term of the Royalty Obligation. In addition, the royalty purchase agreement grants IRH the right to receive certain reports and other information relating to the royalties and contains other representations and warranties, covenants and indemnification obligations that are customary for a transaction of this nature. The entire disclosure of liabilities related to the sale of future royalties. Name: imgn_LiabilityRelatedToSaleOfFutureRoyaltiesTextBlock Name: us-gaap_DeferredRevenueDisclosureAbstract D. Capital Stock During the three months ended September 30, 2015, the Company recorded approximately ($30,000) in expense reduction, respectively, related to stock units outstanding under the Company’s 2001 Non-Employee Director Stock Plan, or the 2001 Plan, compared to ($8,000) in expense reduction recorded during the three months ended September 30, 2014. The value of the stock units are classified as a liability and adjusted to market value at each reporting period as the redemption amount of stock units for this plan will be paid in cash. No stock units have been issued under the 2001 Plan subsequent to June 30, 2004. On November 12, 2013, the Board amended the Compensation Policy for Non-Employee Directors to make certain changes to the compensation of its non-employee directors, including an increase in the fees paid in cash to the non-employee directors. Under the terms of the amended policy, the redemption amount of deferred share units issued will continue to be paid in shares of common stock of the Company on the date a director ceases to be a member of the Board. Annual retainers vest quarterly over approximately one year from the date of grant, contingent upon the individual remaining a director of ImmunoGen as of each vesting date. The number of deferred share units awarded is now fixed per the plan on the date of the award and is no longer based on the market price of the Company’s common stock on the date of the award. All unvested deferred stock awards will automatically vest immediately prior to the occurrence of a change of control. In addition to the deferred share units, the Non-Employee Directors are also entitled to receive a fixed number of stock options determined using the Black-Scholes option pricing model measured on the date of grant, which would be the date of the annual meeting of shareholders. These options vest quarterly over approximately one year from the date of grant. Any new directors will receive a pro-rated award, depending on their date of election to the Board. The directors received a total of 80,000 stock options in each fiscal year 2015 and 2014, and the related compensation expense for the three months ended September 30, 2015 and 2014 is included in the amounts discussed in the “Stock-Based Compensation” section of footnote A above. During the three months ended September 30, 2015, the Company recorded approximately $82,000 in compensation expense, respectively, related to deferred share units issued and outstanding under the Company’s Compensation Policy for Non-Employee Directors, compared to $118,000 in compensation expense recorded during the three months ended September 30, 2014. The entire disclosure for accounts comprising shareholders' equity, comprised of portions attributable to the parent entity and noncontrolling interest, including other comprehensive income, and compensation-related costs for equity-based compensation. Includes, but is not limited to, disclosure of policies, compensation plan details, equity-based arrangements to obtain goods and services, deferred compensation arrangements, and employee stock purchase plan details. E. Commitments and Contingencies Effective July 27, 2007, the Company entered into a lease agreement with Intercontinental Fund III for the rental of approximately 89,000 square feet of laboratory and office space at 830 Winter Street, Waltham, MA through March 2020. The Company uses this space for its corporate headquarters and other operations. In December 2013, the Company modified its lease agreement at 830 Winter Street, Waltham, MA to include approximately 19,000 square feet of additional office space through 2020, concurrent with the remainder of the original lease term. As part of the lease amendment, the Company received a construction allowance of approximately $746,000 to build out office space to the Company’s specifications. The Company obtained physical control of the additional space to begin construction in January 2014. In April, 2014, the Company again modified its lease agreement at this site to extend the lease to 2026. The Company may extend the lease for two additional terms of five years. As part of this lease amendment, the Company received a construction allowance of approximately $1.1 million to build out office space to the Company’s specifications. The Company is required to pay certain operating expenses for the leased premises subject to escalation charges for certain expense increases over a base amount. The Company also leases manufacturing and office space at 333 Providence Highway, Norwood, MA under an agreement through 2018 with an option to extend the lease for an additional term of five years. The Company is required to pay certain operating expenses for the leased premises subject to escalation charges for certain expense increases over a base amount. Effective April 2013, the Company entered into a lease agreement with River Ridge Limited Partnership for the rental of 7,507 square feet of additional office space at 100 River Ridge Drive, Norwood, MA. The initial term of the lease is for five years and two months commencing in July 2013 with an option for the Company to extend the lease for an additional term of five years. The Company is required to pay certain operating expenses for the leased premises subject to escalation charges for certain expense increases over a base amount. The Company entered into a sublease in December 2014 for this space, effective January 2015 through July 2018. The minimum rental commitments for the Company’s facilities, including real estate taxes and other expenses, for the next five fiscal years and thereafter under the non-cancelable operating lease agreements discussed above are as follows (in thousands): 2016 (nine months remaining) Total minimum rental payments from sublease There are no obligations under capital leases as of September 30, 2015, as all of the capital leases were single payment obligations which have all been made. The Company is contractually obligated to make potential future success-based development, regulatory or sales milestone payments in conjunction with certain collaborative agreements. These payments are contingent upon the occurrence of certain future events and, given the nature of these events, it is unclear when, if ever, the Company may be required to pay such amounts. Further, the timing of any future payment is not reasonably estimable. As of September 30, 2015, the maximum amount that may be payable in the future under the Company’s current collaborative agreements is $162 million, $1.4 million of which is reimbursable by a third party under a separate agreement. Disclosure of accounting policy for financial instruments and concentration of credit risk. Name: imgn_FinancialInstrumentsAndConcentrationOfCreditRiskPolicyTextBlock Disclosure of accounting policy for cash and cash equivalents, including the policy for determining which items are treated as cash equivalents. Other information that may be disclosed includes (1) the nature of any restrictions on the entity's use of its cash and cash equivalents, (2) whether the entity's cash and cash equivalents are insured or expose the entity to credit risk, (3) the classification of any negative balance accounts (overdrafts), and (4) the carrying basis of cash equivalents (for example, at cost) and whether the carrying amount of cash equivalents approximates fair value. -Name Financial Reporting Release (FRR) -Paragraph 02-03 Name: us-gaap_CashAndCashEquivalentsPolicyTextBlock Disclosure of accounting policy for determining the fair value of financial instruments. Name: us-gaap_FairValueOfFinancialInstrumentsPolicy Disclosure of accounting policy for major classes of inventories, bases of stating inventories (for example, lower of cost or market), methods by which amounts are added and removed from inventory classes (for example, FIFO, LIFO, or average cost), loss recognition on impairment of inventories, and situations in which inventories are stated above cost. If inventory is carried at cost, this disclosure includes the nature of the cost elements included in inventory. -Paragraph b -Subparagraph i, ii Disclosure of accounting policy for revenue recognition. If the entity has different policies for different types of revenue transactions, the policy for each material type of transaction is generally disclosed. If a sales transaction has multiple element arrangements (for example, delivery of multiple products, services or the rights to use assets) the disclosure may indicate the accounting policy for each unit of accounting as well as how units of accounting are determined and valued. The disclosure may encompass important judgment as to appropriateness of principles related to recognition of revenue. The disclosure also may indicate the entity's treatment of any unearned or deferred revenue that arises from the transaction. -Section B -Paragraph Question 1 -Subparagraph (SAB TOPIC 13.B.Q1) Name: us-gaap_RevenueRecognitionPolicyTextBlock Disclosure of accounting policy for segment reporting. Name: us-gaap_SegmentReportingPolicyPolicyTextBlock Disclosure of accounting policy for stock option and stock incentive plans. This disclosure may include (1) the types of stock option or incentive plans sponsored by the entity (2) the groups that participate in (or are covered by) each plan (3) significant plan provisions and (4) how stock compensation is measured, and the methodologies and significant assumptions used to determine that measurement. Disclosure of accounting policy for reporting subsequent events. Name: us-gaap_SubsequentEventsPolicyPolicyTextBlock Disclosure of accounting policy for treatment of receivables that are billable but have not been billed as of the balance sheet date. Name: us-gaap_TradeAndOtherAccountsReceivableUnbilledReceivablesPolicy Schedule of assets that are required to be measured at fair value on a recurring basis Schedule of inventory Schedule of common stock equivalents, as calculated in accordance with the treasury-stock method Schedule of weighted-average assumptions used to estimate the fair value of each stock option Schedule of percentage of total revenues recognized from each significant customer Tabular disclosure of assets, including [financial] instruments measured at fair value that are classified in stockholders' equity, if any, by class that are measured at fair value on a recurring basis. The disclosures contemplated herein include the fair value measurements at the reporting date by the level within the fair value hierarchy in which the fair value measurements in their entirety fall, segregating fair value measurements using quoted prices in active markets for identical assets (Level 1), significant other observable inputs (Level 2), and significant unobservable inputs (Level 3). Name: us-gaap_FairValueAssetsMeasuredOnRecurringBasisTextBlock Tabular disclosure of securities (including those issuable pursuant to contingent stock agreements) that could potentially dilute basic earnings per share (EPS) in the future that were not included in the computation of diluted EPS because to do so would increase EPS amounts or decrease loss per share amounts for the period presented, by antidilutive securities. Name: us-gaap_ScheduleOfAntidilutiveSecuritiesExcludedFromComputationOfEarningsPerShareTextBlock Tabular disclosure of the carrying amount as of the balance sheet date of merchandise, goods, commodities, or supplies held for future sale or to be used in manufacturing, servicing or production process. -Section 2 -Subparagraph a,b,c Name: us-gaap_ScheduleOfInventoryCurrentTableTextBlock Tabular disclosure of the extent of the entity's reliance on its major customers, if revenues from transactions with a single external customer amount to 10 percent or more of entity revenues, including the disclosure of that fact, the total amount of revenues from each such customer, and the identity of the reportable segment or segments reporting the revenues. The entity need not disclose the identity of a major customer or the amount of revenues that each segment reports from that customer. For these purposes, a group of companies known to the entity to be under common control is considered a single customer, and the federal government, a state government, a local government such as a county or municipality, or a foreign government is each considered a single customer. Name: us-gaap_ScheduleOfRevenueByMajorCustomersByReportingSegmentsTableTextBlock Tabular disclosure of the significant assumptions used during the year to estimate the fair value of stock options, including, but not limited to: (a) expected term of share options and similar instruments, (b) expected volatility of the entity's shares, (c) expected dividends, (d) risk-free rate(s), and (e) discount for post-vesting restrictions. -Subparagraph (f)(2) Name: us-gaap_ScheduleOfShareBasedPaymentAwardStockOptionsValuationAssumptionsTableTextBlock Liability Related to Sale of Future Royalties (Tables) Schedule of Liability account during the period from the inception of the royalty transaction Tabular disclosure of the royalty transaction that were outstanding at the beginning and end of the year, and the amount of proceeds, revenue and expense from future royalty income. Name: imgn_ScheduleOfRoyaltyTransactionActivityTableTextBlock Minimum rental commitments for the next five fiscal years and thereafter under the non-cancelable operating lease agreements Tabular disclosure of future minimum payments required in the aggregate and for each of the five succeeding fiscal years for operating leases having initial or remaining noncancelable lease terms in excess of one year and the total minimum rentals to be received in the future under noncancelable subleases as of the balance sheet date. Name: us-gaap_ScheduleOfFutureMinimumRentalPaymentsForOperatingLeasesTableTextBlock Summary of Significant Accounting Policies (Details) (USD $) Development and Commercialization License Kadcyla Right-to-test agreement Exclusive license Non-exclusive license Phase I clinical trial Oxford BioTherapeutics Ltd Member Number of types of licensing and development agreements with collaborative partners 2 Number of single-target licenses 3 4 1 3 3 3 1 1 2 3 3 5 5 1 1 Number of licenses to multiple individual targets 1 Number of licenses to two related targets 1 Number of related targets 2 1 Period to earn royalty payments 10 years 12 years 10 years 12 years Average involvement period over which the upfront payments on single-target licenses are amortized 6 years 6 months Difference between the full cost to manufacture and amounts received from collaborators for preclinical and clinical materials $ 7,000,000 $ 3,100,000 Number of types of milestone payments under collaborative arrangements 3 Average period over which upfront payments are deferred and recognized 12 months 18 months Number of quarters in arrear for revenue recognition 1 License exercise fee 1,000,000 1,000,000 1,000,000 500,000 2,000,000 License and milestone fees 6,070,000 6,234,000 1,700,000 2,000,000 Number of financial institutions in the U.S. in which cash and cash equivalents are primarily maintained 3 Number of marketable securities held by entity 0 0 Cash and cash equivalents $ 247,843,000 $ 121,798,000 $ 278,109,000 $ 142,261,000 Represents the number of financial institutions in which cash and cash equivalents are primarily maintained. Name: imgn_CashAndCashEquivalentsNumberOfFinancialInstitutions Data Type: xbrli:integerItemType Represents the average involvement period over which the upfront payments on single-target licenses are amortized. Name: imgn_CollaborativeArrangementsAmortizationOfUpfrontPaymentsOnSingleTargetLicensesAverageInvolvementPeriod Data Type: xbrli:durationItemType Represents the period over which the upfront payments under the collaborative agreements are deferred. Name: imgn_CollaborativeArrangementsDeferredUpfrontPaymentsPeriod Represents the difference between the entity's full cost to manufacture preclinical and clinical materials on behalf of its collaborators as compared to total amounts received from collaborators. Name: imgn_CollaborativeArrangementsDifferenceBetweenCostOfManufactureAndAmountReceivedFromCollaborators Represents the period after product launch in which the company will earn royalty payments under the collaborative agreement. Name: imgn_CollaborativeArrangementsPeriodAfterProductLaunchToEarnRoyaltyPayments Name: imgn_ConcentrationRiskCreditRiskFinancialInstrumentsAbstract Represents the number of licenses to multiple individual targets. Name: imgn_NumberOfLicensesToMultipleIndividualTargets Represents the number of licenses to two related targets. Name: imgn_NumberOfLicensesToTwoRelatedTargets Represents the number of related targets. Name: imgn_NumberOfRelatedTargets Represents the number of single-target licenses the company has right to use. Name: imgn_NumberOfSingleTargetLicenses Represents the number of types of licensing and development agreements with collaborative partners. Name: imgn_NumberOfTypesOfLicensingAndDevelopmentAgreementsWithCollaborativePartners Represents the types of milestone payments under collaborative arrangements. Name: imgn_NumberOfTypesOfMilestonePaymentsUnderCollaborativeArrangements Represents the amount of fee received for each license under the collaborative arrangement. Name: imgn_ProceedsFromCollaboratorsPerLicense Represents the number of quarters in arrear for revenue recognition. Name: imgn_RevenueRecognitionNumberOfQuartersArrears Name: us-gaap_CollaborativeArrangementsAndNoncollaborativeArrangementTransactionsLineItems Total debt and equity financial instruments including: (1) securities held-to-maturity, (2) trading securities, and (3) securities available-for-sale. Name: us-gaap_MarketableSecurities Summary of Significant Accounting Policies (Details 2) (Recurring basis, USD $) Fair value hierarchy for the Company's financial assets measured at fair value Cash equivalents $ 240,643 $ 269,304 Quoted Prices in Active Markets for Identical Assets (Level 1) Fair value portion of currency on hand as well as demand deposits with banks or financial institutions. Includes other kinds of accounts that have the general characteristics of demand deposits. Also includes short-term, highly liquid investments that are both readily convertible to known amounts of cash and so near their maturity that they present insignificant risk of changes in value because of changes in interest rates. Name: us-gaap_CashAndCashEquivalentsFairValueDisclosure Name: us-gaap_FairValueAssetsAndLiabilitiesMeasuredOnRecurringAndNonrecurringBasisLineItems Summary of Significant Accounting Policies (Details 3) (USD $) Share data in Thousands, unless otherwise specified Raw materials $ 76,000 $ 279,000 Work in process 1,170,000 2,656,000 Minimum supply period of raw materials that is not supported by firm, fixed orders and/or projections from collaborators considered to expense inventory 12 months Charges to research and development expense related to raw material inventory identified as excess 0 337,000 Reserve for work in process $ 0 Computation of Net Income (Loss) per Common Share Options outstanding to purchase common stock and unvested restricted stock (in shares) 11,494 10,564 Common stock equivalents under treasury stock method (in shares) 1,296 1,147 Represents the minimum supply period based on firm, fixed orders and projections from collaborators that is used to compute raw material write downs. The write-downs represent the cost of raw materials in excess of forecasted sales. Name: imgn_InventoryRawMaterialsWriteDownMinimumSupplyPeriodBasedOnFirmFixedOrdersAndProjectionsFromCollaborators Represents the amount of reserve on inventory work in process. Name: imgn_InventoryWorkInProcessValuationReserves Represents the charges to research and development expense related to raw material inventory identified as excess. Name: imgn_InventoryWriteDownExcessRawMaterialsChargedToResearchAndDevelopmentExpense Represents the number of common share equivalents under the treasury stock method as of the balance sheet date. Name: imgn_NumberCommonStockEquivalentShares Represents the number of shares reserved for issuance under the equity-based awards agreement awarded under the plan that validly exist and are outstanding as of the balance sheet date. Name: imgn_ShareBasedCompensationArrangementByShareBasedPaymentAwardAwardsOutstandingNumber Name: us-gaap_EarningsPerShareAbstract Name: us-gaap_InventoryNetAbstract Carrying amount, net of valuation reserves and adjustments, as of the balance sheet date of unprocessed items to be consumed in the manufacturing or production process. -Subparagraph (SAB TOPIC 5.BB) -Section BB -Subparagraph (SX 210.5-02.6(a)(4)) Name: us-gaap_InventoryRawMaterialsNetOfReserves Carrying amount, net of reserves and adjustments, as of the balance sheet date of merchandise or goods which are partially completed. This inventory is generally comprised of raw materials, labor and factory overhead costs, which require further materials, labor and overhead to be converted into finished goods, and which generally require the use of estimates to determine percentage complete and pricing. Name: us-gaap_InventoryWorkInProcessNetOfReserves Additional disclosure for options Cash received for exercise of stock options $ 4,462,000 $ 144,000 Number of Stock Options Granted (in shares)

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professional_accounting

Marvell Technology Inc. Biofrontera Inc. Amendment to Statement of Changes in Beneficial Ownership (Form 4/A) Soluna Holdings Inc. Duluth Holdings Inc. Quarterly Report (Form 10-Q) dlth-20211031x10q FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 31, 2021 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission File Number 001-37641 201 East Front Street Mount Horeb, Wisconsin (Address of principal executive offices) (Zip Code) (Registrant's telephone number, including area code) Class B Common Stock, No Par Value DLTH NASDAQGlobal Select Market Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þNo o Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes þNo o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer," "smaller reporting company," and "emerging growth company" in Rule 12b-2 of the Exchange Act. Large Accelerated Filer Accelerated Filer Non-accelerated Filer Smaller Reporting Company Emerging Growth Company If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to section 13(a) of the Exchange Act. o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes oNo þ The number of shares outstanding of the Registrant's Class A common stock, no par value, as of December 1, 2021, was 3,364,200. The number of shares outstanding of the Registrant's Class B common stock, no par value, as of December 1, 2021, was 29,698,318. QUARTERLY REPORT ON FORM 10-Q FOR QUARTER ENDED October 31, 2021 Part I-Financial Information Condensed Consolidated Balance Sheets as of October 31, 2021 and January 31, 2021 (Unaudited) Condensed Consolidated Statements of Operations for the three and nine months ended October 31, 2021 and November 1, 2020 (Unaudited) Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended October 31, 2021 and November 1, 2020 (Unaudited) Condensed Consolidated Statement of Shareholders' Equity for the nine months ended October 31, 2021 (Unaudited) Condensed Consolidated Statement of Shareholders' Equity for the nine months ended November 1, 2020 (Unaudited) Condensed Consolidated Statements of Cash Flows for the nine months ended October 31, 2021 and November 1, 2020 (Unaudited) Notes to Condensed Consolidated Financial Statements (Unaudited) Management's Discussion and Analysis of Financial Condition and Results of Operations Controls and Procedures Part II-Other Information Item 1A. Unregistered Sales of Equity Securities and Use of Proceeds PART I. FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets - Assets (Amounts in thousands) Income tax receivable Inventory, less reserves of $1,439and $1,600, respectively Prepaid expenses & other current assets Prepaid catalog costs Operating lease right-of-use assets Finance lease right-of-use assets, net Available-for-sale security Other assets, net The accompanying notes are an integral part of these condensed consolidated financial statements. Condensed Consolidated Balance Sheets - Liabilities and Shareholders' Equity LIABILITIES AND SHAREHOLDERS' EQUITY Trade accounts payable Accrued expenses and other current liabilities Income taxes payable Current portion of operating lease liabilities Current portion of finance lease liabilities Current portion of Duluth long-term debt Current maturities of TRI long-term debt Operating lease liabilities, less current maturities Finance lease liabilities, less current maturities Duluth long-term debt, less current maturities TRI long-term debt, less current maturities Shareholders' equity: Preferred stock, nopar value; 10,000shares authorized; noshares issued or outstanding as of October 31, 2021 and January 31, 2021 Common stock (Class A), nopar value; 10,000shares authorized; 3,364shares issued and outstanding as of October 31, 2021 and January 31, 2021 Common stock (Class B), nopar value; 200,000shares authorized; 29,782shares issued and 29,703shares outstanding as of October 31, 2021 and 29,530shares issued and 29,477shares outstanding as of January 31, 2021 Treasury stock, at cost; 79and 53shares as of October 31, 2021 and January 31, 2021, respectively Capital stock Accumulated other comprehensive income Total shareholders' equity of Duluth Holdings Inc. Noncontrolling interest Total liabilities and shareholders' equity Condensed Consolidated Statements of Operations (Amounts in thousands, except per share figures) Cost of goods sold (excluding depreciation and amortization) Selling, general and administrative expenses Operating income (loss) Other (loss) income, net Income tax expense (benefit) Less: Net loss attributable to noncontrolling interest Net income (loss) attributable to controlling interest Basic earnings (loss) per share (Class A and Class B): Weighted average shares of common stock outstanding Net income (loss) per share attributable to controlling interest Diluted earnings (loss) per share (Class A and Class B): Weighted average shares and equivalents outstanding Condensed Consolidated Statements of Comprehensive Income Other comprehensive income Securities available-for sale: Unrealized security (loss) income arising during the period Other comprehensive (loss) income Comprehensive income (loss) Comprehensive loss attributable to noncontrolling interest Comprehensive income (loss) attributable ‎to controlling interest Condensed Consolidated Statement of Shareholders' Equity Nine Months Ended October 31, 2021 Accumulated Noncontrolling interest in Retained variable interest shareholders' Balance at January 31, 2021 Issuance of common stock Restricted stock forfeitures Restricted stock surrendered for taxes Other comprehensive loss Balance at May 2, 2021 Balance at August 1, 2021 Balance at October 31, 2021 Nine Months Ended November 1, 2020 Balance at February 2, 2020 Balance at November 1, 2020 Condensed Consolidated Statements of Cash Flows Cash flows from operating activities: Adjustments to reconcile net income (loss) to net cash used in operating activities: Stock based compensation Loss on disposal of property and equipment Income taxes receivable Prepaid expense & other current assets Software hosting implementation costs, net Deferred catalog costs Accrued expenses and deferred rent obligations Noncash lease impacts Net cash provided by (used in) operating activities Cash flows from investing activities: Capital contributions towards build-to-suit stores Principal receipts from available-for-sale security Proceeds from disposals Cash flows from financing activities: Proceeds from line of credit Payments on line of credit Proceeds from delayed draw term loan Payments on delayed draw term loan Payments on TRI long term debt Payments on finance lease obligations Payments of tax withholding on vested restricted shares Net cash (used in) provided by financing activities (Decrease) increase in cash, cash equivalents Cash, cash equivalents and restricted cash at beginning of period Cash, cash equivalents and restricted cash at end of period Supplemental disclosure of cash flow information: Interest paid Income taxes paid Supplemental disclosure of non-cash information: Unpaid liability to acquire property and equipment 1. NATURE OF OPERATIONS AND BASIS OF PRESENTATION A. Nature of Operations Duluth Holdings Inc. ("Duluth Trading" or the "Company"), a Wisconsin corporation, is a lifestyle brand of men's and women's casual wear, workwear and accessories sold primarily through the Company's own omnichannel platform. The Company's products are marketed under the Duluth Trading brand, with the majority of products being exclusively developed and sold as Duluth Trading branded merchandise. The Company identifies its operating segments according to how its business activities are managed and evaluated. The Company continues to report onereportable external segment, consistent with the Company's omnichannel business approach. The Company's revenues generated outside the United States were insignificant. The Company has twoclasses of authorized common stock: Class A common stock and Class B common stock. The rights of holders of Class A common stock and Class B common stock are identical, except for voting and conversion rights. Each share of Class A common stock is entitled to tenvotes per share and is convertible at any time into one share of Class B common stock. Each share of Class B common stock is entitled to onevote per share.The Company's Class B common stock trades on the NASDAQ Global Select Market under the symbol "DLTH." B. Basis of Presentation The condensed consolidated financial statements are prepared in accordance with U.S. Generally Accepted Accounting Principles ("U.S. GAAP"). The Company consolidates TRI Holdings, LLC ("TRI") as a variable interest entity (see Note 6 "Variable Interest Entity" for further information). All significant intercompany balances and transactions have been eliminated in consolidation. The Company's fiscal year ends on the Sunday nearest to January 31 of the following year. Fiscal 2021 is a 52-week period and ends on January 30, 2022. Fiscal 2020 was a 52-week period and ended on January 31, 2021. The three months of fiscal 2021 and fiscal 2020 represent the Company's 13 week periods ended October 31, 2021 and November 1, 2020, respectively. The accompanying condensed consolidated financial statements as of and for the three and nine months ended October 31, 2021 and November 1, 2020 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC") and, in the opinion of the Company, include all adjustments (which are normal and recurring in nature) necessary to present fairly the financial position, results of operations and cash flows of the Company for the interim periods presented. Certain information and footnote disclosures normally included in consolidated financial statements prepared in accordance with U.S. GAAP have been condensed or omitted pursuant to such SEC rules and regulations as of and for the three and nine months ended October 31, 2021 and November 1, 2020. These interim condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company's annual report on Form 10-K for the fiscal year ended January 31, 2021. C. COVID-19 In March 2020, a novel strain of coronavirus ("COVID-19") was declared a global pandemic by the World Health Organization. This pandemic has negatively affected the U.S. and global economies, disrupted global supply chains and financial markets, led to significant travel and transportation restrictions, including mandatory business closures and orders to shelter in place. These impacts are discussed within these notes to the condensed consolidated financial statements. The ultimate impact of COVID-19 on our operational and financial performance still depends on future developments outside of our control. Given the uncertainty, we cannot reasonably estimate the continued impact on our business and whether that impact will be different than what we have already experienced. D. Impairment Analysis As of October 31, 2021 and for the three and nine months then ended, no triggering events or indicators of asset impairment were noted. E. Inventory Inventory, consisting of purchased product, is valued at the lower of cost or net realizable value, under the first-in, first-out method. The significant estimates used in inventory valuation are obsolescence (including excess and slow-moving inventory and lower of cost or market reserves) and estimates of inventory shrinkage. Both estimates have calculations that require the Company to make assumptions and apply judgment regarding a number of factors, including market conditions, the selling environment, historical results and current inventory trends. Inventory is adjusted periodically to reflect current market conditions, which requires management's judgment that may significantly affect the ending inventory valuation, as well as gross margin. The reserve for inventory shrinkage is adjusted to reflect the trend of historical physical inventory count results. The Company performs its retail store physical inventory counts in July and the difference between actual and estimated shrinkage, recorded in Cost of goods sold, may cause fluctuations in second fiscal quarter results. F. Prepaid Expenses and Other Assets Prepaid expenses and other assets consist of the following: Pending returns inventory, net Current software hosting implementation costs, net Other prepaid expenses Non-current software hosting implementation costs G. Seasonality of Business The Company's business is affected by the pattern of seasonality common to most apparel businesses. Historically, the Company has recognized a significant portion of its revenue and operating profit in the fourth fiscal quarter of each year as a result of increased sales during the holiday season. H. Cash and cash equivalents The Company considers short-term investments with original maturities of three months or less when purchased to be cash equivalents. Amounts receivable from credit card issuers are typically converted to cash within 2 to 4 days of the original sales transaction and are considered to be cash equivalents. I. Reclassifications Certain reclassifications have been made to the 2020 financial statements in order to conform to the 2021 presentation. There were no changes to previously reported shareholders' equity or net income (loss) as a result of the reclassifications. J. Significant Accounting Policies There have been no significant changes to the Company's significant accounting policies as described in the Company's Annual Report on Form 10-K for the year ended January 31, 2021. 2. LEASES Based on the criteria set forth in ASC Topic 842, Leases ("ASC 842"), the Company recognizes ROU assets and lease liabilities related to leases on the Company's consolidated balance sheets. The Company determines if an arrangement is, or contains, a lease at inception. ROU assets represent the right to use an underlying asset for the lease term and lease liabilities reflect the obligation to make lease payments arising from the lease. At any given time during the lease term, the lease liability represents the present value of the remaining lease payments and the ROU asset is measured at the amount of the lease liability, adjusted for pre-paid rent, unamortized initial direct costs and the remaining balance of lease incentives received. Both the lease ROU asset and liability are reduced to zeroat the end of the lease. The Company leases retail space under non-cancelable lease agreements, which expire on various dates through 2041. Substantially all of these arrangements are store leases. Store leases generally have initial lease terms ranging from five yearsto fifteen yearswith renewal options and rent escalation provisions. At the commencement of a lease, the Company includes only the initial lease term as the option to extend is not reasonably certain. The Company does not record leases with a lease term of 12 months or less on the Company's consolidated balance sheets. When calculating the lease liability on a discounted basis, the Company applies its estimated discount. The Company bases this discount on a collateralized interest rate as well as publicly available data for instruments with similar characteristics. In addition to rent payments, leases for retail space contain payments for real estate taxes, insurance costs, common area maintenance, and utilities that are not fixed. The Company accounts for these costs as variable payments and does not include such costs as a lease component. The expense components of the Company's leases reflected on the Company's consolidated statement of operations were as follows: Consolidated Statement of Operations Finance lease expenses Amortization of right-of-use ‎assets Selling, general and ‎administrative expenses Interest on lease liabilities Total finance lease expense Operating lease expense Amortization of build-to-suit ‎leases capital contribution Variable lease expense Total lease expense Other information related to leases were as follows: Cash paid for amounts included in the measurement of lease liabilities: Financing cash flows from finance leases Operating cash flows from finance leases Operating cash flows from operating leases Weighted-average remaining lease term (in years): Finance leases Operating leases Weighted-average discount rate: Future minimum lease payments under the non-cancellable leases are as follows as of October 31, 2021: 2021 (remainder of fiscal year) Thereafter Total future minimum lease payments Less - Discount Lease liability 3. DEBT AND CREDIT AGREEMENT Debt consists of the following: TRI Senior Secured Note TRI Note Less: current maturities TRI long-term debt Duluth Delayed draw term loan Duluth long-term debt TRI Holdings, LLC TRI entered into a senior secured note ("TRI Senior Secured Note") with an original balance of $26.7million. The TRI Senior Secured Note is scheduled to mature on October 15, 2038and requires installment payments with an interest rate of 4.95%. See Note 6 "Variable Interest Entities" for further information. TRI entered into a promissory note ("TRI Note") with an original balance of $3.5million. The TRI Note is scheduled to mature in November 2038 and requires annual interest payments at a rate of 3.05%, with a final balloon payment due in November 2038. While the above notes are consolidated in accordance with ASC Topic 810, Consolidation, the Company is not the guarantor nor obligor of these notes. Credit Agreement On May 17, 2018, the Company entered into a credit agreement (the "Credit Agreement") which provided for borrowing availability of up to $80.0million in revolving credit (the "Revolver"), and borrowing availability of up to $50.0million in a delayed draw term loan ("DDTL"), for a total credit facility of $130.0million. The $80.0million revolving credit facility was scheduled to mature on May 17, 2023. The $50.0million DDTL was available to draw upon in differing amounts through May 17, 2020 and was scheduled to mature on May 17, 2023. Outstanding balances under the DDTL required quarterly principal payments with a final balloon payment at maturity. The Credit Agreement was secured by essentially all Company assets and required the Company to maintain compliance with certain financial and non-financial covenants, including a maximum rent adjusted leverage ratio and a minimum fixed charge coverage ratio as defined in the Credit Agreement. On April 30, 2020, the Credit Agreement was amended to include an incremental DDTL of $20.5million (the "Incremental DDTL") that was available to draw upon before March 31, 2021, and matured on April 29, 2021, for a total credit facility of $150.5million. The loan covenants were also amended to allow for greater flexibility during the Company's peak borrowing periods in fiscal 2020. The interest rate applicable to the Revolver or DDTL was a fixed rate for a one-, two-, three- or six-month interest period equal to LIBOR (with a 1% floor) for such interest period plus a margin of 225to 300basis points, based upon the Company's rent adjusted leverage. The interest rate applicable to the Incremental DDTL was also a fixed rate over the aforementioned interest periods equal to LIBOR (with a 1% floor) for such interest period plus a margin of 275to 350basis points. On May 14, 2021, the Company terminated the Credit Agreement, and entered into a new credit agreement (the "New Credit Agreement"), which was treated as a modification for accounting purposes. The New Credit Agreement matures on May 14, 2026and provides for borrowings of up to $150.0million that are available under a revolving senior credit facility, with a $5.0million sublimit for issuance of standby letters of credit, as well as a $10.0million sublimit for swing line loans. At the Company's option, the interest rate applicable to the revolving senior credit facility will be a floating rate equal to: (i) the Bloomberg Short-Term Bank Yield Index rate ("BSBY") plus the applicable rate of 1.25% to 2.00% determined based on the Company's rent adjusted leverage ratio, or (ii) the base rate plus the applicable rate of 0.25% to 1.00% based on the Company's rent adjusted leverage ratio. The New Credit Agreement is secured by essentially all Company assets and requires the Company to maintain compliance with certain financial and non-financial covenants, including a maximum rent adjusted leverage ratio and a minimum fixed charge coverage ratio as defined in the New Credit Agreement As of October 31, 2021 and for the nine months then ended, the Company was in compliance with all financial and non-financial covenants contained within the New Credit Agreement. 4. ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accrued expenses and other current liabilities consist of the following: Salaries and benefits Catalog costs Unpaid purchases of property & equipment Accrued advertising Total accrued expenses and other current liabilities 5. FAIR VALUE ASC Topic 820, Fair Value Measurements and Disclosures ("ASC 820"), defines fair value as the price that would be received to sell an asset, or paid to transfer a liability, in an orderly transaction between market participants at the measurement date (i.e., an exit price). The exit price is based on the amount that the holder of the asset or liability would receive or need to pay in an actual transaction (or in a hypothetical transaction if an actual transaction does not exist) at the measurement date. ASC 820 describes a fair value hierarchy based on three levels of inputs that may be used to measure fair value, of which the first two are considered observable and the last unobservable, as follows: Level 1 - Quoted prices in active markets for identical assets or liabilities. Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. The fair value of the Company's available-for-sale security was valued based on a discounted cash flow method (Level 3), which incorporates the U.S. Treasury yield curve, credit information and an estimate of future cash flows. During the nine months ended October 31, 2021, certain changes in the inputs did impact the fair value of the available-for-sale security. The calculated fair value is based on estimates that are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. The amortized cost and fair value of the Company's available-for-sale security and the corresponding amount of gross unrealized gains and losses recognized in accumulated other comprehensive income are as follows: Cost or Amortized Unrealized Fair Value Level 3 security: Corporate trust The Company does not intend to sell the available-for-sale-security in the near term and does not believe that it will be required to sell the security. The Company reviews its securities on a quarterly basis to monitor its exposure to other-than-temporary impairment. Noother-than-temporary impairment was recorded in the unaudited condensed consolidated statements of operations for the nine months ended October 31, 2021 or November 1, 2020. The following table presents future principal receipts related to the Company's available-for-sale security by contractual maturity as of October 31, 2021. After one year through five years After five years through ten years The carrying values and fair values of other financial instruments in the Consolidated Balance Sheets are as follows: Carrying Amount TRI Long-term debt, including short-term portion The above long-term debt, including short-term portion is attributable to the consolidation of TRI in accordance with ASC Topic 810, Consolidation. The fair value was also based on a discounted cash flow method (Level 3) based on credit information and an estimate of future cash flows. As of January 31, 2021, the carrying value of the delayed draw term loan approximated its fair value. 6. VARIABLE INTEREST ENTITY Based upon the criteria set forth in ASC 810, Consolidation, the Company consolidates variable interest entities ("VIEs") in which it has a controlling financial interest and is therefore deemed the primary beneficiary. A controlling financial interest will have both of the following characteristics: (a) the power to direct the VIE activities that most significantly impact economic performance; and (b) the obligation to absorb the VIE losses and the right to receive benefits that are significant to the VIE. The Company has determined that it was the primary beneficiary of onevariable interest entity ("VIE") as of October 31, 2021 and January 31, 2021. The Company leases the Company's headquarters in Mt. Horeb, Wisconsin from TRI. In conjunction with the lease, the Company invested $6.3million in a trust that loaned funds to TRI for the construction of the Company's headquarters. TRI is a Wisconsin limited liability company whose primary purpose and activity is to own this real property. The Company considers itself the primary beneficiary for TRI as the Company has both the power to direct the activities that most significantly impact the entity's economic performance and is expected to receive benefits that are significant to TRI. As the Company is the primary beneficiary, it consolidates TRI and the lease is eliminated in consolidation. The Company does not consolidate the trust as the Company is not the primary beneficiary. The condensed consolidated balance sheets include the following amounts as a result of the consolidation of TRI as of October 31, 2021 and January 31, 2021: Current maturities of long-term debt Noncontrolling interest in VIE 7. EARNINGS (LOSS) PER SHARE Earnings (loss) per share is computed under the provisions of ASC 260, Earnings Per Share. Basic earnings (loss) per share is based on the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share is based on the weighted average number of common shares plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding restricted stock and are considered only for dilutive earnings (loss) per share unless considered anti-dilutive. The reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share calculation is as follows: (in thousands, except per share data) Numerator - net income (loss) attributable to ‎controlling interest Denominator - weighted average shares ‎(Class A and Class B) Dilutive shares Earnings (loss) per share (Class A and Class B) The computation of diluted loss per share for the nine months ended November 1, 2020 excluded (0.1) million shares of unvested restricted stock, respectively, because their inclusion would be anti-dilutive. 8. STOCK-BASED COMPENSATION The Company accounts for its stock-based compensation plan in accordance with ASC 718, Stock Compensation, which requires the Company to measure all share-based payments at grant date fair value and recognize the cost over the requisite service period of the award. Total stock compensation expense associated with restricted stock recognized by the Company was $0.6million and $1.6million for the three and nine months ended October 31, 2021, respectively and $0.3million and $1.1million for the three and nine months ended November 1, 2020, respectively. The Company's total stock compensation expense is included in selling, general and administrative expenses on the Condensed Consolidated Statements of Operations. A summary of the activity in the Company's unvested restricted stock during the nine months ended October 31, 2021 is as follows: Outstanding at January 31, 2021 Forfeited Outstanding at October 31, 2021 At October 31, 2021, the Company had unrecognized compensation expense of $4.2million related to the restricted stock awards, which is expected to be recognized over a weighted average period of 2.4years. 9. PROPERTY AND EQUIPMENT Property and equipment consist of the following: Land and land improvements Office equipment and furniture Accumulated depreciation and amortization Construction in progress 10. REVENUE The Company's revenue primarily consists of the sale of apparel, footwear and hard goods. Revenue for merchandise that is shipped to our customers from our distribution centers and stores is recognized upon shipment. Store revenue is recognized at the point of sale, net of returns, and excludes taxes. Shipping and processing revenue generated from customer orders are included as a component of net sales and shipping and processing expense, including handling expense, is included as a component of selling, general and administrative expenses. Sales tax collected from customers and remitted to taxing authorities is excluded from revenue and is included in accrued expenses. Sales disaggregated based upon sales channel is presented below. Contract Assets and Liabilities The Company's contract assets primarily consist of the right of return for amounts of inventory to be returned that is expected to be resold and is recorded in Prepaid expenses and other current assets on the Company's consolidated balance sheets. The Company's contract liabilities primarily consist of gift card liabilities and are recorded in Accrued expenses and other current liabilities under deferred revenue (see Note 4 "Accrued Expenses and Other Current Liabilities") on the Company's consolidated balance sheets. Upon issuance of a gift card, a liability is established for its cash value. The gift card liability is relieved and revenues on gift cards are recorded at the time of redemption by the customer. Contract assets and liabilities on the Company's consolidated balance sheets are presented in the following table: Contract assets Contract liabilities Revenue from gift cards is recognized when the gift card is redeemed by the customer for merchandise or as a gift card breakage, an estimate of gift cards which will not be redeemed. The Company does not record breakage revenue when escheat liability to the relevant jurisdictions exists. Gift card breakage is recorded within Net sales on the Company's consolidated statement of operations. The following table provides the reconciliation of the contract liability related to gift cards for the nine months ended: Balance as of beginning of period Gift cards sold Gift cards redeemed Gift card breakage Balance as of end of period 11. INCOME TAXES The provision for income taxes for the interim period is based on an estimate of the annual effective tax rate adjusted to reflect the impact of discrete items. Management judgment is required in projecting ordinary income to estimate the Company's annual effective tax rate. The effective tax rate related to controlling interest was 25% for the three months ended October 31, 2021 and 25% for the nine months ended October 31, 2021. The income from TRI was excluded from the calculation of the Company's effective tax rate, as TRI is a limited liability company and not subject to income taxes. 12. RECENT ACCOUNTING PRONOUNCEMENTS In June 2016, the FASB issued Accounting Standards Update No. 2016-13 "Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments," ("ASU 2016-13"), which amends the impairment model by requiring entities to use a forward-looking approach based on expected losses to estimate credit losses on certain types of financial instruments, which include trade and other receivables, loans and held-to-maturity debt securities, to record an allowance for credit risk based on expected losses rather than incurred losses, otherwise known as "CECL". In addition, this guidance changes the recognition for credit losses on available-for-sale debt securities, which can occur as a result of market and credit risk and requires additional disclosures. On November 15, 2019, the FASB issued ASU No. 2019-10 "Financial Instruments-Credit Losses (Topic 326), Derivatives and Hedging (Topic 815, and Leases (Topic 842),"(ASU 2019-10"), which provides framework to stagger effective dates for future major accounting standards and amends the effective dates for certain major new accounting standards to give implementation relief to certain types of entities. ASU 2019-10 amends the effective dates for ASU 2016-13 for smaller reporting companies with fiscal years beginning after December 15, 2022, and interim periods within those years. The Company expects to adopt ASU 2016-13 on January 30, 2023, the first day of the Company's first quarter for the fiscal year ending January 28, 2024, the Company's fiscal year 2023. The Company is evaluating the impact adopting ASU 2016-13 will have on the Company's consolidated financial statements. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of the financial condition and results of our operations should be read in conjunction with the financial statements and related notes of Duluth Holdings Inc. included in Item 1of this Quarterly Report on Form 10-Q and with our audited financial statements and the related notes included in our Annual Report on Form 10-K for the fiscal year ended January 31, 2021 ("2020 Form 10-K"). The Company's fiscal year ends on the Sunday nearest to January 31 of the following year. Fiscal 2021 is a 52-week period and ends on January 30, 2022. Fiscal 2020 was a 52-week period and ended on January 31, 2021. The three and nine months of fiscal 2021 and fiscal 2020 represent our 13 and 39 week periods ended October 31, 2021 and November 1, 2020, respectively. Unless the context indicates otherwise, the terms the "Company," "Duluth," "Duluth Trading," "we," "our," or "us" are used to refer to Duluth Holdings Inc. This Quarterly Report on Form 10-Q contains "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties. All statements other than statements of historical or current facts included in this Quarterly Report on Form 10-Q are forward-looking statements. Forward looking statements refer to our current expectations and projections relating to our financial condition, results of operations, plans, objectives, strategies, future performance and business. You can identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. These statements may include words such as "anticipate," "could," "estimate," "expect," "project," "plan," "potential," "intend," "believe," "may," "might," "will," "objective," "should," "would," "can have," "likely," and other words and terms of similar meaning in connection with any discussion of the timing or nature of future operating or financial performance or other events. For example, all statements we make relating to our estimated and projected earnings, revenue, costs, expenditures, cash flows, growth rates and financial results, our plans and objectives for future operations, growth initiatives, or strategies are forward-looking statements. All forward-looking statements are subject to risks and uncertainties, including the risks and uncertainties described under Part I, Item 1A "Risk Factors," in our 2020 Form 10-K, and other SEC filings, which factors are incorporated by reference herein. Theserisks and uncertainties include, but are not limited to, the following: the prolonged effects of COVID-19 on store traffic and disruptions to our distribution network, supply chains and operations; our ability to maintain and enhance a strong brand image; effectively adapting to new challenges associated with our expansion into new geographic markets; generating adequate cash from our existing stores to support our growth; effectively relying on sources for merchandise located in foreign markets; transportation delays and interruptions, including port congestion; inability to timely and effectively obtain shipments of products from our suppliers and deliver merchandise to our customers; the inability to maintain the performance of a maturing store portfolio; the impact of changes in corporate tax regulations; identifying and responding to new and changing customer preferences; the success of the locations in which our stores are located; our ability to attract and retain customers in the various retail venues and locations in which our stores are located; competing effectively in an environment of intense competition; our ability to adapt to significant changes in sales due to the seasonality of our business; price reductions or inventory shortages resulting from failure to purchase the appropriate amount of inventory in advance of the season in which it will be sold in global market constraints; increases in costs of fuel or other energy, transportation or utility costs and in the costs of labor and employment; failure of our information technology systems to support our current and growing business, before and after our planned upgrades; and other factors that may be disclosed in our SEC filings or otherwise. Moreover, we operate in an evolving environment, new risk factors and uncertainties emerge from time to time and it is not possible for management to predict all risk factors and uncertainties, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statement. We qualify all of our forward-looking statements by these cautionary statements. We undertake no obligation to update or revise these forward-looking statements, except as required under the federal securities laws. We are a lifestyle brand of men's and women's casual wear, workwear and accessories sold primarily through our own omnichannel platform. We offer products nationwide through our website and catalog. In 2010, we initiated our omnichannel platform with the opening of our first store. Since then, we have expanded our retail presence, and as of October 31, 2021, we operated 62 retail stores and three outlet stores. We offer a comprehensive line of innovative, durable and functional products, such as our Longtail T®shirts, Buck NakedTMunderwear, Fire Hose®work pants, and No-Yank®Tank, which reflect our position as the Modern, Self-Reliant American Lifestyle brand. Our brand has a heritage in workwear that transcends tradesmen and appeals to a broad demographic for everyday and on-the-job use. From our heritage as a catalog for those working in the building trades, Duluth Trading has become a widely recognized brand and proprietary line of innovative and functional apparel and gear. Over the last decade, we have created strong brand awareness, built a loyal customer base and generated robust sales momentum. We have done so by sticking to our roots of "there's gotta be a better way" and through our relentless focus on providing our customers with quality, functional products. A summary of our financial results is as follows: Net sales in fiscal 2021 third quarter increased by 7.2% over the prior year third quarter to $145.3 million, and net sales in the first nine months of fiscal 2021 increased by 11.8% over the first nine months of the prior year to $427.8 million; Net income of $2.8 million in fiscal 2021 third quarter compared to the prior year third quarter net income of $0.9 million, and net income in the first nine months of fiscal 2021 of $12.3 million compared to a net loss in the first nine months of fiscal 2020 of $8.3 million; and Adjusted EBITDA increased to $13.2 million in fiscal 2021 third quarter compared to the prior year third quarter Adjusted EBITDA of $11.4 million, and Adjusted EBITDA in the first nine months of fiscal 2021 increased to $44.9 million compared to $16.6 million for the first nine months of the prior year. See the "Reconciliation of Net Income (Loss) to EBITDA and EBITDA to Adjusted EBITDA" section for a reconciliation of our net income (loss) to EBITDA and EBITDA to Adjusted EBITDA, both of which are non-U.S. GAAP financial measures. See also the information under the heading "Adjusted EBITDA" in the section "How We Assess the Performance of Our Business" for our definition of Adjusted EBITDA. The Company continues to progress on further defining and executing the "Big Dam Blueprint," which management believes will unlock the Company's full potential for long-term, sustainable growth. As introduced in the second quarter of 2021, the Big Dam Blueprint focuses on the following key strategic areas: Begin with a digital-first mindsetthat integrates technology into all areas of the business, fundamentally changing how we operate and deliver value to customers. Intensify efforts to optimize Duluth Trading's owned retail channelsby increasing focus and investments in our direct channel as our primary growth vehicle. We are conducting strategic research that will inform decisions on future stores regarding new locations and market share potential, size and layout. Evolve the Company's multi-brand platform as a new pathway to grow the business.Create unique brand positions, across men's and women's, for Duluth, 40Grit, Alaskan Hardgear, Buck Naked, and Best Made to address customer needs for various occasions including work, outdoor recreation, casual lifestyle, and first layer. Invest in the evolution of the Duluth Trading platform to enable the integration of new brands, expand our offerings and broaden our customer base. Carefully test and learn to unlock long-term growth potential.Explore new opportunities to engage current and potential customers through products, services and touchpoints that they expect and value. Increase and, in some areas, accelerate investments to future proof the business. Areas under analysis include greater automation across the logistics network; technology that will improve operations, generate positive impact and sustainable returns; support growth through multiple brands and seamlessly integrate new brands into the portfolio; and attract the talent, skillsets and expertise needed to scale the business. Our management's discussion and analysis includes market sales metrics for our stores, website and catalog sales. Market areas are determined by a third-party that divides the United States and Puerto Rico into 280 unique geographical areas. Our store market sales metrics include sales from our stores, website and catalog. Our non-store market sales metrics include sales from our website and catalog. In March 2020, a novel strain of coronavirus ("COVID-19") was declared a global pandemic by the World Health Organization. This pandemic has negatively affected the U.S. and global economies, disrupted global supply chains and financial markets, led to significant travel and transportation restrictions, including mandatory business closures and orders to shelter in place. The ultimate impact of COVID-19 on our operational and financial performance still depends on future developments outside of our control, including the duration and spread of the pandemic and related actions taken by federal, state and local government officials, and international governments to prevent disease spread. Given the uncertainty, we cannot reasonably estimate store traffic patterns and the prolonged impact on overall consumer demand. We continue to actively evaluate all federal, state and local regulations to ensure compliance by our store operations. How We Assess the Performance of Our Business In assessing the performance of our business, we consider a variety of financial and operating measures that affect our operating results. Net sales reflect our sale of merchandise plus shipping and handling revenue collected from our customers, less returns and discounts. Direct-to-consumer sales are recognized upon shipment of the product and store sales are recognized at the point of sale. Gross profit is equal to our net sales less cost of goods sold. Gross profit as a percentage of our net sales is referred to as gross margin. Cost of goods sold includes the direct cost of purchased merchandise; inventory shrinkage; inventory adjustments due to obsolescence, including excess and slow-moving inventory and lower of cost and net realizable reserves; inbound freight; and freight from our distribution centers to our retail stores. The primary drivers of the costs of individual goods are raw material costs. Depreciation and amortization are excluded from gross profit. We expect gross profit to increase to the extent that we successfully grow our net sales. Our gross profit may not be comparable to other retailers, as we do not include distribution network and store occupancy expenses in calculating gross profit, but instead we include them in selling, general and administrative expenses. Selling, general and administrative expenses include all operating costs not included in cost of goods sold. These expenses include all payroll and payroll-related expenses and occupancy expenses related to our stores and to our operations at our headquarters, including utilities, depreciation and amortization. They also include marketing expense, which primarily includes digital and television advertising, catalog production, mailing and print advertising costs, as well as all logistics costs associated with shipping product to our customers, consulting and software expenses and professional services fees. Selling, general and administrative expenses as a percentage of net sales is usually higher in lower-volume quarters and lower in higher-volume quarters because a portion of the costs are relatively fixed. Our historical sales growth has been accompanied by increased selling, general and administrative expenses. The most significant components of these increases are advertising, rent/occupancy and payroll costs. While we expect these expenses to increase as we continue to grow our organization to support our growing business and increase brand awareness, we believe these expenses will decrease as a percentage of sales over time. We believe Adjusted EBITDA is a useful measure of operating performance, as it provides a clearer picture of operating results by excluding the effects of financing and investing activities by eliminating the effects of interest and depreciation costs and eliminating expenses that are not reflective of underlying business performance. We use Adjusted EBITDA to facilitate a comparison of our operating performance on a consistent basis from period-to-period and to provide for a more complete understanding of factors and trends affecting our business. We define Adjusted EBITDA as consolidated net income before depreciation and amortization, interest expense and provision for income taxes adjusted for the impact of certain items, including non-cash and other items we do not consider representative of our ongoing operating performance. We believe Adjusted EBITDA is less susceptible to variances in actual performance resulting from depreciation, amortization and other items. We also use Adjusted EBITDA as the key financial metric in determining our fiscal 2021 bonus compensation for our employees. This non-GAAP measure may not be comparable to similarly titled measures used by other companies. The following table summarizes our unaudited consolidated results of operations for the periods indicated, both in dollars and as a percentage of net sales. Percentage of Net sales: Cost of goods sold (excluding depreciation ‎and amortization) Three Months Ended October 31, 2021 Compared to Three Months Ended November 1, 2020 Net sales increased $9.7 million, or 7.2%, to $145.3 million in the three months ended October 31, 2021 compared to $135.5 million in the three months ended November 1, 2020. The increase was primarily due to an increase in store market sales. Store market sales increased $9.4 million, or 10.5%, to $103.0 million in the three months ended October 31, 2021 compared to $93.6 million in the three months ended November 1, 2020. The year-over-year sales difference was primarily driven by continued increases in store traffic and conversion as compared to the prior year. Non-store market sales increased slightly by $0.3 million, or 0.7%, to $41.1 million in the three months ended October 31, 2021 compared to $40.7 million in the three months ended November 1, 2020. Gross profit increased $12.6 million, or 17.8%, to $83.6 million in the three months ended October 31, 2021 compared to $71.0 million in the three months ended November 1, 2020. As a percentage of net sales, gross margin increased to 57.6% of net sales in the three months ended October 31, 2021, compared to 52.4% of net sales in the three months ended November 1, 2020. The increase in gross margin rate was driven by a higher mix of full price sales due to lower clearance inventory and fewer promotional events as compared to the same period in the prior year. Selling, general and administrative expenses increased $10.6 million, or 15.5%, to $78.8 million in the three months ended October 31, 2021 compared to $68.2 million in the three months ended November 1, 2020. Selling, general and administrative expenses as a percentage of net sales increased to 54.2% in the three months ended October 31, 2021, compared to 50.3% in the three months ended November 1, 2020. The increase in selling, general and administrative expense was primarily due to higher personnel costs, coupled with increased advertising spend as advertising was limited in the prior year based on our uncertainty about customer demand resulting from the pandemic. Income tax expense was $0.9 million in the three months ended October 31, 2021, compared to an income tax expense of $0.4 million in the three months ended November 1, 2020. The effective tax rate related to controlling interest was 25% for the three months ended October 31, 2021 compared to 29% for the three months ended November 1, 2020. Net Income Attributable to Controlling Interest Net income attributable to controlling interest was $2.8 million, in the three months ended October 31, 2021 compared to net income of $0.9 million in the three months ended November 1, 2020, due to the factors discussed above. Nine Months Ended October 31, 2021 Compared to Nine Months Ended November 1, 2020 Net sales increased $45.0 million, or 11.8%, to $427.8 million in the nine months ended October 31, 2021 compared to $382.8 million in the nine months ended November 1, 2020. The increase was also due to an increase in store market sales, partially offset by a decrease in non-store market sales. Store market sales increased $49.7 million, or 19.9%, to $300.0 million in the nine months ended October 31, 2021 compared to $250.3 million in the nine months ended November 1, 2020. The year-over-year sales difference was driven by temporary store closures in fiscal 2020 beginning on March 20, 2020 through the third week of June, as well as growth in online sales from both existing customers and new buyers. Non-store market sales decreased $5.0 million, or 3.9%, to $123.8 million in the nine months ended October 31, 2021 compared to $128.8 million in the nine months ended November 1, 2020 also due to heavy volume in the prior year as customer purchasing patterns migrating online, coupled with extended free shipping offers, higher promotions and deeper investments in digital prospecting in the prior year. Gross profit increased $35.8 million, or 18.3%, to $231.6 million in the nine months ended October 31, 2021 compared to $195.8 million in the nine months ended November 1, 2020. As a percentage of net sales, gross margin increased to 54.1% of net sales in the nine months ended October 31, 2021, compared to 51.2% of net sales in the nine months ended November 1, 2020. The increase in gross margin rate was driven by a higher mix of full price sales due to lower clearance inventory and fewer promotional events, as well as improved gross margin rates on both full price and clearance items. Selling, general and administrative expenses increased $9.6 million, or 4.8%, to $211.8 million in the nine months ended October 31, 2021 compared to $202.2 million in the nine months ended November 1, 2020. Selling, general and administrative expenses as a percentage of net sales decreased to 49.5% in the nine months ended October 31, 2021, compared to 52.8% in the nine months ended November 1, 2020. The positive leverage was primarily due to shifting to a more efficient digital marketing approach, as well as lower shipping expenses driven in part by a shift in channel mix resulting from higher store traffic during the current year. The increase in selling, general and administrative expense was primarily due to increased wages due to Company retail locations being open for the full fiscal year, wage increases at both the stores and distribution centers, as well as increased depreciation expense associated with investments in technology. Income tax expense was $4.0 million in the nine months ended October 31, 2021, compared to an income tax benefit of $2.8 million in the nine months ended November 1, 2020. The effective tax rate related to controlling interest was 25% for the nine months ended October 31, 2021 compared to 26% for the nine months ended November 1, 2020. Net income attributable to controlling interest was $12.3 million, in the nine months ended October 31, 2021 compared to a net loss of $8.3 million in the nine months ended November 1, 2020, due to the factors discussed above. Reconciliation of Net Income (Loss) to EBITDA and EBITDA to Adjusted EBITDA The following table presents reconciliations of net income (loss) to EBITDA and EBITDA to Adjusted EBITDA, both of which are non-U.S. GAAP financial measures, for the periods indicated below. See the above section titled "How We Assess the Performance of Our Business," for our definition of Adjusted EBITDA. Amortization of internal-use software hosting subscription implementation costs Amortization of build-to-suit operating leases ‎capital contribution As a result of the factors discussed above in the "Results of Operations" section, Adjusted EBITDA increased $1.8 million to $13.2 million in the three months ended October 31, 2021 compared to $11.4 million in the three months ended November 1, 2020. As a percentage of net sales, Adjusted EBITDA increased to 9.1% of net sales in the three months ended October 31, 2021 compared to 8.4% of net sales in the three months ended November 1, 2020. As a result of the factors discussed above in the "Results of Operations" section, Adjusted EBITDA increased $28.3 million to $44.9 million in the nine months ended October 31, 2021 compared to $16.6 million in the nine months ended November 1, 2020. As a percentage of net sales, Adjusted EBITDA increased to 10.5% of net sales in the nine months ended October 31, 2021 compared to 4.3% of net sales in the nine months ended November 1, 2020. Our business relies on cash from operating activities and a credit facility as our primary sources of liquidity. Our primary cash needs have been for inventory, marketing and advertising, payroll, store leases, capital expenditures associated with infrastructure, information technology, and opening new stores. The most significant components of our working capital are cash, inventory, accounts payable and other current liabilities. At October 31, 2021, our net working capital was $89.9 million, including $20.4 million of cash and cash equivalents. We expect to spend approximately $18.5 million in fiscal 2021 on capital expenditures, inclusive of software hosting implementation costs. Capital expenditures includes a total of approximately $16.4 million related to investments in technology and $2.1 million for the one planned new retail store that opened in the third quarter. Due to the seasonality of our business, a significant amount of cash from operating activities is generated during the fourth quarter of our fiscal year. We also use cash in our investing activities for capital expenditures throughout all four quarters of our fiscal year. We believe that our cash flow from operating activities and the availability of cash under our credit facility will be sufficient to cover working capital requirements and anticipated capital expenditures for the foreseeable future. A summary of operating, investing and financing activities is shown in the following table. Operating activities consist primarily of net income adjusted for non-cash items that include depreciation and amortization, stock-based compensation and the effect of changes in operating assets and liabilities. For the nine months ended October 31, 2021, net cash provided by operating activities was $32.8 million, which primarily consisted of net income of $12.2 million, non-cash depreciation and amortization of $21.8 million, and cash used in operating assets and liabilities of $3.0 million. The cash used in operating assets and liabilities of $3.0 million primarily consisted of a $16.0 million increase in inventory and a $7.6 million decrease in income taxes payable offset by a $4.1 million increase in accrued expenses and a $24.9 million increase in trade accounts payable. For the nine months ended November 1, 2020, net cash used in operating activities was $28.6 million, which consisted of net loss of $8.4 million and cash used in operating assets and liabilities of $46.5 million, partially offset by non-cash depreciation and amortization of $21.2 million, stock based compensation of $1.3 million and deferred income taxes of $3.5 million. The cash used in operating assets and liabilities of $46.5 million primarily consisted of a $65.6 million increase in inventory in advance of our peak season, partially offset by a $21.4 million increase in trade accounts payable. Investing activities consist primarily of capital expenditures for growth related to investments in infrastructure, information technology, and new store openings. For the nine months ended October 31, 2021, net cash used in investing activities was $8.9 million and was primarily driven by capital expenditures of $9.1 million for a new distribution center and one new retail store, as well as investments in information technology. For the nine months ended November 1, 2020, net cash used in investing activities was $11.5 million and was primarily driven by capital expenditures of $11.1 million for new retail stores, as well as investments in information technology. Financing activities consist primarily of borrowings and payments related to our revolving line of credit and other long-term debt, as well as payments on finance lease obligations. For the nine months ended October 31, 2021, net cash used in financing activities was $50.6 million, primarily consisting of the full paydown of Duluth's debt. For the nine months ended November 1, 2020, net cash provided by financing activities was $50.7 million, primarily consisting of proceeds of $28.9 million, net from our term loan and proceeds of $23.7 million, net from our revolving line of credit to fund working capital. Contractual Obligations There have been no significant changes to our contractual obligations as described in our Annual Report on Form 10-K for the fiscal year ended January 31, 2021. We are not a party to any material off-balance sheet arrangements. Critical Accounting Policies and Critical Accounting Estimates The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses, as well as the related disclosures of contingent assets and liabilities at the date of the financial statements. We evaluate our accounting policies, estimates, and judgments on an on-going basis. We base our estimates and judgments on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions and conditions and such differences could be material to the consolidated financial statements. As of the date of this filing, there were no significant changes to any of the critical accounting policies and estimates described in our 2020 Form 10-K. See Note 12 "Recent Accounting Pronouncements," of Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1, of this quarterly report on Form 10-Q for information regarding recent accounting pronouncements. Item 3. Quantitative and Qualitative Disclosures About Market Risk There have been no significant changes in the market risks described in our 2020 Form 10-K. See Note 3 "Debt and Credit Agreement," of Notes to Condensed Consolidated Financial Statements included in Part 1, Item 1, of this quarterly report on Form 10-Q, for disclosure on our interest rate related to borrowings under our credit agreement. Item 4. Controls and Procedures Section 13a-15(b) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), requires management of an issuer subject to the Exchange Act to evaluate, with the participation of the issuer's principal executive and principal financial officers, or persons performing similar functions, the effectiveness of the issuer's disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act), as of the end of each fiscal quarter. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective. There were no changes in our internal control over financial reporting (as defined in Rule 13a-15(d) and 15d-15(d) under the Exchange Act) that occurred during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect our internal control over financial reporting. PART II. OTHER INFORMATION Item 1. Legal Proceedings From time to time, we are subject to certain legal proceedings and claims in the ordinary course of business. We are not presently party to any legal proceedings the resolution of which we believe would have a material adverse effect on our business, financial condition, operating results or cash flows. We establish reserves for specific legal matters when we determine that the likelihood of an unfavorable outcome is probable and the loss is reasonably estimable. Item 1A. Risk Factors We operate in a rapidly changing environment that involves a number of risks that may have a material adverse effect on our business, financial condition and results of operations. For a detailed discussion of the risks that affect our business, please refer to the section entitled "Risk Factors" in our 2020 Form 10-K, or other SEC filings. There have been no material changes to our risk factors as previously disclosed in our fiscal 2020 Annual Report on Form 10-K. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds We did not sell any equity securities during the quarter ended October 31, 2021, which were not registered under the Securities Act. The following table contains information of shares acquired from employees in lieu of amounts required to satisfy minimum tax withholding requirements upon the vesting of the employees' restricted stock during the three months ended October 31, 2021. Approximate dollar of shares purchased value of shares that as part of publicly may yet to be announced plans purchased under the paid per share or programs plans or programs August 30, 2021 - October 3, 2021 Item 6. Exhibits Exhibit No. Certification of Chief Executive Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities and Exchange Act, as amended.* Certification of Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a) of the Securities and Exchange Act of 1934, as amended.* Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.* 101.INS XBRL Instance Document** 101.SCH XBRL Taxonomy Extension Schema Document** 101.CAL XBRL Taxonomy Extension Calculation Linkbase Document** 101.DEF XBRL Taxonomy Extension Definition Document** 101.LAB XBRL Taxonomy Extension Label Linkbase Document** 101.PRE XBRL Taxonomy Extension Presentation Linkbase Document** The cover page from the Company's Quarterly Report on Form 10-Q for the quarter ended October 31, 2021 has been formatted in Inline XBRL (Inline Extensible Business Reporting Language and contained in Exhibits 101). Filed herewith In accordance with Regulation S-T, the XBRL-related information in Exhibit 101 to this Quarterly Report on Form 10-Q shall be deemed to be "furnished" and not "filed." ‎(Registrant) /s/ David Loretta David Loretta Senior Vice President and Chief Financial Officer (On behalf of the Registrant and as Principal Financial Officer) /s/ Michael Murphy Vice President and Chief Accounting Officer (On behalf of the Registrant and as Principal Accounting Officer) Smartlinks | Duluth Holdings Inc. | News | Local News | Top Business and Economy News | Finance | Stock Markets | Security Markets | Stock Markets | Security Markets | Company News | Top Company News | Construction and Engineering | Retail | Specialty Stores | Public Companies | Hardware, Gardening and Building Material Retailers | Börse Frankfurt | NYSE American | NYSE ARCA Equities | Nasdaq Global Select Market | BZX Exchange | BYX Exchange | EDGA Exchange | EDGX Exchange | NYSE National | Nasdaq BX | Nasdaq PSX | NYSE Chicago

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WHIRLPOOL CORP /DE/ - FORM 10-K - February 13, 2017 EX-32.1 - EXHIBIT 32.1 - WHIRLPOOL CORP /DE/ exb321-12312016.htm EX-24 - EXHIBIT 24 - WHIRLPOOL CORP /DE/ exb24powerofattorney123120.htm EX-23 - EXHIBIT 23 - WHIRLPOOL CORP /DE/ exb23consentofindependentr.htm EX-21 - EXHIBIT 21 - WHIRLPOOL CORP /DE/ exb21listofsubsidiaries123.htm EX-12 - EXHIBIT 12 - WHIRLPOOL CORP /DE/ exb12ratioofearningstofixe.htm UNITED STATES SECURITIES AND EXCHANGE COMMISSION ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2016 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _______ to _______ Commission file number 1-3932 2000 North M-63, Benton Harbor, Michigan Registrant’s telephone number, including area code (269) 923-5000 Title of each class Name of each exchange on which registered Common stock, par value $1 per share Chicago Stock Exchange and New York Stock Exchange 0.625% Senior Notes due 2020 Securities registered pursuant to Section 12(g) of the Act: NONE Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yesý No¨ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes¨ Noý Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such report), and (2) has been subject to such filing requirements for the past 90 days. Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one) Large accelerated filer ý Accelerated filer ¨ Non-accelerated filer ¨ (Do not check if a smaller reporting company) Smaller reporting company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). The aggregate market value of voting common stock of the registrant held by stockholders not including voting stock held by directors and executive officers of the registrant and certain employee plans of the registrant (the exclusion of such shares shall not be deemed an admission by the registrant that any such person is an affiliate of the registrant) at the close of business on June 30, 2016 (the last business day of the registrant’s most recently completed second fiscal quarter) was $12,263,819,115. On February 3, 2017, the registrant had 74,467,790 shares of common stock outstanding. Portions of the following documents are incorporated herein by reference into the Part of the Form 10-K indicated: Part of Form 10-K into which incorporated The registrant’s proxy statement for the 2017 annual meeting of stockholders (the “Proxy Statement”) ANNUAL REPORT ON FORM 10-K Item 1B. Unresolved Staff Comments Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Selected Financial Data Management's Discussion and Analysis of Financial Condition and Results of Operations Financial Statements and Supplementary Data Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 10. Directors, Executive Officers and Corporate Governance Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Principal Accounting Fees and Services Exhibits, Financial Statement Schedules Form 10-K Summary Whirlpool Corporation ("Whirlpool"), the number one major appliance manufacturer in the world, was incorporated in 1955 under the laws of Delaware as the successor to a business that traces its origin to 1898. Whirlpool manufactures products in 14 countries and markets products in nearly every country around the world under brand names such as Whirlpool, KitchenAid, Maytag, Consul, Brastemp, Amana, Bauknecht, Jenn-Air, Indesit, and Hotpoint*. Whirlpool’s reportable segments consist of North America, Europe, Middle East and Africa ("EMEA"), Latin America and Asia. As of December 31, 2016, Whirlpool had approximately 93,000 employees. As used herein, and except where the context otherwise requires, “Whirlpool,” “the Company,” “we,” “us,” and “our” refer to Whirlpool Corporation and its consolidated subsidiaries. Products and Regions Whirlpool manufactures and markets a full line of major home appliances and related products. Our principal products are laundry appliances, refrigerators and freezers, cooking appliances, dishwashers, mixers and other small domestic appliances. We also produce hermetic compressors for refrigeration systems. The following table provides the percentage of net sales for each class of products which accounted for 10% or more of our consolidated net sales over the last three years: In North America, Whirlpool markets and distributes major home appliances and small domestic appliances under a variety of brand names. In the United States, we market and distribute products primarily under the Whirlpool, Maytag, KitchenAid, Jenn-Air, Amana, Roper, Admiral, Affresh and Gladiator brand names primarily to retailers, distributors and builders. In Canada, we market and distribute major home appliances primarily under the Inglis, Admiral, Whirlpool, Maytag, Jenn-Air, Amana, Roper, Estate and KitchenAid brand names. In Mexico, we market and distribute major home appliances primarily under the Whirlpool, Maytag, Acros, KitchenAid and Supermatic brand names. We sell some products to other manufacturers, distributors, and retailers for resale in North America under those manufacturers’ and retailers’ respective brand names. In EMEA, we market and distribute our major home appliances primarily under the Whirlpool, Bauknecht, Ignis, Maytag, Laden, Indesit and Privileg brand names, and major and small domestic appliances under the KitchenAid, Hotpoint*, and Hotpoint-Ariston brand name. In addition to our operations in Western and Eastern Europe, Turkey and Russia, we have sales subsidiaries in Morocco and Dubai. We market and distribute a full line of products under the Whirlpool and KIC brand names in South Africa. Our European operations also market and distribute products under the Whirlpool, Bauknecht, Maytag, Amana and Ignis brand names to distributors and dealers in Africa and the Middle East. In Latin America, we market and distribute our major home appliances and small domestic appliances primarily under the Consul, Brastemp, Whirlpool and KitchenAid brand names. We manage sales and distribution through our local entities in Brazil, Argentina, Chile, Peru, Ecuador, Colombia and Guatemala. We also serve the countries of Bolivia, Paraguay, Uruguay, Venezuela, and certain Caribbean and Central America countries, where we manage appliances sales and distribution through our accredited distributors. Our Latin America operations also produce hermetic compressors for refrigeration systems. *Whirlpool ownership of the Hotpoint brand in the EMEA and Asia Pacific regions is not affiliated with the Hotpoint brand sold in the Americas In Asia, we have organized the marketing and distribution of our major home appliances and small domestic appliances into five operating groups: (1) mainland China; (2) Hong Kong and Taiwan; (3) India, which includes Bangladesh, Sri Lanka, Nepal and Pakistan; (4) Oceania, which includes Australia, New Zealand and Pacific Islands; and (5) Southeast Asia, which includes Thailand, Singapore, Malaysia, Indonesia, Vietnam, the Philippines, Korea, Myanmar and Japan. We market and distribute our products in Asia primarily under the Whirlpool, Maytag, KitchenAid, Amana, Bauknecht, Jenn-Air, Diqua, and Royalstar brand names through a combination of direct sales to appliance retailers and chain stores and through full-service distributors to a large network of retail stores. Competition in the major home appliance industry is intense, including competitors such as Arcelik, Bosch Siemens, Electrolux, Haier, Kenmore, LG, Mabe, Midea, Panasonic and Samsung, many of which are increasingly expanding beyond their existing manufacturing footprint. Moreover, our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. Competition in our business is based upon a wide variety of factors, including selling price, product features and design, performance, innovation, energy efficiency, quality, cost, distribution and financial incentives. These financial incentives include cooperative advertising, co-marketing funds, salesperson incentives, volume rebates and terms. We believe that we can best compete in the current environment by focusing on introducing new and innovative products, building strong brands, enhancing trade customer and consumer value with our product and service offerings, expanding our regional footprint and trade distribution channels, increasing productivity, improving quality, lowering costs, and taking other efficiency-enhancing measures. Raw Materials and Purchased Components We are generally not dependent upon any one source for raw materials or purchased components essential to our business. In areas where a single supplier is used, alternative sources are generally available and can be developed within the normal manufacturing environment. Some supply disruptions and unanticipated costs may be incurred in transitioning to a new supplier if a prior single supplier relationship was abruptly interrupted or terminated. In the event of a disruption, we believe that we will be able to qualify and use alternate materials, sometimes at premium costs, and that such raw materials and components will be available in adequate quantities to meet forecasted production schedules. Trademarks, Licenses and Patents We consider the trademarks, copyrights, patents, and trade secrets we own, and the licenses we hold, in the aggregate, to be a valuable asset. Whirlpool is the owner of a number of trademarks in the United States and foreign countries. The most important trademarks to North America are Whirlpool, Maytag, Jenn-Air, KitchenAid, Amana and Acros. The most important trademarks to Latin America are Consul, Brastemp, Whirlpool and KitchenAid. The most important trademarks to EMEA are Whirlpool, KitchenAid, Bauknecht, Indesit, Hotpoint*, Hotpoint-Ariston and Ignis. The most important trademarks to Asia are Whirlpool, Royalstar and Diqua. We receive royalties from licensing our trademarks to third parties to manufacture, sell and service certain products bearing the Whirlpool, Maytag, KitchenAid, and Amana brand names. We continually apply for and obtain United States and foreign patents. The primary purpose in obtaining patents is to protect our designs and technologies. Expenditures for research and development relating to new and innovative products and the improvement of existing products were approximately $604 million, $579 million and $563 million in 2016, 2015 and 2014, respectively. Protection of the Environment Our manufacturing facilities are subject to numerous laws and regulations designed to protect or enhance the environment, many of which require federal, state, or other governmental licenses and permits with regard to wastewater discharges, air emissions, and hazardous waste management. Our policy is to comply with all such laws and regulations. Where laws and regulations are less restrictive, we have established and are following our own standards, consistent with our commitment to environmental responsibility. We believe that we are in compliance, in all material respects, with presently applicable governmental provisions relating to environmental protection in the countries in which we have manufacturing operations. Compliance with these environmental laws and regulations did not have a material effect on capital expenditures, earnings, or our competitive position during 2016 and is not expected to be material in 2017. The entire major home appliance industry, including Whirlpool, must contend with the adoption of stricter governmental energy and environmental standards. These standards were phased-in over the past several years and include the general phase-out of ozone-depleting chemicals used in refrigeration, and energy standards for selected major appliances, regulatory restrictions on the materials content specified for use in our products by some jurisdictions and mandated recycling of our products at the end of their useful lives. Compliance with these various standards, as they become effective, will require some product redesign. However, we believe, based on our understanding of the current state of proposed regulations, that we will be able to develop, manufacture, and market products that comply with these regulations. Whirlpool participates in environmental assessments and cleanup at a number of locations globally. These include operating and non-operating facilities, previously owned properties and waste sites, including "Superfund" (under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA)) sites. However, based upon our evaluation of the facts and circumstances relating to these sites along with the evaluation of our technical consultants, we do not presently anticipate any material adverse effect upon our earnings, financial condition, or competitive position arising out of the resolution of these matters or the resolution of any other known governmental proceeding regarding environmental protection matters. Whirlpool China On October 24, 2014, Whirlpool's wholly-owned subsidiary, Whirlpool (China) Investment Co., Ltd., completed its acquisition of a 51% equity stake in Hefei Rongshida Sanyo Electric Co., Ltd. ("Hefei Sanyo"), a joint stock company whose shares are listed and traded on the Shanghai Stock Exchange, which we have since renamed to Whirlpool (China) Co., Ltd. ("Whirlpool China"). The aggregate purchase price for the transaction was RMB 3.4 billion (approximately $551 million at the date of purchase for each step of the transaction) net of cash acquired. Indesit Company S.p.A. On December 3, 2014, Whirlpool completed the final step in its acquisition of Indesit Company S.p.A. ("Indesit") and on the same day Indesit delisted from the Electronic Stock Market organized and managed by Borsa Italiana S.p.A. Total consideration paid for Indesit was €1.1 billion (approximately $1.4 billion at the dates of purchase of each step in the transaction) in aggregate net of cash acquired. Further discussion of these transactions can be found in the Financial Condition and Liquidity section of Management's Discussion and Analysis. For information about the challenges and risks associated with our foreign operations, see “Risks Factors” under Item 1A. For certain other financial information concerning our business segments and foreign and domestic operations, see Note 13 to the Consolidated Financial Statements. For information on our global restructuring plans, and the impact of these plans on our operating segments, see Note 10 to the Consolidated Financial Statements. Executive Officers of the Registrant The following table sets forth the names and ages of our executive officers on February 13, 2017, the positions and offices they held on that date, and the year they first became executive officers: First Became an Executive Jeff M. Fettig Director, Chairman of the Board and Chief Executive Officer Marc R. Bitzer Director, President and Chief Operating Officer Esther Berrozpe Galindo Executive Vice President and President, Whirlpool EMEA João C. Brega Executive Vice President and President, Whirlpool Latin America Joseph T. Liotine Executive Vice President and President, Whirlpool North America James W. Peters Executive Vice President and Chief Financial Officer David T. Szczupak Executive Vice President, Global Product Organization The executive officers named above were elected by our Board of Directors to serve in the office indicated until the first meeting of the Board of Directors following the annual meeting of stockholders in 2017 and until a successor is chosen and qualified or until the executive officer's earlier resignation or removal. Each of our executive officers has held the position set forth in the table above or has served Whirlpool in various executive or administrative capacities for at least the past five years. Financial results and investor information (including Whirlpool’s Form 10-K, 10-Q, and 8-K reports) are accessible at Whirlpool’s website: investors.whirlpoolcorp.com. Copies of our Form 10-K, 10-Q, and 8-K reports and amendments, if any, are available free of charge through our website on the same day they are filed with, or furnished to, the Securities and Exchange Commission. This report contains statements referring to Whirlpool that are not historical facts and are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements, which are intended to take advantage of the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, are based on current projections about operations, industry conditions, financial condition and liquidity. Words that identify forward-looking statements include words such as “may,” “could,” “will,” “should,” “possible,” “plan,” “predict,” “forecast,” “potential,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “believe,” “may impact,” “on track,” and words and terms of similar substance used in connection with any discussion of future operating or financial performance, a merger, or our businesses. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Those statements are not guarantees and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results could differ materially and adversely from these forward-looking statements. We have listed below the most significant strategic, operational, financial, and legal and compliance risks relating to our business. STRATEGIC RISKS Key Risk Risk Description We face intense competition in the major home appliance industry and failure to successfully compete could negatively affect our business and financial performance. Each of our operating segments operates in a highly competitive business environment and faces intense competition from a growing number of competitors, many of which have strong consumer brand equity. Several of these competitors, such as Arcelik, Bosch Siemens, Electrolux, Haier, LG, Mabe, Midea, Panasonic and Samsung are large, well-established companies, many ranking among the Global Fortune 150, and have demonstrated a commitment to success in the global market. Moreover, our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. Competition in the global appliance market is based on a number of factors including selling price, product features and design, performance, innovation, reputation, energy efficiency, quality, cost, distribution, and financial incentives, such as cooperative advertising, co-marketing funds, sales person incentives, volume rebates and terms. Many of our competitors are increasingly expanding beyond their existing manufacturing footprints. Our competitors, especially global competitors with low-cost sources of supply and/or highly protected home markets outside the United States, have aggressively priced their products and/or introduced new products to increase market share and expand into new geographies. If we are unable to successfully compete in this highly competitive environment, our business and financial performance could be negatively affected. The loss of, or substantial decline in, sales to any of our key trade customers, major buying groups, and builders could adversely affect our financial performance. We sell to a sophisticated customer base of large trade customers that have significant leverage as buyers over their suppliers. Most of our products are not sold through long-term contracts, allowing trade customers to change volume among suppliers. As the trade customers continue to become larger, they may seek to use their position to improve their profitability by various means, including improved efficiency, lower pricing, and increased promotional programs. If we are unable to meet their demand requirements, our volume growth and financial results could be negatively affected. The loss of, or substantial decline in volume of, sales to our key trade customers, major buying groups, builders, or any other trade customers to which we sell a significant amount of products, could adversely affect our financial performance. Additionally, the loss of market share or financial difficulties, including bankruptcy and financial restructuring, by these trade customers could have a material adverse effect on our liquidity, financial position and results of operations. Failure to maintain our reputation and brand image could negatively impact our business. Our brands have worldwide recognition, and our success depends on our ability to maintain and enhance our brand image and reputation. Maintaining, promoting and growing our brands depends on our marketing efforts, including advertising and consumer campaigns, as well as product innovation. We could be adversely impacted if we fail to achieve any of these objectives or if, whether or not justified, the reputation or image of our company or any of our brands is tarnished or receives negative publicity. In addition, adverse publicity about regulatory or legal action against us, or product quality issues, could damage our reputation and brand image, undermine our customers' confidence in us and reduce long-term demand for our products, even if the regulatory or legal action is unfounded or not material to our operations. In addition, our success in maintaining, extending and expanding our brand image depends on our ability to adapt to a rapidly changing media environment, including our increasing reliance on social media and online dissemination of advertising campaigns. Inaccurate or negative posts or comments about us on social networking and other websites that spread rapidly through such forums could seriously damage our reputation and brand image. If we do not maintain, extend and expand our brand image, then our product sales, financial condition and results of operations could be materially and adversely affected. An inability to effectively execute and manage our business objectives could adversely affect our financial performance. The highly competitive nature of our industry requires that we effectively execute and manage our business objectives including our global operating platform initiative. Our global operating platform initiative aims to reduce costs, expand margins, drive productivity and quality improvements, accelerate our rate of innovation, and drive shareholder value. Our inability to effectively control costs and drive productivity improvements could affect our profits. In addition, our inability to provide high-quality, innovative products could adversely affect our ability to maintain or increase our sales, which could negatively affect our revenues and overall financial performance. Additionally, our success is dependent on anticipating and appropriately reacting to changes in customer preferences and on successful new product and process development and product relaunches in response to such changes. Our future results and our ability to maintain or improve our competitive position will depend on our capacity to gauge the direction of our key markets and upon our ability to successfully and timely identify, develop, manufacture, market, and sell new or improved products in these changing markets. Our intellectual property rights are valuable, and any inability to protect them could reduce the value of our products, services and brands. We consider our intellectual property rights, including patents, trademarks, copyrights and trade secrets, and the licenses we hold, to be a significant part and valuable aspect of our business. We attempt to protect our intellectual property rights through a combination of patent, trademark, copyright and trade secret laws, as well as licensing agreements and third party nondisclosure and assignment agreements. Our failure to obtain or adequately protect our trademarks, products, new features of our products, or our processes may diminish our competitiveness. We have applied for intellectual property protection in the United States and other jurisdictions with respect to certain innovations and new products, design patents, product features, and processes. We cannot be assured that the U.S. Patent and Trademark Office or any similar authority in other jurisdictions will approve any of our patent applications. Additionally, the patents we own could be challenged or invalidated, others could design around our patents or the patents may not be of sufficient scope or strength to provide us with any meaningful protection or commercial advantage. Further, the laws of certain foreign countries in which we do business, or contemplate doing business in the future, do not recognize intellectual property rights or protect them to the same extent as United States law. As a result, these factors could weaken our competitive advantage with respect to our products, services, and brands in foreign jurisdictions, which could adversely affect our financial performance. Moreover, while we do not believe that any of our products infringe on enforceable intellectual property rights of third parties, others may assert intellectual property rights that cover some of our technology, brands, products, or services. Any litigation regarding patents or other intellectual property could be costly and time-consuming and could divert the attention of our management and key personnel from our business operations. Claims of intellectual property infringement might also require us to enter into costly license agreements or modify our products or services. We also may be subject to significant damages, injunctions against development and sale of certain products or services, or limited in the use of our brands. OPERATIONAL RISKS We face risks associated with our acquisitions and other investments and risks associated with our increased presence in emerging markets. From time to time, we make strategic acquisitions, investments and participate in joint ventures. For example, we acquired Indesit and a majority interest in Hefei Sanyo in the fourth quarter of 2014. These transactions, and other transactions that we have entered into or which we may enter into in the future, can involve significant challenges and risks, including that the transaction does not advance our business strategy or fails to produce a satisfactory return on our investment. We may encounter difficulties in integrating acquisitions with our operations, applying our internal control processes to these acquisitions, and in managing strategic investments. Integrating acquisitions is often costly and may require significant attention from management. Furthermore, we may not realize the degree, or timing, of benefits we anticipate when we first enter into a transaction. While our evaluation of any potential acquisition includes business, legal and financial due diligence with the goal of identifying and evaluating the material risks involved, our due diligence reviews may not identify all of the issues necessary to accurately estimate the cost and potential loss contingencies of a particular transaction, including potential exposure to regulatory sanctions resulting from an acquisition target’s previous activities or costs associated with any quality issues with an acquisition target's legacy products. Our growth plans include efforts to increase revenue from emerging markets, including through acquisitions. Local business practices in these countries may not comply with U.S. laws, local laws or other laws applicable to us or our compliance policies, which non-compliant practices may result in increased liability risks. For example, we may incur unanticipated costs, expenses or other liabilities as a result of an acquisition target’s violation of applicable laws, such as the U.S. Foreign Corrupt Practices Act (FCPA) or similar worldwide anti-bribery laws in non-U.S. jurisdictions. We may incur unanticipated costs or expenses, including post-closing asset impairment charges, expenses associated with eliminating duplicate facilities, litigation, and other liabilities. In addition, our recent and future acquisitions may increase our exposure to other risks associated with operating internationally, including foreign currency exchange rate fluctuations; political, legal and economic instability; inflation; changes in tax rates and tax laws; and work stoppages and labor relations. Risks associated with our international operations may decrease our revenues and increase our costs. For the year ended December 31, 2016, international operations represent approximately 54% of our net sales, including 25% in EMEA, 16% in Latin America, 7% in Asia, 4% in Canada and 2% in Mexico. We expect that international sales will continue to account for a significant percentage of our net sales in the foreseeable future. Accordingly, we face numerous risks associated with conducting international operations, any of which could negatively affect our financial performance. These risks include the following: •political, legal, and economic instability and uncertainty; •foreign currency exchange rate fluctuations; •changes in foreign tax rules, regulations and other requirements, such as changes in tax rates and statutory and judicial interpretations of tax laws; •changes in diplomatic and trade relationships, including sanctions resulting from the current political situation in countries in which we do business; •inflation and/or deflation •changes in foreign country regulatory requirements; •various import/export restrictions and disruptions and the availability of required import/export licenses; •imposition of tariffs and other trade barriers; •managing widespread operations and enforcing internal policies and procedures such as compliance with U.S. and foreign anti-bribery and anti-corruption regulations, such as the FCPA, and antitrust laws; •labor disputes and work stoppages at our operations and suppliers; •government price controls; •the inability to collect accounts receivable; and •limitations on the repatriation or movement of earnings and cash. As a U.S. corporation, we are subject to the FCPA, which may place us at a competitive disadvantage to foreign companies that are not subject to similar regulations. Additionally, any determination that we have violated the FCPA or other anti-corruption laws could have a material adverse effect on us. Terrorist attacks, armed conflicts, civil unrest, natural disasters, governmental actions and epidemics could affect our domestic and international sales, disrupt our supply chain, and impair our ability to produce and deliver our products. Such events could directly impact our physical facilities or those of our suppliers or customers. We may be subject to information technology system failures, network disruptions, cybersecurity attacks and breaches in data security, which may materially adversely affect our operations, financial condition and operating results. We depend on information technology to improve the effectiveness of our operations and to interface with our customers, as well as to maintain financial accuracy and efficiency. Information technology system failures, including suppliers' or vendors' system failures, could disrupt our operations by causing transaction errors, processing inefficiencies, delays or cancellation of customer orders, the loss of customers, impediments to the manufacture or shipment of products, other business disruptions, or the loss of or damage to intellectual property through security breach. In addition, we have outsourced certain information technology support services and administrative functions, such as payroll processing and benefit plan administration, to third-party service providers and may outsource other functions in the future to achieve cost savings and efficiencies. If these service providers do not perform effectively, we may not achieve the expected cost savings and may incur additional costs to correct errors made by such service providers. Depending on the function involved, such errors may also lead to business disruption, processing inefficiencies or the loss of or damage to intellectual property through security breach, or harm employee morale. Our information systems, or those of our third-party service providers, could also be penetrated by outside parties intent on extracting or corrupting information or disrupting business processes. Such unauthorized access could disrupt our business and could result in the loss of assets. Cybersecurity attacks are becoming more sophisticated and include malicious software, attempts to gain unauthorized access to data, and other electronic security breaches that could lead to disruptions in critical systems, unauthorized release of confidential or otherwise protected information, and corruption of data. These events could impact our customers and reputation and lead to financial losses from remediation actions, loss of business or potential liability or an increase in expense, all of which may have a material adverse effect on our business. Product-related liability or product recall costs could adversely affect our business and financial performance. We may be exposed to product-related liabilities, which in some instances may result in product redesigns, product recalls, or other corrective action. In addition, any claim or product recall that results in significant adverse publicity, particularly if those claims or recalls cause customers to question the safety or reliability of our products, may negatively affect our business, financial condition, or results of operations. We maintain product liability insurance, but it may not be adequate to cover losses related to product liability claims brought against us. Product liability insurance could become more expensive and difficult to maintain and may not be available on commercially reasonable terms, if at all. We may also be involved in certain class action and other litigation, for which no insurance is available. A cost effective market for product recall insurance does not exist, so any product recall we initiate could have a significant impact on our operating results and/or cash flows. We regularly engage in investigations of potential quality and safety issues as part of our ongoing effort to deliver quality products to our customers. We are currently investigating a limited number of potential quality and safety issues, and as appropriate, we undertake to effect repair or replacement of appliances. Currently we are implementing a corrective action plan affecting certain of our Indesit and Hotpoint* branded dryers (see Note 6 of the Notes to the Consolidated Financial Statements for additional information on these matters). Actual costs of these and any future issues depend upon several factors, including the number of consumers who respond to a particular recall, repair and administrative costs, whether the cost of any corrective action is borne by Whirlpool or the supplier, and, if borne by Whirlpool, whether we will be successful in recovering our costs from the supplier. The actual costs incurred as a result of these issues and any future issues could have a material adverse effect on our business, financial condition or results of operations. The ability of suppliers to deliver parts, components and manufacturing equipment to our manufacturing facilities, and our ability to manufacture without disruption, could affect our global business performance. We use a wide range of materials and components in the global production of our products, which come from numerous suppliers. Because not all of our business arrangements provide for guaranteed supply and some key parts may be available only from a single supplier or a limited group of suppliers, we are subject to supply and pricing risk. In addition, certain proprietary component parts used in some of our products are provided by single-source unaffiliated third-party suppliers. We would be unable to obtain these proprietary components for an indeterminate period of time if these single-source suppliers were to cease or interrupt production or otherwise fail to supply these components to us, which could adversely affect our product sales and operating results. Our operations and those of our suppliers are subject to disruption for a variety of reasons, including work stoppages, labor relations, intellectual property claims against suppliers, information technology failures, and hazards such as fire, earthquakes, flooding, or other natural disasters, insurance for any of which may not be available, affordable or adequate. Such disruption could interrupt our ability to manufacture certain products. Any significant disruption could negatively impact our revenue and/or earnings performance. Our ability to attract, develop and retain executives and other qualified employees is crucial to our results of operations and future growth. We depend upon the continued services and performance of our key executives, senior management and skilled personnel, particularly professionals with experience in our business and operations and the home appliance industry. We cannot be sure that any of these individuals will continue to be employed by us. Significant time is required to hire and develop skilled replacement personnel. An inability to hire, develop, engage and retain a sufficient number of qualified employees could materially hinder our business by, for example, delaying our ability to bring new products to market or impairing the success of our operations. A deterioration in labor relations could adversely impact our global business. As of December 31, 2016, we had approximately 93,000 employees. We are subject to separate collective bargaining agreements with certain labor unions, which generally have two to three year terms, as well as various other commitments regarding our workforce. We periodically negotiate with certain unions representing our employees and may be subject to work stoppages or may be unable to renew collective bargaining agreements on the same or similar terms, or at all, all of which may also have a material adverse effect on our business, financial condition, or results of operations. Fluctuations and volatility in the cost of raw materials and purchased components could adversely affect our operating results. The sources and prices of the primary materials (such as steel, resins, and base metals) used to manufacture our products and components containing those materials are susceptible to significant global and regional price fluctuations due to supply/demand trends, transportation costs, government regulations (such as conflict mineral provisions) and tariffs, changes in currency exchange rates, price controls, the economic climate, and other unforeseen circumstances. Significant increases in these and other costs in the future could have a material adverse effect on our operating results. Foreign currency fluctuations may affect our financial performance. We generate a significant portion of our revenue and incur a significant portion of our expenses in foreign currencies. Changes in the exchange rates of functional currencies of those operations affect the U.S. dollar value of our revenue and earnings from our foreign operations. We use currency forwards, net investment hedges, and options to manage our foreign currency transaction exposures. We cannot completely eliminate our exposure to foreign currency fluctuations, which may adversely affect our financial performance. In addition, because our consolidated financial results are reported in U.S. dollars, if we generate sales or earnings in other currencies, the translation of those results into U.S. dollars can result in a significant increase or decrease in the amount of those sales or earnings. Finally, the amount of legal contingencies related to foreign operations may fluctuate significantly based upon changes in exchange rates and usually cannot be managed with currency forwards, options or other arrangements. Such fluctuations in exchange rates can significantly increase or decrease the amount of any legal contingency related to our foreign operations and make it difficult to assess and manage the potential exposure. We face inventory and other asset risk. We write down product and component inventories that have become obsolete or do not meet anticipated demand or net realizable value. We also review our long-lived and intangible assets for impairment whenever events or changed circumstances indicate the carrying amount of an asset may not be recoverable. If we determine that impairment has occurred, we record a write-down to adjust carrying value to fair value. No assurance can be given that, given the unpredictable pace of product obsolescence and business conditions with trade customers and in general, we will not incur additional inventory or asset related charges. Such charges could negatively affect our financial condition and operating results. We are exposed to risks associated with the uncertain global economy. Uncertain and changing economic conditions within our regions, along with national debt and fiscal concerns in various regions and government austerity measures, are posing challenges to the industry in which Whirlpool operates. A number of economic factors, including gross domestic product, availability of consumer credit, interest rates, consumer sentiment and debt levels, retail trends, housing starts, sales of existing homes, the level of mortgage refinancing and defaults, fiscal and credit market uncertainty, and foreign currency exchange rates, generally affect demand for our products. Economic uncertainty and related factors exacerbate negative trends in business and consumer spending and may cause certain customers to push out, cancel, or refrain from placing orders for our products. Uncertain market conditions, difficulties in obtaining capital, or reduced profitability may also cause some customers to scale back operations, exit markets, merge with other retailers, or file for bankruptcy protection and potentially cease operations, which can also result in lower sales and/or additional inventory. These conditions may similarly affect key suppliers, which could impair their ability to deliver parts and result in delays for our products or added costs. In addition, these conditions may lead to strategic alliances by, or consolidation of, other appliance manufacturers, which could adversely affect our ability to compete effectively. A decline in economic activity and conditions in certain areas in which we operate have had an adverse effect on our financial condition and results of operations in recent years, and future declines and adverse conditions could have a similar adverse effect. Regional, political and economic instability in countries in which we do business may adversely affect business conditions, disrupt our operations, and have an adverse effect on our financial condition and results of operations. Uncertainty about future economic and industry conditions also makes it more challenging for us to forecast our operating results, make business decisions, and identify and prioritize the risks that may affect our businesses, sources and uses of cash, financial condition and results of operations. We may be required to implement additional cost reduction efforts, including restructuring activities, which may adversely affect our ability to capitalize on opportunities in a market recovery. In addition, our operations are subject to general credit, liquidity, foreign exchange, market and interest rate risks. Our ability to invest in our businesses, fund strategic acquisitions and refinance maturing debt obligations depends in part on access to the capital markets. If we do not timely and appropriately adapt to changes resulting from the uncertain macroeconomic environment and industry conditions, or to difficulties in the financial markets, or if we are unable to continue to access the capital markets, our business, financial condition and results of operations may be materially and adversely affected. Significant differences between actual results and estimates of the amount of future funding for our pension plans and postretirement health care benefit programs, and significant changes in funding assumptions or significant increases in funding obligations due to regulatory changes, could adversely affect our financial results. We have both funded and unfunded defined benefit pension plans that cover certain employees around the world. We also have unfunded postretirement health care benefit plans for eligible retired employees. The Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code, as amended, govern the funding obligations for our U.S. pension plans, which are our principal pension plans. Our U.S. defined benefit plans were frozen as of December 31, 2006 for substantially all participants. For 2007 and beyond, Whirlpool employees may participate in an enhanced defined contribution plan. As of December 31, 2016, our projected benefit obligations under our pension plans and postretirement health and welfare benefit programs exceeded the fair value of plan assets by an aggregate of approximately $1.5 billion, ($1.1 billion of which was attributable to pension plans and $0.4 billion of which was attributable to postretirement health care benefits). Estimates for the amount and timing of the future funding obligations of these pension plans and postretirement health and welfare benefit plans are based on various assumptions. These assumptions include discount rates, expected long-term rate of return on plan assets, life expectancies and health care cost trend rates. These assumptions are subject to change based on changes in interest rates on high quality bonds, stock and bond market returns, and health care cost trend rates, all of which are largely outside our control. Significant differences in results or significant changes in assumptions may materially affect our postretirement obligations and related future contributions and expenses. LEGAL & COMPLIANCE RISKS Unfavorable results of legal and regulatory proceedings could materially adversely affect our business and financial condition and performance. We are subject to a variety of litigation and legal compliance risks relating to, among other things, products, intellectual property rights, income and non-income taxes, environmental matters, corporate matters, commercial matters, competition laws and distribution, marketing and trade practices, anti-bribery, anti-corruption, energy regulations, and employment and benefit matters. For example, we are currently disputing certain income and non-income tax related assessments issued by the Brazilian authorities (see Note 6 and Note 11 of the Notes to the Consolidated Financial Statements for additional information on these matters). Unfavorable outcomes regarding these assessments could have a material adverse effect on our financial position, liquidity, or results of operations in any particular reporting period. Results of such proceedings cannot be predicted with certainty and for some matters, such as class actions, no insurance is cost effectively available. Regardless of merit, such proceedings may be both time-consuming and disruptive to our operations and could divert the attention of our management and key personnel from our business operations. We estimate loss contingencies and establish accruals as required by generally accepted accounting principles, based on our assessment of contingencies where liability is deemed probable and reasonably estimable, in light of the facts and circumstances known to us at a particular point in time. Subsequent developments in legal proceedings, volatility in foreign currency exchange rates and other factors may affect our assessment and estimates of the loss contingency recorded and could result in an adverse effect on our results of operations in the period in which a liability would be recognized or cash flows for the period in which amounts would be paid. Actual results may significantly vary from our reserves. We are subject to, and could be further subject to, governmental investigations or actions by other third parties. We are subject to various federal, foreign and state laws, including antitrust laws, violations of which can involve civil or criminal sanctions. Responding to governmental investigations or other actions may be both time-consuming and disruptive to our operations and could divert the attention of our management and key personnel from our business operations. The impact of these and other investigations and lawsuits could have a material adverse effect on our financial position, liquidity and results of operations. Changes in the legal and regulatory environment could limit our business activities, increase our operating costs, reduce demand for our products or result in litigation. The conduct of our businesses, and the production, distribution, sale, advertising, labeling, safety, transportation and use of many of our products, are subject to various laws and regulations administered by federal, state and local governmental agencies in the United States, as well as to foreign laws and regulations administered by government entities and agencies in markets in which we operate. These laws and regulations may change, sometimes dramatically, as a result of political, economic or social events. Changes in laws, regulations or governmental policy and the related interpretations may alter the environment in which we do business and may impact our results or increase our costs or liabilities. In addition, we incur and will continue to incur capital and other expenditures to comply with various laws and regulations, especially relating to protection of the environment, human health and safety and energy efficiency. These types of costs could adversely affect our financial performance. Additionally, we could be subjected to future liabilities, fines or penalties or the suspension of product production for failing to comply with various laws and regulations, including environmental regulations. Cleanup obligations that might arise at any of our manufacturing sites or the imposition of more stringent environmental laws in the future could adversely affect us. Our principal executive offices are located in Benton Harbor, Michigan. On December 31, 2016, our principal manufacturing operations were carried on at 42 locations in 14 countries worldwide. We occupied a total of approximately 86.4 million square feet devoted to manufacturing, service, sales and administrative offices, warehouse and distribution space. Over 37.9 million square feet of such space was occupied under lease. Whirlpool properties include facilities which are suitable and adequate for the manufacture and distribution of Whirlpool’s products. The Company’s principal manufacturing sites by operating segment were as follows: Principal Manufacturing Locations Information regarding legal proceedings can be found in Note 6 to the Consolidated Financial Statements and is incorporated herein by reference. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Whirlpool’s common stock is traded on the New York Stock Exchange and the Chicago Stock Exchange. As of February 3, 2017, the number of holders of record of Whirlpool common stock was approximately 10,474. Quarterly market and dividend information can be found in Note 14 to the Consolidated Financial Statements. On April 14, 2014, our Board of Directors authorized a share repurchase program of up to $500 million. During the first quarter of 2016, we repurchased 1,507,100 shares at an aggregate purchase price of approximately $225 million under this program. As of March 31, 2016, there were no remaining funds authorized under this program. On April 18, 2016 , our Board of Directors authorized a new share repurchase program of up to $1 billion. For the year ended December 31, 2016, we repurchased 1,749,600 shares at an aggregate purchase price of approximately $300 million under this program. At December 31, 2016, there were approximately $700 million in remaining funds authorized under this program. Share repurchases are made from time to time on the open market as conditions warrant. The program does not obligate us to repurchase any of our shares. The following table summarizes repurchases of Whirlpool's common stock in the three months ended December 31, 2016: Period (Millions of dollars, except number and price per share) Total Number of Shares Purchased Average Price Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs Approximate Dollar Value of Shares that May Yet Be Purchased Under the Plan October 1, 2016 through October 31, 2016 November 1, 2016 through November 30, 2016 December 1, 2016 through December 31, 2016 FIVE-YEAR SELECTED FINANCIAL DATA (Millions of dollars, except share and employee data) Restructuring costs Earnings before income taxes and other items Net earnings available to Whirlpool CONSOLIDATED FINANCIAL POSITION Accounts receivable, inventories and accounts payable, net Property, net Total debt(1) Whirlpool stockholders’ equity PER SHARE DATA Basic net earnings available to Whirlpool Diluted net earnings available to Whirlpool Book value(2) Closing Stock Price—NYSE Operating profit margin Pre-tax margin(3) Net margin(4) Return on average Whirlpool stockholders’ equity(5) Return on average total assets(6) Current assets to current liabilities Total debt as a percent of invested capital(7) Price earnings ratio(8) Common shares outstanding (in thousands): Average number—on a diluted basis Year-end common shares outstanding Year-end number of stockholders Year-end number of employees Five-year annualized total return to stockholders(9) (1) Total debt includes notes payable and current and long-term debt. (2) Total Whirlpool stockholders’ equity divided by average number of shares on a diluted basis. (3) Earnings (loss) before income taxes, as a percent of net sales. (4) Net earnings available to Whirlpool, as a percent of net sales. (5) Net earnings available to Whirlpool, divided by average Whirlpool stockholders’ equity. (6) Net earnings available to Whirlpool, divided by average total assets. (7) Total debt divided by total debt and total stockholders’ equity. (8) Closing stock price divided by diluted net earnings available to Whirlpool. (9) Stock appreciation plus reinvested dividends, divided by share price at the beginning of the period. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND This Management Discussion and Analysis should be read in connection with the Consolidated Financial Statements, Notes to the Consolidated Financial Statements and Selected Financial Data included in this Form 10-K. Certain references to particular information in the Notes to the Consolidated Financial Statements are made to assist readers. ABOUT WHIRLPOOL Whirlpool is the number one major appliance manufacturer in the world with net sales of approximately $21 billion in 2016. We are a leading producer of major home appliances in North America, Europe and Latin America, and have a significant presence throughout China and India. We have received worldwide recognition for accomplishments in a variety of business and social efforts, including leadership, diversity, innovative product design, business ethics, social responsibility and community involvement. We conduct our business through four reportable segments, which we define based on geography. Our reportable segments consist of North America, EMEA, Latin America and Asia. Our customer base includes large, sophisticated trade customers who have many choices and demand competitive products, services and prices. The major home appliance industry operates in an intensely competitive environment, reflecting the impact of both new and established global competitors, including Asian and European manufacturers. The charts below summarize the balance of net sales by reportable segment for 2016, 2015 and 2014, respectively: We monitor country-specific economic factors such as gross domestic product, unemployment, consumer confidence, retail trends, housing starts and completions, sales of existing homes and mortgage interest rates as key indicators of industry demand. In addition to profitability, we also focus on country, brand, product and channel sales when assessing and forecasting financial results. Our leading portfolio of brands includes Whirlpool, Maytag, KitchenAid, Embraco, Brastemp, Consul and Indesit. Our global branded consumer products strategy is to introduce innovative new products, increase brand customer loyalty, expand our presence outside the United States, enhance our trade management platform, improve total cost and quality by expanding and leveraging our global operating platform and, where appropriate, make strategic acquisitions and investments. As we grow revenues in our core products, our strategy is to extend our business by offering products and services that are dependent on and related to our core business and expand into adjacent products, such as Affresh cleaners and Gladiator GarageWorks, through businesses that leverage our core competencies and business infrastructure. During 2016, we had another year of strong performance for Whirlpool Corporation, as we delivered record results through strong operational execution and decisive actions to adjust to changes in global markets. Over the last few years, macroeconomic volatility has been a factor in many of the countries where we operate. We continued to experience volatility during 2016. The Brexit decision in June had a negative impact on British currency and demand, while uncertainty in emerging markets generated additional currency and demand weakness, especially in Brazil, Russia and China. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - (CONTINUED) These challenges, along with a further strengthening U.S. dollar, had a combined negative impact of approximately $600 million in revenue and $2 per share of earnings. Our earnings growth and strong cash generation enabled us to create long-term shareholder value through the execution of our balanced capital allocation approach. We invested in our innovation pipeline through $660 million in capital expenditures while increasing our dividend by 11% and repurchasing $525 million in common stock. These investments continue to be supported by a strong balance sheet, an increased capacity to invest and the confidence that our operating plans will deliver extraordinary levels of shareholder value both now and in the future. Our long-term value creation framework is built upon the strong foundation we have in place: our industry-leading brand portfolio and robust product innovation pipeline, supported by our best cost global operating platform and executed by our exceptional employees throughout the world. We will measure these value-creation components by focusing on the following key metrics: Deliver 3 to 5 percent annual organic net sales growth across our global footprint Grow earnings per share by 10 to 15 percent annually Expand EBIT margins to 10 percent plus by 2020 through strong cost productivity programs and further leveraging our strong brands and innovative new products Generate free cash flow of 5 to 6 percent of net sales by 2018, which represents over 85 percent earnings to free cash conversion We remain confident in our ability to effectively manage our business regardless of the operating environment and expect to continue delivering long-term value for all of our shareholders. The following table summarizes the consolidated results of operations: Consolidated - Millions of dollars (except per share data) Better/(Worse) (0.8)% Gross margin Selling, general and administrative Interest and sundry (income) expense Diluted net earnings available to Whirlpool per share Consolidated Net Sales The following charts summarize units sold and consolidated net sales by operating segment: Consolidated net sales decreased 0.8% compared to 2015 primarily driven by unfavorable impacts from foreign currency and product price/mix, partially offset by higher unit volumes. Excluding the impact of foreign currency, consolidated net sales increased 1.6% compared to 2015. Consolidated net sales for 2015 increased 5.1% compared to 2014 primarily driven by increased volume due to acquisitions and favorable product price/mix, partially offset by the unfavorable impact of foreign currency and a weakened demand environment in emerging markets. Excluding the impact of foreign currency and BEFIEX in 2014, consolidated net sales for 2015 increased 18.1% compared to 2014. We provide the percentage change in net sales, excluding the impact of foreign currency and BEFIEX, as a supplement to the change in net sales as determined by U.S. generally accepted accounting principles ("GAAP") to provide stockholders with a clearer basis to assess Whirlpool's results over time. This measure is considered a non-GAAP financial measure and is calculated by translating the current period net sales in functional currency, to U.S. dollars using the prior-year's exchange rate compared to the prior-year period net sales and BEFIEX. Significant regional trends were as follows: North America net sales increased 3.9% compared to 2015 primarily due to a 7.7% increase in units sold, partially offset by unfavorable impacts from product price/mix and foreign currency. Excluding the impact of foreign currency, net sales increased 5.0% in 2016. North America net sales for 2015 increased 0.9% compared to 2014 primarily due to a 1.4% increase in units sold and favorable product/price mix, partially offset by foreign currency. Excluding the impact of foreign currency, net sales increased 3.2% in 2015. EMEA net sales decreased 8.1% compared to 2015, primarily due to unfavorable impacts from foreign currency, product price/mix, and a 1.9% decrease in units sold. Excluding the impact of foreign currency, net sales decreased 4.3% in 2016. EMEA net sales for 2015 increased 43.4% compared to 2014, primarily due to a 59.7% increase in units sold due to the acquisition of Indesit and favorable product mix, partially offset by unfavorable foreign currency. Excluding the impact of foreign currency, net sales increased 75.3% in 2015. Latin America net sales decreased 4.7% compared to 2015 primarily due to a 11.5% decrease in units sold and unfavorable impacts from foreign currency, partially offset by favorable product price/mix. Excluding the impact of foreign currency, Latin America net sales decreased 1.5% in 2016. Latin America net sales for 2015 decreased 28.5% compared to 2014 primarily due to a 21.3% decrease in units sold and unfavorable foreign currency, partially offset by favorable product mix. Excluding the impact of foreign currency and BEFIEX, Latin America net sales decreased 5.9% in 2015. Asia net sales increased 0.5% compared to 2015 primarily due to a 12.3% increase in units sold, partially offset by unfavorable impacts from product price/mix and foreign currency. Excluding the impact of foreign currency, Asia net sales increased 5.4% in 2016. Asia net sales for 2015 increased 73.6% compared to 2014 primarily due to a 78.8% increase in units sold driven by the acquisition of Hefei Sanyo. Excluding the impact of foreign currency, Asia net sales increased 78.3% in 2015. The chart below summarizes gross margin percentages by operating segment: The consolidated gross margin percentage increased by 10 basis points to 17.8% compared to 2015, primarily due to ongoing cost productivity and acquisition synergies, unit volume growth, and benefits from cost and capacity-reduction initiatives, partially offset by the unfavorable impacts from product price/mix and foreign currency. North America gross margin percentage decreased compared to 2015 primarily due to unfavorable product price/mix, recognition of postretirement-benefit curtailment gains in 2015, and foreign currency, partially offset by unit volume growth and ongoing cost productivity. North America gross margin for 2015 increased compared to 2014 primarily due to ongoing cost productivity and recognition of postretirement-benefit curtailment gains, partially offset by unfavorable foreign currency. EMEA gross margin percentage increased compared to 2015 primarily due to favorable impacts from acquisition synergies, partially offset by unfavorable impacts from foreign currency, product price/mix, unit volume declines, and acquisition-related integration costs. During 2015, EMEA gross margin was flat compared to 2014 primarily due to benefits from the Indesit acquisition, favorable product price/mix, ongoing cost productivity, and capacity optimization initiatives, offset by unfavorable foreign currency, legacy Indesit product corrective action costs and increased investments in marketing, technology and products. Latin America gross margin percentage increased compared to 2015 primarily due to favorable product price/mix and benefits from cost and capacity reduction initiatives, partially offset by unit volume declines due to the weakened demand environment in Brazil. During 2015, Latin America gross margin decreased compared to 2014 primarily due to unfavorable foreign currency and the weakened demand environment in Brazil, partially offset by higher product price/mix. Asia gross margin percentage decreased in 2016, compared to 2015, primarily due to unfavorable product price/mix and increased investments in marketing, technology and products, partially offset by unit volume growth and benefits from ongoing cost productivity. During 2015, Asia gross margin increased compared to 2014 primarily due to acquisition synergies, partially offset by increased investments in marketing, technology and products. The following table summarizes selling, general and administrative expenses as a percentage of sales by operating segment: Millions of dollars As a % of Net Sales Corporate/other Consolidated selling, general and administrative expenses as a percent of consolidated net sales in 2016 and 2015, compared to the previous years, reflect the favorable impact of acquisition synergies, partially offset by foreign currency. We incurred restructuring charges of $173 million, $201 million, and $136 million for the years ended December 31, 2016, 2015 and 2014, respectively. For the full year 2017, we expect to incur up to $200 million of restructuring charges, which will result in ongoing substantial cost reductions. Additional information about restructuring activities can be found in Note 10 of the Notes to the Consolidated Financial Statements. Interest and sundry (income) expense decreased $10 million compared to 2015, primarily due to amounts received pursuant to an agreement, reached in the fourth quarter of 2016, with the seller of Indesit to recover a portion of our acquisition related costs. During 2015, interest and sundry (income) expense decreased $53 million compared to 2014, primarily due to a $64 million gain related to a business investment in Brazil during 2015 and previous year investment expenses related to the Hefei Sanyo and Indesit acquisitions, partially offset by impact from foreign currency. For additional information about the Embraco antitrust matters and legacy product warranty cost, see Note 6 of the Notes to the Consolidated Financial Statements. For additional information about the acquisitions of Hefei Sanyo and Indesit, see the Financial Condition and Liquidity section of Management's Discussion and Analysis. Interest expense decreased by $4 million compared to 2015. This was a result of lower average interest rates on long-term debt, offset by higher average long-term debt balances. During 2015, interest expense was unchanged compared to 2014. This was a result of higher average long-term debt balances, offset by lower average interest rates on long-term debt. Income tax expenses were $186 million, $209 million, and $189 million in 2016, 2015 and 2014, respectively. The decrease in tax expense in 2016 compared to 2015 is primarily due to favorable audits and settlements and tax planning resulting in valuation allowance releases, partially offset by higher pre-tax earnings. The increase in tax expense in 2015 compared to 2014 is primarily due to higher pre-tax earnings, partially offset by a lower effective tax rate. For additional information about our consolidated tax provision, see Note 11 of the Notes to the Consolidated Financial Statements. FORWARD-LOOKING PERSPECTIVE Earnings per diluted share presented below are net of tax, while each adjustment is presented on a pre-tax basis. The aggregate income tax impact of the taxable components of each adjustment is presented in the income tax impact line item at our anticipated 2017 full-year tax rate of 22%. We currently estimate earnings per diluted share and industry demand for 2017 to be within the following ranges: Estimated earnings per diluted share, for the year ending December 31, 2017 Restructuring Expense $(2.62) Income Tax Impact Industry demand (1) Reflects industry demand in the United States. (2) Reflects industry demand in Brazil. For the full-year 2017, we expect to generate cash from operating activities of $1.7 billion to $1.75 billion and free cash flow of approximately $1 billion, including primarily acquisition related restructuring cash outlays of up to $165 million, legacy product warranty and liability costs of $69 million, pension contributions of $42 million and, with respect to free cash flow, capital expenditures of $700 million to $750 million. The table below reconciles projected 2017 cash provided by operating activities determined in accordance with GAAP to free cash flow, a non-GAAP measure. Management believes that free cash flow provides stockholders with a relevant measure of liquidity and a useful basis for assessing Whirlpool’s ability to fund its activities and obligations. There are limitations to using non-GAAP financial measures, including the difficulty associated with comparing companies that use similarly named non-GAAP measures whose calculations may differ from our calculations. We define free cash flow as cash provided by continuing operations less capital expenditures and including proceeds from the sale of assets/businesses, and changes in restricted cash. The change in restricted cash relates to the private placement funds paid by Whirlpool to acquire majority control of Hefei Sanyo in 2014 and which are used to fund capital expenditures and technical resources to enhance Whirlpool China’s research and development and working capital, as required by the terms of the Hefei Sanyo acquisition made in October 2014. Cash provided by operating activities(1) Capital expenditures, proceeds from sale of assets/businesses and changes in restricted cash ~ $1,000 (1) Financial guidance on a GAAP basis for cash provided by (used in) financing activities and cash provided by (used in) investing activities has not been provided because in order to prepare any such estimate or projection, the Company would need to rely on market factors and certain other conditions and assumptions that are outside of its control. The projections above are based on many estimates and are inherently subject to change based on future decisions made by management and the Board of Directors of Whirlpool, and significant economic, competitive and other uncertainties and contingencies. FINANCIAL CONDITION AND LIQUIDITY Our objective is to finance our business through operating cash flow and the appropriate mix of long-term and short-term debt. By diversifying the maturity structure, we avoid concentrations of debt, reducing liquidity risk. We have varying needs for short-term working capital financing as a result of the nature of our business. We regularly review our capital structure and liquidity priorities, which include funding the business through capital and engineering spending to support innovation and productivity initiatives, funding our pension plan and term debt liabilities, providing return to shareholders and potential acquisitions. Our short term potential uses of liquidity include funding our ongoing capital spending, restructuring activities, funding pension plans and returns to shareholders. We also have $560 million of term debt maturing in the next twelve months, and are currently evaluating our options in connection with this maturing debt, which may include repayment through refinancing, through free cash flow generation, or cash on hand. We monitor the credit ratings and market indicators of credit risk of our lending, depository, and derivative counterparty banks regularly, and take certain action to manage credit risk. We diversify our deposits and investments in short term cash equivalents to limit the concentration of exposure by counterparty. As of December 31, 2016, the only country where we had cash or cash equivalents greater than 1% of our consolidated assets was China, which represented 2.4%. In addition, we did not have any third-party accounts receivable greater than 1% of our consolidated assets in any single country outside of North America, with the exceptions of Italy, China, and Brazil which represented 1.0%, 1.0%, and 1.3% respectively. We continue to monitor general financial instability and uncertainty globally. As of December 31, 2016, we had €67 million (approximately $71 million as of December 31, 2016) in outstanding trade receivables and short-term and long-term notes due to us associated with Alno AG, a long-standing European customer. Approximately €49 million (approximately $51 million as of December 31, 2016) of the outstanding receivables were overdue as of December 31, 2016. Our exposure includes not only the outstanding receivables but also the potential risks of an Alno AG bankruptcy and impacts to our distribution process. We believe our reserves related to these outstanding receivables are sufficient. In the fourth quarter of 2016, Whirlpool sold its remaining investment of approximately 10.6 million shares in Alno AG for approximately €5 million (approximately $6 million). We continue to monitor customer financial conditions globally. The Company had cash and cash equivalents of approximately $1.1 billion at December 31, 2016, of which approximately $1.0 billion was held by subsidiaries in foreign countries. For each of its foreign subsidiaries, the Company makes an assertion regarding the amount of earnings intended for permanent reinvestment, with the balance available to be repatriated to the United States. The cash held by foreign subsidiaries for permanent reinvestment is generally used to finance the subsidiaries' operational activities and future foreign investments. Our intent is to permanently reinvest these funds outside of the United States and our current plans do not demonstrate a need to repatriate these funds to fund our U.S. operations. However, if these funds were repatriated, then we would be required to accrue and pay applicable United States taxes (subject to an adjustment for foreign tax credits) and withholding taxes payable to various countries. The repatriation could result in an adjustment to the tax liability after considering available foreign tax credits and other tax attributes. It is not practicable to estimate the amount of the deferred tax liability associated with these unremitted earnings due to the complexity of its hypothetical calculation. Sources and Uses of Cash We met our cash needs during 2016 through cash flows from operations, cash and cash equivalents, and financing arrangements. Our cash and cash equivalents at December 31, 2016 increased $313 million compared to the same period in 2015. The following table summarizes the net increase (decrease) in cash and cash equivalents for the periods presented. Significant drivers of changes in our cash and cash equivalents balance during 2016 are discussed below: Cash Flow Summary Cash provided by (used in): The decrease in cash provided by operating activities during 2016 reflects strong cash earnings and effective credit management, more than offset by cash expenditures related to the legacy product corrective action. The timing of cash flows from operations varies significantly throughout the year primarily due to changes in production levels, sales patterns, promotional programs, funding requirements, credit management, as well as receivable and payment terms. Depending on the timing of cash flows, the location of cash balances, as well as the liquidity requirements of each country, external sources of funding are used to support working capital requirements. Changes in cash used in investing activities during 2016 primarily reflect a reduction in capital expenditures and investment in related businesses, partially offset by increased proceeds from the sale of business assets. In June 2016, Whirlpool China Co., Ltd. (“Whirlpool China”), our majority-owned indirect subsidiary, entered into an agreement to return land use rights for land now occupied by two Whirlpool China plants in Hefei, China to a division of the Hefei municipal government. The aggregate price for the return of land use rights was approximately RMB 687 million (approximately $103 million as of June 27, 2016). Whirlpool China received RMB 280 million (approximately $42 million as of June 27, 2016) of the aggregate return price on June 27, 2016 with the remainder to be paid in installments in 2017 and 2018. The remaining balance is RMB 407 million (approximately $59 million as of December 31, 2016). Cash used in financing activities during 2016 primarily reflects share repurchase activity and repayments of long-term debt. Cash used in financing activities during 2015 primarily reflects share repurchase activity under our share repurchase program. Cash provided by financing activities during 2014 primarily reflects funding required to complete the acquisitions of Hefei Sanyo and Indesit. Whirlpool Subsidiary Share Repurchase On July 12, 2016, Whirlpool S.A. (“WHR SA”) and Brasmotor S.A. (“BMT”), both majority-owned indirect subsidiaries of Whirlpool Corporation, issued public announcements in Brazil reporting that Whirlpool do Brasil Ltda., the controlling shareholder of both WHR SA and BMT, intended to acquire the outstanding common and preferred shares of WHR SA and BMT by means of tender offers for the publicly-held shares. At that time, Whirlpool do Brasil Ltda. and other Whirlpool entities held 99.20% of the common and 95.68% of the preferred shares of WHR SA and 99.40% of the common and 93.55% of the preferred shares of BMT. The tender offers were launched in November 2016 and concluded in December 2016. The offer for BMT was successful and will result in the acquisition of 100% of the shares of BMT after the squeeze-out of the remaining minority shareholders. The cost related to this offer was approximately $25 million as of December 2016. The squeeze-out was completed in January 2017, bringing the total cost to approximately $31 million. The WHR SA tender offer was abandoned because the minimum number of interested minority shareholders was not obtained. On July 15, 2016, $244 million of 7.75% notes matured and were repaid. On June 15, 2016, $250 million of 6.50% notes matured and were repaid. On May 23, 2016, we completed a debt offering of $500 million principal amount of 4.50% notes due in 2046. The notes contain covenants that limit our ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No. 333-203704) filed with the Securities and Exchange Commission on April 29, 2015. On November 2, 2016, Whirlpool Finance Luxembourg S.à. r.l., an indirect, wholly-owned finance subsidiary of Whirlpool Corporation, completed a debt offering of €500 million (approximately $555 million as of the date of issuance) principal amount of 1.250% notes due in 2026. The Company has fully and unconditionally guaranteed these notes. The notes contain covenants that limit Whirlpool Corporation's ability to incur certain liens or enter into certain sale and lease-back transactions. In addition, if we experience a specific kind of change of control, we are required to make an offer to purchase all of the notes at a purchase price of 101% of the principal amount thereof, plus accrued and unpaid interest. The notes are registered under the Securities Act of 1933, as amended, pursuant to our Registration Statement on Form S-3 (File No.333-203704-1) filed with the Securities and Exchange Commission on October 25, 2016 The Company had a total committed credit facilities of approximately $3.1 billion as of December 31, 2016, which is fundamentally unchanged from the committed credit facilitates as of December 31, 2015. The facilities are more geographically diverse and reflect the Company’s growing global operations. The Company believes these facilities are sufficient to support its global operations. We had no borrowings outstanding under the committed credit facilities at December 31, 2016 and 2015, respectively. For additional information about our financing arrangements, see Note 5 of the Notes to the Consolidated Financial Statements. WHIRLPOOL CHINA ACQUISITION On August 12, 2013, Whirlpool's wholly-owned subsidiary, Whirlpool (China) Investment Co., Ltd., reached agreements to acquire a 51% equity stake in Hefei Sanyo, a joint stock company whose shares are listed and traded on the Shanghai Stock Exchange. This transaction was completed on October 24, 2014. Hefei Sanyo has since been renamed to "Whirlpool China Co., Ltd." The aggregate purchase price was RMB 3.4 billion (approximately $551 million at the dates of purchase). The Company funded the total consideration for the shares with cash on hand. The cash paid for the private placement portion of the transaction is considered restricted cash, which is used to fund capital expenditures and technical resources to enhance Whirlpool China’s research and development and working capital, as required by the terms of the Hefei Sanyo acquisition made in October 2014. We expect the acquisition will accelerate Whirlpool's profitable growth in China. During 2014, Whirlpool began integrating the manufacturing, administrative, supply chain and technology operations of Hefei Sanyo. The results of Hefei Sanyo’s operations have been included in the Consolidated Financial Statements beginning October 24, 2014. Hefei Sanyo has an established and broad distribution network that includes a very large number of distribution outlets throughout China. Its significant presence in rural areas complements Whirlpool’s presence in China’s higher-tier cities. With this acquisition, Whirlpool also gained manufacturing scale and a competitive cost structure in the city of Hefei. The ability to consolidate operations offers strong synergies as Whirlpool will provide extensive technical, marketing and product development, combined with Hefei Sanyo’s sales execution and operational strengths, to support the next phase of development in the advancement of Whirlpool China as an important global production and research and development center for the home appliance sector. INDESIT ACQUISITION On December 3, 2014, Whirlpool completed the final step in its acquisition of Indesit. Total consideration paid for Indesit was €1.1 billion (approximately $1.4 billion at the dates of purchase of each step in the transaction) in aggregate net of cash acquired. The Company funded the aggregate purchase price for Indesit through borrowings under its credit facility and commercial paper programs, and repaid a portion of such borrowings through the issuance of an aggregate principal amount of $650 million in senior notes on November 4, 2014 and an aggregate principal amount of €500 million (approximately $525 million as of the date of issuance) in senior notes on March 12, 2015. This transaction has built Whirlpool’s market position within Europe, and we believe will continue to enable sustainable growth given the complementary market positions, product offerings and distribution channels of Whirlpool and Indesit throughout Europe. We expect efficiencies in R&D, capital spending and value chain costs, as well as operational scale with increased volume and the ability to more effectively integrate our product platforms. The results of Indesit’s operations have been included in the Consolidated Financial Statements beginning October 14, 2014. In April 2016, our Board of Directors approved an 11% increase in our quarterly dividend on our common stock to $1 per share from 90 cents per share. Repurchase Program For additional information about our repurchase program, see Note 8 of the Notes to the Consolidated Financial Statements. CONTRACTUAL OBLIGATIONS AND FORWARD-LOOKING CASH REQUIREMENTS The following table summarizes our expected cash outflows resulting from financial contracts and commitments: Payments due by period Long-term debt obligations(1) Operating lease obligations Purchase obligations(2) United States & Foreign pension plans(3) Other postretirement benefits(4) Legal settlements(5) Interest payments related to long-term debt are included in the table above. For additional information about our financing arrangements, see Note 5 of the Notes to the Consolidated Financial Statements. Purchase obligations include our “take-or-pay” contracts with materials vendors and minimum payment obligations to other suppliers. Represents the minimum contributions required for foreign and domestic pension plans based on current interest rates, asset return assumptions, legislative requirements and other actuarial assumptions at December 31, 2016. Management may elect to contribute amounts in addition to those required by law. See Note 12 of the Notes to the Consolidated Financial Statements for additional information. Represents our portion of expected benefit payments under our retiree healthcare plans. For additional information regarding legal settlements, see Note 6 of the Notes to the Consolidated Financial Statements. This table does not include credit facility and commercial paper borrowings. For additional information about short-term borrowings, see Note 5 of the Notes to the Consolidated Financial Statements. This table does not include future anticipated income tax settlements; see Note 11 of the Notes to the Consolidated Financial Statements. We have guarantee arrangements in a Brazilian subsidiary. As a standard business practice in Brazil, the subsidiary guarantees customer lines of credit at commercial banks to support purchases following its normal credit policies. If a customer were to default on its line of credit with the bank, our subsidiary would be required to satisfy the obligation with the bank and the receivable would revert back to the subsidiary. At December 31, 2016 and December 31, 2015, the guaranteed amounts totaled $258 million and $260 million, respectively. The fair value of these guarantees were nominal at December 31, 2016 and December 31, 2015. Our subsidiary insures against credit risk for these guarantees, under normal operating conditions, through policies purchased from high-quality underwriters. We had no losses associated with these guarantees in 2016 or 2015. We have guaranteed a $40 million five-year revolving credit facility between certain financial institutions and a not-for-profit entity in connection with a community and economic development project (“Harbor Shores”). The credit facility, which originated in 2008, was refinanced in December 2012 and we renewed our guarantee through 2017. It was also amended in 2015 and reduced from $43 million to $40 million by Harbor Shores in 2016. The fair value of this guarantee was nominal at December 31, 2016 and December 31, 2015. The purpose of Harbor Shores is to stimulate employment and growth in the areas of Benton Harbor and St. Joseph, Michigan. In the event of default, we must satisfy the guarantee of the credit facility up to the amount borrowed at the date of default. In the ordinary course of business, we enter into agreements with financial institutions to issue bank guarantees, letters of credit and surety bonds. These agreements are primarily associated with unresolved tax matters in Brazil, as is customary under local regulations, and governmental obligations related to certain employee benefit arrangements. As of December 31, 2016 and 2015, we had approximately $327 million and $290 million outstanding under these agreements, respectively. CRITICAL ACCOUNTING POLICIES AND ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles in the United States (GAAP) requires management to make certain estimates and assumptions. We periodically evaluate these estimates and assumptions, which are based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Actual results may differ materially from these estimates. Pension and Other Postretirement Benefits Accounting for pensions and other postretirement benefits involves estimating the costs of future benefits and attributing the cost over the employee’s expected period of employment. The determination of our obligation and expense for these costs requires the use of certain assumptions. Those key assumptions include the discount rate, expected long-term rate of return on plan assets, life expectancy, and health care cost trend rates. These assumptions are subject to change based on interest rates on high quality bonds, stock and bond markets and medical cost inflation, respectively. Actual results that differ from our assumptions are accumulated and amortized over future periods and therefore, generally affect our recognized expense and accrued liability in such future periods. While we believe that our assumptions are appropriate given current economic conditions and actual experience, significant differences in results or significant changes in our assumptions may materially affect our pension and other postretirement benefit obligations and related future expense. Our pension and other postretirement benefit obligations at December 31, 2016 and preliminary retirement benefit costs for 2017 were prepared using the assumptions that were determined as of December 31, 2016. The following table summarizes the sensitivity of our December 31, 2016 retirement obligations and 2017 retirement benefit costs of our United States plans to changes in the key assumptions used to determine those results: Estimated increase (decrease) in 2017 Expense PBO/APBO* United States Pension Plans +/-50bps $ 1/(1) $ (174)/187 Expected long-term rate of return on plan assets (13)/13 United States Other Postretirement Benefit Plan 1/(1) Health care cost trend rate +/-100bps Projected benefit obligation (PBO) for pension plans and accumulated postretirement benefit obligation (APBO) for other postretirement benefit plans. These sensitivities may not be appropriate to use for other years’ financial results. Furthermore, the impact of assumption changes outside of the ranges shown above may not be approximated by using the above results. For additional information about our pension and other postretirement benefit obligations, see Note 12 of the Notes to the Consolidated Financial Statements. We estimate our income taxes in each of the taxing jurisdictions in which we operate. This involves estimating actual current tax expense together with assessing any temporary differences resulting from the different treatment of certain items, such as the timing for recognizing expenses, for tax and accounting purposes. These differences may result in deferred tax assets or liabilities, which are included in our Consolidated Balance Sheets. We are required to assess the likelihood that deferred tax assets, which include net operating loss carryforwards, foreign tax credits and deductible temporary differences, that are expected to be realizable in future years. Realization of our net operating loss and foreign tax credit deferred tax assets is supported by specific tax planning strategies and, where possible, considers projections of future profitability. If recovery is not more likely than not, we provide a valuation allowance based on estimates of future taxable income in the various taxing jurisdictions, and the amount of deferred taxes that are ultimately realizable. If future taxable income is lower than expected or if tax planning strategies are not available as anticipated, we may record additional valuation allowances through income tax expense in the period such determination is made. Likewise, if we determine that we are able to realize our deferred tax assets in the future in excess of net recorded amounts, an adjustment to the deferred tax asset will benefit income tax expense in the period such determination is made. As of December 31, 2016 and 2015, we had total deferred tax assets of $3.2 billion and $3.3 billion, respectively, net of valuation allowances of $150 million and $286 million, respectively. Our income tax expense has fluctuated considerably over the last five years from $133 million in 2012 to $186 million in the current year. The tax expense has been influenced primarily by U.S. energy tax credits, foreign tax credits, audit settlements and adjustments, tax planning strategies, enacted legislation, and dispersion of global income. Future changes in the effective tax rate will be subject to several factors, including business profitability, tax planning strategies, and enacted tax laws. In addition, we operate within multiple taxing jurisdictions and are subject to audit in these jurisdictions. These audits can involve complex issues, which may require an extended period of time to resolve. For additional information about income taxes, see Notes 1, 6 and 11 of the Notes to the Consolidated Financial Statements. Legacy Product Corrective Action Reserves In the normal course of business, we engage in investigations of potential quality and safety issues. As part of our ongoing effort to deliver quality products to consumers, we are currently investigating a limited number of potential quality and safety issues globally. As necessary, we undertake to effect repair or replacement of appliances in the event that an investigation leads to the conclusion that such action is warranted. As part of that process, in 2015, Whirlpool engaged in thorough investigations of incident reports associated with two of its dryer production platforms developed by Indesit. These dryer production platforms were developed prior to Whirlpool's acquisition of Indesit in October 2014. This led to Indesit reporting the issue to regulatory authorities for consideration. These discussions determined that corrective action of the affected dryers was required. Whirlpool has implemented modifications at the point of manufacture to ensure that dryers produced after October 2015 are not affected by this issue. An outreach and service campaign is underway to modify dryers that have already been sold. Such dryers were manufactured between April 2004 and October 2015 and sold in the UK and other countries in the EMEA region under the Hotpoint* and Indesit brand names, as well as various other brands owned by other manufacturers, distributors and retailers whose products Indesit produced. As of December 31, 2016, Whirlpool had $162 million of cash expenditures related to the corrective action. We expect the corrective action affecting these dryers to have future cash expenditures in 2017 of $69 million. For additional information about the legacy product corrective action, see Note 6 of the Notes to the Consolidated Financial Statements. Warranty Obligations The estimation of warranty obligations is determined in the same period that revenue from the sale of the related products is recognized. The warranty obligation is based on historical experience and represents our best estimate of expected costs at the time products are sold. Warranty accruals are adjusted for known or anticipated warranty claims as new information becomes available. New product launches require a greater use of judgment in developing estimates until historical experience becomes available. Future events and circumstances could materially change our estimates and require adjustments to the warranty obligations. For additional information about warranty obligations, see Note 6 of the Notes to the Consolidated Financial Statements. Certain business acquisitions have resulted in the recording of goodwill and trademark assets. Upon acquisition, the purchase price is first allocated to identifiable assets and liabilities, including trademark assets, based on estimated fair value, with any remaining purchase price recorded as goodwill. Primarily, Whirlpool's trademarks and goodwill are considered indefinite-life intangible assets and as such, are not amortized. At December 31, 2016, we had goodwill of approximately $3.0 billion. There have been no changes to our reporting units or allocations of goodwill by reporting units except for the impact of foreign currency. We primarily have trademark assets in our North America, EMEA and Asia operating segments with a total carrying value of approximately $2.6 billion as of December 31, 2016. We perform our annual impairment assessment for goodwill and other indefinite-life intangible assets as of October 1st and more frequently if indicators of impairment exist. In 2016, the Company primarily elected to perform a quantitative analysis using a discounted cash flow model and other valuation techniques, to evaluate goodwill and certain indefinite-life intangible assets. Goodwill Valuations In performing a quantitative assessment, we estimate each reporting units' fair value using the income approach. The income approach uses operating segments projection of estimated operating results and cash flows that are discounted using a weighted-average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The estimated fair value of each operating segment is compared to their respective carrying values. Additionally we validate our estimates of fair value under the income approach by comparing the values of fair value estimates using a market approach. A market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics of the reporting units. We consider the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. If actual results are not consistent with managements’ estimate and assumptions, goodwill may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial statements. Based on the results of our quantitative assessment conducted on October 1, 2016, the fair values of Whirlpool's reporting units continue to exceed their respective carrying values. The range by which the excess fair value of our reporting units' goodwill exceeded their respective carrying values was 4% to 142%. The EMEA reporting unit has excess fair value of 4%. During the fourth quarter 2014, Whirlpool acquired Indesit, resulting in substantially all of the goodwill included in this reporting unit. The range by which the excess fair value of our remaining reporting units' goodwill exceeded their respective carrying values was 70% to 142%. Other Intangible Valuations In performing a quantitative assessment of indefinite life intangible assets other than goodwill, primarily trademarks, we estimate the fair value of these intangible assets using the relief-from-royalty method, which requires assumptions related to projected revenues from our annual long-range plan; assumed royalty rates that could be payable if we did not own the trademark; and a discount rate based on our weighted average cost of capital. If the estimated fair value of the indefinite-lived intangible asset is less than its carrying value, we would recognize an impairment loss. Three trademarks acquired in fourth quarter of 2014 have fair values that exceed their carrying values by less than 10%. The fair values of all other trademarks exceeded their carrying values by more than 10% with the exception of one North American trademark. The fair value of this North American trademark exceeded its carrying value of approximately $1 billion by 6% in 2016 and 5% in 2015. We expect revenue trends for this brand to improve as we continue to execute specific brand investments and product development plans. Additionally, we performed a sensitivity analysis on our estimated fair value noting that a 10% reduction of forecasted revenues, a 50 basis point decrease in royalty rate, or a 50 basis point increase in discount rate would result in an impairment ranging from approximately $22 million to $78 million. If actual results are not consistent with management's estimate and assumptions, trademarks or other indefinite-life intangible assets may be overstated and a charge against net income would be required, which would adversely affect the Company’s financial results of operations. Based on the results of our quantitative assessment performed as of October 1, 2014, impairment of two trademarks was determined to exist, primarily driven by a change in our brand strategy in EMEA as a result of the acquisition of Indesit and resulted in a charge of approximately $12 million in 2014. Our assessment indicates no impairment of any trademarks as of December 31, 2016. For additional information about goodwill and intangible valuations, see Note 2 of the Notes to the Consolidated Financial Statements. ISSUED BUT NOT YET EFFECTIVE ACCOUNTING PRONOUNCEMENTS Additional information regarding recently issued accounting pronouncements can be found in Note 1 of the Notes to the Consolidated Financial Statements. For information regarding certain of our loss contingencies/litigation, see Note 6 of the Consolidated Financial Statements. Antidumping Petition In December 2015, we filed a petition with the U.S. Department of Commerce (DOC) and the United States International Trade Commission (ITC) to address Samsung and LG dumping large residential washers from China. The petition was filed to restore fair competition in the United States that will support significant investment in the production of large residential washers and the creation of U.S. jobs. The Whirlpool washers affected by the imports subject in this case are made in Clyde, Ohio. In December 2016, the DOC issued a final determination that Samsung and LG violated U.S. and international trade laws by dumping washers from China into the U.S. As part of the final determination, the DOC also announced certain antidumping margins for Samsung and LG. In January 2017, the ITC voted unanimously that Samsung and LG's dumping had caused material injury to the U.S. washer industry. As in the case of our December 2011 petition, the DOC and ITC decisions will be followed by administrative review procedures and possible appeals over the next several years. Post-Retirement Benefit Litigation For information regarding post-retirement benefit litigation, see Note 12 of the Consolidated Financial Statements. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements made by us or on our behalf. Certain statements contained in this annual report, including those within the forward-looking perspective section within this Management's Discussion and Analysis, and other written and oral statements made from time to time by us or on our behalf do not relate strictly to historical or current facts and may contain forward-looking statements that reflect our current views with respect to future events and financial performance. As such, they are considered “forward-looking statements” which provide current expectations or forecasts of future events. Such statements can be identified by the use of terminology such as “may,” “could,” “will,” “should,” “possible,” “plan,” “predict,” “forecast,” “potential,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “believe,” “may impact,” “on track,” and similar words or expressions. Our forward-looking statements generally relate to our growth strategies, financial results, product development, and sales efforts. These forward-looking statements should be considered with the understanding that such statements involve a variety of risks and uncertainties, known and unknown, and may be affected by inaccurate assumptions. Consequently, no forward-looking statement can be guaranteed and actual results may vary materially. This document contains forward-looking statements about Whirlpool Corporation and its consolidated subsidiaries (“Whirlpool”) that speak only as of this date. Whirlpool disclaims any obligation to update these statements. Forward-looking statements in this document may include, but are not limited to, statements regarding expected earnings per share, cash flow, productivity and raw material prices. Many risks, contingencies and uncertainties could cause actual results to differ materially from Whirlpool's forward-looking statements. Among these factors are: (1) intense competition in the home appliance industry reflecting the impact of both new and established global competitors, including Asian and European manufacturers; (2) Whirlpool's ability to maintain or increase sales to significant trade customers and the ability of these trade customers to maintain or increase market share; (3) Whirlpool's ability to maintain its reputation and brand image; (4) the ability of Whirlpool to achieve its business plans, productivity improvements, and cost control objectives, and to leverage its global operating platform, and accelerate the rate of innovation; (5) Whirlpool's ability to obtain and protect intellectual property rights; (6) acquisition and investment-related risks, including risks associated with our past acquisitions, and risks associated with our increased presence in emerging markets; (7) risks related to our international operations, including changes in foreign regulations, regulatory compliance and disruptions arising from political, legal and economic instability; (8) information technology system failures, data security breaches, network disruptions, and cybersecurity attacks; (9) product liability and product recall costs; (10) the ability of suppliers of critical parts, components and manufacturing equipment to deliver sufficient quantities to Whirlpool in a timely and cost-effective manner; (11) our ability to attract, develop and retain executives and other qualified employees; (12) the impact of labor relations; (13) fluctuations in the cost of key materials (including steel, resins, copper and aluminum) and components and the ability of Whirlpool to offset cost increases; (14) Whirlpool’s ability to manage foreign currency fluctuations; (15) inventory and other asset risk; (16) the uncertain global economy and changes in economic conditions which affect demand for our products; (17) health care cost trends, regulatory changes and variations between results and estimates that could increase future funding obligations for pension and postretirement benefit plans; (18) litigation, tax, and legal compliance risk and costs, especially if materially different from the amount we expect to incur or have accrued for, and any disruptions caused by the same; (19) the effects and costs of governmental investigations or related actions by third parties; and (20) changes in the legal and regulatory environment including environmental, health and safety regulations. We undertake no obligation to update any forward-looking statement, and investors are advised to review disclosures in our filings with the SEC. It is not possible to foresee or identify all factors that could cause actual results to differ from expected or historic results. Therefore, investors should not consider the foregoing factors to be an exhaustive statement of all risks, uncertainties, or factors that could potentially cause actual results to differ from forward-looking statements. Additional information concerning these and other factors can be found in “Risk Factors” in Item 1A of this report. We have in place an enterprise risk management process that involves systematic risk identification and mitigation covering the categories of enterprise, strategic, financial, operation and compliance and reporting risk. The enterprise risk management process receives Board of Directors and Management oversight, drives risk mitigation decision-making and is fully integrated into our internal audit planning and execution cycle. We are exposed to market risk from changes in foreign currency exchange rates, domestic and foreign interest rates, and commodity prices, which can affect our operating results and overall financial condition. We manage exposure to these risks through our operating and financing activities and, when deemed appropriate, through the use of derivatives. Derivatives are viewed as risk management tools and are not used for speculation or for trading purposes. Derivatives are generally contracted with a diversified group of investment grade counterparties to reduce exposure to nonperformance on such instruments. We use foreign currency forward contracts, currency options, and currency swaps to hedge the price risk associated with firmly committed and forecasted cross-border payments and receipts related to ongoing business and operational financing activities. Foreign currency contracts are sensitive to changes in foreign currency exchange rates. At December 31, 2016, a 10% favorable or unfavorable exchange rate movement in each currency in our portfolio of foreign currency contracts would have resulted in an incremental unrealized gain of approximately $125 million or loss of approximately $145 million. Consistent with the use of these contracts to neutralize the effect of exchange rate fluctuations, such unrealized losses or gains would be offset by corresponding gains or losses, respectively, in the re-measurement of the underlying exposures. We enter into commodity swap contracts to hedge the price risk associated with firmly committed and forecasted commodities purchases, the prices of which are not fixed directly through supply contracts. As of December 31, 2016, a 10% favorable or unfavorable shift in commodity prices would have resulted in an incremental gain or loss of approximately $30 million, respectively, related to these contracts. CONSOLIDATED STATEMENTS OF INCOME Year Ended December 31, (Millions of dollars, except per share data) Intangible amortization Other (income) expense Less: Net earnings available to noncontrolling interests Per share of common stock Weighted-average shares outstanding (in millions) CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Millions of dollars) Other comprehensive income (loss), before tax: Foreign currency translation adjustments Derivative instruments: Net gain (loss) arising during period Less: reclassification adjustment for gain (loss) included in net earnings Derivative instruments, net Marketable securities: Marketable securities, net Defined benefit pension and postretirement plans: Prior service (cost) credit arising during period Less: amortization of prior service credit (cost) and actuarial (loss) Defined benefit pension and postretirement plans, net: Other comprehensive (loss), before tax Income tax benefit (expense) related to items of other comprehensive income (loss) Other comprehensive income (loss), net of tax Less: comprehensive income, available to noncontrolling interests Comprehensive income available to Whirlpool At December 31, Accounts receivable, net of allowance of $185 and $160, respectively Property, net of accumulated depreciation of $6,055 and $5,953, respectively Other intangibles, net of accumulated amortization of $387 and $327, respectively Other noncurrent assets Accrued advertising and promotions Employee compensation Current maturities of long-term debt Noncurrent liabilities Postretirement benefits Other noncurrent liabilities Total noncurrent liabilities Common stock, $1 par value, 250 million shares authorized, 111 million shares issued, and 74 million and 77 million shares outstanding, respectively Treasury stock, 37 million and 33 million shares, respectively Total Whirlpool stockholders’ equity Noncontrolling interests Adjustments to reconcile net earnings to cash provided by (used in) operating activities: Curtailment gain Changes in assets and liabilities (net of effects of acquisitions): Accrued expenses and current liabilities Taxes deferred and payable, net Accrued pension and postretirement benefits Proceeds from sale of assets and business Change in restricted cash Acquisition of Indesit Company S.p.A. Acquisition of Hefei Rongshida Sanyo Electric Co., Ltd. Investment in related businesses Proceeds from borrowings of long-term debt Repayments of long-term debt Net proceeds from short-term borrowings Repurchase of common stock Purchase of noncontrolling interest shares Common stock issued Cash provided by (used in) financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Cash paid for interest Cash paid for income taxes CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY Accumulated Other Comprehensive Income (Loss) Treasury Stock/ Additional Paid- in-Capital Balances, December 31, 2013 Other comprehensive (loss) Stock issued (repurchased)

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professional_accounting

REPORT OF FOREIGN PRIVATE ISSUER PURSUANT TO RULE 13a-16 OR 15d-16 Dated: August 19, 2016 Commission File No. 001-34104 NAVIOS MARITIME ACQUISITION CORPORATION 7 Avenue de Grande Bretagne, Office 11B2 Monte Carlo, MC 98000 Monaco Indicate by check mark whether the registrant files or will file annual reports under cover Form 20-F or Form 40-F: Form 20-F x Form 40-F ¨ Indicate by check mark if the registrant is submitting the Form 6-K in paper as permitted by Regulation S-T Rule 101(b)(1): Yes ¨ No x Indicate by check mark whether the registrant by furnishing the information contained in this Form is also thereby furnishing the information to the Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of 1934. If “Yes” is marked, indicate below the file number assigned to the registrant in connection with Rule 12g3-2(b): Operating and Financial Review Exhibit List Financial Statements Index This Report on Form 6-K is hereby incorporated by reference into the Navios Maritime Acquisition Corporation Registration Statements on Form F-3, File Nos. 333-170896 and 333-191266. Operating and Financial Review and Prospects The following is a discussion of the financial condition and results of operations for the three and six month periods ended June 30, 2016 and 2015 of Navios Maritime Acquisition Corporation (referred to herein as “we,” “us” or “Navios Acquisition”). All of the financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“U.S. GAAP”). You should read this section together with the consolidated financial statements and the accompanying notes included in Navios Acquisition’s 2015 Annual Report filed on Form 20-F with the Securities and Exchange Commission. This Report contains forward-looking statements (as defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended) concerning future events and expectations, including with respect to Navios Acquisition’s future dividends, 2016 cash flow generation and Navios Acquisition’s growth strategy and measures to implement such strategy; including expected vessel acquisitions and entering into further time charters. Words such as “may,” “expects,” “intends,” “plans,” “believes,” “anticipates,” “hopes,” “estimates,” and variations of such words and similar expressions are intended to identify forward-looking statements. Such statements include comments regarding expected revenue and time charters. These forward-looking statements are based on the information available to, and the expectations and assumptions deemed reasonable by, Navios Acquisition at the time this filing was made. Although Navios Acquisition believes that the expectations reflected in such forward-looking statements are reasonable, no assurance can be given that such expectations will prove to have been correct. These statements involve known and unknown risks and are based upon a number of assumptions and estimates which are inherently subject to significant uncertainties and contingencies, many of which are beyond the control of Navios Acquisition. Actual results may differ materially from those expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, the creditworthiness of our charterers and the ability of our contract counterparties to fulfill their obligations to us, tanker industry trends, including charter rates and vessel values and factors affecting vessel supply and demand, the aging of our vessels and resultant increases in operation and dry docking costs, the loss of any customer or charter or vessel, our ability to repay outstanding indebtedness, to obtain additional financing and to obtain replacement charters for our vessels, in each case, at commercially acceptable rates or at all, increases in costs and expenses, including but not limited to: crew wages, insurance, provisions, port expenses, lube oil, bunkers, repairs, maintenance and general and administrative expenses, the expected cost of, and our ability to comply with, governmental regulations and maritime self-regulatory organization standards, as well as standard regulations imposed by our charterers applicable to our business, potential liability from litigation and our vessel operations, including discharge of pollutants, general domestic and international political conditions, competitive factors in the market in which Navios Acquisition operates; risks associated with operations outside the United States; and other factors listed from time to time in the Navios Acquisition’s filings with the Securities and Exchange Commission, including its Form 20Fs and Form 6Ks. Navios Acquisition expressly disclaims any obligations or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in Navios Acquisition’s expectations with respect thereto or any change in events, conditions or circumstances on which any statement is based. Navios Acquisition makes no prediction or statement about the performance of its common stock. Recent Developments and History On August 10, 2016, the Board of Directors declared a quarterly cash dividend in respect of the second quarter of 2016 of $0.05 per share of common stock payable on September 21, 2016 to stockholders of record as of September 14, 2016. The declaration and payment of any further dividends remain subject to the discretion of the Board of Directors and will depend on, among other things, Navios Acquisition’s cash requirements as measured by market opportunities and restrictions under its credit agreements and other debt obligations and such other factors as the Board of Directors may deem advisable. Amendment of Management Agreement In May 2016, Navios Acquisition amended its existing Management Agreement with Navios Tankers Management Inc. (“the Manager” or “Navios Tankers”), a wholly-owned subsidiary of Navios Maritime Holdings Inc. (“Navios Holdings”), and fixed the fees for ship management services of its owned fleet for two additional years through May 2018 at a daily fee of; (a) $6,350 per MR2 product tanker and chemical tanker vessel; (b) $7,150 per LR1 product tanker vessel; and (c) the current rate of $9,500 per VLCC. Dry docking expenses are reimbursed at cost for all vessels. Vessel Sales On January 27, 2016, Navios Acquisition sold the Nave Lucida to an unaffiliated third party for a sale price of $18.6 million. Navios Acquisition prepaid $12.1 million, the amount of the respective tranche drawn from the Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB facility that financed the Nave Lucida. In April 2016, Navios Acquisition agreed to sell to an unaffiliated third party the Nave Constellation, a 2013-built chemical tanker of 45,281 dwt, and the Nave Universe, a 2013-built chemical tanker of 45,513 dwt, for an aggregate sale price of $74.6 million. The vessels are expected to be sold during the second half of 2016, following the completion of their chartering commitments. The sale of the vessels is expected to result in a gain. Proceeds from the sale of the vessels will be used to fully repay the outstanding amount of the HSH Nordbank AG credit facility. Equity Transactions On January 6, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1.0 million to the holder upon redemption. On April 1, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of puttable common stock and paid $1.0 million to the holder upon such redemption. On July 1, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1.0 million to the holder upon redemption. As of June 30, 2016, Navios Acquisition had the following equity outstanding: 150,782,990 shares of common stock and 1,000 shares of Series C Convertible Preferred Stock issued to Navios Holdings. As of August 17, 2016, our fleet consisted of a total of 38 double-hulled tanker vessels, aggregating approximately 4.0 million deadweight tons, or dwt. The fleet includes eight VLCC tankers (over 200,000 dwt per ship), which transport crude oil, eight Long Range 1 (“LR1”) product tankers (60,000-79,999 dwt per ship), 18 Medium Range 2 (“MR2”) product tankers (30,000-59,999 dwt per ship) and four chemical tankers (25,000 dwt-45,000 dwt per ship), which includes the two chemical tankers agreed to be sold, which transport refined petroleum products and bulk liquid chemicals. All our vessels are currently chartered-out to high-quality counterparties, including affiliates of Shell, Navig8 and Mansel with an average remaining charter period of approximately 1.1 years. As of August 17, 2016, we had charters covering 98.2% of available days in 2016 and 56.6% of available days in 2017. Built/ Date DWT Net Charter Rate (1) Profit Sharing Owned Vessels Constellation(11) Chemical Tanker 2013 45,281 $ 16,088 50%/50% October 2016 Nave Universe(11) Chemical Tanker 2013 45,513 $ 16,088 50%/50% September 2016 Nave Polaris Chemical Tanker 2011 25,145 Floating Rate (8) None November 2016 Nave Cosmos Nave Velocity MR2 Product Tanker 2015 49,999 $ 14,319 (6) 50%/50% February 2017 Nave Sextans MR2 Product Tanker 2015 49,999 $ 16,294 None January 2018 Nave Pyxis MR2 Product Tanker 2014 49,998 $ 16,294 None February 2018 Nave Luminosity MR2 Product Tanker 2014 49,999 $ 14,319 50%/50% September 2016 $ 14,072 50%/50% September 2017 Nave Jupiter MR2 Product Tanker 2014 49,999 $ 15,306 50%/50% May 2017 MR2 Product Tanker 2013 50,626 $ 15,976 (5) 100% September 2016 $ 16,296 100% September 2017 Nave Alderamin Nave Bellatrix MR2 Product Tanker 2013 49,999 $ 14,813 50%/50% January 2017 Nave Capella MR2 Product Tanker 2013 49,995 $ 18,071 (12) None January 2017 Nave Orion MR2 Product Tanker 2013 49,999 $ 14,813 50%/50% March 2017 Nave Titan MR2 Product Tanker 2013 49,999 $ 15,306 50%/50% June 2017 Nave Aquila MR2 Product Tanker 2012 49,991 $ 14,566 (3) 50%/50% November 2016 Nave Atria MR2 Product Tanker 2012 49,992 $ 14,813 50%/50% July 2017 Nave Orbit MR2 Product Tanker 2009 50,470 $ 17,750 (15) None November 2017 Nave Equator MR2 Product Tanker 2009 50,542 $ 17,000 None October 2017 Nave Equinox MR2 Product Tanker 2007 50,922 $ 15,950 ice- transit premium(4) Nave Pulsar ice-transit Nave Dorado Nave Atropos LR1 Product Tanker 2013 74,695 $ 13,825 50%/50% October 2016 Floating Rate (14) None October 2019 Nave Rigel LR1 Product Tanker 2013 74,673 $ 18,022 50%/50% August 2019 Nave Cassiopeia LR1 Product Tanker 2012 74,711 Floating Rate (14) None February 2019 Nave Cetus LR1 Product Tanker 2012 74,581 $ 18,022 50%/50% April 2019 Nave Estella LR1 Product Tanker 2012 75,000 $ 11,850 90% up to $17,000 January 2017 50% above $17,000 Nave Andromeda LR1 Product Tanker 2011 75,000 $ 14,000 100% up to $17,000 November 2016 Nave Ariadne LR1 Product Tanker 2007 74,671 $ 17,775 50%/50% May 2018 Nave Cielo Nave Buena Suerte (10) VLCC 2011 297,491 Floating Rate (13) None August 2017 Nave Quasar(10) VLCC 2010 297,376 Floating Rate (7) None March 2018 Nave Synergy VLCC 2010 299,973 Floating Rate (7) None February 2018 Nave Galactic(10) VLCC 2009 297,168 Floating Rate (9) None September 2017 Nave Spherical VLCC 2009 297,188 $ 41,475 None November 2017 Nave Neutrino(10) VLCC 2003 298,287 $ 43,480 None September 2016 $ 37,520 None September 2017 Nave Electron(10) VLCC 2002 305,178 Floating Rate (7) None December 2017 Nave Photon VLCC 2008 297,395 $ 40,488 None December 2017 (1) Net time charter-out rate per day (net of commissions), presented in USD. (2) Estimated dates assuming the midpoint of the redelivery period by charterers, including owner’s extension options not declared yet. (3) Charterer’s option to extend the charter for one year at $15,553 net plus profit sharing. Profit sharing will be calculated monthly and profits will be split equally between each party. The profit sharing formula incorporates a $1,000 premium above the relevant index. (4) Profit sharing based on a formula which incorporates a premium when vessels are trading in ice. For the Nave Equinox, the premium is $1,900 net per day and for the Nave Pulsar based on pool results. (5) Rate can reach a maximum of $21,302 net per day calculated based on a formula. Both rate and ceiling increase by 2% annually. (6) Charterer’s option to extend for an additional year at a rate of $15,306 net per day plus 50% profit sharing. (7) Rate based on VLCC pool earnings. (8) Rate based on chemical tankers pool earnings. (9) Rate is based upon daily BITR TD3. Navios Acquisition will receive 100% of the index rate up to $39,500 net per day, 90% of the index rate from $41,969 net per day to $44,438 net per day and 50% of any amount in excess of $44,438 net per day. The contract provides for a minimum rate of $29,625 net per day and $27,156 net per day for the last nine months of the contract. (10) Navios Acquisition has granted an option to Navios Midstream, exercisable until November 2016, to purchase the vessel from Navios Acquisition at fair market value. (11) Vessel is expected to be sold during the second half of 2016, following the completion of its chartering commitments. (12) Charterer’s option to extend for one year at $20,244 net per day. (13) Rate is based upon daily BITR TD3. Navios Acquisition will receive 100% of the index rate up to $41,969 net per day, 90% up until $44,438 net per day and 50% of any amount in excess of $44,438 net per day. The contract provides a minimum rate of $19,750 net per day. (14) Rate based on LR1 pool earnings. (15) Charterer’s option to extend for two years at $20,500 net per day. Charter Policy and Industry Outlook Our core fleet currently, consists of 38 vessels, of which eight are VLCCs, 26 are product tankers and four are chemical tankers, which includes the two chemical tankers we have agreed to sell. All of our vessels are chartered-out to high-quality counterparties, including affiliates of Shell, Navig8 and Mansel, with an average remaining charter period of approximately one year. Many of our charters have profit sharing arrangements (see fleet table above). While all of our vessels are currently chartered-out, we intend to deploy any vessels that would become open—not chartered-out—to leading charterers in a mix of long, medium and short-term time charters, depending on the vessels’ positions, seasonality and market outlook. This chartering strategy is intended to allow us to capture increased profits during strong charter markets, while developing relatively stable cash flows from longer-term time charters. We will also seek profit sharing arrangements in our long-term time charters, to provide us with potential incremental revenue above the contracted minimum charter rates. We intend to selectively grow our fleet using Navios Holdings’ global network of relationships and extensive experience in the marine transportation industry, coupled with our financial resources and financing capability, to acquire young, high-quality, modern, double-hulled vessels in the product, crude oil and chemical tanker sectors. Vessel prices in these sectors have been severely affected by the continuing scarcity of debt financing available to shipping industry participants resulting from the worldwide financial crisis and because of charter rates for crude, product and chemical tankers that have fallen from their highs of 2008. Factors Affecting Navios Acquisition’s Results of Operations We believe the principal factors that will affect our future results of operations are the general economic, regulatory, political and governmental conditions that affect the shipping industry and those that specifically affect conditions in countries and markets in which our vessels engage in business. Other key factors that will be fundamental to our business, future financial condition and results of operations include: • the demand for seaborne transportation services; • the ability of Navios Holdings’ commercial and chartering operations to successfully employ our vessels at economically attractive rates, particularly as our fleet expands and our charters expire; • the effective and cost efficient technical management of our vessels; • Navios Holdings’ ability to satisfy technical, health, safety and compliance standards of oil majors and major commodity traders; and • the strength of and growth in the number of our customer relationships, especially with oil majors and major commodity traders. In addition to the factors discussed above, we believe certain specific factors will impact our condensed consolidated results of operations. These factors include: • the charter hire earned by our vessels under our charters; • our access to capital required to acquire additional vessels and/or to implement our business strategy; • our ability to sell vessels at prices we deem satisfactory; • our level of debt, our ability to repay such debt and to fulfill other financial obligations; • the level of any dividend to our stockholders. Voyage and Time Charter Revenues are driven primarily by the number of vessels in the fleet, the number of days during which such vessels operate and the amount of daily charter hire rates that the vessels earn under charters, which, in turn, are affected by a number of factors, including: • the duration of the charters; • the level of spot market rates at the time of charters; • decisions relating to vessel acquisitions and disposals; • the amount of time spent positioning vessels; • the amount of time that vessels spend in dry dock undergoing repairs and upgrades; • the age, condition and specifications of the vessels; and • the aggregate level of supply and demand in the tanker shipping industry. Time charters are available for varying periods, ranging from a single trip (spot charter) to long-term which may be many years. In general, a long-term time charter assures the vessel owner of a consistent stream of revenue. Operating the vessel in the spot market affords the owner greater spot market opportunity, which may result in high rates when vessels are in high demand or low rates when vessel availability exceeds demand. Vessel charter rates are affected by world economics, international events, weather conditions, strikes, governmental policies, supply and demand, and many other factors that might be beyond the control of management. The cost to maintain and operate a vessel increases with the age of the vessel. Older vessels are less fuel efficient, cost more to insure and require upgrades from time to time to comply with new regulations. The average age of Navios Acquisition’s owned fleet is 5.4 years. But, as such fleet ages or if Navios Acquisition expands its fleet by acquiring previously owned and older vessels the cost per vessel would be expected to rise and, assuming all else, including rates, remains constant, vessel profitability would be expected to decrease. Navios Acquisition reports financial information and evaluates its operations by charter revenues. Navios Acquisition does not use discrete financial information to evaluate operating results for each type of charter. As a result, management reviews operating results solely by revenue per day and operating results of the fleet and thus Navios Acquisition has determined that it operates under one reportable segment. Set forth below are selected historical and statistical data for Navios Acquisition for each of the three and six month periods ended June 30, 2016 and 2015 that the Company believes may be useful in better understanding the Company’s financial position and results of operations. Three month period ended Six month period ended (unaudited) 2015 Available days(1) Operating days(2) Fleet utilization(3) 99.8 % 99.7 % 99.8 % 99.7 % Vessels operating at period end AVERAGE DAILY RESULTS Time Charter Equivalent Rate per day(4) Navios Acquisition believes that the important measures for analyzing trends in its results of operations consist of the following: (1) Available days: Available days for the fleet represent total calendar days the vessels were in Navios Acquisition’s possession for the relevant period after subtracting off-hire days associated with scheduled repairs, dry dockings or special surveys. The shipping industry uses available days to measure the number of days in a relevant period during which vessels should be capable of generating revenues. (2) Operating days: Operating days are the number of available days in the relevant period less the aggregate number of days that the vessels are off-hire due to any reason, including unforeseen circumstances. The shipping industry uses operating days to measure the aggregate number of days in a relevant period during which vessels actually generate revenues. (3) Fleet utilization: Fleet utilization is the percentage of time that Navios Acquisition’s vessels were available for generating revenue, and is determined by dividing the number of operating days during a relevant period by the number of available days during that period. The shipping industry uses fleet utilization to measure a company’s efficiency in finding suitable employment for its vessels and minimizing the amount of days that its vessels are off hire for reasons other than scheduled repairs, dry dockings and special surveys. (4) Time Charter Equivalent Rate: Time Charter Equivalent (“TCE”) Rate is defined as voyage and time charter revenues less voyage expenses during a period divided by the number of available days during the period. The TCE Rate is a standard shipping industry performance measure used primarily to present the actual daily earnings generated by vessels of various types of charter contracts for the number of available days of the fleet. Period-over-Period Comparisons For the Three Month Period ended June 30, 2016 compared to the Three Month Period ended June 30, 2015 The following table presents consolidated revenue and expense information for the three month periods ended June 30, 2016 and 2015. This information was derived from the unaudited condensed consolidated statements of income of Navios Acquisition for the respective periods. Expressed in thousands of U.S. dollars Three Month period Ended June 30, 2016 (unaudited) Three Month period Time charter and voyage expenses (1,017 ) (996 ) Direct vessel expenses (24,318 ) (24,293 ) General and administrative expenses Depreciation and amortization Interest expense and finance cost Gain on sale of vessels — 5,771 Equity in net earnings of affiliated companies Other expense, net (994 ) (240 ) Revenue: Revenue for the three month period ended June 30, 2016 decreased by $5.9 million or 7.4% to $74.5 million, as compared to $80.4 million for the same period of 2015. The decrease was mainly attributable to: (i) the decrease in profit sharing by $7.2 million to $1.3 million recognized in the three month period ended June 30, 2016, as compared to $8.6 million for the same period in 2015; and (ii) the decrease in revenue by $6.9 million due to the sale of two VLCCs in June 2015 and one MR2 tanker vessel in January 2016. The decrease was partially mitigated by the increase in revenue following the deliveries of two vessels from April 2015 until June 30, 2016. Available days of the fleet decreased to 3,437 days for the three month period ended June 30, 2016, as compared to 3,523 days for the three month period ended June 30, 2015. The TCE Rate decreased to $21,380 for the three month period ended June 30, 2016, from $22,541 for the three month period ended June 30, 2015. Time charter and voyage expenses: Time charter and voyage expenses for each of the three month periods ended June 30, 2016 and 2015 amounted to $1.0 million. Direct vessel expenses: Direct vessel expenses, comprising of the amortization of dry dock and special survey costs and expenses incurred in connection with specialized work performed on certain vessels of our fleet amounted to $1.4 million for the three month period ended June 30, 2016, as compared to $0.3 million for the three month period ended June 30, 2015. Management fees: Management fees for each of the three month periods ended June 30, 2016 and 2015 amounted to $24.3 million. Pursuant to the Management Agreement, the Manager provided commercial and technical management services to Navios Acquisition’s vessels for a daily fee of: (a) $6,000 per MR2 product tanker and chemical tanker vessel; (b) $7,000 per LR1 product tanker vessel; and (c) $9,500 per VLCC, through May 2016. Navios Acquisition fixed the fees for commercial and technical ship management services of the fleet for two additional years from May 29, 2016 following the expiration of the previous fixed fee period, through May 2018, at a daily fee of: (a) $6,350 per MR2 product tanker and chemical tanker vessel; (b) $7,150 per LR1 product tanker vessel; and (c) the current daily fee of $9,500 per VLCC. Dry docking expenses are reimbursed by Navios Acquisition, at cost. General and administrative expenses: Total general and administrative expenses for the three month period ended June 30, 2016 increased by $2.1 million to $6.0 million compared to $3.9 million for the three month period ended June 30, 2015. The increase was mainly attributable to $2.8 million of compensation authorized and approved by the Compensation committee of Navios Acquisition in December 2015, that was accrued on the statements of income for the three month period ended June 30, 2016; partially mitigated by: (i) a $0.4 million decrease in stock based compensation expense; and (ii) an approximately $0.3 million decrease in administrative expenses paid to Navios Holdings and other general and administrative expenses, including professional, other fees and travel expenses. Depreciation and amortization: Depreciation and amortization decreased by $0.6 million to $14.3 million for the three month period ended June 30, 2016 as compared to $14.9 million for the three month period ended June 30, 2015. The decrease was mainly attributable to the Nave Constellation and the Nave Universe that were classified as vessels held for sale (See Note 6). Depreciation of a vessel is calculated using an estimated useful life of 25 years from the date the vessel was originally delivered from the shipyard. Gain on sale of vessels: The gain on sale of vessels for the three month period ended June 30, 2016 was $0 as compared to $5.8 million for the three month period ended June 30, 2015, which resulted from sale of the Nave Celeste and the C. Dream to Navios Maritime Midstream Partners L.P. (“Navios Midstream”). Interest income: Interest income for the three month period ended June 30, 2016 increased by $0.6 million to $0.9 million compared to $0.3 million for the three month period ended June 30, 2015. Interest expense and finance cost: Interest expense and finance cost for the three month period ended June 30, 2016 decreased by $0.2 million to $18.9 million, as compared to $19.1 million for the three month period ended June 30, 2015. The decrease was due to the decrease in amortization and write-off of deferred finance cost by approximately $0.4 million to $0.8 million for the three month period ended June 30, 2016 as compared to $1.3 million for the same period of 2015 and was partially mitigated by a $0.2 million increase in interest expense due to the increase in the weighted average interest rate for the three month period ended June 30, 2016 to 6.00% from 5.91%, during the three month period ended June 30, 2015. The average outstanding loan balance was $1,187.9 million for the three month period ended June 30, 2016 as compared to $1,187.6 million for the three month period ended June 30, 2015. As of June 30, 2016 and 2015, the outstanding loan balance under Navios Acquisition’s credit facilities was $1,181.9 million and $1,124.3 million, respectively. Equity in net earnings of affiliated companies: Equity in net earnings of affiliated companies for each of the three month periods ended June 30, 2016 and 2015 amounted to $3.7 million. This amount consists of the equity in net earnings of Navios Midstream of $3.4 million ($3.2 million for the three month period ended June 30, 2015) and $0.3 million ($0.4 million for the three month period ended June 30, 2015) resulted from the equity in net earnings of Navios Europe I Inc. (“Navios Europe I”) and Navios Europe II Inc. (“Navios Europe II”), for the three month period ended June 30, 2016. Other expense, net: Other expense, net for the three month period ended June 30, 2016 was $1.0 million and included the deductible and other costs for the litigation initiated in March 2016. For the comparative period of 2015, other expense, net was $0.2 million. For the Six Month Period ended June 30, 2016 compared to the Six Month Period ended June 30, 2015 The following table presents consolidated revenue and expense information for the six month periods ended June 30, 2016 and 2015. This information was derived from the unaudited condensed consolidated statements of income of Navios Acquisition for the respective periods. For the Six (unaudited) For the Six $ 154,914 $ 159,019 Revenue: Revenue for the six month period ended June 30, 2016 decreased by $4.1 million or 2.6% to $154.9 million, as compared to $159.0 million for the same period of 2015. The decrease was mainly attributable to: (i) the decrease in profit sharing by $8.8 million to $7.4 million recognized in the six month period ended June 30, 2016, as compared to $16.2 million for the same period in 2015; and (ii) the decrease in revenue by $14.7 million due to the sale of two VLCCs in June 2015 and one MR2 tanker vessel in January 2016. The decrease was partially mitigated by the increase in revenue following deliveries of four vessels during the period from January 2015 until June 30, 2016. Available days of the fleet decreased to 6,914 days for the six month period ended June 30, 2016, as compared to 6,961 days for the six month period ended June 30, 2015. The TCE Rate decreased to $22,055 for the six month period ended June 30, 2016, from $22,531 for the six month period ended June 30, 2015. Time charter and voyage expenses: Time charter and voyage expenses for the six month period ended June 30, 2016 increased by $0.2 million to $2.4 million as compared to $2.2 million for the six month period ended June 30, 2015. The increase was attributable to a $0.5 million increase in voyage expenses, partially mitigated by a $0.3 million decrease in broker commissions. Direct vessel expenses: Direct vessel expenses, comprising of the amortization of dry dock and special survey costs and expenses incurred in connection with specialized work performed on certain vessels of our fleet, amounted to $2.0 million for the six month period ended June 30, 2016, as compared to $0.7 million for the six month period ended June 30, 2015. Management fees: Management fees for the six month period ended June 30, 2016 increased by $0.2 million to $48.5 million, as compared to $48.3 million for the six month period ended June 30, 2015. The increase was mainly attributable to the increase in the management fees in effect as of May 29, 2016, described below. Pursuant to the Management Agreement, the Manager provided commercial and technical management services to Navios Acquisition’s vessels for a daily fee of: (a) $6,000 per MR2 product tanker and chemical tanker vessel; (b) $7,000 per LR1 product tanker vessel; and (c) $9,500 per VLCC, through May 2016. Navios Acquisition fixed the fees for commercial and technical ship management services of the fleet for two additional years from May 29, 2016, following the expiration of the previous fixed fee period, through May 2018, at a daily fee of: (a) $6,350 per MR2 product tanker and chemical tanker vessel; (b) $7,150 per LR1 product tanker vessel; and (c) the current daily fee of $9,500 per VLCC. Dry docking expenses are reimbursed by Navios Acquisition at cost. General and administrative expenses: Total general and administrative expenses for the six month period ended June 30, 2016 increased by $2.4 million to $9.5 million compared to $7.1 million for the six month period ended June 30, 2015. The increase was mainly attributable to: (a) $2.8 million compensation authorized and approved by the Compensation committee of Navios Acquisition in December 2015 accrued on the statements of income for the six month period ended June 30, 2016; and (b) a $0.4 million increase in administrative expenses paid to Navios Holdings and other general and administrative expenses, including professional, other fees and travel expenses, partially mitigated by $0.8 million decrease in stock based compensation. Depreciation and amortization: Depreciation and amortization decreased by $0.6 million to $29.2 million for the six month period ended June 30, 2016 as compared to $29.8 million for the six month period ended June 30, 2015. The decrease in depreciation and amortization was mainly attributable to the Nave Constellation and the Nave Universe that were classified as vessels held for sale (See Note 6) and to the sale of the Nave Lucida in January 2016. Depreciation of a vessel is calculated using an estimated useful life of 25 years from the date the vessel was originally delivered from the shipyard. Gain on sale of vessels: The gain on sale of vessels for the six month period ended June 30, 2016, was $2.3 million, as compared to $5.8 million for the same period of 2015. On January 27, 2016, Navios Acquisition sold the Nave Lucida to an unaffiliated third party purchaser for a sale price of $18.6 million. The gain on sale of $2.3 million was calculated as the sale price less the carrying value of the vessel of $16.2 million and related selling expenses of $0.1 million. The gain on sale of vessels for the six month period ended June 30, 2015 resulted from the sale of the Nave Celeste and the C. Dream to Navios Midstream. Interest income: Interest income for the six month period ended June 30, 2016 amounted to $1.5 million, as compared to $0.6 million for the six month period ended June 30, 2015. Interest expense and finance cost: Interest expense and finance cost for the six month period ended June 30, 2016 increased by $0.7 million to $38.0 million, as compared to $37.3 million for the six month period ended June 30, 2015. The increase was due to the increase in the weighted average interest rate for the six month period ended June 30, 2016 to 5.97% from 5.92%, during the six month period ended June 30, 2015, partially mitigated by the slight decrease of $0.1 million in the amortization and write-off of deferred finance cost to $1.9 million in the six month period ended June 30, 2016, as compared to $2.0 million for the same period of 2015. The average outstanding loan balance amounted to $1,194.5 million for the six month period ended June 30, 2016 as compared to $1,181.5 million for the six month period ended June 30, 2015. As of June 30, 2016 and 2015, the outstanding loan balance under Navios Acquisition’s credit facilities was $1,181.9 million and $1,124.3 million, respectively. Equity in net earnings of affiliated companies: Equity in net earnings of affiliated companies increased by $1.5 million to $8.6 million for the six month period ended June 30, 2016, as compared to $7.1 million for the same period in 2015. This amount consists of the equity in net earnings of Navios Midstream of $7.9 million and $6.5 million for the same period of 2015 and of the equity in net earnings of Navios Europe I and Navios Europe II of $0.7 million and $0.6 million for the same period of 2015. Other expense, net: Other expense, net for the six month period ended June 30, 2016 was $1.7 million and included the deductible and other costs for the litigation initiated in March 2016. For the comparative period of 2015, other expense, net was $0.7 million. Our primary short-term liquidity needs are to fund general working capital requirements, dry docking expenditures, minimum cash balance maintenance as per our credit facility agreements and debt repayment, while our long-term liquidity needs primarily relate to expansion and investment capital expenditures and other maintenance capital expenditures and debt repayment. Expansion capital expenditures are primarily for the purchase or construction of vessels to the extent the expenditures increase the operating capacity of or revenue generated by our fleet, while maintenance capital expenditures primarily consist of dry docking expenditures and expenditures to replace vessels in order to maintain the operating capacity of or revenue generated by our fleet. We anticipate that our primary sources of funds for our short-term liquidity needs will be cash flows from operations, proceeds from asset sales and bank borrowings, which we believe will be sufficient to meet our existing short-term liquidity needs for at least the next 12 months. Generally, our long-term sources of funds will be from cash from operations, long-term bank borrowings and other debt or equity financings. We expect that we will rely upon cash from operations and upon external financing sources, including bank borrowings, to fund acquisitions, expansion and investment capital expenditures and other commitments we have entered into. We cannot assure you that we will be able to secure adequate financing or obtain additional funds on favorable terms, to meet our liquidity needs. Under its share repurchase program, Navios Acquisition is authorized to repurchase up to $50.0 million of its common stock, over a two-year period until December 2016, unless extended. The timing and amount of purchases under the program will be determined by management based upon market conditions and other factors, and will be subject to restrictions under Navios Acquisition’s credit facilities and indenture. Navios Acquisition may use funds to repurchase its outstanding capital stock and/or indebtedness from time to time. Repurchases may be made in the open market, or through privately negotiated transactions or otherwise, in compliance with applicable laws, rules and regulations, at prices and on terms Navios Acquisition deems appropriate and subject to its cash requirements for other purposes, compliance with the covenants under Navios Acquisition’s debt agreements, and other factors management deems relevant. Cash flows for the six month period ended June 30, 2016 compared to the six month period ended June 30, 2015: The following table presents cash flow information for the six month periods ended June 30, 2016 and 2015. Period Ended (unaudited) Six Month Net cash used in financing activities Cash and cash equivalents, beginning of the period Cash and cash equivalents, end of period Cash provided by operating activities for the six month period ended June 30, 2016 as compared to the six month period ended June 30, 2015: Net cash provided by operating activities decreased by $3.9 million to $50.2 million for the period ended June 30, 2016 as compared to net cash provided by operating activities of $54.1 million for the same period in 2015. The decrease is analyzed as follows: The net income for the six month period ended June 30, 2016 was $36.0 million compared to $46.4 million for the six month period ended June 30, 2015. In determining net cash provided by operating activities for the six month period ended June 30, 2016, the net income was adjusted for the effect of depreciation and amortization of $29.2 million, $2.3 million gain on sale of vessels, $1.9 million for amortization and a write-off of deferred finance cost and bond premium, $1.3 million for the amortization of dry dock and special survey costs, $0.5 million stock based compensation and $0.8 million for earnings in affiliates, net of dividends received. Amounts due from related parties, short-term, increased by $3.8 million in the six month period ended June 30, 2016, which mainly related to payment of management fees for our vessels. Please refer to the relevant discussion below, under “Related Parties Transactions”. Accounts receivable increased by $1.7 million from $14.2 million for the year ended December 31, 2015, to $15.9 million for the six month period ended June 30, 2016. The increase was attributed to the increase in receivables due from charterers. Restricted cash from operating activities increased by $0.1 million due to increase in the cash held in retention accounts for the payment of interest under our credit facilities. Amounts due from related parties, long-term, increased by $11.8 million in the six month period ended June 30, 2016, which mainly related to payment of special survey and dry docking expenses for certain vessels of our fleet and the increase in Navios Revolving Loans II. Please refer to the relevant discussion below, under “Related Parties Transactions”. Accounts payable were $2.4 million for the six month period ended June 30, 2016 and $2.8 million for the year ended December 31, 2015. The decrease of $0.4 million was due to a $0.5 million decrease in payables to brokers, partially mitigated by an approximately $0.2 million increase in other payables. Prepaid expenses and other current assets decreased by $1.4 million to $2.3 million for the six month period ended June 30, 2016 from $3.7 million for the year ended December 31, 2015. The total decrease in prepaid expenses and other current assets primarily resulted from a $2.6 million reclassification of working capital advances required under certain charter contracts, under the long-term assets. The decrease of $2.6 million was partially mitigated by a $1.2 million increase in other prepaid expenses. Payment for dry dock and special survey costs incurred in the six month period ended June 30, 2016 was $2.3 million and relates to dry dock and special survey costs incurred for certain vessels of the fleet. There was no payment for dry dock and special survey costs in the same period of 2015. Other long-term assets increased by $3.9 million to $5.9 million for the six month period ended June 30, 2016 from $1.9 million for the year ended December 31, 2015, due to $1.3 million mainly representing advances to certain counterparties for working capital purposes and $2.6 million of working capital reclassified from current assets. Accrued expenses increased by $3.4 million to $13.2 million for the six month period ended June 30, 2016, from $9.8 million on December 31, 2015. The increase was attributable to a $3.3 million increase in accrued legal and professional expenses and a $0.1 million increase in accrued voyage expenses. Deferred revenue primarily relates to cash received from charterers prior to it being earned. These amounts are recognized as revenue over the voyage or charter period. Deferred revenue decreased by $1.1 million to $6.5 million for the six month period ended June 30, 2016 from $7.6 million on December 31, 2015. Cash provided by investing activities for the six month period ended June 30, 2016 as compared to the six month period ended June 30, 2015: Net cash provided by investing activities decreased by $17.4 million to $17.0 million as of June 30, 2016 from $34.5 million as of June 30, 2015. Net cash provided by investing activities for the six month period ended June 30, 2016, resulted from: (i) $18.4 million net proceeds from the sale of the Nave Lucida; and (ii) $2.9 million in dividends received from Navios Midstream. The $21.3 million increase was mitigated by a $4.3 million loan granted to Navios Europe II (Navios Revolving Loans II). Net cash provided by investing activities for the six month period ended June 30, 2015, resulted from: (i) $71.2 million net proceeds from the sale of vessels; and (ii) $0.8 million from dividends received from affiliates. The $72.0 million increase was mitigated by (a) $29.4 million paid for the acquisition of vessels; (b) $4.8 million paid for investments in affiliates (from which $4.3 million relates to the investment in Navios Europe II and approximately $0.6 million was paid to Navios Midstream to acquire 32,509 general partner units in order for Navios Acquisition to maintain its 2.0% general partnership interest); and (c) a $3.3 million loan granted to Navios Europe II. Cash used in financing activities for the six month period ended June 30, 2016 as compared to the six month period ended June 30, 2015: Net cash used in financing activities decreased by $16.8 million to $52.5 million outflow at June 30, 2016 from $69.3 million outflow in the six month period ended June 30, 2015. The decrease in net cash used in financing activities resulted from: (i) $34.7 million of loan repayments; (ii) $15.9 million of dividends paid; and (iii) $2.0 million of redemption of puttable common stock. Net cash used in financing activities for the six month period ended June 30, 2015 resulted from: (i) $64.2 million of loan repayments; (ii) $16.2 million of dividends paid; (iii) a $11.3 million payment to a related party; (iv) $3.5 million for the redemption of convertible shares and puttable common stock; and (v) a $0.1 million decrease in restricted cash, and was partially offset by $26.0 million loan proceeds net of deferred finance cost. Reconciliation of EBITDA to Net Cash from Operating Activities (unaudited) Three Month Net (decrease)/ increase in operating assets (5,054 ) (677 ) 16,905 4,455 Net decrease/ (increase) in operating liabilities 8,774 20,666 (1,415 ) 14,646 Net interest cost 18,033 18,808 36,504 36,742 Amortization of deferred finance cost (822 ) (1,263 ) (1,864 ) (1,993 ) Earnings in affiliates, net of dividends received 343 (2,279 ) 833 1,159 (264 ) (662 ) (528 ) (1,318 ) — 5,771 2,282 5,771 EBITDA(1) $ 45,186 $ 60,398 $ 102,954 $ 113,606 $ 1,935 $ 61,902 $ 17,027 $ 34,469 $ (21,216 ) $ (65,742 ) $ (52,533 ) $ (69,309 ) (1) EBITDA represents net income before interest and finance cost, before depreciation and amortization, income taxes, gain on sale of vessel and stock-based compensation. We use EBITDA as a liquidity measure and reconcile EBITDA to net cash provided by/ (used in) operating activities, the most comparable U.S. GAAP liquidity measure. EBITDA in this document is calculated as follows: net cash provided by/(used in) operating activities adding back, when applicable and as the case may be, the effect of: (i) net increase/(decrease) in operating assets; (ii) net (increase)/decrease in operating liabilities; (iii) net interest cost; (iv) amortization of deferred finance cost and other related expenses; (v) provision for losses on accounts receivable; (vi) equity in net earnings of affiliated companies, net of dividends received; (vii) payments for dry dock and special survey costs; (viii) gain/(loss) on sale of assets/subsidiaries; and (ix) impairment charges. Navios Acquisition believes that EBITDA is the basis upon which liquidity can be assessed and presents useful information to investors regarding Navios Acquisition’s ability to service and/or incur indebtedness, pay capital expenditures, meet working capital requirements and pay dividends. Navios Acquisition also believes that EBITDA is used: (i) by potential lenders to evaluate potential transactions; (ii) to evaluate and price potential acquisition candidates; and (iii) by securities analysts, investors and other interested parties in the evaluation of companies in our industry. EBITDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for the analysis of Navios Acquisition results as reported under U.S. GAAP. Some of these limitations are: (i) EBITDA does not reflect changes in, or cash requirements for, working capital needs; and (ii) although depreciation and amortization are non-cash charges, the assets being depreciated and amortized may have to be replaced in the future. EBITDA does not reflect any cash requirements for such capital expenditures. Because of these limitations, EBITDA should not be considered as a principal indicator of Navios Acquisition’s performance. Furthermore, our calculation of EBITDA may not be comparable to that reported by other companies due to differences in methods of calculation. EBITDA for the three month period ended June 30, 2016 decreased by $15.2 million to $45.2 million from $60.4 million in the same period of 2015. The decrease in EBITDA was mainly due to: (i) a $5.9 million decrease in revenue; (ii) $5.8 million of gain from sale of vessels recognized in the three month period ended June 30, 2015; (iii) a $2.1 million increase in general and administrative expenses; (iv) a $0.8 million increase in other expense, net; and (v) $0.7 million increase in direct vessel expenses (excluding amortization of dry dock and special survey costs), partially mitigated by a $0.1 million increase in equity in net earnings of affiliated companies. EBITDA for the six month period ended June 30, 2016 decreased by $10.7 million to $103.0 million from $113.6 million in the same period of 2015. The decrease in EBITDA was mainly due to: (i) a $4.1 million decrease in revenue; (ii) the decrease in the gain on sale of vessels by $3.5 million; (iii) a $2.4 million increase in general and administrative expenses; (iv) a $1.0 million increase in other expense, net; (v) a $0.3 million increase in time charter expenses; (vi) a $0.2 million increase in management fees; and (vii) $0.7 million increase in direct vessel expenses (excluding amortization of dry dock and special survey costs), partially mitigated by a $1.5 million increase in equity in net earnings of affiliated companies. Long-Term Debt Obligations and Credit Arrangements Ship Mortgage Notes 8 1/8% First Priority Ship Mortgages: On November 13, 2013, the Company and its wholly owned subsidiary, Navios Acquisition Finance (US) Inc. (“Navios Acquisition Finance” and together with the Company, the “2021 Co-Issuers”) issued $610.0 million in first priority ship mortgage notes (the “Existing Notes”) due on November 15, 2021 at a fixed rate of 8.125%. On March 31, 2014, the Company completed a sale of $60.0 million of its first priority ship mortgage notes due in 2021 (the “Additional Notes,” and together with the Existing Notes, the “2021 Notes”). The terms of the Additional Notes are identical to the Existing Notes and were issued at 103.25% plus accrued interest from November 13, 2013. The net cash received amounted to $59.6 million. The 2021 Notes are fully and unconditionally guaranteed on a joint and several basis by all of Navios Acquisition’s subsidiaries with the exception of Navios Acquisition Finance (a co-issuer of the 2021 Notes). The 2021 Co-Issuers have the option to redeem the 2021 Notes in whole or in part, at any time: (i) before November 15, 2016, at a redemption price equal to 100% of the principal amount, plus a make-whole premium, plus accrued and unpaid interest, if any; and (ii) on or after November 15, 2016, at a fixed price of 106.094% of the principal amount, which price declines ratably until it reaches par in 2019, plus accrued and unpaid interest, if any. At any time before November 15, 2016, the 2021 Co-Issuers may redeem up to 35% of the aggregate principal amount of the 2021 Notes with the net proceeds of an equity offering at 108.125% of the principal amount of the 2021 Notes, plus accrued and unpaid interest, if any, so long as at least 65% of the aggregate principal amount of the Existing Notes remains outstanding after such redemption. In addition, upon the occurrence of certain change of control events, the holders of the 2021 Notes will have the right to require the 2021 Co-Issuers to repurchase some or all of the 2021 Notes at 101% of their face amount, plus accrued and unpaid interest to the repurchase date. The 2021 Notes contain covenants which, among other things, limit the incurrence of additional indebtedness, issuance of certain preferred stock, the payment of dividends, redemption or repurchase of capital stock or making restricted payments and investments, creation of certain liens, transfer or sale of assets, entering in transactions with affiliates, merging or consolidating or selling all or substantially all of the 2021 Co-Issuers’ properties and assets and creation or designation of restricted subsidiaries. The 2021 Co-Issuers were in compliance with the covenants as of June 30, 2016. The Existing Notes and the Additional Notes are treated as a single class for all purposes under the indenture including, without limitation, waivers, amendments, redemptions and other offers to purchase and the Additional Notes rank evenly with the Existing Notes. The Additional Notes and the Existing Notes have the same CUSIP number. The Company’s 2021 Notes are fully and unconditionally guaranteed on a joint and several basis by all of the Company’s subsidiaries with the exception of Navios Acquisition Finance (a co-issuer of the 2021 notes). The Company’s 2021 Notes are unregistered. The guarantees of our subsidiaries that own mortgaged vessels are senior secured guarantees and the guarantees of our subsidiaries that do not own mortgaged vessels are senior unsecured guarantees. All subsidiaries, including Navios Acquisition Finance, are 100% owned. Navios Acquisition does not have any independent assets or operations. Navios Acquisition does not have any subsidiaries that are not guarantors of the 2021 Notes. As of June 30, 2016, the Company had secured credit facilities with various banks with a total outstanding balance of $511.9 million. The purpose of the facilities was to finance the construction or acquisition of vessels or refinance existing indebtedness. All of the facilities are denominated in U.S. Dollars and bear interest based on LIBOR plus spread ranging from 250 bps to 320 bps per annum. The facilities are repayable in either semi-annual or quarterly installments, followed by balloon payments with maturities, ranging from October 2016 to October 2022. Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB: In November 2015, Navios Acquisition, entered into a term loan facility of up to $125.0 million (divided into five tranches) with Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB for: (i) the financing of the purchase price of the Nave Spherical; and (ii) the refinancing of the existing facility with Deutsche Bank AG Filiale Deutschlandgescäft and Skandinaviska Enskilda Banken AB. Four of the five tranches of the facility are repayable in 20 quarterly installments of between approximately $0.4 million and $1.9 million, each with a final balloon repayment to be made on the last repayment date. The fifth tranche is repayable in 16 quarterly installments of between approximately $0.7 million and $0.8 million, each. The maturity date of the loan is in the fourth quarter of 2020. The credit facility bears interest at LIBOR plus 295 bps per annum. On January 27, 2016, Navios Acquisition sold the Nave Lucida to an unaffiliated third party for net cash proceeds of $18.4 million. Navios Acquisition prepaid $12.1 million being the respective tranche of the Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB facility that was drawn to finance the Nave Lucida. Following the prepayment of January 2016, an amount of $0.2 million was written-off from the deferred financing cost. As of June 30, 2016, $105.3 million was outstanding under this facility. As of June 30, 2016, no amount was available to be drawn from our facilities. The loan facilities include, among other things, compliance with loan to value ratios and certain financial covenants: (i) minimum liquidity higher of $40.0 million or $1.0 million per vessel; (ii) net worth ranging from $50.0 million to $135.0 million; and (iii) total liabilities divided by total assets, adjusted for market values to be lower than 75%. It is an event of default under the credit facilities if such covenants are not complied with, including the loan to value ratios for which the Company may provide sufficient additional security to prevent such an event. As of June 30, 2016, the Company was in compliance with the covenants in each of its credit facilities. Amounts drawn under the facilities are secured by first preferred mortgages on Navios Acquisition’s vessels and other collateral and are guaranteed by each vessel-owning subsidiary. The credit facilities contain a number of restrictive covenants that prohibit or limit Navios Acquisition from, among other things: incurring or guaranteeing indebtedness; entering into affiliate transactions; changing the flag, class, management or ownership of Navios Acquisition’s vessels; changing the commercial and technical management of Navios Acquisition’s vessels; selling Navios Acquisition’s vessels; and subordinating the obligations under each credit facility to any general and administrative costs relating to the vessels, including the fixed daily fee payable under the management agreement. The credit facilities also require Navios Acquisition to comply with the ISM Code and ISPS Code and to maintain valid safety management certificates and documents of compliance at all times. Off-Balance Sheet Arrangements – Legal Proceedings Charter hire payments to third parties for chartered-in vessels are treated as operating leases for accounting purposes. As of June 30, 2016, Navios Acquisition was contingently liable to charter-in certain vessels from Navios Midstream. Please see discussion below under “Contractual Obligations”. The Company is involved in various disputes and arbitration proceedings arising in the ordinary course of business. Provisions have been recognized in the financial statements for all such proceedings where the Company believes that a liability may be probable, and for which the amounts are reasonably estimable, based upon facts known at the date of the financial statements were prepared. In the opinion of the management, the ultimate disposition of these matters individually and in aggregate will not materially affect the Company’s financial position, results of operations or liquidity. On April 1, 2016, Navios Holdings was named as a defendant in a putative shareholder derivative lawsuit brought by two alleged shareholders of Navios Acquisition purportedly on behalf of nominal defendant, Navios Acquisition, in the United States District Court for the Southern District of New York, captioned Metropolitan Capital Advisors International Ltd., et al. v. Navios Maritime Holdings, Inc. et al., No. 1:16-cv-02437. The lawsuit challenged the March 9, 2016 loan agreement between Navios Holdings and Navios Acquisition pursuant to which Navios Acquisition agreed to provide a $50.0 million credit facility (the “Revolver”) to Navios Holdings. On April 14, 2016, Navios Holdings and Navios Acquisition announced that the Revolver had been cancelled, and that no borrowings had been made under the Revolver. In June 2016, the parties reached an agreement resolving the plaintiffs’ application for attorneys’ fees and expenses which was approved by an order of the Court. The litigation was dismissed upon notice of the order being provided to Navios Acquisition’s shareholders via the inclusion of the order as an attachment to a Navios Acquisition Form 6-K and the payment of $0.8 million by Navios Acquisition in satisfaction of the plaintiffs’ request for attorneys’ fees and expenses. A copy of the order was provided as an exhibit to Navios Acquisition’s Form 6-K filed with the Securities and Exchange Commission on June 9, 2016. Contractual Obligations The following table summarizes our long-term contractual obligations as of June 30, 2016: Payments due by period (Unaudited) (In thousands of U.S. dollars) Less than 1 year 1-3 years 3-5 years More than 5 years Total Long-term debt obligations(1) $ 76,420 $ 157,655 $ 202,732 $ 745,125 $ 1,181,932 Total contractual obligations (1) The amount identified does not include interest costs associated with the outstanding credit facilities, which are based on LIBOR, plus the costs of complying with any applicable regulatory requirements and a margin ranging from 250 bps to 320 bps per annum or the $670.0 million 2021 Notes which have a fixed rate of 8.125%. Navios Holdings, Navios Acquisition and Navios Maritime Partners L.P. (“Navios Partners”) have made available to Navios Europe I (in each case, in proportion to their ownership interests in Navios Europe I) revolving loans up to $24.1 million to fund working capital requirements (collectively, the “Navios Revolving Loans I”). As of June 30, 2016, the amount undrawn from the revolving facility was $9.1 million, of which Navios Acquisition is committed to fund $4.3 million. See Note 7 for the Investment in Navios Europe I and the respective ownership interests. Navios Holdings, Navios Acquisition and Navios Partners have made available to Navios Europe II (in each case, in proportion to their ownership interests in Navios Europe II) revolving loans up to $38.5 million to fund working capital requirements (collectively, the “Navios Revolving Loans II”). As of June 30, 2016, the amount undrawn under the Navios Revolving Loans II was $14.1 million, of which Navios Acquisition is committed to fund $6.7 million. See Note 7 for the Investment in Navios Europe II and the respective ownership interests. On November 18, 2014, Navios Acquisition entered into backstop agreements with Navios Midstream. In accordance with the terms of the backstop agreements, Navios Acquisition has provided a backstop commitment to charter-in the Shinyo Ocean and the Shinyo Kannika for a two-year period as of their scheduled redelivery at the currently contracted rate if the market charter rate is lower than the currently contracted rate. Further, Navios Acquisition has provided a backstop commitment to charter-in the Nave Celeste for a two-year period as of its scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35,000 if the market charter rate is lower than the charter-out rate of $35,000. Navios Acquisition has also provided a backstop commitment to charter-in the option vessels, the Nave Galactic and the Nave Quasar, for a four-year period as of their scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35,000 if the market charter rate is lower than the charter-out rate of $35,000. Conversely, if market charter rates are higher during the backstop period, such vessels will be chartered-out to third-party charterers at prevailing market rates and Navios Acquisition’s backstop commitment will not be triggered. The backstop commitment does not include any profit sharing. The Navios Holdings Credit Facilities: In March 2016, Navios Acquisition entered into the $50.0 million Revolver with Navios Holdings, which was available for multiple drawings up to a limit of $50.0 million. The Revolver had a margin of LIBOR plus 300bps and a maturity until December 2018. On April 14, 2016, Navios Acquisition and Navios Holdings announced that the Revolver was terminated. No borrowings had been made under the Revolver. Please refer to “Legal Proceedings” in Note 13. On November 11, 2014, Navios Acquisition entered into a short-term credit facility with Navios Holdings pursuant to which Navios Acquisition could borrow up to $200.0 million for general corporate purposes. The facility provided for an arrangement fee of $4.0 million and bore fixed interest of 600 bps. All amounts drawn under this facility were fully repaid by the maturity date of December 29, 2014. In 2010, Navios Acquisition entered into a $40.0 million credit facility with Navios Holdings, which matured in December 2015. The facility was available for multiple drawings up to a limit of $40.0 million and had a margin of LIBOR plus 300 basis points. As of its maturity date, December 31, 2015, all amounts drawn were fully repaid. Management fees: Pursuant to the Management Agreement dated May 28, 2010 and as amended in May 2012 and May 2014, the Manager provided commercial and technical management services to Navios Acquisition’s vessels for a fixed daily fee of: (a) $6,000 per MR2 product tanker and chemical tanker vessel; (b) $7,000 per LR1 product tanker vessel; and (c) $9,500 per VLCC, through May 2016. Pursuant to an amendment to the Management Agreement dated as of May 19, 2016, Navios Acquisition fixed the fees for commercial and technical ship management services of the fleet for two additional years from May 29, 2016 following the expiration of the previous fixed fee period, through May 2018, at a daily fee of: (a) $6,350 per MR2 product tanker and chemical tanker vessel; (b) $7,150 per LR1 product tanker vessel; and (c) the current daily fee of $9,500 per VLCC. Effective March 30, 2012, Navios Acquisition can, upon request to Navios Holdings, partially or fully defer the reimbursement of dry docking and other extraordinary fees and expenses under the Management Agreement to a later date, but not later than January 5, 2016, and if reimbursed on a later date, such amounts will bear interest at a rate of 1% per annum over LIBOR. Commencing as of September 28, 2012, Navios Acquisition can, upon request, reimburse Navios Holdings partially or fully, for any fixed management fees outstanding for a period of not more than nine months under the Management Agreement at a later date, but not later than January 5, 2016, and if reimbursed on a later date, such amounts will bear interest at a rate of 1% per annum over LIBOR. Total management fees for each of the three month periods ended June 30, 2016 and 2015 amounted to $24.3 million. Total management fees for each of the six month periods ended June 30, 2016 and 2015 amounted to $48.5 million and $48.3 million, respectively. Included in direct vessel expenses, there is an amount of $0.7 million for the three and six month period ended June 30, 2016, that was incurred for specialized work performed in connection with certain vessels. General and administrative expenses: On May 28, 2010, Navios Acquisition entered into an Administrative Services Agreement with Navios Holdings, pursuant to which Navios Holdings provides certain administrative management services to Navios Acquisition which include: bookkeeping, audit and accounting services, legal and insurance services, administrative and clerical services, banking and financial services, advisory services, client and investor relations and other services. Navios Holdings is reimbursed for reasonable costs and expenses incurred in connection with the provision of these services. In May 2014, Navios Acquisition extended the duration of its existing Administrative Services Agreement with Navios Holdings, until May 2020. For the three month periods ended June 30, 2016 and 2015 the administrative services rendered by Navios Holdings amounted to $2.4 million and $1.9 million, respectively. For the six month periods ended June 30, 2016 and 2015 the expense arising from administrative services rendered by Navios Holdings amounted to $4.8 million and $3.9 million, respectively. Balance due from related parties (excluding Navios Europe I and Navios Europe II): Balance due from related parties as of June 30, 2016 and December 31, 2015 was $24.3 million and $15.5 million, respectively, and included the short-term and long-term amounts due from Navios Holdings and Navios Midstream. The balances mainly consisted of administrative expenses and special survey and dry docking expenses for certain vessels of our fleet, as well as management fees, in accordance with our Management Agreement. Omnibus Agreements Acquisition Omnibus Agreement: Navios Acquisition entered into an omnibus agreement (the “Acquisition Omnibus Agreement”) with Navios Holdings and Navios Partners in connection with the closing of Navios Acquisition’s initial vessel acquisition, pursuant to which, among other things, Navios Holdings and Navios Partners agreed not to acquire, charter-in or own liquid shipment vessels, except for container vessels and vessels that are primarily employed in operations in South America without the consent of an independent committee of Navios Acquisition. In addition, Navios Acquisition, under the Acquisition Omnibus Agreement, agreed to cause its subsidiaries not to acquire, own, operate or charter-in drybulk carriers under specific exceptions. Under the Acquisition Omnibus Agreement, Navios Acquisition and its subsidiaries grant to Navios Holdings and Navios Partners a right of first offer on any proposed sale, transfer or other disposition of any of its drybulk carriers and related charters owned or acquired by Navios Acquisition. Likewise, Navios Holdings and Navios Partners agreed to grant a similar right of first offer to Navios Acquisition for any liquid shipment vessels they might own. These rights of first offer will not apply to a: (a) sale, transfer or other disposition of vessels between any affiliated subsidiaries, or pursuant to the existing terms of any charter or other agreement with a counterparty; or (b) merger with or into, or sale of substantially all of the assets to, an unaffiliated third party. Midstream Omnibus Agreement: Navios Acquisition entered into an omnibus agreement (the “Midstream Omnibus Agreement”), with Navios Midstream, Navios Holdings and Navios Partners in connection with the Navios Midstream IPO, pursuant to which Navios Acquisition, Navios Midstream, Navios Holdings, Navios Partners and their controlled affiliates generally have agreed not to acquire or own any VLCCs, crude oil tankers, refined petroleum product tankers, LPG tankers or chemical tankers under time charters of five or more years without the consent of the Navios Midstream General Partner. The Midstream Omnibus Agreement contains significant exceptions that will allow Navios Acquisition, Navios Holdings, Navios Partners or any of their controlled affiliates to compete with Navios Midstream under specified circumstances. Under the Midstream Omnibus Agreement, Navios Midstream and its subsidiaries will grant to Navios Acquisition a right of first offer on any proposed sale, transfer or other disposition of any of its VLCCs or any crude oil tankers, refined petroleum product tankers, LPG tankers or chemical tankers and related charters owned or acquired by Navios Midstream. Likewise, Navios Acquisition will agree (and will cause its subsidiaries to agree) to grant a similar right of first offer to Navios Midstream for any of the VLCCs, crude oil tankers, refined petroleum product tankers, LPG tankers or chemical tankers under charter for five or more years it might own. These rights of first offer will not apply to a: (a) sale, transfer or other disposition of vessels between any affiliated subsidiaries, or pursuant to the terms of any charter or other agreement with a charter party; or (b) merger with or into, or sale of substantially all of the assets to, an unaffiliated third-party. Backstop Agreement: On November 18, 2014, Navios Acquisition entered into backstop agreements with Navios Midstream. In accordance with the terms of the backstop agreements, Navios Acquisition has provided a backstop commitment to charter-in the Shinyo Ocean and the Shinyo Kannika for a two-year period as of their scheduled redelivery at the currently contracted rate if the market charter rate is lower than the currently contracted rate. Further, Navios Acquisition has provided a backstop commitment to charter-in the Nave Celeste for a two-year period as of its scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35,000 if the market charter rate is lower than the charter-out rate of $35,000. Navios Acquisition has also provided a backstop commitment to charter-in the option vessels, the Nave Galactic and the Nave Quasar for a four-year period as of their scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35,000 if the market charter rate is lower than the charter-out rate of $35,000. Conversely, if market charter rates are higher during the backstop period, such vessels will be chartered-out to third-party charterers at prevailing market rates and Navios Acquisition’s backstop commitment will not be triggered. The backstop commitment does not include any profit sharing. Navios Midstream General Partner Option Agreement with Navios Holdings: Navios Acquisition entered into an option agreement, dated November 18, 2014, with Navios Holdings under which Navios Acquisition grants Navios Holdings the option to acquire any or all of the outstanding membership interests in Navios Midstream General Partner and all of the incentive distribution rights in Navios Midstream representing the right to receive an increasing percentage of the quarterly distributions when certain conditions are met. The option shall expire on November 18, 2024. Any such exercise shall relate to not less than twenty-five percent of the option interest and the purchase price for the acquisition of all or part of the option interest shall be an amount equal to its fair market value. Option Vessels: In connection with the IPO of Navios Midstream, Navios Acquisition has granted options to Navios Midstream, exercisable until November 2016, to purchase five more VLCCs (other than the Nave Celeste and the C. Dream) from Navios Acquisition at fair market value. Balance due from Navios Europe I: Navios Holdings, Navios Acquisition and Navios Partners have made available to Navios Europe I (in each case, in proportion to their ownership interests in Navios Europe I) revolving loans up to $24.1 million to fund working capital requirements (collectively, the “Navios Revolving Loans I”). See Note 7 for the Investment in Navios Europe I and the respective ownership interests. Balance due from Navios Europe I as of June 30, 2016 amounted to $11.2 million (December 31, 2015: $10.3 million) which included the Navios Revolving Loans I of $7.1 million (December 31, 2015: $7.1 million), the non-current amount of $1.8 million (December 31, 2015: $1.4 million) related to the accrued interest income earned under the Navios Term Loans I under the caption “Due from related parties, long-term” and the accrued interest income earned under the Navios Revolving Loans I of $2.3 million (December 31, 2015: $1.7 million) under the caption “Due from related parties, short-term.” The Navios Revolving Loans I and the Navios Term Loans I earn interest and an annual preferred return, respectively, at 12.7% per annum, on a quarterly compounding basis and are repaid from free cash flow (as defined in the loan agreement) to the fullest extent possible at the end of each quarter. There are no covenant requirements or stated maturity dates. As of June 30, 2016, the amount undrawn under the Navios Revolving Loans I was $9.1 million, of which Navios Acquisition was committed to fund $4.3 million. Balance due from Navios Europe II: Navios Holdings, Navios Acquisition and Navios Partners have made available to Navios Europe II (in each case, in proportion to their ownership interests in Navios Europe II) revolving loans up to $38.5 million to fund working capital requirements (collectively, the “Navios Revolving Loans II”). See Note 7 for the Investment in Navios Europe II and respective ownership interests. Balance due from Navios Europe II as of June 30, 2016 amounted to $14.4 million (December 31, 2015: $8.5 million) which included the Navios Revolving Loans II of $11.6 million (December 31, 2015: $7.3 million), the non-current amount of $1.3 million (December 31, 2015: $0.6 million), related to the accrued interest income earned under the Navios Term Loans II under the caption “Due from related parties, long-term” and the accrued interest income earned under the Navios Revolving Loans II of $1.5 million (December 31, 2015: $0.6 million), under the caption “Due from related parties, short-term.” The Navios Revolving Loans II and the Navios Term Loans II earn interest and an annual preferred return, respectively, at 18% per annum, on a quarterly compounding basis and are repaid from free cash flow (as defined in the loan agreement) to the fullest extent possible at the end of each quarter. There are no covenant requirements or stated maturity dates. As of June 30, 2016, the amount undrawn under the Navios Revolving Loans II was $14.1 million, of which Navios Acquisition was committed to fund $6.7 million. Quantitative and Qualitative Disclosures about Market Risks Our functional and reporting currency is the U.S. dollar. We engage in worldwide commerce with a variety of entities. Although our operations may expose us to certain levels of foreign currency risk, our transactions are predominantly U.S. dollar denominated. Transactions in currencies other than U.S. dollars are translated at the exchange rate in effect at the date of each transaction. Differences in exchange rates during the period between the date a transaction denominated in a foreign currency is consummated and the date on which it is either settled or translated, are recognized in the statements of income. As of June 30, 2016, Navios Acquisition had a total of $1,181.9 million in long-term and short-term indebtedness. Borrowings under our credit facilities bear interest at rates based on a premium over U.S. $ LIBOR except for the interest rate on the Existing Notes and the Additional Notes which is fixed. Therefore, we are exposed to the risk that our interest expense may increase if interest rates rise. For the six month period ended June 30, 2016, we paid interest on our outstanding debt at a weighted average interest rate of 5.97%. A 1% increase in LIBOR would have increased our interest expense for the six month period ended June 30, 2016 by $2.7 million. Concentration of Credit Risk Financial instruments, which potentially subject us to significant concentrations of credit risk, consist principally of trade accounts receivable. We closely monitor our exposure to customers for credit risk. We have policies in place to ensure that we trade with customers with an appropriate credit history. For the six month period ended June 30, 2016, Navig8, Shell and Mansel accounted for 34.6%, 19.8% and 14.5% respectively, of Navios Acquisition’s revenue. For the year ended December 31, 2015, Navios Acquisition’s customers representing 10% or more of total revenue were Navig8, Shell and Mansel, which accounted for 35.2%, 13.6% and 10.8% respectively, of Navios Acquisition’s revenue. Cash deposits and cash equivalents in excess of amounts covered by government-provided insurance are exposed to loss in the event of non-performance by financial institutions. Navios Acquisition does maintain cash deposits and equivalents in excess of government-provided insurance limits. Navios Acquisition also minimizes exposure to credit risk by dealing with a diversified group of major financial institutions. Inflation has had a minimal impact on vessel operating expenses and general and administrative expenses. Our management does not consider inflation to be a significant risk to direct vessel expenses in the current and foreseeable economic environment. In March 2016, the FASB issued Accounting Standards Update No. 2016-09, “Compensation—Stock Compensation (Topic 718)” (“ASU 2016-09”). ASU 2016-09 simplifies several aspects of accounting for stock based compensation including the tax consequences, classification of awards as equity or liabilities, forfeitures and classification on the statement of cash flows. The ASU is effective for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. Early application is permitted. The Company is currently assessing the impact that adopting this new accounting guidance will have on its consolidated financial statements and footnotes disclosures. In February 2016, the FASB issued Accounting Standards Update No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”). ASU 2016-02 will apply to both types of leases — capital (or finance) leases and operating leases. According to the new Accounting Standard, lessees will be required to recognize assets and liabilities on the balance sheet for the rights and obligations created by all leases with terms of more than 12 months. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years. Early application is permitted. The Company is currently assessing the impact that adopting this new accounting guidance will have on its consolidated financial statements and footnotes disclosures. In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements-Going Concern (Subtopic 205-40): Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern”. This standard requires management to assess an entity’s ability to continue as a going concern, and to provide related footnote disclosures in certain circumstances. Before this new standard, no accounting guidance existed for management on when and how to assess or disclose going concern uncertainties. The amendments are effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016. Early application is permitted. The adoption of the new standard is not expected to have a material impact on the Company’s results of operations, financial position or cash flows. In May 2014, the FASB issued ASU 2014-09 “Revenue from Contracts with Customers” clarifying the method used to determine the timing and requirements for revenue recognition on the statements of income. Under the new standard, an entity must identify the performance obligations in a contract, the transaction price and allocate the price to specific performance obligations to recognize the revenue when the obligation is completed. The amendments in this update also require disclosure of sufficient information to allow users to understand the nature, amount, timing and uncertainty of revenue and cash flow arising from contracts. The new accounting guidance was originally effective for interim and annual periods beginning after December 15, 2016. On July 9, 2015, the FASB finalized a one-year deferral of the effective date for the new revenue standard. The standard will be effective for public entities for annual reporting periods beginning after December 15, 2017 and interim periods therein. The Company is currently reviewing the effect of ASU No. 2014-09 on its revenue recognition. Critical Accounting Policies Navios Acquisition’s interim consolidated financial statements have been prepared in accordance with US GAAP. The preparation of these financial statements requires Navios Acquisition to make estimates in the application of our accounting policies based on the best assumptions, judgments and opinions of management. Actual results may differ from these estimates under different assumptions or conditions. Critical accounting policies are those that reflect significant judgments or uncertainties, and potentially result in materially different results under different assumptions and conditions. Other than as described below, all significant accounting policies are as described in Note 2 to the consolidated financial statements included in the Company’s Annual Report on Form 20-F for the year ended December 31, 2015 filed with the Securities and Exchange Commission on March 22, 2016. 101 The following materials from Navios Maritime Acquisition Corporation’s 6-K containing its financial statements for the three and six months ended June 30, 2016, formatted in eXtensible Business Reporting Language (XBRL): (i) Condensed Consolidated Balance Sheets at June 30, 2016 (unaudited) and December 31, 2015; (ii) Unaudited Condensed Consolidated Statements of Income for each of the three and six month periods ended June 30, 2016 and 2015; (iii) Unaudited Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2016 and 2015; (iv) Unaudited Condensed Consolidated Statements of Changes in Equity for the six month periods ended June 30, 2016 and 2015; and (v) the Condensed Notes to the Consolidated Financial Statements (unaudited). UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS AT JUNE 30, 2016 AND DECEMBER 31, 2015 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME FOR THE THREE AND SIX MONTH PERIODS ENDED JUNE 30, 2016 AND 2015 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTH PERIODS ENDED JUNE 30, 2016 AND 2015 UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY FOR THE SIX MONTH PERIODS ENDED JUNE 30, 2016 AND 2015 CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (Expressed in thousands of U.S. Dollars except share data) Notes June 30, (unaudited) December 31, 3 $ 69,536 $ 54,805 Restricted cash 3 6,904 6,840 Due from related parties, short-term 12 21,661 17,837 Vessels, net 4 1,335,363 1,441,635 Vessels held for sale 6 62,072 — Deferred dry dock and special survey costs, net Investment in affiliates 7, 12 201,711 204,808 Due from related parties, long-term 7, 12 28,257 16,474 $ 1,761,319 $ 1,774,091 Accrued expenses 9 13,211 9,802 Current portion of long-term debt, net of deferred finance cost Long-term debt, net of current portion, premium and net of deferred finance cost 10 1,089,901 1,134,940 Deferred gain on sale of assets 13 — — Puttable common stock 450,000 and 650,000 shares issued and outstanding with $4,500 and $6,500 redemption amount as of June 30, 2016 and December 31, 2015, respectively Preferred stock, $0.0001 par value; 10,000,000 shares authorized; 1,000 series C shares and 4,000 series A and C shares issued and outstanding as of June 30, 2016 and December 31, 2015, respectively Common stock, $0.0001 par value; 250,000,000 shares authorized; 150,782,990 and 149,782,990 issued and outstanding as of June 30, 2016 and December 31, 2015, respectively 14 541,384 540,856 20,103 — See unaudited condensed notes to consolidated financial statements. CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Expressed in thousands of U.S. dollars- except share and per share data) For the Three For the Three For the Six For the Six Months Months Months Months Ended Ended Ended Ended June 30, 2016 June 30, 2015 June 30, 2016 June 30, 2015 Notes (unaudited) (unaudited) (unaudited) (unaudited) (1,017 ) (996 ) (2,438 ) (2,186 ) 12 (1,405 ) (348 ) (2,049 ) (697 ) 12 (24,318 ) (24,293 ) (48,504 ) (48,335 ) (5,981 ) (3,903 ) (9,510 ) (7,068 ) 4 (14,294 ) (14,880 ) (29,177 ) (29,771 ) 4 — 5,771 2,282 5,771 880 302 1,534 573 7 3,731 3,651 8,622 7,089 (994 ) (240 ) (1,682 ) (684 ) Dividend on Series B preferred shares — (27 ) — (54 ) Dividend on Series D preferred shares — (61 ) — (199 ) Dividend declared on restricted shares (35 ) (70 ) (70 ) (140 ) Undistributed income attributable to Series C participating preferred shares Net income attributable to common shareholders, basic 16 $ 11,558 $ 24,933 $ 34,132 $ 43,770 — 27 — 54 — 61 — 199 Net income attributable to common shareholders, diluted Net income per share, basic Weighted average number of shares, basic 150,084,084 150,580,595 149,668,699 150,455,682 Net income per share, diluted Weighted average number of shares, diluted (Expressed in thousands of U.S. dollars) Notes For the Six Months (unaudited) For the Six Months Operating Activities Amortization and write-off of deferred finance cost and bond premium Amortization of deferred dry dock and special survey costs 4 (2,282 ) (5,771 ) Equity in net earnings of affiliated companies, net of dividends received (833 ) (1,159 ) Changes in operating assets and liabilities: Decrease in prepaid expenses and other current assets Increase in accounts receivable Increase in due from related parties short-term Increase in restricted cash (64 ) (50 ) (Increase)/ decrease in other long term assets (3,930 ) 210 (Decrease)/ increase in accounts payable (387 ) 726 Increase in accrued expenses Payments for dry dock and special survey costs (2,324 ) — Increase in due from related parties long-term Decrease in due to related parties — (17,462 ) (Decrease)/ increase in deferred revenue (1,607 ) 1,452 Investing Activities Acquisition of vessels 4 — (29,397 ) Dividends received from affiliates Net proceeds from sale of vessels Loans receivable from affiliates Financing Activities Loan proceeds, net of deferred finance cost — 25,954 10 (34,682 ) (64,198 ) Dividend paid 8 (15,851 ) (16,170 ) Payment to related party Decrease in restricted cash — (130 ) Redemption of convertible shares and puttable common stock $ (52,533 ) $ (69,309 ) Cash and cash equivalents, beginning of year Supplemental disclosures of cash flow information Cash interest paid, net of capitalized interest Non-cash investing activities Capitalized finance fees $ — $ 19 Accrued interest on loan to affiliates Investment in affiliates received upon sale of vessels $ — $ 27,111 Non-cash financing activities Dividends payable $ — $ 8,035 $ — $ (914 ) Due to related party $ — $ 914 $ 528 $ 1,318 CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY (Expressed in thousands of U.S. dollars, except share data) Preferred Stock Common Stock Shares Amount Number of Shares Amount Additional Paid-in Capital Retained Earnings Total Balance, December 31, 2014 (Revised) 4,540 $ — 151,664,942 $ 15 $ 557,125 $ (66,347 ) $ 490,793 Conversion of preferred stock into puttable common stock — — 400,000 — — — — Redemption of puttable common stock — — (25,000 ) — — — — Conversion of preferred stock into common stock (162 ) — 64,800 — — — — Stock- based compensation (see Note 14) — — — — 1,318 — 1,318 Dividend paid/ declared — — — — (16,238 ) — (16,238 ) — — — — — 46,396 46,396 Balance, June 30, 2015 (Revised unaudited) Balance, December 31, 2015 4,000 $ — 149,782,990 $ 15 $ 540,856 $ — $ 540,871 — — (200,000 ) — — — — Conversion of Series A preferred stock into common stock (3,000 ) — 1,200,000 — — — — Dividend paid/ declared (see Note 8) — — — — — (15,851 ) (15,851 ) Balance, June 30, 2016 (unaudited) 1,000 $ — 150,782,990 $ 15 $ 541,384 $ 20,103 $ 561,502 UNAUDITED CONDENSED NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Expressed in thousands of U.S. Dollars except share and per share data) NOTE 1: DESCRIPTION OF ORGANIZATION AND BUSINESS OPERATIONS Navios Maritime Acquisition Corporation (“Navios Acquisition” or the “Company”) (NYSE: NNA) owns a large fleet of modern crude oil, refined petroleum product and chemical tankers providing worldwide marine transportation services. The Company’s strategy is to charter its vessels to international oil companies, refiners and large vessel operators under long, medium and short-term charters. The Company is committed to providing quality transportation services and developing and maintaining long-term relationships with its customers. The operations of Navios Acquisition are managed by a subsidiary of Navios Maritime Holdings Inc. (“Navios Holdings”). Navios Acquisition was incorporated in the Republic of Marshall Islands on March 14, 2008. On July 1, 2008, Navios Acquisition completed its initial public offering, or its “IPO”. On May 28, 2010, Navios Acquisition consummated the vessel acquisitions which constituted its initial business combination. Following such transaction, Navios Acquisition commenced its operations as an operating company. On January 6, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1,000 to the holder upon redemption. On March 11, 2016, 1,200,000 shares of common stock were issued as a result of the conversion of 3,000 shares of Series A Convertible Preferred Stock. On April 1, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1,000 to the holder upon redemption. As of June 30, 2016, Navios Holdings had 43.3% of the voting power and 46.3% of the economic interest in Navios Acquisition. As of June 30, 2016, Navios Acquisition had outstanding: 150,782,990 shares of common stock and 1,000 shares of Series C Convertible Preferred Stock issued to Navios Holdings. NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of presentation: The accompanying interim condensed consolidated financial statements are unaudited, but, in the opinion of management, reflect all adjustments for a fair statement of Navios Acquisition’s consolidated balance sheets, statement of changes in equity, statements of income and cash flows for the periods presented. The results of operations for the interim periods are not necessarily indicative of results for the full year. The footnotes are condensed as permitted by the requirements for interim financial statements and accordingly, do not include information and disclosures required under accounting principles generally accepted in the United States of America (“U.S. GAAP”) for complete financial statements. All such adjustments are deemed to be of a normal recurring nature. These interim financial statements should be read in conjunction with the Company’s consolidated financial statements and notes included in Navios Acquisition’s 2015 Annual Report filed on Form 20-F with the Securities and Exchange Commission (“SEC”). Revision of prior period financial statements The Company has historically accounted for its investment in the common units of Navios Maritime Midstream Partners L.P. (“Navios Midstream”) as available for sale securities, with the change in the market value of those securities recorded in other comprehensive income. The Company has reevaluated its accounting for those interests and concluded that they should be accounted for under the equity method of accounting. Management evaluated the materiality of the error, quantitatively and qualitatively, and determined it was not material to any of our previously issued financial statements. Accordingly, the Company has revised its previously reported results and related disclosures as of and for the three and six month period ended June 30, 2015 to correct its accounting. The schedule below provides a summary of the impact of the adjustment on the Company’s consolidated financial statements as of and for the six month period ended June 30, 2015 (amounts in thousands). As previously reported Correction Adjustment As Revised 183,922 18,640 202,562 Investment in available-for-sale securities 19,274 (19,274 ) — 1,556,375 (634 ) 1,555,741 634 (634 ) — 522,903 (634 ) 522,269 Statements of Operations/ Statement of Comprehensive Income(1) For the Three Unrealized holding income on investments in available-for-sale-securities 1,901 (1,901 ) — Total comprehensive income(1) (1) The Company no longer presents “Total Comprehensive Income” consistent with ASC 220-10-15-3(a) because following the correction, it has no other comprehensive income to report. The revision had an immaterial impact on previously reported amounts of operating, investing or financing cash flows, and had no impact on previously reported amounts of basic or diluted earnings per share. No corrections have been made to previously reported net income or net income attributable to common stockholders because the impacts on these line items were determined to be inconsequential. (b) Principles of consolidation: The accompanying consolidated financial statements include the accounts of Navios Acquisition, a Marshall Islands corporation, and its majority owned subsidiaries. All significant intercompany balances and transactions have been eliminated in the consolidated statements. The Company also consolidates entities that are determined to be variable interest entities (“VIEs”) as defined in the accounting guidance, if it determines that it is the primary beneficiary. A variable interest entity is defined as a legal entity where either (a) equity interest holders as a group lack the characteristics of a controlling financial interest, including decision making ability and an interest in the entity’s residual risks and rewards, or (b) the equity holders have not provided sufficient equity investment to permit the entity to finance its activities without additional subordinated financial support, or (c) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both and substantially all of the entity’s activities either involve or are conducted on behalf of an investor that has disproportionately few voting rights. (c) Equity method investments: Affiliates are entities over which the Company generally has between 20% and 50% of the voting rights, or over which the Company has significant influence, but it does not exercise control. Investments in these entities are accounted for under the equity method of accounting. Under this method, the Company records an investment in the stock of an affiliate at cost, and adjusts the carrying amount for its share of the earnings or losses of the affiliate subsequent to the date of investment and reports the recognized earnings or losses in income. Dividends received from an affiliate reduce the carrying amount of the investment. The Company recognizes gains and losses in earnings for the issuance of shares by its affiliates, provided that the issuance of such shares qualifies as a sale of such shares. When the Company’s share of losses in an affiliate equals or exceeds its interest in the affiliate, the Company does not recognize further losses, unless the Company has incurred obligations or made payments on behalf of the affiliate. Navios Acquisition evaluates its equity method investments, for other than temporary impairment, on a quarterly basis. Consideration is given to (1) the length of time and the extent to which the fair value has been less than the carrying value, (2) the financial condition and near-term prospects and (3) the intent and ability of the Company to retain its investments for a period of time sufficient to allow for any anticipated recovery in fair value. (d) Subsidiaries: Subsidiaries are those entities in which the Company has an interest of more than one half of the voting rights and/or otherwise has power to govern the financial and operating policies. The acquisition method of accounting is used to account for the acquisition of subsidiaries if deemed to be a business combination. The cost of an acquisition is measured as the fair value of the assets given up, shares issued or liabilities undertaken at the date of acquisition. The excess of the cost of acquisition over the fair value of the net assets acquired and liabilities assumed is recorded as goodwill. As of June 30, 2016, and 2015 the entities included in these consolidated financial statements were: Navios Maritime Acquisition Corporation and Subsidiaries: Nature Country of Incorporation 2016 2015 Aegean Sea Maritime Holdings Inc. Sub-Holding Company Marshall Is. 1/1 - 6/30 1/1 - 6/30 Amorgos Shipping Corporation Vessel-Owning Company Marshall Is. 1/1 - 6/30 1/1 - 6/30 Andros Shipping Corporation Antikithira Shipping Corporation Antiparos Shipping Corporation Amindra Navigation Co. Crete Shipping Corporation Folegandros Shipping Corporation Ikaria Shipping Corporation Ios Shipping Corporation Vessel-Owning Company Cayman Is. 1/1 - 6/30 1/1 - 6/30 Kithira Shipping Corporation Kos Shipping Corporation Mytilene Shipping Corporation Holding Company Marshall Is. 1/1 - 6/30 1/1 - 6/30 Navios Acquisition Finance (U.S.) Inc. Co-Issuer Delaware 1/1 - 6/30 1/1 - 6/30 Rhodes Shipping Corporation Serifos Shipping Corporation Shinyo Dream Limited Vessel-Owning Company(3) Hong Kong — 1/1 - 6/17 Shinyo Loyalty Limited Vessel-Owning Company(1) Hong Kong 1/1 - 6/30 1/1 - 6/30 Shinyo Navigator Limited Sifnos Shipping Corporation Skiathos Shipping Corporation Skopelos Shipping Corporation Syros Shipping Corporation Thera Shipping Corporation Tinos Shipping Corporation Oinousses Shipping Corporation Psara Shipping Corporation Antipsara Shipping Corporation Samothrace Shipping Corporation Thasos Shipping Corporation Limnos Shipping Corporation Skyros Shipping Corporation Alonnisos Shipping Corporation Vessel-Owning Company(4) Marshall Is. 1/1 - 6/30 1/1 - 6/30 Makronisos Shipping Corporation Iraklia Shipping Corporation Paxos Shipping Corporation Antipaxos Shipping Corporation Donoussa Shipping Corporation Schinousa Shipping Corporation Navios Acquisition Europe Finance Inc Sikinos Shipping Corporation Vessel-Owning Company(3) Marshall Is. — 1/1 - 6/17 Kerkyra Shipping Corporation Lefkada Shipping Corporation Zakynthos Shipping Corporation Leros Shipping Corporation Kimolos Shipping Corporation Samos Shipping Corporation Tilos Shipping Corporation Vessel-Owning Company Marshall Is. 1/1 - 6/30 — Delos Shipping Corporation Navios Maritime Midstream Partners GP LLC (1) Former vessel-owner of the Shinyo Splendor which was sold to an unaffiliated third party on May 6, 2014. (2) Former vessel-owner of the Shinyo Navigator which was sold to an unaffiliated third party on December 6, 2013. (3) Navios Midstream acquired all of the outstanding shares of capital stock of the vessel-owning subsidiary in June 2015. (4) Each company had the rights over a shipbuilding contract of an MR2 product tanker vessel. In February 2015, these shipbuilding contracts were terminated, with no exposure to Navios Acquisition, due to the shipyard’s inability to issue a refund guarantee. (5) Former vessel-owner of the Nave Lucida which was sold to an unaffiliated third party on January 27, 2016. (e) Use of estimates: The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities as of the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. On an on-going basis, management evaluates the estimates and judgments, including those related to uncompleted voyages, future dry dock dates, the selection of useful lives for tangible assets and scrap value, expected future cash flows from long-lived assets to support impairment tests, provisions necessary for accounts receivable, provisions for legal disputes and contingencies. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ from those estimates under different assumptions and/or conditions. (f) Vessels, net: Vessels are stated at historical cost, which consists of the contract price, delivery and acquisition expenses and capitalized interest costs while under construction. Vessels acquired in an asset acquisition or in a business combination are recorded at fair value. Subsequent expenditures for major improvements and upgrading are capitalized, provided they appreciably extend the life, increase the earning capacity or improve the efficiency or safety of the vessels. Expenditures for routine maintenance and repairs are expensed as incurred. Depreciation is computed using the straight line method over the useful life of the vessels, after considering the estimated residual value. Management estimates the residual values of our tanker vessels based on a scrap value of $360 per lightweight ton, as we believe these levels are common in the shipping industry. Residual values are periodically reviewed and revised to recognize changes in conditions, new regulations or other reasons. Revisions of residual values affect the depreciable amount of the vessels and affect depreciation expense in the period of the revision and future periods. Management estimates the useful life of our vessels to be 25 years from the vessel’s original construction. However, when regulations place limitations over the ability of a vessel to trade on a worldwide basis, its useful life is re-estimated to end at the date such regulations become effective. (g) Vessels held for sale: Vessels are classified as “Vessels held for sale” when all of the following criteria are met: management has committed to a plan to sell the vessel; the vessel is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of vessels; an active program to locate a buyer and other actions required to complete the plan to sell the vessel have been initiated; the sale of the vessel is probable and transfer of the vessel is expected to qualify for recognition as a completed sale within one year; the asset is being actively marketed for sale at a price that is reasonable in relation to its current fair value and actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn. Vessels classified as held for sale are measured at the lower of their carrying amount or fair value less cost to sell. These vessels are not depreciated once they meet the criteria to be held for sale. (h) Impairment of long-lived asset group: Vessels, other fixed assets and other long-lived assets held and used by Navios Acquisition are reviewed periodically for potential impairment whenever events or changes in circumstances indicate that the carrying amount of a particular asset may not be fully recoverable. Navios Acquisition’s management evaluates the carrying amounts and periods over which long-lived assets are depreciated to determine if events or changes in circumstances have occurred that would require modification to their carrying values or useful lives. In evaluating useful lives and carrying values of long-lived assets, certain indicators of potential impairment are reviewed such as, undiscounted projected operating cash flows, vessel sales and purchases, business plans and overall market conditions. Undiscounted projected net operating cash flows are determined for each asset group (consisting of the individual vessel and the intangible with respect to the time charter agreement to that vessel) and compared to the vessel carrying value and related carrying value of the intangible with respect to the time charter agreement attached to that vessel or the carrying value of deposits for new buildings, if any. Within the shipping industry, vessels are often bought and sold with a charter attached. The value of the charter may be favorable or unfavorable when comparing the charter rate to then current market rates. The loss recognized either on impairment (or on disposition) will reflect the excess of carrying value over fair value (selling price) for the vessel individual asset group. (i) Revenue Recognition: Revenue is recorded when services are rendered, under a signed charter agreement or other evidence of an arrangement, the price is fixed or determinable, and collection is reasonably assured. Revenue is generated from the voyage charter and the time charter of vessels. Voyage revenues for the transportation of cargo are recognized ratably over the estimated relative transit time of each voyage. A voyage is deemed to commence when a vessel is available for loading and is deemed to end upon the completion of the discharge of the current cargo. Estimated losses on voyages are provided for in full at the time such losses become evident. Under a voyage charter, a vessel is provided for the transportation of specific goods between specific ports in return for payment of an agreed upon freight per ton of cargo. Revenues from time chartering of vessels are accounted for as operating leases and are thus recognized on a straight-line basis as the average revenue over the rental periods of such charter agreements, as service is performed. A time charter involves placing a vessel at the charterers’ disposal for a period of time during which the charterer uses the vessel in return for the payment of a specified daily hire rate. Under time charters, operating costs such as for crews, maintenance and insurance are typically paid by the owner of the vessel. Profit sharing revenues are calculated at an agreed percentage of the excess of the charterer’s average daily income (calculated on a quarterly or half-yearly basis) over an agreed amount and accounted for on an accrual basis based on provisional amounts and for those contracts that provisional accruals cannot be made due to the nature of the profit share elements, these are accounted for on the actual cash settlement. Revenues are recorded net of address commissions. Address commissions represent a discount provided directly to the charterers based on a fixed percentage of the agreed upon charter or freight rate. Since address commissions represent a discount (sales incentive) on services rendered by the Company and no identifiable benefit is received in exchange for the consideration provided to the charterer, these commissions are presented as a reduction of revenue. Pooling arrangements: For vessels operating in pooling arrangements, the Company earns a portion of total revenues generated by the pool, net of expenses incurred by the pool. The amount allocated to each pool participant vessel, including the Company’s vessels, is determined in accordance with an agreed-upon formula, which is determined by points awarded to each vessel in the pool based on the vessel’s age, design and other performance characteristics. Revenue under pooling arrangements is accounted for on the accrual basis and is recognized when an agreement with the pool exists, price is fixed, service is provided and the collectability is reasonably assured. The allocation of such net revenue may be subject to future adjustments by the pool however, such changes are not expected to be material. NOTE 3: CASH AND CASH EQUIVALENTS Cash and cash equivalents consisted of the following: Cash on hand and at banks Short-term deposits Total cash and cash equivalents Short-term deposits relate to time deposit accounts held in banks for general purposes. Cash deposits and cash equivalents in excess of amounts covered by government-provided insurance are exposed to loss in the event of non-performance by financial institutions. The Company does maintain cash deposits and equivalents in excess of government-provided insurance limits. The Company also minimizes exposure to credit risk by dealing with a diversified group of major financial institutions. Restricted cash consists of an amount of $6,904 and $6,840 as of June 30, 2016 and as of December 31, 2015, respectively, which are held in retention accounts in order to service debt and interest payments, as required by certain of Navios Acquisition’s credit facilities. NOTE 4: VESSELS, NET Cost Accumulated Depreciation Net Book Balance at January 1, 2015 $ 1,487,606 $ (111,675 ) $ 1,375,931 207,000 (57,164 ) 149,836 (104,274 ) 20,142 (84,132 ) — (29,177 ) (29,177 ) (16,817 ) 1,794 (15,023 ) Transferred to “Vessels held for sale” (Note 6) Balance at June 30, 2016 On January 27, 2016, Navios Acquisition sold the Nave Lucida to an unaffiliated third party for net cash proceeds of $18,449. Navios Acquisition prepaid $12,097 which reflects the respective tranche drawn from the Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB facility that was established to finance the Nave Lucida. On January 8, 2015, Navios Acquisition took delivery of the Nave Sextans, a newbuilding, 49,999 dwt, MR2 product tanker, from an unaffiliated third party for a total cost of $33,373. On February 11, 2015, Navios Acquisition took delivery of the Nave Velocity, a newbuilding, 49,999 dwt, MR2 product tanker, from an unaffiliated third party for a total cost of $39,233. On June 18, 2015, Navios Midstream exercised its option to acquire the shares of the vessel-owning subsidiaries of the Nave Celeste and the C. Dream from Navios Acquisition for a sale price of $100,000. The sale price consisted of $73,000 cash consideration and the issuance of 1,592,920 Subordinated Series A Units to Navios Acquisition. The gain on sale of vessels amounted to $5,771. For the six month periods ended June 30, 2016 and 2015, capitalized interest amounted to $0 and $104, respectively. For each of the three month periods ended June 30, 2016 and 2015, capitalized interest amounted to $0. NOTE 5: GOODWILL Goodwill as of June 30, 2016 and December 31, 2015 consisted of the following: Balance January 1, 2015 Balance December 31, 2015 Balance June 30, 2016 NOTE 6: VESSELS HELD FOR SALE During April 2016, Navios Acquisition entered into two separate Memoranda of Agreement (“MOA”) with an unaffiliated third party, for the disposal of the Nave Constellation, a 2013-built chemical tanker of 45,281 dwt, and the Nave Universe, a 2013-built chemical tanker of 45,513 dwt, for an aggregate sale price of $74,600. Both vessels are subject to an existing time charter and management has committed to a plan to sell the vessels within the next twelve months. As of June 30, 2016, the vessels have been classified as held for sale as the relevant criteria for the classification were met and, therefore, they are presented in the condensed consolidated balance sheets as held for sale. The sale of the vessels is expected to result in a gain and therefore, the vessels are reflected at their carrying value of $62,072. Proceeds from the sale of the vessels will be used to fully repay the outstanding amount of the HSH Nordbank AG credit facility (See Note 10). NOTE 7: INVESTMENT IN AFFILIATES Navios Europe I On October 9, 2013, Navios Holdings, Navios Acquisition and Navios Maritime Partners L.P. (“Navios Partners”) established Navios Europe Inc. (“Navios Europe I”) and have ownership interests of 47.5%, 47.5% and 5.0%, respectively. On December 18, 2013, Navios Europe I acquired ten vessels for aggregate consideration consisting of: (i) cash which was funded with the proceeds of senior loan facility (the “Senior Loan I”) and loans aggregating $10,000 from Navios Holdings, Navios Acquisition and Navios Partners (in each case, in proportion to their ownership interests in Navios Europe I) (collectively, the “Navios Term Loans I”); and (ii) the assumption of a junior participating loan facility (the “Junior Loan I”). In addition to the Navios Term Loans I, Navios Holdings, Navios Acquisition and Navios Partners will also make available to Navios Europe I (in each case, in proportion to their ownership interests in Navios Europe I) revolving loans up to $24,100 to fund working capital requirements (collectively, the “Navios Revolving Loans I”). On an ongoing basis, Navios Europe I is required to distribute cash flows (after payment of operating expenses, amounts due pursuant to the terms of the Senior Loan I and repayments of the Navios Revolving Loans I) according to a defined waterfall calculation as follows: • First, Navios Holdings, Navios Acquisition and Navios Partners will each earn a 12.7% preferred distribution on the Navios Term Loans I and the Navios Revolving Loans I; and • Second, any remaining cash is then distributed on an 80%/20% basis, respectively, between (i) the Junior Loan I holder and (ii) the holders of the Navios Term Loans I. The Navios Term Loan I will be repaid from the future sale of vessels owned by Navios Europe I and is deemed to be the initial investment by Navios Acquisition. Navios Acquisition evaluated its investment in Navios Europe I under ASC 810 and concluded that Navios Europe I is a “VIE” and that the Company is not the party most closely associated with Navios Europe I and, accordingly, is not the primary beneficiary of Navios Europe I based on the following: • the power to direct the activities that most significantly impact the economic performance of Navios Europe I are shared jointly between: (i) Navios Holdings, Navios Acquisition and Navios Partners; and (ii) and the Junior Loan I holder; and • while Navios Europe I’s residual is shared on an 80%/20% basis, respectively, between (i) the Junior Loan I holder and (ii) Navios Holdings, Navios Acquisition and Navios Partners, the Junior Loan I holder is exposed to a substantial portion of Navios Europe I’s risks and rewards. Navios Acquisition further evaluated its investment in the common stock of Navios Europe I under ASC 323 and concluded that it has the ability to exercise significant influence over the operating and financial policies of Navios Europe I and, therefore, its investment in Navios Europe I is accounted for under the equity method. The fleet of Navios Europe I is managed by subsidiaries of Navios Holdings. As of June 30, 2016 and December 31, 2015, the estimated maximum potential loss by Navios Acquisition in Navios Europe I would have been $17,012 and $15,764, respectively, which represents the Company’s carrying value of its investment of $5,766 (December 31, 2015: $5,498) the Company’s portion of the carrying balance of the Navios Revolving Loans I including accrued interest on the Navios Term Loans I of $8,924 (December 31, 2015: $8,523), which is included under “Due from related parties, long-term” and the accrued interest income on the Navios Revolving Loans I in the amount of $2,322 (December 31, 2015: $1,743) which is included under “Due from related parties, short-term”. Refer to Note 12 for the terms of the Navios Revolving Loans I. Income recognized for the three month period ended June 30, 2016 was $136 (June 30, 2015: $210). Income recognized for the six month period ended June 30, 2016 was $268 (June 30, 2015: $210). Accounting for basis difference The initial investment in Navios Europe I recorded under the equity method of $4,750, at the inception included the Company’s share of the basis difference between the fair value and the underlying book value of the assets of Navios Europe I, which amounted to $6,763. This difference is amortized through “Equity in net earnings of affiliated companies” over the remaining life of Navios Europe I. As of June 30, 2016 and December 31, 2015, the unamortized difference between the carrying amount of the investment in Navios Europe I and the amount of the Company’s underlying equity in net assets of Navios Europe I was $5,048, and $5,386, respectively. Navios Europe II On February 18, 2015, Navios Holdings, Navios Acquisition and Navios Partners established Navios Europe (II) Inc. (“Navios Europe II”) and have ownership interests of 47.5%, 47.5% and 5.0%, respectively. From June 8, 2015 through December 31, 2015, Navios Europe II acquired fourteen vessels for: (i) cash consideration of $145,550 (which was funded with the proceeds of $131,550 of senior loan facilities (the “Senior Loans II”) and loans aggregating $14,000 from Navios Holdings, Navios Acquisition and Navios Partners (in each case, in proportion to their ownership interests in Navios Europe II) (collectively, the “Navios Term Loans II”); and (ii) the assumption of a junior participating loan facility (the “Junior Loan II”) with a face amount of $182,150 and fair value of $99,147. In addition to the Navios Term Loans II, Navios Holdings, Navios Acquisition and Navios Partners will also make available to Navios Europe II (in each case, in proportion to their ownership interests in Navios Europe II) revolving loans up to $38,500 to fund working capital requirements (collectively, the “Navios Revolving Loans II”). On an ongoing basis, Navios Europe II is required to distribute cash flows (after payment of operating expenses, amounts due pursuant to the terms of the Senior Loans and repayments of the Navios Revolving Loans II) according to a defined waterfall calculation as follows: • First, Navios Holdings, Navios Acquisition and Navios Partners will each earn a 18.0% preferred distribution on the Navios Term Loans II and the Navios Revolving Loans II; and • Second, any remaining cash is then distributed on an 80%/20% basis, respectively, between (i) the Junior Loan II holder and (ii) the holders of the Navios Term Loans II. The Navios Term Loan II will be repaid from the future sale of vessels owned by Navios Europe II and is deemed to be the initial investment by Navios Acquisition. Navios Acquisition evaluated its investment in Navios Europe II under ASC 810 and concluded that Navios Europe II is a “VIE” and that the Company is not the party most closely associated with Navios Europe II and, accordingly, is not the primary beneficiary of Navios Europe II based on the following: • the power to direct the activities that most significantly impact the economic performance of Navios Europe II are shared jointly between: (i) Navios Holdings, Navios Acquisition and Navios Partners; and (ii) the Junior Loan holder II; and • while Navios Europe II’s residual is shared on an 80%/20% basis, respectively, between: (i) the Junior Loan holder II; and (ii) Navios Holdings, Navios Acquisition and Navios Partners, the Junior Loan II holder is exposed to a substantial portion of Navios Europe II’s risks and rewards. Navios Acquisition further evaluated its investment in the common stock of Navios Europe II under ASC 323 and concluded that it has the ability to exercise significant influence over the operating and financial policies of Navios Europe II and, therefore, its investment in Navios Europe II is accounted for under the equity method. The fleet of Navios Europe II is managed by subsidiaries of Navios Holdings. As of June 30, 2016, the estimated maximum potential loss by Navios Acquisition in Navios Europe II would have been $21,083 (December 31, 2015: $15,867), which represents the Company’s carrying value of the investment of $6,672 (December 31, 2015: $7,342), the Company’s balance of the Navios Revolving Loans II including accrued interest on the Navios Term Loans II of $12,904 (December 31, 2015: $7,952), which is included under “Due from related parties, long-term”, and the accrued interest income on the Navios Revolving Loans II in the amount of $1,507 (December 31, 2015: $573), which is included under “Due from related parties, short-term”. Refer to Note 12 for the terms of the Navios Revolving Loans II. Loss recognized for the three month period ended June 30, 2016 was $396. Loss recognized for the six month period ended June 30, 2016 was $670. For the six month period ended June 30, 2015, Navios Europe II had minimal operations and therefore, the Company did not record any equity method investee income/ (loss). The initial investment in Navios Europe II recorded under the equity method of $6,650, at the inception included the Company’s share of the basis difference between the fair value and the underlying book value of the assets of Navios Europe II, which amounted to $9,419. This difference is amortized through “Equity in net earnings of affiliated companies” over the remaining life of Navios Europe II. As of June 30, 2016, the unamortized difference between the carrying amount of the investment in Navios Europe II and the amount of the Company’s underlying equity in net assets of Navios Europe II was $8,424. As of December 31, 2015, the unamortized difference between the carrying amount of the investment in Navios Europe II and the amount of the Company’s underlying equity in net assets of Navios Europe II was $8,895. Navios Midstream (Revised) On October 13, 2014, the Company formed in the Marshall Islands a wholly-owned subsidiary, Navios Midstream. The purpose of Navios Midstream is to own, operate and acquire crude oil tankers, refined petroleum product tankers, chemical tankers and liquefied petroleum gas tankers under long-term employment contracts. On the same day, the Company formed in the Marshall Islands a limited liability company, Navios Maritime Midstream Partners GP LLC (the “Navios Midstream General Partner”) a wholly-owned subsidiary to act as the general partner of Navios Midstream. Navios Midstream completed an IPO of its units on November 18, 2014 and is listed on the NYSE under the symbol “NAP.” In connection with the IPO of Navios Midstream in November 2014, Navios Acquisition sold all of the outstanding shares of capital stock of four of Navios Acquisition’s vessel-owning subsidiaries (Shinyo Ocean Limited, Shinyo Kannika Limited, Shinyo Kieran Limited and Shinyo Saowalak Limited) in exchange for: (i) all of the estimated net cash proceeds from the IPO amounting to $110,403; (ii) $104,451 of the $126,000 borrowings under Navios Midstream’s new credit facility; (iii) 9,342,692 subordinated units and 1,242,692 common units; and (iv) 381,334 general partner units, representing a 2.0% general partner interest in Navios Midstream, and all of the incentive distribution rights in Navios Midstream to the Navios Midstream General Partner. The Company evaluated its investment in Navios Midstream under ASC 810 and concluded that Navios Midstream is not a “VIE”. The Company further evaluated the power to control the board of directors of Navios Midstream under the voting interest model. As of the IPO date, Navios Acquisition, as the general partner, delegated all its powers to the board of directors of Navios Midstream and does not have the right to remove or replace the elected directors from the board of directors. Elected directors were appointed by the general partner, but as of the IPO date are deemed to be elected directors. The elected directors represent the majority of the board of directors of Midstream and therefore, the Company concluded that it does not hold a controlling financial interest in Navios Midstream but concluded that it does maintain significant influence and deconsolidated the vessels sold as of the IPO date. Following the deconsolidation of Navios Midstream, the Company accounts for all of its interest in the general partner and in each of the common and subordinated units under the equity method of accounting. In connection with the sale of Nave Celeste and the C. Dream to Navios Midstream in June 2015, Navios Acquisition received 1,592,920 Subordinated Series A Units of Navios Midstream, as part of the sales price. In conjunction with the transaction, Navios Midstream also issued 32,509 general partner units to the General Partner for $551, in order for the General Partner to maintain its 2.0% general partnership interest. The Company analyzed its investment in the subordinated Series A units and concluded that this is to be accounted for under the equity method on the basis that the Company has significant influence over Navios Midstream. The Company’s investment in the subordinated Series A units was fair valued at $17.02 per unit, in total $27,111 on the date of the sale of the vessels to Navios Midstream. Following the above transactions, as of June 30, 2016 the Company owned a 2.0% general partner interest in Navios Midstream through the Navios Midstream General Partner and a 58.85% limited partnership interest through the ownership of subordinated units (45.15%), the subordinated series A units (7.7%) and through common units (6.01%), based on all of the outstanding common, subordinated and general partner units. As of June 30, 2016 and December 31, 2015, the carrying amount of the investment in Navios Midstream was $189,273 and $191,968, respectively. The initial investment in Navios Midstream following the completion of the IPO recorded under the equity method of $183,141, as of the deconsolidation date included the Company’s share of the basis difference between the fair value and the underlying book value of Navios Midstream’s assets, which amounted to $20,169. Of this difference, an amount of $(332) was allocated on the intangibles assets and $20,501 was allocated on the tangible assets. This difference is amortized through “Equity in net earnings of affiliated companies” over the remaining life of Navios Midstream’s tangible and intangible assets. In connection with the sale of the Nave Celeste and the C. Dream, the Company recognized its incremental investment upon the receipt of the Subordinated series A units in Navios Midstream, which amounted to $27,665 under “Investment in affiliates”. The investment was recognized at fair value at $17.02 per unit. The incremental investment included the Company’s share of the basis difference between the fair value and the underlying book value of Navios Midstream’s assets at the transaction date, which amounted to $2,554. Of this difference an amount of $(72) was allocated to the intangible assets and $2,626 was allocated to the tangible assets. This difference is amortized through “Equity in net earnings of affiliated companies” over the remaining life of Navios Midstream’s tangible and intangible assets. As of June 30, 2016 and December 31, 2015, the unamortized difference between the carrying amount of the investment in Navios Midstream and the amount of the Company’s underlying equity in net assets of Navios Midstream was $21,839 and $22,120, respectively. This difference is amortized through “Equity in net earnings of affiliated companies” over the remaining life of Navios Midstream’s tangible and intangible assets. For the three month period ended June 30, 2016 and 2015, total income from Navios Midstream recognized in “Equity in net earnings of affiliated companies” was $3,442 and $3,229, respectively. For the six month period ended June 30, 2016 and 2015, total income from Navios Midstream recognized in “Equity in net earnings of affiliated companies” was $7,946 and $6,495, respectively. Dividends received during the three month period ended June 30, 2016 were $5,320 ($4,524 for the three month period ended June 30, 2015). Dividends received during the six month period ended June 30, 2016 were $10,640 ($6,688 for the six month period ended June 30, 2015). Summarized financial information of the affiliated companies is presented below: Midstream Navios Europe I Navios Europe II Navios Europe II Cash and cash equivalents, including restricted cash $ 38,219 $ 10,209 $ 16,905 $ 37,834 $ 11,839 $ 17,366 6,199 16,382 15,433 4,078 15,377 16,897 Long-term debt including current portion, net of deferred finance cost and discount 197,495 91,326 124,215 197,819 96,580 129,185 Financial liabilities at fair value* — 70,930 18,777 — 68,535 23,568 (*) representing the fair value of Junior Loan I and Junior Loan II, respectively. June 30, 2016 Three month period ended $ 22,695 $ 10,418 $ 6,760 $ 18,350 $ 10,765 $ 994 Net (loss)/income before non-cash change in fair value of Junior Loan — (449 ) (6,889 ) — 527 414 Net income/(loss) 5,889 (1,955 ) (3,220 ) 5,394 (1,069 ) 414 June 30, 2016 Six month period ended $ 46,844 $ 20,530 $ 14,726 $ 35,053 $ 19,860 $ 994 Net (loss)/ income before non-cash change in fair value of Junior Loan — (739 ) (11,913 ) — (1,355 ) 414 13,384 (3,134 ) (7,122 ) 11,706 (4,800 ) 414 NOTE 8: DIVIDEND PAYABLE On February 4, 2016, the Board of Directors declared a quarterly cash dividend in respect of the fourth quarter of 2015 of $0.05 per share of common stock payable on March 23, 2016 to stockholders of record as of March 17, 2016. A dividend in the aggregate amount of $7,928 was paid on March 23, 2016 out of which $7,544 was paid to the stockholders of record as of March 17, 2016 and $384 was paid to Navios Holdings, the holder of the 1,000 shares of Series C Preferred Stock. On May 11, 2016, the Board of Directors declared a quarterly cash dividend in respect of the first quarter of 2016 of $0.05 per share of common stock payable on June 22, 2016 to stockholders of record as of June 17, 2016. A dividend in the aggregate amount of $7,923 was paid on June 22, 2016 out of which $7,539 was paid to the stockholders of record as of June 17, 2016 and $384 was paid to Navios Holdings, the holder of the 1,000 shares of Series C Preferred Stock. The declaration and payment of any further dividends remain subject to the discretion of the Board of Directors and will depend on, among other things, Navios Acquisition’s cash requirements as measured by market opportunities and restrictions under its credit agreements and other debt obligations and such other factors as the Board of Directors may deem advisable. NOTE 9: ACCRUED EXPENSES Accrued expenses as of June 30, 2016 and December 31, 2015 consisted of the following: Accrued voyage expenses Accrued loan interest Accrued legal and professional fees Total accrued expenses Included in accrued legal and professional fees is the amount of $2,750, that was authorized and approved by the Compensation committee of Navios Acquisition in December 2015 subject to fulfillment of certain service conditions that were provided and completed during the second quarter of 2016. The amount is recorded in general and administrative expenses on the statements of income for the three and the six month periods ended June 30, 2016. NOTE 10: BORROWINGS Commerzbank AG, Alpha Bank AE, Credit Agricole Corporate and Investment Bank BNP Paribas S.A. and DVB Bank S.E. Eurobank Ergasias S.A. $52,200 Norddeutsche Landesbank Girozentrale DVB Bank S.E. and Credit Agricole Corporate and Investment Bank Ship Mortgage Notes $670,000 Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB HSH Nordbank AG $40,300 BNP Paribas $44,000 Less: Deferred finance cost, net Add: bond premium Total borrowings Less: current portion, net of deferred finance cost Total long-term borrowings, net of current portion, bond premium and deferred finance cost Ship Mortgage Notes: 8 1/8% First Priority Ship Mortgages: On November 13, 2013, the Company and its wholly owned subsidiary, Navios Acquisition Finance (US) Inc. (“Navios Acquisition Finance” and together with the Company, the “2021 Co-Issuers”) issued $610,000 in first priority ship mortgage notes (the “Existing Notes”) due on November 15, 2021 at a fixed rate of 8.125%. On March 31, 2014, the Company completed a sale of $60,000 of its first priority ship mortgage notes due in 2021 (the “Additional Notes,” and together with the Existing Notes, the “2021 Notes”). The terms of the Additional Notes are identical to the Existing Notes and were issued at 103.25% plus accrued interest from November 13, 2013. The net cash received amounted to $59,598. The Company’s 2021 Notes are fully and unconditionally guaranteed on a joint and several basis by all of the Company’s subsidiaries with the exception of Navios Acquisition Finance (a co-issuer of the 2021 notes). The Company’s 2021 Notes are unregistered. The guarantees of our subsidiaries that own mortgaged vessels are senior secured guarantees and the guarantees of our subsidiaries that do not own mortgaged vessels are senior unsecured guarantees. All subsidiaries, including Navios Acquisition Finance are 100% owned. Navios Acquisition does not have any independent assets or operations. Except as provided above, Navios Acquisition does not have any subsidiaries that are not guarantors of the 2021 Notes. As of June 30, 2016, the Company had secured credit facilities with various banks with a total outstanding balance of $511,932. The purpose of the facilities was to finance the construction or acquisition of vessels or refinance existing indebtedness. All of the facilities are denominated in U.S. Dollars and bear interest based on LIBOR plus spread ranging from 250 bps to 320 bps per annum. The facilities are repayable in either semi-annual or quarterly installments, followed by balloon payments with maturities, ranging from October 2016 to October 2022. See also the maturity table included below. Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB: In November 2015, Navios Acquisition, entered into a term loan facility of up to $125,000 (divided into five tranches) with Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB for: (i) the financing of the purchase price of the Nave Spherical; and (ii) the refinancing of the existing facility with Deutsche Bank AG Filiale Deutschlandgescäft and Skandinaviska Enskilda Banken AB. The refinancing was treated as a modification for accounting purposes. Four of the five tranches of the facility are repayable in 20 quarterly installments of between approximately $435 and $1,896, each with a final balloon repayment to be made on the last repayment date. The fifth tranche is repayable in 16 quarterly installments of between approximately $709 and $803, each. The maturity date of the loan is in the fourth quarter of 2020. The credit facility bears interest at LIBOR plus 295 bps per annum. On January 27, 2016, Navios Acquisition sold the Nave Lucida to an unaffiliated third party for net cash proceeds of $18,449. Navios Acquisition prepaid $12,097 being the respective tranche of the Deutsche Bank AG Filiale Deutschlandgeschäft and Skandinaviska Enskilda Banken AB facility that was drawn to finance the Nave Lucida. Following the prepayment of January 2016, an amount of $214, was written-off from the deferred financing cost. As of June 30, 2016, $105,259 was outstanding under this facility. The Navios Holdings Credit Facility: In March 2016, Navios Acquisition entered into a $50,000 credit facility with Navios Holdings, which was available for multiple drawings up to a limit of $50,000 (the “Revolver”). The Revolver had a margin of LIBOR plus 300bps and a maturity until December 2018. On April 14, 2016, Navios Acquisition and Navios Holdings announced that the Revolver was terminated. No borrowings had been made under the Revolver. Please refer to “Legal Proceedings” discussion in Note 13. The loan facilities include, among other things, compliance with loan to value ratios and certain financial covenants: (i) minimum liquidity higher of $40,000 or $1,000 per vessel; (ii) net worth ranging from $50,000 to $135,000; and (iii) total liabilities divided by total assets, adjusted for market values to be lower than 75%. It is an event of default under the credit facilities if such covenants are not complied with, including the loan to value ratios for which the Company may provide sufficient additional security to prevent such an event. The maturity table below reflects the principal payments of all notes and credit facilities outstanding as of June 30, 2016 for the next five years and thereafter based on the repayment schedule of the respective loan facilities (as described above) and the outstanding amount due under the 2021 Notes. Long-Term Debt Obligations: June 30, 2022 and thereafter NOTE 11: FAIR VALUE OF FINANCIAL INSTRUMENTS The following methods and assumptions were used to estimate the fair value of each class of financial instruments: Cash and cash equivalents: The carrying amounts reported in the consolidated balance sheets for interest bearing deposits approximate their fair value because of the short maturity of these investments. Restricted Cash: The carrying amounts reported in the consolidated balance sheets for interest bearing deposits approximate their fair value because of the short maturity of these investments. Due from related parties, short-term: The carrying amount of due from related parties, short-term reported in the balance sheet approximates its fair value due to the short-term nature of these receivables. Due from related parties, long-term: The carrying amount of due from related parties, long-term reported in the balance sheet approximates its fair value. Other long-term debt, net of deferred finance cost: As a result of the adoption of ASU 2015-03, the book value has been adjusted to reflect the net presentation of deferred financing costs. The outstanding balance of the floating rate loans continues to approximate its fair value, excluding the effect of any deferred finance cost. Ship Mortgage Notes and premiums: The fair value of the 2021 Notes, which has a fixed rate, was determined based on quoted market prices, as indicated in the table below. Book Value Fair Value Book Value Fair Value $ 6,904 $ 6,904 $ 6,840 $ 6,840 Ship mortgage notes and premium $ 658,844 $ 529,722 $ 658,048 $ 589,185 Other long-term debt, net of deferred finance cost Fair Value Measurements The estimated fair value of our financial instruments that are not measured at fair value on a recurring basis, categorized based upon the fair value hierarchy, are as follows: Level I: Inputs are unadjusted, quoted prices for identical assets or liabilities in active markets that we have the ability to access. Valuation of these items does not entail a significant amount of judgment. Level II: Inputs other than quoted prices included in Level I that are observable for the asset or liability through corroboration with market data at the measurement date. Level III: Inputs that are unobservable. The Company did not use any Level III inputs as of June 30, 2016. Fair Value Measurements at June 30, 2016 Using Total Level I Level II Level III $ 69,536 $ 69,536 $ — $ — $ 6,904 $ 6,904 $ — $ — $ 529,722 $ 529,722 $ — $ — Other long-term debt(1) $ 511,932 $ — $ 511,932 (1) $ — Due from related parties, long-term (Europe I, Europe II) $ 21,828 $ — $ 21,828 $ — Fair Value Measurements at December 31, 2015 Using (1) The fair value of the Company’s other long-term debt is estimated based on currently available debt with similar contract terms, interest rate and remaining maturities as well as taking into account the Company’s creditworthiness. NOTE 12: TRANSACTIONS WITH RELATED PARTIES The Navios Holdings Credit Facilities: In March 2016, Navios Acquisition entered into the $50,000 Revolver with Navios Holdings, which was available for multiple drawings up to a limit of $50,000. The Revolver had a margin of LIBOR plus 300bps and a maturity until December 2018. On April 14, 2016, Navios Acquisition and Navios Holdings announced that the Revolver was terminated. No borrowings had been made under the Revolver. Please refer to “Legal Proceedings” in Note 13. On November 11, 2014, Navios Acquisition entered into a short-term credit facility with Navios Holdings pursuant to which Navios Acquisition could borrow up to $200,000 for general corporate purposes. The facility provided for an arrangement fee of $4,000, and bore fixed interest of 600 bps. All amounts drawn under this facility were fully repaid by the maturity date of December 29, 2014. In 2010, Navios Acquisition entered into a $40,000 credit facility with Navios Holdings, which matured in December 2015. The facility was available for multiple drawings up to a limit of $40,000 and had a margin of LIBOR plus 300 basis points. As of its maturity date, December 31, 2015, all amounts drawn were fully repaid. Management fees: Pursuant to the Management Agreement dated May 28, 2010 and as amended in May 2012 and May 2014, the Manager provided commercial and technical management services to Navios Acquisition’s vessels for a fixed daily fee of: (a) $6.0 per MR2 product tanker and chemical tanker vessel; (b) $7.0 per LR1 product tanker vessel; and (c) $9.5 per VLCC, through May 2016. Pursuant to an amendment to the Management Agreement dated as of May 19, 2016, Navios Acquisition fixed the fees for commercial and technical ship management services of the fleet for two additional years from May 29, 2016, following the expiration of the previous fixed fee period, through May 2018, at a daily fee of (a) $6.4 per MR2 product tanker and chemical tanker vessel; (b) $7.2 per LR1 product tanker vessel; and (c) the current daily fee of $9.5 per VLCC. Total management fees for each of the three month periods ended June 30, 2016 and 2015 amounted to $24,318 and $24,293, respectively. Total management fees for each of the six month periods ended June 30, 2016 and 2015 amounted to $48,504 and $48,335, respectively. Included in direct vessel expenses, there is an amount of $730 for the three and six month period ended June 30, 2016, that was incurred for specialized work performed in connection with certain vessels. For each of the three month periods ended June 30, 2016 and 2015 the expense arising from administrative services rendered by Navios Holdings amounted to $2,375 and $1,935, respectively. For each of the six month periods ended June 30, 2016 and 2015 the expense arising from administrative services rendered by Navios Holdings amounted to $4,768 and $3,861, respectively. Balance due from related parties (excluding Navios Europe I and Navios Europe II): Balance due from related parties as of June 30, 2016 and December 31, 2015 was $24,262 and $15,520, respectively, and included the short-term and long-term amounts due from Navios Holdings and Navios Midstream. The balances mainly consisted of administrative expenses and special survey and dry docking expenses for certain vessels of our fleet, as well as management fees, in accordance with the Management Agreement. Under the Midstream Omnibus Agreement, Navios Midstream and its subsidiaries will grant to Navios Acquisition a right of first offer on any proposed sale, transfer or other disposition of any of its VLCCs or any crude oil tankers, refined petroleum product tankers, LPG tankers or chemical tankers and related charters owned or acquired by Navios Midstream. Likewise, Navios Acquisition will agree (and will cause its subsidiaries to agree) to grant a similar right of first offer to Navios Midstream for any of the VLCCs, crude oil tankers, refined petroleum product tankers, LPG tankers or chemical tankers under charter for five or more years it might own. These rights of first offer will not apply to a: (a) sale, transfer or other disposition of vessels between any affiliated subsidiaries, or pursuant to the terms of any charter or other agreement with a charter party or, (b) merger with or into, or sale of substantially all of the assets to, an unaffiliated third-party. Backstop Agreement: On November 18, 2014, Navios Acquisition entered into backstop agreements with Navios Midstream. In accordance with the terms of the backstop agreements, Navios Acquisition has provided a backstop commitment to charter-in the Shinyo Ocean and the Shinyo Kannika for a two-year period as of their scheduled redelivery at the currently contracted rate if the market charter rate is lower than the currently contracted rate. Further, Navios Acquisition has provided a backstop commitment to charter-in the Nave Celeste for a two-year period as of its scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35 if the market charter rate is lower than the charter-out rate of $35. Navios Acquisition has also provided a backstop commitment to charter-in the option vessels, the Nave Galactic and the Nave Quasar for a four-year period as of their scheduled redelivery, at the net time charter-out rate per day (net of commissions) of $35 if the market charter rate is lower than the charter-out rate of $35. Conversely, if market charter rates are higher during the backstop period, such vessels will be chartered-out to third-party charterers at prevailing market rates and Navios Acquisition’s backstop commitment will not be triggered. The backstop commitment does not include any profit sharing. Balance due from Navios Europe I: Navios Holdings, Navios Acquisition and Navios Partners have made available to Navios Europe I (in each case, in proportion to their ownership interests in Navios Europe I) revolving loans up to $24,100 to fund working capital requirements (collectively, the “Navios Revolving Loans I”). See Note 7 for the Investment in Navios Europe I and the respective ownership interests. Balance due from Navios Europe I as of June 30, 2016 amounted to $11,246 (December 31, 2015: $10,266) which included the Navios Revolving Loans I of $7,125 (December 31, 2015: $7,125), the non-current amount of $1,799 (December 31, 2015: $1,398) related to the accrued interest income earned under the Navios Term Loans I under the caption “Due from related parties, long-term” and the accrued interest income earned under the Navios Revolving Loans I of $2,322 (December 31, 2015: $1,743) under the caption “Due from related parties, short-term.” The Navios Revolving Loans I and the Navios Term Loans I earn interest and an annual preferred return, respectively, at 12.7% per annum, on a quarterly compounding basis and are repaid from free cash flow (as defined in the loan agreement) to the fullest extent possible at the end of each quarter. There are no covenant requirements or stated maturity dates. As of June 30, 2016, the amount undrawn under the Navios Revolving Loans I was $9,100, of which Navios Acquisition was committed to fund $4,323. Balance due from Navios Europe II: Navios Holdings, Navios Acquisition and Navios Partners have made available to Navios Europe II (in each case, in proportion to their ownership interests in Navios Europe II) revolving loans up to $38,500 to fund working capital requirements (collectively, the “Navios Revolving Loans II”). See Note 7 for the Investment in Navios Europe II and respective ownership interests. Balance due from Navios Europe II as of June 30, 2016 amounted to $14,411 (December 31, 2015: $8,525) which included the Navios Revolving Loans II of $11,602 (December 31, 2015: $7,327), the non-current amount of $1,302 (December 31, 2015: $625) related to the accrued interest income earned under the Navios Term Loans II under the caption “Due from related parties, long-term” and the accrued interest income earned under the Navios Revolving Loans II of $1,507 (December 31, 2015: $573) under the caption “Due from related parties, short-term.” The Navios Revolving Loans II and the Navios Term Loans II earn interest and an annual preferred return, respectively, at 18% per annum, on a quarterly compounding basis and are repaid from free cash flow (as defined in the loan agreement) to the fullest extent possible at the end of each quarter. There are no covenant requirements or stated maturity dates. As of June 30, 2016, the amount undrawn under the Navios Revolving Loans II was $14,075, of which Navios Acquisition was committed to fund $6,686. NOTE 13: COMMITMENTS AND CONTINGENCIES On November 18, 2014, Navios Acquisition entered into a backstop agreement with Navios Midstream. In accordance with the terms of the backstop agreement, Navios Acquisition has committed to charter–in the Shinyo Ocean and Shinyo Kannika for a two-year period at the time of their redelivery at the currently contracted rate if the market charter rate is lower than the currently contracted rate. Furthermore, Navios Acquisition has committed to charter–in the following option vessels: a) Nave Celeste for a two-year period at the time of her redelivery at the currently contracted rate if the market charter rate is lower than the currently contracted rate and b) Nave Galactic and Nave Quasar for a four-year period at the net time charter-out rate per day (net of commissions) of $35 if the market charter rate is lower than the charter-out rate of $35. Conversely, if market charter rates are higher during the backstop period, such vessels will be chartered out to third-party charterers at prevailing market rates and Navios Acquisition’s backstop commitment will not be triggered. The backstop commitment does not include any profit-sharing. On April 1, 2016, Navios Holdings was named as a defendant in a putative shareholder derivative lawsuit brought by two alleged shareholders of Navios Acquisition purportedly on behalf of nominal defendant, Navios Acquisition, in the United States District Court for the Southern District of New York, captioned Metropolitan Capital Advisors International Ltd., et al. v. Navios Maritime Holdings, Inc. et al., No. 1:16-cv-02437. The lawsuit challenged the March 9, 2016 loan agreement between Navios Holdings and Navios Acquisition pursuant to which Navios Acquisition agreed to provide a $50,000 credit facility (the “Revolver”) to Navios Holdings. On April 14, 2016, Navios Holdings and Navios Acquisition announced that the Revolver had been cancelled, and that no borrowings had been made under the Revolver. In June 2016, the parties reached an agreement resolving the plaintiffs’ application for attorneys’ fees and expenses which was approved by an order of the Court. The litigation was dismissed upon notice of the order being provided to Navios Acquisition’s shareholders via the inclusion of the order as an attachment to a Navios Acquisition Form 6-K and the payment of $775 by Navios Acquisition in satisfaction of the plaintiffs’ request for attorneys’ fees and expenses. A copy of the order was provided as an exhibit to Navios Acquisition’s Form 6-K filed with the Securities and Exchange Commission on June 9, 2016. NOTE 14: PREFERRED AND COMMON STOCK As of December 31, 2015, the Company was authorized to issue 10,000,000 shares of $0.0001 par value preferred stock with such designations, voting and other rights and preferences as may be determined from time to time by the Board of Directors. On March 30, 2011, pursuant to an Exchange Agreement Navios Holdings exchanged 7,676,000 shares of Navios Acquisition’s common stock it held for 1,000 non-voting Series C Convertible Preferred Stock of Navios Acquisition. Each holder of shares of Series C Convertible Preferred Stock shall be entitled at their option at any time, after March 31, 2013 to convert all or any of the outstanding shares of Series C Convertible Preferred Stock into a number of fully paid and non-assessable shares of Common Stock determined by multiplying each share of Series C Convertible Preferred Stock to be converted by 7,676, subject to certain limitations. Upon the declaration of a common stock dividend, the holders of the Series C Convertible Preferred Stock are entitled to receive dividends on the Series C Convertible Preferred Stock in an amount equal to the amount that would have been received in the number of shares of Common Stock into which the Shares of Series C Convertible Preferred Stock held by each holder thereof could be converted. For the purpose of calculating earnings / (loss) per share this preferred stock is treated as in-substance common stock and is allocated income / (losses) and considered in the diluted calculation. On September 17, 2010, Navios Acquisition issued 3,000 shares of the Company’s authorized Series A Convertible Preferred Stock to an independent third party as a consideration for certain consulting and advisory fees related to the VLCC acquisition. The preferred stock has no voting rights, is only convertible into shares of common stock and does not participate in dividends until such time as the shares are converted into common stock. The Series A shares of preferred stock were fully converted to common stock that was issued on March 11, 2016. On October 29, 2010, Navios Acquisition issued 540 shares of the Company’s authorized Series B Convertible Preferred Stock to the seller of the two LR1 product tankers. The preferred stock contains a 2% per annum dividend payable quarterly starting on January 1, 2011 and upon declaration by the Company’s Board commences payment on March 31, 2011. The Series B Convertible Preferred Stock, plus any accrued but unpaid dividends, will mandatorily convert into shares of common stock as follows: 30% of the outstanding amount will convert on June 30, 2015 and the remaining outstanding amounts will convert on June 30, 2020 at a price per share of common stock not less than $25.00. The holder of the preferred stock shall have the right to convert the shares of preferred stock into common stock prior to the scheduled maturity dates at a price of $35.00 per share of common stock. The preferred stock does not have any voting rights. On June 30, 2015, 162 shares of Series B Convertible Preferred Stock (being 30% of the 540 shares originally issued), with nominal value of $10 per share, were mandatorily converted into 64,800 shares of common stock at a conversion ratio of 1:25. On October 27, 2015, the remaining 378 shares of Series B Convertible Preferred Stock (being 70% of the 540 shares originally issued), with nominal value of $10 per share, were converted into 108,000 shares of common stock at a conversion ratio of 1:35. As of June 30, 2016, the Company was authorized to issue 10,000,000 shares of $0.0001 par value preferred stock with such designations, voting and other rights and preferences as may be determined from time to time by the Board of Directors. As of June 30, 2016, the Company’s issued and outstanding preferred stock consisted of the 1,000 Series C Convertible Preferred Stock. As of December 31, 2015, the Company’s issued and outstanding preferred stock consisted of the 1,000 Series C Convertible Preferred Stock and the 3,000 Series A Convertible Preferred Stock. Series D Convertible Preferred Stock On each of August 31, 2012, October 31, 2012, February 13, 2013 and April 24, 2013, Navios Acquisition issued 300 shares of its authorized Series D Convertible Preferred Stock (nominal and fair value $3,000) to a shipyard, in partial settlement of the purchase price of each of the newbuilding LR1 product tankers, Nave Cassiopeia, Nave Cetus, Nave Atropos and Nave Rigel. The preferred stock includes a 6% per annum dividend payable quarterly, starting one year after delivery of each vessel. The Series D Convertible Preferred Stock mandatorily converted into shares of common stock 30 months after issuance at a price per share of common stock equal to $10.00. The holder of the preferred stock shall have the right to convert such shares of preferred stock into common stock prior to the scheduled maturity dates at a price of $7.00 per share of common stock. The Series D Convertible Preferred Stock does not have any voting rights. Navios Acquisition is obligated to redeem the Series D Convertible Preferred Stock (or converted common shares) at their nominal value of $10.00 at the holder’s option. Beginning 18 months and no later than 60 months after the issuance of the preferred stock, the holder can exercise the option to request the redemption of up to 250 shares of preferred stock (or such number that has been converted to common shares) on a quarterly basis. The fair value was determined using a combination of the Black-Scholes model and discounted projected cash flows for the conversion option and put, respectively. The model used takes into account the credit spread of Navios Acquisition, the volatility of its stock, as well as the price of its stock at the issuance date. The convertible preferred stock is classified as temporary equity (i.e., apart from permanent equity) as a result of the redemption feature upon exercise of the put option granted to the holder of the preferred stock. In January 2015, Navios Acquisition redeemed, through the holder’s put option, 250 shares of the Series D Convertible Preferred Stock and paid $2,500 to the holder upon redemption. In March 2015, 200 shares of Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of common stock. In conjunction with the conversion, the 200,000 shares of common stock have been reclassified to puttable common stock within temporary equity, as a result of an embedded put option of the holder for up to 30 months after the conversion date. In April 2015, Navios Acquisition redeemed, through the holder’s put option, 75 shares of the Series D Convertible Preferred Stock and paid $750 to the holder upon redemption. In April 2015, 200 shares of Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of common stock. In conjunction with the conversion, the 200,000 shares of common stock have been reclassified to puttable common stock within temporary equity, as a result of an embedded put option of the holder for up to 30 months. In July 2015, Navios Acquisition redeemed, through the holder’s put option 50 shares of its Series D Convertible Preferred Stock and paid $500 to the holder upon redemption. In August 2015, 200 shares of Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of common stock. In conjunction with the conversion, the 200,000 shares of common stock have been reclassified to puttable common stock within temporary equity, as a result of an embedded put option of the holder for up to 30 months after the conversion date. In October 2015, Navios Acquisition redeemed, through the holder’s put option 25 shares of its Series D Convertible Preferred Stock and paid $250 to the holder upon redemption. In October 2015, 200 shares of Series D Convertible Preferred Stock were converted into 200,000 shares of common stock. In conjunction with the conversion, the 200,000 shares of common stock have been reclassified to puttable common stock within temporary equity, as a result of an embedded put option of the holder for up to 30 months after the conversion date. On January 6, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1,000 to the holder upon such redemption. As of each of June 30, 2016 and December 31, 2015, no shares of Series D Convertible Preferred Stock were outstanding: Series D Preferred Stock preferred shares 1,200 $ 12,000 Conversion of 800 shares of the Series D Preferred Stock into 800,000 shares of puttable common stock Redemption of Series D Preferred Stock — $ — As of June 30, 2016 and December 31, 2015, the following shares of puttable common stock were outstanding: Puttable Common Stock common shares Amount (150,000 ) (1,500 ) 650,000 $ 6,500 Redemption of 200,000 shares of the puttable common stock Common Stock and puttable common stock Pursuant to an Exchange Agreement entered into on March 30, 2011, Navios Holdings exchanged 7,676,000 shares of Navios Acquisition’s common stock it held for 1,000 non-voting shares of Series C Convertible Preferred Stock of Navios Acquisition. On February 20, 2014, Navios Acquisition completed the public offering of 14,950,000 shares of its common stock at $3.85 per share, raising gross proceeds of $57,556. These figures include 1,950,000 shares sold pursuant to the underwriters’ option, which was exercised in full. Total net proceeds of the above transactions, net of agents’ costs of $3,022 and offering costs of $247, amounted to $54,289. On March 2, 2015, 200 shares of the Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of puttable common stock and on April 24, 2015, 25,000 shares of such puttable common stock were redeemed for $250. On April 30, 2015, 200 shares of the Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of puttable common stock. On June 30, 2015, 162 shares of Series B Convertible Preferred Stock were converted into 64,800 shares of common stock. On July 15, 2015, Navios Acquisition redeemed, through the holder’s put option, 50,000 shares of the puttable common stock and paid $500 to the holder upon redemption. On August 13, 2015, 200 shares of the Series D Convertible Preferred Stock were mandatorily converted into 200,000 shares of puttable common stock. On October 2, 2015, Navios Acquisition redeemed, through the holder’s put option, 75,000 shares of the puttable common stock and paid $750 to the holder upon redemption. On October 26, 2015, 200 shares of the Series D Convertible Preferred Stock were converted into 200,000 shares of puttable common stock. On October 27, 2015, 378 shares of Series B Convertible Preferred Stock were mandatorily converted into 108,000 shares of common stock. Under the share repurchase program, for up to $50,000, approved and authorized by the Board of Directors, Navios Acquisition has repurchased 2,704,752 shares for a total cost of approximately $9,904, as of December 31, 2015. As of June 30, 2016, the Company was authorized to issue 250,000,000 shares of $0.0001 par value common stock. In October 2013, Navios Acquisition authorized and issued to its directors in the aggregate of 2,100,000 restricted shares of common stock and options to purchase 1,500,000 shares of common stock having an exercise price of $3.91 per share and an expiration term of 10 years. These awards of restricted common stock and stock options are based on service conditions only and vest ratably over a period of over three years (33.33% each year). The holders of restricted stock are entitled to dividends paid on the same schedule as paid to the common stockholders of the company. The fair value of restricted stock is determined by reference to the quoted stock price on the date of grant of $3.99 per share (or total fair value of $8,379). The fair value of stock option grants is determined with reference to option pricing model, and principally adjusted Black-Scholes models, using historical volatility, historical dividend yield, zero forfeiture rate, risk free rate equal to 10-year US treasury bond and the simplified method for determining the expected option term since the Company does not have sufficient historical exercise data upon which to have a reasonable basis to estimate the expected option term. The fair value of stock options was calculated to $0.79 per option (or $1,188). Compensation expense is recognized based on a graded expense model over the vesting period of three years from the date of the grant. The effect of compensation expense arising from the stock-based arrangements described above amounted to $264 and $662, for the three month period ended June 30, 2016 and 2015, respectively, and was reflected in general and administrative expenses on the statements of income. For the six month period ended June 30, 2016 and 2015, the effect of compensation expense arising from the stock-based arrangements described above amounted to $528 and $1,318, respectively. The recognized compensation expense for the period was presented as adjustment to reconcile net income to net cash provided by operating activities on the statements of cash flows. There were no restricted stock or stock options exercised, forfeited or expired during the three and six month periods ended June 30, 2016 and 2015, respectively. Restricted shares outstanding and not vested amounted to 700,005 shares as of June 30, 2016 and the number of stock options outstanding as of June 30, 2016 amounted to 1,500,000. The estimated compensation cost relating to service conditions of non-vested (a) stock options and (b) restricted stock not yet recognized was $42 and $295, respectively, as of June 30, 2016 and is expected to be recognized over the weighted average period of 0.32 years. The weighted average contractual life of stock options outstanding as at June 30, 2016 was 7.3 years. NOTE 15: SEGMENT INFORMATION The following table sets out operating revenue by geographic region for Navios Acquisition’s reportable segment. Revenue is allocated on the basis of the geographic region in which the customer is located. Tanker vessels operate worldwide. Revenues from specific geographic region which contribute over 10% of total revenue are disclosed separately. Revenue by Geographic Region Vessels operate on a worldwide basis and are not restricted to specific locations. Accordingly, it is not possible to allocate the assets of these operations to specific countries. $ 46,750 $ 55,303 $ 98,740 $ 105,624 9,862 10,780 19,118 21,245 NOTE 16: EARNINGS PER COMMON SHARE Income per share is calculated by dividing net income available to common stockholders by the weighted average number of shares of common stock of Navios Acquisition outstanding during the period. Potential common shares of 9,176,000 for each of six months period ended June 30, 2016 and 2015 (which include Series C Convertible Preferred Stock and Stock options) have an anti-dilutive effect (i.e. those that increase income per share) and are therefore excluded from the calculation of diluted income per share. Months Ended June 30, 2016 For the Three June 30 2015 For the Six June 30, 2016 For the Six Numerator: Less: Dividend declared on Series D preferred shares Net income attributable to common stockholders, diluted Denominator: Denominator for basic net income per share — weighted average shares Series A preferred stock — 1,200,000 468,132 1,200,000 — 216,000 — 216,000 — 801,020 — 1,069,258 Restricted shares 700,005 1,400,006 700,005 1,400,006 Denominator for diluted net income per share — adjusted weighted average shares Basic net income per share Diluted net income per share NOTE 17: INCOME TAXES Marshall Islands, Cayman Islands, British Virgin Islands, and Hong Kong, do not impose a tax on international shipping income. Under the laws of these countries, the countries of incorporation of the Company and its subsidiaries and /or vessels’ registration, the companies are subject to registration and tonnage taxes which have been included in the daily management fee. In accordance with the currently applicable Greek law, foreign flagged vessels that are managed by Greek or foreign ship management companies having established an office in Greece are subject to duties towards the Greek state which are calculated on the basis of the relevant vessels’ tonnage. The payment of said duties exhausts the tax liability of the foreign ship owning company and the relevant manager against any tax, duty, charge or contribution payable on income from the exploitation of the foreign flagged vessel. The amount included in Navios Acquisition’s statements of income for the six months ended June 30, 2016, and 2015 related to the Greek Tonnage tax was $612 and $538, respectively, and for the three months ended June 30, 2016 and 2015, it was $0 and $21, respectively. Pursuant to Section 883 of the Internal Revenue Code of the United States (the “Code”), U.S. source income from the international operation of ships is generally exempt from U.S. income tax if the company operating the ships meets certain incorporation and ownership requirements. Among other things, in order to qualify for this exemption, the company operating the ships must be incorporated in a country, which grants an equivalent exemption from income taxes to U.S. corporations. All the Navios Acquisition’s ship-operating subsidiaries satisfy these initial criteria. In addition, these companies must meet an ownership test. Subject to proposed regulations becoming finalized in their current form, the management of Navios Acquisition believes by virtue of a special rule applicable to situations where the ship operating companies are beneficially owned by a publicly traded company like Navios Acquisition, the second criterion can also be satisfied based on the trading volume and ownership of the Company’s shares, but no assurance can be given that this will remain so in the future. NOTE 18: SUBSEQUENT EVENTS On July 1, 2016, Navios Acquisition redeemed, through the holder’s put option, 100,000 shares of the puttable common stock and paid cash of $1,000 to the holder upon redemption. /s/ Angeliki Frangou Angeliki Frangou

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COMPANY REGISTRATION NO. 08936878 (England and Wales) GWENT INVESTMENTS LIMITED FOR THE YEAR ENDED 31 DECEMBER 2017 Mr D S Lewis Mr L Jones (Appointed 2 June 2018) Llanover House Llanover Road Rhonda Cynon Taff CF37 4DY UHY Hacker Young Lanyon House Mission Court NP20 2DW Directors' responsibilities statement The directors present their annual report and financial statements for the year ended 31 December 2017. Principal activities The principal activity of the company continued to be that of an investment company. The directors who held office during the year and up to the date of signature of the financial statements were as follows: Mrs J H lewis (Resigned 1 June 2018) Results and dividends The results for the year are set out on page 5. Ordinary dividends were paid amounting to £15,000,000 (2016: £9,078,895). The directors do not recommend payment of a further dividend. The auditor, UHY Hacker Young, is deemed to be reappointed under section 487(2) of the Companies Act 2006. Statement of disclosure to auditor So far as each person who was a director at the date of approving this report is aware, there is no relevant audit information of which the company’s auditor is unaware. Additionally, the directors individually have taken all the necessary steps that they ought to have taken as directors in order to make themselves aware of all relevant audit information and to establish that the company’s auditor is aware of that information. The directors are responsible for preparing the annual report and the financial statements in accordance with applicable law and regulations. Company law requires the directors to prepare financial statements for each financial year. Under that law the directors have elected to prepare the financial statements in accordance with United Kingdom Generally Accepted Accounting Practice (United Kingdom Accounting Standards and applicable law). Under company law the directors must not approve the financial statements unless they are satisfied that they give a true and fair view of the state of affairs of the company and of the profit or loss of the company for that period. In preparing these financial statements, the directors are required to: select suitable accounting policies and then apply them consistently; make judgements and accounting estimates that are reasonable and prudent; prepare the financial statements on the going concern basis unless it is inappropriate to presume that the company will continue in business. The directors are responsible for keeping adequate accounting records that are sufficient to show and explain the company’s transactions and disclose with reasonable accuracy at any time the financial position of the company and enable them to ensure that the financial statements comply with the Companies Act 2006. They are also responsible for safeguarding the assets of the company and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. TO THE MEMBER OF GWENT INVESTMENTS LIMITED We have audited the financial statements of Gwent Investments Limited (the 'company') for the year ended 31 December 2017 which comprise the statement of comprehensive income, the balance sheet, the statement of changes in equity and notes to the financial statements, including a summary of significant accounting policies. The financial reporting framework that has been applied in their preparation is applicable law and United Kingdom Accounting Standards, including FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland (United Kingdom Generally Accepted Accounting Practice). In our opinion the financial statements: give a true and fair view of the state of the company's affairs as at 31 December 2017 and of its profit for the year then ended; have been properly prepared in accordance with United Kingdom Generally Accepted Accounting Practice; and have been prepared in accordance with the requirements of the Companies Act 2006. Basis for opinion We conducted our audit in accordance with International Standards on Auditing (UK) (ISAs (UK)) and applicable law. Our responsibilities under those standards are further described in the Auditor's responsibilities for the audit of the financial statements section of our report. We are independent of the company in accordance with the ethical requirements that are relevant to our audit of the financial statements in the UK, including the FRC’s Ethical Standard , and we have fulfilled our other ethical responsibilities in accordance with these requirements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our opinion. Conclusions relating to going concern We have nothing to report in respect of the following matters in relation to which the ISAs (UK) require us to report to you where: the directors' use of the going concern basis of accounting in the preparation of the financial statements is not appropriate; or the directors have not disclosed in the financial statements any identified material uncertainties that may cast significant doubt about the company’s ability to continue to adopt the going concern basis of accounting for a period of at least twelve months from the date when the financial statements are authorised for issue . The directors are responsible for the other information. The other information comprises the information included in the annual report, other than the financial statements and our auditor’s report thereon. Our opinion on the financial statements does not cover the other information and, except to the extent otherwise explicitly stated in our report, we do not express any form of assurance conclusion thereon. In connection with our audit of the financial statements, our responsibility is to read the other information and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audit or otherwise appears to be materially misstated. If we identify such material inconsistencies or apparent material misstatements, we are required to determine whether there is a material misstatement in the financial statements or a material misstatement of the other information. If, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Opinions on other matters prescribed by the Companies Act 2006 In our opinion, based on the work undertaken in the course of our audit : the information given in the strategic report and the directors' r eport for the financial year for which the financial statements are prepared is consistent with the financial statements ; and the strategic report and the directors' report have been prepared in accordance with applicable legal requirements. INDEPENDENT AUDITOR'S REPORT (CONTINUED) Matters on which we are required to report by exception In the light of the knowledge and understanding of the company and its environment obtained in the course of the audit, we have not identifie d material misstatements in the strategic report and the directors' r eport . We have nothing to report in respect of the following matters where the Companies Act 2006 requires us to report to you if, in our opinion: adequate accounting records have not been kept, or returns adequate for our audit have not been received from branches not visited by us; or the financial statements are not in agreement with the accounting records and returns; or certain disclosures of directors' remuneration specified by law are not made; or we have not received all the information and explanations we require for our audit. Responsibilities of directors As explained more fully in the directors' r esponsibilities s tatement, the directors are responsible for the preparation of the financial statements and for being satisfied that they give a true and fair view, and for such internal control as the directors determine is necessary to enable the preparation of financial statements that are free from material misstatement, whether due to fraud or error. In preparing the financial statements, the directors are responsible for assessing the company ' s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless the directors either intend to liquidate the company or to cease operations, or have no realistic alternative but to do so. Auditor's responsibilities for the audit of the financial statements Our objectives are to obtain reasonable assurance about whether the financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs (UK) will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these financial statements. A further description of our responsibilities for the audit of the financial statements is located on the Financial Reporting Council’s website at: http://www.frc.org.uk/auditorsresponsibilities . This description forms part of our auditor’s report. Use of our report This report is made solely to the company's member in accordance with Chapter 3 of Part 16 of the Companies Act 2006. Our audit work has been undertaken so that we might state to the company's member those matters we are required to state to them in an auditor's report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the company and the company's member for our audit work, for this report, or for the opinions we have formed. Mr Paul Byett (Senior Statutory Auditor) for and on behalf of UHY Hacker Young Interest receivable and similar income Interest payable and similar expenses Profit before taxation Tax on profit Profit for the financial year The profit and loss account has been prepared on the basis that all operations are continuing operations. AS AT Tangible assets Cash at bank and in hand Creditors: amounts falling due within one year (18,286,987) Net current liabilities Total assets less current liabilities Creditors: amounts falling due after more than one year Provisions for liabilities Capital and reserves Called up share capital Profit and loss reserves The financial statements were approved by the board of directors and authorised for issue on 28 May 2020 and are signed on its behalf by: Balance at 1 January 2016 Period ended 31 December 2016: Profit and total comprehensive income for the period Balance at 31 December 2016 Year ended 31 December 2017: Profit and total comprehensive income for the year Gwent Investments Limited is a private company limited by shares incorporated in England and Wales. The registered office is Llanover House, Llanover Road, Pontypridd, Rhonda Cynon Taff, CF37 4DY. Accounting convention These financial statements have been prepared in accordance with FRS 102 “The Financial Reporting Standard applicable in the UK and Republic of Ireland” (“FRS 102”) and the requirements of the Companies Act 2006. The financial statements are prepared in sterling , which is the functional currency of the company. Monetary a mounts in these financial statements are rounded to the nearest £ 1 . The financial statements have been prepared under the historical cost convention, modified to include the revaluation of freehold properties. The principal accounting policies adopted are set out below. This company is a qualifying entity for the purposes of FRS 102, being a member of a group where the parent of that group prepares publicly available consolidated financial statements , including this company, which are intended to give a true and fair view of the assets, liabilities, financial position and profit or loss of the group . T he company has therefore taken advantage of e xemptions from the following disclosure requirements: Section 4 ‘Statement of Financial Position’ – Reconciliation of the opening and closing number of shares ; Section 7 ‘Statement of Cash Flows’ – Presentation of a statement of cash f low and related notes and disclosures ; Section 11 ‘Basic Financial Instruments’ and Section 12 ‘Other Financial Instrument Issues’ – Carrying amounts, interest income/expense and net gains/losses for each category of financial instrument; basis of determining fair values; details of collateral, loan defaults or breaches, details of hedges, hedging fair value changes recognised in profit or loss and in other comprehensive income ; Section 26 ‘Share based Payment’ – Share-based payment expense charged to profit or loss, reconciliation of opening and closing number and weighted average exercise price of share options, how the fair value of options granted was measured, measurement and carrying amount of liabilities for cash-settled share-based payments, explanation of modifications to arrangements ; Section 33 ‘Related Party Disclosures’ – Compensation for key management personnel . The financial statements of the company are consolidated in the financial statements of Gwent Holdings Limited. These consolidated financial statements are available from its registered office, C/O UHY Hacker Young, Lanyon House, Mission Court, Newport, Wales, NP20 2DW. The company has taken advantage of the exemption under section 400 of the Companies Act 2006 not to prepare consolidated accounts. The financial statements present information about the company as an individual entity and not about its group . Gwent Investments Limited is a wholly owned subsidiary of Gwent Holdings Limited and the results of Gwent Investments Limited are included in the consolidated financial statements of Gwent Holdings Limited which are available from the registered office at Llanover House, Llanover Road, Pontypridd, Rhonda Cynon Taff, CF37 4DY. A true t the time of approving the financial statements , t he directors have a reasonable expectation that the company has adequate resources to continue in operational existence for the foreseeable future. Thus t he directors continue to adopt the going concern basis of accounting in preparing the financial statements. Tangible fixed assets Tangible fixed assets are initially measured at cost and subsequently measured at cost or valuation, net of depreciation and any impairment losses. NOTES TO THE FINANCIAL STATEMENTS (CONTINUED) Depreciation is recognised so as to write off the cost or valuation of assets less their residual values over their useful lives on the following bases: 15% on cost The gain or loss arising on the disposal of an asset is determined as the difference between the sale proceeds and the carrying value of the asset, and is credited or charged to profit or loss . Fixed asset investments Interests in subsidiaries are initially measured at cost and subsequently measured at cost less any accumulated impairment losses. The investments are assessed for impairment at each reporting date and any impairment losses or reversals of impairment losses are recognised immediately in profit or loss. A subsidiary is an entity controlled by the company . Control is the power to govern the financial and operating policies of the entity so as to obtain benefits from its activities. Stocks are stated at the lower of cost and estimated selling price less costs to complete and sell. In respect of work in progress, cost includes a relevant proportion of overheads according to the stage of completion. The company has elected to apply the provisions of Section 11 ‘Basic Financial Instruments’ and Section 12 ‘Other Financial Instruments Issues’ of FRS 102 to all of its financial instruments. Financial instruments are recognised in the company's balance sheet when the company becomes party to the contractual provisions of the instrument. Financial assets and liabilities are offset , with the net amounts presented in the financial statements , when there is a legally enforceable right to set off the recognised amounts and there is an intention to settle on a net basis or to realise the asset and settle the liability simultaneously. Debtors and creditors with no stated interest rate and receivable or payable within one year are recorded at transaction price. Any losses arising from impairment are recognised in the profit and loss account in other administrative expenses. Changes in the fair value of derivatives that are designated and qualify as fair value hedges are recognised in profit or loss immediately, together with any changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. The tax expense represents the sum of the tax currently payable and deferred tax. Current tax The tax currently payable is based on taxable profit for the year. Taxable profit differs from net profit as reported in the profit and loss account because it excludes items of income or expense that are taxable or deductible in other years and it further excludes items that are never taxable or deductible. The company’s liability for current tax is calculated using tax rates that have been enacted or substantively enacted by the reporting end date. Deferred tax liabilities are generally recognised for all timing differences and deferred tax assets are recognised to the extent that it is probable that they will be recovered against the reversal of deferred tax liabilities or other future taxable profits. Such assets and liabilities are not recognised if the timing difference arises from goodwill or from the initial recognition of other assets and liabilities in a transaction that affects neither the tax profit nor the accounting profit. Leases are classified as finance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership to the lessees. All other leases are classified as operating leases. Assets held under finance leases are recognised as assets at the lower of the assets fair value at the date of inception and the present value of the minimum lease payments. The related liability is included in the balance sheet as a finance lease obligation. Lease payments are treated as consisting of capital and interest elements. The interest is charged to profit or loss so as to produce a constant periodic rate of interest on the remaining balance of the liability. Judgements and key sources of estimation uncertainty In the application of the company’s accounting policies, the directors are required to make judgements, estimates and assumptions about the carrying amount of assets and liabilities that are not readily apparent from other sources. The estimates and associated assumptions are based on historical experience and other factors that are considered to be relevant. Actual results may differ from these estimates. The estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognised in the period in which the estimate is revised where the revision affects only that period, or in the period of the revision and future periods where the revision affects both current and future periods. Operating loss for the year is stated after charging/(crediting): Depreciation of owned tangible fixed assets Depreciation of tangible fixed assets held under finance leases Profit on disposal of tangible fixed assets Cost of stocks recognised as an expense Income from fixed asset investments Income from shares in group undertakings Interest on bank overdrafts and loans Interest on finance leases and hire purchase contracts Origination and reversal of timing differences The actual charge/(credit) for the year can be reconciled to the expected charge for the year based on the profit or loss and the standard rate of tax as follows: Expected tax charge based on the standard rate of corporation tax in the UK of 20.00% (2016: 20.00%) Tax effect of expenses that are not deductible in determining taxable profit Tax effect of income not taxable in determining taxable profit Unutilised tax losses carried forward Taxation charge/(credit) for the year Final paid At 1 January 2017 At 31 December 2017 Depreciation and impairment Depreciation charged in the year Carrying amount The net carrying value of tangible fixed assets includes the following in respect of assets held under finance leases or hire purchase contracts. Investment property comprises Freehold properties held for capital appreciation. The fair value of the investment property is not considered to be different to its historical cost, no revaluation has been considered necessary during the period. During the year all investment properties were transferred to the parent company, Gwent Holdings Limited. The carrying value of land and buildings comprises: Investments in subsidiaries Movements in fixed asset investments Shares in group undertakings Cost or valuation The addition relates to additional consideration of £1.0m agreed in July 2018 in relation to the company's acquisition of Merthyr (Holdings) Limited (formerly Miller Argent (Holdings) Limited and its subsidiary Merthyr (South Wales) Limited (formerly Miller Argent (South Wales) Limited). The acquisition happened on 7th January 2016; the consideration included a contingent element based on future operating performance; during the period following the acquisition the terms of the contingent consideration were re-negotiated and in July 2018 the parties agreed on a figure of £11.0m being the final settlement , bringing the total consideration to £20.8m. Acquisition costs of £164,484 were capitalised. Details of the company's subsidiaries at 31 December 2017 are as follows: Name of undertaking % Held Merthyr (Ffos-y-Fran) Limited (previously Blackstone (Ffos-y-Fran) Limited) Merthyr Holdings Limited (previously Blackstone Holdings Limited) Merthyr (Nominee No. 1) Limited (previously Blackstone (Nominee No.1) Limited) Merthyr (South Wales) Limited (previously Blackstone (South Wales) Limited) Ffos-y-Fran (Commoners) Limited The registered office address for the above is Cwmbargoed Disposal Point Fochriw Road, Cwmbargoed, Merthyr Tydfil, Wales, CF48 4AE. Amounts falling due within one year: Amounts owed by group undertakings Other debtors Obligations under finance leases Trade creditors Amounts owed to group undertakings Other taxation and social security Other creditors Accruals and deferred income Bank loans and overdrafts Other creditors relates to the deferred contingent consideration in relation to the acquisition of Merthyr Holdings Limited, formerly Miller Argent (Holdings) Limited, refer to note 10. Loans and overdrafts Payable within one year Payable after one year The long-term loans are secured by fixed charges over the Tangible fixed assets held in Blackstone (South Wales) Limited. The loan is subject to a variable interest rate which is currently 2.25% per annum above 0.5% Base rate. Interest is calculated on the daily total of the then outstanding balance of the Loan (including any outstanding finance charge). Finance lease obligations Future minimum lease payments due under finance leases: In two to five years Finance lease payments represent rentals payable by the company for motor vehicles. Leases include purchase options at the end of the lease period, and no restrictions are placed on the use of the assets. The average lease term is 3 years. All leases are on a fixed repayment basis and no arrangements have been entered into for contingent rental payments. Deferred taxation The following are the major deferred tax liabilities and assets recognised by the company and movements thereon: Balances: Accelerated capital allowances Statutory database figures differ from the trial balance: Deferred tax balances There were no deferred tax movements in the year. The deferred tax liability set out above is expected to reverse within 12 months and relates to accelerated capital allowances that are expected to mature within the same period. Ordinary share capital Issued and fully paid 1,800,001 Ordinary of £1 each At the year end, a balance due from Merthyr (South Wales) Limited, a fellow subsidiary within the group, totalling £ 8,690,614 (2016: £nil) During the year ending 31 December 201 7 , the company received dividends from Merthyr Holdings Limited totalling £ 15,000,000 (2016: £9,281,623). At the year end, a balance due from Merthyr Holdings Limited was outstanding totalling £ 2,985,000 (2016: £ nil ). Merthyr Holdings Limited is the immediate parent company. During the year ending 31 December 201 7 , the company paid dividends to Gwent Holdings Limited totalling £ 15,000,000 (2016: £9,281,623). At the year end, a balance was due to Gwent Holdings Limited of £17,825,147 (2016: £nil) Gwent Holdings Limited is the intermediate parent company . The company has taken advantage of the exemption not to disclose transactions with related parties being a wholly owned member of a group. Consolidated accounts of the ultimate parent company, Gwent Holdings Limited are available on request. Directors' transactions Dividends totalling £0 (2016 - £0) were paid in the year in respect of shares held by the company's directors. Parent company and controlling party The ultimate parent company is Gwent Holdings Limited. The largest and smallest publicly available consolidated financial statements to include the company are those of Gwent Holdings Limited. Copies of the Gwent Holdings Limited. Consolidated financial statements are available from C/O UHY Hacker Young, Lanyon House, Mission Court, Newport, Wales, NP20 2DW. The ultimate controlling party is Mrs J H Lewis. 2017-12-31 2017-01-01 false CCH Software CCH Accounts Production 2020.100 Mr D S Lewis Mrs J H lewis Mr L Jones 08936878 2017-01-01 2017-12-31 08936878 bus:Director4 2017-01-01 2017-12-31 08936878 bus:Director7 2017-01-01 2017-12-31 08936878 bus:Director6 2017-01-01 2017-12-31 08936878 bus:Director1 2017-01-01 2017-12-31 08936878 bus:Director2 2017-01-01 2017-12-31 08936878 bus:Director3 2017-01-01 2017-12-31 08936878 bus:RegisteredOffice 2017-01-01 2017-12-31 08936878 2017-12-31 08936878 2016-01-01 2016-12-31 08936878 core:RetainedEarningsAccumulatedLosses 2016-01-01 2016-12-31 08936878 core:RetainedEarningsAccumulatedLosses 2017-01-01 2017-12-31 08936878 2016-12-31 08936878 core:PlantMachinery 2017-12-31 08936878 core:ComputerEquipment 2017-12-31 08936878 core:MotorVehicles 2017-12-31 08936878 core:PlantMachinery 2016-12-31 08936878 core:ComputerEquipment 2016-12-31 08936878 core:MotorVehicles 2016-12-31 08936878 core:CurrentFinancialInstruments core:WithinOneYear 2017-12-31 08936878 core:CurrentFinancialInstruments core:WithinOneYear 2016-12-31 08936878 core:CurrentFinancialInstruments 2017-12-31 08936878 core:CurrentFinancialInstruments 2016-12-31 08936878 core:Non-currentFinancialInstruments 2017-12-31 08936878 core:Non-currentFinancialInstruments 2016-12-31 08936878 core:ShareCapital 2017-12-31 08936878 core:ShareCapital 2016-12-31 08936878 core:RetainedEarningsAccumulatedLosses 2017-12-31 08936878 core:RetainedEarningsAccumulatedLosses 2016-12-31 08936878 core:ShareCapital 2015-12-31 08936878 core:RetainedEarningsAccumulatedLosses 2015-12-31 08936878 2015-12-31 08936878 core:PlantMachinery 2017-01-01 2017-12-31 08936878 core:ComputerEquipment 2017-01-01 2017-12-31 08936878 core:MotorVehicles 2017-01-01 2017-12-31 08936878 core:PlantMachinery 2016-01-01 2016-12-31 08936878 core:UKTax 2017-01-01 2017-12-31 08936878 core:UKTax 2016-01-01 2016-12-31 08936878 core:PlantMachinery 2016-12-31 08936878 core:ComputerEquipment 2016-12-31 08936878 core:MotorVehicles 2016-12-31 08936878 2016-12-31 08936878 core:FreeholdInvestmentProperty 2016-12-31 08936878 core:Subsidiary1 2017-01-01 2017-12-31 08936878 core:Subsidiary2 2017-01-01 2017-12-31 08936878 core:Subsidiary3 2017-01-01 2017-12-31 08936878 core:Subsidiary4 2017-01-01 2017-12-31 08936878 core:Subsidiary5 2017-01-01 2017-12-31 08936878 core:Subsidiary1 1 2017-01-01 2017-12-31 08936878 core:Subsidiary2 2 2017-01-01 2017-12-31 08936878 core:Subsidiary3 3 2017-01-01 2017-12-31 08936878 core:Subsidiary4 4 2017-01-01 2017-12-31 08936878 core:Subsidiary5 5 2017-01-01 2017-12-31 08936878 core:Non-currentFinancialInstruments 1 2017-12-31 08936878 core:Non-currentFinancialInstruments 1 2016-12-31 08936878 core:WithinOneYear 2017-12-31 08936878 core:WithinOneYear 2016-12-31 08936878 core:BetweenTwoFiveYears 2017-12-31 08936878 core:BetweenTwoFiveYears 2016-12-31 08936878 bus:PrivateLimitedCompanyLtd 2017-01-01 2017-12-31 08936878 bus:FRS102 2017-01-01 2017-12-31 08936878 bus:Audited 2017-01-01 2017-12-31 08936878 bus:FullAccounts 2017-01-01 2017-12-31 xbrli:pure xbrli:shares iso4217:GBP

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professional_accounting

ATTO Dashboard Atento (ATTO) 6-KAtento Reports Fiscal 2021 Third Quarter and 9M Results 99.1 Atento Reports Fiscal 2021 Third Quarter and 9M Results ATTO similar filings 1 Apr 22 Current report (foreign) (amended) 30 Mar 22 Atento Reports Fiscal 2021 Fourth Quarter and Full Year Results 29 Dec 21 Atento announces signing of new super senior revolving credit facility 15 Nov 21 Atento Reports Fiscal 2021 Third Quarter and 9M Results 22 Oct 21 Current report (foreign) 5 Aug 21 ATTO20210804_6K 5 Aug 21 Atento Reports Fiscal 2021 Second Quarter and First Half Results Pursuant to Rule 13a-16 or 15d-16 of the Securities Exchange Act of 1934 For the month of September, 2021 Commission File Number 001-36671 Atento S.A. (Translation of Registrant's name into English) 1 rue Hildegard Von Bingen Grand Duchy of Luxembourg (Address of principal executive office) Form 20-F: x Form 40-F: o Indicate by check mark if the registrant is submitting the Form 6-K in paper as permitted by Regulation S-T Rule 101(b)(1): Yes: o No: x Note: Regulation S-T Rule 101(b)(1) only permits the submission in paper of a Form 6-K if submitted solely to provide an attached annual report to security holders. Note: Regulation S-T Rule 101(b)(7) only permits the submission in paper of a Form 6-K if submitted to furnish a report or other document that the registrant foreign private issuer must furnish and make public under the laws of the jurisdiction in which the registrant is incorporated, domiciled or legally organized (the registrant’s “home country”), or under the rules of the home country exchange on which the registrant’s securities are traded, as long as the report or other document is not a press release, is not required to be and has not been distributed to the registrant’s security holders, and, if discussing a material event, has already been the subject of a Form 6-K submission or other Commission filing on EDGAR. For the Nine Months ended September 30, 2021 PART I - OTHER INFORMATION 37 LEGAL PROCEEDINGS 37 RISK FACTORS 37 Atento s.a. AND SUBSIDIARIES UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL INFORMATION FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 INTERIM CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL POSITION As of December 31, 2020 and September 30, 2021 (In thousands of U.S. dollars, unless otherwise indicated) ASSETS Notes December 31, September 30, (audited) (unaudited) NON-CURRENT ASSETS 604,327 584,454 Intangible assets 6 106,643 82,954 Goodwill 7 103,014 95,146 Right-of-use assets 9 137,842 141,017 Property, plant and equipment 8 90,888 88,590 Non-current financial assets 70,275 83,935 Trade and other receivables 11 20,995 31,033 Other non-current financial assets 11 38,192 36,258 Derivative financial instruments 12 11,088 16,644 Other taxes recoverable 4,815 4,525 Deferred tax assets 90,850 88,287 CURRENT ASSETS 571,796 527,230 Trade and other receivables 324,850 334,275 Trade and other receivables 11 299,086 304,937 Current income tax receivable 25,764 29,338 Other taxes recoverable 36,794 46,265 Other current financial assets 11 1,158 1,036 Cash and cash equivalents 11 208,994 145,654 TOTAL ASSETS 1,176,123 1,111,684 The accompanying notes are an integral part of the interim condensed consolidated financial information. EQUITY AND LIABILITIES Notes December 31, September 30, TOTAL EQUITY 119,676 31,218 EQUITY ATTRIBUTABLE TO: OWNERS OF THE PARENT COMPANY 119,676 31,218 Share capital 10 49 49 Share premium 613,619 617,594 Treasury shares 10 (12,312) (13,227) Retained losses (178,988) (226,843) Translation differences (280,715) (321,908) Hedge accounting effects (37,360) (41,090) Stock-based compensation 15,383 16,643 NON-CURRENT LIABILITIES 651,662 694,631 Debt with third parties 12 594,636 598,204 Derivative financial instruments 12 5,220 58,357 Provisions and contingencies 13 45,617 34,306 Non-trade payables 4,296 2,009 Other taxes payable 1,893 1,755 CURRENT LIABILITIES 404,785 385,835 Debt with third parties 12 133,187 97,575 Trade and other payables 249,723 263,475 Trade payables 59,415 65,638 Income tax payables 16,838 9,001 Other taxes payables 97,104 103,591 Other non-trade payables 76,366 85,245 TOTAL EQUITY AND LIABILITIES 1,176,123 1,111,684 INTERIM CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS For the nine months ended September 30, 2020 and 2021 For the three months ended September 30, For the nine months ended September 30, Notes 2020 2021 2020 2021 Revenue 352,723 368,637 1,042,673 1,121,976 Other operating income 1,088 1,884 3,050 5,185 Other gains and own work capitalized 36 13 41 46 Supplies (18,473) (22,071) (51,174) (71,739) Employee benefit expenses (259,910) (271,853) (793,889) (844,634) Depreciation (18,420) (18,942) (56,011) (54,155) Amortization (11,592) (11,883) (34,172) (35,616) Changes in trade provisions (1,562) (679) (3,502) 965 Other operating expenses (29,097) (24,661) (89,417) (70,732) OPERATING PROFIT 14,793 20,445 17,599 51,296 Finance income 2,010 1,941 13,013 11,502 Finance costs (18,773) (18,047) (51,596) (64,659) Change in fair value of financial instruments - (16,663) - (41,208) Net foreign exchange (loss)/gain (8,819) 7,404 (18,095) 13,219 NET FINANCE EXPENSE (25,582) (25,365) (56,678) (81,146) LOSS BEFORE INCOME TAX (10,789) (4,920) (39,079) (29,850) Income tax (expense)/benefit 14 (2,303) (6,754) 224 (16,751) LOSS FOR THE PERIOD (13,092) (11,674) (38,855) (46,601) LOSS ATTRIBUTABLE TO: OWNERS OF THE PARENT (13,092) (11,674) (38,855) (46,601) Basic loss per share (in U.S. dollars) 15 (0.93) (0.83) (2.75) (3.31) Diluted loss per share (in U.S. dollars) 15 (0.93) (0.83) (2.75) (3.31) INTERIM CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) Other comprehensive income/(loss) to be reclassified to profit and loss in subsequent periods: Net investment hedge (138) 37,563 17,324 5,118 Exchange differences on translation of foreign operations (825) (14,591) (60,886) (8,848) Translation differences 9,326 (24,835) (37,399) (41,193) Other comprehensive income/(loss) 8,363 (1,863) (80,961) (44,923) Total comprehensive income/(loss) (4,729) (13,537) (119,816) (91,524) Total comprehensive income/(loss) attributable to: Owners of the parent (4,729) (13,537) (119,816) (91,524) INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY Share capital Share premium Treasury shares Retained losses Translation differences Hedge accounting effects Stock-based compensation Total owners of the parent company Total equity Balance at January 1, 2020 49 619,461 (19,319) (127,070) (271,273) (8,872) 14,044 207,020 207,020 Comprehensive income/(loss) for the period - - - (38,855) (37,399) (43,562) - (119,816) (119,816) Loss for the period - - - (38,855) - - - (38,855) (38,855) Other comprehensive income/(loss), net of taxes - - - - (37,399) (43,562) - (80,961) (80,961) Stock-based compensation - - - - - - 3,120 3,120 3,120 Share delivered - (5,781) 8,274 - - - (2,493) - - Acquisition of treasury shares - - (918) - - - - (918) (918) Monetary correction caused by hyperinflation - - - (3,419) - - - (3,419) (3,419) Balance at September 30, 2020 (*) 49 613,680 (11,963) (169,344) (308,672) (52,434) 14,671 85,987 85,987 Balance at January 1, 2021 49 613,619 (12,312) (178,988) (280,715) (37,360) 15,383 119,676 119,676 Comprehensive income/(loss) for the period - - - (46,601) (41,193) (3,730) - (91,524) (91,524) Other comprehensive income/(loss), net of taxes - - - - (41,193) (3,730) - (44,923) (44,923) Shares delivered - 3,975 (37) - - - (3,938) - - (*) unaudited INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS For the nine months ended Loss before income tax (39,079) (29,850) Adjustments to reconcile loss before income tax to net cash flows: Amortization and depreciation 90,183 89,771 Changes in trade provisions 3,502 (965) Share-based payment expense 3,120 8,381 Change in provisions 22,013 14,167 Losses on disposal of property, plant and equipment (512) (614) Losses on disposal of financial assets 136 203 Finance income (13,013) (11,502) Finance costs 51,596 64,659 Change in fair value of financial instruments - 41,208 Net foreign exchange differences 18,095 (13,219) Changes in other (gains)/losses and own work capitalized (718) (339) Changes in working capital: Changes in trade and other receivables (13,131) (52,421) Changes in trade and other payables 7,461 45,831 Other assets/(payables) (15,015) (33,844) (20,685) (40,434) Interest paid (42,351) (54,864) Interest received 11,700 11,771 Income tax paid (7,289) (17,127) Other payments (8,496) (20,149) Net cash flows from operating activities 68,202 41,097 Payments for acquisition of intangible assets (5,348) (1,021) Payments for acquisition of property, plant and equipment (21,967) (32,985) Payments for financial instruments (37) (1,780) Net cash flows used in investing activities (27,352) (35,786) Proceeds from borrowing from third parties 109,635 501,767 Repayment of borrowing from third parties (41,043) (523,182) Payments of lease liabilities (31,513) (35,746) Acquisition of treasury shares (918) (878) Net cash flows provided by/(used in) financing activities 36,161 (58,039) Net increase/(decrease) in cash and cash equivalents 77,011 (52,728) Foreign exchange differences (5,112) (10,612) Cash and cash equivalents at beginning of period 124,706 208,994 Cash and cash equivalents at end of period 196,605 145,654 NOTES TO THE INTERIM CONDENSED CONSOLIDATED FINANCIAL INFORMATION FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2021 1. COMPANY ACTIVITY AND CORPORATE INFORMATION (a) Description of business Atento S.A. (the “Company”) and its subsidiaries (“Atento Group”) offer customer relationship management services to their clients through contact centers or multichannel platforms. The Company was incorporated on March 5, 2014 under the laws of the Grand Duchy of Luxembourg. Its current registered office in Luxembourg is 1, rue Hildegard Von Bingen, L-1282, Luxembourg. The majority direct shareholders of the Company are Mezzanine Partners II Offshore Lux Sarl II, Mezzanine Partners II Onshore Lux Sarl II, Mezzanine Partners II Institutional Lux Sarl II, Mezzanine Partners II AP LUX SARL II, Chesham Investment Pte Ltd. and Taheebo Holdings LLC, Arch Reinsurance Ltd. The Company may act as the guarantor of loans and securities, as well as assisting companies in which it holds direct or indirect interests or that form part of its group. The Company may secure funds, with the exception of public offerings, through any kind of lending, or through the issuance of bonds, securities or debt instruments in general. The Company may also carry on any commercial, industrial, financial, real estate business or intellectual property related activity that it deems necessary to meet the aforementioned corporate purposes. The corporate purpose of its subsidiaries, with the exception of the intermediate holding companies, is to establish, manage and operate CRM centers through multichannel platforms; provide telemarketing, marketing and “call center” services through service agencies or in any other format currently existing or which may be developed in the future by the Atento Group; provide telecommunications, logistics, telecommunications system management, data transmission, processing and internet services and to promote new technologies in these areas; offer consultancy and advisory services to clients in all areas in connection with telecommunications, processing, integration systems and new technologies, and other services related to the above. The Company’s ordinary shares are traded on NYSE under the symbol “ATTO”. The interim condensed consolidated financial information was approved by the Board of Directors on November 5, 2021. (b) Seasonality Our performance is subject to seasonal fluctuations, which is primarily due to (i) our clients generally spending less in the first quarter of the year after the year -end holiday season, (ii) the initial costs to train and hire new employees at new service delivery centers to provide additional services to our clients which are usually incurred in the first quarter of the year, and (iii) statutorily mandated minimum wage and salary increases of operators, supervisors and coordinators in many of the countries in which we operate which are generally implemented at the beginning of the first quarter of each year, whereas revenue increases related to inflationary adjustments and contracts negotiations generally take effect after the first quarter. We have also found that growth in our revenue increases in the last quarter of the year, especially in November and December, as the year-end holiday season begins and we have an increase in business activity resulting from the handling of holiday season promotions offered by our clients. These seasonal effects also cause differences in revenue and expenses among the various quarters of any year, which means that the individual quarters of a year should not be directly compared with each other or used to predict annual operating results. 2. BASIS OF PRESENTATION OF THE INTERIM CONDENSED CONSOLIDATED FINANCIAL INFORMATION The interim condensed consolidated financial information for the nine months ended September 30, 2021 has been prepared in accordance with IAS 34 - Interim Financial Reporting as issued by the International Accounting Standards Board (“IASB”) prevailing at September 30, 2021. The information does not have all disclosure requirements for the presentation of full annual financial statements and thus should be read in conjunction with the consolidated financial statements prepared in accordance with International Financial Reporting Standards (“IFRS”) for the year ended December 31, 2020. The interim condensed consolidated financial information have been prepared on a historical costs basis, except for Argentina that is adjusted for inflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies in Argentina, and derivative financial instruments, which have been measured at fair value. The interim condensed consolidated financial information is for the Atento Group. The figures in this interim condensed consolidated financial information are expressed in thousands of U.S. dollars, and all values are rounded to the nearest thousand, unless otherwise indicated. U.S. Dollar is the Atento Group’s presentation currency. 3. ACCOUNTING POLICIES There were no significant changes in accounting policies and calculation methods used for the interim condensed consolidated financial information as of September 30, 2021 in relation to those presented in the annual financial statements for the year ended December 31, 2020. a) Critical accounting estimates and assumptions The preparation of the interim condensed consolidated financial information under IAS 34 requires the use of certain assumptions and estimates that affect the recognized amount of assets, liabilities, income and expenses, as well as the related disclosures. Some of the accounting policies applied in preparing the accompanying interim condensed consolidated financial information required Management to apply significant judgments in order to select the most appropriate assumptions for determining these estimates. These assumptions and estimates are based on Management experience, the advice of consultants and experts, forecasts and other circumstances and expectations prevailing at year end. Management’s evaluation takes into account the global economic situation in the sector in which the Atento Group operates, as well as the future outlook for the business. By virtue of their nature, these judgments are inherently subject to uncertainty. Consequently, actual results could differ substantially from the estimates and assumptions used. Should this occur, the values of the related assets and liabilities would be adjusted accordingly. Although these estimates were made on the basis of the best information available at each reporting date on the events analyzed, events that take place in the future might make it necessary to change these estimates in coming years. Changes in accounting estimates would be applied prospectively in accordance with the requirements of IAS 8, “Accounting Policies, Changes in Accounting Estimates and Errors”, recognizing the effects of the changes in estimates in the related interim condensed consolidated statements of operations. An explanation of the estimates and judgments that entail a significant risk of leading to a material adjustment in the carrying amounts of assets and liabilities in the coming financial period is as follows: Impairment of goodwill The Atento Group tests goodwill for impairment annually, in accordance with the accounting principle disclosed in the consolidated financial statements for the year ended December 31, 2020. Goodwill is subject to impairment testing as part of the cash-generating unit to which it has been allocated. The recoverable amounts of cash-generating units defined in order to identify potential impairment in goodwill are determined on the basis of value in use, applying five-year financial forecasts based on the Atento Group’s strategic plans, approved and reviewed by Management. These calculations entail the use of assumptions and estimates and require a significant degree of judgment. The main variables considered in the sensitivity analyses are growth rates, discount rates using the Weighted Average Cost of Capital (“WACC”) and the key business variables. The Atento Group assesses the recoverability of deferred tax assets based on estimates of future earnings. The ability to recover these deferred amounts depends ultimately on the Atento Group’s ability to generate taxable earnings over the period in which the deferred tax assets remain deductible. This analysis is based on the estimated timing of the reversal of deferred tax liabilities, as well as estimates of taxable earnings, which are sourced from internal projections and are continuously updated to reflect the latest trends. The appropriate classification of tax assets and liabilities depends on a series of factors, including estimates as to the timing and realization of deferred tax assets and the projected tax payment schedule. Actual income tax receipts and payments could differ from the estimates made by the Atento Group as a result of changes in tax legislation or unforeseen transactions that could affect the tax balances. The Atento Group has recognized deferred tax assets corresponding to losses carried forward since, based on internal projections, it is probable that it will generate future taxable profits against which they may be utilized. The carrying amount of deferred income tax assets is reviewed at each reporting date and reduced to the extent that it is no longer probable that sufficient taxable profits will be available to allow all or part of that deferred tax asset to be utilized. Unrecognized deferred income tax assets are reassessed at each reporting date and are recognized to the extent that it has become probable that future taxable profits will allow the deferred tax asset to be recovered. Provisions and contingencies Provisions are recognized when the Atento Group has a present obligation as a result of a past event, it is probable that an outflow of resources will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation. This obligation may be legal or constructive, deriving from, inter alia, regulations, contracts, customary practice or public commitments that would lead third parties to reasonably expect that the Atento Group will assume certain responsibilities. The amount of the provision is determined based on the best estimate of the outflow of resources embodying economic benefit that will be required to settle the obligation, taking into account all available information as of the reporting date, including the opinions of independent experts such as legal counsel or consultants. No provision is recognized if the amount of liability cannot be estimated reliably. In such cases, the relevant information is disclosed in the notes to the interim condensed consolidated financial information. Given the uncertainties inherent in the estimates used to determine the amount of provisions, actual outflows of resources may differ from the amounts recognized originally on the basis of these estimates. Fair value of derivatives The Atento Group uses derivative financial instruments to mitigate risks, primarily derived from possible fluctuations in interest and exchange rates. Derivatives are recognized at the inception of the contract at fair value. The fair values of derivative financial instruments are calculated on the basis of observable market data available, either in terms of market prices or through the application of valuation techniques. The valuation techniques used to calculate the fair value of derivative financial instruments include the discounting of future cash flow associated with the instruments, applying assumptions based on market conditions at the valuation date or using prices established for similar instruments, among others. These estimates are based on available market information and appropriate valuation techniques. The fair values calculated could differ significantly if other market assumptions and/or estimation techniques were applied. The estimates and assumptions included in the financial statements include our assessment of potential impacts arising from the COVID-19 pandemic that may affect the amounts reported and the accompanying notes. To-date, no significant impacts on our collection experience and expected credit losses have been noted and we do not currently anticipate any material impairments of our long-lived assets or of our indefinite-lived intangible assets as a result of the COVID-19 pandemic. We will continue to monitor the impacts and will prospectively revise our estimates as appropriate. b) Standards issued but not yet effective There are no other standards that are not yet effective and that would be expected to have a material impact on the Atento Group in the current or future reporting periods and on foreseeable future transactions. 4. MANAGEMENT OF FINANCIAL RISK 4.1 Financial risk factors The Atento Group's activities are exposed to various types of financial risks: market risk (including currency risk, interest rate risk and country risk), credit risk and liquidity risk. The Atento Group's global risk management policy aims to minimize the potential adverse effects of these risks on the Atento Group's results of operations. The Atento Group also uses derivative financial instruments to hedge certain risk exposures. This unaudited interim condensed consolidated financial information does not include all financial risk management information and disclosures required in the annual financial statements and therefore they should be read in conjunction with the Atento Group’s consolidated financial statements as of and for the year ended December 31, 2020. For the nine months ended September 30, 2021 there have not been changes in any risk management policies. To manage or mitigate country risk, we repatriate the funds generated in the Americas and Brazil that are not required for the pursuit of new profitable business opportunities in the region and subject to the restrictions of our financing agreements. Interest rate risk arises mainly as a result of changes in interest rates which affect: finance costs of debt bearing interest at variable rates (or short-term maturity debt expected to be renewed), as a result of fluctuations in interest rates, and the value of non-current liabilities that bear interest at fixed rates. Atento Group’s finance costs are exposed to fluctuation in interest rates. At September 30, 2021, 3.1% of financial debt with third parties bore interests ate variable rates, while at December 31, 2020 this amount was 4.5%. In both December 31, 2020 and September 30, 2021, the exposure was to the Brazilian CDI rate and the TJLP (Brazilian Long-Term Interest Rate). The Atento Group’s policy is to monitor the exposure to interest at risk. As of September 30, 2021, there were no outstanding interest rate hedging instruments. Foreign Currency Risk Our foreign currency risk arises from our local currency revenues, receivables and payables while the U.S. dollar is our presentation currency. We benefit to a certain degree from the fact that the revenue we collect in each country, in which we have operations, is generally denominated in the same currency as the majority of the expenses we incur. In accordance with our risk management policy, whenever we deem it appropriate, we manage foreign currency risk by using derivatives to hedge any exposure incurred in currencies other than those of the functional currency of the countries. The main source of our foreign currency risk is related to the Senior Secured Notes due 2026 denominated in U.S. dollars. Upon issuance of the Notes, we entered into cross-currency swaps pursuant to which we exchange an amount of U.S. dollars for a fixed amount of Euro, Peruvian Soles and Brazilian Reais. The total amount of interest (coupon) payments are covered until maturity date and 80% of principal is covered until February 2024. On February 10, 2021, Atento Luxco 1 S.A., closed an offering of 500,000 thousand U.S. dollars aggregate principal amount of 8.0% Senior Secured Notes due February 10, 2026 in a private placement transaction. On February 17, 2021, Atento Luxco 1 S.A. purchased 275,815 thousand U.S. dollars of its 6.125% Senior Secured Notes due 2022 in a tender offer. The notes were purchased at a price equal to 1,015.31 U.S. dollars per 1,000 U.S. dollars principal amount. On February 18, 2021, Atento Luxco 1 S.A redeemed the remainder 224,185 thousand U.S. dollars of its 6.125% Senior Secured Notes due2022. The redemption price was equal to 1,015.31 U.S. dollars per 1,000 U.S. dollars principal amount, plus accrued and unpaid interest on the principal amount of the Notes, which was equal to 1,016.67 U.S. dollars per 1,000 U.S. dollars principal amount. With these transactions, the Company completed the refinancing of all 500,000 thousand U.S. dollars aggregate principal amount of its 6.125% Senior Secured Notes due 2022, extending the Company’s average life to 4.5 years from 1.5 years. As of September 30, 2021, the estimated fair value of the cross-currency swaps totaled a net liability of 41,713 thousand U.S. dollars (net asset of 5,868 thousand U.S. dollars as of December 31, 2020). The Atento Group seeks to conduct all of its business with reputable national and international companies and institutions established in their countries of origin, to minimize credit risk. As a result of this policy, the Atento Group has no material adjustments to make to its credit accounts. Accordingly, the Atento Group’s commercial credit risk management approach is based on continuous monitoring of the risks assumed and the financial resources necessary to manage the Group’s various units, in order to optimize the risk-reward relationship in the development and implementation of business plans in the course of their regular business. Credit risk arising from cash and cash equivalents is managed by placing cash surpluses in high quality and highly liquid money-market assets. These placements are regulated by a master agreement revised annually on the basis of the conditions prevailing in the markets and the countries where Atento operate. The master agreement establishes: (i) the maximum amounts to be invested per counterparty, based on their ratings (long- and short-term debt rating); (ii) the maximum period of the investment; and (iii) the instruments in which the surpluses may be invested. The Atento Group’s maximum exposure to credit risk is primarily limited to the carrying amounts of its financial assets. The Atento Group holds no guarantees as collection insurance. The Atento Group seeks to match its debt maturity schedule to its capacity to generate cash flows to meet the payments falling due, factoring in a degree of cushion. In practice, this has meant that the Atento Group’s average debt maturity must be long enough to support business operation normal conditions (assuming that internal projections are met). The Atento Group’s Finance Department, which is in charge of the capital management, takes various factors into consideration when determining the Group’s capital structure. The Atento Group’s capital management goal is to determine the financial resources necessary both to continue its recurring activities and to maintain a capital structure that optimizes own and borrowed funds. The Atento Group sets an optimal debt level in order to maintain a flexible and comfortable medium-term borrowing structure in order to be able to carry out its routine activities under normal conditions and to address new opportunities for growth. Debt levels are kept in line with forecast future cash flows and with quantitative restrictions imposed under financing contracts. In addition to these general guidelines, we take into account other considerations and specifics when determining our financial structure, such as country risk, tax efficiency and volatility in cash flow generation. The Super Senior Revolving Credit Facility carries no financial covenant obligations regarding debt levels. However, the notes do impose limitations of the distributions on dividends, payments or distributions to shareholders, the incurring of additional debt, and on investments and disposal of assets. As of the date of these interim condensed consolidated financial information, the Atento Group was in compliance with all restrictions established in the aforementioned financing contracts and does not foresee any future non-compliance. To that end, the Atento Group regularly monitors figures for net financial debt with third parties and EBITDA. 4.2 Fair value estimation a) Level 1: The fair value of financial instruments traded on active markets is based on the quoted market price at the reporting date. b) Level 2: The fair value of financial instruments not traded in active market (i.e. OTC derivatives) is determined using valuation techniques. Valuation techniques maximize the use of available observable market data, and place as little reliance as possible on specific company estimates. If all of the significant inputs required to calculate the fair value of financial instrument are observable, the instrument is classified in Level 2. The Atento Group’s Level 2 financial instruments comprise interest rate swaps used to hedge floating rate loans and cross currency swaps. c) Level 3: If one or more significant inputs are not based on observable market data, the instrument is classified in Level 3. The Atento Group’s assets and liabilities measured at fair value as of December 31, 2020 and September 30, 2021 are classified as Level 2. No transfers were carried out between the different levels during the period. 5. SEGMENT INFORMATION The following tables present financial information for the Atento Group’s operating segments for the nine months ended September 30, 2020 and 2021 (in thousand U.S. dollars): Thousands of U.S. dollars EMEA Americas Brazil Other and eliminations Total Group Sales to third parties 168,467 418,702 451,436 - 1,038,605 Sales to group companies 5 7,422 1,017 (4,376) 4,068 Other operating income and expense (160,626) (389,204) (402,076) 17,015 (934,891) EBITDA 7,846 36,920 50,377 12,639 107,782 Depreciation and amortization (9,142) (33,260) (47,546) (235) (90,183) Operating profit/(loss) (1,296) 3,660 2,831 12,404 17,599 Financial results 533 (6,396) (33,872) (16,943) (56,678) Income tax (585) (5,217) 9,667 (3,641) 224 Profit/(loss) for the period (1,348) (7,953) (21,374) (8,180) (38,855) Capital expenditure 3,035 6,375 14,122 (101) 23,431 Intangible, Goodwill and PP&E (as of December 31, 2020) 43,794 150,046 232,930 494 427,264 Allocated assets (as of December 31, 2020) 377,634 521,300 560,476 (297,535) 1,161,875 Allocated liabilities (as of December 31, 2020) 132,791 280,691 476,192 182,947 1,072,621 Sales to group companies - 3,033 705 (3,665) 73 EBITDA 18,897 45,193 64,097 12,880 141,067 Operating profit/(loss) 9,333 10,482 18,748 12,733 51,296 Financial results (2,099) (2,149) (25,717) (51,181) (81,146) Income tax (6,053) (7,733) 1,392 (4,357) (16,751) Profit/(loss) for the period 1,181 600 (5,577) (42,805) (46,601) Capital expenditure 3,826 10,640 33,425 (1) 47,890 Intangible, Goodwill and PP&E (as of September 30, 2021) 41,269 140,789 225,324 325 407,707 Allocated assets (as of September 30, 2021) 372,794 532,518 517,773 (311,401) 1,111,684 Allocated liabilities (as of September 30, 2021) 139,798 328,328 438,876 173,464 1,080,466 "Other and eliminations" includes activities of the intermediate holding in Spain (Atento Spain Holdco, S.L.U.), Luxembourg holdings, as well as inter-group transactions between segments. 6. INTANGIBLE ASSETS The following table presents the breakdown of intangible assets between December 31, 2020 and September 30, 2021: Balance at December 31, 2020 Additions Disposals Reclassifications between Intangible and PP&E Translation differences Hyperinflation Adjustments Balance at September 30, 2021 Development 3,101 233 - - (80) 196 3,450 Customer base 243,341 - - - 9,378 3,211 255,930 Software 188,117 2,718 (14,332) 13,324 (16,024) 1,531 175,334 Other intangible assets 56,958 - (1,907) - (24,153) 194 31,092 Work in progress 75 174 (21) - (112) - 116 Total cost 491,592 3,125 (16,260) 13,324 (30,991) 5,132 465,922 Accumulated amortization Development (1,335) (123) - - 163 (195) (1,490) Customer base (172,005) (16,301) 693 - (3,079) (2,932) (193,624) Software (140,858) (17,787) 14,311 - 10,853 (1,053) (134,534) Other intangible assets (45,715) (1,403) 1,908 - 15,708 (194) (29,696) Total accumulated amortization (359,913) (35,614) 16,912 - 23,645 (4,374) (359,344) Impairment (25,037) - - - 1,412 - (23,625) Net intangible assets 106,643 (32,489) 652 13,324 (5,934) 758 82,954 The main changes in intangible assets between the nine-month period ended September 30, 2021 and the year ended the December 31, 2020 are related to amortization of period and the negative impact of exchange variance. 7. GOODWILL Goodwill was mainly generated on December 1, 2012 from the acquisition of the Customer Relationship Management (“CRM”) business from Telefónica, S.A. and on December 30, 2014 from the acquisition of Casa Bahia Contact Center Ltda. (“CBCC”). On September 2, 2016, additional goodwill was generated from the acquisition of RBrasil, and on June 9, 2017 an additional goodwill from the acquisition of Interfile in the amount of 8,400 thousand U.S. dollars was recorded in Brazil. The breakdown and changes in goodwill between December 31, 2020 and September 30, 2021 are as follow: 12/31/2020 Hyperinflation Peru 27,103 - (3,355) 23,748 Chile 16,245 - (1,867) 14,378 Colombia 5,463 - (573) 4,890 Mexico 1,820 - (58) 1,762 Brazil 50,790 - (2,266) 48,524 Argentina 1,593 17,109 (16,858) 1,844 Total 103,014 17,109 (24,977) 95,146 The variations of amounts related to the period ended December 31, 2020 and September 30, 2021 are mainly related to exchange variance of Argentine Peso against the U.S. dollar. 8. PROPERTY, PLANT AND EQUIPMENT (PP&E) The following table presents the breakdown of property, plant and equipment between December 31, 2020 and September 30, 2021: Balance at December 31, 2020 Reclassification to right-of-use assets Additions Disposals Transfers Reclassifications between Intangible and PP&E Translation differences Balance at September 30, 2021 Buildings 15,824 - 48 - (797) - (1,165) - 13,910 Plant and machinery 4,519 - 40 - (1,208) - (88) 23 3,286 Furniture, tools and other tangible assets 315,448 558 4,912 (39,433) 11,298 4,870 (20,673) 5,906 282,886 PP&E under construction 14,070 (9,237) 39,765 (2,041) (10,975) (18,194) (688) - 12,700 Total cost 349,861 (8,679) 44,765 (41,474) (1,682) (13,324) (22,614) 5,929 312,782 Accumulated depreciation Buildings (4,586) - (150) - (2,969) - 281 - (7,424) Plant and machinery (8,265) - (237) 14 4,804 - 579 (24) (3,129) Furniture, tools and other tangible assets (246,122) (423) (17,947) 39,398 (153) - 17,129 (5,521) (213,639) Total accumulated depreciation (258,973) (423) (18,334) 39,412 1,682 - 17,989 (5,545) (224,192) Property, plant and equipment 90,888 (9,102) 26,431 (2,062) - (13,324) (4,625) 384 88,590 The variations of amounts related to the period ended December 31, 2020 and September 30, 2021 are related mainly to the negative impact of exchange variance, due to Brazilian Real and Argentine Peso devaluation against the U.S. dollar. 9. LEASES The Atento Group holds the following right-of-use assets: Net carrying amount of asset 12/31/2020 9/30/2021 Furniture, tools and other tangible assets 9,518 14,714 Buildings 128,324 126,303 Total 137,842 141,017 Leases are shown as follow in the balance sheet between December 31, 2020 and September 30, 2021: Additions/ (Disposals) Reclassification between PPEQ and right-of-use assets Translation difference September 30, 2021 Right-of-use assets 237,651 14,439 8,679 (38,874) 221,895 (-) Accumulated depreciation (99,809) (34,714) 423 53,222 (80,878) Total 137,842 (20,275) 9,102 14,348 141,017 10. Equity As of September 30, 2021, share capital stood at 49 thousand U.S dollars, equivalent to €33,979 (49 thousand U.S. dollars, equivalent to €33,979 as of December 31, 2020), divided into 15,000,000 shares (15,000,000 shares in December 31, 2020). On July 28, 2020, an extraordinary shareholder’s meeting approved the reverse share split of 75,406,357 ordinary shares without nominal value, representing the entire share capital of the Company, into 15,000,000 ordinary shares without nominal value using a ratio of 5.027090466672970, and subsequently amending article 5 of the articles of association of the Company. Mezzanine Partners II Offshore Lux Sarl II, Mezzanine Partners II, Onshore Lux Sarl II, Mezzanine Partners II Institutional Lux Sarl II and Mezzanine Partners II AP LUX SARL II, owns 25.36%; Chesham Investment Pte Ltd. owns 21.85%, and Taheebo Holdings LLC owns 14,87% of ordinary shares of Atento S.A. Share premium The share premium refers to the difference between the subscription price that the shareholders paid for the shares and their nominal value. Since this is a capital reserve, it can only be used to increase capital, offset losses, redeem, reimburse or repurchase shares. On January 2, 2020, the Company vested the total of 1,305,065 TRSUs, issued by treasury shares, with an impact in share premium of 5,842 thousand of U.S. dollars. On January 4, 2021, the Company vested the total of 149,154 TRSUs, issued by treasury shares, and on August 3, 2021, the Company vested the total of 493,871 SOPs, being exercised 92,065 SOPs, issued by treasury shares, with a total impact in share premium of 3,975 thousand of U.S. dollars. In 2020, as a result of the vesting of 1,305,065 TRSUs (corresponding to 259,606 shares of the reserve share split), Atento S.A. had 4,226,592 shares in treasury (corresponding to 840,763 shares of the reserve share split). As of July 28, 2020, Atento S.A. announced a reverse share split that converted the Company’s entire share capital of 75,406,357 into15,000,000 shares. At that time Atento S.A. had 4,771,076 shares on treasury that became 949,073. Considering the reverse share split basis, during 2020, Atento S.A. repurchased 169,739 shares at a cost of 1,337 thousand of U.S. dollars and an average price of $7.87. As of September 30, 2021, Atento S.A. had 850,808 shares in treasury (1,010,502 shares as of December 31, 2020, in the reverse share split basis). According to commercial legislation in Luxembourg, Atento S.A. must transfer 5% of its year profits to legal reserve until the amount reaches 10% of share capital. The legal reserve cannot be distributed. On February 26, 2020, the Board of Directors has proposed the allocation to legal reserve of the amount of sixty-seven with forty-seven cents Euros (EUR 67.47). At July 28, 2020, the Annual Meeting resolves to (i) allocate the amount of EUR 67.47 to the legal reserve of the Company out of the profit of EUR 1,071,315.52 and (ii) to carry forward the remaining amount of the profit to the next financial year. At September 30, 2021, no legal reserve had been established, mainly due to the losses incurred by Atento S.A. Hedge accounting effects The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as hedges of the foreign currency exposure of a net investment in a foreign operation are considered net investment hedges. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting. Certain of the Company’s derivatives are designated as net investment hedges of a portion of the Company’s net investments in consolidated subsidiaries, using the forward method to assess and measure hedge effectiveness. Other of the Company’s derivatives are designated as net investment hedges of a portion of the Company’s net investments in consolidated subsidiaries, using the spot method to assess and measure hedge effectiveness. Net investment hedges are recorded at fair value on the balance sheet, with the effective portion of the derivative’s change in fair value being recorded in Other Comprehensive Income. Certain derivative instruments do not qualify for hedge accounting. Changes in the fair value of any derivative instrument that does not qualify for hedge accounting are recognized immediately in profit or loss and are included in “Change in fair value of financial instruments”. Translation differences Translation differences reflect the differences arising on account of exchange rate fluctuations when converting the net assets of fully consolidated foreign companies from local currency into Atento Group’s presentation currency (U.S. dollars). a) Description of share-based payment arrangements On July 2, 2018, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. The share-based payment had the following arrangements: 1. Time Restricted Stock Units (“RSUs”) (equity settled) • Grant date: July 2, 2018 • Amount: 1,065,220 RSUs • Vesting period: 100% of the RSUs vests on January 4, 2021 • There are no other vesting conditions The 5 Years Plan On March 1, 2019, Atento granted a new share-based payment arrangement to Board directors (a total of 238,663 RSUs) in a one-time award with a five-year vesting period of 20% each year. 1. Time Restricted Stock Units (“RSU”) (equity settled) • Grant date: March 1, 2019 • Amount: 238,663 RSUs • Vesting period: 20% of the RSUs each year beginning on January 2, 2020 and last vested on January 4, 2024 On June 3, 2019, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. The share-based payment had the following arrangements: • Grant date: June 3, 2019 The 2020 Plan – Board and Extraordinary On March 2, 2020, Atento granted a new share-based payment arrangement to Board directors and an Extraordinary Grant for a total in a one-time award with a one-year vesting period. • Amount: 153,846 and 16,722 RSUs The 2020 Plan – Stock Option On August 3, 2020, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. The share-based payment is composed by Stock Options with the following arrangements: 1. Stock Options (“SOP”) • Grant date: August 3, 2020 • Amount: 1,524,065 SOPs • Vesting period: 1/3 each year (August 3, 2021, August 3, 2022 and August 3, 2023) • Expiration date: 4.5 years since the grant date or on February 3, 2025 On August 3, 2020, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. This payment is composed by a Long-Term Performance Award with the following arrangements: 2. Long-Term Performance Award • Amount: USD 4,305,100 • *Matching shares Amount: USD 2,152,550 • Vesting conditions: linked to the degree of achievement of the objective – 3-year average EBITDA margin (external view / as reported) and the possibility to opt to receive part of this incentive in shares – at least 50% (*with a 3-year holding restriction to receive the additional matching shares) The 2020 Plan – Extraordinary SOP On August 3, 2020, Atento granted a new share-based payment arrangement to directors as an Extraordinary Grant for a total in a one-time award with a three-year vesting period. • Amount: 195,000 SOPs • Vesting period: 100% of the SOPs vests on August 3, 2023 As of January 4, 2021, a total of 149,154 TRSUs vested, which is composed of 105,728 RSUs of the 2018 Plan granted on July 2, 2018, 30,604 RSUs of the Board of directors Plan granted on March 2, 2020, 3,327 RSUs of the Extraordinary Plan granted on March 2, 2020 and 9,495 RSUs of the 20% of the 5 Years Plan granted on March 1, 2019. The 2021 Special Grant On January 29, 2021, Atento granted a new share-based payment arrangement to Board directors for a total in a one-time award with a two-year performance conditions vesting period. 1. Performance Restricted Stock Units (“PRSU”) (equity settled) • Grant date: January 29, 2021 • Amount: 121,802 PRSUs • Vesting period: 100% of the PRSUs will vests on 2023 (50% subject to 2021 EBITDA’s achievement targets and 50% subject to 2022 EBITDA´s achievement targets) • There are no other vesting conditions. Board Grant 2021 On February 24, 2021, Atento granted a new share-based payment arrangement to Board directors for a total in a one-time award with a one-year vesting period. • Grant date: February 24, 2021 • Amount: 51,803 RSUs • Vesting period: 100% of the RSUs will vests on January 3, 2022 As of June 9, 2021, was issued a complementary grant of 3,204 new RSUs, linked to a new appointment in the Board. On February 24, 2021, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. The share-based payment is composed by Stock Options with the following arrangements: • Vesting period: 1/3 each year (February 24, 2022, February 24, 2023 and February 26, 2024) • Expiration date: 4.5 years since the grant date or on August 25, 2025 As of September 1, 2021, was issued a new grant of 17,343 SOPs to a new Board member. On February 24, 2021, Atento granted a new share-based payment arrangement to directors, officers and other employees, for the Company and its subsidiaries. This payment is composed by a Long-Term Performance Award with the following arrangements: • *Matching shares Amount: USD 2,704,918.5 As of September 1, 2021, was issued a new amount of USD 137,504 to a new Board member. On August 3, 2021, a total of 493,871 SOPs vested of the 2020 Plan - Stock Option ("SOP"), which represents 1/3 of the Plan. b) Measurement of fair value The fair value of the RSUs, for all arrangements, has been measured using the Black-Scholes model. For all arrangements are equity settled and the fair value of RSUs is measured at grant date and not remeasured subsequently. c) Outstanding RSUs On January 4, 2021, the Company vested the total of 149,154 TRSUs. And on August 3, 2021, a total of 493,871 SOPs vested. The 2018 Plan Time RSU Outstanding December 31, 2020 531,385 Outstanding December 31, 2020 after Reverse Split (**) 105,728 Vested after Reverse Split (**) (105,728) Outstanding September 30, 2021 - The 2019 Plan – 5 Years Time RSU Outstanding December 31, 2020 after Reverse Split (**) 37,981 Vested after Reverse Split (**) (9,495) Forfeited (*) (24,530) Outstanding September 30, 2021 3,956 Outstanding December 31, 2020 2,138,442 Outstanding September 30, 2021 402,776 The 2020 Plan – Board and Extraordinary Time RSU Vested after Reverse Split (**) (33,931) The 2020 Plan – Stock Option SOP Vested (493,871) The 2020 Plan – Performance Award Performance Award (USD) Forfeited (*) (455,000) Outstanding September 30, 2021 3,801,300 The 2020 Plan – Extraordinary SOP SOP Forfeited (*) - The 2021 Special Grant Performance RSU Granted January 29, 2021 121,802 Board Grant 2021 Time RSU Granted February 24, 2021 51,803 Complementary Granted June 9, 2021 3,204 Outstanding September 30, 2021 44,935 Granted February 24, 2021 621,974 Complementary granted September 1, 2021 17,343 Granted February 24, 2021 5,409,837 Complementary granted September 1, 2021 137,504 (*) RSUs are forfeited during the year due to employees failing to satisfy the service conditions. (**) Number of RSUs converted by the ratio of 5.027090466672970. d) Impacts in Profit or Loss In the nine months ended September 30, 2021 8,878 thousand U.S. dollars related to stock-based compensation and the related social charges were recorded as employee benefit expenses. 11. FINANCIAL ASSETS As of December 31, 2020 and September 30, 2021 all the financial assets of the Company are classified as amortized cost, and all Cross Currency Swaps are designated as Net Investment Hedges to the extent they are eligible. Credit risk arises from the possibility that the Atento Group might not recover its financial assets at the amounts recognized and in the established terms. Atento Group Management considers that the carrying amount of financial assets is similar to the fair value. As of September 30, 2021, Atento Teleservicios España S.A., Atento Brasil S.A. and Atento Colombia S.A. have entered into factoring agreements without recourse, anticipating an amount of 132,759 thousand U.S. dollars, receiving cash net of discount, the related trade receivables were realized and interest expenses was recognized in the statement of operations. As of December 31, 2020, Atento Teleservicios España S.A., Atento Chile S.A., Teleatento del Perú S.A.C, Atento Brasil S.A. and Atento Mexico have entered into factoring agreements without recourse, anticipating an amount of 117,295 thousand U.S. dollars, receiving cash net of discount, the related trade receivables were realized and interest expenses was recognized in the statement of operations. Details of other financial assets as of December 31, 2020 and September 30, 2021 are as follow: Other non-current receivables (*) 5,972 6,866 Non-current guarantees and deposits 32,220 29,392 Total non-current 38,192 36,258 Other current receivables 12 13 Current guarantees and deposits 1,146 1,023 Total current 1,158 1,036 Total 39,350 37,282 (*) “Other non-current receivables” as of December 31, 2020 and September 30, 2021 primarily comprise a loan granted by the subsidiary RBrasil to third parties. The effective annual interest rate is CDI + 3.75% p.a., maturity in five years beginning on May 4, 2017, when the value of the loan will be amortized in a single installment. The breakdown of “Trade and other receivables” as of December 31, 2020 and September 30, 2021 is as follows: Non-current trade receivables 8,477 15,361 Other non-financial assets (*) 12,518 15,672 Current trade receivables 274,355 283,467 Other receivables 4,678 1,028 Prepayments 14,698 14,723 Personnel 5,355 5,719 Total current 299,086 304,937 (*) “Other non-financial assets” as of September 30, 2021 primarily comprise tax credits with the Brazilian social security authority (Instituto Nacional do Seguro Social), recorded in Atento Brasil S.A. For the purpose of the interim condensed consolidated financial statements of cash flows, cash and cash equivalents are comprised of the following: Deposits held at call 139,264 99,732 Short-term financial investments 69,730 45,922 “Short-term financial investments” comprises short-term fixed-income securities in Brazil, which mature in less than 90 days and accrue interest pegged to the CDI. 12. FINANCIAL LIABILITIES Details of debt with third parties as of December 31, 2020 and September 30, 2021 are as follow: Senior Secured Notes 493,701 487,873 Bank borrowing 1,420 577 Lease liabilities 99,515 109,754 Total non-current 594,636 598,204 Senior Secured Notes 11,910 5,556 Super Senior Credit Facility 30,038 25,024 Bank borrowing 38,055 22,435 Lease liabilities 53,184 44,560 Total current 133,187 97,575 TOTAL DEBT WITH THIRD PARTIES 727,823 695,779 Senior Secured Notes On August 10, 2017, Atento Luxco 1 S.A., closed an offering of 400,000 thousand U.S. dollars aggregate principal amount of 6.125% Senior Secured Notes due 2022 in a private placement transaction. The notes are due in August 2022. The 2022 Senior Secured Notes are guaranteed on a senior secured basis by certain of Atento’s wholly owned subsidiaries. The issuance costs of 11,979 thousand U.S. dollars related to this new issuance are recorded at amortized cost using the effective interest method. On April 4, 2019, Atento Luxco 1 S.A., closed an offering of an additional $100.0 million in aggregate principal amount of its 6.125% Senior Secured Notes due 2022 (the "Additional Notes"). The Additional Notes were offered as additional notes under the indenture, dated as of August 10, 2017, pursuant to which the Issuer previously issued $400.0 million aggregate principal amount of its 6.125% Senior Secured Notes due 2022 (the "Existing Notes"). The Additional Notes and the Existing Notes are treated as the same series for all purposes under the indenture and collateral agreements, each as amended and supplemented, that govern the Existing Notes and the Additional Notes. On February 10, 2021, Atento Luxco 1 S.A., closed an offering of a $500.0 million aggregate principal amount of 8.0% Senior Secured Notes due February 10, 2026 in a private placement transaction. Atento Luxco 1 used the net proceeds to repurchase all of its 6.125% Senior Secured Notes due 2022. On February 17, 2021, Atento Luxco 1 S.A. purchased 275,815 thousand U.S. dollars of its 6.125% Senior Secured Notes due 2022 in a tender offer. The notes were purchased at a price equal to 1,015.31 U.S. dollars per 1,000 U.S. dollars principal amount. And on February 18, 2021, Atento Luxco 1 S.A. redeemed the remainder 224,185 thousand U.S. dollars of its 6.125% Senior Secured Notes due 2022. The redemption price was equal to 1,015.31 U.S. dollars per 1,000 U.S. dollars principal amount, plus accrued and unpaid interest on the principal amount of the Notes, which was equal to 1,016.67 U.S. dollars per 1,000 U.S. dollars principal amount. With these transactions, the Company completed the refinancing of all 500,000 thousand U.S. dollars aggregate principal amount of its 6.125% Senior Secured Notes due 2022, extending the Company’s average life to 4.5 years from 1.5 years. All interest payments are made on a half yearly basis. The fair value of the Senior Secured Notes, calculated on the basis of their quoted price on September 30, 2021 is 539,942 thousand U.S. dollars. The fair value hierarchy of the Senior Secured Notes is Level 1 as the fair value is based on the quoted market price at the reporting date. The terms of the Indenture governing the 2026 Senior Secured Notes, among other things, limit, in certain circumstances, the ability of Atento Luxco 1 and its restricted subsidiaries to: incur certain additional indebtedness; make certain dividends distributions, investments and other restricted payments; sell the property or assets to another person; incur additional liens; guarantee additional debt; and enter into transaction with affiliates. As of September 30, 2021, we were in compliance with these covenants. The outstanding amount at September 30, 2021 is 493,429 thousand U.S. dollars. Details of the corresponding debt at each reporting date are as follow: Maturity Currency Principal Accrued interests Total debt Principal Accrued interests Total debt 2022 U.S. dollar 493,701 11,910 505,611 - - - 2026 U.S. dollar - - - 487,873 5,556 493,429 Bank borrowings On February 3, 2014, Atento Brasil S.A. entered into a credit agreement with Banco Nacional de Desenvolvimento Econômico e Social - BNDES (“BNDES”) in an aggregate principal amount of 300,000 thousand Brazilian Reais (the “BNDES Credit Facility”), equivalent to 109,700 thousand U.S. dollars as of each disbursement date. The total amount of the BNDES Credit Facility is divided into five tranches subject to the following interest rates: Tranche Interest Rate Tranche A Long-Term Interest Rate (Taxa de Juros de Longo Prazo -TJLP) plus 2.5% per annum Tranche B SELIC Rate plus 2.5% per annum Tranche C 4.0% per year Tranche D 6.0% per year Tranche E Long-Term Interest Rate (Taxa de Juros de Longo Prazo -TJLP) Each tranche intends to finance different purposes, as described below: • Tranche A and B: investments in workstations, infrastructure, technology, services and software development, marketing and commercialization, within the scope of BNDES program – BNDES Prosoft. • Tranche C: IT equipment acquisition, covered by law 8.248/91, with national technology, necessary to execute the project described on tranches “A” and “B”. • Tranche D: acquisitions of domestic machinery and equipment, within the criteria of FINAME, necessary to execute the project described on tranches “A” and “B”. • Tranche E: investments in social projects to be executed by Atento Brasil S.A. BNDES releases amounts under the credit facility once the debtor meets certain requirements in the contract including delivering the guarantee (stand-by letter of credit) and demonstrating the expenditure related to the project. Since the beginning of the credit facility, the following amounts were released: (Thousands of U.S. dollars) Date Tranche A Tranche B Tranche C Tranche D Tranche E Total March 27, 2014 11,100 5,480 7,672 548 - 24,800 April 16, 2014 4,714 2,357 3,300 236 - 10,607 July 16, 2014 - - - - 270 270 August 13, 2014 27,584 3,013 4,430 477 - 35,504 Subtotal 2014 43,398 10,850 15,402 1,261 270 71,181 March 26, 2015 5,753 1,438 2,042 167 - 9,400 April 17, 2015 12,022 3,006 4,266 349 - 19,643 December 21, 2015 7,250 1,807 - - 177 9,234 Subtotal 2015 25,025 6,251 6,308 516 177 38,277 October 27, 2016 - - - - 242 242 Subtotal 2016 - - - - 242 242 Total 68,423 17,101 21,710 1,777 689 109,700 This facility should be repaid in 48 monthly instalments. The first payment was made on March 15, 2016 and the last payment would be due on February 15, 2020, however Atento Brasil S.A. repaid in advance on April 30, 2019 all the outstanding amount. The amount repaid was BRL61.7 million (equivalent to $15.6 million) plus interest accrued and a penalty of BRL 0.7 million (equivalent to $0.2 million). The BNDES Credit Facility contains covenants that restrict Atento Brasil S.A.’s ability to transfer, assign, change or sell the intellectual property rights related to technology and products developed by Atento Brasil S.A. with the proceeds from the BNDES Credit Facility. As of September 30, 2021, Atento Brasil S.A. was in compliance with these covenants. The BNDES Credit Facility does not contain any other financial maintenance covenant. The BNDES Credit Facility contains customary events of default including the following: (i) reduction of the number of employees without providing program support for outplacement, as training, job seeking assistance and obtaining pre-approval of BNDES; (ii) existence of unfavourable court decision against the Company for the use of children as workforce, slavery or any environmental crimes and (iii) inclusion in the by-laws of Atento Brasil S.A. of any provision that restricts Atento Brasil S.A’s ability to comply with its financial obligations under the BNDES Credit Facility. On September 26, 2016, Atento Brasil S.A. entered into a new credit agreement with BNDES in an aggregate principal amount of 22,000 thousand Brazilian Reais, equivalent to 6,808 thousand U.S. dollars as of September 30, 2016. The interest rate of this facility is Long-Term Interest Rate (Taxa de Juros de Longo Prazo - TJLP) plus 2.0% per annum. The facility should be repaid in 48 monthly instalments. The first payment was due on November 15, 2018 and the last payment will be due on October 15, 2022. This facility is intended to finance an energy efficiency project to reduce power consumption by implementing new lightening, air conditioning and automation technology. On November 24, 2017, 6,500 thousand Brazilian Reais (equivalent to 1,993 thousand U.S. dollars as of November 30, 2017) were released under this facility. As of September 30, 2021, the outstanding amount under BNDES Credit Facility was 328 thousand U.S. dollars. The fair value as of September 30, 2021 calculated based on discounted cash flow is 312 thousand U.S. dollars. On August 10, 2017, Atento Luxco 1 S.A. entered into a new Super Senior Revolving Credit Facility (the “Super Senior Revolving Credit Facility”) which provides borrowings capacity of up to 50,000 thousand U.S. dollars and will mature on February 10, 2022. Banco Bilbao Vizcaya Argentaria, S.A., as the agent, the Collateral Agent and BBVA Bancomer, S.A., Institución de Banca Múltiple, Grupo Financiero BBVA Bancomer, Morgan Stanley Bank N.A. and Goldman Sachs Bank USA are acting as arrangers and lenders under the Super Senior Revolving Credit Facility. The Super Senior Revolving Credit Facility may be utilized in the form of multi-currency advances for terms of one, two, three or six months. The Super Senior Revolving Credit Facility bears interest at a rate per annum equal to LIBOR or, for borrowings in euro, EURIBOR or, for borrowings in Mexican Pesos, TIIE plus an opening margin of 4.25% per annum. The margin may be reduced under a margin ratchet to 3.75% per annum by reference to the consolidated senior secured net leverage ratio and the satisfaction of certain other conditions. The terms of the Super Senior Revolving Credit Facility Agreement limit, among other things, the ability of the Issuer and its restricted subsidiaries to (i) incur additional indebtedness or guarantee indebtedness; (ii) create liens or use assets as security in other transactions; (iii) declare or pay dividends, redeem stock or make other distributions to stockholders; (iv) make investments; (v) merge, amalgamate or consolidate, or sell, transfer, lease or dispose of substantially all of the assets of the Issuer and its restricted subsidiaries; (vi) enter into transactions with affiliates; (vii) sell or transfer certain assets; and (viii) agree to certain restrictions on the ability of restricted subsidiaries to make payments to the Issuer and its restricted subsidiaries. These covenants are subject to a number of important conditions, qualifications, exceptions and limitations that are described in the Super Senior Revolving Credit Facility Agreement. The Super Senior Revolving Credit Facility Agreement includes a financial covenant requiring the drawn super senior leverage ratio not to exceed 0.35:1.00 (the “SSRCF Financial Covenant”). The SSRCF Financial Covenant is calculated as the ratio of consolidated drawn super senior facilities debt to consolidated pro forma EBITDA for the twelve month period preceding the relevant quarterly testing date and is tested quarterly on a rolling basis, subject to the Super Senior Revolving Credit Facility being at least 35% drawn (excluding letters of credit (or bank guarantees), ancillary facilities and any related fees or expenses) on the relevant test date. The SSRCF Financial Covenant only acts as a draw stop to new drawings under the Revolving Credit Facility and, if breached, will not trigger a default or an event of default under the Super Senior Revolving Credit Facility Agreement. The Issuer has four equity cure rights in respect of the SSRCF Financial Covenant prior to the termination date of the Super Senior Revolving Credit Facility Agreement, and no more than two cure rights may be exercised in any four consecutive financial quarters. As of September 30, 2021, we were in compliance with this covenant. On October 16, 2017, Atento El Salvador S.A. de C.V. entered into an overdraft credit line agreement with Banco de America Central, S.A. - BAC for an amount of 1,600,000 thousand U.S. dollars, maturing in one year, extendable with simple exchange of letters with an annual interest rate of 8.0% per annum. As of September 30, 2021, the outstanding balance was paid on the due date. On October 14, 2020, Atento El Salvador S.A. de C.V. entered into an overdraft credit line agreement with Inversiones Financieras Banco Agrícola, S.A. for an amount of 1,200,000 thousand U.S. dollars, maturing in one year, extendable with simple exchange of letters with an annual interest rate of 6.5% per annum. As of September 30, 2021, the outstanding balance was paid on the due date. On March 25, 2020, Atento Luxco 1 S.A. withdrew the full amount of 50,000 thousand U.S. dollars maturing on September 21, 2020 with an annual interest rate of Libor + 4.25%. On September 21, 2020, the full amount of 50,000 thousand U.S. dollars was rolled over until December 20, 2020, at the same interest rate. On December 20, 2020, Atento Luxco 1 S.A. repaid 20,000 thousand U.S. dollars and the outstanding 30,000 thousand U.S. dollars as of such date was rolled over until March 22, 2021. On March 22, 2021, the amount of 30,000 thousand U.S. dollars was rolled over until June 21, 2021, at the same interest rate. On June 21, 2021, the amount of 30,000 thousand U.S. dollars was rolled over until September 22, 2021, at the same interest rate. On September 22, 2021, Atento Luxco 1 S.A. repaid 5,000 thousand U.S. dollars and the outstanding 25,000 thousand U.S. dollars as of such date was rolled over until November 22, 2021, at the same interest rate. As of September30, 2021, the outstanding amount under this facility was 25,024 thousand U.S. dollars. On October 14, 2020, Atento Brasil entered into a bank credit certificate with Banco do Brasil for an amount of 30,000 thousand Brazilian Reais, maturing on February 28, 2021 with an annual interest rate of CDI plus 2,127%. On February 28, 2021, Atento Brasil rolled-over the bank credit certificate (cédula de crédito bancário) with Banco do Brasil for an amount of 30,000 thousand Brazilian Reais, until August 28, 2021, with an annual interest rate of CDI plus 2,65%. On August 28, 2021, Atento Brasil rolled-over the bank credit certificate with Banco do Brasil for an amount of 30,000 thousand Brazilian Reais, until Aug 28, 2022, at the same interest rate. As of September 30, 2021, the outstanding balance was 5,553 thousand U.S. dollars. On March 13, 2020, Atento Brasil S.A. entered into a financing agreement with Banco Itaú (“Risco Sacado”) for the annual Microsoft software licenses, for an amount of 24,499 thousand Brazilian Reais, maturing on April 1, 2021, with an annual interest rate of 7.2%. The total outstanding balance was paid on the due date. On April 6, 2020, Atento Brasil S.A. entered into a loan agreement with Banco Santander for an amount of 110,000 thousand Brazilian Reais, maturing on April 06, 2021 with an annual interest rate of CDI plus 4.96% per annum. On July 13, Atento Brasil S.A. made a partial amortization in the amount of 60,000 thousand Brazilian Reais plus accrued interest. The total outstanding balance was paid on the due date. On June 12, 2020, Atento Brasil entered into a financing agreement with Banco De Lage Landen for an amount of 10,000 thousand Brazilian Reais to finance the purchase of Microsoft software licenses, maturing on June 30, 2023 with an annual interest rate of 9.0% per annum. Atento Brasil drew down on the financing agreement on July 01, 2020. The outstanding balance as of September 30, 2021 was 1,287 thousand U.S. dollars. On August 26, 2020, Atento Brasil entered into a bank credit certificate (cédula de crédito bancário) with Banco ABC Brasil for an amount of 50,000 thousand Brazilian Reais, maturing on February 22, 2021 with an annual interest rate of CDI plus 2.70% per annum. On February 22, 2021, Atento Brasil rolled-over the bank credit certificate with Banco ABC Brasil for an amount of 50,000 thousand Brazilian Reais, until February 22, 2022 with an annual interest rate of CDI plus 2.75% per annum. The balance under the loan agreement as of September 30, 2021 was 9,270 thousand U.S. dollars. On December 15, 2020, Atento Brasil entered into a bank credit certificate (cédula de crédito bancário) with Banco ABC Brasil for an amount of 35,000 thousand Brazilian Reais, maturing on June 14, 2021 with an annual interest rate of CDI plus 2.50% per annum. On June 14, 2021, Atento Brasil rolled-over the bank credit certificate with Banco ABC Brasil for an amount of 35,000 thousand Brazilian Reais, until June 9, 2022, at the same interest rate. As of September 30, 2021, the outstanding balance was 6,574 thousand U.S. dollars. Details of derivative financial instruments as of December 31, 2020 and September 30, 2021 are as follow: Assets Liabilities Assets Liabilities Cross currency swaps - net investment hedges 11,088 (5,220) 16,644 (58,357) Total 11,088 (5,220) 16,644 (58,357) Non-current portion 11,088 (5,220) 16,644 (58,357) Atento Luxco1 entered into Cross-Currency Swaps to reduce its foreign exchange risk, since it generates cashflow in local currencies. With these instruments, the company ensures that its cashflow in local currencies is swapped into a fixed dollar amount, the currency used to pay debt obligations, therefore reducing foreign exchange risks. Derivatives held for trading are classified as current assets or current liabilities. The fair value of a hedging derivative is classified as a non-current asset or a non-current liability, as applicable, if the remaining maturity of the hedged item exceeds twelve months. Otherwise, it is classified as a current asset or liability. On April 1, 2015, the Company started a hedge accounting for net investment hedge related to exchange risk between the U.S. dollar and foreign operations in Euro (EUR), Mexican Peso (MXN), Colombian Peso (COP) and Peruvian Nuevo Sol (PEN). In connection with the Refinancing process, 8 of the 10 derivatives contracts designated as Net Investment Hedges were terminated between August 1, 2017 and August 4, 2017, generating positive cash of 46,080 thousand U.S. dollars, net of charges. During August 2017, Atento Luxco 1 also entered into new Cross-Currency Swaps related to exchange risk between U.S. dollars and Euro (EUR), Mexican Peso (MXN), Brazilian Reais (BRL) and Peruvian Nuevo Sol (PEN). Except for the Cross-Currency Swap between U.S. dollars and Brazilian Reais (BRL), all Cross-Currency Swaps were designated for hedge accounting as net investment hedge. On January 1, 2019, the Company designated the Cross-Currency Swap between U.S. dollars and Brazilian Reais for hedge accounting as net investment hedge. Prior to the date of designation of the Cross-Currency Swap, this hedging instrument was electively not designated as a hedge accounting because the change in fair value was intended to partially offset changes in the USD-BRL foreign currency component of the BRL denominated intercompany debt, which were recorded in earnings. Effective January 1, 2019, the intercompany debt was reclassified as “permanent in equity” (which assumes that the related payable is neither planned nor likely to occur in the foreseeable future, since it is in substance, a part of the entity’s net investment in that foreign operation) and, as a consequence, the changes arising from the exchange rate are recorded in other comprehensive income. On January 1, 2020 Atento decided to assign the loan agreement between Atento Luxco 1 and Atento Mexico Holdco as “permanent in equity”, with its maturities to be renewed per indefinite time, since the repayment is neither planned nor likely to occur in the foreseeable future. Therefore, changes related to the USD-MXN exchange rate are now recorded in other comprehensive income. In connection with the new 8.0% Senior Secured Notes due 2026, Atento Luxco 1 S.A. entered into new Cross-Currency Swaps related to exchange rate risk between U.S. dollars and Euro (EUR), Brazilian Reais (BRL) and Peruvian Soles (PEN). The new coupon payments were hedged 70% in USD/BRL, 15% in USD/EUR and 15% in USD/PEN with final maturity on February 10, 2026. The USD/BRL Cross-Currency Swap was structured as Fix-Float, where Atento receives USD at a fixed rate and pays BRL at a floating rate (percentage of CDI). Also, Atento Luxco 1 S.A. hedged 56% of the principal in USD/BRL, 14% in USD/PEN and 10% in USD/EUR, with maturity on February 05, 2024. All previous (coupon-only) cross-currency swaps with maturity in August 2022 were terminated. At September 30, 2021, details of net investment hedges were as follow: Cross-curry swaps - Net Investment Hedges Bank Maturity Purchase currency Selling currency Notional (thousands) Fair value asset/(liability) Other comprehensive income Statements of operations - Change in fair value D/(C) D/(C) D/(C) D/(C) Nomura International Aug-22 USD EUR 34,109 - (482) 28 - Goldman Sachs Aug-22 USD MXN 1,065,060 - (128) 169 (48) Goldman Sachs Aug-22 USD PEN 194,460 - (475) 136 - Goldman Sachs Aug-22 USD BRL 754,440 - (7,007) 840 (1) Santander Jan-20 USD EUR 20,000 - 1,742 - - Santander Jan-20 USD MXN 11,111 - (2,113) - - Goldman Sachs Jan-20 USD EUR 48,000 - 3,587 - - Goldman Sachs Jan-20 USD MXN 40,000 - (7,600) - - Nomura International Jan-20 USD MXN 23,889 - (4,357) - - Nomura International Jan-20 USD EUR 22,000 - 1,620 - - Goldman Sachs Jan-18 USD PEN 13,800 - 22 - - Goldman Sachs Jan-18 USD COP 7,200 - (80) - - BBVA Jan-18 USD PEN 55,200 - 71 - - BBVA Jan-18 USD COP 28,800 - (359) - - Morgan Stanley Aug-22 USD BRL 308,584 - (2,987) 398 - Morgan Stanley Aug-22 USD PEN 66,000 - (158) 43 - Goldman Sachs Aug-22 USD MXN 1,065,060 - 2,229 - - Goldman Sachs Aug-22 USD PEN 194,460 - 2,965 - - Nomura International plc Feb-26 USD EUR 61,526 3,398 (2,739) 2,740 (858) Nomura International plc Feb-26 USD BRL 276,450 (8,588) 1,093 (1,093) 7,214 Nomura International plc Feb-26 USD USD 50,000 (3) - - (167) Morgan Stanley Feb-26 USD BRL 551,350 (18,053) 5,514 (5,514) 11,849 Morgan Stanley Feb-26 USD USD 100,000 517 - - (927) Morgan Stanley Feb-26 USD PEN 277,050 12,730 (9,787) 9,787 (2,771) Goldman Sachs Feb-26 USD BRL 1,101,000 (31,456) 2,416 (2,416) 27,416 Goldman Sachs Feb-26 USD USD 200,000 (258) - - (499) Total (41,713) (17,013) 5,118 41,208 Derivative financial instrument - asset 16,644 Derivative financial instrument - liability (58,357) Gains and losses on net investment hedges accumulated in equity will be taken to the statement of operations when the foreign operation is partially disposed of or sold. Lease liabilities December 31, 2020 Additions/ (Disposals) Payments Interest accrued Interest paid Transfer Translation difference September 30, 2021 Current liabilities 53,184 10,598 (35,746) 10,353 (709) 15,919 (9,039) 44,560 Non-current liabilities 99,515 16,113 - - - (15,919) 10,045 109,754 Total 152,699 26,711 (35,746) 10,353 (709) - 1,006 154,314 The future lease liabilities payments are as follow: 2021 2022 2023 2024 2025 Others Total Lease liabilities payments 13,927 51,494 45,674 30,952 18,490 21,405 181,942 13. PROVISIONS AND CONTINGENCIES Atento has contingent liabilities arising from lawsuits in the normal course of its business. Contingent liabilities with a probable likelihood of loss are recorded as liabilities and the breakdown is as follows: Provisions for liabilities 18,165 16,593 Provisions for taxes 17,971 7,893 Provisions for dismantling 8,379 8,751 Other provisions 1,102 1,069 Provisions for taxes 1,925 159 Provisions for dismantling 24 290 Total current 21,875 24,785 “Provisions for liabilities” primarily relate to provisions for legal claims underway in Brazil. Atento Brasil S.A. has made payments in escrow related to legal claims from ex-employees, amounting to 26,763 thousand U.S. dollars and 22,981 thousand U.S. dollars as of December 31, 2020 and September 30, 2021, respectively. Also, the variation of the period was impacted by the Brazilian Reais and Argentinian Peso depreciations against the U.S. dollar. “Provisions for taxes” mainly relate to probable contingencies in Brazil with respect to social security payments and other taxes, which are subject to interpretations by tax authorities. Atento Brasil S.A. has made payments in escrow related to taxes claims of 2,393 thousand U.S. dollars and 2,306 thousand U.S. dollars as of December 31, 2020 and September 30, 2021, respectively. The amount recognized under “Provision for dismantling” corresponds to the necessary cost of dismantling of the installations held under operating leases to bring them to its original condition. As of September 30, 2021, lawsuits outstanding in the courts were as follow: At September 30, 2021, Atento Brasil was involved in 8,762 labor-related disputes (9,208 labor disputes as of December 31, 2020), being 8,620 of labor massive and 43 of outliers and others, filed by Atento’s employees or ex-employees for various reasons, such as dismissals or claims over employment conditions in general. The total amount of the main claims classified as possible was 32,217 thousand U.S. dollars (33,598 thousand U.S. dollars on December 31, 2020), of which 17,874 thousand U.S. dollars Labor Massive-related, 1,573 thousand U.S. dollars Labor Outliers-related and 12,771 thousand U.S. dollars Special Labor cases related. On September 30, 2021, the subsidiary RBrasil Soluções S.A. holds contingent liabilities of labor nature classified as possible in the amount of 56 thousand U.S. dollars. On September 30, 2021, the subsidiary Interfile holds contingent liabilities of labor nature and social charges classified as possible in the amount of 134 thousand U.S. dollars. As of September 30, 2021, Atento Brasil S.A. is party to 10 civil lawsuits ongoing for various reasons (10 on December 31, 2020) which, according to the Company’s external attorneys, materialization of the risk event is possible. The total amount of the claims is 3,055 thousand U.S. dollars (3,464 thousand U.S. dollars on December 31, 2020). As of September 30, 2021, the subsidiary RBrasil Soluções S.A. holds 21 civil lawsuits ongoing for various reasons classified as possible in the amount of 24 thousand U.S. dollars. On September 30, 2021, the subsidiary Interfile holds 4 civil lawsuits ongoing for various reasons classified as possible in the amount of 70 thousand U.S. dollars. As of September 30, 2021 Atento Brasil is party to 38 disputes ongoing with the tax authorities and social security authorities for various reasons relating to infraction proceedings filed (42 on December 31, 2020) which, according to the Company’s external attorneys, materialization of the risk event is possible. The total amount of these claims is 29,384 thousand U.S. dollars (38,198 thousand U.S. dollars on December 31, 2020). In March 2018, Atento Brasil S.A. an indirect subsidiary of Atento S.A. received a tax notice from the Brazilian Federal Revenue Service, related to Corporate Income Tax (IRPJ) and Social Contribution on Net Income (CSLL) for the period from 2013 to 2015. Tax authorities has challenged the disallowance of the expenses related to goodwill tax amortization, the deductibility of certain financing costs originated by the acquisition of Atento Brasil S.A. by Bain Capital in 2012, and the Withholding Income Tax for the period of 2012 related to payments made to certain of our former shareholders. The amount of the tax assessment from the Brazilian Federal Revenue Service, not including interest and penalties, was 350,542 thousand Brazilian Reais (approximately 66,453 thousand U.S. dollars considering the current currency exchange rate) and was assessed by the Company’s outside legal counsel as possible loss to the merit discussion. Since we disagree with the proposed tax assessment, we are defending our position, which we believe is meritorious, through applicable administrative and, if necessary, judicial remedies. On September 26, 2018 the Federal Tax Office issued a decision accepting the application of the statute of limitation on the withholding tax discussion. We and the Public Attorney appealed to the Administrative Tribunal (CARF). On February 11, 2020 CARF issued a partially favorable decision to Atento, confirming the application of the statute of limitation on the withholding tax discussion and reducing the penalty imposed. On September 18, 2020 the decision issued by CARF regarding the Withholding Income Tax became final (the Public Attorney filed a Special Appeal challenging the penalty reduction and Atento Brasil filed a Special Appeal challenging the goodwill and the financing costs discussion. Both Appeals were not judged yet). Thus, the tax at stake was reduced from 350,542 thousand Brazilian Reais to 230,771 thousand Brazilian Reais (approximately 43,748 thousand U.S. dollars considering the current currency exchange rate). Based on our interpretation of the relevant law and based on the advice of our legal and tax advisors, we believe the position we have taken is sustainable. Consequently, no provisions are recognized regarding these proceedings. Afterward the issuance of the tax notice in March 2018, the Brazilian tax administration started a procedure to audit the Corporate Income Tax (IRPJ) and Social Contribution on Net Income (CSLL) of Atento Brasil S.A. for the period from 2016 to 2017. This tax audit was concluded on July 10, 2020 with the notification of a tax assessment that rejected the deductibility of the above-mentioned financing expenses and the deductibility of the tax amortization of goodwill. The total tax assessment notified by the Brazilian Federal Revenue Service, not including interest and penalties, was 101,604 thousand Brazilian Reais (approximately 19,261 thousand U.S. dollars considering the current currency exchange rate). We disagree with the proposed tax assessment and we are defending our position, which we believe is meritorious, through applicable administrative and, if necessary, judicial remedies. On September 30, 2021, the subsidiaries Interfile and Interservicer hold 19 disputes with the tax authorities and social security authorities ongoing for various reasons classified as possible in the amount of 507 thousand U.S. dollars. At September 30, 2021, Atento Teleservicios España S.A.U. including its branches and our other Spanish companies were party to labor-related disputes filed by Atento employees or former employees for different reasons, such as dismissals and disagreements regarding employment conditions. According to the Company’s external lawyers, materialization of the risk event is possible for 785 thousand U.S. dollars. At September 30, 2021, Atento Mexico through its two entities (Atento Servicios, S.A. de C.V. and Atento Atencion y Servicios, S.A. de C.V.) is a party of labor related disputes filed by Atento employees that abandoned their employment or former employees that base their claim on justified termination reasons, totaling 15,571 thousand U.S. dollars (Atento Servicios, S.A. de C.V. 10,696 thousand U.S. dollars and Atento Atencion y Servicios, S.A. de C.V. 4,875 thousand U.S. dollars), according to the external labor law firm for possible risk labor disputes. 14. INCOME TAX The breakdown of the Atento Group’s income tax expense is as follows: Current tax expense (7,264) (3,872) (16,094) (16,883) Deferred tax 4,620 (2,473) 16,857 1,670 Tax adjustments over previous years 341 (409) (539) (1,538) Total income tax (expense)/benefit (2,303) (6,754) 224 (16,751) For the three months ended September 30, 2021, Atento Group’s interim condensed consolidated financial information presented a loss before income tax in the amount of loss of 4,920 thousand U.S. dollars and an income tax expense of 6,754 thousand U.S. dollars compared to a loss before income tax in the amount of 10,789 thousand U.S. dollars and an income tax expense of 2,303 thousand U.S. dollars for the three months ended September 30, 2020. The increasing of 4,451 thousand U.S. dollars in the income tax expense for the period refers mainly to the income tax result of Atento Brasil which has changed from a tax loss position in 2020 to a profitable tax base in the current fiscal year (3,308 thousand U.S. dollars effect) as well as a 1,336 thousand U.S. dollars amount that relates to the consolidation of deferred tax assets effects in the Spanish entities. For the nine months ended September 30, 2021, Atento Group’s interim condensed consolidated financial information presented a loss before income tax in the amount of 29,850 thousand U.S. dollars and an income tax expense of 16,751 thousand U.S. dollars compared to a loss before income tax in the amount of 39,079 thousand U.S. dollars and an income tax benefit of 224 thousand U.S. dollars for the nine months ended September 30, 2020. As previously mentioned, the income tax expense variation of 16,975 thousand U.S. dollars refers mainly to the income tax result of Atento Brasil which has changed from a tax loss position in 2020 to a profitable tax base in the current fiscal year as well as the consolidation of deferred tax assets effects in the Spanish entities (9,546 thousand U.S. dollars and 4,925 thousand U.S. dollars, respectively). IFRIC 23 Uncertainty over Income Tax Treatment Atento reviewed the tax treatment under the terms of IFRIC 23 in all subsidiaries and as at the reporting date, the Group did not identify any material impact on the financial statements. Atento implemented a process for periodically review the income tax treatments consistent under IFRIC 23 requirements across the group. 15. EARNINGS/(LOSS) PER SHARE Basic earnings/(loss) per share is calculated by dividing the profit/(loss) attributable to equity owners of the Company by the weighted average number of ordinary shares outstanding during the periods as demonstrated below: Result attributable to equity owners of the Company Atento’s loss attributable to equity owners of the parent (in thousands of U.S. dollars) (13,092) (11,674) (38,855) (46,601) Weighted average number of ordinary shares (*) 14,040,360 14,080,509 14,109,041 14,079,695 Basic loss per share (in U.S. dollars) (0.93) (0.83) (2.75) (3.31) (*) As a consequence of the reverse share split occurred on July 28, 2020, weighted average number of ordinary shares was calculated by applying the ratio of conversion of 5.027090466672970 into the previous weighted average number of ordinary shares outstanding. Diluted results per share are calculated by adjusting the weighted average number of ordinary shares outstanding to reflect the conversion of all dilutive ordinary shares. The weighted average number of ordinary shares outstanding used to calculate both basic and diluted net loss per share attributable to common stockholders is the same. The losses in the periods presented are anti-dilutive. Adjusted weighted average number of ordinary shares (*) 14,040,360 14,080,509 14,109,041 14,079,695 Diluted loss per share (in U.S. dollars) (1) (0.93) (0.83) (2.75) (3.31) (1) For the three and nine months ended September 30, 2020 and 2021 potential ordinary shares of 1,515,763 and 10,558,968, respectively, relating to the stock option plan were excluded from the calculation of diluted loss per share as the losses in the period are anti-dilutive. 16. RELATED PARTIES The directors of the Company as of the date on which the interim condensed consolidated financial information were prepared are John Madden, Roberto Rittes, David Garner, Antenor Camargo, Bill Payne, Antonio Viana-Baptista and Carlos López-Abadía. At September 30, 2021, some members of Board of Directors have the right to the stock-based compensation as described in Note 10. Key management personnel Key management personnel include those persons empowered and responsible for planning, directing and controlling the Atento Group’s activities, either directly or indirectly. The following table shows the total remuneration paid to the Atento Group’s key management personnel in the nine months ended September 30, 2020 and 2021: For the nine months ended September 30, Total remuneration paid to key management personnel 3,211 4,102 17. OTHER INFORMATION a. Guarantees and commitments As of September 30, 2021, the Atento Group has guarantees to third parties amounting to 272,230 thousand U.S. dollars (307,403 thousand U.S. dollars at December 31, 2020). 18. SUBSEQUENT EVENTS a) Cyber-security attack As disclosed by press release and in the relevant 6-K, Atento S.A. detected a cyber-security attack on its IT systems in Brazil on Sunday, October 17, 2021. Atento immediately deployed all available cyber security protocols to assess and contain the threat. Atento’s top priority has always been to ensure the protection and integrity of its customers' data and systems. In order to prevent any possible risk to its clients, Atento proactively isolated the impacted systems inside of Atento and also suspended the connections from its systems to those of customers in Brazil. That is what caused the interruption of the service. At this time, all the operations in Brazil have been resumed while investigations are still ongoing. Atento is working closely with its advisors and the relevant authorities to assess the business impact of the incident and take the appropriate measures. PART I - OTHER INFORMATION See Note 13 to the unaudited interim condensed consolidated financial information. There were no material changes to the risk factors described in section “Risk Factors” in our Annual Form 20-F, for the year ended December 31, 2020, other than the information disclosed in the 6-K published as October 22, 2021. Date: November 15, 2021. By: /s/ Carlos López-Abadía Name: Carlos López-Abadía By: /s/ José Antonio de Sousa Azevedo Name: José Antonio de Sousa Azevedo Title: Chief Financial Officer

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professional_accounting

HomeKaplan FinancialKaplan Publishing +44 (0)161 259 7400 Contents [Hide] 1 Chapter 22: MULTIPLE CHOICE QUESTIONS Chapter 22: MULTIPLE CHOICE QUESTIONS Chapter 2: Statement of financial position and income statement (1) Which of the following is the accounting equation AAssets – Liabilities – Capital = Drawings + Profit BAssets = Liabilities – Capital + Profit – Drawings CAssets – Liabilities – Capital = Profit – Drawings DAssets + Liabilities = Capital + Profit – Drawings (2 marks) (2) Which of the following statements is true? AThe income statement illustrates a business’ financial position. BThe income statement includes dividends paid CThe income statement illustrates the business’ financial performance DThe income statement has to show the results for one year (3) What is included in the statement of financial position of a business? ACapital, drawings, assets and liabilities BCapital, dividends paid, sales and assets CAssets, liabilities, profit on disposals of non-current assets and introduced capital DDividends paid, assets, discounts and liabilities (4) Which of the following is incorrect? AThe statement of financial position and income statement form part of the financial statements of a business BThe statement of financial position illustrates the accounting equation CThe income statement illustrates the accounting equation DThe statement of financial position and income statement illustrate the financial position and performance of the business (5) Which statement is not true? AInventory is shown on the income statement and in the statement of financial position BExpenses should be included on the income statement CInventory should be included on the statement of financial position only DReceivables are included in current assets on the statement of financial position Chapter 3: Double entry bookkeeping (6) Which of the following is correct? (7) A credit balance on a ledger account indicates: Aan asset or an expense Ba liability or an expense Can amount owing to the organisation Da liability or revenue (8) The double entry system of bookkeeping normally results in which of the following balances on the ledger accounts? (9) The main aim of accounting is to: Amaintain ledger accounts for every asset and liability Bprovide financial information to users of such information Cproduce a trial balance Drecord every financial transaction individually (10) A Debit entry could lead to: Aan increase in assets or a decrease in expenses Ban increase in sales or an increase in liabilities Ca decrease in sales or a decrease in assets Da decrease in liabilities or an increase in expenses (11) A credit entry could lead to: Aan increase in assets or increase in liabilities Ban increase in expense or an increase in share capital Can increase in liabilities or an increase in share capital Dan increase in liabilities and a decrease in sales Chapter 4: Inventory (12) Tracey’s business sells three products – A, B and C. The following information was available at the year-end: The value of inventory at the year-end should be: B$670 D$550 (13) An inventory record card shows the following details: What is the value of inventory at 31 January using the FIFO method? D$1,000 (14) What would be the effect on a business’ profit, which has been calculated including inventory at cost, of discovering that one of its inventory items which cost $7,500 has a net realisable value of $8,500? Aan increase of $8,500 Ban increase of $1,000 Cno effect at all Da decrease of $1,000 (15) According to IAS 2 Inventories, which of the following costs should be included in valuing the inventories of a manufacturing company? (1)Carriage outwards (2)Depreciation of factory plant (3)Carriage inwards (4)General administrative overheads AAll four items B1, 3 and 4 only C1 and 2 only D2 and 3 only (16) The closing inventory of X amounted to $116,400 excluding the following two inventory lines: 400 items which had cost $4 each. All were sold after the statement of financial position date for $3 each, with selling expenses of $200 for the batch. 200 different items which had cost $30 each. These items were found to be defective at the statement of financial position date. Rectification work after the statement of financial position amounted to $1,200, after which they were sold for $35 each, with selling expenses totalling $300. Which of the following total figures should appear in the statement of financial position of X for inventory? A$122,300 B$121,900 C$122,900 D$123,300 Chapter 5: Sales tax (17) All the sales of Gail, a retailer, were made at a price inclusive of sales tax at the standard rate of 17.5% and all purchases and expenses bore sales tax at the standard rate. For the three months ended 31 March 2005 gross sales were $23,500, purchases were $12,000 (net) and expenses $800 (net). How much is due to the tax authority for the quarter? B$1,400 (18) The sales account is: Acredited with the total of sales made, including sales tax Bcredited with the total of sales made, excluding sales tax Cdebited with the total of sales made, including sales tax Ddebited with the total of sales made, excluding sales tax (19) If sales (including sales tax) amounted to $27,612.50 and purchases (excluding sales tax) amounted to $18,000, the balance on the sales tax account, assuming all items are subject to sales tax at 17.5%, would be: A$962.50 debit B$962.50 credit C$1,682.10 debit D$1,682.10 credit (20) A business commenced with capital in cash of $1,000. Inventory costing $800 net of sales tax at 17.5% is purchased on credit. Half of this inventory is then sold for $1,000 plus sales tax, the customer paying promptly in cash. The accounting equation after these transactions would show: Aassets $1,775 less liabilities $175 equals capital $1,600 Bassets $2,775 less liabilities $975 equals capital $1,200 Cassets $2,575 less liabilities $800 equals capital $1,775 Dassets $2,575 less liabilities $975 equals capital $1,600 Chapter 6: Accruals and prepayments (21) The electricity account for the year ended 30 April 2005 was as follows: Which of the following is the appropriate entry for electricity? (22) The year end of Lansdown is 31 December. The company pays for its electricity by a standing order of $100 per month. On 1 January 2005 the statement from the electricity supplier showed that the company had overpaid by $25. Lansdown received electricity bills for the four quarters starting on 1 January 2005 and ending on 31 December 2005 for $350, $375, $275 and $300 respectively. Which of the following is the correct entry for electricity in Lansdown’s income statement and statement of financial position for the year ending 31 December 2005? (23) At 1 January 2005, Michael had a prepayment of $200 in respect of rent. He paid $1,200 on 1 March 2005 in respect of the year ended 28 February 2006 What is the charge to the income statement in respect of rent for the year ended 31 December 2005? A $1,400 B $1,200 C $1,100 D $1,300 (24) At 31 December 2003, Tony had accrued $240 in respect of light and heat for the quarter ending 31 December 2003. In January 2004 he discovered that he had under-accrued by $10. The bills for the next four quarters were as follows (q.e. = quarter ended): Tony always accrues for expenses based on the last bill. What is the charge to the income statement in respect of light and heat for the 15-month period ended 31 March 2005? C $930 D $920 (25) Stationery paid for during the year amounted to $1,350. At the beginning of the year there was an inventory of stationery on hand of $165 and an outstanding stationery invoice for $80. At the end of the year there was an inventory of stationery on hand of $140 and an outstanding stationery invoice for $70. The stationery figure to be shown in the income statement for the year is: Chapter 7: Irrecoverable debts and allowances for receivables (26) At 30 April 2005, Gareth has a receivables balance of $50,000 and an allowance for receivables of $800. Following a review of receivables, Gareth wishes to write off an irrecoverable debt of $1,000 and adjust his allowance to 5% of receivables. What will be the adjusted balance of the allowance for receivables? (27) As at 31 March, Phil had receivables of $82,500. Following a review of receivables, Phil has decided to write off the following irrecoverable debts: Phil would like to provide against a specific debt of $250 and based on past experience, make a general allowance at 2% of receivables. The current balance on the allowance for receivables account is $2,000. Phil also received $300 from a debt that had been previously been written off. What is the charge to the income statement in respect of irrecoverable debt expense and the entry on the statement of financial position for net receivables at 31 March? (28) At the start of the year Joe had an allowance of $700 against receivables. During the year $450 of this amount went bad and $150 was received; the balance remained unpaid at the year end. Another amount of $170 went bad. At the year-end it was decided to provide for a new debt of $240. What was the total irrecoverable debt expense for the year? A $170 B $260 (29) Doris currently has a receivables balance of $47,800 and an allowance for receivables of $1,250. She has received $150 in respect of half of a debt that she had provided against. She now believes the other half of the debt to be bad and wishes to write it off. She also wishes to maintain her allowance at 2% receivables. What is the total charge to the income statement in respect of these items? A $150 debit B $150 credit C $300 debit D $300 credit (30) At the year end, Harold has a receivables balance of $100,000 and an allowance for receivables of $5,000. He has not yet accounted for a receipt of $500 in respect of a debt which he had previously provided against or a receipt of $1,000 in respect of a debt which had been written off in the previous year. Harold wishes to maintain his allowance for receivables at 7% of receivables. What balances will be shown in his statement of financial position at the year-end for receivables and the allowance for receivables? (31) James has been advised that one of his customers has ceased trading and that it is almost certain that he will not recover the balance of $720 owed by this customer. What entry should James make in his general ledger? (32) Gordon’s receivables owe a total of $80,000 at the year end. These include $900 of long-overdue debts that might still be recoverable, but for which Gordon has created an allowance for receivables. Gordon has also provided an allowance of $1,582, which is the equivalent of 2% of the other receivables’ balances. What best describes Gordon’s allowance for receivables as at his year end? A a specific allowance of $900 and an additional allowance of $1,582 based on past history B a specific allowance of $1,582 and an additional allowance of $900 based on past history C a specific allowance of $2,482 D a general allowance of $2,482 Chapter 8: Noncurrent assets (33) At 1 January 2005, Mary has motor vehicles which cost $15,000. On 31 August 2005 she sells a motor vehicle for $5,000 which had originally cost $8,000 and which had a NBV of $4,000 at the date of disposal. She purchased a new motor vehicle which cost $10,000 on 30 November 2005. Her policy is to depreciate motor vehicles at a rate of 25% pa on the straight-line basis, based on the number of months’ ownership. What is the depreciation charge for the year ended 31 December 2005? (34) Which of the following best explains what is meant by ‘capital expenditure’? Aexpenditure on non-current assets, including repairs and maintenance Bexpenditure on expensive assets Cexpenditure relating to the issue of share capital Dexpenditure relating to the acquisition or improvement of noncurrent assets (35) A non-current asset was purchased at the beginning of Year 1 for $2,400 and depreciated by 20% pa by the reducing-balance method. At the beginning of Year 4 it was sold for $1,200. The result of this was: A a loss on disposal of $240.00 B a loss on disposal of $28.80 C a profit on disposal of $28.80 D a profit on disposal of $240.00 (36) Giles bought a new machine from abroad. The machine cost $100,000 and delivery and installation costs were $7,000. Testing it amounted to $5,000. Training employees on how to use the machine cost of $1,000. What should be the cost of the machine in the company’s statement of financial position? A $100,000 B $107,000 C $112,000 D $113,000 (37) Joseph’s machinery cost account showed a balance of $5,000 at 1 January 2005. During the year he had the following transactions: Joseph depreciates machines at a rate of 10% pa on the straight-line basis based on the number of months’ ownership. What is the depreciation charge in respect of machinery for the year ended 31 December 2005? (38) B acquired a lorry on 1 May 20X0 at a cost of $30,000. The lorry has an estimated useful life of four years, and an estimated resale value at the end of that time of $6,000. B charges depreciation on the straight-line basis, with a proportionate charge in the period of acquisition. What will the depreciation charge for the lorry be in B’s ten-month accounting period to 30 September 20X0? Chapter 9: From trial balance to financial statements The following is the extract of Jessie’s trial balance as at 31 December 2005: The following notes are provided: (i) Buildings are depreciated at 2% pa on a straight-line basis. (ii) Plant and machinery is depreciated at 25% pa on a reducing balance basis. (iii)Additional irrecoverable debts of $3,200 were discovered at the year end. It has been decided to make an allowance for receivables of 5% on the adjusted receivables at the year end. (iv)The monthly rental charge is $3,000. (v)The insurance charge for the year is $24,000. Using the above information attempt the following questions. (39) The depreciation charge for buildings for the year and the net book value (NBV) at the year-end will be: (40) The depreciation charge for plant and machinery for the year and the NBV at the year-end will be: (41) The total irrecoverable debt expense for the year and the closing net receivable balance will be: (42) What is the charge for rent and insurance for the year and the closing accrual and prepayment? Chapter 10: Books of prime entry and control accounts (43) Which of the following is not the purpose of a receivables ledger control account? A A receivables ledger control account provides a check on the arithmetic accuracy of the personal ledger B A receivables ledger control account helps to locate errors in the trial balance C A receivables ledger control account ensures that there are no errors in the personal ledger D Control accounts deter fraud (44) Which one of the following is a book of prime entry and part of the double-entry system? A the journal B the petty cash book C the sales day book D the purchase ledger (45) On 1 January 2005 the balance of receivables was $22,000. Calculate the closing receivables after taking the following into consideration: A $30,000 B $23,000 C $12,000 D $28,000 Chapter 11: Control account reconciliations (46) A receivables ledger control account had a closing balance of $8,500. It contained a contra to the purchase ledger of $400, but this had been entered on the wrong side of the control account. The correct balance on the control account should be: A $7,700 debit B $8,100 debit C $8,400 debit D $8,900 debit (47) The receivables ledger control account at 1 May had balances of $32,750 debit and $1,275 credit. During May sales of $125,000 were made on credit. Receipts from receivables amounted to $122,500 and cash discounts of $550 were allowed. Refunds of $1,300 were made to customers. The closing credit balance is $2,000. The closing debit balances at 31 May should be: (48) A supplier sends you a statement showing a balance outstanding of $14,350. Your own records show a balance outstanding of $14,500. The reason for this difference could be that: A The supplier sent an invoice for $150 which you have not yet received B The supplier has allowed you $150 cash discount which you had omitted to enter in your ledgers C You have paid the supplier $150 which he has not yet accounted for D You have returned goods worth $150 which the supplier has not yet accounted for (49) A credit balance of $917 brought forward on Y’s account in the books of X means that: A X owes Y $917 B Y owes X $917 C X has paid Y $917 D X is owed $917 by Y (50) In a receivables ledger control account, which of the following lists is composed only of items which would appear on the credit side of the account? A Cash received from customers, sales returns, irrecoverable debts written off, contras against amounts due to suppliers in the accounts payable ledger B Sales, cash refunds to customers, irrecoverable debts written off, discounts allowed C Cash received from customers, discounts allowed, interest charged on overdue accounts, irrecoverable debts written off D Sales, cash refunds to customers, interest charged on overdue accounts, contras against amounts due to suppliers in the accounts payable ledger Chapter 12: Bank reconciliations (51) The following information relates to a bank reconciliation. (i)The bank balance in the cash book before taking the items below into account was $5,670 overdrawn. (ii)Bank charges of $250 on the bank statement have not been entered in the cash book. (iii)The bank has credited the account in error with $40 which belongs to another customer. (iv)Cheque payments totalling $325 have been correctly entered in the cash book but have not been presented for payment. (v)Cheques totalling $545 have been correctly entered on the debit side of the cash book but have not been paid in at the bank. What was the balance as shown by the bank statement before taking the items above into account? A $5,670 overdrawn B $5,600 overdrawn C $5,740 overdrawn D $6,100 overdrawn (52) At 31 August 2005 the balance on the company’s cash book was $3,600 credit. Examination of the bank statements revealed the following: Standing orders amounting to $180 had not been recorded in the cash book. Cheques paid to suppliers of $1,420 did not appear on the bank statements. What was the balance on the bank statement at 31 August 2005? (53) An organisation’s cash book has an operating balance of $485 credit. The following transactions then took place: cash sales $1,450 including sales tax of $150 receipts from customers of debts of $2,400 payments to payables of debts of $1,800 less 5% cash discount dishonoured cheques from customers amounting to $250. The resulting balance in the bank column of the cash book should be: C $1,905 credit D $2,375 credit (54) The cash book shows a bank balance of $5,675 overdrawn at 31 March 2005. It is subsequently discovered that a standing order for $125 has been entered twice and that a dishonoured cheque for $450 has been debited in the cash book instead of credited. The correct bank balance should be: (55) The attempt below at a bank reconciliation statement has been prepared by Q Limited. Assuming the bank statement balance of $38,600 to be correct, what should the cash book balance be? A $76,500 overdrawn, as stated C $700 overdrawn D $5,900 cash at bank (56) After checking a business cash book against the bank statement, which of the following items could require an entry in the cash book? (1)Bank charges (2)A cheque from a customer which was dishonoured (3)Cheque not presented (4)Deposits not credited (5)Credit transfer entered in bank statement (6)Standing order entered in bank statement. A 1, 2, 5 and 6 B 3 and 4 C 1, 3, 4 and 6 D 3, 4, 5 and 6 Chapter 13: Correction of errors and suspense accounts (57) Faulty goods costing $210 were returned to a supplier but this was recorded as $120 in the ledger accounts. What is the journal entry necessary to correct the error? (58) A suspense account was opened when a trial balance failed to agree. The following errors were later discovered: a gas bill of $420 had been recorded in the gas account as $240 discount of $50 given to a customer had been credited to discounts received interest received of $70 had been entered in the bank account only. The original balance on the suspense account was: A debit $210 B credit $210 C debit $160 D credit $160 (59) Molly starts up in business as a florist on 1 April 2004. For the first six months, she has a draft profit of $12,355. On investigation you discover the following: Rent paid for the 12 months ending 31 March 2005 of $800 has not been recorded in the accounts. Closing inventory in the accounts at a cost of $1,000 has a net realisable value of $800. What is the adjusted profit for the period? (60) In an accounting system where individual receivables and payables ledger accounts are maintained as an integral part of the double entry, which of the following errors will not be identified by a trial balance? A overcasting of the sales day book B undercasting of the analysed cash book C failure to transfer a non-current asset to the disposal account when sold D transposition error in an individual receivables account (61) A trial balance has been extracted and a suspense account opened. One error relates to the misposting of an amount of $400, being discount received from suppliers, which was posted to the wrong side of the discount received account What is the correcting journal entry? (62) A company, Y, purchased some plant on 1 January 20X0 for $38,000. The payment for the plant was correctly entered in the cash book but was entered on the debit side of plant repairs account. Y charges depreciation on the straight-line basis at 20% pa, with a proportionate charge in the year of acquisition and assuming no scrap value at the end of the life of the asset. How will Y’s profit for the year ended 31 March 20X0 be affected by the error? A Understated by $30,400 B Understated by $36,100 C Understated by $38,000 D Overstated by $1,900 (63) The trial balance of Z failed to agree, the totals being: A suspense account was opened for the amount of the difference and the following errors were found and corrected: (i)The totals of the cash discount columns in the cash book had not been posted to the discount accounts. The figures were discount allowed $3,900 and discount received $5,100. (ii)A cheque for $19,000 received from a customer was correctly entered in the cash book but was posted to the customer’s account as $9,100. What will the remaining balance on the suspense account be after the correction of these errors? A $25,300 credit B $7,700 credit C $27,700 credit (64) The trial balance of C did not agree, and a suspense account was opened for the difference. Checking in the bookkeeping system revealed a number of errors. (1)$4,600 paid for motor van repairs was correctly treated in the cash book but was credited to motor vehicles asset account. (2)$360 received from B, a customer, was credited in error to the account of BB. (3)$9,500 paid for rent was debited to the rent account as $5,900. (4)The total of the discount allowed column in the cash book had been debited in error to the discounts received account. (5)No entries had been made to record a cash sale of $100. Which of the errors above would require an entry to the suspense account as part of the process of correcting them? A 3 and 4 C 2 and 5 D 2 and 3 Chapter 14: Incomplete records (65) Ashley started a business on 1 January 2005. He acquired the following assets: He also opened a business bank account and paid in $4,000. At the end of the first year of trading, he had the following: He had drawn $1,000 in cash during the period. What was Ashley’s profit or loss for the year? A $140 loss B $140 profit C $1,860 loss D $1,860 profit (66) George started a business by investing $10,000 into a business bank account. At the end of his first year’s trading he had earned a profit of $5,000 and had the following assets and liabilities: During the year he had withdrawn $2,000 from the business. How much further capital had he introduced in the year? (67) If Harry’s mark-up on cost of sales is 15%, what is his gross profit margin? A 12.5% B 13.04% C 15% D 17.65% (68) A sole trader had opening capital of $10,000 and closing capital of $4,500. During the period the owner introduced capital of $4,000 and withdrew $8,000 for her own use. Her profit or loss during the period was: A $9,500 loss B $1,500 loss C $7,500 profit D $17,500 profit (69) From the following information, calculate the value of purchases: (70) Carol owns a shop. The only information available for the year ended 31 December 2005 is as follows: What were the purchases of the shop for the year? (71) The following information is relevant to the calculation of the sales figure for Alpha, a sole trader who does not keep proper accounting records: The figure which should appear in Alpha’s income statement for sales is: (72) A sole trader who does not keep full accounting records wishes to calculate her sales revenue for the year. The information available is: Which of the following is the sales revenue figure for the year calculated from these figures? (73) A business compiling its accounts for the year to 31 January each year pays rent quarterly in advance on 1 January, 1 April, 1 July and 1 October each year. After remaining unchanged for some years, the rent was increased from $24,000 per year to $30,000 per year as from 1 July 20X0. Which of the following figures is the rent expense which should appear in the income statement for the year ended 31 January 20X1? (74) On 31 December 20X0 the inventory of V was completely destroyed by fire. The following information is available: (1)Inventory at 1 December 20X0 at cost $28,400. (2)Purchases for December 20X0 $49,600. (3)Sales for December 20X0 $64,800. (4)Standard gross profit percentage on sales revenue 30%. Based on this information, which of the following is the amount of inventory destroyed? Chapter 15: Company accounts (75) Geese’s trial balance shows an overprovision in respect of income tax for the year ended 31 December 2004 of $5,000. Geese estimates that tax liability in respect of the year ended 31 December 2005 will be $23,000. What is the tax charge in Geese’s income statement and the statement of financial position entry for the year ended 31 December 2005? (76) The correct journal entry to record the issue of 100,000 50c shares (fully paid) at an issue price of $2.50 a share is: (77) A company has the following share capital: In addition to providing for the year’s preference dividend, an ordinary dividend of 2c per share is to be paid. What are total dividends for the year? (78) Revenue reserves are: A accumulated and undistributed profits of a company B amounts which cannot be distributed as dividends C amounts set aside out of profits to replace revenue items D amounts set aside out of profits for a specific purpose (79) On 1 April 2004 the balance on B’s accumulated profit account was $50,000 credit. The balance on 31 March 2005 was $100,000 credit. On 10 March 2005 dividends of $50,000 were declared in respect of the year ended 31 March 2005, payable on 31 May 2005. Based on this information, profit after tax (but before dividends) for the year ended 31 March 2005 was: A Nil Chapter 16: Accounting standards (80) Jackson’s year end is 31 December 2005. In February 2006 a major credit customer went into liquidation and the directors believe that they will not be able to recover the $450,000 owed to them. How should this item be treated in the financial statements of Jackson for the year ended 31 December 2005? A The irrecoverable debt should be disclosed by note B The financial statements are not affected C The debt should be provided against D The financial statements should be adjusted to reflect the irrecoverable debt (81) A former employee is claiming compensation of $50,000 from Harriot, a limited liability company. The company’s solicitors have stated that they believe that the claim is unlikely to succeed. The legal costs relating to the claim are likely to be in the region of $5,000 and will be incurred regardless of whether or not the claim is successful. How should these items be treated in the financial statements of Harriot Ltd? A Provision should be made for $55,000 B Provision should be made for $50,000 and the legal costs should be disclosed by note C Provision should be made for $5,000 and the compensation of $50,000 should be disclosed by note D No provisions should be made but both items should be disclosed by note (82) Cowper has spent $20,000 researching new cleaning chemicals in the year ended 31 December 2005. It has also spent $40,000 developing a new cleaning product which will not go into commercial production until next year. The development project meets the criteria laid down in IAS 38. How should these costs be treated in the financial statements of Cowper for the year ended 31 December 2005? A $60,000 should be capitalised as an intangible asset on the statement of financial position B $40,000 should be capitalised as an intangible asset and should be amortised; $20,000 should be written off to the income statement C $40,000 should be capitalised as an intangible asset and should not be amortised; $20,000 should be written off to the income statement D $60,000 should be written off to the income statement (83) The directors of ABC estimated that inventory which had cost $50,000 had a net realisable value of $40,000 at 30 June 2005 and recorded it in the financial statements for the year ended 30 June 2005 at this lower value in accordance with IAS 2. They have since found out that the net realisable value of the inventory is only likely to be $30,000. What adjustments, if any, should be made in the financial statements in respect of this inventory? A No adjustments required B Increase the value of inventory by $10,000 C Decrease the value of inventory by $10,000 D Decrease the value of inventory by $20,000 (84) Which of the following items are non-adjusting items per IAS 10? (a)the issue of new share or loan capital (b)financial consequences of losses of non-current assets or inventory as a result of fires or floods (c)information regarding the value of inventory sold at less than cost thus resulting in a reduction in the value of inventory (d)mergers and acquisitions (e)bankruptcy of a credit customer. A (a), (b) and (d) B (c) and (e) C (a), (d) and (e) D (b), (c) and (e) (85) Which of the following correctly describes how research and development expenditure should be treated in accordance with IAS 38? A Research and development expenditure must be written off to the income statement as incurred B Research and development expenditure should be capitalised as an intangible asset on the statement of financial position C Research expenditure should be written off to the income statement; development expenditure must be capitalised as an intangible asset provided that certain criteria are met D Research expenditure should be capitalised as an intangible asset provided that certain criteria are met; development expenditure should be written off to the income statement (86) Who issues International Financial Reporting Standards? A The Auditing Practices Board B The Stock Exchange C The International Accounting Standards Board D The government (87) Which of the following statements concerning the accounting treatment of research and development expenditure are true, according to IAS 38 Intangible Assets? (1)If certain criteria are met, research expenditure may be recognised as an asset. (2)Research expenditure, other than capital expenditure on research facilities, should be recognised as an expense as incurred. (3)In deciding whether development expenditure qualifies to be recognised as an asset, it is necessary to consider whether there will be adequate finance available to complete the project. (4)Development expenditure recognised as an asset must be amortised over a period not exceeding five years. (5)The financial statements should disclose the total amount of research and development expenditure recognised as an expense during the period. A 1, 4 and 5 B 2, 4 and 5 C 2, 3 and 4 D 2, 3 and 5 (88) IAS10 Events after the reporting period regulates the extent to which events after the reporting period date should be reflected in financial statements. Which of the following lists of such events consists only of items that, according to IAS10 should normally be classified as non-adjusting? A Insolvency of a debtor whose account receivable was outstanding at the statement of financial position date, issue of shares or loan notes, a major merger with another company B Issue of shares or loan notes, changes in foreign exchange rates, major purchases of non-current assets C A major merger with another company, destruction of a major non-current asset by fire, discovery of fraud or error which shows that the financial statements were incorrect D Sale of inventory giving evidence about its value at the statement of financial position date, issue of shares or loan notes, destruction of a major non-current asset by fire Chapter 17: Statement of cash flows (89) In the year ended 31 December 2005, Lamb bought new vehicles from Warwick Motors with a list price of $100,000 for $70,000 cash and an allowance against old motor vehicles of $30,000. The value of the vehicles taken in part exchange was $27,000. Lamb sold other vehicles with a net book value of $12,000 for $15,000 cash. In Lamb’s statement of cash flow for the year ended 31 December 2005, how would the above transactions be presented under the heading ‘Investing activities’? (90) Baldrick has the following balances in its statement of financial position as at 30 June 2004 and 30 June 2005: In the year ended 30 June 2005 taxation of $550 was paid. The additional loan notes were issued on 30 June 2005. What is the operating profit of Baldrick for the year ended 30 June 2005? (91) At 31 December 2004, Topaz had provided $50,000 in respect of income tax. At 31 December 2005, the company estimated that its income tax bill in respect of the year would be $57,000. The amount charged in the income statement for the year ended 31 December 2005 in respect of income tax was $60,000. How much will appear in the statement of cash flows for the year ended 31 December 2005 in respect of income tax? (92) Evans had the following balances in its statement of financial positions as at 30 June 2004 and 2005: How much will appear in the cash flow statement for the year ended 30 June 2005 under the heading of ‘Financing activities’? A $nil B $10,000 inflow C $30,000 inflow D $40,000 inflow The following information relates to Questions 93 and 94. Scents had the following balances in its statement of financial positions as at 30 September 2004 and 2005: (93) How much will appear in the statement of cash flows for the year ended 30 September 2005 for the loan interest and preference dividend paid? (94) How much will appear in the statement of cash flows for the year ended 30 September 2005 for the ordinary dividend paid? (95) IAS 7 Statement of cash flows requires the statement of cash flows prepared using the indirect method to include the calculation of net cash from operating activities. Which of the following lists consists only of items which could appear in such a calculation? A Depreciation, increase in receivables, decrease in payables, proceeds of sale of plant B Increase in payables, decrease in inventories, profit on sale of plant, depreciation C Increase in payables, depreciation, decrease in receivables, proceeds of sale of plant D Depreciation, interest paid, equity dividends paid, purchase of plant Chapter 18: Consolidated statement of financial position (96) At the 1 January 20X2 Y acquired 75% of the share capital of Z for $400,000. At that date the share capital of Z consisted of 600,000 ordinary shares of 50c each and its reserves were $50,000. The fair value of NCI at the date of acquisition was $100,000. In the consolidated statement of financial position of Y and its subsidiary Z at 31 December 20X6, what amount should appear for goodwill? (97) Skinny acquired 75% of the share capital Coltart for $35,000 on the 1 January 20X4. Details of the share capital and reserves of Skinny and Coltart at 31 December 20X6 are as follows: At the date of acquisition Coltart had reserves of $10,000. What figure should appear in the consolidated statement of financial position of Skinny and its subsidiary Coltart for reserves as at 31 December 20X6? (98) Austen acquired 60% of the share capital of Dicken for $300,000 on 1 January 20X5. Details of the share capital and reserves of Austen and Dickens at 31 December 20X6 are as follows: At the date of acquisition Dickens had reserves of $60,000. The fair value of NCI at acquisition was $80,000. What figure should appear in the consolidated statement of financial position of Austen and its subsidiary Dickens for reserves as at 31 December 20X6? (99) At the 1 January 20X5 Purves acquired 80% of the share capital of Trollope for $100,000. At that date the share capital of Trollope consisted of 50,000 $1 shares and reserves of $30,000. At the 31 December 20X6 the reserves of Purves and Trollope were as follows: The fair value of NCI at acquisition was $75,000. What figure should appear in the consolidated statement of financial position of Purves and its subsidiary Trollope, for non- controlling interest? (100) At the 1 January 20X3 Y acquired 80% of the share capital of Z for $750,000. At that date the share capital of Z consisted of 600,000 ordinary shares of $1 each and its reserves were $50,000. The fair value of non-controlling interest was valued at $150,000. Chapter 19: Consolidated income statement (101) X owns 60% of the equity share capital of Y and 40% of the equity share capital of Z. The income statement of the three entities showed the following turnover for the year ended 31 August 20X7: During the year X sold goods to Y and Z for $2 million and $1 million respectively. All goods were sold on to third parties by Y and Z by the end of the year. How much will be included in the consolidated income statement of the X group for Turnover for the year ended 31 August 20X7? A $24m B $21m C $22m D $28m (102) Sat is the sole subsidiary of Shindo. The cost of sales figures for 20X1 for Sat and Shindo were $11 million and $10 million respectively. During 20X1 Shindo sold goods which had cost $2 million to Sat for $3 million. Sat has not yet sold any of these goods. What is the consolidated cost of sales figure for 20X1? A $16 million B $18 million C $19 million D $20 million (103) Crunchy Co acquired 70% of the ordinary share capital of Nut Co six years ago. The following information relates to Nut Co for the year ended 30 June 20X3: What is the profit attributable to the non-controlling interest in the consolidated income statement? (104) K Co acquired 60% of the ordinary share capital of Special Co five years ago. The following information relates to Special Co for the year ended 30 September 20X3: What is the profit attributable tot the non-controlling interest in the consolidated income statement? (105) P Ltd acquired 60% of the ordinary shares of S Ltd several years ago when the reserves of S stood at $980. In the year ended 31 July 20X7 P sold goods to S costing $500 for $600.(20% mark up on cost). At the year end half of these goods still remained in inventory. What will be the provision for unrealised profit adjustment for the year ended 31 July 20X7, for the P group? A Deduct $500 from the cost of sales B Deduct $50 from the cost of sales C Add $50 to the cost of sales D Add $100 to the cost of sales (106) Which of the following statements regarding the method of consolidation is true? (1)Subsidiaries are equity accounted (2)Associates are consolidated in full A Neither statement B Statement 1 only C Both statements D Statement 2 only (107) Which of the following statements rare true? (1)An associated undertaking is when a parent has control over the associate (2)Associates are equity accounted (3)Subsidiaries are consolidated in full (4)An associate is a non-controlling interest A all of the above B Statement 2 and 3 only C None of the above Chapter 20: Interpretation of financial statements The following information relates to question 108 and 109. (108) What is the return on capital employed for the years 20X5 and 20X6? (109) What is the total gearing for the years 20X5 and 20X6? (110) From the following information regarding the year to 31 August 20X6, what is the payables payment period? A 41 days B 48 days C 54 days D 57 days (111) From the following information regardinng the year to 31 March 20X6, what are the current and quick ratios? (112) Sale are $260,000. Purchases are $150,000. Opening inventory is $22,000. Closing inventory is $26,000. What is the inventory turnover? A 6.1 times B 10 times C 7 times D 10.8 times Chapter 21: The regulatory and conceptual framework (113) When preparing financial statements under historic cost accounting in periods of inflation, directors: A must reduce asset values B must increase asset values C must reduce dividends D need make no adjustments (114) If the owner of a business takes goods from inventory for his own personal use, the accounting concept to be considered is the: A relevance concept B capitalisation concept C money measurement concept D separate entity concept (115) A ‘true and fair view’ is one which: A presents the accounts in such a way as to exclude errors which would affect the actions of those reading them B occurs when the accounts have been audited C shows the accounts of an organisation in an understandable format D shows the assets on the statement of financial position at their current market price (116) Which concept is followed when a business records the cost of a non-current asset even though it does not legally own it? A substance over form B prudence C accruals D going concern (117) The IASB Framework for the Preparation and Presentation of Financial Statements gives five characteristics that make financial information reliable. These five characteristics are: A prudence, consistency, understandability, faithful representation, substance over form B accruals basis, going concern concept, consistency, prudence, true and fair view C faithful representation, neutrality, substance over form, completeness, consistency, faithful and free D free from material error, prudence, faithful representation, neutrality, completeness (118) The accounting concept or convention which, in times of rising prices, tends to understate asset values and overstate profits, is the: A going concern concept B prudence concept C realisation concept D historical cost concept Created at 8/24/2012 11:22 AM by System Account (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London Last modified at 8/24/2012 11:23 AM by System Account (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London Ratings & Comments (Click the stars to rate the page) There are no items to show in this view. 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VIKING ENERGY GROUP, INC. - FORM 10-Q - May 16, 2011 EX-32.1 - VIKING ENERGY GROUP, INC. v222458_ex32-1.htm For the quarterly period ended: March 31, 2011 For the transition period from ______________ to _______________ SINOCUBATE, INC. (State or other jurisdiction of incorporation or (IRS Employer Identification No.) organization) 65 Broadway, 7 th Floor Issuer’s telephone number (Former name, former address and former fiscal year, if changed since last report) Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Non Accelerated Filer Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes ¨ No ¨ Not Applicable The number of shares of common stock outstanding as of March 31, 2011 was 995,655. SINOCUBATE INC. (A Development Stage Company) PART I – FINANCIAL INFORMATION Balance Sheets (Unaudited) Statement of Operations and Comprehensive Loss (Unaudited) Statement of Cash Flows (Unaudited) Statement of Stockholders' Deficiency (Unaudited) F-5 – F-6 Notes to Financial Statements (Unaudited) F-7 – F-11 PART II – OTHER INFORMATION SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (Amounts expressed in US dollars) (audited) LIABILITIES AND STOCKHOLDERS’ DEFICIENCY Capital stock Preferred stock, $0.001 par value, 5,000,000 shares authorized, no shares issued or outstanding as of March 31, 2011 Common stock, $0.001 par value, 100,000,000 shares authorized 995,655 shares issued and outstanding as of March 31, 2011 Deficit accumulated during the development stage STATEMENT OF OPERATIONS AND COMPREHENSIVE LOSS (Date of Inception Stage) to Interest on notes payable Management and consultant fees Loss before other items Loss on disposition of equipment Write-down of intangible assets Write-off of payables Write-off of notes payable Gain on settlement of lawsuit Gain on sale of investment Operating loss from discontinued operations Gain on sales of discontinued operations Basic and diluted income (loss) per Common share – continuing operations (0.002 – discontinued operations – total Weighted average number of common share outstanding – basic and diluted Foreign currency translation adjustment The accompanying notes are an integral part of these financial statements (Date of Inception of the $ (2,000 ) $ (4,000 ) $ (1,057,405 ) — — 27,387 Accrued interest on notes payable Accrued expenses and service costs assumed by majority shareholder 2,000 4,000 104,508 Foreign exchange effect on notes payable — — 5,303 Issuance of common stock for services — — 225,184 — — (73,607 ) — — (108,121 ) Gain on sale of investments Changes in non-cash working capital items: Cash used in continuing operations Proceeds from sale of subsidiary — — 1 Proceeds from assets disposition — — (5,808 ) Settlement of notes payable Effect of exchange rate changes on cash Cash, beginning of period Cash, ending of period $ — $ — $ — STATEMENT OF STOCKHOLDERS’ DEFICIENCY Paid-in May 3, 1989 (Inception) through December 31, 1997 Shares issued for cash Share issued for services Subscription receivable Share issued for intangible assets Shares issued for settlement of debt Subscription received Stock option benefit Repurchase of common stock for treasury Cancellation of agreement Share issues for cash on exercise of options Share issues for consulting services Share issues for intangible assets Share issued for software Shares issued for cash on exercise of options Share issued for debt Share issued for consulting services Share issues for debt Discount on notes payable Issuance of new shares Cancellation of shares Services assumed by majority stockholder Change in par value of common share from $0.01 per share to $0.001 per share Balance at December 31, 2008 (audited) Balance at March 31, 2011 (Unaudited) ) $ Interim Financial Statements The foregoing unaudited interim financial statements have been prepared in accordance with generally accepted accounting principles or GAAP for interim financial information and with the instructions to Form 10-Q as promulgated by the Securities and Exchange Commission or the SEC. Accordingly, these financial statements do not include all of the disclosures required by generally accepted accounting principles for complete financial statements. The accompanying unaudited financial statements and related notes should be read in conjunction with the audited financial statements and the Form 10-K of the Company for the year ended December 31, 2010. In the opinion of management, the unaudited interim financial statements furnished herein include all adjustments, all of which are of a normal recurring nature, necessary for a fair statement of the results for the interim period presented. The results of operations for such periods are not necessarily indicative of the results expected for a full year or for any future period. Nature of Business and Going Concern Assumption Since November 2008, the Company has sought to enter into contractual arrangements with entities that allows the Company to either purchase outright the assets and/or business operations of such entities or to enter into business arrangements, such as joint ventures or similar combinations with such entities to manage and operate such entities. The Company is a development stage company as defined by the Financial Accounting Standards Board Accounting Standards Codification, or FASB ASC 915, “Development Stage Entities.” The Company was incorporated under the laws of the State of Florida on May 3, 1989 as Sparta Ventures Corp. and remained inactive until June 27, 1998. The name of the Company was changed to Thermal Ablation Technologies Corporation on October 8, 1998 and then to Poker.com, Inc. on August 10, 1999. On September 15, 2003, the Company changed its name to LegalPlay Entertainment Inc. and on November 8, 2006, the name of the Company was changed to Synthenol Inc. Effective November 3, 2008, the Company merged with and into a wholly-owned subsidiary, SinoCubate, Inc., which remained the surviving entity of the merger. SinoCubate was formed in the State of Nevada on September 11, 2008. The merger resulted in a change of name of the Company from Synthenol Inc. to SinoCubate, Inc. and a change in the state of incorporation of the Company from Florida to Nevada. On December 19, 2009, Viking Investments, LLC, an entity controlled and managed by Tom Simeo, the Company’s chairman, chief executive officer and president, announced a strategic partnership with Viking, whereby Viking, in exchange for a fee, and SinoCubate will work together and assist various business entities in the Peoples Republic of China or the PRC in their endeavors to become publicly listed companies in the United States. In connection with the strategic agreement, the Company was to newly issue 4,750,000 shares of the Company’s common stock to Viking in exchange for One Hundred Thousand (100,000) shares of common stock of Renhuang Pharmaceuticals, Inc. or Renhuang owned by Viking, and newly issue 15,000,000 shares of the Company’s common stock to Viking in exchange for entry into the strategic partnership agreement. In connection with the foregoing transactions, Philip Wan and Yung Kong Chin were appointed directors and officers of the Company and were each granted warrants to purchase 50,000 shares of common stock of the Company at an exercise price of $0.26 per share exercisable in whole or in part at any time during the 3 years after issuance. Effective, March 26, 2010, the parties elected to terminate the strategic partnership agreement and the directors and officers appointed thereby, Messrs. Wan and Chin, resigned as directors and officers of the Company and agreed not to exercise their warrants to purchase the Company’s shares. The Company has subsequently cancelled the warrants. No shares were issued to Viking and neither the Company nor Viking has monetary or other demand on the other related to the cancellation. The Company’s ability to continue as a going concern is dependent upon its ability to generate future profitable operations and/or to obtain the necessary financing to meet its obligations and repay its liabilities arising from normal business operations when they come due. Management has no formal plan in place to address this concern but considers that the Company will be able to obtain additional funds by equity financing and/or related party advances; however there is no assurance of additional funding being available. As of the date of this Report, the Company has not entered into an agreement with any entity and there can be no assurance that the Company will ever be able to identify and enter into an agreement with an entity or whether, if the Company successful enters into an agreement with a suitable entity, such combination may become successful and/or profitable. The financial statements of the Company have been prepared in accordance with GAAP and are expressed in U.S. dollars. The Company’s fiscal year-end is December 31. The preparation of financial statements in conformity with GAAP requires management to make certain estimates and assumptions that affect the reported amounts and timing of revenues and expenses, the reported amounts and classification of assets and liabilities, and disclosure of contingent assets and liabilities. The Company’s actual results could vary materially from management’s estimates and assumptions. Significant areas requiring the use of management estimates relate to the determination expected tax rates for future income tax recoveries and the warrants. Other Comprehensive Income FASB ASC 220 “Comprehensive Income,” establishes standards for the reporting and display of comprehensive income and its components in the financial statements. For the three months ended March, 2011 and 2010, comprehensive loss was ($2,000) and $(4,000), respectively. The Company accounts for income taxes under FASB Codification Topic 740-10-25 (“ASC 740-10-25”). Under ASC 740-10-25, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under ASC 740-10-25, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets likely. The Company did not incur any material impact to its financial condition or results of operations due to the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company is subject to U.S federal jurisdiction income tax examinations for the tax years 2006 through 2009. In addition, the Company is subject to state and local income tax examinations for the tax years 2006 through 2009. The Company may issue stock options to employees and stock options or warrants to non-employees in non-capital raising transactions for services and for financing costs. The Company has adopted ASC Topic 718 (formerly SFAS 123R), “Accounting for Stock-Based Compensation”, which establishes a fair value method of accounting for stock-based compensation plans. In accordance with guidance now incorporated in ASC Topic 718, the cost of stock options and warrants issued to employees and non-employees is measured on the grant date based on the fair value. The fair value is determined using the Black-Scholes option pricing model. The resulting amount is charged to expense on the straight-line basis over the period in which the Company expects to receive the benefit, which is generally the vesting period. The fair value of stock warrants was determined at the date of grant using the Black-Scholes option pricing model. The Black-Scholes option model requires management to make various estimates and assumptions, including expected term, expected volatility, risk-free rate, and dividend yield. The expected term represents the period of time that stock-based compensation awards granted are expected to be outstanding and is estimated based on considerations including the vesting period, contractual term and anticipated employee exercise patterns. Expected volatility is based on the historical volatility of the Company’s stock. The risk-free rate is based on the U.S. Treasury yield curve in relation to the contractual life of stock-based compensation instrument. The dividend yield assumption is based on historical patterns and future expectations for the Company dividends. Assumption used to estimate the fair value of stock warrants on the granted date are as follows: Issuance Date Risk-free rate Expected term (years) The stock warrants granted during 2009 were exercisable immediately, the fair value on the grant date using the Black-Scholes option pricing model was $24,020, and have been recorded as compensation costs. The Company did not issue any stock options or warrants during 2010 and in 2010, the Company cancelled all warrants issued in 2009. In June 2009, the FASB issued Topic 105, which became the source of authoritative GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date of this Topic, the Codification will supersede all then-existing non-SEC accounting and reporting standards. All other non-SEC accounting literature not included in the Codification will become non-authoritative. This Topic identifies the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements of nongovernmental entities that are presented in conformity with GAAP and arranged these sources of GAAP in a hierarchy for users to apply accordingly. This Topic is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of this topic did not have a material impact on the Company’s disclosure of the financial statements. In January 2010, the FASB issued an amendment to ASC 820, Fair Value Measurements and Disclosure, to require reporting entities to separately disclose the amounts and business rationale for significant transfers in and out of Level 1 and Level 2 fair value measurements and separately present information regarding purchase, sale, issuance, and settlement of Level 3 fair value measures on a gross basis. This standard, for which the Company is currently assessing the impact, is effective for interim and annual reporting periods beginning after December 15, 2009 with the exception of disclosures regarding the purchase, sale, issuance, and settlement of Level 3 fair value measures which are effective for fiscal years beginning after December 15, 2010. The adoption of this standard is not expected to have a significant impact on the Company’s financial statements. In February 2010, the FASB issued ASU No. 2010-09 “Subsequent Events (ASC Topic 855) “Amendments to Certain Recognition and Disclosure Requirements” (“ASU No. 2010-09”). ASU No. 2010-09 requires an entity that is an SEC filer to evaluate subsequent events through the date that the financial statements are issued and removes the requirement for an SEC filer to disclose a date, in both issued and revised financial statements, through which the filer had evaluated subsequent events. The adoption of this standard did not have an impact on the Company’s financial statements. In September 2009, FASB amended ASC 605, as summarized in ASU 2009-13, Revenue Recognition: Multiple-Deliverable Revenue Arrangements. As summarized in ASU 2009-13, ASC Topic 605 has been amended: (1) to provide updated guidance on whether multiple deliverables exist, how the deliverables in an arrangement should be separated, and the consideration allocated; (2) to require an entity to allocate revenue in an arrangement using estimated selling prices of deliverables if a vendor does not have VSOE or third-party evidence of selling price; and (3) to eliminate the use of the residual method and require an entity to allocate revenue using the relative selling price method. The accounting changes in ASU 2009-13 are both effective for fiscal years beginning on or after June 15, 2010, with early adoption permitted. Adoption may either be on a prospective basis or by retrospective application. The Company is currently evaluating the potential impact that the adoption of this statement will have on its financial position and results from operations and will adopt the provision of this statement in fiscal 2011. In February 2010, the FASB Accounting Standards Update 2010-10 (ASU 2010-10), “Consolidation (Topic 810): Amendments for Certain Investment Funds.” The amendments in this Update are effective as of the beginning of a reporting entity’s first annual period that begins after November 15, 2009 and for interim periods within that first reporting period. Early application is not permitted. The Company’s adoption of provisions of ASU 2010-10 did not have a material effect on the financial position, results of operations or cash flows. In April 2010, the FASB issued ASU 2010-17, Revenue Recognition - Milestone Method (Topic 605): Milestone Method of Revenue Recognition. This ASU codifies the consensus reached in EITF Issue No. 08-9, “Milestone Method of Revenue Recognition.” The amendments to the Codification provide guidance on defining a milestone and determining when it may be appropriate to apply the milestone method of revenue recognition for research or development transactions. Consideration that is contingent on achievement of a milestone in its entirety may be recognized as revenue in the period in which the milestone is achieved only if the milestone is judged to meet certain criteria to be considered substantive. Milestones should be considered substantive in their entirety and may not be bifurcated. An arrangement may contain both substantive and nonsubstantive milestones, and each milestone should be evaluated individually to determine if it is substantive. ASU 2010-17 is effective on a prospective basis for milestones achieved in fiscal years, and interim periods within those years, beginning on or after June 15, 2010. Early adoption is permitted. If a vendor elects early adoption and the period of adoption is not the beginning of the entity’s fiscal year, the entity should apply 2010-17 retrospectively from the beginning of the year of adoption. Vendors may also elect to adopt the amendments in this ASU retrospectively for all prior periods. The Company does not expect the provisions of ASU 2010-17 to have a material effect on the financial position, results of operations or cash flows of the Company In April 2010, the FASB issued ASU 2010-18, Receivables (Topic 310): Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset, codifies the consensus reached in EITF Issue No. 09-I, “Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset.” The amendments to the Codification provide that modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. ASU 2010-18 does not affect the accounting for loans under the scope of Subtopic 310-30 that are not accounted for within pools. Loans accounted for individually under Subtopic 310-30 continue to be subject to the troubled debt restructuring accounting provisions within Subtopic 310-40. ASU 2010-18 is effective prospectively for modifications of loans accounted for within pools under Subtopic 310-30 occurring in the first interim or annual period ending on or after July 15, 2010. Early application is permitted. Upon initial adoption of ASU 2010-18, an entity may make a one-time election to terminate accounting for loans as a pool under Subtopic 310-30. This election may be applied on a pool-by-pool basis and does not preclude an entity from applying pool accounting to subsequent acquisitions of loans with credit deterioration. The Company does not expect the provisions of ASU 2010-18 to have a material effect on the financial position, results of operations or cash flows of the Company. On April 3, 2009, the Company entered into an agreement with Viking, providing that effective August 15, 2008, Viking will pay for any services performed on behalf of the Company by third parties until such time that Viking is no longer the majority shareholder of the Company. For the quarter ended March 31, 2011, Viking assumed professional and other service fee in the aggregate amount of $2,000 on its own. For the quarter ended March 31, 2010, Viking assumed professional and other service fee in the aggregate amount of $4,000 on its own. On December 19, 2009, the Company announced a strategic partnership with Viking, whereby Viking, in exchange for a fee, and SinoCubate will work together and assist various business entities in the Peoples Republic of China or the PRC in their endeavors to become publicly listed companies in the United States. In connection with the strategic agreement, the Company was to newly issue 4,750,000 shares of the Company’s common stock to Viking in exchange for One Hundred Thousand (100,000) shares of common stock of Renhuang Pharmaceutical, Inc. or Renhuang owned by Viking, and newly issue 15,000,000 shares of the Company’s common stock to Viking in exchange for entry into the strategic partnership agreement. In connection with the foregoing transactions, Philip Wan and Yung Kong Chin were appointed directors and officers of the Company and were each granted warrants to purchase 50,000 shares of common stock of the Company at an exercise price of $0.26 per share exercisable in whole or in part at any time during the 3 years after issuance. Effective, March 26, 2010, the parties elected to terminate the strategic partnership agreement and the directors and officers appointed thereby, Messrs. Wan and Chin, resigned as directors and officers of the Company and agreed not to exercise their warrants to purchase the Company’s shares. The Company has subsequently cancelled the warrants. No shares were issued to Viking and neither the Company nor Viking has monetary or other demand on the other related to the cancellation. Supplemental Cash Flow Information (Date of Inception the Development stage) to Cash paid for: Income taxes (recovery) Common shares issued to settle notes payable Expenses assumed by principal stockholders On April 1, 2008, the Company entered into an agreement with an unrelated third party, Ryerson Corporation A.V.V. or Ryerson, to sell all the issued and outstanding shares of its wholly-owned subsidiaries, 564448 BC Ltd. or 564448 and Casino Marketing S.A. or CMSA for consideration of $1. All inter-company debts between CMSA, 564448 and the Company were cancelled. As part of the agreement, Ryerson also assumed all of the liabilities of CMSA and 564448. As such, the Company recognized a gain on the disposition of the subsidiaries. Proceeds Liabilities assumed by purchaser of Casino Marketing S.A. as of April 1, 2008 Liabilities assumed by purchaser of 564448 BC Ltd. as of April 1, 2008 Termination of agreement Effective, March 26, 2010, the parties elected to terminate the strategic partnership agreement and the directors and officers appointed thereby, Messrs. Wan and Chin, resigned as directors and officers of the Company and agreed not to exercise their warrants to purchase the Company’s shares. The Company has subsequently cancelled the warrants. No shares were issued to Viking and neither the Company nor Viking has monetary or other demand on the other related to the cancellation. In preparing the management’s discussion and analysis, the registrant presumes that you have read or have access to the discussion and analysis for the preceding fiscal year. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS This document includes “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 or the Reform Act. All statements other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, including, but not limited to, any projections of earning, revenue or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new services or developments; any statements regarding future economic conditions of performance; and statements of belief; and any statements of assumptions underlying any of the foregoing. Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: our ability to raise capital and the terms thereof; ability to gain an adequate player base to generate the expected revenue; competition with established gaming websites; adverse changes in government regulations or polices; and other factors referenced in this Form 10-Q. The use in this Form 10-Q of such words as “believes”, “plans”, “anticipates”, “expects”, “intends”, and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements. These forward-looking statements present the Company’s estimates and assumptions only as of the date of this Report. Except for the Company’songoing obligation to disclose material information as required by the federal securities laws, the Company does not intend, and undertakes no obligation, to update any forward-looking statements. Although the Company believes that the expectations reflected in any of the forward-looking statements are reasonable, actual results could differ materially from those projected or assumed or any of the Company’s forward-looking statements. The Company’s future financial condition and results of operations, as well as any forward-looking statements, are subject to change and inherent risks and uncertainties. PLAN OF OPERATIONS The Company’s current business plan is to seek, investigate, and, if warranted, enter into contractual arrangements with entities that enables the Company to either purchase outright the assets and and/or business operations of such entities or to enter into business arrangements, such as joint ventures or similar combinations with such entities to manage and operate such entities as affiliated entities of the Company. As of the date of this Report, the Company has not entered into an agreement with any such entity and there can be no assurance that the Company will ever be able to identify and enter into an agreement with an entity or whether, if the Company successful enters into an agreement with an entity, such combination may become successful and/or profitable. The Company is in immediate need of further working capital and options are being explored with respect to financing in the form of debt, equity or a combination thereof. Investigation and Selection of Business Opportunities To a large extent, a decision to participate in a specific contractual arrangement may be made upon the principal shareholders’analysis of the quality of the other company’s management and personnel, the anticipated acceptability of new products or marketing concepts, the merit of technological changes, the perceived benefit the Company will derive from entering into such an arrangement, and numerous other factors which are difficult, if not impossible, to analyze through the application of any objective criteria. In many instances, it is anticipated that the historical operations of a specific business opportunity may not necessarily be indicative of the potential for the future because of the possible need to access capital, shift marketing approaches substantially, expand significantly, change product emphasis, change or substantially augment management, or make other changes. The Company will be dependent upon the owners of a business opportunity to identify any such problems which may exist and to implement, or be primarily responsible for the implementation of, required changes. Because the Company may participate in a business opportunity with a newly organized firm or with a firm which is entering a new phase of growth, it should be emphasized that the Company will incur further risks, because management in many instances will not have proved its abilities or effectiveness, the eventual market for such company’s products or services will likely not be established, and such company may not be profitable when acquired. It is emphasized that the Company may effect transactions having a potentially adverse impact upon the Company’s shareholders pursuant to the authority and discretion of the Company’s management and board of directors without submitting any proposal to the stockholders for their consideration. Holders of the Company’s securities should not anticipate that the Company will necessarily furnish such holders, prior to any contractual arrangement or combination, with financial statements, or any other documentation, concerning a target company or its business. In some instances, however, a proposed arrangement may be submitted to the stockholders for their consideration, either voluntarily by such directors to seek the stockholders’ advice and consent or because federal and/or state law so requires. The Company is unable to predict when it may participate in a business opportunity. Prior to making a decision to participate in a business opportunity, the Company will generally request that it be provided with written materials regarding the business opportunity containing such items as a description of products, services and company history; management resumes; financial information; available projections, with related assumptions upon which they are based; an explanation of proprietary products and services; evidence of existing patents, trademarks, or services marks, or rights thereto; present and proposed forms of compensation to management; a description of transactions between such company and its affiliates during relevant periods; a description of present and required facilities; an analysis of risks and competitive conditions; a financial plan of operation and estimated capital requirements; audited financial statements, or if they are not available, unaudited financial statements, together with reasonable assurances that audited financial statements would be able to be produced within a reasonable period of time following completion of a merger transaction; and other information deemed relevant. As part of the Company’s investigation, the Company’s officers may meet personally with management and key personnel of the target entity, may visit and inspect material facilities, obtain independent analysis or verification of certain information provided, check references of management and key personnel, and take other reasonable investigative measures, to the extent allowed by the Company’s limited financial resources. There are no loan arrangements or arrangements for any financing whatsoever relating to any business opportunities is currently available. Going Concern Qualification RESULTS OF CONTINUING OPERATIONS The following discussion of the financial condition and results of operation of the Company should be read in conjunction with the Financial Statements and the related Notes included elsewhere in this Report. Three months ended March 31, 2011 compared to the three months ended March 31, 2010 Liquidity and Capital Resources At March 31, 2011 and March 31, 2010, the Company had no cash holding or working capital. The Company is in immediate need of further working capital and options may be considered with respect to financing in the form of debt, equity or a combination thereof. The ability of the Company to continue as a going concern and fund its operations through the remainder of 2011 is contingent upon being able to raise funds through either equity or debt financing or a combination of both. The Company had no net sales at March 31, 2011 or March 31, 2010. The operating expenses decreased by $2,000 to $2,000 in the three months period ended March 31, 2011 from $4,000 in the corresponding period in 2010. The decrease was mainly due to lower consulting fees for the Company’s quarterly filings with the SEC. The Company incurred a net loss of $2,000 at March 31, 2011 compared with net loss of $4,000 at March 31, 2010. The decrease in net loss was mainly due to less consulting fees in the current three months period ended March 31, 2011 compared to the same period of 2010. The Company has adopted various accounting policies that govern the application of accounting principles generally accepted in the United States of America in the preparation of the Company’s financial statements which requires it to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Although these estimates are based on management’s knowledge of current events and actions the Company may undertake in the future, the final results may ultimately differ from actual results. Certain accounting policies involve significant judgments and assumptions, which have a material impact on the Company’s financial condition and results. Management believes its critical accounting policies reflect its most significant estimates and assumptions used in the presentation of the Company’s financial statements. The Company’s critical accounting policies include debt management and accounting for stock-based compensation. The Company does not have off-balance sheet arrangements, financings, or other relationships with unconsolidated entities or other persons, also known as “special purpose entities” As a smaller reporting company as defined by Rule 12b-2 of the Securities Exchange Act of 1934, the Company is not required to provide the information under this item. Disclosure Controls and Procedures The Company does not currently maintain controls and procedures that are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act are recorded, processed, summarized, and reported within the time periods specified by the Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to provide reasonable assurance that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Under the supervision and with the participation of management, including the Company’s Chief Executive Officer, the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2010 have been evaluated, and, based upon this evaluation, the Company’s Chief Executive Officer has concluded that these controls and procedures are effective in providing reasonable assurance of compliance. Management and directors will continue to monitor and evaluate the effectiveness of the Company's internal controls and procedures and the Company's internal controls over financial reporting on an ongoing basis and are committed to taking further action and implementing additional enhancements or improvements, as necessary and as funds allow. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer and Chief Financial Officer Certificate of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350 /s/ Tom Simeo Tom Simeo Chief Executive Officer, Treasurer Director and Secretary Stock widget Quote for SBAT.OB/ Investing forum VIKING ENERGY GROUP, INC. Reports

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professional_accounting

PENN NATIONAL GAMING INC (Mark One) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2011 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number: 0-24206 PENN NATIONAL GAMING, INC. 825 Berkshire Blvd., Suite 200 (Former name, former address, and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act: Large accelerated filer x Accelerated filer o Non-accelerated filer o Smaller reporting company o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. Outstanding as of October 27, 2011 Common Stock, par value $.01 per share 78,233,972 (includes 431,017 shares of restricted stock) This report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results may vary materially from expectations. Although Penn National Gaming, Inc. and its subsidiaries (collectively, the “Company”) believe that our expectations are based on reasonable assumptions within the bounds of our knowledge of our business and operations, there can be no assurance that actual results will not differ materially from our expectations. Meaningful factors that could cause actual results to differ from expectations include, but are not limited to, risks related to the following: our ability to receive, or delays in obtaining, the regulatory approvals required to own, develop and/or operate our facilities, or other delays or impediments to completing our planned acquisitions or projects, including favorable resolution of any related litigation; our ability to secure state and local permits and approvals necessary for construction; construction factors, including delays, unexpected remediation costs, local opposition and increased cost of labor and materials; the passage of state, federal or local legislation (including referenda) that would expand, restrict, further tax, prevent or negatively impact operations in or adjacent to the jurisdictions in which we do business (such as a smoking ban at any of our facilities) or in jurisdictions where we seek to do business; the effects of local and national economic, credit, capital market, housing, and energy conditions on the economy in general and on the gaming and lodging industries in particular; the activities of our competitors and the emergence of new competitors; increases in the effective rate of taxation at any of our properties or at the corporate level; our ability to recover proceeds on significant insurance claims; our ability to identify attractive acquisition and development opportunities and to agree to terms with partners for such transactions; the costs and risks involved in the pursuit of such opportunities and our ability to complete the acquisition or development of, and achieve the expected returns from, such opportunities; our expectations for the continued availability and cost of capital; the maintenance of agreements with our horsemen, pari-mutuel clerks and other organized labor groups; the outcome of pending legal proceedings; changes in accounting standards; our dependence on key personnel; the impact of terrorism and other international hostilities; the impact of weather; and other factors as discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, subsequent Quarterly Reports on Form 10-Q and Current Reports on Form 8-K as filed with the United States Securities and Exchange Commission. The Company does not intend to update publicly any forward-looking statements except as required by law. PENN NATIONAL GAMING, INC. AND SUBSIDIARIES PART I. ITEM 1. Condensed Consolidated Balance Sheets — September 30, 2011 and December 31, 2010 Condensed Consolidated Statements of Income — Three and Nine Months Ended September 30, 2011 and 2010 Condensed Consolidated Statements of Changes in Shareholders’ Equity — Nine Months Ended September 30, 2011 and 2010 Condensed Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2011 and 2010 Notes to the Condensed Consolidated Financial Statements MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK CONTROLS AND PROCEDURES PART II. ITEM 1A. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS DEFAULTS UPON SENIOR SECURITIES (Removed and Reserved) EXHIBIT INDEX PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS (in thousands, except share and per share data) Receivables, net of allowance for doubtful accounts of $3,241 and $3,332 at September 30, 2011 and December 31, 2010, respectively Insurance receivable Prepaid expenses Investment in and advances to unconsolidated affiliates Other intangible assets Debt issuance costs, net of accumulated amortization of $3,313 and $45,234 at September 30, 2011 and December 31, 2010, respectively Loan receivable Total other assets Current maturities of long-term debt Accrued expenses Accrued salaries and wages Gaming, pari-mutuel, property, and other taxes Insurance financing Long-term liabilities Long-term debt, net of current maturities Noncurrent tax liabilities Other noncurrent liabilities Preferred stock ($.01 par value, 1,000,000 shares authorized, 12,275 shares issued and outstanding at September 30, 2011 and December 31, 2010) Common stock ($.01 par value, 200,000,000 shares authorized, 78,216,509 and 78,414,022 shares issued at September 30, 2011 and December 31, 2010, respectively) Accumulated other comprehensive loss (7,885 Total shareholders’ equity Total liabilities and shareholders’ equity See accompanying notes to the consolidated financial statements. Three Months Ended September 30, Nine Months Ended September 30, Food, beverage and other Management service fee Less promotional allowances (39,641 (103,757 Net revenues General and administrative Impairment losses Insurance deductible charges, net of recoveries Total operating expenses Other income (expenses) Gain (loss) from unconsolidated affiliates Loss on early extinguishment of debt Total other expenses Income from operations before income taxes Taxes on income Less: Net loss attributable to noncontrolling interests Net income attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries Earnings per common share attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries: Condensed Consolidated Statements of Changes in Shareholders’ Equity (in thousands, except share data) (unaudited) Penn National Gaming, Inc. shareholders Paid-In Retained Accumulated Other Noncontrolling (Loss) Income Income (Loss) Balance, December 31, 2009 Repurchase of preferred stock Repurchase of noncontrolling interest Stock option activity, including tax benefit of $402 Share activity (1,526,400 Restricted stock activity Change in fair value of interest rate swap contracts, net of income taxes of $6,732 Change in fair value of corporate debt securities Foreign currency translation adjustment Balance, September 30, 2010 Stock option activity, including tax benefit of $2,317 Cumulative-effect of adoption of amendments to ASC 924 regarding jackpot liabilities, net of income taxes of $1,068 (in thousands) (unaudited) Operating activities Adjustments to reconcile net income including noncontrolling interests to net cash provided by operating activities: Amortization of items charged to interest expense and interest income (Gain) loss on sale of fixed assets (Gain) loss from unconsolidated affiliates Loss on police services contract termination at Hollywood Casino Aurora Charge for stock-based compensation Decrease (increase), net of businesses acquired Increase (decrease), net of businesses acquired Gaming, pari-mutuel, property and other taxes Other current and noncurrent liabilities Other noncurrent tax liabilities Net cash provided by operating activities Investing activities Expenditures for property and equipment Proceeds from sale of property and equipment Insurance proceeds related to damaged property and equipment Investment in joint ventures, net of proceeds received Decrease (increase) in cash in escrow Cash acquired, net of acquisitions of businesses and licenses Net cash used in investing activities Financing activities Proceeds from exercise of options Repurchase of common stock Proceeds from issuance of long-term debt, net of issuance costs Principal payments on long-term debt Proceeds from insurance financing Payments on insurance financing Tax benefit from stock options exercised Net cash used in financing activities Cash and cash equivalents at beginning of year Cash and cash equivalents at end of period Supplemental disclosure Interest expense paid Income taxes paid Non-cash transaction: On June 1, 2011, following the purchase of all of the outstanding debt of The M Resorts LLC in October 2010 and the receipt of requisite regulatory approvals, the Company acquired the business in exchange for the debt. This non-cash transaction at the acquisition date, resulted in the removal of the Company’s loan receivable and increased property and equipment, net, total current assets, total other assets and total current liabilities by $203.7 million, $13.7 million, $2.4 million and $17.3 million, respectively. 1. Organization and Basis of Presentation Penn National Gaming, Inc. (“Penn”) and its subsidiaries (collectively, the “Company”) is a diversified, multi-jurisdictional owner and manager of gaming and pari-mutuel properties. As of September 30, 2011, the Company owns, manages, or has ownership interests in twenty-five facilities in the following eighteen jurisdictions: Colorado, Florida, Illinois, Indiana, Iowa, Louisiana, Maine, Maryland, Mississippi, Missouri, Nevada, New Jersey, New Mexico, Ohio, Pennsylvania, Texas, West Virginia, and Ontario. The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The consolidated financial statements include the accounts of Penn and its subsidiaries. Investment in and advances to unconsolidated affiliates that are 50% or less owned are accounted for under the equity method. All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses for the reporting periods. Actual results could differ from those estimates. For purposes of comparability, certain prior year amounts have been reclassified to conform to the current year presentation. Operating results for the nine months ended September 30, 2011 are not necessarily indicative of the results that may be expected for the year ending December 31, 2011. The notes to the consolidated financial statements contained in the Annual Report on Form 10-K for the year ended December 31, 2010 should be read in conjunction with these consolidated financial statements. 2. Summary of Significant Accounting Policies Revenue Recognition and Promotional Allowances Gaming revenue is the aggregate net difference between gaming wins and losses, with liabilities recognized for funds deposited by customers before gaming play occurs, for chips and “ticket-in, ticket-out” coupons in the customers’ possession, and for accruals related to the anticipated payout of progressive jackpots. Progressive slot machines, which contain base jackpots that increase at a progressive rate based on the number of coins played, are charged to revenue as the amount of the jackpots increase. Food, beverage and other revenue, including racing revenue, is recognized as services are performed. Racing revenue includes the Company’s share of pari-mutuel wagering on live races after payment of amounts returned as winning wagers, its share of wagering from import and export simulcasting, and its share of wagering from its off-track wagering facilities. Revenue from the management service contract for Casino Rama is based upon contracted terms and is recognized when services are performed. Revenues are recognized net of certain sales incentives in accordance with Financial Accounting Standards Board (the “FASB”) Accounting Standards Codification (“ASC”) 605-50, “Revenue Recognition—Customer Payments and Incentives.” The Company records certain sales incentives and points earned in point-loyalty programs as a reduction of revenue. The retail value of accommodations, food and beverage, and other services furnished to guests without charge is included in gross revenues and then deducted as promotional allowances. The estimated cost of providing such promotional allowances is primarily included in food, beverage and other expense. The amounts included in promotional allowances for the three and nine months ended September 30, 2011 and 2010 are as follows: Total promotional allowances The estimated cost of providing such complimentary services for the three and nine months ended September 30, 2011 and 2010 are as follows: Total cost of complimentary services The Company calculates earnings per share (“EPS”) in accordance with ASC 260, “Earnings Per Share” (“ASC 260”). Basic EPS is computed by dividing net income applicable to common stock, excluding net income attributable to noncontrolling interests, by the weighted-average number of common shares outstanding during the period. Diluted EPS reflects the additional dilution for all potentially-dilutive securities such as stock options and unvested restricted shares. At September 30, 2011, the Company had outstanding 12,275 shares of Series B Redeemable Preferred Stock (the “Preferred Stock”), which the Company determined qualified as a participating security as defined in ASC 260. Under ASC 260, a security is considered a participating security if the security may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. In accordance with ASC 260, a company is required to use the two-class method when computing EPS when a company has a security that qualifies as a “participating security.” The two-class method is an earnings allocation formula that determines EPS for each class of common stock and participating security according to dividends declared (or accumulated) and participation rights in undistributed earnings. A participating security is included in the computation of basic EPS using the two-class method. Under the two-class method, basic EPS for the Company’s Common Stock is computed by dividing net income attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries applicable to common stock by the weighted-average common shares outstanding during the period. Diluted EPS for the Company’s Common Stock is computed using the more dilutive of the two-class method or the if-converted method. The following table sets forth the allocation of net income attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries for the three and nine months ended September 30, 2011 and 2010 under the two-class method: Net income attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries applicable to preferred stock Net income attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries applicable to common stock The following table reconciles the weighted-average common shares outstanding used in the calculation of basic EPS to the weighted-average common shares outstanding used in the calculation of diluted EPS for the three and nine months ended September 30, 2011 and 2010: Determination of shares: Weighted-average common shares outstanding Assumed conversion of dilutive employee stock-based awards Assumed conversion of preferred stock Diluted weighted-average common shares outstanding Reflecting the issuance of the Preferred Stock and the repurchase of 225 shares of Preferred Stock during the year ended December 31, 2010, the Company is required to adjust its diluted weighted-average common shares outstanding for the purpose of calculating diluted EPS as follows: 1) when the price of the Company’s Common Stock is less than $45, the diluted weighted-average common shares outstanding is increased by 27,277,778 shares (regardless of how much the stock price is below $45); 2) when the price of the Company’s Common Stock is between $45 and $67, the diluted weighted-average common shares outstanding is increased by an amount which can be calculated by dividing $1.23 billion (face value) by the current price per share of the Company’s Common Stock, which will result in an increase in the diluted weighted-average common shares outstanding of between 18,320,896 shares and 27,277,778 shares; and 3) when the price of the Company’s Common Stock is above $67, the diluted weighted-average common shares outstanding is increased by 18,320,896 shares (regardless of how much the stock price exceeds $67). Options to purchase 2,786,303 shares and 2,855,652 shares were outstanding during the three and nine months ended September 30, 2011, respectively, but were not included in the computation of diluted EPS because they were antidilutive. Options to purchase 8,517,332 shares and 8,453,582 shares were outstanding during the three and nine months ended September 30, 2010, respectively, but were not included in the computation of diluted EPS because they were antidilutive. The following table presents the calculation of basic and diluted EPS for the Company’s Common Stock: Calculation of basic EPS attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries: Calculation of diluted EPS attributable to the shareholders of Penn National Gaming, Inc. and subsidiaries: Diluted EPS The Company accounts for stock compensation under ASC 718, “Compensation-Stock Compensation,” which requires the Company to expense the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This expense is recognized ratably over the requisite service period following the date of grant. The fair value for stock options was estimated at the date of grant using the Black-Scholes option-pricing model, which requires management to make certain assumptions. The risk-free interest rate was based on the U.S. Treasury spot rate with a term equal to the expected life assumed at the date of grant. Expected volatility was estimated based on the historical volatility of the Company’s stock price over a period of 5.77 years, in order to match the expected life of the options at the grant date. There is no expected dividend yield since the Company has not paid any cash dividends on its Common Stock since its initial public offering in May 1994 and since the Company intends to retain all of its earnings to finance the development of its business for the foreseeable future. The weighted-average expected life was based on the contractual term of the stock option and expected employee exercise dates, which was based on the historical and expected exercise behavior of the Company’s employees. Forfeitures are estimated at the date of grant based on historical experience. The following are the weighted-average assumptions used in the Black-Scholes option-pricing model at September 30, 2011 and 2010: Risk-free interest rate Expected volatility Weighted-average expected life (years) Forfeiture rate Beginning in the fourth quarter of 2010, the Company issued cash-settled phantom stock unit awards, which vest over a period up to five years. Cash-settled phantom stock unit awards entitle employees and directors to receive cash based on the fair value of the Company’s Common Stock on the vesting date. These phantom stock unit awards are accounted for as liability awards and are re-measured at fair value each reporting period until they become vested with compensation expense being recognized over the requisite service period in accordance with ASC 718-30 “Compensation—Stock Compensation, Awards Classified as Liabilities.” As of September 30, 2011, there was $5.8 million of total unrecognized compensation cost that will be recognized over the grants remaining vesting period. For the three and nine months ended September 30, 2011, the Company recognized $0.5 million and $1.5 million, respectively, of compensation expense associated with these awards. Additionally, the Company has issued stock appreciation rights to certain employees, which vest over a period of four years. The Company’s stock appreciation rights are accounted for as liability awards since they will be settled in cash. The fair value of these awards is calculated during each reporting period and estimated using the Black-Scholes option pricing model based on the various inputs discussed previously. As of September 30, 2011, there was $4.7 million of total unrecognized compensation cost that will be recognized over the awards remaining weighted average vesting period. For the three and nine months ended September 30, 2011, the Company recognized $0.3 million and $1.0 million, respectively, of compensation expense associated with these awards. Accounting for Derivatives and Hedging Activities The Company uses fixed and variable-rate debt to finance its operations. Both funding sources have associated risks and opportunities, such as interest rate exposure, and the Company’s risk management policy permits the use of derivatives to manage this exposure. The Company does not hold or issue derivative financial instruments for trading or speculative purposes. Thus, uses of derivatives are strictly limited to hedging and risk management purposes in connection with managing interest rate exposure. Acceptable derivatives for this purpose include interest rate swap contracts, futures, options, caps, and similar instruments. When using derivatives, the Company has historically desired to obtain hedge accounting, which is conditional upon satisfying specific documentation and performance criteria. In particular, the underlying hedged item must expose the Company to risks associated with market fluctuations and the instrument used as the hedging derivative must generate offsetting effects in prescribed magnitudes. If these criteria are not met, a change in the market value of the financial instrument and all associated settlements would be recognized as gains or losses in the period of change. Under cash flow hedge accounting, effective derivative results are initially recorded in other comprehensive income (“OCI”) and later reclassified to earnings, coinciding with the income recognition relating to the variable interest payments being hedged (i.e., when the interest expense on the variable-rate liability is recorded in earnings). Any hedge ineffectiveness (which represents the amount by which hedge results exceed the variability in the cash flows of the forecasted transaction due to the risk being hedged) is recorded in current period earnings. Under cash flow hedge accounting, derivatives are included in the consolidated balance sheets as assets or liabilities at fair value. Currently, the Company has a number of interest rate swap contracts in place. These contracts serve to mitigate income volatility for a portion of its variable-rate funding. In effect, these interest rate swap contracts synthetically convert the portion of variable-rate debt being hedged to the equivalent of fixed-rate funding. Under the terms of the swap contracts, the Company receives cash flows from the swap contract counterparties to offset the benchmark interest rate component of variable interest payments on the hedged financings, in exchange for paying cash flows based on the swap contracts’ fixed rates. These two respective obligations are net-settled periodically. The fair value of the Company’s interest rate swap contracts is measured as the present value of all expected future cash flows based on the LIBOR-based swap yield curve as of the date of the valuation, subject to a credit adjustment to the LIBOR-based yield curve’s implied discount rates. The credit adjustment reflects the Company’s best estimate as to the Company’s credit quality at September 30, 2011. The interest rate swap contract liabilities are included in accrued interest within the consolidated balance sheets at September 30, 2011 and December 31, 2010. Effective July 1, 2011, the Company de-designated its interest rate swap contracts that historically qualified for cash flow hedge accounting. This was due to the new $2.15 billion senior secured credit facility that the Company entered into in July 2011. As a result, the loss in OCI related to these swaps of $4.7 million will be amortized to interest expense over the swaps remaining lives. The total notional value of these swaps at September 30, 2011 was $440 million, with $200 expiring in October 2011 and the remainder maturing in December 2011. Subsequent to the de-designation date of July 1, 2011, the Company has accounted for changes in the fair value of these derivatives in earnings as a component of interest expense in the consolidated statements of income. In addition, the Company had certain other derivative instruments that were not designated to qualify for hedge accounting, which expired in May 2011. The periodic change in the mark-to-market of these derivative instruments had been recorded in current period earnings in interest expense in the consolidated statements of income. Credit risk relating to derivative counterparties is mitigated by using multiple, highly rated counterparties, and the credit quality of each is monitored on an ongoing basis. See Note 8 for additional information related to the Company’s derivatives. 3. New Accounting Pronouncements In September 2011, the FASB issued amendments to simplify how entities test goodwill for impairment. Under the updated guidance, an entity now has the option to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. If the assessment of qualitative factors leads to a determination that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then the entity is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing it against its carrying amount. If the carrying amount of a reporting unit exceeds its fair value, then the entity is required to perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any. Under the new guidance, an entity can elect to bypass the qualitative assessment for any reporting unit in any period and proceed directly to performing the first step of the two-step goodwill impairment. The amendments are effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. Early adoption is permitted. In June 2011, the FASB issued amendments to guidance regarding the presentation of comprehensive income. The amendments eliminate the option to present components of other comprehensive income as part of the statement of changes in stockholders’ equity. The amendments require that comprehensive income be presented in either a single continuous statement or in two separate but consecutive statements. In a single continuous statement, the entity would present the components of net income and total net income, the components of other comprehensive income and a total of other comprehensive income, along with the total of comprehensive income in that statement. In the two-statement approach, the entity would present components of net income and total net income in the statement of net income and a statement of other comprehensive income would immediately follow the statement of net income and include the components of other comprehensive income and a total for other comprehensive income, along with a total for comprehensive income. The amendments also require the entity to present on the face of the financial statements any reclassification adjustments for items that are reclassified from other comprehensive income to net income in the statement(s) where the components of net income and the components of other comprehensive income are presented. The amendments do not change the items that must be reported in other comprehensive income, when an item of other comprehensive income must be reclassed to net income or the option to present components of other comprehensive income either net of related tax effects or before related tax effects. The amendments are effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and should be applied retrospectively. In October 2011, the FASB decided to defer the specific requirement to present items that are reclassified from other comprehensive income to net income alongside their respective components of net income and other comprehensive income. The Company is currently evaluating its options on how it will present comprehensive income upon adoption of these amendments. In May 2011, the FASB issued amendments to existing fair value measurement guidance in order to achieve common requirements for measuring fair value and disclosures in accordance with GAAP and International Financial Reporting Standards. The guidance clarifies how a principal market is determined, addresses the fair value measurement of instruments with offsetting market or counterparty credit risks, addresses the concept of valuation premise and highest and best use, extends the prohibition on blockage factors to all three levels of the fair value hierarchy and requires additional disclosures. The amendments are to be applied prospectively and are effective during interim and annual periods beginning after December 15, 2011. The Company does not anticipate that these amendments will have a material impact on the consolidated financial statements. In April 2010, the FASB issued guidance on accruing for jackpot liabilities. The guidance clarifies that an entity should not accrue jackpot liabilities (or portions thereof) before a jackpot is won if the entity can legally avoid paying that jackpot (for example, by removing the gaming machine from the casino floor). Jackpots should be accrued and charged to revenue when an entity has the obligation to pay the jackpot. This guidance applies to both base jackpots and the incremental portion of progressive jackpots. However, the guidance only affected the accounting for base jackpots, as the guidance uses the same principle that is applied by the Company to the incremental portion of progressive jackpots. The guidance was effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2010. This guidance was applied by recording a cumulative-effect adjustment to opening retained earnings in the period of adoption. The Company adopted the guidance as of January 1, 2011, and as such, recorded a cumulative-effect adjustment, which increased retained earnings by $2.9 million. 4. Acquisition and Other Recent Business Ventures M Resort Transaction On June 1, 2011, following the purchase of all of the outstanding debt of The M Resorts LLC (the “M Resort”) for $230.5 million and the receipt of requisite regulatory approvals, the Company acquired the business in exchange for the debt. The Company purchased all of the outstanding bank and subordinated debt of the M Resort in October 2010 at which time the Company also secured the right to acquire the business of the M Resort in exchange for the property’s outstanding debt obligations. At December 31, 2010, the $230.5 million loan was recorded as a loan receivable within total other assets on the consolidated balance sheet. This non-cash transaction resulted in the removal of the Company’s loan receivable and the preliminary purchase price allocation resulted in an increase to property and equipment, net, total current assets, total other assets, and total current liabilities, by $203.7 million, $13.7 million, $2.4 million, and $17.3 million, respectively based on their estimated fair values as of June 1, 2011. Opened in March 2009, the M Resort, located approximately ten miles from the Las Vegas strip in Henderson, Nevada, is situated on over 90 acres on the southeast corner of Las Vegas Boulevard and St. Rose Parkway. The resort features over 92,000 square feet of gaming space. M Resort also offers 390 guest rooms and suites, nine restaurants and five destination bars, more than 60,000 square feet of meeting and conference space, a 4,700 space parking facility, a spa and fitness center and a 100,000 square foot events piazza. Acquisition of Texas Joint Venture Interest On April 8, 2011, the Company established a joint venture that owns and operates racetracks in Texas. See Note 5 for further discussion. Sale of Maryland Jockey Club Interest In July 2011, the Company sold its joint venture interest in the Maryland Jockey Club. See Note 5 for further discussion. Rosecroft Acquisition On February 28, 2011, the Company completed its acquisition of Rosecroft Raceway in Oxon Hill, Maryland following the completion of a bankruptcy auction and approval of the purchase by a U.S. Bankruptcy Court judge. Rosecroft Raceway, located approximately 13 miles south of Washington, D.C., is situated on approximately 125 acres just outside the Washington I-495 Beltway in Prince George’s county. The Rosecroft facility features a 5/8-mile standardbred racing oval track with a seven race paddock, a 53,000 square foot grandstand building, and a 96,000 square foot three story clubhouse building with dining facilities. In August 2011, Rosecroft Raceway re-opened for simulcasting and live harness racing resumed in late October 2011. 5. Investment In and Advances to Unconsolidated Affiliates As of September 30, 2011, investment in and advances to unconsolidated affiliates primarily includes the Company’s 50% interest in Freehold Raceway, its 50% investment in Kansas Entertainment, LLC (“Kansas Entertainment”), which is a joint venture with International Speedway Corporation (“International Speedway”), and its 50% joint venture with Maxxam, Inc. (“Maxxam”) that owns and operates racetracks in Texas which is more fully described below. Texas Joint Venture On April 8, 2011, following final approval by the Texas Racing Commission, the Company completed its investment in a joint venture with Maxxam that owns and operates the Sam Houston Race Park in Houston, Texas, the Valley Race Park in Harlingen, Texas, and a license for a planned racetrack in Laredo, Texas. Under the terms of the joint venture, the Company secured a 50% interest in the joint venture, which has sole ownership of the above facilities including interests in 323 acres at Sam Houston Race Park, 80 acres at Valley Race Park, and an option to purchase 135 acres for the planned racetrack in Laredo, Texas. Sam Houston Race Park, opened in April 1994, is located in Northwest Houston along Beltway 8 near the intersection of Highway 249. Sam Houston Race Park hosts thoroughbred and quarter horse racing and offers daily simulcast operations, as well as hosts various special events, private parties and meetings, concerts and national touring festivals throughout the year. Valley Race Park, which was opened in 1990 and acquired by Sam Houston Race Park in 2000, is a 91,000 square foot dog racing and simulcasting facility located in Harlingen, Texas. The Company intends to work collaboratively with Maxxam to strengthen and enhance the existing racetrack operations as well as pursue other opportunities, including the potential for gaming operations at the pari-mutuel facilities, to maximize the overall value of the business. As part of the agreement for the joint venture, the Company agreed to fund, upon the legalization of gaming, a loan to the joint venture for up to $375 million to cover development costs that cannot be financed through third party debt. This loan commitment is in place through December 31, 2015, however it may be extended to December 31, 2016 in order to obtain gaming referendum approval in the event gaming legislation approval has occurred prior to December 31, 2015. If the joint venture elects to utilize the loan, the rates to be paid will be LIBOR plus 800 to 900 basis points for a senior financing and an additional 500 to 600 basis points for a subordinated financing. The Company determined that the joint venture did not qualify as a variable interest entity (“VIE”) at September 30, 2011. Using the guidance for entities that are not VIEs, the Company determined that it did not have a controlling financial interest in the joint venture at, and for the three and nine months ended September 30, 2011, primarily as it did not have the ability to direct the activities of the joint venture that most significantly impacted the joint venture’s economic performance without the input of Maxxam. Therefore, the Company did not consolidate its investment in the joint venture at, and for the three and nine months ended September 30, 2011. Kansas Entertainment Kansas Entertainment is proceeding with its construction of its planned $411 million facility, inclusive of licensing fees, which is expected to feature a 95,000 square foot casino with approximately 2,000 slot machines, 52 table games and 12 poker tables, a 1,253 space parking structure, as well as a variety of dining and entertainment facilities. The Company and International Speedway share equally the cost of developing and constructing the proposed facility. The Company estimates that its share of the project will be approximately $155 million. During the three and nine months ended September 30, 2011, the Company funded $22.8 million and $44.2 million, respectively, for capital expenditures and other operating expenses. In July 2011, the Company sold its joint venture interest in Maryland RE & R LLC, a joint venture with MI Developments, Inc. that owns and operates the Maryland Jockey Club. This transaction resulted in a gain of $20.2 million which is included in gain (loss) from unconsolidated affiliates within the consolidated statements of income for the three and nine months ended September 30, 2011. 6. Property and Equipment Property and equipment, net, consists of the following: Building and improvements Furniture, fixtures, and equipment Total property and equipment Less accumulated depreciation Total property and equipment increased by $392.9 million primarily due to the M Resort transaction that closed on June 1, 2011, as well as expenditures for the facilities under construction in Ohio. Depreciation expense, for property and equipment, totaled $51.8 million and $157.6 million for the three and nine months ended September 30, 2011, respectively, as compared to $52.3 million and $152.7 million for the three and nine months ended September 30, 2010, respectively. Interest capitalized in connection with major construction projects was $1.7 million and $3.5 million for the three and nine months ended September 30, 2011, respectively, as compared to $1.6 million and $4.4 million for the three and nine months ended September 30, 2010, respectively. 7. Goodwill and Other Intangible Assets In accordance with ASC 350, “Intangibles-Goodwill and Other,” the Company does not amortize goodwill, rather it is tested annually, or more frequently if indicators of impairment exist, for impairment by comparing the fair value of the reporting units to their carrying amount. If the carrying amount of a reporting unit exceeds its fair value in step 1 of the impairment test, then step 2 of the impairment test is performed to determine the implied value of goodwill for that reporting unit. If the implied value of goodwill is less than the goodwill allocated for that reporting unit, an impairment loss is recognized. Additionally, the Company considers its gaming licenses, racing permits and the majority of its trademark intangible assets as indefinite-life intangible assets that do not require amortization based on the Company’s future expectations to operate its gaming facilities indefinitely as well as the Company’s historical experience in renewing these intangible assets at minimal cost with various state gaming and racing commissions. A reconciliation of goodwill and accumulated goodwill impairment losses is as follows (in thousands): Balance at December 31, 2010: Accumulated goodwill impairment losses Goodwill, net Balance at September 30, 2011: The table below presents the gross carrying value, accumulated amortization, and net book value of each major class of intangible asset at September 30, 2011 and December 31, 2010: Accumulated Net Book Indefinite-life intangible assets The Company’s intangible asset amortization expense was $0.4 million and $2.0 million for the three and nine months ended September 30, 2011, respectively, as compared to $1.6 million and $5.0 million for the three and nine months ended September 30, 2010, respectively. The following table presents expected intangible asset amortization expense based on existing intangible assets at September 30, 2011 (in thousands): Remainder of 2011 The Company’s remaining goodwill and other intangible assets by reporting unit at September 30, 2011 is shown below (in thousands): Reporting Unit Remaining Goodwill and Hollywood Casino Lawrenceburg Hollywood Casino Aurora Argosy Casino Riverside Black Gold Casino at Zia Park Argosy Casino Alton Argosy Casino Sioux City Hollywood Casino Baton Rouge 8. Long-term Debt and Derivatives Long-term debt, net of current maturities, is as follows: Senior secured credit facility $250 million 6 ¾% senior subordinated notes due March 2015 $325 million 8 ¾% senior subordinated notes due August 2019 Other long-term obligations Less current maturities of long-term debt Less discount on senior secured credit facility Term Loan B The following is a schedule of future minimum repayments of long-term debt as of September 30, 2011 (in thousands): Total minimum payments On July 14, 2011, the Company entered into a new $2.15 billion senior secured credit facility, which is comprised of a $700 million revolving credit facility that will mature in July 2016, a $700 million variable rate Term Loan A due in July 2016 and a $750 million variable rate Term Loan B due in July 2018. The interest rates payable on the facilities are based on the leverage ratios of the Company as defined in the debt agreements, however, based on current borrowing levels, the Company will pay LIBOR plus 150 basis points on the revolver and Term Loan A and LIBOR plus 275 basis points on Term Loan B (subject to a 1% LIBOR floor). The Company utilized the proceeds of the two term loan borrowings and cash on hand to retire its previous senior secured credit facility obligation of $1,518.1 million (which had significant principal repayments due at the end of 2011 and 2012) and pay transaction costs and accrued interest and fees on the retired debt. As a result of this refinancing, the Company incurred debt extinguishment charges of $10.2 million during the three months ended September 30, 2011. The Company’s senior secured credit facility had a gross outstanding balance of $1,639.4 million at September 30, 2011, consisting of $200.0 million drawn under the revolving credit facility, a $691.3 million Term Loan A facility, and a $748.1 million Term Loan B facility. Additionally, at September 30, 2011, the Company was contingently obligated under letters of credit issued pursuant to the $2.15 billion senior secured credit facility with face amounts aggregating $25.0 million, resulting in $475.0 million of available borrowing capacity as of September 30, 2011 under the revolving credit facility. 6 3/4% Senior Subordinated Notes In July 2011, the Company announced its intention to redeem all of its $250 million senior subordinated notes. The redemption price was $1,022.50 per $1,000 principal amount, plus accrued and unpaid interest, which was paid in August 2011. The Company funded the redemption of its $250 million senior subordinated notes from its new revolving credit facility and available cash. The Company recorded a $7.6 million loss on early extinguishment of debt during the three months ended September 30, 2011 related to debt issuance costs write-offs and the call premium on the $250 million senior subordinated notes. The Company’s senior secured credit facility and $325 million 83/4% senior subordinated notes require it, among other obligations, to maintain specified financial ratios and to satisfy certain financial tests, including fixed charge coverage, interest coverage, senior leverage and total leverage ratios. In addition, the Company’s senior secured credit facility and $325 million 83/4% senior subordinated notes restrict, among other things, the Company’s ability to incur additional indebtedness, incur guarantee obligations, amend debt instruments, pay dividends, create liens on assets, make investments, engage in mergers or consolidations, and otherwise restricts corporate activities. At September 30, 2011, the Company was in compliance with all required covenants. Interest Rate Swap Contracts In accordance with the terms of its previous senior secured credit facility, the Company was required to enter into fixed-rate debt or interest rate swap agreements in an amount equal to 50% of the Company’s consolidated indebtedness, excluding the revolving credit facility, within 100 days of the closing date of the previous senior secured credit facility. This requirement was not included in the new senior secured credit facility. As discussed in Note 2, the Company de-designated its cash flow hedges on July 1, 2011 in connection with its new senior secured credit facility. The effect of derivative instruments on the consolidated statement of income for the three months ended September 30, 2011 was as follows (in thousands): Location of Gain (Loss) Derivatives Not Designated as Recognized in Income Gain (Loss) Recognized Hedging Instruments on Derivative in Income on Derivative The effect of derivative instruments on the consolidated statement of income for the nine months ended September 30, 2011 was as follows (in thousands): Gain (Loss) Recognized in Reclassified from Derivatives in a OCI on Derivative AOCI into Income Recognized in Income on Cash Flow Hedging Relationship (Effective Portion) Derivative (Ineffective Portion) In addition, during the three and nine months ended September 30, 2011, the Company amortized $2.8 million and $5.3 million, respectively, in OCI related to the derivatives that were de-designated as hedging instruments under ASC 815, “Derivatives and Hedging,” as compared to $4.2 million and $12.7 million for the three and nine months ended September 30, 2010, respectively. In the coming twelve months, the Company anticipates that losses of approximately $1.8 million will be reclassified from OCI to earnings, as part of interest expense. The following table sets forth the fair value of the interest rate swap contract liabilities included in accrued interest within the consolidated balance sheets at September 30, 2011 and December 31, 2010: Derivatives designated as hedging instruments Total derivatives designated as hedging instruments Derivatives not designated as hedging instruments Total derivatives not designated as hedging instruments Total derivatives A reconciliation of the liability for unrecognized tax benefits is as follows: Noncurrent Balance at January 1, 2011 Additions based on current year positions Additions based on prior year positions Decreases due to settlements and/or reduction in liabilities Currency translation adjustments Balance at September 30, 2011 The decrease in the Company’s liability for unrecognized tax benefits during the nine months ended September 30, 2011 was primarily due to the reversal of previously recorded unrecognized tax benefit reserves in the second quarter of 2011 for years that either the statue of limitations has lapsed in 2011 or that have been favorably settled. The Company’s effective tax rate (income taxes as a percentage of income from operations before income taxes) decreased to 35.1% and 36.7% for the three and nine months ended September 30, 2011, respectively, as compared to 41.6% and 42.3% for the three and nine months ended September 30, 2010, respectively. The reason is primarily due to the reversal of previously recorded unrecognized tax benefit reserves in the second quarter of 2011 for years that either the statue of limitations has lapsed in 2011 or that have been favorably settled coupled with favorable state income tax benefits received from the impact of certain subsidiary restructurings completed in the third quarter of 2011. Lastly, the Company also had an impairment charge in the second quarter of 2010 on the Company’s Columbus property which had an unfavorable impact to the Company’s effective rate by lowering income from operations before income taxes. The Company is subject to various legal and administrative proceedings relating to personal injuries, employment matters, commercial transactions and other matters arising in the normal course of business. The Company does not believe that the final outcome of these matters will have a material adverse effect on the Company’s consolidated financial position or results of operations. In addition, the Company maintains what it believes is adequate insurance coverage to further mitigate the risks of such proceedings. However, such proceedings can be costly, time consuming and unpredictable and, therefore, no assurance can be given that the final outcome of such proceedings may not materially impact the Company’s consolidated financial condition or results of operations. Further, no assurance can be given that the amount or scope of existing insurance coverage will be sufficient to cover losses arising from such matters. The following proceedings could result in costs, settlements, damages, or rulings that materially impact the Company’s consolidated financial condition or operating results. In each instance, the Company believes that it has meritorious defenses, claims and/or counter-claims, and intends to vigorously defend itself or pursue its claim. The Illinois Legislature passed into law House Bill 1918, effective May 26, 2006, which singled out four of the nine Illinois casinos, including the Company’s Hollywood Casino Joliet and Hollywood Casino Aurora, for a 3% surcharge to subsidize local horse racing interests. On May 30, 2006, Hollywood Casino Joliet and Hollywood Casino Aurora joined with the two other riverboats affected by the law, Harrah’s Joliet and the Grand Victoria Casino in Elgin (collectively, the “Four Casinos”), and filed suit in the Circuit Court of the Twelfth Judicial District in Will County, Illinois (the “Court”), asking the Court to declare the law unconstitutional. Hollywood Casino Joliet and Hollywood Casino Aurora began paying the 3% surcharge into a protest fund which accrued interest during the pendency of the lawsuit. In two orders dated March 29, 2007 and April 20, 2007, the Court declared the law unconstitutional under the Uniformity Clause of the Illinois Constitution and enjoined the collection of this surcharge. The State of Illinois requested, and was granted, a stay of this ruling. As a result, Hollywood Casino Joliet and Hollywood Casino Aurora continued paying the 3% surcharge into the protest fund until May 25, 2008, when the 3% surcharge expired. The State of Illinois appealed the ruling to the Illinois Supreme Court. On June 5, 2008, the Illinois Supreme Court reversed the trial court’s ruling and issued a decision upholding the constitutionality of the 3% surcharge. On January 21, 2009, the Four Casinos filed a petition for certiorari, requesting the U.S. Supreme Court to hear the case. Seven amicus curiae briefs supporting the plaintiffs’ request were also filed. On June 8, 2009, the U.S. Supreme Court decided not to hear the case. On June 10, 2009, the Four Casinos filed a petition with the Court to open the judgment based on new evidence that came to light during the investigation of former Illinois Governor Rod Blagojevich that the 2006 law was procured by corruption. On August 17, 2009, the Court dismissed the Four Casinos’ petition to reopen the case, and the Four Casinos decided not to pursue an appeal of the dismissal. On December 15, 2008, former Illinois Governor Rod Blagojevich signed Public Act No. 95-1008 requiring the Four Casinos to continue paying the 3% surcharge to subsidize Illinois horse racing interests. On January 8, 2009, the Four Casinos filed suit in the Court, asking it to declare the law unconstitutional. The 3% surcharge being paid pursuant to Public Act No. 95-1008 was paid into a protest fund where it accrued interest. The defendants filed a motion to dismiss, which was granted on August 17, 2009. The Four Casinos appealed the dismissal and filed motions to keep the payments in the protest fund while the appeal is being litigated. The motion to keep the monies in the protest fund was denied and the funds were released to the racetracks. On January 27, 2011, the Illinois appellate court affirmed the trial court’s dismissal of this case. Hollywood Casino Joliet and Hollywood Casino Aurora asked the Illinois Supreme Court to hear an appeal of this dismissal and this request was denied. The monies paid into the protest fund have been transferred by the State of Illinois to the racetracks. The payment of the 3% surcharge under the 2008 statute ended on July 14, 2011 with the opening of the new casino in Des Plaines, Illinois. On June 12, 2009, the Four Casinos filed a lawsuit in Illinois Federal Court naming former Illinois Governor Rod Blagojevich, his campaign fund, racetrack owner John Johnston, and his two racetracks as defendants alleging a civil conspiracy in violation of the Racketeer Influenced and Corrupt Organizations Act, 18 U.S.C. §1962(c),(d) (“RICO”), based on an illegal scheme to secure the enactment of the 3% surcharge legislation in exchange for the payment of money by Johnston and entities controlled by him. The Four Casinos sought to impose a constructive trust over all funds paid under the surcharge, and therefore all of the Illinois racetracks were named as parties to the lawsuit. The defendants in the RICO case filed motions to dismiss. On December 7, 2009, the district court denied the motions to dismiss the RICO count, but it granted the motion to dismiss the constructive trust count, stating that it did not have jurisdiction in this case to impose the constructive trust. The Four Casinos appealed this dismissal to the Seventh Circuit Court of Appeals, which affirmed the dismissal in an en banc opinion. The Illinois racetracks are now free to use the monies that they received from the 3% surcharge. Since the passing of House Bill 1918 into law, Hollywood Casino Joliet and Hollywood Casino Aurora have recognized approximately $55.2 million in expense as a result of the 3% surcharge, including $0.4 million and $5.5 million during the three and nine months ended September 30, 2011, respectively. The 3% surcharge is included in gaming expense within the consolidated statements of income. On July 16, 2008, the Company was served with a purported class action lawsuit brought by plaintiffs seeking to represent a class of shareholders who purchased shares of the Company’s Common Stock between March 20, 2008 and July 2, 2008. The lawsuit alleges that the Company’s disclosure practices relative to the proposed transaction with Fortress Investment Group LLC and Centerbridge Partners, L.P. and the eventual termination of that transaction were misleading and deficient in violation of the Securities Exchange Act of 1934. The complaint, which seeks class certification and unspecified damages, was filed in federal court in Maryland. The complaint was amended, among other things, to add three new named plaintiffs and to name Peter M. Carlino, Chairman and Chief Executive Officer, and William J. Clifford, Senior Vice President and Chief Financial Officer, as additional defendants. The Company filed a motion to dismiss the complaint in November 2008, and the court granted the motion and dismissed the complaint with prejudice. The plaintiffs filed a motion for reconsideration, which was denied on October 21, 2009. The plaintiffs subsequently appealed the dismissal to the Fourth Circuit Court of Appeals and an oral argument was heard on October 26, 2010. On March 14, 2011, the Fourth Circuit Court of Appeals affirmed the decision of the lower court. The plaintiffs have requested the U.S. Supreme Court to consider an appeal of the decision. In October 2011, the U.S. Supreme Court denied the application for an appeal. On September 11, 2008, the Board of County Commissioners of Cherokee County, Kansas (the “County”) filed suit against Kansas Penn Gaming, LLC (“KPG,” a wholly-owned subsidiary of Penn created to pursue a development project in Cherokee County, Kansas) and the Company in the District Court of Shawnee County, Kansas. The petition alleges that KPG breached its pre-development agreement with the County when KPG withdrew its application to manage a lottery gaming facility in Cherokee County and currently seeks in excess of $50 million in damages. In connection with their petition, the County obtained an ex-parte order attaching the $25 million privilege fee paid to the Kansas Lottery Commission in conjunction with the gaming application for the Cherokee County zone. The defendants have filed motions to dissolve and reduce the attachment. Those motions were denied. Following discovery, both parties have filed dispositive motions. On September 23, 2008, KPG filed an action against HV Properties of Kansas, LLC (“HV”) in the U.S. District Court for the District of Kansas seeking a declaratory judgment from the U.S. District Court finding that KPG has no further obligations to HV under a Real Estate Sale Contract (the “Contract”) that KPG and HV entered into on September 6, 2007, and that KPG properly terminated this Contract under the terms of the Repurchase Agreement entered into between the parties effective September 28, 2007. HV filed a counterclaim claiming KPG breached the Contract, and seeks $37.5 million in damages. On October 7, 2008, HV filed suit against the Company claiming the Company is liable to HV for KPG’s alleged breach based on a Guaranty Agreement signed by the Company. Both cases were consolidated. Following extensive discovery and briefings, on July 23, 2010, the court granted KPG’s motion for summary judgment and dismissed HV’s claim. KPG filed a motion requesting reimbursement of the attorneys’ fees and costs incurred in litigating this case pursuant to the terms of the Contract and was awarded approximately $0.9 million. HV has appealed both rulings of the district court. On March 11, 2011, CD Gaming Ventures, LLC (“CD Gaming”), a wholly-owned subsidiary of the Company and developer of the Columbus casino, filed suit in U.S. District Court against the City of Columbus (the “City”), Columbus officials, Franklin County and County officials. The lawsuit alleged that the City, Franklin County and various city and county officials violated the Company’s rights under the U.S. and Ohio Constitutions, principally by removing preexisting sewer and water service in an effort to force annexation of the constitutionally-authorized casino site into the City. CD Gaming asked the court for an injunction preventing the City and the county from denying water and sewer service to the casino site and also sought monetary damages. On May 24, 2011, the City and CD Gaming announced they had reached a contingent agreement, subject to final documentation, that would result in the annexation of the casino site into the City in exchange for water and sewer service and other considerations. The agreement was conditioned, among other things, on the sale of real estate previously purchased by the Company in downtown Columbus for $11 million and an acceptable settlement agreement with certain affiliates of the Columbus Dispatch. A sale agreement for the real estate in downtown Columbus closed on August 23, 2011 and a release and settlement agreement has been finalized with certain affiliates of the Columbus Dispatch. 11. Shareholders’ Equity On June 9, 2011, the Board of Directors authorized the extension of the repurchase program previously authorized by the Board of Directors on June 9, 2010 which provided for the purchase of up to $300 million of the Company’s Common Stock. The current authorization extends the repurchase program until the Annual Meeting of Shareholders in 2012, unless otherwise extended or shortened by the Board of Directors. During the three months ended September 30, 2011, the Company repurchased 755,517 shares of its Common Stock in open market transactions for approximately $27.1 million at an average price of $ 35.78 per share. 12. Segment Information During the three months ended September 30, 2011, the Company realigned its reporting structure in connection with the hiring of an additional senior vice president of regional operations. The Company now has three senior vice presidents of regional operations who oversee various properties based primarily on their geographic locations and whom report directly to the Company’s President and Chief Operating Officer. This event impacted how the Company’s Chief Executive Officer, who is the Company’s Chief Operating Decision Maker (“CODM”) as that term is defined in ASC 280, “Segment Reporting” (“ASC 280”), measures and assesses the Company’s business performance and has caused the Company to conclude that it now has reportable segments. Therefore, the Company has aggregated its properties into three reportable segments: (i) Midwest, (ii) East/West, and (iii) Southern Plains consistent with how the Company’s CODM reviews and assesses the Company’s financial performance. The Midwest reportable segment consists of the following properties: Hollywood Casino Lawrenceburg, Hollywood Casino Aurora, Hollywood Casino Joliet, and Argosy Casino Alton. It also includes the Company’s Casino Rama management service contract as well as the two Ohio properties that are currently under construction, Hollywood Casino Toledo and Hollywood Casino Columbus, which are scheduled to open in the second and fourth quarter of 2012, respectively. The East/West reportable segment consists of the following properties: Hollywood Casino at Charles Town Races, Hollywood Casino Perryville, Hollywood Slots Hotel and Raceway, Hollywood Casino at Penn National Race Course, Black Gold Casino at Zia Park, and M Resort. The Southern Plains reportable segment consists of the following properties: Argosy Casino Riverside, Argosy Casino Sioux City, Hollywood Casino Baton Rouge, Hollywood Casino Tunica, Hollywood Casino Bay St. Louis, and Boomtown Biloxi. It also includes the Company’s 50% investment in Kansas Entertainment, which will own the Hollywood Casino at Kansas Speedway that is scheduled to open in the first quarter of 2012. The Other category consists of the Company’s standalone racing operations, namely Beulah Park, Raceway Park, Rosecroft Raceway, Sanford-Orlando Kennel Club, and the Company’s joint venture interests in Freehold Raceway, Maryland Jockey Club (which was sold in July 2011), Sam Houston Race Park and Valley Race Park. If the Company is successful in obtaining gaming operations at these locations, they would be assigned to one of the Company’s regional executives and reported in their respective reportable segment. The Other category also includes Bullwhackers and the Company’s corporate overhead operations which does not meet the definition of an operating segment under ASC 280. The following tables present certain information with respect to the Company’s segments. Intersegment revenues between the Company’s segments were not material in any of the periods presented below. East/West (2) Three months ended September 30, 2011 (Loss) gain from unconsolidated affiliates Loss from unconsolidated affiliates Nine months ended September 30, 2011 Balance sheet at September 30, 2011 Goodwill and other intangible assets, net Balance sheet at December 31, 2010

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professional_accounting

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 New York 13-0872805 6400 Poplar Avenue, Memphis, TN 38197 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (paragraph 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨ Smaller company ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x The number of shares outstanding of the registrant’s common stock as of August 2, 2010 was 437,024,711. Financial Statements 1 Consolidated Statement of Operations - Three Months and Six Months Ended June 30, 2010 and 2009 1 Consolidated Balance Sheet - June 30, 2010 and December 31, 2009 2 Consolidated Statement of Cash Flows - Six Months Ended June 30, 2010 and 2009 3 Condensed Notes to Consolidated Financial Statements 4 Management’s Discussion and Analysis of Financial Condition and Results of Operations 27 Quantitative and Qualitative Disclosures About Market Risk 46 Controls and Procedures 47 Legal Proceedings 48 Risk Factors * Unregistered Sales of Equity Securities and Use of Proceeds 48 Defaults upon Senior Securities * [Removed and Reserved] * Other Information * * Omitted since no answer is called for, answer is in the negative or inapplicable. June 30, Six Months Ended $ 6,121 $ 5,802 $ 11,928 $ 11,470 Cost of products sold (Note 5) 472 508 893 1,008 Net (gains) losses on sales and impairments of businesses 118 520 (57 ) 1,038 Equity earnings (losses), net of taxes 7 (32 ) 5 (59 ) 100 140 (53 ) 401 $ 93 $ 136 $ (69 ) $ 393 $ 0.22 $ 0.32 $ (0.16 ) $ 0.93 $ 0.125 $ 0.025 $ 0.150 $ 0.275 2010 December 31, Less: Common stock held in treasury, at cost, 2010 – 1.2 shares and 2009 – 3.9 shares $ (53 ) $ 401 Deferred income tax provision (benefit), net Payments related to restructuring and legal reserves (2 ) (24 ) Equity (earnings) losses, net (5 ) 59 Alternative fuel mixture credits receivable 0 (189 ) (75 ) 107 43 (165 ) Acquisitions, net of cash acquired (155 ) (8 ) (32 ) (59 ) (309 ) (2,617 ) (66 ) (118 ) (69 ) 23 NOTE 1 – BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States and in accordance with the instructions to Form 10-Q and, in the opinion of Management, include all adjustments that are necessary for the fair presentation of International Paper Company’s (International Paper or the Company) financial position, results of operations, and cash flows for the interim periods presented. Except as disclosed herein, such adjustments are of a normal, recurring nature. Results for the first six months of the year may not necessarily be indicative of full year results. It is suggested that these consolidated financial statements be read in conjunction with the audited financial statements and the notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, as amended, (Form 10-K) which have previously been filed with the Securities and Exchange Commission. International Paper accounts for its investment in Ilim Holding S.A. (Ilim), a separate reportable industry segment, using the equity method of accounting. Due to the complex organizational structure of Ilim’s operations, and the extended time required to prepare consolidated financial information in accordance with accounting principles generally accepted in the United States, the Company reports its share of Ilim’s operating results on a one-quarter lag basis. NOTE 2 – RECENT ACCOUNTING DEVELOPMENTS Accounting For Distributions to Shareholders: In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-01, “Accounting for Distributions to Shareholders with Components of Stock and Cash,” which clarifies that the stock portion of a distribution to shareholders that allows them to elect to receive cash or stock with a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate is considered a share issuance that is reflected in earnings per share prospectively and is not a stock dividend for purposes of applying Accounting Standards Codification (ASC) 505, “Equity,” and ASC 260, “Earnings Per Share.” This guidance was effective for interim and annual periods ending on or after December 15, 2009 (calendar year 2009), and should be applied on a retrospective basis. The application of the requirements of this guidance had no effect on the accompanying consolidated financial statements. Accounting for Decreases in Ownership of a Subsidiary: In January 2010, the FASB issued ASU 2010-02, “Accounting and Reporting for Decreases in Ownership of a Subsidiary,” which clarifies the scope of the guidance for the decrease in ownership of a subsidiary in ASC 810, “Consolidations,” and expands the disclosures required for the deconsolidation of a subsidiary or derecognition of a group of assets. This guidance was effective on a retrospective basis to January 1, 2009. The application of the requirements of this guidance had no effect on the accompanying consolidated financial statements. Revenue Arrangements with Multiple Deliverables: In September 2009, the FASB issued ASU 2009-13, “Multiple-Deliverable Revenue Arrangements,” which amends the multiple-element arrangement guidance under ASC 605, “Revenue Recognition.” This guidance amends the criteria for separating consideration for products or services in multiple-deliverable arrangements. This guidance establishes a selling price hierarchy for determining the selling price of a deliverable, eliminates the residual method of allocation, and requires that arrangement consideration be Condensed Notes to Consolidated Financial Statements—(Continued) allocated at the inception of the arrangement to all deliverables using the relative selling price method. In addition, this guidance significantly expands required disclosures related to a vendor’s multiple-deliverable revenue arrangements. This guidance is effective prospectively for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 (calendar year 2011). The Company is currently evaluating the provisions of this guidance but does not anticipate that it will have a material effect on its consolidated financial statements. Variable Interest Entities: In June 2009, the FASB issued ASU 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities,” which amends the consolidation guidance that applies to variable interest entities under ASC 810, “Consolidations.” This guidance changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. This guidance was effective for financial statements issued in fiscal years (and interim periods) beginning after November 15, 2009 (calendar year 2010). The Company adopted this guidance on January 1, 2010 and it did not have an effect on the accompanying consolidated financial statements. Transfers of Financial Assets: In June 2009, the FASB issued ASU 2009-16, “Accounting for Transfers of Financial Assets,” which amends the derecognition guidance in ASC 860, “Transfers and Servicing.” This guidance eliminates the concept of qualifying special-purpose entities, changes the requirements for derecognizing financial assets and requires additional disclosures. This guidance was effective for financial asset transfers occurring after the beginning of an entity’s first fiscal year beginning after November 15, 2009 (calendar year 2010). The Company adopted this guidance on January 1, 2010 and it did not have an effect on the accompanying consolidated financial statements. Subsequent Events: In May 2009, the FASB issued ASC 855, “Subsequent Events,” which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. This guidance is effective prospectively for interim and annual periods ending after June 15, 2009. In February 2010, the FASB issued ASU 2010-09, which amends ASC 855 to address certain implementation issues related to performing and disclosing subsequent events procedures. The Company included the requirements of this guidance in the preparation of the accompanying consolidated financial statements. Other-Than-Temporary Impairment for Debt Securities: In April 2009, the FASB issued new guidance under ASC 320, “Investments – Debt and Equity Securities,” which provides a new other-than-temporary impairment model for debt securities. This guidance was effective for financial statements issued for fiscal years (and interim periods) ending after June 15, 2009. The application of the requirements of this guidance did not have a material effect on the accompanying consolidated financial statements. Fair Value Measurements: In April 2009, the FASB issued guidance under ASC 820, “Fair Value Measurements and Disclosures,” which provides guidance on estimating the fair value of an asset or liability (financial or nonfinancial) when the volume and level of activity for the asset or liability have significantly decreased and on identifying transactions that are not orderly. The application of the requirements of this guidance did not have a material effect on the accompanying consolidated financial statements. In August 2009, the FASB issued ASU 2009-05, “Measuring Liabilities at Fair Value,” which further amends ASC 820 by providing clarification for circumstances in which a quoted price in an active market for the identical liability is not available. The Company included the disclosures required by this guidance in the accompanying consolidated financial statements. In January 2010, the FASB issued ASU 2010-06, which further amends ASC 820 to add new disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. This new guidance also clarifies the level of disaggregation, inputs and valuation techniques used to measure fair value and amends guidance under ASC 715 related to employers’ disclosures about postretirement benefit plan assets to require that disclosures be provided by classes of assets instead of by major categories of assets. This guidance was effective for the first reporting period (including interim periods) beginning after December 15, 2009, except for the requirement to provide Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The Company included the disclosures required by this guidance in the accompanying consolidated financial statements. The Company does not anticipate that the adoption of the remaining requirements of this guidance will have a material effect on its consolidated financial statements. NOTE 3 – EQUITY A summary of the changes in equity for the six months ended June 30, 2010 and 2009 is provided below: Equity Noncontrolling Interests Total Equity Total $ 6,023 $ 232 $ 6,255 $ 4,169 $ 232 $ 4,401 69 0 69 68 0 68 (26 ) 0 (26 ) (10 ) 0 (10 ) Common stock dividends ($0.15 per share in 2010 and $0.275 per share in 2009) (68 ) 0 (68 ) (122 ) 0 (122 ) Dividends paid to noncontrolling interests by subsidiary 0 (1 ) (1 ) 0 (4 ) (4 ) Noncontrolling interests of acquired entities Acquisition of noncontrolling interests (12 ) (7 ) (19 ) 0 0 0 Comprehensive income (loss): (69 ) 16 (53 ) 393 8 401 (267 ) 0 (267 ) 246 0 246 (8 ) 0 (8 ) 9 0 9 Less: Reclassification adjustment for (gains) losses included in net earnings (loss) (6 ) 0 (6 ) 29 0 29 Total comprehensive income (loss) Balance, June 30 NOTE 4 – EARNINGS PER SHARE ATTRIBUTABLE TO INTERNATIONAL PAPER COMPANY COMMON SHAREHOLDERS Basic earnings per common share are computed by dividing earnings by the weighted average number of common shares outstanding. Diluted earnings per common share are computed assuming that all potentially dilutive securities, including “in-the-money” stock options, were converted into common shares at the beginning of each period. A reconciliation of the amounts included in the computation of earnings per common share, and diluted earnings per common share is as follows: Net earnings (loss) – assuming dilution Effect of dilutive securities Restricted stock performance share plan (a) Stock options (b) Basic earnings (loss) per common share Diluted earnings (loss) per common share (a) Securities are not included in the table in periods when antidilutive. (b) Options to purchase 19.9 million shares and 23.1 million shares for the three months ended June 30, 2010 and 2009, respectively, and options to purchase 19.9 million shares and 23.1 million shares for the six months ended June 30, 2010 and 2009, respectively, were not included in the computation of diluted common shares outstanding because their exercise price exceeded the average market price of the Company’s common stock for each respective reporting period. NOTE 5 – RESTRUCTURING CHARGES AND OTHER ITEMS During the three months ended June 30, 2010, restructuring and other charges totaling $144 million before taxes ($88 million after taxes) were recorded. Details of this charge were as follows: Before-Tax Charges After-Tax Franklin, Virginia mill closure costs (including $46 million of accelerated depreciation and $36 million of environmental closure costs) S&A reduction initiative Write-off of Ohio Commercial Activity tax receivable During the three months ended March 31, 2010, restructuring and other charges totaling $215 million before taxes ($132 million after taxes) were recorded. Details of this charge were as follows: Franklin, Virginia mill closure costs (including $190 million of accelerated depreciation) Shorewood Packaging reorganization Additionally, a $46 million after-tax charge was recorded during the three months ended March 31, 2010 for tax adjustments related to incentive compensation and postretirement prescription drug coverage (see Note 10). During the three months ended June 30, 2009, restructuring and other charges totaling $79 million before taxes ($55 million after taxes) were recorded. Details of this charge were as follows: 2008 overhead reduction program – severance and benefits Etienne mill – severance and other costs Additionally, the income tax provision for the three months ended June 30, 2009 included a $156 million charge to establish a valuation allowance for deferred tax assets in France, and a $26 million credit related to the settlement of certain tax issues (see Note 10). During the three months ended March 31, 2009, restructuring and other charges totaling $83 million before taxes ($65 million after taxes) were recorded. Details of this charge were as follows: 2008 overhead reduction program – severance and benefit Inverurie mill closure costs Franklin, Virginia lumber mill, sheet converting plant and converting innovations center closure costs Additionally, during the three months ended March 31, 2009, a $20 million charge was recorded related to certain tax adjustments (see Note 10). Alternative Fuel Mixture Credits The U.S. Internal Revenue Code provided a tax credit for companies that use alternative fuel mixtures to produce energy to operate their businesses. The credit, equal to $0.50 per gallon of alternative fuel contained in the mixture, was refundable to the taxpayer. In January 2009, the Company received notification that its application to be registered as an alternative fuel mixer had been approved. During the six months ended June 30, 2009, the Company filed claims for alternative fuel mixture credits covering eligible periods subsequent to November 2008 totaling approximately $1.0 billion, including $189 million recorded in Accounts and notes receivable at June 30, 2009 and $833 million that was received in cash. Accordingly, the accompanying consolidated statement of operations includes credits of approximately $482 million and $1.0 billion for the three months and six months ended June 30, 2009, respectively, in Cost of products sold ($294 million and $624 million after taxes), representing eligible alternative fuel mixture credits earned through June 30, 2009. The credit expired on December 31, 2009. NOTE 6 – ACQUISITIONS, EXCHANGES AND JOINT VENTURES On June 30, 2010, International Paper announced that it had completed the previously announced acquisition of SCA Packaging Asia (SCA) for a preliminary purchase price of $206 million, including $172 million in cash plus assumed debt of $34 million, subject to post-closing adjustments. The preliminary purchase price allocation will be finalized in the first half of 2011. The SCA packaging business in Asia consists of 13 corrugated box plants and two specialty packaging facilities, which are primarily in China, along with locations in Singapore, Malaysia and Indonesia. On August 4, 2008, International Paper completed the acquisition of the assets of Weyerhaeuser Company’s Containerboard, Packaging and Recycling (CBPR) business for approximately $6 billion in cash, subject to post-closing adjustments. The CBPR operating results are included in International Paper’s North American Industrial Packaging business from the date of acquisition. Selling and administrative expenses for the three months and six months ended June 30, 2009 included charges of $18 million before taxes ($11 million after taxes) and $54 million before taxes ($33 million after taxes), respectively, of costs related to the integration of the CBPR business. NOTE 7 – BUSINESSES HELD FOR SALE AND DIVESTITURES During the three months ended June 30, 2009, based on a current strategic plan update of projected future operating results of the Company’s Etienne, France mill, a determination was made that the current book value of the mill’s long-lived assets exceeded their estimated fair value, calculated using the probability-weighted present value of projected future cash flows. As a result, a $48 million charge, before and after taxes, was recorded to write down the long-lived assets of the mill to their estimated fair value. This charge is included in Net (gains) losses on sales and impairments of businesses in the accompanying consolidated statement of operations. NOTE 8 – SUPPLEMENTAL FINANCIAL STATEMENT INFORMATION Temporary investments with an original maturity of three months or less are treated as cash equivalents and are stated at cost. Temporary investments were as follows: Inventories by major category were: Depreciation expense was as follows: $ 348 $ 351 $ 703 $ 686 There was no material activity related to asset retirement obligations during the six months ended June 30, 2010 or 2009. Certain cash payments made were as follows: Income tax payments/(refunds) (99 ) 12 (91 ) 13 (a) Interest expense and interest income exclude approximately $5 million and $15 million for the three months and six months ended June 30, 2010, respectively, and $28 million and $72 million for the three months and six months ended June 30, 2009, respectively, related to investments in and borrowings from variable interest entities for which the Company has a legal right of offset. Equity earnings (losses), net of taxes includes the Company’s share of earnings or losses from its investment in Ilim and certain other smaller investments. Equity earnings (losses), net of taxes, related to Ilim were as follows: Equity earnings (losses), net of taxes – Ilim $ 5 $ (30 ) $ 2 $ (56 ) The components of the Company’s postretirement benefit expense were as follows: $ 0 $ 0 $ 1 $ 1 Amortization of prior service credit (8 ) (7 ) (16 ) (14 ) Net postretirement benefit expense (a) $ 0 $ 4 $ 3 $ 14 (a) Excludes charges of $0.4 million and $1.9 million for the three months and six months ended June 30, 2009, respectively, for termination benefits related to cost reduction programs recorded in Restructuring and other charges in the consolidated statement of operations. NOTE 9 – GOODWILL AND OTHER INTANGIBLES The following tables present changes in goodwill balances as allocated to each business segment for the six months ended June 30, 2010 and 2009: Papers Consumer Packaging Distribution Total $ 1,131 $ 2,423 $ 1,765 $ 400 $ 5,719 0 (1,765 ) (1,664 ) 0 (3,429 ) 1,131 658 101 400 2,290 (6 ) (22 ) 0 0 (28 ) 0 (13 )(c) 0 0 (13 ) 1,125 2,388 1,765 400 5,678 $ 1,125 $ 623 $ 101 $ 400 $ 2,249 (a) Represents accumulated goodwill impairment charges since the adoption of ASC 350, “Intangibles – Goodwill and Other” in 2002. (b) Represents the effects of foreign currency translations and reclassifications. (c) Reflects a reduction from tax benefits generated by the deduction of goodwill amortization for tax purposes in Brazil. $ 989 $ 2,302 $ 1,766 $ 399 $ 5,456 989 537 102 399 2,027 140 (c) (11 )(d) 0 0 129 (c) Reflects purchase accounting adjustments related to the CBPR acquisition. (d) Reflects a reduction from tax benefits generated by the deduction of goodwill amortization for tax purposes in Brazil. The net carrying amount of identifiable intangible assets, excluding goodwill, was as follows: $ 7 $ 9 $ 15 $ 17 NOTE 10 – INCOME TAXES Unrecognized Tax Benefits Accrued Estimated $ (308 ) $ (95 ) The Company currently estimates that, as a result of ongoing discussions, pending tax settlements and expirations of statutes of limitations, the amount of unrecognized tax benefits could be reduced by approximately $15 million during the next 12 months. During the three months ended March 31, 2010, the Company recorded in Income tax provision (benefit), charges totaling $46 million, consisting of a $14 million adjustment of deferred income tax assets relating to incentive compensation payments during the quarter and a $32 million charge to reduce deferred income tax assets related to post-retirement prescription drug coverage (Medicare Part D reimbursement) as a result of the recently enacted “Healthcare and Education Reconciliation Act of 2010.” During the three months ended June 30, 2009, in connection with the ongoing evaluation of the Company’s Etienne mill in France, the Company determined that the future realization of previously recorded deferred tax assets in France, including net operating loss carryforwards, no longer met the “more likely than not” standard for asset recognition. Accordingly, a charge of $156 million, before and after taxes, was recorded in the quarter to establish a valuation allowance for all of these assets. Additionally, during the quarter, as a result of an agreement on the 2004 and 2005 U.S. federal income tax audit and the related state income tax effects, a $26 million credit was recorded. During the three months ended March 31, 2009, the Company recorded in Income tax provision (benefit), charges totaling $20 million, consisting of a $14 million adjustment of deferred income taxes relating to incentive compensation payments during the quarter and a $6 million charge relating to recent state income tax legislation. NOTE 11 – COMMITMENTS AND CONTINGENCIES During the three months ended September 30, 2009, in connection with an environmental site remediation action under CERCLA, International Paper submitted to the EPA a feasibility study for the site. The EPA has indicated that it intends to select a proposed remedial action alternative from those identified in the study and present this proposal for public comment. Since it is not currently possible to determine the final remedial action that will be required, the Company has accrued an estimate of the minimum costs that could be required for this site. When the remediation plan is finalized by the EPA, it is possible that the remediation costs could be significantly higher than amounts currently recorded. In June 2010, the South Carolina Department of Health and Environmental Control (DHEC) finalized its previously proposed consent order to the Company with a civil penalty of $115,000. The penalty was levied for self-disclosed failures by the Company’s Georgetown mill to operate within carbon monoxide and total reduced sulfur emission limits under the mill’s Part 70 (Title V) Air Quality Operating Permit. International Paper is involved in various inquiries, administrative proceedings and litigation relating to contracts, sales of property, intellectual property, environmental and safety matters, tax, personal injury, labor and employment and other matters, some of which allege substantial monetary damages. While any proceeding or litigation has the element of uncertainty, the Company believes that the outcome of any of the lawsuits or claims that are pending or threatened, or all of them combined, will not have a material adverse effect on its consolidated financial statements. NOTE 12 – VARIABLE INTEREST ENTITES AND PREFERRED SECURITIES OF SUBSIDIARIES In connection with the 2006 sale of approximately 5.6 million acres of forestlands, International Paper received installment notes (the Timber Notes) totaling approximately $4.8 billion. The Timber Notes, which do not require principal payments prior to their August 2016 maturity, are supported by irrevocable letters of credit obtained by the buyers of the forestlands. During the three months ended December 31, 2006, International Paper contributed the Timber Notes to newly formed entities (the Borrower Entities) in exchange for Class A and Class B interests in the Investor Entities. Subsequently, International Paper contributed its $200 million Class A interests in the Borrower Entities, along with approximately $400 million of International Paper promissory notes, to other newly formed entities (the Investor Entities, and together with the Borrower Entities, the Entities) in exchange for Class A and Class B interests in these entities, and simultaneously sold its Class A interests in the Investor Entities to a third party investor. As a result, at December 31, 2006, International Paper held Class B interests in the Borrower Entities and Class B interests in the Investor Entities valued at approximately $5.0 billion. International Paper has no obligation to make any further capital contributions to these Entities and did not provide any financial support that was not previously contractually required for the six months ended June 30, 2010 and the year ended December 31, 2009. Also during 2006, the Entities acquired approximately $4.8 billion of International Paper debt obligations for cash, resulting in a total of approximately $5.2 billion of International Paper debt obligations held by the Entities at December 31, 2006. The various agreements entered into in connection with these transactions provide that International Paper has, and intends to affect, a legal right to offset its obligation under these debt instruments with its investments in the Entities. Accordingly, for financial reporting purposes, International Paper has offset approximately $5.1 billion of Class B interests in the Entities against $5.1 billion of International Paper debt obligations held by these Entities at June 30, 2010 and December 31, 2009. Remaining borrowings of $131 million and $144 million at June 30, 2010 and December 31, 2009, respectively, are included in Long-term debt in the accompanying consolidated balance sheet. Additional debt related to the above transaction of $38 million and $46 million is included in short-term debt at June 30, 2010 and December 31, 2009, respectively. International Paper also holds variable interests in two financing entities that were used to monetize long-term notes received from the sale of forestlands in 2002 and 2001. International Paper transferred notes (the Monetized Notes) and cash having a value of approximately $1.0 billion to these entities in exchange for preferred interests, and accounted for the transfers as a sale of the notes with no associated gain or loss. In the same period, the entities acquired approximately $1.0 billion of International Paper debt obligations for cash. International Paper has no obligation to make any further capital contributions to these entities and did not provide any financial support that was not previously contractually required during the six months ended June 30, 2010 and the year ended December 31, 2009. At June 30, 2010, International Paper’s $542 million preferred interest in one of the entities has been offset against related debt obligations since International Paper has, and intends to affect, a legal right of offset to net-settle these two amounts. International Paper’s preferred interest in the remaining entity of $484 million is included in Investments in the accompanying consolidated balance sheets at June 30, 2010 and December 31, 2009. Other outstanding debt related to the above transactions of $445 million and $465 million is included in Long-term debt and $25 million and $7 million is included in short-term debt in the accompanying consolidated balance sheets at June 30, 2010 and December 31, 2009, respectively. Based on an analysis of these entities under guidance that considers the potential magnitude of the variability in the structures and which party has a controlling financial interest, International Paper determined that it is not the primary beneficiary of the above entities, and therefore, should not consolidate its investments in these entities. It was also determined that the source of variability in the structures is the value of the Timber Notes and Monetized Notes, the assets most significantly impacting each structure’s economic performance. The credit quality of the Timber Notes and Monetized Notes are supported by irrevocable letters of credit obtained by the third party buyers which are 100% cash collateralized. International Paper analyzed which party has control over the economic performance of each entity, and concluded International Paper does not have control over significant decisions surrounding the Timber Notes, Monetized Notes and letters of credit and therefore is not the primary beneficiary. The Company’s maximum exposure to loss equals the value of the Timber Notes and Monetized Notes, however, an analysis performed by the Company concluded the likelihood of this exposure is remote. Preferred Securities of Subsidiaries: In March 2003, Southeast Timber, Inc. (Southeast Timber), a consolidated subsidiary of International Paper, issued $150 million of preferred securities to a private investor with future dividend payments based on LIBOR. Southeast Timber, which through a subsidiary initially held approximately 1.5 million acres of forestlands in the southern United States, was International Paper’s primary vehicle for sales of southern forestlands. As of June 30, 2010, substantially all of these forestlands have been sold. These preferred securities may be put back to International Paper by the private investor upon the occurrence of certain events, and have a liquidation preference that approximates their face amount. The $150 million preferred third-party interest is included in Noncontrolling interests in the accompanying consolidated balance sheet. Distributions paid to the third-party investor were $3 million and $4 million for the six months ended June 30, 2010 and 2009, respectively. The expense related to these preferred securities is shown in Net earnings (loss) attributable to noncontrolling interests in the accompanying consolidated statement of operations. NOTE 13 – DEBT In May 2010, International Paper repaid approximately $108 million of notes with interest rates ranging from 5.3% to 9.375% and original maturities from 2015 to 2019. Pre-tax early debt retirement costs of $21 million related to these debt repayments are included in Restructuring and other charges in the accompanying consolidated statement of operations (offset by a $3 million gain on associated interest rate swaps as discussed in Note 14). During the three months ended March 31, 2010, International Paper repaid approximately $120 million of notes with interest rates ranging from 5.25% to 7.4% and original maturities from 2010 to 2027. Pre-tax early debt retirement costs of $5 million related to first-quarter debt repayments are included in Restructuring and other charges in the accompanying consolidated statement of operations (offset by a $1 million gain on associated interest rate swaps as discussed in Note 14). In May 2009, International Paper issued $1 billion of 9.375% senior unsecured notes with a maturity date in May 2019. The proceeds from this borrowing were used, along with available cash, to repay approximately $875 million of notes with interest rates ranging from 4.0% to 9.25% and original maturities from 2010 to 2012. In April 2009, International Paper repaid $313 million of the $2.5 billion long-term debt issued in connection with the CBPR business acquisition. As of December 31, 2009, this debt was repaid. Also in April 2009, International Paper Company Europe Ltd, a wholly-owned subsidiary of International Paper, repaid $75 million of notes issued in connection with the Ilim Holdings S.A. joint ventures that matured. Pre-tax early debt retirement costs of $46 million related to these debt repayments are included in Restructuring and other charges in the accompanying consolidated statement of operations. In March 2009, International Paper Investments (Luxembourg) S.a.r.l, a wholly-owned subsidiary of International Paper, borrowed $468 million of long-term debt with an initial interest rate of LIBOR plus a margin of 450 basis points that varied upon the credit rating of the Company, and a maturity date in March 2012. International Paper used the $468 million of proceeds from the loan and cash of approximately $170 million to repay its 500 million euro-denominated debt (equivalent to $638 million at date of payment) with an original maturity date in August 2009. As of July 31, 2009, the $468 million loan was repaid. Other debt activities during the three months ended March 31, 2009 included the repayment of approximately $366 million of notes with interest rates ranging from 4.25% to 5.0% that had matured. At June 30, 2010 and December 31, 2009, International Paper classified $100 million and $450 million, respectively, of bank notes and current maturities of long-term debt as Long-term debt. International Paper has the intent and ability, as evidenced by its contractually committed credit facility, to renew or convert these obligations. At June 30, 2010, International Paper had $8.9 billion of debt with a fair value of approximately $10 billion. The fair value of the Company’s long-term debt is estimated based on the quoted market prices for the same or similar issues. NOTE 14 – DERIVATIVES AND HEDGING ACTIVITIES International Paper periodically uses derivatives and other financial instruments to hedge exposures to interest rate, commodity and currency risks. International Paper does not hold or issue financial instruments for trading purposes. For hedges that meet the hedge accounting criteria, International Paper, at inception, formally designates and documents the instrument as a fair value hedge, a cash flow hedge or a net investment hedge of a specific underlying exposure, as well as the risk management objective and strategy for undertaking each hedge transaction. Derivatives are recorded in the consolidated balance sheet at fair value, determined using available market information or other appropriate valuation methodologies, in Other current assets, Deferred charges and other assets, Other accrued liabilities and Other liabilities. The earnings impact resulting from changes in the fair value of derivative instruments is recorded in the same line item in the consolidated statement of operations as the underlying exposure being hedged or in Accumulated other comprehensive income (AOCI) for derivatives that qualify as cash flow hedges. Any ineffective portion of a financial instrument’s change in fair value is recognized currently in earnings together with changes in the fair value of any derivatives not designated as hedges. Foreign exchange contracts are used by International Paper to offset the earnings impact relating to the variability in exchange rates on certain monetary assets and liabilities denominated in non-functional currencies and are not designated as hedges. Changes in the fair value of these instruments, recognized currently in earnings to offset the remeasurement of the related assets and liabilities, were immaterial for the six months ended June 30, 2010 and totaled a loss of approximately $52 million for the six months ended June 30, 2009. As of June 30, 2010 and December 31, 2009, outstanding undesignated foreign exchange contracts included the following: Undesignated Volumes Sell / Buy Sell Notional Sell Notional U.S. dollar / Brazilian real U.S. dollar / European euro European euro / Great British pounds European euro / Polish zloty European euro/ U.S. dollar South Korean won / U.S. dollar Interest rate swap agreements at June 30, 2010, of $1 billion floating-to-fixed notional and an offsetting $1 billion fixed-to-floating notional, do not qualify as hedges under the accounting guidance and mature in September 2010. Changes in the fair value of these instruments, recognized in earnings, totaled a gain of $15 million for the six months ended June 30, 2010. Fair Value Hedges For derivative instruments that are designated and qualify as fair value hedges, the gain or loss on the derivative, as well as the offsetting gain or loss on the hedged item attributable to the hedged risk, are recognized in earnings. International Paper utilizes interest rate swaps as fair value hedges of the benchmark interest rates of fixed-rate debt. At June 30, 2010 and December 31, 2009, the outstanding notional amounts of interest rate swap agreements that qualify as fully effective fair value hedges were approximately $274 million and $1.1 billion, respectively. During the three months ended June 30, 2010, in connection with early debt extinguishment, interest rate swap hedges with a notional value of $2 million were undesignated as effective fair value hedges. The resulting gain was immaterial. Also, related to early debt extinguishment, deferred gains of $3 million related to previously terminated effective interest rate swaps were recognized in earnings. This gain is included in Restructuring and other charges in the accompanying consolidated statement of operations. In June 2010, interest rate swap agreements designated as fair value hedges with a notional value of $100 million were terminated. The termination was not in connection with early retirement of debt. The resulting gain of $3 million was deferred and recorded in Long-term debt and will be amortized as an adjustment of interest expense over the life of the underlying debt through 2019. In January 2010, approximately $700 million fixed-to-floating interest rate swaps that were issued in 2009 were terminated. These terminations were not in connection with early debt retirements. The resulting $2 million gain was deferred and recorded in Long-term debt and is being amortized as an adjustment of interest expense over the life of the underlying debt through 2015. During the three months ended March 31, 2010, a previously deferred gain of $1 million was recognized in earnings in connection with early debt retirements. This gain is included in Restructuring and other charges in the accompanying consolidated statement of operations. During the three months ended June 30, 2009, the Company entered into a series of fixed-to-floating interest rate swap agreements with a notional amount of $500 million. These fixed-to-floating interest rate swaps were terminated as effective fair value hedges in the third quarter of 2009. During the three months ended March 31, 2009, an interest rate swap agreement designated as a fair value hedge with a notional value of $100 million was terminated. The termination was not in connection with early retirement of debt. The resulting gain of $11 million was deferred and recorded in Long-term debt and will be amortized as an adjustment of interest expense over the life of the underlying debt through 2016. Cash Flow Hedges For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative is reported as a component of AOCI and reclassified into earnings in the same period or periods in which the hedged transaction affects earnings. Financial instruments designated as cash flow hedges are assessed both at inception and quarterly thereafter to ensure they are effective in offsetting changes in the cash flows of the related underlying exposures. The fair value of the hedge instruments are reclassified out of AOCI to earnings if the hedge ceases to be highly effective or if the hedged transaction is no longer probable. International Paper utilizes interest rate swaps as cash flow hedges of the benchmark interest rate of future interest payments. At June 30, 2010 and December 31, 2009, there were no outstanding interest rate swap agreements that qualified as cash flow hedges. Commodity Risk To minimize volatility in earnings due to large fluctuations in the price of commodities, International Paper utilizes swap contracts to manage risks associated with market fluctuations in energy prices. These contracts are designated as cash flow hedges of forecasted commodity purchases. At June 30, 2010, the hedged volumes of these energy contracts totaled 500,000 barrels of fuel oil and 17 million MMBTU (Million British Thermal Units) of natural gas. These contracts had maturities of three years or less as of June 30, 2010. At December 31, 2009, the hedged volumes totaled 900,000 barrels of fuel oil and 21 million MMBTUs of natural gas. Deferred losses totaling $15 million after taxes at June 30, 2010 are expected to be recognized through earnings within the next 12 months. Foreign Currency Risk Foreign exchange contracts are also used as cash flow hedges of certain forecasted transactions denominated in foreign currencies to manage volatility associated with these transactions and to protect International Paper from currency fluctuations between the contract date and ultimate settlement. At June 30, 2010, these contracts have maturities of three years or less. Deferred gains of $10 million after taxes at June 30, 2010 are expected to be recognized through earnings within the next 12 months. As of June 30, 2010 and December 31, 2009, the following outstanding foreign exchange contracts were entered into as cash flow hedges of forecasted transactions: Designated Volumes European euro / Brazilian real Great British pounds / Brazilian real On June 30, 2010, foreign exchange contracts to sell 123 million U.S. dollars and buy Brazilian reals were undesignated as cash flow hedges of an International Paper wholly-owned subsidiary’s foreign exchange risk due to the forecasted transactions not being probable. Since the forecasted transactions remain reasonably possible, the fair value of the contracts, a $2 million asset, was deferred in AOCI and will be reclassified out of AOCI to earnings when the forecasted transactions are no longer reasonably possible or when the hedged transactions affect earnings. Information on these contracts is included with derivatives not designated as hedging instruments and is included in the appropriate tables. International Paper’s financial assets and liabilities that are recorded at fair value on a recurring basis consist of derivative contracts, including interest rate swaps, foreign currency forward contracts, and other financial instruments that are used to hedge exposures to interest rate, commodity and currency risks. In addition, a consolidated subsidiary of International Paper contains an embedded derivative. For these financial instruments and the embedded derivative, fair value is determined at each balance sheet date using an income approach. Below is a description of the valuation calculation and the inputs used for each class of contract: Interest rate forward contracts are valued using swap curves obtained from an independent market data provider. The market value of each contract is the sum of the fair value of all future interest payments between the contract counterparties, discounted to present value. The fair value of the future interest payments is determined by comparing the contract rate to the derived forward interest rate and present valued using the appropriate derived interest rate curve. Fuel Oil Contracts Fuel oil forward contracts are valued using the average of two forward fuel oil curves as quoted by third parties. The fair value of each contract is determined by comparing the strike price to the forward price of the corresponding fuel oil contract and present valued using the appropriate interest rate curve. Natural Gas Contracts All natural gas contracts are traded over-the-counter and settled using the NYMEX last day settle price; therefore, forward contracts are valued using the closing prices of the NYMEX natural gas future contracts. The fair value of each contract is determined by comparing the strike price to the closing price of the corresponding natural gas future contract and present valued using the appropriate interest rate curve. Foreign currency forward contracts are valued using foreign currency forward and interest rate curves obtained from an independent market data provider. The forward rates are interpolated for each date a contract matures. The fair value of each contract is determined by comparing the contract rate to the interpolated forward rate. The fair value is present valued using the appropriate derived interest rate curve. Embedded Derivative The embedded derivative is valued using a hypothetical interest rate derivative with identical terms. The hypothetical interest rate derivative contracts are fair valued as described above under Interest Rate Contracts. Since the volume and level of activity of the markets that each of the above contracts are traded in has been normal, the fair value calculations have not been adjusted for inactive markets or disorderly transactions. The guidance for fair value measurements and disclosures sets out a fair value hierarchy that groups fair value measurement inputs into three classifications: Level 1, Level 2 and Level 3. Level 1 inputs are quoted prices in an active market for identical assets or liabilities. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability. Transfers between levels are recognized at the end of the reporting period. All of International Paper’s fair value measurements use Level 2 inputs. The following table provides a summary of the impact of our derivative instruments in the consolidated balance sheet: Assets Liabilities Interest rate contracts – fair value $ 10 (a) $ 5 (d) $ 0 $ 20 (j) Fuel oil contracts – cash flow 6 (b) 16 (e) 1 (f) 4 (f) Natural gas contracts – cash flow 0 0 40 (g) 38 (k) 18 (b) 32 (b) 4 (h) 0 $ 34 $ 53 $ 45 $ 62 $ 0 $ 1 (b) $ 16 (i) $ 29 (l) Embedded derivatives 9 (c) 6 (c) 0 0 5 (b) 2 (b) 1 (f) 2 (f) $ 14 $ 9 $ 17 $ 31 (a) Includes $2 million recorded in Accounts and notes receivable, net, and $8 million recorded in Deferred charges and other assets in the accompanying consolidated balance sheet. (b) Included in Other current assets in the accompanying consolidated balance sheet. (c) Included in Deferred charges and other assets in the accompanying consolidated balance sheet. (d) Includes $2 million recorded in Accounts and notes receivable, net, and $3 million recorded in Deferred charges and other assets in the accompanying consolidated balance sheet. (e) Includes $13 million recorded in Other current assets and $3 million recorded in Deferred charges and other assets in the accompanying consolidated balance sheet. (f) Included in Other accrued liabilities in the accompanying consolidated balance sheet. (g) Includes $29 million recorded in Other accrued liabilities and $11 million recorded in Other liabilities in the accompanying consolidated balance sheet. (h) Includes $2 million recorded in Other accrued liabilities and $2 million recorded in Other liabilities in the accompanying consolidated balance sheet. (i) Includes $8 million recorded in Other accrued liabilities and $8 million recorded in Other liabilities in the accompanying consolidated balance sheet. (j) Included in Other liabilities in the accompanying consolidated balance sheet. (k) Includes $26 million recorded in Other accrued liabilities and $12 million recorded in Other liabilities in the accompanying consolidated balance sheet. (l) Includes $23 million recorded in Other accrued liabilities and $6 million recorded in Other liabilities in the accompanying consolidated balance sheet. The following table provides the change in AOCI, net of tax, related to derivative instruments for the six months ended June 30: Gain or (Loss) Recognized in OCI Location of Gain or (Loss) OCI into Income (Gain) or Loss $ 0 $ (3 ) Interest expense, net $ 0 $ 10 (3 ) 15 Cost of products sold (1 ) 5 (14 ) (18 ) Cost of products sold 11 13 9 15 Cost of products sold (16 ) 1 $ (8 ) $ 9 $ (6 ) $ 29 International Paper evaluates credit risk by monitoring its exposure with each counterparty to ensure that exposure stays within acceptable policy limits. Credit risk is also mitigated by contractual provisions with the majority of our banks. Most of the contracts include a credit support annex that requires the posting of collateral by the counterparty or International Paper based on each party’s rating and level of exposure. Based on the Company’s current credit rating, the collateral threshold is generally $10 million. If the lower of the Company’s credit rating by Moody’s or S&P were to drop below investment grade, the Company would be required to post collateral for all derivatives in a net liability position, although no derivatives would terminate. The fair values of derivative instruments containing credit-risk-related contingent features in a net liability position were $30 million as of June 30, 2010 and $65 million as of December 31, 2009. The Company was required to post $2 million of collateral as of June 30, 2010 and an immaterial amount of collateral as of December 31, 2009 due to exceeding the counterparty’s collateral threshold in the normal course of business. In addition, existing derivative contracts (except foreign exchange contracts) provide for netting across derivative positions in the event a counterparty defaults on a payment obligation. International Paper currently does not expect any of the counterparties to default on their obligations. NOTE 15 – RETIREMENT PLANS International Paper maintains pension plans that provide retirement benefits to substantially all salaried U.S. employees hired prior to July 1, 2004 and substantially all hourly and union employees regardless of hire date. These employees generally are eligible to participate in the plans upon completion of one year of service and attainment of age 21. Salaried employees hired after June 30, 2004, who are not eligible for these pension plans, receive an additional company contribution to their individual savings plans. The pension plans provide defined benefits based on years of credited service and either final average earnings (salaried employees), hourly job rates or specified benefit rates (hourly and union employees). A detailed discussion of these plans is presented in Note 16 to the financial statements included in International Paper’s 2009 Form 10-K. (157 ) (158 ) (315 ) (316 ) Net periodic pension expense (a) $ 57 $ 46 $ 116 $ 107 (a) Excludes charges of $17 million and $48 million for the three months and six months ended June 30, 2009, respectively, for termination benefits related to cost reduction programs recorded in Restructuring and other charges in the consolidated statement of operations. The Company’s funding policy for its qualified pension plans is to contribute amounts sufficient to meet legal funding requirements, plus any additional amounts that the Company may determine to be appropriate considering the funded status of the plan, tax deductibility, the cash flows generated by the Company, and other factors. The Company continually reassesses the amount and timing of any discretionary contributions and made a voluntary contribution of $500 million on July 27, 2010 (see Note 18). The nonqualified defined benefit plans are funded to the extent of benefit payments, which totaled $11 million for the six months ended June 30, 2010. NOTE 16 – STOCK-BASED COMPENSATION International Paper has an Incentive Compensation Plan (ICP) which, upon the approval by the Company’s shareholders in May 2009, replaced the Company’s Long-Term Incentive Compensation Plan (LTICP). The ICP authorizes the grants of restricted stock, restricted or deferred stock units, performance awards payable in cash or stock upon the attainment of specified performance goals, dividend equivalents, stock options, stock appreciation rights, other stock-based awards in the discretion of the Committee, and cash-based awards. The ICP is administered by the Management Development and Compensation Committee of the Board of Directors (the Committee). A detailed discussion of the ICP and LTICP, including the stock option program and executive continuity award program that provided for tandem grants of restricted stock and stock options, is presented in Note 18 to the financial statements included in International Paper’s 2009 Form 10-K. As of June 30, 2010, 17 million shares were available for grant under the ICP. Total stock-based compensation cost recognized in Selling and administrative expenses in the accompanying consolidated statement of operations for the six months ended June 30, 2010 and 2009 was $21 million and $47 million, respectively. The actual tax deduction realized for stock-based compensation costs related to non-qualified stock options was zero for both of the six months ended June 30, 2010 and 2009. The actual tax deduction realized for stock-based compensation costs related to restricted and performance shares was $75 million and $28 million for the six months ended June 30, 2010 and 2009, respectively. At June 30, 2010, $74 million, net of estimated forfeitures, of compensation cost related to unvested restricted performance shares, executive continuity awards and restricted stock attributable to future performance had not yet been recognized. This amount will be recognized in expense over a weighted-average period of 1.6 years. Performance-Based Restricted Share Program: Under the Performance Share Program (PSP), contingent awards of International Paper common stock are granted by the Committee to approximately 1,200 employees. Awards are earned based on the achievement of defined performance rankings of return on investment (ROI) and total shareholder return (TSR) compared to peer groups. Awards are weighted 75% for ROI and 25% for TSR for all participants except for officers for whom awards are weighted 50% for ROI and 50% for TSR. The ROI component of the PSP awards is valued at the closing stock price on the day prior to the grant date. As the ROI component contains a performance condition, compensation expense, net of estimated forfeitures, is recorded over the requisite service period based on the most probable number of awards expected to vest. The TSR component of the PSP awards is valued using a Monte Carlo simulation as the TSR component contains a market condition. The Monte Carlo simulation estimates the fair value of the TSR component based on the expected term of the award, the risk-free rate, expected dividends, and the expected volatility for the Company and its competitors. The expected term was estimated based on the vesting period of the awards, the risk-free rate was based on the yield on U.S. Treasury securities matching the vesting period, the expected dividends were assumed to be zero for all companies, and the volatility was based on the Company’s historical volatility over the expected term. PSP awards issued to certain members of senior management are liability awards, which are required to be remeasured at fair value at each balance sheet date. The valuation of these PSP liability awards is computed based on the same methodology as other PSP awards. The following table sets forth the assumptions used to determine compensation cost for the market condition component of the PSP plan: June 30, 2010 Six Months Ended Risk-free interest rate 0.23% - 1.49% 0.23% - 1.49% The following summarizes the activity for PSP for the six months ended June 30, 2010: Nonvested Shares Weighted Average Outstanding at December 31, 2009 6,066,050 $ 24.28 3,842,626 28.93 Shares Issued (a) (2,772,975 ) 33.35 (201,822 ) 21.26 Outstanding at June 30, 2010 (a) Includes 130,714 shares held for payout at the end of the performance period. Stock Option Program: The Company discontinued its stock option program in 2004 for members of executive management, and in 2005 for all other eligible U.S. and non-U.S. employees. The following summarizes the option activity under the plan for the six months ended June 30, 2010: Options Weighted Exercise Price Weighted Remaining Life (years) Aggregate 22,217,057 $ 39.24 (23,650 ) 34.12 19,936,298 $ 37.33 2.6 $ 0 All options were fully vested and exercisable as of June 30, 2010. Executive Continuity and Restricted Stock Award Program: The following summarizes the activity of the Executive Continuity and Restricted Stock Award Program for the six months ended June 30, 2010: 83,000 $ 33.93 131,500 26.48 Shares Issued 171,500 $ 28.80 NOTE 17 – INDUSTRY SEGMENT INFORMATION International Paper’s industry segments, Industrial Packaging, Printing Papers, Consumer Packaging, Distribution and Forest Products, are consistent with the internal structure used to manage these businesses. All segments are differentiated on a common product, common customer basis consistent with the business segmentation generally used in the Forest Products industry. The Company also has a 50% equity interest in Ilim in Russia that is a separate reportable industry segment. Sales by industry segment for the three months and six months ended June 30, 2010 and 2009 were as follows: Ended June 30, Six Months Ended $ 2,440 $ 2,270 $ 4,660 $ 4,450 Consumer Packaging Corporate and Intersegment Sales Operating profit by industry segment for the three months and six months ended June 30, 2010 and 2009 were as follows: $ 192 (b) $ 382 (d,e,f) $ 233 (b) $ 742 (d,e,f) 47 (c) 279 (d,g) (31 )(c) 591 (d,g) 48 (h) 114 (d,h) 76 (h) 226 (d,h) Operating Profit (a) Noncontrolling interests/equity earnings adjustment (i) Corporate items, net (54 ) (44 ) (105 ) (95 ) (31 ) (59 ) (34 ) (111 ) $ 118 $ 520 $ (57 ) $ 1,038 Equity earnings (loss), net of taxes – Ilim (a) (a) In addition to the operating profits shown above, International Paper recorded equity earnings, net of taxes, of $5 million and $2 million for the three months and six months ended June 30, 2010, respectively, and equity losses, net of taxes, of $30 million and $56 million for the three months and six months ended June 30, 2009, respectively, related to its equity investment in Ilim Holding S.A., a separate reportable industry segment. (b) Includes charges of $1 million and $2 million for additional closure costs for the Etienne mill in France for the three months ended June 30, 2010 and March 31, 2010, respectively, and $3 million of additional closure costs for U.S. mills for the three months ended March 31, 2010. (c) Includes charges of $111 million and $204 million for the three months ended June 30, 2010 and March 31, 2010, respectively, for shutdown costs for the Franklin mill. (d) Includes gains of $208 million and $416 million for the Industrial Packaging segment, $197 million and $437 million for the Printing Papers segment, and $77 million and $169 million for the Consumer Packaging segment for the three months and six months ended June 30, 2009, respectively, relating to alternative fuel mixture credits. (e) Includes charges of $48 million to write down the assets at the Etienne mill in France to estimated fair value and $15 million for severance and other costs related to the Etienne mill. (f) Includes charges of $18 million and $54 million for the three months and six months ended June 30, 2009, respectively, for CBPR integration costs. (g) Includes charges of $4 million and $10 million for the three months and six months ended June 30, 2009, respectively, for shutdown costs for the Louisiana mill and the Franklin lumber mill, sheet converting plant and converting innovations center, and a charge of $23 million for the six months ended June 30, 2009 for the closure of the Inverurie, Scotland, mill. (h) Includes charges of $1 million for both the three months ended June 30, 2010 and 2009 and $4 million and $3 million for the six months ended June 30, 2010 and 2009, respectively, related to the reorganization of the Company’s Shorewood operations. (i) Operating profits for industry segments include each segment’s percentage share of the profits of subsidiaries included in that segment that are less than wholly owned. The pre-tax noncontrolling interest and equity earnings for these subsidiaries are included here to present consolidated earnings before income taxes and equity earnings. NOTE 18 – SUBSEQUENT EVENT On July 22, 2010, the Company announced that it had signed an agreement to sell 163,000 acres of properties located in the southeastern United States to an affiliate of Rock Creek Capital (the Partnership) for $200 million. A minimum of $160 million will be received at closing, with the balance, plus interest, to be received no later than three years from closing. In addition, the Company will receive 20% of the Partnership’s net profits after it achieves certain financial returns. On July 27, 2010, the Company made a $500 million voluntary contribution to its qualified defined benefit plan (see Note 15). International Paper produced solidly improving results in the second quarter of 2010, as earnings per share before special items increased to $0.42, up from $0.04 per share in the first quarter of 2010 and more than double the $0.20 per share reported for the second quarter of 2009. Improvement was driven by revenue growth and significant margin expansion, both due to a combination of the realization of previously announced price increases, volume growth in most of our businesses and geographies, strong mill and converting operations, and benefits from ongoing cost reduction efforts. While extraordinarily high costs that negatively impacted our first quarter results for both virgin and recycled fiber did begin to decline during the second quarter, they remained elevated from historical levels. Also, our strong earnings were generated in spite of higher maintenance outage expenses in the second quarter of 2010, which reduced earnings by approximately $0.05 per share as compared with the 2010 first quarter. Importantly, as North American results are slowly improving, we were particularly pleased with the global balance provided by our second quarter results, with all of our international operations recording strong results. Our European paper and packaging operations generated record earnings in the second quarter of 2010, as did our Asia operations. Looking ahead to the third quarter of 2010, our expectations are shaped by our views on current global macroeconomic conditions. We believe the North American market will continue to grow slowly. The outlook for economic growth is better in other parts of the globe where we market our products, particularly in Russia, Latin America and China. The story in Europe is mixed, as markets in Germany, Poland and Turkey are strong, but the balance of Europe for the most part is weak. Based on our views, we expect demand to continue to grow in the third quarter, although at a slower pace. We expect continued realization of our announced paper and coated paperboard price increases and significant incremental realization of our announced North American corrugated packaging price increases. We expect lower maintenance outages across the Company’s mill system. We expect input costs to stabilize, but remain high. We do, however, expect a continued favorable trend in wood costs, but are less certain about the outlook for recycled fiber costs. We expect a significant increase in other costs, primarily for compensation accruals, among others. All things considered, we expect third quarter earnings to increase meaningfully from second quarter levels. Earnings per share attributable to International Paper shareholders before special items is a non-GAAP measure. Diluted earnings (loss) per share attributable to International Paper shareholders is the most direct comparable GAAP measure. The Company calculates earnings per share before special items by excluding the after-tax effect of items considered by management to be unusual from the earnings reported under GAAP. Management uses this measure to focus on on-going operations, and believes that it is useful to investors because it enables them to perform meaningful comparisons of past and present operating results. The Company believes that using this information, along with diluted earnings (loss) per share, provides for a more complete analysis of the results of operations by quarter. The following is a reconciliation of earnings per share attributable to International Paper shareholders before special items to diluted earnings (loss) per share attributable to International Paper shareholders. June 30, Three Months Ended Earnings Per Share Before Special Items $ 0.42 $ 0.20 $ 0.04 (0.21 ) (0.13 ) (0.31 ) CBPR business integration costs — (0.03 ) 0 — 0.69 0 Net losses on sales and impairments of businesses Income tax adjustments — (0.30 ) (0.11 ) Diluted Earnings (Loss) Per Common Share as $ 0.21 $ 0.32 $ (0.38 ) For the second quarter of 2010, International Paper Company reported net sales of $6.1 billion, compared with $5.8 billion in the second quarter of 2009 and $5.8 billion in the first quarter of 2010. Net earnings attributable to International Paper totaled $93 million, or $0.21 per share, in the 2010 second quarter. This compared with earnings of $136 million, or $0.32 per share, in the second quarter of 2009 and a loss of $162 million, or $0.38 per share, in the first quarter of 2010. Compared with the second quarter of 2009, earnings in the 2010 second quarter benefited from higher average sales price realizations ($81 million), higher sales volumes and lower lack-of-order downtime ($53 million), lower operating costs and a more favorable mix of products sold ($44 million), higher earnings from land and mineral sales ($25 million), lower net interest expense ($11 million), and a lower income tax expense ($6 million) reflecting a lower estimated tax rate. These benefits were offset by higher raw material and freight costs ($133 million), a provision for bad debt related to a large envelope company ($22 million), and slightly higher corporate items and other costs ($5 million). Equity earnings, net of taxes, relating to International Paper’s investment in Ilim Holding S.A. were $35 million higher in the 2010 second quarter than in the 2009 second quarter. Net special items were a loss of $88 million in the 2010 second quarter, compared with a gain of $50 million in the 2009 second quarter. Compared with the first quarter of 2010, earnings benefited from higher average sales price realizations ($125 million), higher sales volumes and lower lack-of-order downtime ($21 million), lower operating costs and a more favorable mix of products sold ($28 million), higher earnings from land and mineral sales ($22 million), decreased corporate items and other costs ($3 million), and a lower income tax provision ($3 million) reflecting a lower estimated effective tax rate in the second quarter of 2010. These benefits were offset by higher raw material and freight costs ($8 million), higher mill outage costs ($11 million), and a provision for bad debt for a large envelope company ($22 million). Net interest expense increased ($4 million). Equity earnings, net of taxes for Ilim Holding, S.A. increased by $8 million versus the first quarter. Net special items were losses of $88 million in the 2010 second quarter and $178 million in the 2010 first quarter. To measure the performance of the Company’s business segments from period to period without variations caused by special or unusual items, International Paper’s management focuses on business segment operating profit. This is defined as earnings before taxes, equity earnings and noncontrolling interests net of taxes, excluding interest expense, corporate charges and special items that include restructuring charges and (gains) losses on sales and impairments of businesses. The following table presents a reconciliation of net earnings attributable to International Paper to its operating profit: June 30, March 31, Earnings (Loss) Attributable to International Paper Company $ 93 $ 136 $ (162 ) Add back (deduct): 25 348 (24 ) Equity (earnings) loss, net of taxes (7 ) 32 2 Noncontrolling interests, net of taxes 118 520 (175 ) Noncontrolling interests / equity earnings included in operations (7 ) (8 ) (8 ) Corporate items Special items: $ 353 $ 788 $ 20 Industry Segment Operating Profit Total Industry Segment Operating Profit (1) (1) In addition to the operating profits shown above, International Paper recorded equity earnings, net of taxes, of $5 million for the three months ended June 30, 2010 and equity losses, net of taxes, of $30 million for the three months ended June 30, 2009 and $3 million for the three months ended March 31, 2010 related to its equity investment in Ilim Holding S.A., a separate reportable industry segment. Industry segment operating profits of $353 million in the 2010 second quarter were lower than the $788 million ($306 million excluding gains from alternative fuel mixture credits) in the 2009 second quarter, but higher than the $20 million in the 2010 first quarter. Compared with the second quarter of 2009, earnings in the current quarter benefited from higher average sales price realizations ($122 million), higher sales volumes and decreased lack-of-order downtime ($80 million), lower operating costs and a more favorable mix of products sold ($66 million), higher gains from land and mineral sales ($37 million), and slightly lower corporate items and other costs ($2 million). These benefits were offset by higher raw material and freight costs ($200 million) and a provision for bad debt for a large envelope company ($33 million). Special items consisted of a loss of $113 million in the 2010 second quarter and a gain of $396 million in the 2009 second quarter. Compared with the 2010 first quarter, operating profits benefited from higher average sales price realizations ($185 million), higher sales volumes and lower lack-of-order downtime ($31 million), lower operating costs and a more favorable mix of products sold ($42 million), higher gains from land and mineral sales ($32 million), and lower corporate items and other costs ($6 million). These benefits were offset by higher mill outage costs ($17 million), higher raw material and freight costs ($12 million), and a bad debt provision for a large envelope company ($33 million). Special items consisted of losses of $113 million in the 2010 second quarter and $212 million in the first quarter of 2010. During the 2010 second quarter, International Paper took approximately 214,000 tons of downtime of which essentially none was market-related, compared with approximately 1,035,000 tons of downtime in the second quarter of 2009, which included 229,000 tons that were market-related and 554,000 tons related to capacity reductions at our Albany, Pineville, Franklin, and Valliant mills. The market-related downtime in the first quarter of 2010 included 52,000 tons of downtime, including approximately 34,000 tons that were related to lack of wood, and 18,000 related to capacity reductions at our Franklin mill. Market-related downtime is taken to balance internal supply with our customer demand to help manage inventory levels, while maintenance downtime, which makes up the majority of the difference between total downtime and market-related downtime, is taken periodically during the year. Sales Volumes by Product (1) Sales volumes of major products for the three-month and six-month periods ended June 30, 2010 and 2009 were as follows: In thousands of short tons Containerboard Saturated Kraft Bleached Kraft European Industrial Packaging Asia Industrial Packaging U.S. Uncoated Papers European and Russian Uncoated Papers Brazilian Uncoated Papers Asian Uncoated Papers Market Pulp (2) U.S. Coated Paperboard European Coated Paperboard Asian Coated Paperboard Other Consumer Packaging (1) Sales volumes include third party and inter-segment sales and exclude sales of equity investees. (2) Includes internal sales to mills. The income tax provision was $25 million for the 2010 second quarter. Excluding a benefit of $56 million relating to the tax effects of special items, the effective tax rate for operations was 31%. An income tax benefit of $24 million was recorded for the 2010 first quarter. Excluding a $32 million expense to reduce deferred income tax assets related to postretirement prescription drug coverage (Medicare Part D reimbursements), a $14 million expense to reduce deferred income tax assets relating to incentive compensation payments and a benefit of $83 million relating to the tax effects of special items, the effective tax rate for operations was 32%. The income tax provision was $348 million for the 2009 second quarter. Excluding a $156 million charge to establish a valuation allowance for deferred tax assets in France, a $26 million benefit relating to the completion of the 2004 and 2005 U.S. federal income tax audit and related state income tax effects, and an expense of $157 million relating to the tax effects of special items, the effective income tax rate for operations was 33% for the quarter. Interest Expense and Corporate Items Net interest expense for the 2010 second quarter was $157 million compared with $149 million in the 2010 first quarter and $173 million in the 2009 second quarter. The lower net expense compared with the second quarter of 2009 is due to the repayment of $2.5 billion of debt in 2009. Corporate items, net, of $54 million in the 2010 second quarter were higher than the $51 million of net expense in the 2010 first quarter and the $44 million of net expense in the 2009 second quarter. The increase compared with the second quarter of 2009 was due to higher pension costs. During the three months ended June 30, 2010, restructuring and other charges totaling $144 million before taxes ($88 million after taxes) were recorded, including a $111 million pre-tax charge ($68 million after taxes) for closure costs related to the paper mill and associated operations in Franklin, Virginia (including $46 million of accelerated depreciation and $36 million of environmental closure costs), a $2 million pre-tax charge ($1 million after taxes) for costs associated with the Company’s S&A reduction initiative, an $18 million pre-tax charge ($11 million after taxes) for costs related to the early extinguishment of debt, an $11 million pre-tax charge ($7 million after taxes) to write off an Ohio Commercial Activity tax receivable and a $2 million pre-tax charge ($1 million after taxes) for other items. During the three months ended March 31, 2010, restructuring and other charges totaling $215 million before taxes ($132 million after taxes) were recorded, including a $204 million pre-tax charge ($124 million after taxes) for closure costs related to the paper mill and associated operations in Franklin, Virginia (including accelerated depreciation of $190 million), a $4 million pre-tax charge ($2 million after taxes) for costs related to the early extinguishment of debt, a $3 million pre-tax charge ($2 million after taxes) for costs associated with the reorganization of the Company’s Shorewood Packaging operations and charges of $4 million (before and after taxes) for other items. Additionally, a $46 million after-tax charge was recorded for tax adjustments related to incentive compensation and postretirement prescription drug coverage. During the three months ended June 30, 2009, restructuring and other charges totaling $79 million before taxes ($55 million after taxes) were recorded, including a $34 million charge before taxes ($21 million after taxes) for severance and benefit costs associated with the Company’s 2008 overhead reduction program, a $25 million charge before taxes ($16 million after taxes) related to early debt extinguishment costs, a $15 million charge, before and after taxes, for severance and other costs related to the Company’s Etienne mill in France, and a $5 million charge before taxes ($3 million after taxes) for other closure costs. Additionally, the second quarter income tax provision included a $156 million charge to establish a valuation allowance for deferred tax assets in France, and a $26 million credit related to the settlement of certain tax issues. During the three months ended March 31, 2009, restructuring and other charges totaling $83 million before taxes ($65 million after taxes) were recorded, including a $52 million charge before taxes ($32 million after taxes) for severance and benefits associated with the Company’s 2008 overhead reduction program, a $23 million charge before taxes ($28 million after taxes) for closure costs related to the Inverurie mill in Scotland, a $6 million charge before taxes ($4 million after taxes) related to the shutdown of certain operations at the Franklin, Virginia mill, and a $2 million pre-tax charge ($1 million after taxes) for costs associated with the reorganization of the Company’s Shorewood Packaging operations. Additionally, a $20 million charge was recorded for certain tax adjustments. BUSINESS SEGMENT OPERATING RESULTS The following presents business segment discussions for the second quarter of 2010. 2nd Quarter 1st Quarter Six Months 2nd Quarter 1st Quarter Six Months $ 2,440 $ 2,220 $ 4,660 $ 2,270 $ 2,180 $ 4,450 192 41 233 382 360 742 Industrial Packaging net sales for the second quarter of 2010 were 10% higher than in the first quarter of 2010 and 7% higher than in the second quarter of 2009. Operating profits included $1 million and $2 million in the second and first quarters of 2010, respectively, of additional expenses related to the closure of the Etienne mill in France. In addition, operating profits in the first quarter of 2010 included $3 million of costs associated with the integration of the Weyerhaeuser Containerboard, Packaging and Recycling (CBPR) acquisition. Operating profits in the second quarter of 2009 included a gain of $208 million relating to alternative fuel mixture credits, $63 million of costs associated with the closure of the Etienne mill and $18 million for costs associated with the integration of the CBPR acquisition. Excluding these items, operating profits in the second quarter of 2010 were significantly higher than in the first quarter of 2010, but 24% lower than in the second quarter of 2009. North American Industrial Packaging net sales were $2.1 billion in the second quarter of 2010 compared with $1.9 billion in the first quarter of 2010 and $2.0 billion in the second quarter of 2009. Operating profits were $172 million in the second quarter of 2010 compared with $20 million ($23 million excluding facility closure costs) in the first quarter of 2010 and $431 million ($241 million excluding alternative fuel mixture credits and CBPR integration costs) in the second quarter of 2009. Sales volumes in the second quarter of 2010 increased compared with the first quarter of 2010 reflecting strengthening demand in North American box and worldwide linerboard markets. Average sales price realizations were higher due to the full-quarter impact of price increases effective in January 2010 and the partial realization of additional increases effective in the second quarter for containerboard and boxes. Input costs decreased due to lower wood and energy costs, partially offset by recycled fiber costs which were moderating throughout the second quarter, but were higher on average for the quarter. Operating costs improved due to strong productivity and lower consumption of inputs in the mills and box plants. Planned maintenance downtime costs were about $30 million lower than in the first quarter of 2010, but were still at a relatively high level. In the first quarter of 2010, 15,000 tons of lack-of-wood downtime was taken, compared with none in the second quarter of 2010. Costs in the second quarter associated with the closure of the Jonesboro, Arkansas box plant were about $4 million. Compared with the second quarter of 2009, sales volumes improved in the second quarter of 2010 due to stronger customer demand for boxes and for exported linerboard. Average sales price realizations were higher reflecting the year-to-date cumulative effect of 2010 announced price increases. Input costs have increased sharply, primarily for recycled fiber and wood. Manufacturing operating costs were favorable reflecting the fixed cost savings from the closures of the Albany and Pineville mills in the 2009 fourth quarter. Planned maintenance downtime costs were $5 million lower than in the second quarter of 2009. In 2010, capacity was reduced by 377,000 tons per quarter related to the 2009 shutdowns of the Albany and Pineville mills and idling of a paper machine at the Valliant mill. In the second quarter of 2009, the business took 550,000 tons of lack-of-order downtime including 98,000 tons associated with the idling of a paper machine at the Valliant mill. Entering the third quarter of 2010, sales volumes are expected to continue to grow, but at a slower rate, reflecting strong demand for boxes and linerboard. Average sales price realizations should be significantly higher due to the realization of previously announced price increases. Input costs for wood and recycled fiber are expected to moderate, but energy costs are expected to increase. Planned maintenance downtime costs should be about $37 million lower, but operating costs are expected to be significantly higher due to increased corporate expense allocations. European Industrial Packaging net sales were $235 million in the second quarter of 2010 compared with $245 million in the first quarter of 2010 and $240 million in the second quarter of 2009. Operating profits were $18 million ($19 million excluding facility closure costs) in the second quarter of 2010 compared with $22 million ($24 million excluding facility closure costs) in the first quarter of 2010 and a loss of $49 million (a gain of $14 million excluding facility closure costs) in the second quarter of 2009. Sales volumes in the second quarter of 2010 were about even with the first quarter of 2010 reflecting solid demand in industrial markets, but fruit and vegetable markets were adversely affected by poor weather conditions throughout Europe. Average sales margins decreased as box price increases only partially offset higher costs for kraft and recycled containerboard. Other input costs, primarily for energy, were slightly lower, but freight costs were slightly higher due to more export shipments from Morocco. Compared with the second quarter of 2009, total sales volumes decreased due to the shutdown of the Etienne mill, however sales volumes for boxes increased reflecting improved demand for packaging in the industrial markets, offset by a weaker fruit and vegetable season. Average sales margins were lower as sharp price increases for kraft and recycled linerboard resulted in margin compression. Other input costs and operating costs were both about flat. However, earnings were favorably impacted by savings from the closure of the Etienne mill. Looking ahead to the third quarter of 2010, sales volumes are expected to be seasonally lower due to summer holiday season and the completion of the summer fruit and vegetable seasons in Morocco and Spain. Average sales prices for boxes should be stable, but average margins are expected to reflect continuing increases in containerboard costs. Asian Industrial Packaging net sales were $85 million in both the second and first quarters of 2010 compared with $75 million in the second quarter of 2009. Operating profits for the distribution activities of the business were about $1 million in the second quarter of 2010 compared with losses of $1 million in both the first quarter of 2010 and the second quarter of 2009. Operating profits for the packaging operations were gains of about $1 million for both the second quarter of 2010 and the second quarter of 2009 and about breakeven in the first quarter of 2010. Third quarter results will reflect the impact of the SCA acquisition. Operating Profit (Loss) 47 (78 ) (31 ) 279 312 591 Printing Papers net sales for the second quarter of 2010 were 3% higher than in the first quarter of 2010 and 6% higher than in the second quarter of 2009. Operating profits included $111 million and $204 million in the second and first quarters of 2010, respectively, for closure costs for the Franklin mill. Operating profits in the second quarter of 2009 included a gain of $197 million for alternative fuel mixture credits and costs of $4 million for facility closures. Excluding these items, operating profits in the second quarter of 2010 were 25% higher than in the first quarter of 2010 and 84% higher than in the second quarter of 2009. North American Printing Papers net sales were $675 million in the second quarter of 2010 compared with $685 million in both the first quarter of 2010 and the second quarter of 2009. Operating profits were a loss of $65 million (a gain of $46 million excluding facility closure costs) in the second quarter of 2010 compared with a loss of $134 million (a gain of $70 million excluding facility closure costs) in the first quarter of 2010 and income of $205 million ($61 million excluding alternative fuel mixture credits and facility closure costs) in the second quarter of 2009. Compared with the first quarter of 2010, sales volumes in the second quarter of 2010 decreased in both domestic and export markets. However, average sales price realizations increased reflecting the full-quarter impact of price increases effective in February and a partial realization of a June price increase for uncoated freesheet paper. Input costs for wood and energy were lower, while freight costs increased. Manufacturing operating costs were favorable reflecting cost savings related to the closure of the Franklin mill. Planned maintenance outages were taken at three mills during the second quarter of 2010 as compared with one mill in the first quarter of 2010 which resulted in $19 million of additional downtime costs. In addition, operating profits in the second quarter of 2010 included a $33 million bad debt expense. We incurred lack-of-wood downtime of 18,000 tons in the first quarter of 2010, compared with none in the current quarter. Sales volumes in the second quarter of 2010 decreased from the second quarter of 2009 partially due to reduced capacity related to the permanent closure of the Franklin mill. Average sales price realizations improved reflecting sales price increases announced during 2010. Additionally, average margins increased due to a greater proportion of higher-margin domestic shipments. Input costs for wood and purchased pulp were higher, but were partially offset by lower costs for chemicals. Freight costs were also higher. Planned maintenance downtime costs were slightly higher in the second quarter of 2010, while operating costs were favorable. In the second quarter of 2009, 132,000 tons of lack-of-order downtime was taken, but capacity has been reduced by 150,000 tons per quarter in 2010 due to the closure of the Franklin mill. Entering the third quarter of 2010, domestic sales volumes are expected to be seasonally stronger. Average sales price realizations should continue to increase reflecting the realization of uncoated freesheet paper price increases effective in the second quarter. Average margins are expected to improve as higher demand in the domestic market allows for a more favorable geographic mix. Planned mill maintenance downtime costs should be about $9 million lower than in the second quarter of 2010. Input costs should moderate as lower wood costs are partially offset by higher energy and chemicals costs. Increased corporate expense allocations will cause operating costs to be higher. European Printing Papers net sales were $320 million in the second quarter of 2010 compared with $315 million in both the first quarter of 2010 and the second quarter of 2009. Operating profits were $55 million in the second quarter of 2010 compared with $48 million in the first quarter of 2010 and $16 million in the second quarter of 2009. Sales volumes and average sales price realizations for uncoated freesheet paper in the second quarter of 2010 were higher than in the first quarter of 2010 reflecting a strong demand coupled with supply constraints in the market. Pulp sales volumes increased in Russia and average sales price realizations for pulp were higher due to strong demand, particularly in China, and supply restrictions in the global market resulting from the February 2010 Chilean earthquake. Manufacturing operating costs were slightly favorable, but planned maintenance downtime costs were $8 million higher than in the first quarter of 2010 related to an outage at the Svetogorsk mill. Input costs for wood were higher, but were partially offset by lower energy costs. Foreign exchange effects had a slightly more negative impact in the second quarter of 2010 than in the 2010 first quarter. Compared with the 2009 second quarter, sales volumes in the 2010 second quarter were lower primarily due to the closure of the Inverurie, Scotland mill at the end of the 2009 first quarter. Average sales price realizations for uncoated freesheet paper increased due to improved market conditions, and market pulp prices were significantly higher. Manufacturing costs were favorable due to excellent performance at all three mills and the fixed cost savings from the closure of the Inverurie mill. In the second quarter of 2009, there was a planned maintenance outage at the Saillat mill which was not repeated in the second quarter of 2010. Input costs for wood and energy were higher, but were partially offset by lower costs for chemicals. Foreign exchange effects had a significantly greater negative impact on earnings in the second quarter of 2010 compared with the second quarter of 2009. In the 2010 third quarter, average sales price realizations for uncoated freesheet paper are expected to be at about second-quarter levels. However, pulp prices are expected to decline from the recent very high levels. Planned maintenance downtime costs should be higher due to an outage at the Kwidzyn mill, and sales volumes are expected to be lower due to the associated reduction in production. Input costs for wood, energy and chemicals are expected to be higher. Brazilian Printing Papers net sales were $275 million in the second quarter of 2010 compared with $225 million in the first quarter of 2010 and $215 million in the second quarter of 2009. Operating profits were $39 million in the second quarter of 2010 compared with $11 million in the first quarter of 2010 and $23 million in the second quarter of 2009. Sales volumes in the second quarter of 2010 increased compared with the first quarter of 2010 reflecting improved demand for uncoated freesheet paper in both domestic and Latin American export markets. Average sales price realizations were higher as uncoated freesheet paper sales price increases were realized in the domestic market and in Latin American export markets. Average margins were favorably affected by a greater proportion of higher-margin domestic sales. Input costs for purchased pulp and energy were higher. Operating costs were about flat, but planned maintenance downtime costs were higher. In addition, operating profits in the first quarter of 2010 included a charge of $15 million for bad debts. Compared with the second quarter of 2009, sales volumes were higher due to increased export market sales. Average sales price realizations increased for uncoated freesheet paper in export markets and for pulp. However, the higher proportion of sales to lower-margin export markets unfavorably impacted average sales margins. Input costs were lower reflecting decreased costs for wood and chemicals, partially offset by higher costs for energy. Manufacturing operating costs were favorable due to lower consumption of wood and energy. Planned maintenance downtime costs were higher with outages at three mills in the second quarter of 2010 compared with only one mill in the second quarter of 2009. Entering the 2010 third quarter, sales volumes are expected to be stable, but average margins are expected to increase due to seasonally stronger domestic market demand for uncoated freesheet paper. Average sales price realizations should improve particularly in export markets with the realization of announced price increases. Costs associated with planned maintenance downtime will be about flat. Input costs are expected to be about flat, while operating costs are expected to be higher. Asian Printing Papers net sales were $15 million in the second quarter of 2010 compared with $25 million in the first quarter of 2010 and $10 million in the second quarter of 2009. Operating profits were about breakeven in all periods presented. U.S. Market Pulp net sales were $160 million in the second quarter of 2010 compared with $155 million in the first quarter of 2010 and $135 million in the second quarter of 2009. Operating profits were $18 million in the second quarter of 2010 compared with a loss of $3 million in the first quarter of 2010 and income of $35 million (a loss of $14 million excluding alternative fuel mixture credits and facility closure costs) in the second quarter of 2009. Sales volumes in the second quarter of 2010 were lower than in the first quarter of 2010, but average margins improved, reflecting price increases in all pulp species and an increase in shipments of higher-margin fluff pulp. Average sales price realizations were significantly higher for softwood, hardwood and fluff pulp reflecting strong global demand. Input costs decreased for wood and energy, but distribution costs increased due to higher freight rates and shipping inefficiencies. Planned maintenance downtime costs were about flat. Operating costs were favorable due to improved performance at the mills. Compared with the second quarter of 2009, sales volumes decreased, but the earnings improved due to higher average margins. Average sales price realizations increased significantly, reflecting the impact of stronger market demand coupled with supply constraints resulting from the Chilean earthquake. Input costs for wood and energy were higher, but were partially offset by lower costs for chemicals. Freight costs were also higher. Planned maintenance downtime costs were $12 million in the second quarter of 2010 compared with none in the second quarter of 2009. Operating costs were unfavorable. Lack-of-order downtime decreased from 10,000 tons in the second quarter of 2009 to none in the second quarter of 2010. Looking ahead to the third quarter of 2010, average sales price realizations are expected to continue to improve as previously announced price increases for fluff pulp are realized. Sales volumes are expected to increase as market demand remains strong. No planned maintenance outages are scheduled in the third quarter. Input costs for wood are expected to decrease, but should be offset by higher operating costs due to increased corporate expense allocations. $ 845 $ 805 $ 1,650 $ 770 $ 715 $ 1,485 Consumer Packaging net sales for the second quarter of 2010 were 5% higher than in the first quarter of 2010 and 10% higher than in the second quarter of 2009. Operating profits in the second and first quarters of 2010 included $1 million and $3 million, respectively, of costs associated with the reorganization of the Shorewood business, while operating profits in the second quarter of 2009 included a gain of $77 million for alternative fuel mixture credits and costs of $1 million related to the Shorewood reorganization. Excluding these items, operating profits in the second quarter of 2010 were 58% higher than in the first quarter of 2010 and 29% higher than in the second quarter of 2009. North American Consumer Packaging net sales were $580 million in the second quarter of 2010 compared with $550 million in the first quarter of 2010 and $565 million in the second quarter of 2009. Operating profits in the second quarter of 2010 were $16 million ($17 million excluding Shorewood reorganization costs) compared with a loss of $4 million (a loss of $1 million excluding Shorewood reorganization costs) in the first quarter of 2010 and earnings of $93 million ($17 million excluding alternative fuel mixture credits and Shorewood reorganization costs) in the second quarter of 2009. Coated Paperboard sales volumes in the second quarter of 2010 increased compared with the first quarter of 2010 across all product lines reflecting the continued strengthening of demand that began at the end of the first quarter. Average sales price realizations were higher due to the partial realization of price increases announced during the quarter. Input costs for wood were higher on average for the quarter, but were trending downward. Planned maintenance downtime costs were $13 million higher in the second quarter with outages at two mills compared with only one mill in the first quarter. Manufacturing costs were favorable reflecting improved performance at all mills. During the second quarter of 2010, the mills took no lack-of-order downtime compared with 17,000 tons of combined lack-of-order and lack-of-wood downtime in the first quarter of 2010. Compared with the second quarter of 2009, sales volumes were higher reflecting recovering market demand. Average sales price realizations were lower due to the carry-over impact of price decreases that occurred in the third and fourth quarters of 2009. Input costs, primarily for wood, were higher. Manufacturing operating costs were about even with the second quarter of 2009, while planned maintenance downtime costs were slightly lower. In the second quarter of 2009, the business took 82,000 tons of lack-of-order downtime. Capacity in 2010 has been reduced by 35,000 tons per quarter related to the shutdown of the paperboard machine at the Franklin mill at the end of 2009. Shorewood sales in the second quarter of 2010 were slightly lower than in the first quarter of 2010 reflecting declines in the home entertainment and display segments offset by increases in the tobacco segment. Average margins improved, primarily in the consumer products and tobacco segments. Operating costs were favorable, reflecting the impact of cost reduction efforts. Compared with the second quarter of 2009, sales volumes were lower due to decreased sales in the tobacco segment. Average margins improved due to strong margins in the consumer products and tobacco segments. Foodservice sales volumes in the second quarter of 2010 were higher than in the first quarter of 2010 due to a seasonal increase in cold cup shipments. However, average margins decreased slightly due to the higher cold cup product mix. Input costs for resins and board increased, but operating costs improved. Compared with the second quarter of 2009, sales volumes in the second quarter of 2010 improved and the mix of products sold was comparable. Average sales price realizations were down. Average margins were squeezed by higher input costs, primarily for resins. However, these factors were substantially offset by more favorable operating costs. Looking forward to the third quarter of 2010, coated paperboard sales volumes are expected to continue to improve as customer demand remains solid. Average sales price realizations should increase as sales price increases announced in the second quarter are realized. Planned maintenance downtime costs are expected to be about $19 million lower than in the second quarter with no third-quarter outages planned. Input costs, especially for wood, are expected to moderate and decrease on average for the quarter, however as a result of increased corporate expense allocations, operating costs should be higher. Shorewood’s sales volumes are expected to increase reflecting seasonally higher demand in the home entertainment segment. Input costs for board are expected to be higher, but operating costs should be lower. Sales volumes for Foodservice should continue to improve as market demand remains solid. Average sales price realizations should increase reflecting the pass-through of earlier input cost increases for board and resins. However, board costs are expected to continue to increase in the third quarter which may put pressure on margins. European Consumer Packaging net sales were $80 million in the second quarter of 2010 compared with $85 million in the first quarter of 2010 and $80 million in the second quarter of 2009. Operating profits were $19 million in the second quarter of 2010 compared with $20 million in the first quarter of 2010 and $14 million in the second quarter of 2009. Sales volumes in the second quarter of 2010 were slightly lower than in the first quarter of 2010. Average sales price realizations increased in Poland, but were flat in Russia. Planned maintenance downtime costs were higher reflecting an outage at the Svetogorsk mill. Input costs were higher for wood. Compared with the second quarter of 2009, sales volumes in the second quarter of 2010 were lower. Average sales price realizations improved, particularly in Poland. Input costs for wood and energy increased. Operating results in the 2010 third quarter will reflect costs associated with the annual planned maintenance shutdown of the Kwidzyn mill. Asian Consumer Packaging net sales were $185 million in the second quarter of 2010 compared with $170 million in the first quarter of 2010 and $125 million in the second quarter of 2009. Operating profits were $13 million in the second quarter of 2010 compared with $12 million in the first quarter of 2010 and $7 million in the second quarter of 2009. Compared with the first quarter of 2010, operating profits in the second quarter of 2010 were about flat. Average sales price realizations were higher primarily for folding carton board and coated bristols, but the favorable earnings impact was offset by increased costs for pulp and utilities. Sales volumes declined slightly, but market demand remained solid and our plant ran at capacity. Compared with the second quarter of 2009, average sales price realizations were significantly higher, but were largely offset by increased input costs, primarily for pulp. Sales volumes increased slightly. Entering the third quarter of 2010, average sales price realizations are expected to decrease, primarily for folding carton board and coated bristols, reflecting competitive pressures and a seasonal decline in demand, although sales volumes are expected to remain at second-quarter levels. Input costs for pulp should decline, but at a slower pace than the decline in sales prices. International Paper and Sun Paper have agreed to expand their coated board joint venture with the addition of a 550,000 ton per year coated board machine targeting the high-end market segments in China and the rest of Asia. This machine, which will cost approximately $300 million ($55 million of IP cash), will be located in Yanzhou, China, the same location as the IP Sun joint venture’s three other coated board machines. It is expected to start-up in the first quarter of 2012. The addition of this new machine will expand the IP Sun joint venture’s annual capacity to 1.3 million metric tons. The project is now pending government approval. 26 21 47 10 (7 ) 3 Distribution’s 2010 second quarter sales were 3% higher than in the first quarter of 2010 and 2% higher than the second quarter of 2009. Operating profits in the second quarter of 2010 were 24% higher than in the first quarter of 2010, and more than double earnings in the second quarter of 2009. Sales of papers and graphic arts supplies and equipment in the second quarter of 2010 totaled $1.0 billion, unchanged when compared with both the first quarter of 2010 and second quarter of 2009. Trade margins as a percent of sales for printing papers were unchanged from the first quarter of 2010, but increased from the second quarter of 2009. Packaging sales were $400 million in the second quarter of 2010 compared with $300 million in both the first quarter of 2010 and second quarter of 2009. Trade margins as a percent of sales for packaging products decreased from both the first quarter of 2010 and second quarter of 2009 reflecting changing product and service mix. Sales of facility supply products totaled $250 million in the second quarter of 2010, unchanged from the first quarter of 2010, but down compared with $300 million in the second quarter of 2009. Operating profits were $26 million in the second quarter of 2010 compared with $21 million in the first quarter of 2010 and $10 million in the second quarter of 2009. Compared with the first quarter of 2010, operating profits increased principally due to higher prices. Increased sales volume and improved trade margins were the primary causes of the earnings improvement compared with the 2009 second quarter. Looking ahead to the 2010 third quarter, operating results are expected to benefit from improved seasonal sales volumes while being negatively impacted by higher corporate expenses. $ 5 $ 10 $ 15 $ 10 $ 5 $ 15 Forest Products sales and profits are driven mainly by land and mineral rights sales, which can vary from quarter to quarter due to various factors. Operating profits in the second quarter of 2010 were primarily due to a $39 million gain on the sale of mineral rights on more than 7 million acres throughout the U.S. to Natural Resources Partners. Entering the third quarter of 2010, the amount and timing of operating profits will reflect the sales of remaining acreage. The Company has announced an agreement to sell 163,000 acres of land for approximately $200 million. The transaction is expected to close in the third quarter of 2010. The Company has approximately 24,000 acres of other land remaining, primarily composed of timberland tracts. Equity Earnings, Net of Taxes – Ilim Holding S.A. On October 5, 2007, International Paper and Ilim Holding S.A. (Ilim) announced the completion of a 50:50 joint venture to operate in Russia. Due to the complex organizational structure of Ilim’s operations, and the extended time required to prepare consolidated financial information in accordance with accounting principles generally accepted in the United States, the Company reports its share of Ilim’s operating results on a one-quarter lag basis. Accordingly, the accompanying consolidated statement of operations for the three months ended June 30, 2010 includes the Company’s 50% share of Ilim’s operating results for the three-month period ended March 31, 2010 under the caption “Equity earnings (losses) net of taxes.” Ilim is reported as a separate reportable industry segment. The Company recorded equity earnings, net of taxes, of $5 million in the second quarter of 2010 related to operations in the first quarter of 2010 compared with a loss of $3 million recorded in the first quarter of 2010 related to operations in the fourth quarter of 2009. Sales volumes in the first quarter of 2010 increased from the prior quarter due to higher market pulp shipments and slightly higher containerboard shipments. Average sales price realizations increased significantly for market pulp with more modest increases for linerboard and other paper products in both domestic and export markets, reflecting a continued strengthening of demand as well as the impact of the first-quarter Chilean earthquake. Input costs were unfavorable due to January 1 increases in tariffs for natural gas, electricity and steam. Wood costs were also higher due to the seasonal difficulties in harvesting and transportation caused by the winter weather. Increases in railway tariffs negatively impacted freight costs. Operating costs were unfavorable due to seasonally higher energy consumption and wage increases for union employees. Additionally, in the first quarter of 2010, the after-tax foreign exchange impact was a slight loss compared with a loss of $2 million recorded in the fourth quarter of 2009. In the second quarter of 2009, the Company recorded an equity loss, net of taxes, for Ilim of $30 million related to operations in the first quarter of 2009. Compared to the first quarter of 2009, sales volumes in the first quarter of 2010 increased, primarily for market pulp and containerboard, reflecting strong demand with the majority of the improvement in domestic markets. Average sales price realizations were favorable for softwood and hardwood pulp in the domestic and Chinese export markets as well as for linerboard. In addition, operating results in the first quarter of 2009 included a $2 million provision for the write-down of assets to be permanently shut down. Foreign exchange losses on the remeasurement of U.S. dollar-denominated debt were $22 million in the first quarter of 2009. Looking forward to the results we expect to record in the Company’s third quarter of 2010 for Ilim’s second quarter, average sales price realizations are expected to be significantly higher as demand for pulp in China continues to grow and linerboard price increases are realized. Input costs are expected to increase, primarily for wood, but operating costs should be favorable reflecting improvements in chemical and wood consumption. The foreign exchange impact is not expected to be significant. A key element of the proposed joint venture strategy is a long-term investment program in which the joint venture will invest, through cash from operations and additional borrowings by the joint venture, approximately $1.5 billion in Ilim’s three mills over approximately five years. This planned investment in the Russian pulp and paper industry will be used to upgrade equipment, increase production capacity and allow for new high-value coated and uncoated paper, pulp and corrugated packaging product development. This capital expansion strategy was initiated in the second quarter of 2010 with the announcement of a $700 million project to build a new pulp line at Ilim’s Bratsk mill in Siberia, followed in June by the announcement of a $270 million project to install a new coated and uncoated woodfree paper machine at the Koryazhma mill. These projects are being financed through additional borrowings by the joint venture and cash flow from operations. Cash provided by continuing operations totaled $800 million for the first six months of 2010, down from $2.2 billion for the comparable 2009 six-month period. Earnings from continuing operations adjusted for non-cash charges were $1.1 billion for the first six months of 2010 compared to $1.9 billion for the first six months of 2009. Cash used for working capital components totaled $336 million for the first six months of 2010, down from a source of $269 million for the comparable 2009 six-month period. The Company generated free cash flow of approximately $395 million and $1.1 billion in the first six months of 2010 and 2009, respectively. Free cash flow is a non-GAAP measure and the most comparable GAAP measure is cash provided by operations. Management uses free cash flow as a liquidity metric because it measures the amount of cash generated that is available to maintain our assets, make investments or acquisitions, pay dividends and reduce debt. The following is a reconciliation of free cash flow to cash provided by operations: ‘ Six Months Ended Cash provided by operations Cash invested in capital projects Cash received from alternative fuel mixture credits Free Cash Flow $ 395 $ 1,097 Investments in capital projects totaled $273 million in the first six months of 2010 compared to $259 million in the first six months of 2009. Full-year 2010 capital spending is currently expected to be approximately $800 million, or about 55% of depreciation and amortization expense for our current businesses. Cash used for acquisitions (net of cash acquired) for the first six months of 2010 totaled $155 million related to the Company’s purchase of SCA Packaging Asia. Financing activities for the first six months of 2010 included a $143 million net reduction in debt versus a $1.1 billion net reduction during the comparable 2009 six-month period. In the second quarter of 2010, International Paper repaid approximately $108 million of notes with interest rates ranging from 5.3% to 9.375% and original maturities from 2015 to 2019. In connection with these early debt extinguishments, interest rate swap hedges with a notional value of $2 million were undesignated as effective fair value hedges. The resulting gain was immaterial. Pre-tax early debt retirement costs of $18 million related to these debt repayments, net of gains on swap terminations, are included in Restructuring and other charges in the accompanying consolidated statement of operations. In June 2010, interest rate swap agreements designated as fair value hedges with a notional value of $100 million were terminated. The termination was not in connection with the early retirement of debt. The resulting gain of $3 million was deferred and recorded in Long-term debt and will be amortized as an adjustment of interest expense over the life of the underlying debt through 2019. In the first quarter of 2010, International Paper repaid approximately $120 million of notes with interest rates ranging from 5.25% to 7.4% and original maturities from 2010 to 2027. In connection with these early debt retirements, previously deferred gains of $1 million related to earlier swap terminations were recognized in earnings. Pre-tax early debt retirement costs of $4 million related to these debt repayments, net of gains on swap terminations, are included in Restructuring and other charges in the accompanying consolidated statement of operations. Also in the first quarter of 2010, approximately $700 million of fixed-to-floating interest rate swaps were issued in 2009 were terminated. These terminations were not in connection with early debt retirements. The resulting $2 million gain was recorded in Long-term debt and is being amortized as an adjustment of interest expense over the life of the underlying debt through 2015. In May 2009, International Paper issued $1 billion of 9.375% senior unsecured notes with a maturity date in May 2019. The proceeds from this borrowing were used, along with available cash, to repay approximately $875 million of notes with interest rates ranging from 4.0% to 9.25% and original maturities from 2010 to 2012. In April 2009, International Paper repaid $313 million of the $2.5 billion long-term debt issued in connection with the CBPR business acquisition. As of December 31, 2009, this debt was repaid. Also in April 2009, International Paper Company Europe Ltd, a wholly-owned subsidiary of International Paper, repaid $75 million of notes issued in connection with the Ilim Holdings S.A. joint ventures that matured. Pre-tax early debt retirement costs of $25 million related to these debt repayments, net of gains on swap terminations, are included in Restructuring and other charges in the accompanying consolidated statement of operations. In March 2009, International Paper Investments (Luxembourg) S.ar.l, a wholly-owned subsidiary of International Paper, borrowed $468 million of long-term debt with an initial interest rate of LIBOR plus a margin of 450 basis points that varied upon the credit rating of the Company, and a maturity date in March 2012. International Paper used the $468 million of proceeds from the loan and cash of approximately $170 million to repay its 500 million euro-denominated debt (equivalent to $638 million at date of payment) with an original maturity date in August 2009. As of July 2009, the $468 million loan was repaid. Other debt activity for the three months ended March 2009 included the repayment of approximately $366 million of notes with interest rates ranging from 4.25% to 5.0% that had matured. Also in the first quarter of 2009, International Paper terminated an interest rate swap with a notional value of $100 million designated as a fair value hedge, resulting in a gain of $11 million that was deferred and recorded in Long-term debt in the accompanying consolidated balance sheet. As the swap agreement was terminated early, the resulting gain will be amortized to earnings over the life of the related debt through April 2016. At June 30, 2010 and December 31, 2009, International Paper classified $100 million and $450 million, respectively, of bank notes and Current maturities of long-term debt as Long-term debt. International Paper has the intent and ability, as evidenced by its fully committed credit facility, to renew or convert these obligations. During the first six months of 2010, International Paper issued approximately 2.7 million shares of treasury stock, net of restricted stock withholding, and 1.0 million shares of common stock for various plans. Payments of restricted stock withholding taxes totaled $26 million. During the first six months of 2009, the Company issued approximately 2.5 million shares of treasury stock, net of restricted stock withholding, and 2.5 million shares of common stock for various plans. Payments of restricted stock withholding taxes totaled $10 million. Common stock dividend payments totaled $66 million and $118 million for the first six months of 2010 and 2009, respectively. Dividends were $0.150 per share and $0.275 per share for the first six months in 2010 and 2009, respectively. In March 2009, the Company had announced that the quarterly dividend would be reduced to $0.025 per share in the 2009 second quarter. In April 2010, International Paper announced that the quarterly common stock dividend would be increased from $0.025 per share to $0.125 per share, effective for the dividend payable June 15, 2010 to shareholders of record on May 17, 2010. At June 30, 2010, contractual obligations for future payments of debt maturities by calendar year were as follows (in millions): $284 in 2010; $232 in 2011; $233 in 2012; $136 in 2013; $558 in 2014; $784 in 2015; and $6,704 thereafter. At June 30, 2010, International Paper’s contractually committed credit agreements totaled $2.5 billion which management believes are adequate to cover expected operating cash flow variability during the current economic cycle. The credit agreements generally provide for interest rates at a floating rate index plus a pre-determined margin dependent upon International Paper’s credit rating. The committed liquidity facilities include a $1.5 billion contractually committed bank credit agreement that expires in November 2012 and has a facility fee of 0.50% payable quarterly. The liquidity facilities also include up to $1.0 billion of commercial paper-based financings based on eligible receivable balances ($1.0 billion at June 30, 2010) under a receivables securitization program. On January 13, 2010, the Company amended the receivables securitization program to, among other things, extend the maturity date from January 2010 to January 2011. The amended agreement has a facility fee of 0.50% payable monthly. International Paper expects to be able to meet projected capital expenditures, service existing debt and meet working capital and dividend requirements through 2010 through current cash balances and cash from operations, supplemented as required by its existing credit facilities. The Company will continue to rely upon debt and capital markets for the majority of any necessary long-term funding not provided by operating cash flows. Funding decisions will be guided by our capital structure planning objectives. The primary goals of the Company’s capital structure planning are to maximize financial flexibility and preserve liquidity while reducing interest expense. The majority of International Paper’s debt is accessed through global public capital markets where we have a wide base of investors. Ilim Holding S.A. Shareholder’s Agreement In October 2007, in connection with the formation of the Ilim Holding S.A. joint venture (Ilim), International Paper entered into a shareholders’ agreement that includes provisions relating to the reconciliation of disputes among the partners. This agreement provides that at any time after the second anniversary of the formation of Ilim, either the Company or its partners may commence procedures specified under the deadlock provisions. Under certain circumstances, the Company would be required to purchase its partners’ 50% interest in Ilim. Any such transaction would be subject to review and approval by Russian and other relevant anti-trust authorities. Based on the provisions of the agreement, International Paper estimates that the current purchase price for its partners’ 50% interests would be approximately $425 million to $450 million, which could be satisfied by payment of cash or International Paper common stock, or some combination of the two, at the Company’s option. Any such purchase by International Paper would result in the consolidation of Ilim’s financial position and results of operations in all subsequent periods. The parties have informed each other that they have no current intention to commence procedures specified under the deadlock provision of the shareholders’ agreement, although they have the right to do so, and they are no longer discussing a deferral of the timeframe to commence those procedures. The U.S. Internal Revenue Code provided a tax credit for companies that use alternative fuel mixtures to produce energy to operate their businesses. The credit, equal to $.50 per gallon of alternative fuel contained in the mixture, was refundable to the taxpayer. As is the case with other tax credits, claims are subject to possible future review by the U.S. Internal Revenue Service, who has the authority to propose adjustments to the amounts claimed. In January 2009, the Company received notification that its application to be registered as an alternative fuel mixer had been approved. During the first six months of 2009, the Company filed claims for alternative fuel mixture credits covering eligible periods subsequent to November 2008 totaling approximately $1.0 billion, including $189 million recorded in Accounts and notes receivable at June 30, 2009 and $833 million that was received in cash. Accordingly, the accompanying consolidated statement of operations includes credits of approximately $482 million and $1.0 billion for the three and six months ended June 30, 2009, respectively, in Cost of products sold ($294 million and $624 million after taxes), representing eligible alternative fuel mixture credits earned through June 30, 2009. This credit expired on December 31, 2009. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires International Paper to establish accounting policies and to make estimates that affect both the amounts and timing of the recording of assets, liabilities, revenues and expenses. Some of these estimates require judgments about matters that are inherently uncertain. Accounting policies whose application may have a significant effect on the reported results of operations and financial position of International Paper, and that can require judgments by management that affect their application, include the accounting for contingencies, impairment or disposal of long-lived assets, goodwill and other intangible assets, pensions, postretirement benefits other than pensions, and income taxes. The Company has included in its 2009 Form 10-K a discussion of these critical accounting policies, which are important to the portrayal of the Company’s financial condition and results of operations and require management’s judgments. The Company has not made any changes in these critical accounting policies during the first six months of 2010. Impairment of Long-Lived Assets and Goodwill An impairment of a long-lived asset exists when the asset’s carrying amount exceeds its fair value, and is recorded when the carrying amount is not recoverable through future operations. A goodwill impairment exists when the carrying amount of goodwill exceeds its fair value. Assessments of possible impairments of long-lived assets and goodwill are made when events or changes in circumstances indicate that the carrying value of the asset may not be recoverable through future operations. Additionally, testing for possible impairment of recorded goodwill and intangible asset balances is required annually. The amount and timing of any impairment charges based on these assessments require the estimation of future cash flows and the fair market value of the related assets based on management’s best estimates of certain key factors, including future selling prices and volumes, operating, raw material, energy and freight costs, and various other projected operating and economic factors. As these key factors change in future periods, the Company will update its impairment analyses to reflect its latest estimates and projections. SIGNIFICANT ACCOUNTING ESTIMATES Pension Accounting Net pension expense totaled approximately $116 million for International Paper’s U.S. plans for the six months ended June 30, 2010, or about $9 million more than the pension expense for the first six months of 2009. Net pension expense for non-U.S. plans was about $2 million and $3 million for the first six months of 2010 and 2009, respectively. The increase in U.S. plan pension expense was principally due to a decrease in the assumed discount rate to 5.80% in 2010 from 6.00% in 2009 and higher amortization of unrecognized actuarial losses. After consultation with our actuaries, International Paper determines key actuarial assumptions on December 31 of each year that are used to calculate liability information as of that date and pension expense for the following year. Key assumptions affecting pension expense include the discount rate, the expected long-term rate of return on plan assets, the expected rate of future salary increases, and various demographic assumptions including expected mortality. The discount rate assumption is determined based on a yield curve that incorporates approximately 500 Aa-graded bonds. The plan’s projected cash payments are then matched to the yield curve to develop the discount rate. The expected long-term rate of return on plan assets is based on projected rates of return for current and planned asset classes in the plan’s investment portfolio. At June 30, 2010, the market value of plan assets for International Paper’s U.S. plans totaled approximately $6.4 billion, consisting of approximately 44% equity securities, 36% fixed income securities, and 20% real estate and other assets. The Company’s funding policy for its qualified pension plans is to contribute amounts sufficient to meet legal funding requirements, plus any additional amounts that the Company may determine to be appropriate considering the funded status of the plans, tax deductibility, the cash flow generated by the Company, and other factors. The Company continually reassesses the amount and timing of any discretionary contributions and elected to make a $500 million voluntary contribution on July 27, 2010. The U.S. nonqualified plans are only funded to the extent of benefits paid which are expected to be $36 million in 2010. Accounting for Uncertainty in Income Taxes The guidance for accounting for uncertainty in income taxes requires management to make judgments regarding the probability that certain income tax positions taken by the Company in filing tax returns in the various jurisdictions in which it operates will be sustained upon examination by the respective tax authorities based on the technical merits of these tax positions, and to make estimates of the amount of tax benefits that will be realized upon the settlement of these positions. Certain statements in this Quarterly Report on Form 10-Q, and in particular, statements found in Item 2, Management’s Discussion and Analysis of Financial Condition and Results of Operations, that are not historical in nature may constitute forward-looking statements. These statements are often identified by the words, “will,” “may,” “should,” “continue,” “anticipate,” “believe,” “expect,” “plan,” “appear,” “project,” “estimate,” “intend,” and words of a similar nature. Such statements reflect the current views of International Paper with respect to future events and are subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied in these statements. Factors that could cause actual results to differ include, among other things, the following: changes in the cost or availability of raw materials, energy and transportation; economic cyclicality and changes in consumer preferences in the industries in which we operate; changes in the pricing and demand for our products; the effects of competition in the United States and internationally; adverse business and economic conditions; downgrades in credit ratings; the impairment of financial institutions with which we execute transactions; pension and health care costs; the amount of our debt obligations and our ability to refinance or repay our debt; pension plan funding obligations that could be material over the next several years; changes in international conditions; unanticipated expenditures relating to the cost of compliance with environmental and other governmental regulations; results of legal proceedings; material disruptions at one of our manufacturing facilities; and risks related to operations conducted by joint ventures. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. Information relating to quantitative and qualitative disclosures about market risk is shown on page 46 of International Paper’s 2009 10-K, which information is incorporated herein by reference. There have been no material changes in the Company’s exposure to market risk since December 31, 2009. Evaluation of Disclosure Controls and Procedures: Disclosure controls and procedures are controls and procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act of 1934, as amended (Exchange Act), is recorded, processed, summarized and completely and accurately reported (and accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure) within the time periods specified in the Securities and Exchange Commission’s rules and forms. As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rules 13a-15(e) and 15d-15(e) of the Exchange Act. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective. Changes in Internal Controls over Financial Reporting: Other than as set forth below, there have been no changes in our internal controls during the quarter ended June 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting. During the 2010 second quarter, the Company acquired SCA Packaging Asia. Integration activities, including a preliminary assessment of internal controls over financial reporting, are currently in process. The initial annual assessment of internal controls over financial reporting for SCA Packaging Asia will be conducted over the course of our 2011 assessment cycle. The Company has ongoing initiatives to standardize and upgrade its financial, operating and supply chain systems. The system upgrades will be implemented in stages, by business, over the next several years. Management believes the necessary procedures are in place to maintain effective internal controls over financial reporting as these initiatives continue. A discussion of material developments in the Company’s litigation and settlement matters occurring in the period covered by this report is found in Note 11 to the Financial Statements in this Form 10-Q. PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS. Purchased (a) Average Price per Share Total Number of Shares Purchased as Part of a Publicly Announced Plan or Program Maximum Number (or Approximate Dollar Value) of Shares that May Yet Be Purchased Under the Plans or Programs April 1, 2010 – April 30, 2010 1,282 $ 25.91 N/A N/A June 1, 2010 – June 30, 2010 7,346 23.23 N/A N/A 8,628 N/A N/A N/A (a) Shares acquired from employees from share withholdings to pay income taxes under the Company’s restricted stock programs. No activity occurred in months during the quarter not presented above. (a) Exhibits 10.1 Restricted Stock and Deferred Compensation Plan for Non-Employee Directors, Amended and Restated as of May 10, 2010. 11 Statement of Computation of Per Share Earnings. 12 Computation of Ratio of Earnings to Fixed Charges and Preferred Stock Dividends. 31.1 Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32 Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 101.INS XBRL Instance Document. * 101.SCH XBRL Taxonomy Extension Schema. * 101.CAL XBRL Taxonomy Extension Calculation Linkbase. * 101.DEF XBRL Taxonomy Extension Definition Linkbase. * 101.LAB XBRL Taxonomy Extension Label Linkbase. * 101.PRE XBRL Taxonomy Extension Presentation Linkbase. * *- Furnished herewith. Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. (Registrant) /s/ TIM S. NICHOLLS Tim S. Nicholls Senior Vice President and Chief /s/ ROBERT J. GRILLET Robert J. Grillet Vice President – Finance and Controller

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CAMBIUM LEARNING GROUP, INC. - FORM 10-K - March 26, 2010 EX-21.1 - EXHIBIT 21.1 - CAMBIUM LEARNING GROUP, INC. c98282exv21w1.htm þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission file number 001-34575 Cambium Learning Group, Inc. (State or Other Jurisdiction of Incorporation or Organization) 27-0587428 (I.R.S. Employer Identification No.) 1800 Valley View Lane, Suite 400, Dallas, Texas (Address of Principal Executive Offices) 75234-8923 (Zip Code) Registrant’s telephone number, including area code: Common Stock, par value $0.001 per share The NASDAQ Global Market (Title of class) (Name of exchange on which registered) Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No þ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer o Non-accelerated filer þ Smaller reporting company o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ The common stock of the registrant commenced publicly trading on December 9, 2009. Accordingly, there was no public market for the registrant’s common stock as of June 30, 2009, the last business day of the registrant’s most recently completed second fiscal quarter. The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of March 19, 2010 was 43,858,676. Documents Incorporated by Reference: Part III incorporates certain information by reference from the registrant’s definitive proxy statement for the 2010 Annual Meeting of Stockholders, which definitive proxy statement will be filed by the registrant with the Securities and Exchange Commission within 120 days after the end of the registrant’s fiscal year ended December 31, 2009. Item 1. Business Item 1B. Unresolved Staff Comments Item 2. Properties Item 3. Legal Proceedings Item 4. (Removed and Reserved) Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Item 6. Selected Financial Data Item 7A. Quantitative and Qualitative Disclosures About Market Risk Item 8. Financial Statements and Supplementary Data Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Item 9A. Controls and Procedures Item 9B. Other Information Item 10. Directors, Executive Officers and Corporate Governance Item 11. Executive Compensation Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters Item 13. Certain Relationships and Related Transactions, and Director Independence Item 14. Principal Accounting Fees and Services Item 15. Exhibits, Financial Statement Schedules Exhibit 21.1 Cautionary Note Regarding Forward-looking Statements. This report contains forward-looking statements within the meaning of the federal securities laws that involve risks and uncertainties, and which are based on beliefs, expectations, estimates, projections, forecasts, plans, anticipations, targets, outlooks, initiatives, visions, objectives, strategies, opportunities, drivers and intents of our management. Such statements are made in reliance upon the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. All statements other than statements of historical facts included in this report, including statements regarding our future financial position, economic performance and results of operations, as well as our business strategy, objectives of management for future operations, and the information set forth under “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. Forward-looking statements can be identified by, among other things, the use of forward-looking language, such as “believes,” “expects,” “estimates,” “projects,” “forecasts,” “plans,” “anticipates,” “targets,” “outlooks,” “initiatives,” “visions,” “objectives,” “strategies,” “opportunities,” “drivers,” “intends,” “scheduled to,” “seeks,” “may,” “will,” or “should” or the negative of those terms, or other variations of those terms or comparable language, or by discussions of strategy, plans, targets, models or intentions. Forward-looking statements speak only as of the date they are made, and except for our ongoing obligations under the federal securities laws, we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements. Accordingly, you are cautioned that any such forward-looking statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Although we believe that the expectations reflected in such forward-looking statements are reasonable as of the date made, expectations may prove to have been materially different from the results expressed or implied by such forward-looking statements, as it is impossible for us to anticipate all factors that could affect our actual results. We discuss certain of these risks in greater detail under the heading “Risk Factors” in Item 1A of this report. Unless otherwise required by law, we also disclaim any obligation to update our view of any such risks or uncertainties or to announce publicly the results of any revisions to the forward-looking statements made in this report. Item 1. Business. Unless otherwise expressly indicated in this Item 1, the discussions set forth herein are as of December 31, 2009. Cambium Learning Group, Inc. (the “Company”, “we”, “us”, or “our”) was incorporated under the laws of the State of Delaware in June 2009. On December 8, 2009, we completed the mergers of Voyager Learning Company (“VLCY”) and VSS-Cambium Holdings II Corp. (“Cambium”) into two of our wholly owned subsidiaries, resulting in VLCY and Cambium becoming our wholly owned subsidiaries. Following the completion of the mergers, all of the outstanding capital stock of VLCY’s operating subsidiaries, Voyager Expanded Learning, Inc. and LAZEL, Inc., were transferred to Cambium Learning, Inc., Cambium’s operating subsidiary (“Cambium Learning”). The results of VLCY are included in the Company’s operations beginning with the December 8, 2009 merger date; therefore, the 2009 financial information contained in this report consists of the results of the Company for the full year but only include VLCY for the last 23 days of the year. The transaction was accounted for as an “acquisition” of VLCY by Cambium, as that term is used under U.S. Generally Accepted Accounting Principles (“U.S. GAAP”), for accounting and financial reporting purposes under the applicable accounting guidance for business combinations. In making this determination, management considered that (a) the newly developed entity did not have any significant pre-combination activity and, therefore, did not qualify to be the accounting acquirer, and (b) the former sole stockholder of Cambium is the majority holder of the combined entity, while the prior owners of VLCY became minority holders in the combined entity. As a result, the historical financial statements of Cambium have become the historical financial statements of the Company. We currently operate in three business segments: Voyager, a comprehensive intervention business; Sopris, a supplemental solutions business; and Cambium Learning Technologies, an education technology business. Throughout our three business segments, we provide research-based education solutions for students in Pre-K through 12th grade, including intervention curricula, educational technologies and services focused almost exclusively on serving the needs of the nation’s most at risk students and learners challenged in realizing their full potential. We have extensive experience in information aggregation and dissemination, content development and educational publishing. Cambium Learning was founded in December 2002 to create a leading company focused on the at-risk and special student populations. In 2007, Cambium Learning was acquired by a consortium of equity sponsors led by Veronis Suhler Stevenson (“VSS”). A significant portion of Cambium Learning’s growth has resulted from the acquisition and growth of companies acquired by Cambium Learning and from newly introduced programs developed by authors and researchers. In October 2003, Cambium Learning acquired Metropolitan Teaching & Learning, Inc. Metropolitan Teaching & Learning, Inc. was founded in 1998, and has developed culturally responsive instructional materials and customized programs for use in urban markets, with particular emphasis on mathematics. In February 2004, Cambium Learning acquired Sopris West Educational Services, Inc., a provider of intervention programs in literacy, mathematics, and behavior. In April 2005, Cambium Learning acquired Kurzweil Education Systems, Inc., which develops reading enabling technologies for struggling readers and individuals with visual impairments. In February 2006, Cambium Learning acquired IntelliTools, Inc., a provider of assistive hardware and software technologies for the special education and at-risk market segments in math and literacy. VLCY’s predecessor company, Bell & Howell Company, was incorporated in Delaware in 1907. On January 31, 2005, VLCY completed the acquisition of Voyager Expanded Learning, Inc., in support of its long-term strategy to grow its educational business for grades K-12. On June 30, 2007, ProQuest Company amended Article I of its certificate of incorporation solely to change the corporate name from ProQuest Company to Voyager Learning Company. The name change and amendment were completed pursuant to a merger of VLCY’s wholly owned subsidiary with and into VLCY. Our mission is to deliver solutions that bring all of America’s students to their learning potential. We currently focus on six areas related to Pre-K-12 education: reading programs and resources; math and science programs and resources; professional development programs; intervention solutions; services; and learning technologies. Our intervention solutions address both the behavioral and academic needs of the students we serve. We are a leading provider of results-driven reading and math intervention programs, professional development programs regarding the teaching of reading and math, subscription-based online supplemental reading, online and print based math and science resources and programs, and a core reading program for school districts throughout the United States. We are also a leading company focused on the tools and resources for the greatest at-risk and special education students. Our products have achieved acceptance across a broad, economically and geographically diverse customer base. Our customer base and sales force cover every state in the United States, from small to large districts. We count some of the nation’s largest districts among our major customers, including Los Angeles, Clark County, Nevada, Houston, New York City, Buffalo, Richmond, Virginia, Cleveland, Milwaukee, and Miami-Dade County. The breadth of this customer base provides us with a national platform from which to launch new products, address new markets, and cross-sell products to existing customers. Our customers generally purchase our reading, math, intervention or professional development programs along with any necessary implementation services or training for a single school year. For many of our products, in subsequent school years, customers wishing to serve the same number of students generally need to purchase new student materials or renew access to online content, but do not typically repurchase teacher materials. Our Learning A-Z and ExploreLearning businesses’ online subscriptions generally run for a twelve-month period. Strategy for Growth and Development Our strategy for growth and development is based upon the following: We focus our efforts on the Pre-K-12 at-risk and special education markets. We believe that the Pre-K-12 at-risk and special education markets represent approximately 40% of the U.S. student population and that these markets have traditionally been under-served by major providers of educational programs and services. Key federal and state programs address the specific needs of at-risk and special student populations. We believe the intervention category will experience growth as greater funding, resources and education focus are diverted to the at-risk student population. We offer content-driven products and services designed to provide school districts with tools to improve the performance of at-risk and special student populations. We have developed relationships with authors who are known for their expertise in improving the cognitive and behavioral performance of at-risk and special education students. These authors are engaged by us to develop content and then to refine that content once feedback is obtained from our customers. We also employ both in-house and contracted developers of curriculum and on-line content. Our content is designed to benefit from our assistive technology platforms, which feature student facing practice components, data management, and formative assessment reporting, which enable teachers to build upon core concepts and enable students to scaffold from a limited educational base to more highly developed educational experiences. We employ a multi-faceted sales strategy to increase market penetration. We employ multiple interrelated sales channels to market and sell our products and services. These channels include selling efforts by our own direct sales force as well as by our authors, supplemented by product training sessions, strategic sales initiatives, direct catalog marketing, special customer events and resellers. Marketing and sales are focused on those schools and school districts having the significant percentages of at-risk and special student populations. We intend to explore strategic acquisitions. We operate in a highly fragmented market. We believe that this fragmentation is likely to continue to present viable consolidation opportunities. We intend to explore strategic product, service and company acquisitions in the future. Our growth prospects derive from several other potential sources. We believe that our growth will be driven by a number of factors, including: • expanding at-risk and special education populations; • prospective increases in federal funding aimed at our primary student constituency, or at-risk students; • positive student results achieved in school districts using our programs; • growth in services, such as teacher training and professional development; and • new programs addressing adjacent markets characterized by different student learning needs. Funding Sources for Our Solutions The recent recession, declines in the property tax base, and high unemployment in many states has caused most state and local governments to face large budget deficits, creating constrictions in education funding across the country. As a result of state and local government spending cuts, including reduced spending on education, overall funding for our solutions has been negatively impacted since the 2008 recession. The magnitude and duration of the state and local budget crisis and its impact on education funding can not be forecasted but is at least expected to continue throughout 2010. United States federal funding in education historically has represented approximately 10% of the money spent on public education in America. However, the federal education programs play a prominent role in our sales as they provide funds to school districts to specifically supplement state and local funding for at-risk students. Federal funding is distributed to school districts in order for them to provide supplemental services and materials targeted to at-risk students which allowed schools to focus on academic intervention for struggling students and on closing the achievement gap between subgroups of students. School districts use these federal funds, in part to purchase our solutions which are largely geared for the at-risk student population. Two such important and historically long lasting funding sources are the Title I and Title III portions of the Elementary and Secondary Education Act (ESEA) for economically disadvantaged children and the Individuals with Disabilities Education Act (IDEA) for students with disabilities eligible for special education. In 2009, the American Recovery and Reinvestment Act (ARRA) provided unprecedented increases in funding to Title I and IDEA. While our sales benefited from ARRA funds, schools have used the majority of these funds to augment declining overall budgets and specifically to retain teaching staff. While the ARRA funds have provided a much needed economic boost in the face of the state and local budget crisis, the ARRA funds are temporary and are available for use only through the 2010 — 2011 government fiscal year. The Obama Administration with the Congress has used a portion of the ARRA funds to create additional funding opportunities for state education agencies and the 15,000 school districts across our country. These programs include “Race to the Top” and “Investing in Innovation” which allow states and local districts to compete for new funding targeted toward reforms in education, including turning around the county’s lowest performing schools. On March 13, 2010, the U.S. Department of Education released “A Blueprint for Reform; The Reauthorization of the Elementary and Secondary Education Act.” This Blueprint provides incentives for states to adopt common academic standards that prepare students to succeed in college and the workplace as well as to create data and accountability systems that are capable of measuring student growth. Measuring academic growth in students must also be incorporated into evaluating teacher and principal performance. “Race to the Top” funding will be provided to allow states and local districts to implement the reforms outlined in the Blueprint, as a prelude to ESEA Reauthorization. Prior to the merger transaction completed on December 8, 2009, we had two reportable segments: Published Products and Learning Technologies. Subsequent to the merger transaction, we operate as three reportable segments with separate management teams and infrastructures that offer various products and services, as follows: • Voyager, our comprehensive intervention business; • Sopris, our supplemental solutions business; and • Cambium Learning Technologies, our technology based education product business. During 2009, net sales were $52.9 million for Voyager, $25.2 million for Sopris and $22.9 million for Cambium Learning Technologies. We also have shared services such as accounting, information technology, human resources, legal, facilities and corporate management that are not allocated to these segments. Note, however, that while combined revenues for the two pre-merger companies was approximately $200 million in 2009, assuming no merger had occured, we report only $101 million for 2009 because we only include VCLY financial results for the last 23 days of 2009 under business combination accounting. Educating at-risk and special education student populations requires intervention efforts that differ in approach and intensity from traditional instructional materials that largely address on-grade level students. Our comprehensive intervention business is conducted under the Voyager business segment. These products offer a complete suite of comprehensive intervention products, blending content, services and technology to meet student needs. We offer reading programs, math programs and professional development programs under the Voyager business unit. Voyager Reading Programs. The reading programs in the Voyager business unit consist of: Voyager Passporttm; LANGUAGE!; Passport Reading Journeystm; Read Well; Voyager Universal Literacy System®; Ticket to Read®; TimeWarp® Plus; Voyager Pasaportetm; and We Can!. Voyager Passport is a comprehensive reading intervention system for grades K-5. Voyager Passport provides direct, systematic instruction in each of the five essential reading components (phonemic awareness, phonics, fluency, vocabulary, and comprehension) and is designed as an intervention program for grade K-5 students for whom a core reading program is not sufficient. The lessons are typically daily and run 30 to 40 minutes in duration. They are based on the latest scientific research regarding effective reading instruction and are carefully designed to effectively and efficiently address each of the strategies and skills necessary to improve the reading ability of struggling readers. LANGUAGE!, our principal literacy offering, is a complete literacy program that targets students in grades 3-12 achieving at or below the 35th percentile. The program consists of a 36-unit curriculum organized into six levels that cover phonemic awareness and phonics, word recognition and spelling, vocabulary and morphology, grammar and usage, listening and reading comprehension and speaking and writing. LANGUAGE! is designed for special education students, as well as students learning to speak English. The curriculum is a mastery-based curriculum. Students exit as soon as they achieve grade-level proficiency, which will vary depending on the specific needs of the student and where the student enters the program. Passport Reading Journeys is a targeted intervention program designed to accelerate reading for struggling readers in middle school and high school, grades 6-9. The lesson format integrates reading, comprehension, vocabulary, fluency and writing. Age-appropriate content, real-life journeys on DVDs, online interactive lessons, and captivating text hold student interest and motivate students to read for both information and enjoyment. The program targets the affective domain as much as the cognitive domain as many struggling readers have lost confidence, are not engaged, and are close to dropping out. The program meets all of the instructional recommendations of the Reading Next Report, which is a research report outlining the key elements of effective literacy intervention for middle and high school students, and provides teachers with the tools necessary to help students become successful readers. Read Well targets at-risk students in grades K-2. The program is a research-based and data-driven reading curriculum that addresses all five components of effective reading instruction — phonemic awareness, phonics, vocabulary, comprehension and fluency. The Voyager Universal Literacy System is a comprehensive core reading curriculum for grades K-3 that explicitly and systematically teaches the five essential components of reading instruction as outlined by the National Reading Panel in 2000. Ticket to Read (www.tickettoread.com) is an interactive web-based program offered with Voyager’s Passport and Universal Literacy System programs. Ticket to Read is designed to improve reading by allowing students to practice various aspects of reading skills. Instruction is leveled, self-paced and teacher-monitored. Students are motivated by a leader board, a virtual clubhouse that includes earning online tickets and other rewards, games, and engaging self-selected passages on a variety of topics as they build vocabulary, fluency, phonics and reading comprehension skills. Approximately one-quarter of the use takes place after school hours, including weekends, further enabling students to reinforce what they have learned in the classroom and enabling parents and/or guardians to become more involved in their children’s education. TimeWarp Plus is a four-to-six week summer reading intervention program which immerses grade K-9 students in reading adventures to build essential reading skills that can prevent summer learning loss and prepare students for the coming year. TimeWarp Plus is a balanced, research-based reading program offered as a two-to-four hour daily reading instruction focused around exciting, adventure-based themes and hands-on learning experiences. Student engagement and maximizing teacher time are key components of the program. Voyager Pasaporte provides students in grades K-3 with targeted reading intervention in Spanish, using a similar scientifically-based reading research and framework as Voyager Passport. The lessons typically run daily for 30 to 40 minutes in duration. They are based on the latest scientific research regarding effective reading instruction and are carefully designed to effectively and efficiently address each of the strategies and skills necessary to improve the reading ability of struggling Spanish-speaking children who cannot read effectively in any language. Built-in assessment and progress monitoring tools provide teachers with vital information about student learning so they can adjust instruction as needed. We Can! is a multilingual early childhood program which is designed to develop both social and academic skills. The program offers flexible lesson plans for customized instruction, a classroom management system and learning center choices. We Can! also fits within a variety of Pre-K settings. Voyager Math Programs. The math programs in the Voyager business unit consist of: Vmath®, Vmath Summer Adventure, TransMath, Algebra Rescue and Voyages. Vmath is a targeted, systematic intervention system that is aligned with the tenets of the National Council of Teachers of Mathematics and is designed to complement and enhance all major math programs by building upon and reinforcing the concepts, skills, and strategies of a core math program. Through 30 to 40 minutes of daily instruction, Vmath helps struggling students build a foundation in math and learn the skills and concepts crucial to achieving grade-level success. VmathLive is a standalone or complementary online math capability, targeting additional student practice for grades 3-8. Vmath Summer Adventure targets math students who may need summer intervention to prevent summer learning loss in math as well as in reading. Vmath Summer Adventure combines explicit instruction in essential math concepts and skills and real-life adventures to stimulate student interest and understanding over a shortened summer school program for grades K-8. TransMath targets students in the 25th percentile and below in grades 5-12. TransMath provides students with in-depth, sequential skill building of foundational math concepts through reform-based and procedural instruction. Multisensory strategies are designed to promote problem-solving proficiency, vocabulary development and mathematical discourse. Algebra Rescue targets students at risk of failure in algebra and teaches them a variety of core objectives through activities intended to make learning fun. Students may participate in Algebra Rescue in small groups, as a supplement to basal curricula, or as a stand-alone algebra intervention program. Voyages targets grades K-5 and is a core mathematics program designed by teachers, for teachers. Educators may utilize Voyages as a core program, as an intervention program or as part of a gifted and talented program. Voyager Professional Development Programs. The professional development programs in the Voyager business unit include VoyagerU®, our professional development program for teachers, coaches and administrators consisting of courses in literacy and math. VoyagerU is a professional development program delivered to teachers, coaches and educators in collaboration with state-wide and school district-wide professional development initiatives. It is designed to improve teacher effectiveness by providing a consistent approach to teaching reading and math. The program blends independent student instruction with facilitator-led training. We offer courses that are comprehensive or targeted for specific skills. Participants may earn college credit and hours toward professional development requirements. VoyagerU is designed to improve teacher instruction and student reading performance. Sopris The Sopris business unit is our supplemental education materials business. Supplemental interventions are typically smaller “footprint” offerings as measured either by the cost per student to implement or their more targeted (less comprehensive) skills coverage. These products typically are used to complement core programs by focusing on specific skill deficits and providing intense remediation of those deficits. The Sopris business unit is a collection of many products, titles and resources. Sopris’ primary products are Step Up to Writing; Rewards; Dynamic Indicators of Basic Early Literacy Skills (DIBELS/IDEL); Language Essentials for Teachers of Reading and Spelling (LETRS); The Six Minute Solution; and Algebra Ready. Step Up to Writing is a strategies-based program that spans grades K-12 and addresses students who score at or below the basic skill level in writing. The program teaches students to write both narrative and expository pieces, actively engage with reading materials and develop study skills. Step Up to Writing is designed to fit alongside a school district’s existing reading program and to be integrated into any standard curriculum or instructional system. Rewards is a research-based, reading intervention program designed for general and special education, remedial reading, summer school and after-school programs. The program focuses on de-coding, fluency, vocabulary, comprehension, test-taking abilities and content-area reading and writing. DIBELS/IDEL is a literary screening and progress monitoring tool. Students from grades K-3 take benchmark assessments three times a year in order to measure the critical areas of early reading: awareness, phonics, fluency, comprehension and vocabulary. Students in grades 4-6 are assessed in the areas of fluency and comprehension. For those with reading difficulties, progress monitoring assessments are given to determine the effectiveness of the interventions being used. IDEL offers DIBELS materials for Spanish-speaking students. LETRS is a stand-alone professional development program for educators. The training program is delivered through a combination of print materials, online courses, software and face-to-face training. LETRS Institutes are grouped into a series of three-day sessions presented by certified national LETRS trainers and engage educators through group activities and hands-on practice. The Six Minute Solution targets grades K-12 and helps students improve reading fluency. This peer-mentoring and feedback system is designed to complement a reading curriculum. Algebra Ready teaches students fundamental mathematics and is designed to prepare them for algebra and geometry. Students can utilize Algebra Ready during summer school, extended days, or as a supplement to a core math curriculum. Growth for Sopris is partially dependent on new product additions. In late 2009, we added DISE (Direct Instruction Spoken English), an intervention program for English learners at grades 4-12. Additionally, we recently announced that we had signed an agreement with a well-known author to publish RAVE-O (Reading through Automaticity, Vocabulary, Engagement, and Orthography), an intensive, multisensory, small group reading intervention for primary through intermediate grades. RAVE-O is expected to be available in summer 2010. Cambium Learning Technologies Cambium Learning Technologies leverages technology to help students reach their potential. The technology solutions are offered under four different industry leading brands: Learning A-Z, ExploreLearning, Kurzweil Educational Systems and IntelliTools. Learning A-Z. Learning A-Z is a group of related websites known as Reading A-Ztm, Raz-Kidstm, Reading-Tutorstm, Vocabulary A-Ztm and Writing A-Ztm, which provide online supplemental reading, writing and vocabulary lessons, books, and other resources for students and teachers. Science A-Z tm, a Learning A-Z website, is aimed at the supplemental science market. We sell online supplemental reading, math and science products under the Learning A-Z brand. There are three free websites (LearningPagetm, Sites for Teachers and Sites for Parents), which aid in directing interested parents, teachers, schools and districts to six subscription-based sites: Reading A-Z, Raz-Kids, Reading-Tutors, Vocabulary A-Z, Writing A-Z, and Science A-Z. Each of these websites offers products available for purchase through online subscriptions. Reading A-Z offers thousands of research-based, printable teacher materials to teach guided reading, phonological awareness, phonics, comprehension, fluency, letter recognition and formation, high-frequency words, poetry and vocabulary. The teaching resources include professionally developed downloadable leveled books (27 levels), a systematic phonics program that includes decodable books, high-frequency word books, poetry books, nursery rhymes, vocabulary books, read-aloud books, lesson plans, worksheets, graphic organizers and reading assessments. All leveled books, worksheets, graphic organizers and quizzes are available as printable PDF files and as projectables for use on interactive and non-interactive whiteboards. The leveled books and a variety of other books are available in Spanish and French, as well as a version with UK spellings. Raz-Kids is a student-centered online collection of interactive leveled books and quizzes designed to guide and motivate emergent and reluctant readers, as well as improve the skills of fluent readers. Students can listen to and read books as well as record their reading and then take an online quiz while receiving immediate feedback. Students earn stars for their reading activity. The stars can then be spent in each student’s personal clubhouse-like environment for purchasing a catalog full of items that include aliens and other fun characters. The program currently consists of over 300 online books along with companion quizzes and worksheets spread over 27 levels of difficulty. The website also features a classroom management system for teachers to build rosters, assign books and review student reading activity. Reading-Tutors is a low-cost, easy-to-use collection of research-based resource packets for tutors. Each of the 400 packets contains items tutors need to help emerging readers gain key literacy skills in the alphabet, phonological awareness, phonics, high-frequency words, fluency and comprehension. It also has all the resources needed to train tutors as well as set up and administer a successful tutoring program. Vocabulary A-Z provides customized and pre-made vocabulary lessons for use by teachers to improve student vocabularies. Vocabulary A-Z has thousands of vocabulary words that can be used to generate custom vocabulary lessons and assessments. Word activities and worksheets are available based on the word lists the user generates. The Vocabulary A-Z lesson generator incorporates best practices from current educational research. Writing A-Z provides teachers with a comprehensive collection of resources to enhance the writing proficiency of students in grades K-6. The site provides core writing lessons grouped by genre, including student packets with leveled materials, mini-lessons that target key writing processes and skills, and writing tools for organizing and improving writing. Science A-Z provides teachers with an online collection of resources to improve student skills in both science and reading. The website offers a collection of downloadable resources organized into thematic units aligned with state standards. The materials are categorized into four scientific domains: life, earth, physical and process science. The thematic units are organized into three grade-level groupings: K-2, 3-4, and 5-6. The themed packs include lessons, books, high- interest information sheets, career sheets, and process activities. Within each grade span, all books and information sheets are written to a high, medium and low level of difficulty. The website includes many other science resources, including science fair resources and a monthly “Science In the News” feature. ExploreLearning. ExploreLearningtm is a subscription-based online library of interactive simulations in math and science for grades 3-12. ExploreLearning supplies online simulations in math and science. ExploreLearning has won National Science Foundation funding, supports the tenets of the National Council of Teachers of Mathematics and has received positive mention in books published by the Association of Supervision and Curriculum Development and the National Science Teachers Association. ExploreLearning materials are correlated to state standards and over 120 math and science textbooks. Like Learning A-Z, ExploreLearning is an online subscription-based business. Kurzweil Educational Systems. Kurzweil Educational Systems is a program that primarily targets students in middle school through higher education struggling with reading and writing, specifically those students with ADHD, dyslexia and visual impairments. Kurzweil Educational Systems produces the following two software products for individuals with learning difficulties and for those who are visually impaired: • Kurzweil 3000. Kurzweil 3000 is a reading, writing and learning software package for students with dyslexia, attention deficit disorder or other learning difficulties, including physical impairments or language learning needs. • Kurzweil 1000. Kurzweil 1000 provides visually impaired users access to printed and electronic materials. Documents and digital files are converted from text to speech and read aloud in a variety of voices that can be modified to suit individual preferences. In addition, this software provides users with document creation and editing, studying and study skills for note-taking, summarizing and outlining text. IntelliTools. IntelliTools offers hardware products that target students with physical, visual and cognitive disabilities that make using a standard keyboard and mouse difficult. IntelliTools also offers software products that target elementary and middle school special education students struggling with reading and math. IntelliTools’ products include: • IntelliKeys® USB, which is a programmable alternative keyboard with supporting software for students or adults who have difficulty using a standard keyboard. • IntelliTools Classroom Suite, which is an authoring and application tool intended to boost achievement on standards-based tests and help meet adequate yearly progress goals under the No Child Left Behind Act. • IntelliTools, which offers software products with a simple interface for students to use. The software includes lessons, activities and assessments that reinforce reading, writing and math skills with the capability to generate reports and provide detailed data tracking. We continually seek to take advantage of new product and technology opportunities and view product development to be essential to maintaining and growing our market position. We have developed relationships with authors who are known for their expertise in improving the cognitive and behavioral performance of at-risk and special education students. Many authors are leaders in their respective fields, such as literacy, mathematics, and positive school climate. These authors are engaged by us to develop content and then to refine that content once feedback is obtained from our customers. We also employ both in-house and contracted developers of curriculum and on-line content. We generally conduct an extensive refresh of our products every three to five years to incorporate the latest research, bring images current, and update factual content. The web-based products are enhanced continuously. Between the product refreshes, we often develop variations, expansions (i.e., more grade levels) and other basic enhancements of our products. As of December 31, 2009, we had 112 employees in curriculum development. Research and development expense was $5.6 million for 2009 and $6.4 million for 2008. In addition, we capitalize certain expenditures also related to curriculum and technology development. Sales Force Organization We generally organize our marketing and sales force around our Voyager, Sopris and Cambium Learning Technologies business units. We have separate sales forces by unit and sales producers sell all available products in the unit and are generalist relationship managers. They are supported by product or subject matter experts as well as a corporate marketing team. As of December 31, 2009, our sales force consisted of 91 field and 43 inside sales producers for a total of 134 direct sales producers, excluding sales management and marketing. Where we elect to use both field and inside sales producers in a business unit, we tend to segment the customers primarily based on size of a territory, whereby larger territories are covered by field representatives and smaller territories are covered more effectively by inside sales employees. We also use direct marketing through catalogs and are increasingly making use of e-commerce and the Internet to sell our products. Sales and marketing expense was $23.4 million for 2009 and $24.6 million for 2008. The market for our products is highly competitive. We compete with a wide range of companies from large publishers covering a broad array of products to small providers who specialize in very limited areas. We compete with: • Basal text book suppliers, which often offer intervention products as part of their core reading programs, including Houghton Mifflin/Harcourt (Riverdeep), Scott Foresman (Pearson), and The McGraw-Hill Companies; • Supplemental suppliers, including School Specialty, Haights Cross Communications and The Hampton-Brown Company; • Technology suppliers, including Scientific Learning, Educational Resources, Renaissance Learning, and Plato Learning; and • Service providers, including Sylvan Learning and Kaplan Early Learning Company. Concentration Risk We are not overly dependent upon any one customer or a few customers, the loss of which would have a material adverse effect on our business. We have a broad customer base; in the three years ended December 31, 2009 for both VLCY and the Company, no single customer accounted for more than 10% of our total net sales in any one year. On a combined basis, our top ten customers accounted for less than 17% of our net sales in 2009. Our quarterly operating results fluctuate due to a number of factors, including the academic school year, funding cycles, the amount and timing of new products and spending patterns. In addition, customers experience cyclical funding issues that can impact revenue patterns. Historically, we have experienced our lowest sales and earnings in the first and fourth fiscal quarters with our highest sales and earnings in the second and third fiscal quarters. Governmental Regulations Our operations are governed by laws and regulations relating to equal employment opportunity, workplace safety, information privacy, and worker health, including the Occupational Safety and Health Act and regulations under that Act. Additionally, as a company that often bids on various state, local and federally funded programs, we are subject to various governmental procurement policies and regulations. We believe that we are in compliance in all material respects with applicable laws and regulations and that future compliance will not have a material adverse effect upon our consolidated operations or financial condition. Our future success is substantially dependent on the performance of our management team and our ability to attract and retain qualified technical and managerial personnel. As of December 31, 2009, we had a total of 622 employees. None of our employees are represented by collective bargaining agreements. We regard our relationship with our employees to be good. Ronald Klausner. Ronald Klausner, age 56, currently serves as a Class III director and our Chief Executive Officer. Mr. Klausner has served as one of our directors since December 8, 2009. Mr. Klausner served as President of Voyager Expanded Learning from October 2005 until December 8, 2009, when he became our Chief Executive Officer. Prior to that, Mr. Klausner served as President of ProQuest Information and Learning Company (a subsidiary of VLCY until it was sold in 2007) from April 2003 to October 2005. Mr. Klausner came to VLCY from D&B (formerly known as Dun & Bradstreet), a global business information and technology solutions provider, where he worked for 27 years. He most recently served as D&B’s Senior Vice President, U.S. Sales, leading a segment with more than $900 million in revenue. Previously, Mr. Klausner led global data and operations, and customer service, providing business-to-business, credit, marketing and purchasing information in over 200 countries. David F. Cappellucci. David F. Cappellucci, age 53, currently serves as a Class I director and our President. Mr. Cappellucci has served as one of our directors since December 8, 2009. Mr. Cappellucci served as the Chief Executive Officer of Cambium from April 2007 until December 8, 2009 and has 24 years of experience in the education industry. Before co-founding Cambium in December of 2002, Mr. Cappellucci spent 13 years with Houghton Mifflin Company, where he served in a variety of senior management positions, overseeing strategy, mergers and acquisitions, planning and operations at both the corporate level and within a number of business units, including the K-12 School Publishing Group and the Educational and Business Software Divisions. In 2000, Mr. Cappellucci co-founded Classwell Learning Group, an education company formed within the Houghton Mifflin organization. Through 2002, Mr. Cappellucci served as President and Chief Executive Officer of Classwell Learning Group, which was described as the “best new brand in the education market” by a major industry magazine in 2002. From 1992 to 1997, Mr. Cappellucci served as Senior Vice President of Elementary Education for Simon & Schuster. Prior to that, Mr. Cappellucci was Vice President of Finance, Planning and Operations for Houghton Mifflin’s K-12 school and assessment businesses. Bradley C. Almond. Bradley C. Almond, age 43, currently serves as our Senior Vice President and Chief Financial Officer. Mr. Almond served as Chief Financial Officer of VLCY since January 2009 and continues to serve as our subsidiary’s Chief Financial Officer. Mr. Almond joined VLCY in November 2006 as Chief Financial Officer of the Voyager Expanded Learning operating unit. Before joining VLCY, Mr. Almond was Chief Financial Officer, Treasurer and Vice President of Administration at Zix Corporation, a publicly traded email encryption and e-prescribing service provider located in Dallas, Texas, since 2003. From 1998 to 2003, Mr. Almond worked at Entrust Inc., where he held a variety of management positions, including president of Entrust Japan, general manager of Entrust Asia and Latin America, vice president of finance and vice president of sales and customer operations. Mr. Almond is a licensed Certified Public Accountant. John Campbell. John Campbell, age 49, currently serves as Senior Vice President and the President of the Cambium Learning Technologies business unit. Mr. Campbell served as Chief Operating Officer of Voyager Expanded Learning from January 2004 until December 8, 2009. Before joining VLCY, Mr. Campbell served as Chief Operating Officer and business unit head of a research based reading company (Breakthrough to Literacy) within McGraw-Hill. Prior to joining Breakthrough/McGraw-Hill, he served as Director of Technology for Tribune Education. Additionally, Mr. Campbell has experience as General Manager of a software start-up (Insight) and as Director of Applications and Technical Support for a hardware manufacturer (Commodore International). George A. Logue. George A. Logue, age 58, currently serves as Executive Vice President and the President of the Supplemental Solutions business unit. Mr. Logue served as the Executive Vice President of Cambium from June 2003 until December 8, 2009 and has 35 years of education industry experience. Before joining Cambium, Mr. Logue spent 18 years in various leadership roles with Houghton Mifflin Company. At Houghton Mifflin, Mr. Logue served as Executive Vice President of the School Division from 1996 to 2003. Prior to serving as Executive Vice President of Houghton Mifflin, Mr. Logue was Vice President for Sales and Marketing from 1994 to 1996. Carolyn W. Getridge. Carolyn W. Getridge, age 65, currently serves as our Senior Vice President of Human Resources and Urban Development. She joined VLCY in 1997 as a member of the team that launched the company after a distinguished 30-year career in public education. Immediately prior to joining Voyager, Ms. Getridge was Superintendent of the Oakland Unified School District. Ms. Getridge also served as Associate Superintendent of Curriculum and Instruction in Oakland and as Director of Education Programs for the Alameda (CA) County Office of Education. Todd W. Buchardt. Todd W. Buchardt, age 50, currently serves as our Senior Vice President, General Counsel and Secretary. Mr. Buchardt served VLCY as Senior Vice President since November 2002, Vice President since March 2000, and General Counsel and Secretary since 1998. Before joining VLCY, Mr. Buchardt held various legal positions with First Data Corporation from 1986 to 1998. We regard a substantial portion of our technologies and content as proprietary and rely primarily on a combination of patent, copyright, trademark and trade secret laws, and employee or vendor non-disclosure agreements, to protect our rights. We have developed relationships with authors who are known for their expertise in improving the cognitive and behavioral performance of at-risk and special education students. Many authors are leaders in their respective fields, such as literacy, mathematics, and positive school climate. These authors are engaged by us to develop content and then to refine that content once feedback is obtained from our customers. We act as exclusive agents for these well-known authors, whereby we publish their works under a royalty arrangement. We also derive a substantial amount of our curriculum content through in-house development efforts. To a much lesser degree, we also license from third parties published works, certain technology content or services upon which we rely to deliver certain products and services. Curriculum developed in-house or developed through the use of independent contractors is our proprietary property. Certain curriculum might be augmented or complemented with third party products, which may include printed materials, videos or photographs. This additional third party content may be sourced from various providers who retain the appropriate trademarks and copyrights to the material and agree to our use under a nonexclusive, fee-based arrangement. We use U.S.-registered trademarks to identify various products which we develop. The trademarks survive as long as they are in use and the registration of these trademarks is renewed. Website Access to Company Reports We make available free of charge through our website, www.cambiumlearning.com, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, Forms 3, 4 and 5 filed on behalf of our directors, officers and other affiliate persons, and all amendments to those reports as soon as reasonably practical after such material is electronically filed with, or furnished to, the Securities and Exchange Commission (“SEC”). We also will provide any of the foregoing information without charge upon written request to Cambium Learning Group, Inc., 1800 Valley View Lane, Suite 400, Dallas, Texas 75234-8923, Attention: Investor Relations. We are providing the address to our website solely for the information of our investors. Our website and the information contained therein or incorporated therein are not intended to be incorporated into this Annual Report on Form 10-K. We have adopted a Senior Financial Officers Code of Ethics and a Code of Business Conduct to promote such standards as (1) honest and ethical conduct; (2) full, fair, accurate, timely and understandable disclosure in our periodic reports; and (3) compliance with applicable governmental rules and regulations. Amendments to, or waivers from, the code of ethics will be posted on our website. A copy of the code of ethics and the code of business conduct are posted on our website, www.cambiumlearning.com, within the “Investor Relations” section under the heading “Corporate Governance”. The code of ethics is also available in print to anyone who requests it by writing to the Company at the following address: Cambium Learning Group, Inc., 1800 Valley View Lane, Suite 400, Dallas, Texas 75234-8923, Attention: Investor Relations. We have also implemented a whistleblower hotline, as required under the Sarbanes-Oxley Act of 2002, by engaging a third party service that provides anonymous reporting for serious workplace ethical issues via telephone and/or the Internet. This section should be read in conjunction with the Consolidated Financial Statements of the Company and the notes thereto included in this Annual Report on Form 10-K for the year ended December 31, 2009. Risks Related to our Business Changes in funding for public schools could cause the demand for our products to decrease. We derive a significant portion of our revenues from public schools, which are heavily dependent on federal, state and local government funding. In addition, the school appropriations process is often slow, unpredictable and subject to many factors outside of our control. Budget cuts, curtailments, delays, changes in leadership, shifts in priorities or general reductions in funding could reduce or delay our revenues. Funding difficulties experienced by schools, which have been exacerbated by the current economic downturn and state budget deficits, could also cause those institutions to demand price reductions and could slow or reduce purchases of intervention products, which in turn could materially harm our business. Our business may be adversely affected by changes in educational funding at the federal, state or local level, resulting from changes in legislation, changes in state procurement processes, changes in government leadership, emergence of other funding or legislative priorities and changes in the condition of the local, state or U.S. economy. While state and federal funding for elementary and high school education has steadily increased over the long term, recent reductions in related appropriations and other declines in budgeted revenues in states that have traditionally purchased products and services have caused some school districts to reduce spending on the types of products and services that we sell, and both have been affected by these reductions. Moreover, future reductions in federal funding provided to the states or reductions in the state and local tax bases could create an unfavorable environment, leading to budget shortfalls resulting in decreases in educational funding. Any decreased funding for public schools may harm our recurring and new business materially if our customers are not able to find and obtain alternative sources of funding. On March 13, 2010, the U.S. Department of Education released “A Blueprint for Reform: The Reauthorization of the Elementary and Secondary Education Act.” The blueprint provides incentives for states to adopt academic standards that prepare students to succeed in college and the workplace and create accountability systems that measure student growth toward meeting the goal that all children graduate and succeed in college. The blueprint builds on the following key priorities: (1) college- and career-ready students; (2) great teachers and leaders in every school; (3) equity and opportunity for all students; (4) raise the bar and reward excellence; and (5) promote innovation and continuous improvement. This blueprint could provide a means for overhauling the No Child Left Behind Act, although we do not yet know how any legislation resulting from this blueprint will affect funding for our products and services. We receive significant sales from certain states and reductions in public school education spending in those states could cause the demand for our products to decrease. In 2009, VLCY and Cambium, on a combined basis, derived significant sales from the following three states in the following approximate percentages: California — 10%; Florida — 9%; and Texas — 12%. California and Florida experienced significant budget problems in 2009 as a result of the current economic downturn and have announced that they anticipate reductions in their 2010 spending for education relative to fiscal 2008/2009 levels. To the extent that the economic situation in any of these states causes reductions in public school spending, our sales to these states could be materially reduced which could harm our business and financial condition. We participate in state adoptions and sales may be materially reduced if we are not able to replace sales in years subsequent to the first year of adoption or if states elect to defer or eliminate adoption purchases. We participate in state-wide adoptions for education products, as well as intervention products when states issue specific adoption calls for intervention products. The cost of participating in such adoptions is high, with no guarantee of future sales. In addition, sales are traditionally high in the first year of adoption but decline in subsequent years, making it difficult to replace first year sales. After an adoption has occurred, states may elect to allow school districts to use adoption funds for alternative purposes other than the purposes stated in the initial adoption, as has occurred in Florida in 2009. Postponements of district-level adoptions could also limit market potential in other states. We may not be able to recover costs we incur for participating in adoptions and sales may be materially reduced if we are not able to replace sales in years subsequent to adoption years or if states elect to defer or eliminate adoption purchases. Changes in school procurement policies may adversely affect our business. School districts choose to procure educational materials in various ways which can change quickly necessitating a change in our sales strategy or sales investments. Districts and states may switch procurement decisions from a centralized (district-wide) to a decentralized (school by school) decision, states may switch from state-wide standard adoptions to flexible district level procurement, and customers could increasingly utilize competitive requests for proposals (RFP) or procurement via the Internet. Any of these changes could cause us to modify our sales strategy or cause us to expend greater sales effort to win business and if we are slow to respond the result could be a material loss of market share. Our failure to expand our customer base could diminish incremental revenues from certain products. We sell products that require customers to purchase certain replenishment materials year after year if they chose to continue serving the same number of students. Sales of these consumable items and replacement materials typically involve considerably less revenue than the initial sale. Therefore, our ability to maintain and grow sales and profitability will depend significantly upon the ability to acquire new customers or increase sales to existing customers. Acquiring new customers or expanding student use within existing customers could prove challenging as a result of competition from larger competitors, reductions in state and local funding, customer preferences and any requirement to provide enhancements to product capabilities. We may also be adversely affected by existing customers who reduce or discontinue use of our products and services, which may occur if our product offering is less competitive with those of our competitors, or as a result of budgetary constraints which have become increasingly acute in the current economic downturn. If we are not successful in continuing to acquire additional customers or expanding business from our existing customers, our earnings may be adversely affected. Our sales growth and profitability will depend, in part, on our ability to attract and retain productive resellers. Historically, we have used resellers as a sales channel for certain products. Entities that resell our products may discontinue selling the products or choose to substitute a competing product, or they may not dedicate sufficient attention and resources to our products that they are selling. Should any of our current or future resellers perform below our expectations, or should we lose one or more relationships with one of our current resellers, or fail to establish relationships with additional or replacement resellers, our sales and profitability could be adversely affected. We may be unable to integrate successfully the businesses of Cambium and VLCY and realize the anticipated benefits of the mergers. The mergers of Cambium and VLCY involved the combination of two companies which, prior to the mergers, operated as independent companies. We have devoted and will continue to be required to devote significant management attention and resources to integrating the businesses practices and operations of the two previously separate companies. Potential difficulties we may encounter in the integration process include, without limitation, the following: • the inability to successfully combine the businesses of Cambium and VLCY in a manner that permits us to achieve the cost savings and revenue synergies anticipated to result from the mergers, which would result in the anticipated benefits of the mergers not being realized partly or wholly in the time frame currently anticipated or at all; • lost sales and customers as a result of certain customers of either of the two companies deciding not to do business with us, including the risks associated with changing the customer relationship from one sales representative to another sales representative; • complexities associated with managing the combined businesses; and • integrating personnel from the two companies while maintaining focus on providing consistent, high-quality products and customer service. In addition, it is possible that the integration process could result in the diversion of management’s attention, the disruption or interruption of, or the loss of momentum in, ongoing business of the combined company or inconsistencies in products, services, standards, controls, procedures and policies, any of which could adversely affect our ability to maintain relationships with customers and employees, or our ability to achieve the anticipated benefits of the mergers, or could reduce the earnings or otherwise adversely affect our business and financial results. The integration process may be difficult, unpredictable and subject to substantial delay because the businesses are complex, were developed independently and were designed without regard to such integration. Moreover, prior to the mergers, the businesses were headquartered in different geographical regions, which may further complicate integration efforts and make integration of the two companies more challenging. In some instances, Cambium and VLCY historically served the same customers, and some of these customers may decide that it is desirable to seek out additional or different vendors in order to ensure that we are competitive with other companies. If we cannot successfully integrate these businesses and continue to provide customers with products, services and new features on a timely basis, we may lose customers and our business and results of operations may be harmed materially. We also may incur additional unanticipated costs in the integration of the businesses of Cambium and VLCY. Our sales and profitability will depend on our ability to continue to develop new products and services that appeal to customers and end users and respond to changing customer preferences. We operate in markets that are characterized by continuous and rapid change, including product introductions and enhancements, changes in customer demands and evolving industry standards. In a period of rapid change, the technological and curriculum life cycles of our products are difficult to estimate. The demand for some of our more “mature” products and services has begun to migrate to other, newer products and services. As a result, we will need to continuously reassess our product and service offerings. We could make investments in new products and services that may not be profitable, or whose profitability may be significantly lower than what we have experienced historically. If we are unable to anticipate trends and develop new products or services responding to changing customer preferences, our revenues and profitability could be adversely affected. Our business could be harmed if we are unable to develop new products and invest in existing products in an appropriate balance to keep our company competitive in the marketplace. Our business is anticipated to be seasonal and our operating results are anticipated to fluctuate seasonally. Our business is likely to be subject to seasonal fluctuations. Historically, revenue and income from operations have been higher during the second and third calendar quarters. In addition, the quarterly results of operations have fluctuated in the past, and our quarterly results of operations can be expected to continue to fluctuate in the future, as a result of many factors, including: • general economic trends; • state and local budgets for education; • the traditional cyclical nature of educational material sales; • school, library and consumer purchasing decisions; • unpredictable funding of schools and libraries by federal, state and local governments; • consumer preferences and spending trends; • the need to increase inventories in advance of the primary selling season; and • the timing of introductions of new products and services. If we are unable to compete effectively, we may be unable to successfully attract and retain customers and our profitability could be materially harmed. The market for our products and services is highly competitive and is characterized by frequent product developments and enhancements of existing products. We cannot assure you that products or services introduced by others will not adversely affect our business. Many companies, both privately and publicly owned, develop products and services similar to our products. These competitors include basal text book suppliers, which often offer intervention products as part of their core reading programs, supplemental suppliers, technology suppliers and service providers. Several of our competitors have substantially greater financial, research and development, manufacturing and marketing resources than us as well as greater name recognition and larger customer bases. Accordingly, our competitors may be able to respond more quickly to new technologies and changes in customer requirements, have more favorable access to suppliers and devote greater resources to the development and sale of their products and services. These competitors may be successful in developing products and services that are more effective or less costly than any products or services that we may provide currently or may develop in the future. Any incursions by competitors could materially and adversely affect our ability to attract and retain customers and thus may materially harm our business. Our intellectual property protection may be inadequate, which may allow others to use our technologies and thereby reduce our ability to compete. The technology underlying our services and products may be vulnerable to attack by our competitors. We rely on a combination of trademark, copyright and trade secret laws, employee and third party nondisclosure agreements and other contracts to establish and protect our technology and other intellectual property rights. The steps that we have taken in order to protect our proprietary technology may not be adequate to prevent misappropriation of our technology or to prevent third parties from developing similar technology independently. Technology content licensed from third parties may not continue to be available. We license from third parties technology content upon which we rely to deliver products and services to customers. This technology may not continue to be available to us on commercially reasonable terms or at all. Moreover, we may face claims from persons who claim that our licensed technologies infringe upon or violate those persons’ proprietary rights. These types of claims, regardless of the outcome, may be costly to defend and may divert management’s efforts and resources. Our products could infringe on the intellectual property of others, which may cause us to engage in costly litigation and to pay substantial damages or restrict or prohibit us from selling our products. Third parties may assert infringement or other intellectual property claims against us based on their intellectual property rights. If any of these claims are successful, we may be required to pay substantial damages, possibly including treble damages, for past infringement. We also may be prohibited from selling our products or providing certain content without first obtaining a license from the third party, which, if available at all, may require us to pay additional fees or royalties to the third party. Even if infringement claims against us are without merit, defending a lawsuit takes significant time, is often expensive and may divert management attention away from other business concerns. Our success will depend in part on our ability to attract and retain key personnel. Our success depends in part on our ability to attract and retain highly qualified executives and management, as well as creative and technical personnel. Members of our senior management team have substantial industry experience that is critical to the execution of our business plan. If they or other key employees were to leave the Company, and we were unable to find qualified and affordable replacements for these individuals, our business could be harmed materially. Our customer contracts are not likely to insulate us from potential reductions in revenues. We provide products and services to several governmental agencies, school districts and educational facilities under contractual arrangements that, in most cases, are terminable at-will. We may have no recourse in the event of a customer’s cancellation of a contract that is terminable at-will. In addition, contracts awarded pursuant to a procurement process are subject to challenge by competitors and other parties during and after that process. The termination or successful challenge of significant contracts could materially and adversely affect our business, financial condition, results of operations and liquidity. Increases in operating costs and expenses, many of which are beyond our control, could materially and adversely affect our operating performance. We must control our employee compensation expenses and our printing, paper and distribution (such as postage, shipping and fuel) costs in order to be profitable. Our ability to control compensation expenses is limited by our need to offer our employees competitive salaries and benefit packages in order to attract and retain the quality of employees required to grow and expand our business. Our ability to control compensation expenses is also limited by general economic factors, including those affecting costs of health insurance, as well as by trends specific to the employee skills that we require. Paper prices fluctuate based on worldwide demand and supply for paper, in general, as well as for the specific types of paper we use. If there is a significant disruption in the supply of paper or a significant increase in paper costs, which would generally be beyond our control, or if our strategies to manage these costs are ineffective, our results of operations could be materially and adversely affected. Acquisitions, if completed, could adversely affect our operations. We may seek potential acquisitions of products, technologies and businesses in the education industry that could complement or expand our current product and service offerings and businesses. In the event that we identify appropriate acquisition candidates, we may not be able to successfully negotiate, finance or integrate the acquired products, technologies or businesses. Furthermore, such an acquisition could cause a diversion of management’s time and resources. Any particular acquisition, if completed, may materially and adversely affect our business, results of operations, financial condition or liquidity. The failure to manage growth properly could have a material adverse effect upon our business, results of operations, financial condition or liquidity. The educational products industry is a fragmented industry. If this industry becomes more concentrated over time, it will be important for us to grow and to manage our growth effectively. Our ability to manage our growth, if any, will require us to expand our management team and assure that our systems and controls are designed to support this growth. Any measurable growth in business will result in additional demands on customer support, sales, marketing, administrative and technical resources, and upon our related systems and controls. We may not be able to successfully address these additional demands, and our operating and financial control systems may not be adequate to support our future operations and anticipated growth. We use the Internet extensively, and federal or state governments may adopt laws or regulations that could expose us to substantial liability and/or taxation in connection with these activities. As a result of increasing usage of the Internet, federal and state governments may adopt laws or regulations regarding commercial online services, the Internet, user privacy, intellectual property rights, content and taxation of online communications. Laws and regulations directly applicable to online commerce or Internet communications are becoming more prevalent and could expose us to substantial liability. Furthermore, various proposals at the federal, state and local levels could impose additional taxes on Internet sales. These laws, regulations and proposals could decrease Internet commerce and other Internet uses and adversely affect the success of our online products and business. We could experience system failures, software errors or capacity constraints, any of which would cause interruptions in the delivery of electronic content to customers and ultimately may cause us to lose customers. Any significant delays, disruptions or failures in the systems, or errors in the software, that we use for the technology-based component of our products, as well as for internal operations, could harm our business materially. We have occasionally suffered computer and telecommunication outages or related problems in the past. The growth of our customer base, as well as the number of websites we provide, could strain our systems in the future and will likely magnify the consequences of any computer and telecommunications problems that we may experience. Many of the systems that we use to deliver our services to customers are located in multiple facilities across several states. However, destruction or disruption at a single site can cause a system-wide failure. Although we maintain property insurance on these premises, claims for any system failure could exceed our coverage. In addition, our products could be affected by failures associated with third party hosting providers or by failures of third party technology used in our products, and we may have no control over remedying these failures. Any failures or problems with our systems or software could force us to incur significant costs to remedy the failure or problem, decrease customer demand for our products, tarnish our reputation and harm our business materially. Our systems face security risks and we need to ensure the privacy of our customers. Our systems and websites may be vulnerable to unauthorized access by hackers, computer viruses and other disruptive problems. Any security breaches or problems could lead to misappropriation of our customers’ information, our websites, our intellectual property and other rights, as well as disruption in the use of our systems and websites. Any security breach related to our websites could tarnish our reputation and expose us to damages and litigation. We also may incur significant costs to maintain our security precautions or to correct problems caused by security breaches. Furthermore, to maintain these security measures, we may be required to monitor our customers’ access to our websites, which may cause disruption to customers’ use of our systems and websites. These disruptions and interruptions could harm our business materially. We have a single distribution center and could experience significant disruption of business and ultimately lose customers in the event it was damaged or destroyed. In the first quarter of 2010, we completed the integration of VLCY’s Dallas, Texas distribution facility into Cambium’s distribution facility in Frederick, Colorado. As a result, we store and distribute the majority of our printed materials through this single warehouse in Frederick, Colorado. In the event that this distribution facility was damaged or destroyed, we would be delayed in responding to customer requests. Customers often purchase materials very close to the school year and such delivery delays could cause our customers to turn to competitors for products they need immediately. While we maintain adequate property insurance, the loss of customers could have a long-term, detrimental impact on our reputation and business. The complexity of our distribution operations may subject us to technological risk. Our distribution center is highly automated, which means that their operations are complicated and may be subject to a number of risks related to computer viruses, the proper operation of software and hardware, electronic or power interruptions and other system failures. Risks associated with upgrading or expanding the warehouse may significantly disrupt or increase the cost of operating this center. Our business may not grow as anticipated if we are not able to maintain and enhance our brands. We believe that maintaining and enhancing our brands is important to attracting and retaining customers. Our success in growing brand awareness will depend in part on our ability to continually provide high quality programs and solutions that enhance the learning process. Competitors may offer goods and services similar to those offered by us, which may diminish the value of our brand. In addition, some of our brand names are new, or have changed or may be changed, and we may not successfully maintain and grow the brand equity. Failure to efficiently manage our direct marketing initiatives could negatively affect our business. We use various direct marketing strategies to market our products, including direct mailings, catalogs, online marketing and telemarketing. In each case, we rely on our customer list, which is a database containing information about our current and prospective customers. We use this database to develop and implement our direct marketing campaigns. Managing the frequency of our direct marketing campaigns and delivering appropriately tailored products in these campaigns is crucial to maintaining and increasing our customer base and achieving adequate results from our direct marketing efforts. We also face the risk of unauthorized access to our customer database or the corruption of our database as a result of technology failure or otherwise. Enhancing and refreshing the database, maintaining the ability to use the information available from the database, and properly using the available information is vital to the success of our business, and our failure to do so could lead to decreased sales and could materially and adversely affect our results of operations, financial condition and liquidity. Both Cambium and VLCY have been subjected to material accounting irregularities in recent years, which could result in enhanced regulatory scrutiny in the future and could undermine the confidence that some investors may have in the integrity of our financial statements. During 2008, Cambium discovered certain irregularities relating to the control and use of cash and certain other general ledger items which revealed a substantial misappropriation of assets spanning fiscal 2004 through fiscal 2008. These irregularities were perpetrated by a former employee, resulting in embezzlement losses, before the effect of income taxes, amounting to $14.0 million. See “MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.” In early 2006, VLCY (then known as ProQuest Company) announced that it had identified potential material irregularities in its accounting that were to be investigated by VLCY’s audit committee, with the assistance of outside experts. In July 2006, VLCY announced that its audit committee had completed its investigation and issued a statement that detailed the key findings, including that the evidence indicated that a single individual was responsible for the misstatements. After completion of that investigation, VLCY restated certain of its previously filed financial statements. The fact that both Cambium and VLCY have experienced material accounting irregularities within the past six years could result in enhanced regulatory scrutiny and could impair the confidence of investors, financing sources, research analysts and potential acquirers in the integrity of our financial statements. Risks Related to Ownership of our Common Stock An active, liquid trading market for our common stock may not develop. Prior to the listing of our common stock on the NASDAQ Global Market in December 2009, there has been no public market for our securities in the United States or elsewhere. Accordingly, we cannot assure you that an active trading market will develop or be sustained or that the market price of our common stock will not decline. The price at which our common stock has traded has been highly volatile. The stock market has experienced extreme volatility that often has been unrelated to the performance of its listed companies. Moreover, only a limited number of our shares are traded each day, which could increase the volatility of the price of our stock. These market fluctuations might cause our stock price to fall regardless of our performance. The market price of our common stock might fluctuate significantly in response to many factors, some of which are beyond our control, including the following: • actual or anticipated fluctuations in our annual and quarterly results of operations; • changes in securities analysts’ expectations; • variations in our operating results, which could cause us to fail to meet analysts’ or investors’ expectations; • announcements by state governments regarding spending on educational programs; • announcements by our competitors or us of significant new products, contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; • conditions and trends in our industry; • general market, economic, industry and political conditions; • changes in market values of comparable companies; • additions or departures of key personnel; • stock market price and volume fluctuations attributable to inconsistent trading volume levels; and • future sales of equity or debt securities, including sales which dilute existing investors. We do not foresee paying cash dividends in the foreseeable future and, as a result, our investors’ sole source of gain, if any, will depend on capital appreciation, if any. We do not plan to declare or pay any cash dividends on our shares of common stock in the foreseeable future and currently intend to retain future earnings, if any, for future operation, debt reduction and expansion. Any decision to declare and pay dividends in the future will be made at the discretion of our board of directors and will depend on, among other things, our results of operations, financial condition, restrictions imposed by applicable law, business and investment strategy, contractual limitations and other factors that our board of directors may deem relevant. In addition, our ability to pay dividends may be limited by covenants of any existing and future indebtedness we or our subsidiaries incur, including the Cambium Learning senior secured credit agreement and the Cambium Learning senior unsecured credit agreement. As a result, our stockholders may not receive any return on an investment in our common stock unless they sell our common stock for a price greater than that which they paid for it. Moreover, investors may not be able to resell their shares of the Company at or above the price they paid for them. Our majority stockholder has a contractual right to increase its percentage of ownership in our company which, if exercised, would dilute the ownership percentage of all other stockholders and could reduce the price of our common stock. Our majority stockholder, VSS-Cambium Holdings III, LLC, the holding company through which VSS owns its interest in the company, and funds managed or controlled by VSS, have the right to increase their percentage ownership of our company at a discount from market price. Under a stockholders agreement entered into in connection with the mergers, at any time and from time to time at or prior to December 8, 2011, VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS have the right to purchase from us, in cash, at a 10% discount from market price, up to the lesser of 7,500,000 shares of our common stock or shares of our common stock with an aggregate purchase price of $20 million. VSS-Cambium Holdings III, LLC also holds a warrant which was exercisable for up to 526,834 shares of our common stock at December 31, 2009 and may become exercisable for more shares in the future. If VSS-Cambium Holdings III, LLC decides to exercise its right to purchase shares of our common stock under the stockholders agreement or exercises its warrant, it could result in a reduction to the price of our common stock. The existence of a majority stockholder may adversely affect the market price of our common stock and could delay, hinder or prevent a change in corporate control or result in the entrenchment of management and the board of directors, and our majority stockholder has a contractual right to maintain its percentage ownership in our company. VSS-Cambium Holdings III, LLC, owns a majority of our outstanding common stock. Accordingly, VSS-Cambium Holdings III, LLC will likely have the ability to determine the outcome of matters submitted to our stockholders for approval, including the election and removal of directors and any merger, consolidation or sale of all or substantially all our assets. In addition, VSS-Cambium Holdings III, LLC will likely have the ability to control our management, affairs and operations. Accordingly, this concentration of ownership may harm the market price of our common stock by delaying, deferring or preventing a change in control or impeding a merger, consolidation, takeover or other business combination. The ownership of a large block of stock by a single stockholder may reduce our market liquidity. Should VSS-Cambium Holdings III, LLC determine to sell any of its position in the future, sales of substantial amounts of our common stock on the market, or even the possibility of these sales, may adversely affect the market price of our common stock. These sales, or even the possibility of these sales, also may make it more difficult for us to raise capital through the issuance of equity securities at a time and at a price it deems appropriate. Moreover, VSS-Cambium Holdings III, LLC has a contractual right to maintain its percentage ownership in our company. Specifically, under the terms of a stockholders agreement entered into in connection with the mergers, if we were to engage in a new issuance of our securities, VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS would have preemptive rights to purchase an amount of our securities that would enable them to maintain their same collective percentage of ownership in our company following the new issuance. VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS would have these preemptive rights for so long as those entities collectively beneficially own, in the aggregate, at least 25% of the outstanding shares of our common stock. Thus, while other holders of our securities would risk suffering a reduction in percentage ownership in connection with a new issuance of securities by us, VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS would, through this preemptive right, have the opportunity to avoid a reduction in percentage ownership. We are a “controlled company” within the meaning of the NASDAQ rules and, as a result, qualify for, and rely on, exemptions from various corporate governance standards, which limits the presence of independent directors on our board of directors and board committees. Due to the fact that VSS-Cambium Holdings III, LLC owns a majority of our outstanding common stock, we are deemed a “controlled company” for purposes of NASDAQ Rule 5615(c)(2). Under this rule, a company of which more than 50% of the voting power for the election of directors is held by an individual, a group or another company is a “controlled company” and is exempt from certain NASDAQ corporate governance requirements, including requirements that a majority of the board of directors consist of independent directors, that compensation of officers be determined or recommended to the board of directors by a majority of independent directors or by a compensation committee that is composed entirely of independent directors and that director nominees be selected or recommended for selection by a majority of the independent directors or by a nominating committee composed solely of independent directors. We intend to rely upon these exemptions. Accordingly, our stockholders may not have the same protections afforded to stockholders of other companies that are required to comply fully with the NASDAQ rules. Since the “controlled company” exemption does not extend to the composition of audit committees, we are required to have an audit committee that consists of at least three directors, each of whom must be “independent” based on independence criteria set forth in Rule 10A-3 of the Securities Exchange Act of 1934 (the “Exchange Act”). Our board of directors has adopted an audit committee charter which will govern our audit committee. These three directors must also satisfy the requirements set forth in NASDAQ Rule 5605(a) and (c). The audit committee is currently composed entirely of independent directors. Cambium Learning has a significant amount of senior secured and senior unsecured debt and will have the obligation to make principal and interest payments on that debt, and to comply with restrictions contained in credit agreements with our senior secured and senior unsecured lenders. Cambium Learning has an aggregate of $156.8 million of outstanding senior secured and senior unsecured debt as of December 31, 2009, consisting of $97.2 million under senior secured term loans, $54.6 million under senior unsecured notes, and $5.0 million drawn under a revolving credit facility. The amount of leverage could have important consequences for holders of our securities, including: • a substantial portion of the cash provided from operations will be committed to the payment of our debt service and will not be available for other purposes; • our ability to obtain additional financing in the future for working capital, capital expenditures or acquisitions may be limited; and • the level of indebtedness of our combined company may limit our flexibility in reacting to changes in our business environment. Our senior secured and senior unsecured term loan facilities mature on April 11, 2013 and April 11, 2014, respectively, and must be either repaid, refinanced or extended on those respective dates. We may not be able to extend the debt at that time (or prior thereto in the case of acceleration) and equity or debt financing may not be available to replace some or all of the maturing debt on acceptable terms, if at all. The failure of the original Cambium Learning investors to own at least 35% of our common stock or the sale by the VSS funds of more than 15% of their common stock would constitute an event of default under the Cambium Learning credit agreements, entitling the lenders to accelerate the repayment of all outstanding indebtedness. Cambium Learning’s senior secured and senior unsecured credit agreements contain various restrictions on changes in the direct or indirect ownership or control of Cambium Learning. These restrictions are embodied in the credit agreements’ “Change in Control” definition and under their “Events of Default” provisions. In addition to customary ownership and control changes, a “Change in Control” would occur if at least 35% of our common stock were not owned by at least one of the original investors in Cambium Learning or if the VSS funds sold more than 15% of our common stock owned by them (through VSS-Cambium Holdings III, LLC). As of December 31, 2009, the original Cambium Learning investors, through VSS-Cambium Holdings III, LLC, own approximately 55% of our common stock. Future issuances of common or other capital stock by us could dilute the original Cambium Learning investors’ ownership percentage below the requisite 35% amount. However, the investment funds controlled by VSS, which are among the original Cambium Learning investors, have the contractual right (but not the obligation) to subscribe for additional shares of our common stock in order to maintain their ownership level and thereby prevent unwanted dilution. This contractual right requires these investment funds to pay consideration to acquire any such additional shares. We cannot assure you that these funds will at any time elect to exercise their subscription right or will have the funds to do so. The occurrence of a “Change in Control” would constitute an “Event of Default” under the credit agreements. Either the administrative agent or a majority of the lenders have the right, upon the occurrence of an “Event of Default,” to terminate all commitments to make revolving loans, and to accelerate all outstanding revolving and term loans by declaring them immediately due and payable. Neither we nor Cambium Learning is expected to have sufficient cash on hand to repay these loans in full upon such an acceleration. We may seek to raise additional funds, finance additional acquisitions or develop strategic relationships by issuing additional securities, including capital stock. In the future, we may seek to raise additional funds, finance additional acquisitions or develop or engage in strategic relationships by issuing equity or debt securities. The issuance of equity securities, including debt securities that are convertible into equity, would reduce the percentage ownership of our existing stockholders. Furthermore, any newly issued equity securities could have rights, preferences and privileges senior to those of the holders of our common stock. The issuance of new debt securities could also subject us to covenants which constrain our ability to grow or otherwise take steps that may be favored by our holders of common stock. Under the terms of a stockholders agreement that we entered into on December 8, 2009 in compliance with the mergers, so long as our sole stockholder and funds controlled by VSS beneficially own in the aggregate at least 25% of the outstanding shares of our common stock, they will have preemptive rights which generally give them the opportunity to purchase an amount of our securities in a new issuance of securities by us that would enable them to maintain their same collective percentage ownership in us following the new issuance. Thus, while other stockholders risk suffering a reduction in percentage ownership in connection with an issuance of securities by us, VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS will have the opportunity to avoid a reduction in percentage ownership. In addition, under the stockholders agreement, until December 8, 2011, VSS-Cambium Holdings III, LLC and funds managed or controlled by VSS will have the right to purchase from us, in cash, at a 10% discount from market price, up to the lesser of 7,500,000 shares of our common stock or shares of our common stock with a discounted purchase price of $20 million. Any purchases of stock at a discount from the market price may dilute the ownership percentage and equity ownership of all other stockholders. Provisions of our organizational documents and Delaware law may delay or deter a change of control. Our organizational documents contain provisions that may have the effect of discouraging, delaying or preventing a change of control of, or unsolicited acquisition proposals for, our company. These include provisions that: • vest our board of directors with the sole power to set the number of directors of our company; • provide that our board of directors will be elected on a staggered term basis, so that generally only one-third of the board will be elected at each annual meeting of stockholders; • limit the persons that may call special meetings of stockholders; • establish advance notice requirements for stockholder proposals and director nominations; and • limit stockholder action by written consent. Also, our board of directors has the authority to issue shares of preferred stock in one or more series and to fix the rights and preferences of these shares, all without stockholder approval. Any series of preferred stock is likely to be senior to our common stock with respect to dividends, liquidation rights and, possibly, voting rights. The ability of our board of directors to issue preferred stock also could have the effect of discouraging unsolicited acquisition proposals, thus adversely affecting the market price of our common stock. In addition, Delaware corporate law makes it difficult for stockholders that recently have acquired a large interest in a corporation to cause the merger or acquisition of the corporation against the directors’ wishes. Under Section 203 of the Delaware General Corporate Law (the “DGCL”), a Delaware corporation such as the Company may not engage in any merger or other business combination with an interested stockholder or such stockholder’s affiliates or associates for a period of three years following the date that such stockholder became an interested stockholder, except in limited circumstances, including by approval of the corporation’s board of directors. If we are unable to favorably assess the effectiveness of our internal control over financial reporting, or if our auditors are unable to provide an unqualified attestation report on our internal control over financial reporting, the stock price of our common stock could be adversely affected. Pursuant to Sections 302 and 404 of the Sarbanes-Oxley Act of 2002, our management will be required to certify to and report on, and our auditors will be required to attest to, the effectiveness of our internal control over financial reporting. The rules governing the standards that must be met for management to assess our internal control over financial reporting are complex, and require significant documentation, testing and possible remediation. Our management was not required to perform an assessment of internal control over financial reporting for the fiscal year ended December 31, 2009. Our management expects to complete an assessment and certification on, and for our auditors to attest to, the effectiveness of internal control over financial reporting beginning with our annual report on Form 10-K for the fiscal year ending December 31, 2010. Compliance with regulatory requirements relating to internal controls is expensive and may cause us to focus a significant amount of management time and other internal resources on these matters. We also may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our internal control over financial reporting. In addition, in connection with the attestation process by our auditors, we may encounter problems or delays in completing the implementation of any identified improvements or receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal control over financial reporting, or if our auditors are unable to provide an unqualified attestation report on internal control over financial reporting, investor confidence and the market price of our common stock could be adversely affected. Item 1B. Unresolved Staff Comments. Item 2. Properties. Our principal corporate office is located in Dallas, Texas. We lease office and warehouse facilities in Dallas, Texas, Charlottesville, Virginia, Tucson, Arizona, Frederick, Colorado, Natick, Massachusetts and Ann Arbor, Michigan. Some leases contain renewal and escalation clauses for a proportionate share of operating expenses. The Frederick, Colorado warehouse is under a build-to-suit lease and so is included in our property, computers and equipment but is not considered owned for purposes of the table below. The following table provides summary information in square feet with respect to these facilities as of December 31, 2009, excluding the 95,873 square foot warehouse facility in Dallas, Texas, which was integrated into the Frederick, Colorado warehouse in the first quarter of 2010. (sq ft) We believe the buildings and equipment used in our continuing operations generally to be in good condition and adequate for our current needs and that additional space will be available as needed. We are not presently engaged in any pending legal proceeding material to our financial condition, results of operations or liquidity. Item 4. (Removed and Reserved). Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Market Information: Our common stock is traded on the NASDAQ Global Market under the symbol “ABCD.” Below are the high and low sale prices for each quarter since our common stock commenced publicly trading on December 9, 2009. Fiscal Quarter High Low High Low N/A N/A N/A N/A Fourth (Since December 9, 2009) $ 14.80 $ 3.62 N/A N/A Record Holders: As of December 31, 2009, there were 104 holders of record of our common stock. The holders of record at year-end 2009 do not include any previous VLCY stockholders who have not yet returned their letters of transmittal to exchange their VLCY shares for our shares of common stock in connection with the mergers. Purchases Of Equity Securities: We made no repurchases of our equity securities in the fiscal year ended December 31, 2009. Dividends: We have not declared or paid any cash dividends to our stockholders. Any future determination to pay dividends, if any, will be at the discretion of our board of directors. Securities Authorized for Issuance Under Equity Compensation Plans: We have securities authorized for issuance under the Cambium Learning Group, Inc. 2009 Equity Incentive Plan (“Incentive Plan”). In connection with the then pending merger with VLCY, on July 31, 2009, the Company’s board of directors and sole stockholder approved the Incentive Plan. The general purposes of the Incentive Plan are to attract and retain the best available personnel for positions of substantial responsibility, to provide additional incentives to employees, directors and consultants, and to promote the success of the Company. Securities authorized for issuance under equity compensation plans at December 31, 2009 are as follows: Number of securities Number of securities to be Weighted-average remaining available for issued upon exercise of exercise price of future issuance (in thousands, except per share amounts) outstanding options outstanding options under equity Plan Category and rights and rights incentive plan (a) Equity compensation plans approved by security holders 2,256 $ 6.03 2,744 Equity compensation plans not approved by security holders (a) Excludes securities reflected in the first column, “Number of securities to be issued upon exercise of outstanding options and rights”. Recent Sales of Unregistered Securities: The following is a description of the Company’s securities that were issued or sold by the Company during the period covered by this report and which were not registered under the Securities Act of 1933, as amended (the “Securities Act”): As described elsewhere in this Annual Report on Form 10-K, on December 8, 2009, the Company completed its acquisition of each of Cambium and VLCY pursuant to the terms of the merger agreement entered into in connection with the transaction. With respect to the acquisition of Cambium, under the terms of the merger agreement, the Company acquired all of the common stock of Cambium through the merger of a wholly owned subsidiary of the Company with and into Cambium, with Cambium continuing as the surviving corporation (the “Cambium Merger”). As a result of the effectiveness of the Cambium Merger, Cambium became a wholly owned subsidiary of the Company. Under the merger agreement, as consideration for the Cambium Merger, the shares of Cambium’s common stock held by VSS-Cambium Holdings III, LLC, the sole stockholder of Cambium immediately prior to the Cambium Merger (the “Cambium Stockholder”), were converted into the right to receive 20,491,870 shares of the Company’s common stock. In addition, as part of the Cambium Merger consideration, the Cambium Stockholder received a warrant (the “Warrant”) to purchase a number of shares of the Company’s common stock determined by a formula set forth in the merger agreement, which Warrant is currently exercisable for a total of 526,834 shares. Immediately prior to the effective time of the mergers, the Company also issued the Cambium Stockholder an additional 3,846,154 shares of Company common stock in exchange for a $25 million contribution the Cambium Stockholder made to the Company. All of the above-described issuances and sales of securities of the Company (including both of common stock of the Company and of the Warrant) to the Cambium Stockholder were exempt from registration under Section 4(2) of the Securities Act. Stock Performance Graph: No performance graph has been included in this report since our common stock began publicly trading on December 9, 2009, and therefore only was publicly traded for the 23-day period from December 9, 2009 through December 31, 2009 during our last fiscal year. Item 6. Selected Financial Data. The tables below present summary selected historical consolidated financial data derived from our consolidated financial statements prepared in accordance with GAAP. You should read the information set forth below in conjunction with our consolidated financial statements and related notes, management’s discussion and analysis of financial condition and results of operations and other financial information presented elsewhere herein. The summary selected historical consolidated financial data for the year ended December 31, 2006, the period from January 1, 2007 through April 11, 2007 (the “2007 predecessor period”), the period from January 29, 2007 through December 31, 2007 (the “2007 successor period”), the year ended December 31, 2008 and the year ended December 31, 2009 have been derived from our audited consolidated financial statements. The summary selected historical consolidated financial data for the year ended December 31, 2005 have been derived from our unaudited consolidated financial statements prepared on a basis consistent with the accounting policies used for our audited financial statements. On December 8, 2009, we completed the mergers of VLCY and Cambium into two of our wholly-owned subsidiaries resulting in VLCY and Cambium becoming our wholly-owned subsidiaries. Following the completion of the mergers, all of the outstanding capital stock of VLCY’s operating subsidiaries, Voyager Expanded Learning, Inc. and LAZEL, Inc. were transferred to Cambium Learning. The transaction was accounted for as an “acquisition” of VLCY by Cambium, as that term is used under U.S. GAAP, for accounting and financial reporting purposes under the applicable accounting guidance for business combinations. As a result, the historical financial statements of Cambium have become the historical financial statements of the Company and the results of VLCY are included from the merger date. Period from Predecessor January 29, Period from (Inception) 2007 Predecessor Predecessor Year Ended Year Ended through through Year Ended Year Ended December 31, December 31, December 31, April 11, December 31, December 31, (in thousands, except per share data) 2009 2008 2007(1) 2007 2006 2005 $ 90,385 $ 89,207 $ 71,266 $ 15,238 $ 92,882 $ 75,430 Service revenues 10,663 10,524 9,581 3,176 13,542 9,726 101,048 99,731 80,847 18,414 106,424 85,156 Total operating expenses, excluding in-process research and development, impairment, and embezzlement (115,108 ) (104,648 ) (81,305 ) (32,179 ) (97,955 ) (81,017 ) — — (890 ) — — (500 ) Goodwill and other intangible asset impairment(3) (9,105 ) (75,966 ) — — — (4,132 ) Embezzlement and related expense(2) (129 ) (7,254 ) (5,732 ) (1,000 ) (3,261 ) (290 ) (Loss) income before interest, other income (expense), and income taxes (23,294 ) (88,137 ) (7,080 ) (14,765 ) 5,208 (783 ) Gain from settlement with previous stockholders(4) — 30,202 — — — — Net (loss) income (35,765 ) (69,560 ) (13,931 ) (11,812 ) 440 (1,212 ) Net (loss) income per common share $ (1.63 ) $ (3.39 ) $ (0.68 ) $ (4.34 ) $ 0.16 $ (0.45 ) Predecessor Predecessor December 31, December 31, December 31, December 31, December 31, (in thousands) 2009 2008 2007 2006 2005 Balance Sheet Data: $ 13,345 $ 2,418 $ 1,206 $ 1,642 $ 9,823 393,841 270,477 369,138 138,028 115,034 Total long term debt, less current portion 150,487 153,787 176,402 17,500 17,500 Total members’ interest and stockholders’ equity 139,772 68,204 130,080 78,895 65,620 Footnotes to the Selected Financial Data: (1) On January 29, 2007, VSS-Cambium Holdings, LLC was formed for the purpose of acquiring all of the capital stock of Cambium Learning. That acquisition was completed on April 12, 2007. The consolidated financial statements present the Company as of December 31, 2007 (Successor basis reflecting activity of the Company from January 29, 2007 and including the results of Cambium Learning from April 12, 2007) and the period January 1, 2007 through April 11, 2007 (Predecessor basis for the period prior to Company’s acquiring Cambium Learning). (2) We discovered in 2008 that a former employee had perpetrated a significant misappropriation of assets during a period beginning in 2004 and extending through April 2008. (3) Reflects the non-cash effect of the impairment write-down of goodwill and other intangible assets during 2009, 2008, and 2005 resulting from a reduction in the fair value of assets. (4) For fiscal 2008, we received a settlement from our previous stockholders relating to the embezzlement we suffered. For further information, see Note 3 to our Consolidated Financial Statements. Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. Organization of Information This section includes the following sections: • Results of Operations • Year Ended December 31, 2009 Compared to Year Ended December 31, 2008 • Year Ended December 31, 2008 (“fiscal 2008”) Compared to Period from January 29, 2007 through December 31, 2007 (“2007 successor period”) and Period from January 1, 2007 through April 11, 2007 (“2007 predecessor period”) • Liquidity and Capital Resources • Non-GAAP Measures • Capital Expenditures and Outlook • Commitments and Contractual Obligations • Off-Balance Sheet Arrangements • Critical Accounting Policies and Estimates • Recently Issued Financial Accounting Standards On December 8, 2009, we completed the business combination of Cambium and VLCY as contemplated by the Agreement and Plan of Mergers, dated as of June 20, 2009, among us, VLCY, Vowel Acquisition Corp., our wholly-owned subsidiary, Cambium, a wholly-owned subsidiary of VSS-Cambium Holdings III, LLC, Consonant Acquisition Corp., our wholly owned subsidiary, and Vowel Representative, LLC, solely in its capacity as stockholders’ representative. We refer to this agreement and plan of mergers in this report as the merger agreement. Pursuant to the merger agreement, we acquired all of the common stock of each of Cambium and VLCY through the merger of Consonant Acquisition Corp. with and into Cambium, with Cambium continuing as the surviving corporation (the “Cambium Merger”), and the concurrent merger of Vowel Acquisition Corp. with and into VLCY, with VLCY continuing as the surviving corporation (the “Voyager Merger”). As a result of the effectiveness of the mergers, Cambium and VLCY became our wholly owned subsidiaries. Under the terms of the merger agreement, each outstanding share of VLCY’s common stock was converted in the Voyager Merger into the right to receive at the election of each stockholder, either (i) $6.50 in cash, without interest, or (ii) one share of our common stock, plus, regardless of the election made, additional consideration consisting of cash and a contingent value right, as described in the merger agreement. The amount of cash available to satisfy cash elections by the VLCY stockholders was limited to $67.5 million in the aggregate. As anticipated, the cash consideration payable to the former VLCY stockholders was insufficient to accommodate all of the cash elections that were made. Accordingly, the amount of cash paid to the former VLCY stockholders who elected to exchange shares of VLCY common stock for cash was to be reduced, pro rata, in accordance with agreed procedures set forth in the merger agreement. Pursuant to these procedures, we paid $67.5 million in cash to the former holders of VLCY’s common stock and issued to those stockholders a total of 19.5 million shares of common stock. The cash consideration paid to the former VLCY stockholders consisted of $25 million contributed by VSS-Cambium Holdings III, LLC and $42.5 million contributed by VLCY. In exchange for its contribution of $25 million, VSS-Cambium Holdings III, LLC received 3.8 million shares of our common stock issued at the ascribed value of $6.50 per share. The shares of Cambium’s common stock held by VSS-Cambium Holdings III, LLC, its sole stockholder, were converted in the Cambium Merger into the right to receive 20.5 million shares of the our common stock. In addition, as part of the merger consideration, VSS-Cambium Holdings III, LLC received a warrant to purchase a number of shares of our common stock determined by a formula set forth in the merger agreement, which is currently equal to 0.5 million shares. In connection with the consummation of this transaction we entered into a stockholders agreement pursuant to which we granted VSS-Cambium Holdings III, LLC and funds managed and controlled by VSS the right to purchase up to 7.5 million shares of our common stock as provided for in the stockholders agreement. The merger transaction was accounted for as an “acquisition” of VLCY by Cambium, as that term is used under U.S. GAAP, for accounting and financial reporting purposes under the applicable accounting guidance for business combinations. In making this determination, management considered that (a) the newly developed entity did not have any significant pre-combination activity and, therefore, did not qualify to be the accounting acquirer, and (b) the former sole stockholder of Cambium is the majority holder of the combined entity, while the prior owners of VLCY became minority holders in the combined entity. As a result, the historical financial statements of Cambium have become the historical financial statements of the Company. The results of VLCY are included in the Company’s operations beginning with the December 8, 2009 merger date; therefore, the 2009 financials include VLCY for the last 23 days of the year and the results of the Company for the full year. Our historical segment reporting results have been adjusted for comparative purposes to reflect the current organizational structure. These reclassifications required certain assumptions and estimates. See Note 21 to the financial statements for further information on our reportable segments. Fiscal Year 2009 Compared to Fiscal Year 2008 Throughout the first half of 2009, we continued to experience the adverse developments in the education funding environment, including the reductions in Reading First funding and reductions in available state and local funds as many state and local governments struggled with deficits caused in part by the decline in property tax receipts, which significantly decreased the funding available to schools to purchase our products and services. Some school districts found it difficult to secure alternative funding sources in the midst of these market conditions. Additionally, we experienced declines in key adoption states, such as Alabama and Florida, where we enjoyed significant sales success in 2008. During the latter half of 2009, we began to see the positive impact, both directly and indirectly, of the American Reinvestment and Recovery Act (ARRA) passed in February 2009. The Act provides significant new federal funding for various education initiatives over the next two years. While the education funding is for a broad set of education initiatives, we believe that schools and districts directed and may continue to direct some of the new funding for programs which use our products. In some instances, if ARRA funding is not used directly for programs using our products, we may still be receiving an indirect benefit. When the ARRA funding is used to assist schools to meet their overall financial needs, other funds may be freed up to use for our programs. While success in winning some of these funds for our products is not certain at this time, we believe it has the potential to continue to stabilize some of the negative funding trends which emerged in 2008, continue in 2009 and are expected to prevail into 2010. The following trends have or may have an impact on our revenues and profitability: • The acquisition of VLCY in late 2009 added several online subscription-based products to our portfolio. We expect to see growth in these products in the coming years. • We have a growing portfolio to address the math needs of the market, including products such as Vmath, Algebra Rescue, Transitional Math and ExploreLearning. We have experienced success in the growth of our math capabilities and expect that the market for these products will continue to be strong in 2010. • We believe our product diversification, such as growth in the online offerings, math intervention and new reading intervention products for higher grades, will allow us to strengthen our ability to sustain market share in a troubled market and capture market share when the market recovers. • We believe our focus on product usage and an overall partnership approach with the customer to implement our solutions with fidelity will result in higher success rates, and such success, if achieved, will lead to customer retention and growth through reference sales. • We believe there is a trend to direct greater funding to special needs or at risk children in the United States. New funding sources, such as Race to the Top, could provide additional funds for our products should recipients of these funding sources chose to direct them to programs that utilize our products and services. • We believe that the economic crisis faced by many states and local entities will continue in 2010 and have a continued depressive effect on general spending and thus could negatively impact our short term sales prospects. • Efforts taken in 2009 by both VLCY and Cambium to reduce their cost structures, including a reduction in force, better align our cost structure to current market conditions. We expect to achieve further significant cost savings throughout 2010 and 2011 as we integrate VLCY and Cambium, which will be partially offset by one-time integration cots to achieve these synergies. • We performed a goodwill impairment analysis in the second quarter of 2009 and as a result of the execution of the merger agreement in late June, which was considered a triggering event, and in consideration of the continuing impact of adverse marketplace and economic conditions. As a result of this analysis, we recorded a goodwill impairment charge of $9.1 million in the second quarter. The following tables set forth information regarding Cambium’s net sales, costs and expenses, operating loss and other components of our statements of operations. The results and percentages for the years ended December 31, 2009 and 2008, the successor period from January 29, 2007 (inception) through December 31, 2007 and the predecessor period from January 1, 2007 through April 11, 2007 are set forth in the tables below. Due to purchase accounting adjustments, some amounts may not be comparable between each period presented. Successor Period, from January 29, Predecessor Period 2007 (inception) from January 1, Year Ended Year Ended through December 2007 through April December 31, 2009 December 31, 2008 31, 2007 11, 2007 % of % of % of % of (in thousands) Amount Sales Amount Sales Amount Sales Amount Sales $ 44,329 43.9 % $ 40,424 40.5 % $ 35,827 44.3 % $ 4,132 22.4 % 23,431 23.2 % 27,495 27.6 % 21,496 26.6 % 5,136 27.9 % 8,594 8.5 % 7,924 7.9 % 7,275 9.0 % 2,287 12.4 % 1,754 1.7 % 2,217 2.2 % 2,064 2.6 % 773 4.2 % 315 0.3 % 383 0.4 % 242 0.3 % 116 0.6 % 101,048 100.0 % 99,731 100.0 % 80,847 100.0 % 18,414 100.0 % 10,678 10.6 % 11,214 11.2 % 13,106 16.2 % 1,136 6.2 % 6,350 6.3 % 6,003 6.0 % 4,755 5.9 % 1,699 9.2 % 26 0.0 % — 0.0 % — 0.0 % — 0.0 % Cost of service revenues 172 0.2 % 253 0.3 % 119 0.1 % 64 0.3 % Amortization expense Total cost of sales Research and development expense Sales and marketing expense General and administrative expense 30,519 30.2 % 16,156 16.2 % 11,142 13.8 % 13,676 74.3 % Depreciation and amortization expense 9,723 9.6 % 11,453 11.5 % 9,338 11.6 % 732 4.0 % — 0.0 % — 0.0 % 890 1.1 % — 0.0 % Goodwill impairment charge 9,105 9.0 % 75,966 76.2 % — — — — Embezzlement and related expense 129 0.1 % 7,254 7.3 % 5,732 7.1 % 1,000 5.4 % Loss before interest, other income (expense) and income taxes (23,294 ) (23.1 )% (88,137 ) (88.4 )% (7,080 ) (8.8 )% (14,765 ) (80.2 )% Net interest income (expense) (19,477 ) (19.3 )% (18,434 ) (18.5 )% (13,132 ) (16.2 )% (742 ) (4.0 )% Gain from settlement with previous stockholders — — 30,202 30.3 % — — — — Loss on extinguishment of debt — — (5,632 ) (5.6 )% — — — — Other income (expense), net (698 ) (0.7 )% (981 ) (1.0 )% (1,557 ) (1.9 )% 1 0.0 % 7,704 7.6 % 13,422 13.5 % 7,838 9.7 % 3,694 20.1 % $ (35,765 ) (35.4 )% $ (69,560 ) (69.7 )% $ (13,931 ) (17.2 )% $ (11,812 ) (64.1 )% Year Ended December 31, 2009 Compared to Year Ended December 31, 2008 Net sales for the year ended December 31, 2009 increased $1.3 million, or 1.3%, to $101.0 million from $99.7 million in the same period for 2008. Our net sales for 2009 were impacted by several significant declines, such as the nationwide economic slowdown, which caused the amount of funding available to schools to decline, a decline in our Sopris segment related to our assessment product, and declines in key adoption states such as Alabama and Florida. Regarding the decline in adoption states, we enjoyed increased sales performance in 2008 in these states but the nature of the adoption leads to lower sales in the year following the adoption. Offsetting these declines was the impact of the acquisition of VLCY, contributing an incremental $4.5 million in net sales, and increases in sales of our math products as well as some growth in several new and existing customers. Voyager. The Voyager segment’s net sales in 2009 increased $4.6 million, or 9.5%, to $52.9 million from net sales of $48.3 million in 2008. Product sales increased $3.9 million, or 9.7%, to $44.3 million from net sales of $40.4 million in 2008. Service revenues increased $0.7 million, or 8.5%, to $8.6 million from net sales of $7.9 million in 2008. The increase in year over year net sales was due mainly to the impact of the acquisition of VLCY, contributing an incremental $3.0 million in product sales and $0.8 million in service revenues. Additionally, Voyager was able to offset the decline in the state adoption sales in Alabama and Florida and overcome the general state and local funding crisis with increases in sales of our math products as well as some growth in several new and existing customers. Sopris. The Sopris segment’s net sales in 2009 decreased $4.5 million, or 15.2%, to $25.2 million from net sales of $29.7 million in 2008. The decline in sales of supplementary program sales was mainly due to a decrease in sales of DIBELS in Florida, as Florida developed its own assessment program. Additionally, we renegotiated and extended a relationship with a customer in 2008 and were able to secure an additional up-front 2009 royalty payment that was recognized in 2008. Cambium Learning Technologies. The Cambium Learning Technologies segment’s net sales in 2009 increased $1.3 million, or 5.9%, to $22.9 million from net sales of $21.7 million in 2008. The increase in year over year net sales was due mainly to the impact of the acquisition of VLCY, contributing an incremental $0.7 million in product sales. Cost of product sales include expenses to print, purchase, handle and warehouse product, as well as royalty costs. Cost of product sales for the year ended December 31, 2009 decreased $0.7 million, or 3.2%, to $19.6 million from $20.2 million in 2008. The decrease in cost of sales was mainly due to efficiency gains from cost-cutting measures. As a percentage of product sales, cost of product sales decreased one percentage point to 21.7% for the year ended December 31, 2009 from 22.7% in the same period in 2008. Voyager. The Voyager segment’s cost of product sales for the year ended December 31, 2009 decreased $0.5 million, or 4.8%, to $10.7 million from $11.2 million in 2008. The decrease in cost of sales was mainly due to improved cost management performance. Sopris. The Sopris segment’s cost of product sales for the year ended December 31, 2009 increased $0.3 million, or 5.8%, to $6.4 million from $6.0 million in 2008. The increase in cost of sales was due to a change in product mix toward products with higher incremental costs. Cambium Learning Technologies. The Cambium Learning Technologies segment’s cost of product sales for the year ended December 31, 2009 decreased $0.5 million, or 16.2%, to $2.5 million from cost of sales of $3.0 million in 2008. The decrease in cost of sales was mainly due to improved cost management performance. Cost of service revenues include all costs to provide services and support to customers. Cost of service revenues for the year ended December 31, 2009 decreased $0.2 million, or 2.8%, to $7.3 million from $7.5 million in 2008. The decrease in cost of sales was mainly due to efficiency gains from cost-cutting measures. As a percentage of service revenues cost of service revenues decreased to 68.1% for the year ended December 31, 2009 from 70.9% in the same period in 2008. Voyager. The Voyager segment’s cost of service revenues for the year ended December 31, 2009 increased $0.3 million, or 4.7%, to $6.0 million from $5.7 million in 2008. The increase was driven by higher service revenues, partially offset by efficiency gains from cost-cutting measures. Sopris. The Sopris segment’s cost of service revenues for the year ended December 31, 2009 decreased $0.4 million, or 26.6%, to $1.1 million from cost of service revenues of $1.5 million in 2008. The decrease was driven by lower service revenues and efficiency gains from cost-cutting measures. Cambium Learning Technologies. The Cambium Learning Technologies segment’s cost of service revenues for the year ended December 31, 2009 remained relatively flat, decreasing $0.1 million, or 32.0%, to $0.2 million from $0.3 million in 2008. Amortization expense included in cost of sales includes amortization for acquired pre-publication costs and technology, acquired publishing rights, and developed pre-publication and technology. Amortization for 2009 increased $1.6 million, or 9.8%, to $17.5 million from $16.0 million in 2008. Approximately $0.7 million of the increase is related to the acquired pre-publication costs and technology acquired in the VLCY acquisition. The remainder of the increase was mainly due to higher pre-publication amortization as a result of investments made in new programs. Research and development expenditures include costs to research, evaluate and develop educational products, net of capitalization. Research and development expenses for year ended December 31, 2009 decreased $0.8 million, or 12.5%, to $5.6 million from $6.4 million in the same period of 2008, due to planned spending decreases as a result of weak economic conditions in 2009. As a percentage of sales, research and development expenses decreased to 5.6% of sales in 2009 compared to 6.4% in 2008. Sales and marketing expenditures include all costs to maintain our various sales channels, including the salaries and commission paid to our sales force, and costs related to our advertising and marketing efforts. Sales and marketing expenses for year ended December 31, 2009 decreased $1.2 million, or 5.0%, to $23.4 million from $24.6 million in the same period of 2008. As a percentage of sales, selling and marketing expenses decreased to 23.1% of sales in the 2009 compared to 24.7% in 2008. Selling costs decreased for the year ended December 31, 2009 in comparison to the same period in 2008 due to the costs incurred in 2008 to participate in several state adoption activities. We also experienced lower catalog and mailing costs due to a lower volume of catalogs mailed in 2009 compared to 2008. General and administrative expenses for year ended December 31, 2009 increased $14.4 million, or 88.9%, to $30.5 million from $16.2 million in the same period of 2008. The increase was primarily due to the incurrence of $15.5 million in merger-related transaction and integration expenses in 2009 with only immaterial amounts incurred in 2008. Excluding these costs, general and administrative expenses were down $1.1 million, or 6.9% in 2009 compared to 2008, primarily as a result of cost-cutting measures. Shipping costs for the year ended December 31, 2009 decreased $0.8 million, or 35.6%, to $1.5 million from $2.3 million in 2008. The decrease in these shipping costs was due mainly to cost containment and efficiencies. Depreciation and amortization expense for the year ended December 31, 2009 decreased $1.7 million, or 15.1%, to $9.7 million from $11.5 million in the same period of 2008. The decrease in this amortization was due mainly to lower contract and reseller network intangible amortization, partially offset by the depreciation and amortization related to assets acquired in the VLCY acquisition. Goodwill impairment We review the carrying value of goodwill for impairment at least annually and whenever certain triggering events occur. As a result of the signing of the merger agreement, we assessed the carrying values of our reporting units as of June 30, 2009. The first step of impairment testing showed the carrying value of our Published Products unit exceeded its fair value and that a step two analysis was needed. Step two impairment testing determined that the goodwill balance as of the measurement date was partially impaired and a $9.1 million impairment charge was recorded. Due to the weakening of the economy and the impact that economic conditions were having on our customers and business in the latter portion of fiscal 2008, we identified deterioration in the expected future financial performance of our published products segment. As a result, we recorded an impairment loss of $76.0 million for this segment in 2008, reflecting the difference between the fair value and recorded value for goodwill. Under the new segment structure, both the 2008 and the 2009 goodwill impairment charges were assigned to the Voyager segment. Embezzlement and related expenses In 2008, we discovered certain irregularities relating to the control and use of cash and certain other general ledger items which revealed a misappropriation of assets over a period of more than four years. These irregularities were perpetrated by a former Cambium Learning employee, resulting in substantial embezzlement losses and related expenses. Embezzlement and related expenses for the year ended December 31, 2009 were $0.1 million compared to $7.3 million in the same period of 2008. The decrease in the embezzlement and related expenses was mainly due to the non-recurring nature of the embezzlement loss and related expenses that were incurred in the year ended December 31, 2008. Net interest income (expense) in the year ended December 31, 2009, increased $1.0 million, or 5.7%, to $19.5 million from $18.4 million in the same period of 2008. This increase was mainly due to higher interest expense on both our senior secured and senior unsecured debt as a result of the permanent waiver and amendments to the credit agreement we signed on August 22, 2008. Under the terms and conditions of the permanent waiver and amendment, the interest rates on Cambium’s senior secured and senior unsecured debt were increased. See “— Liquidity and Capital Resources — Long Term Debt.” In 2009, we recorded an income tax benefit of $7.7 million. Pre-tax losses at statutory tax rates provided a federal tax benefit of approximately $15.2 million. The impairment charge to non-deductible goodwill did not result in a tax benefit which is $3.2 million less than the amount expected based on the federal statutory tax rate. Certain merger costs are non-deductible and did not result in a tax benefit which is $4.7 million less than the amount expected based on the federal statutory tax rate. Furthermore, after the merger with VLCY, we established a valuation allowance on our net Federal deferred tax assets. In 2008, we recorded an income tax benefit of $13.4 million. Pre-tax losses at statutory rates provided a federal tax benefit of approximately $29.0 million. The impairment charge to non-deductible goodwill did not result in a tax benefit which is approximately $26.6 million less than the amount expected based on the federal statutory rate. We also recorded non-taxable book income related to a purchase adjustment, which resulted in a tax benefit of $10.2 million. For fiscal 2008, we received a total settlement from previous stockholders of $30.2 million relating to the embezzlement we suffered. The total settlement consisted of $20 million in escrowed funds, together with additional payments of $9.3 million and interest income of $0.9 million. The total settlement amount of $30.2 million was used to cover costs and to pay down a portion of a senior secured credit facility. Because the embezzlement was discovered after the initial purchase allocation was made in connection with the acquisition, the entire settlement amount was recorded on our consolidated statement of operations as a gain from settlement with the previous stockholders. For fiscal 2008, we recorded a loss on the extinguishment of debt of $5.6 million related to the modification of our senior secured credit facility and senior unsecured promissory notes resulting from the execution of an amendment of those documents and the delivery by the lenders of a permanent waiver. The associated unamortized deferred financing costs as of August 22, 2008 of $4.6 million and amendment fees of $1.0 million related to the permanent waiver were recorded as a loss on extinguishment of debt. Year Ended December 31, 2008 (“fiscal 2008”) Compared to Period from January 29, 2007 through December 31, 2007 (“2007 successor period”) and Period from January 1, 2007 through April 11, 2007 (“2007 predecessor period”) Net sales for fiscal 2008 were $99.7 million, compared to $80.8 million for the 2007 successor period and $18.4 million for the 2007 predecessor period. Voyager. The Voyager segment’s net sales for fiscal 2008 were $48.3 million, compared to $43.1 million for the 2007 successor period and $6.4 million for the 2007 predecessor period. The overall decrease of $1.2 million, or 2.4%, was due to a $1.7 million decrease in service revenues partially offset by a $0.5 million increase in core product sales. The decline in service revenues was mainly due to lower sales for conferences and institutes as the impact of state budget shortfalls significantly affected attendance. The increase in core intervention programs sales was principally attributable to a couple of key states and school districts, including Florida and Milwaukee, funded and purchased Cambium’s core programs and services. Sopris. The Sopris segment’s net sales for fiscal 2008 were $29.7 million, compared to $23.6 million for the 2007 successor period and $5.9 million for the 2007 predecessor period. The overall increase of $0.2 million, or 0.8%, was due to a $0.9 million increase in product sales partially offset by a $0.7 million decrease in service revenues. The increase in supplementary program sales were due to higher DIBELs license fees, partially offset by a decrease in sales across most titles as the market for Sopris in general was weak due to state funding issues. The decline in service revenues was mainly due to the impact of state budget shortfalls. Cambium Learning Technologies. The Cambium Learning Technologies segment’s net sales for fiscal 2008 were $21.7 million compared to $14.2 million for the 2007 successor period and $6.1 million for the 2007 predecessor period. The overall increase of $1.4 million, or 6.9%, was mainly due to higher international sales. Cost of product sales was $20.2 million for fiscal 2008, compared to $19.7 million for the 2007 successor period and $3.9 million for the 2007 predecessor period. The overall decrease of $3.4 million, or 14.4%, was due to lower royalty costs as well as a $2.9 million adjustment for inventory step-up associated with purchase accounting included in the 2007 successor period, offset by a $0.3 million increase in employee severance costs associated with the December 2007 Petaluma, California office closure. The lower royalty costs were the result of a higher portion of total sales attributable to Cambium Learning Technologies and Read Well products, which carry a lower royalty rate than other Cambium products. Voyager. The Voyager segment’s cost of product sales for fiscal 2008 decreased $3.0 million, or 21.3%, to $11.2 million from cost of product sales of $13.1 million for the 2007 successor period and $1.1 million for the 2007 predecessor period. The decrease in cost of sales was mainly due to material cost improvements, lower inventory reserve provisions and a $1.8 million adjustment for inventory step-up associated with purchase accounting included in the 2007 successor period. Sopris. The Sopris segment’s cost of product sales for fiscal 2008 decreased $0.5 million, or 7.0%, to $6.0 million from cost of product sales of $4.8 million for the 2007 successor period and $1.7 million for the 2007 predecessor period. The decrease in cost of sales was mainly due to a $1.1 million adjustment for inventory step-up associated with purchase accounting included in the 2007 successor period, partially offset by increased costs commensurate with an increase in product sales from 2007 to 2008. Cambium Learning Technologies. The Cambium Learning Technologies segment’s cost of product sales for fiscal 2008 increased $0.1 million, or 2.7%, to $3.0 million from cost of product sales of $1.9 million for the 2007 successor period and $1.1 million for the 2007 predecessor period. The increase in cost of sales is mainly due to increased net sales. Cost of service revenues was $7.5 million for fiscal 2008, compared to $6.3 million for the 2007 successor period and $1.9 million for the 2007 predecessor period. The decrease resulted from lower service revenues. Voyager. The Voyager segment’s cost of service revenues for fiscal 2008 decreased $0.6 million, or 8.6%, to $5.7 million from cost of service revenues of $4.9 million for the 2007 successor period and $1.4 million for the 2007 predecessor period. The decrease resulted from lower net sales. Sopris. The Sopris segment’s cost of service revenues for fiscal 2008 decreased $0.3 million, or 16.2%, to $1.5 million from cost of service revenues of $1.3 million for the 2007 successor period and $0.5 million for the 2007 predecessor period. The decrease resulted from lower net sales. Cambium Learning Technologies. Cost of service revenues for fiscal 2008 increased $0.1 million, or 38.3%, to $0.3 million from cost of service revenues of $0.1 million for the 2007 successor period and $0.1 million for the 2007 predecessor period. Amortization expense was $16.0 million for fiscal 2008, compared to $11.7 million for the 2007 successor period and $3.4 million for the 2007 predecessor period. The overall increase of $0.9 million, or 5.7%, was mainly due to the revaluation of publishing rights and developed technology intangible assets as a result of the purchase of Cambium by VSS-Cambium Holdings, LLC. This revaluation resulted in higher amortization in the 2007 successor period and fiscal 2008. Our research and development expense was $6.4 million for fiscal 2008, $5.2 million for the 2007 successor period and $1.7 million for the 2007 predecessor period. The overall decrease from 2007 to 2008 of $0.6 million, or 8.1%, was mainly due to reductions in contracted development spending. Our sales and marketing expense was $24.6 million for fiscal 2008, $15.1 million for the 2007 successor period and $6.4 million for the 2007 predecessor period. The overall increase from 2007 to 2008 of $3.1 million, or 14.7%, was mainly due to higher selling costs in 2008 in anticipation of increased sales opportunities in adoption states. General and administrative expenses Our general and administrative expenses were $16.2 million for fiscal 2008, $11.1 million for the 2007 successor period and $13.7 million for the 2007 predecessor period. The overall decrease from 2007 to 2008 of $8.7 million, or 34.9%, was mainly due to $5.1 million of acquisition related costs and a $2.9 million charge related to the modification of our stock option plan included in the 2007 predecessor period. Shipping costs were $2.3 million in fiscal 2008, compared to $2.7 million in the 2007 successor period and $0.4 million in the 2007 predecessor period. The overall decrease of $0.8 million, or 26.3%, was due to increased shipping efficiencies. Depreciation and amortization expense was $11.5 million in fiscal 2008, compared to $9.3 million in the 2007 successor period and $0.7 million in the 2007 predecessor period. The overall increase of $1.4 million, or 13.7%, was due to the acquisition of Cambium by VSS-Cambium Holdings, LLC. As a result of the acquisition, other intangible assets were revalued, resulting in an increase in amortization in the 2007 successor period and fiscal 2008. We discovered in fiscal 2008 that a former employee of Cambium Learning had perpetrated a significant misappropriation of assets during a period beginning in 2004 and extending through April 2008. We identified $14.0 million of embezzlement losses, which included $1.8 million for fiscal 2008, $5.7 million for the 2007 successor period and $1.0 million for the 2007 predecessor period. In addition, we incurred fees and expenses of $5.5 million in investigating and responding to this embezzlement matter in fiscal 2008. This amount is net of the $1.6 million appraised value of five boats that were seized by the Company from the former employee, who had used embezzled funds to acquire those boats. A total of $192.3 million of goodwill was recorded in connection with the acquisition of Cambium Learning by VSS-Cambium Holdings, LLC. Due to the weakening of the economy and the impact that economic conditions were having on our customers and business in the latter portion of fiscal 2008, we identified significant deterioration in the expected future financial performance of our published products product line. As a result, we recorded an impairment loss of $76.0 million within our published products unit for 2008, reflecting the difference between the fair value and recorded value for goodwill. The fair value was determined based upon management’s forecasts, which are dependent on multiple assumptions and estimates, including estimates regarding anticipated future educational funding and the actual performance and future projections of the Company. Under the new segment structure, the 2008 goodwill impairment charge was assigned to the Voyager segment. Net interest income (expense) was $18.4 million for fiscal 2008, compared to $13.1 million for the 2007 successor period and $0.7 million for the 2007 predecessor period. The overall increase of $4.6 million, or 32.9%, was due principally to higher interest expense as a result of the acquisition of Cambium by VSS-Cambium Holdings, LLC on April 11, 2007 and the higher interest rate incurred in 2008 as a result of the embezzlement we suffered. We recorded a $7.8 million income tax benefit in the 2007 successor period and a $3.7 million benefit in the 2007 predecessor period. The 2007 predecessor period includes non-deductible transaction costs of $5.1 million. Because sales seasonality affects operating cash flow, we normally incur a net cash deficit from all of our activities through the early part of the third quarter of the year. We typically fund these seasonal deficits through the drawdown of cash, supplemented by borrowings on our revolving senior credit facility. The primary source of liquidity is cash flow from operations and the primary liquidity requirements relate to debt service, pre-publication costs, capital investments and working capital. We believe that based on current and anticipated levels of operating performances, cash flow from operations and availability under the senior secured revolving credit facility, we will be able to make required payments of principal and interest on our debt and fund our working capital and capital expenditure requirements for the next 12 months. Our long-term debt is held by our subsidiary, Cambium Learning, and as of December 31, 2009 consists of: • $97.2 million of floating rate senior secured notes due April 11, 2013; and • $54.6 million of 13.75% senior unsecured notes due April 11, 2014 Senior Secured Notes. The senior secured notes were issued pursuant to a senior secured credit facility consisting of a $30 million revolving loan and a $128 million term loan. The term loan requires quarterly principal payments of $320,000. Our senior notes are secured by all of Cambium Learning’s personal property. The interest rate on the senior notes is based on the one-, three- or six-month LIBOR or Alternative Base Rate (ABR) plus a spread tied to Cambium Learning’s credit ratings, subject to a floor on each of the two rates. Based on the credit ratings as of yearend 2009, the spread for LIBOR was 6.5%. The LIBOR rate cannot be less than 3.0%, and the ABR rate cannot be less than 4.0%. As of December 31, 2009, the interest rate on the senior secured notes was 9.5%. As of December 31, 2009, we had borrowings of $5.0 million under the revolver and, subject to borrowing base capacity limitations for outstanding letters of credit, had $23.5 million available to borrow under the revolver. In the first quarter of 2010, our credit ratings were upgraded by Standard & Poor’s and Moody’s Investor Services. As a result of the credit rating upgrades, the spread for LIBOR decreased from 6.5% to 5.0%, with a continued LIBOR floor of 3.0% and the effective interest rate became 8.0%. Senior Unsecured Notes. The senior unsecured notes require cash interest payments equal to 10% on a quarterly basis. Any additional interest beyond the 10% rate is added to the principal of the notes (paid in kind) and is not payable until April 11, 2014. The initial interest rate on the senior unsecured notes was 11.75% per annum. That rate was increased by 200 basis points in connection with the negotiation of the permanent waiver and credit agreement amendments in 2008. The rate was further increased by an additional 50 basis points as of March 31, 2009 by virtue of the Company’s total leverage ratio (as defined under the senior unsecured notes) exceeding 5.5 to 1 as of March 31, 2009; however, as a result of the merger with VLCY, the total leverage decreased below 5.5 to 1 and the rate was decreased by 50 basis points. Thus, as of December 31, 2009, the interest rate on the subordinated notes was 13.75% per annum. Assuming the all-in interest rate on the senior unsecured notes were to remain at 13.75% until April 11, 2014, the value of these notes, including accrued interest, will be $64.2 million. Covenants. The senior secured credit facility includes a total leverage ratio financial covenant. The ratio is calculated quarterly using an adjusted EBITDA calculation, which is defined as earnings before interest, taxes, depreciation, and amortization, and other adjustments allowed under the terms of the senior secured credit agreement, on a rolling 12-month basis. The facility also contains customary covenants, including limitations on Cambium Learning’s ability to incur debt, and events of default as defined by the agreement. The senior secured credit facility limits Cambium Learning’s ability to pay dividends, to make advances and to otherwise engage in inter-company transactions. Effective as of the quarter ended March 31, 2009, the senior secured credit facility requires the total leverage ratio to be no greater than 6.5:1. The senior unsecured notes include a financial covenant, which requires that beginning with the quarter ended March 31, 2009, we maintain as of the end of each fiscal quarter consolidated adjusted EBITDA of not less than $25.0 million (adjusted EBITDA is also on a rolling 12-month basis and is defined in substantially the same manner as under the senior secured credit facility). The senior unsecured notes also contain customary covenants, including limitations on our ability to incur debt. If Cambium Learning fails to comply with these financial covenants, the Company has the right to make a cash contribution to the capital of Cambium Learning, the aggregate amount not to be in excess of the minimum amount necessary to cure the relevant failure to comply with the financial covenant. This right to make a cash contribution is available for no more than one fiscal quarter in a fiscal year. Cambium Learning’s total leverage ratio was 7.33:1 for the four-quarter period ended June 30, 2009, which ratio was greater than the maximum permitted under the credit facility, and its adjusted EBITDA was $23.1 million for the four-quarter period ended June 30, 2009, or $1.9 million less than the minimum required $25.0 million. Accordingly, as of August 14, 2009, Cambium Learning was in non-compliance with these covenants. On August 14, 2009, Cambium notified both its senior secured lenders and its senior unsecured lenders that VSS-Cambium Holdings, LLC intended to cure the non-compliance. On August 17, 2009, $3.0 million of capital was contributed to Cambium Learning by its stockholder to fund the cure. On August 20, 2009, the $3.0 million was paid by Cambium Learning to the senior secured lenders and the principal amount outstanding on our senior secured credit agreement was reduced by a corresponding amount. For purposes of calculating covenant compliance, the amount of the capital contribution will be included in the adjusted EBITDA calculations through the quarter ending March 31, 2010. We are permitted one such cure right in each fiscal year. Therefore, under the existing credit agreements, we are in compliance with our financial covenants for the year ended December 31, 2009 and, based on our performance to date, we expect to be in compliance with our financial covenants for the quarter ending March 31, 2010. The required total leverage ratio changes each year and will be 5.5:1 for fiscal year 2010, 4.5:1 for fiscal year 2011, and 4.0:1 thereafter. We are still completing our debt compliance reporting, but based on the calculation of adjusted EBITDA per the credit agreement, as shown in “Non-GAAP Measures” below we expect to report a total leverage ratio for the year ended December 31, 2009 of approximately 3.0, which is in compliance with the debt covenant requirement that the total leverage ratio be no greater than 6.5:1. Further, we are in compliance with the requirement that adjusted EBITDA per the credit agreement be in excess of $25.0 million. Our ability to satisfy our debt service and maintain compliance with loan covenants in the future will depend in part on the operating performance of our Company, which will in turn be affected in part by prevailing economic conditions in the markets we serve and other factors, many of which are beyond our control. If a default in our covenants were to occur in the future, and we were unable to cure such default (if such default were curable under the credit agreement), our lenders may accelerate the indebtedness under the credit agreements and, upon any such acceleration, Cambium Learning would be required to repay or refinance all such indebtedness. Neither we nor Cambium Learning may have sufficient funds to repay the indebtedness and there may not be equity or debt financing opportunities available to us on acceptable terms, or at all. See “Non-GAAP Measures” below for a reconciliation among net loss, EBITDA and adjusted EBITDA for purposes of measuring operating performance and adjusted EBITDA under our credit agreements. The calculation of adjusted EBITDA used for purposes of the credit agreements supplements the adjustments to EBITDA we use for purposes of measuring operating performance with additional adjustments to EBITDA recognized by Cambium Learning’s lenders. Amendment to Notes. Cambium Learning entered into an amendment to each of its credit agreements on October 29, 2009. Since the senior secured credit agreement and the senior unsecured credit agreement are substantially similar agreements, each of the amendments is substantially similar to the other. The amendments were permitted under the terms of the merger agreement, and provide for the following important modifications to the credit agreements: • Change in Control Definition. Prior to the amendment, the original investors in Cambium Learning were required to own or control a majority of the outstanding economic or voting interests of Cambium Learning. This majority threshold is being reduced to 35%. • VSS Funds Ownership. VSS is not permitted to sell or otherwise transfer any of the Company’s common stock that it directly or indirectly owns, unless it continues to directly or indirectly own or control at least 35% of the outstanding Company common stock, and it has not sold or otherwise transferred, in the aggregate, more than 15% of its Company common stock. • Increase in Material Indebtedness. An event of default would occur if a “change in control” occurred under any of Cambium Learning’s other “material indebtedness.” The term “material indebtedness” includes the senior unsecured notes, as well as any other debt, the principal amount of which exceeds a specified threshold. The $5 million threshold is being increased under the amendment to $7.5 million. • Exceptions to Restricted Payments. Cambium Learning is prohibited from paying dividends, unless the specific type of payment is permitted. Additional types of payments are being permitted to allow the following: • Up to $3.0 million to fund public company, administrative, overhead, franchise tax and related costs incurred by the Company; and • Up to $750,000 in annual board of director compensation and expenses. • The annual monitoring fee previously payable to VSS is being eliminated. • Permitted Acquisition Basket Reset. The amount of consideration payable in an acquisition is limited under the credit agreements, and the limitations are being reset after giving effect to the acquisition of Voyager Expanded Learning by Cambium Learning in connection with the mergers. The limitation will be reset to a cumulative $150 million amount, but any single acquisition is limited to $20 million until the ratio of senior secured debt to EBITDA (as calculated under the credit agreements) does not exceed 2.50 to 1.0, and the ratio of total leverage to EBITDA (as calculated under the credit agreements) does not exceed 3.50 to 1.0, at which time the single acquisition limit will be increased to $100 million. • Definition of Consolidated EBITDA. The definition of Consolidated EBITDA, which is used for calculating leverage ratios under the senior secured credit agreement, and the minimum EBITDA covenant under the senior unsecured credit agreement are being modified to allow additional add-backs for the following items: • Deferred revenue associated with a permitted acquisition; • Up to $24.0 million in M&A costs related to the mergers; • Up to $2.0 million in costs incurred in closing of locations or lease terminations in connection with the mergers; • Up to $5.0 million in severance costs incurred in connection with the mergers; • Up to $3.0 million in integration costs incurred connection with the mergers; and • M&A costs for future transactions (whether or not completed) of up to $5.0 million for closed transactions and $0.5 million for failed transactions in any calendar year, and $2.0 million in the aggregate. In addition, the amendments ratify and approve the mergers and the related transactions. Each of the lenders who executed the amendment on or before October 28, 2009 received a fee equal to 20 basis points of the amount of its loans and commitments under the credit agreements, for an aggregate fee payable to all lenders equal to approximately $0.3 million. In 2009, cash provided from operating activities was $1.9 million. Cash from operations was partially offset by cash outflows of $11.6 million of transaction costs related to the merger transaction. Cash from operations is seasonal with more cash generated in the second half of the year than in the first half of the year. Cash is historically generated during the second half of the year because the buying cycle of school districts generally starts at the beginning of each new school year in the fall. Other significant inflows of cash during fiscal 2009 included: • $25.0 million of capital contributed by Cambium’s stockholders related to the VLCY acquisition; and • $3.0 million of capital contributed by Cambium’s stockholders to fund the cure to a senior secured credit agreement financial covenant regarding Cambium Learning’s total leverage ratio for the second quarter of 2009. Other significant uses of cash during fiscal 2009 included: • $9.7 million of cash paid for the VLCY acquisition, net of cash acquired; • $5.9 million for principal payments on debt and capital leases; and • $3.4 million of expenditures related to property, plant, equipment, pre-publication costs, and software. Non-GAAP Measures Our historical financial statements include VLCY results only for the 23-day period subsequent to the December 8, 2009 acquisition date. Further, the net losses for both the Company and VLCY as reported on a GAAP basis include material non-recurring and non-operational items. We believe that earnings (loss) from operations before interest and other income (expense), income taxes, and depreciation and amortization, or EBITDA, and Adjusted EBITDA, which further excludes non-recurring and non-operational items, provide useful information for investors to assess the results of the ongoing business of the combined company. EBITDA and Adjusted EBITDA are not prepared in accordance with GAAP and may be different from similarly named, non-GAAP financial measures used by other companies. Non-GAAP financial measures should not be considered a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. We believe that Adjusted EBITDA provides useful information to investors because it reflects the underlying performance of the ongoing operations of the combined company and provides investors with a view of the combined company’s operations from management’s perspective. Adjusted EBITDA excludes items that do not reflect the underlying performance of the combined company by removing significant one-time or certain non-cash items from earnings. We use Adjusted EBITDA to monitor and evaluate the operating performance of the combined company and as the basis to set and measure progress towards performance targets, which directly affect compensation for employees and executives. We generally use these non-GAAP measures as measures of operating performance and not as measures of liquidity. Below is a reconciliation between net loss and Adjusted EBITDA for the years ended December 31, 2009 and 2008. Reconciliation Between Net Loss and Adjusted EBITDA for the Year Ended December 31, 2009 VLCY Non-recurring or non-operating costs excluded from Adjusted EBITDA: Pre-Merger Total Legacy Stock-based Embezzlement Adj Related Total Results Combined Transaction Integration VLCY Compensation and to Purchase Goodwill Adjusted GAAP (342 days) Results Costs Costs Corporate Expense Related Accounting Impairment EBITDA (a) (b) (c) (d) (e) (f) (g) $ 52,923 $ 77,758 $ 130,681 $ — $ — $ — $ — $ — $ 509 $ — $ 131,190 25,185 — 25,185 — — — — — — — 25,185 22,940 20,970 43,910 — — — — — 883 — 44,793 101,048 98,728 199,776 — — — — — 1,392 — 201,168 26,848 30,839 57,687 — (71 ) — — — 148 — 57,764 Cost of sales — amortization 17,527 16,220 33,747 — — — — — — — 33,747 5,611 4,331 9,942 — — — — — — — 9,942 Sales and marketing expenses 23,368 28,753 52,121 — (155 ) — — — 108 — 52,074 30,519 24,740 55,259 (23,507 ) (2,027 ) (2,304 ) (216 ) — — — 27,205 9,723 2,081 11,804 — — — — — — — 11,804 Embezzlement and related 129 — 129 — — — — (129 ) — — — 9,105 27,175 36,280 — — — — — — (36,280 ) — Income (loss) from operations (23,294 ) (37,286 ) (60,580 ) 23,507 2,253 2,304 216 129 1,136 36,280 5,245 10 70 80 — — — — — — — 80 (19,487 ) (628 ) (20,115 ) — — — — — — — (20,115 ) (698 ) 3,279 2,581 — — — — — — — 2,581 7,704 190 7,894 — — — — — — — 7,894 (35,765 ) (34,375 ) (70,140 ) 23,507 2,253 2,304 216 129 1,136 36,280 (4,315 ) Normal EBITDA Adjustments: (10 ) (70 ) (80 ) — — — — — — — (80 ) 19,487 628 20,115 — — — — — — — 20,115 698 (3,279 ) (2,581 ) — — — — — — — (2,581 ) (7,704 ) (190 ) (7,894 ) — — — — — — — (7,894 ) $ 3,956 $ (18,985 ) $ (15,029 ) $ 23,507 $ 2,253 $ 2,304 $ 216 $ 129 $ 1,136 $ 36,280 $ 50,796 GAAP Pre-Merger Total Legacy Stock-based Embezzlement Lease Results Results Combined Transaction Integration VLCY Compensation and Goodwill Termination Adjusted Cambium (FY 2008) Results Costs Costs Corporate Expense Related Impairment Costs EBITDA (a) (b) (c) (d) (e) (g) (h) $ 48,348 $ 80,743 $ 129,091 $ — $ — $ — $ — $ — $ — $ — $ 129,091 99,731 98,531 198,262 — — — — — — — 198,262 16,156 30,660 46,816 (26 ) (287 ) (18,069 ) (878 ) — — — 27,556 11,453 2,861 14,314 — — — — — — — 14,314 7,254 — 7,254 — — — — (7,254 ) — — — 75,966 43,141 119,107 — — — — — (119,107 ) — — Lease termination costs — 11,673 11,673 — — — — — — (11,673 ) — (88,137 ) (83,276 ) (171,413 ) 26 287 18,069 878 7,254 119,107 11,673 (14,119 ) 86 1,485 1,571 — — — — — — — 1,571 23,589 (363 ) 23,226 — — — — — — — 23,226 Net loss (income) (69,560 ) (81,504 ) (151,064 ) 26 287 18,069 878 7,254 119,107 11,673 6,230 (86 ) (1,485 ) (1,571 ) — — — — — — — (1,571 ) (23,589 ) 363 (23,226 ) — — — — — — — (23,226 ) (13,422 ) (1,160 ) (14,582 ) — — — — — — — (14,582 ) $ (60,718 ) $ (61,918 ) $ (122,636 ) $ 26 $ 287 $ 18,069 $ 878 $ 7,254 $ 119,107 $ 11,673 $ 34,658 (a) Adjustment is to eliminate external incremental costs incurred by the Company and VLCY that are directly related to the merger transaction. (b) Adjustment is to eliminate costs directly associated with the integration of the Company and VLCY, including severance and other costs incurred to achieve synergies and the cost of retention and change in control agreements directly related to the merger. Integration costs also include approximately $0.3 million in 2008 related to the closure of our IntelliTools office in Petaluma, California, representing rent and other operating costs for the Petaluma office from the time we leased a smaller facility in January 2008 until its closure. (c) Represents corporate overhead costs for VLCY that are primarily related to the restatement of VLCY’s financial statements and the related activities for VLCY to become current with its SEC filings, costs to transition VLCY’s corporate office from Ann Arbor, Michigan to Dallas, Texas, and internal costs required to complete the strategic alternatives process that culminated in the proposed merger transaction. Going forward, we expect to incur ongoing corporate overhead and public company costs of approximately $4 million annually. For the year ended December 31, 2008, the adjustment represents the total costs of these activities less the $4 million estimate which we consider to be ongoing. Because VLCY’s restatement process and the relocation of VLCY’s corporate headquarters were substantially completed by the end of fiscal 2008, non-recurring corporate costs for the pre-merger period of 2009 are primarily related to internal costs of VLCY’s strategic alternative process. (d) For the period from January 1, 2007 through April 11, 2007, we held in escrow $0.6 million in connection with stock-based awards. As a result of the settlement with the former stockholders in 2008, the rights to the $0.6 million held in escrow were foregone. This amount was recorded as income in interest and other expenses in our historical statement of operations for 2008 and, accordingly, is excluded from EBITDA. Voyager’s historical statements of operations include stock-based compensation expense of $0.9 million for 2008 and $0.2 million for the pre-merger period of 2009. As of the merger date, 2.3 million stock options were granted to executives resulting in stock-based compensation expense of approximately $37,000 included in the Company’s Consolidated Statements of Operations for the year ended December 31, 2009. (e) During 2008, the Company discovered certain irregularities relating to the control and use of cash and certain other general ledger items which revealed a substantial misappropriation of assets over a period of more than four years. These irregularities were perpetrated by a former employee, resulting in embezzlement losses, net of recoveries. For further information, see Note 3 to our Consolidated Financial Statements included herein. (f) Under applicable accounting guidance for business combinations, an acquiring entity is required to recognize all of the assets acquired and liabilities assumed in a transaction at the acquisition date fair value. In our Consolidated Financial Statements for 2009, net sales have been reduced by $1.4 million due to the write-down of deferred revenue to its estimated fair value as of the merger date. The write-down was determined by estimating the cost to fulfill the related future customer obligations plus a normal profit margin. Partially offsetting this impact, cost of sales and marketing expenses were reduced by $0.3 million for other purchase accounting adjustments, primarily a write-down of deferred costs to zero at the acquisition date. The adjustment of deferred revenue and deferred costs to fair value is required only at the purchase accounting date; therefore, its impact on net sales, cost of sales, and sales and marketing expense is non-recurring. (g) For additional information on goodwill impairment charges, see Note 8 to our Consolidated Financial Statements included herein. (h) Lease termination charges are for the discontinuance of office space and other leases resulting from the transition of VLCY’s corporate headquarters from Ann Arbor, Michigan to Dallas, Texas. Our senior secured credit agreement and our senior unsecured credit agreement contain a financial covenant regarding a total leverage ratio based on adjusted EBITDA and the senior unsecured credit agreement also contains a financing covenant regarding minimum adjusted EBITDA (calculated as set forth in the credit agreements) as of the end of each fiscal quarter. In addition to the adjustments shown in Adjusted EBITDA in the table above, our credit agreements allow additional adjustments that permit the add-back of specified non-operational expenses that, in the view of the lenders, are reasonable adjustments to EBITDA. These are shown in the table below. We have not presented these additional adjustments as part of the Unaudited EBITDA and Adjusted EBITDA data above because they are adjustments that management would not commonly make in internal use of Adjusted EBITDA for establishing and measuring operational performance targets. These additional adjustments are set forth in the table below to provide a reconciliation of the adjusted EBITDA allowed by our credit agreements to our Adjusted EBITDA as presented above and represent the adjusted EBITDA per the credit agreement for 2009 that we expect to report to our lenders at the end of the first quarter. 2009 Adjusted EBITDA per (In thousands) Credit Agreement Adjusted EBITDA per table above Additional adjustments allowed to EBITDA per the Company’s credit agreement: Equity cure Certain operating taxes Management fees Employee severance (non-integration) Certain legal costs Amendment fees in excess of amount allowed (171 ) Adjusted EBITDA per the credit agreement We are still completing our debt compliance reporting, but based on the above adjusted EBITDA per the credit agreement, we expect to report a total leverage ratio for the year ended December 31, 2009 of approximately 3.0, which is in compliance with the debt covenant requirement that the total leverage ratio be no greater than 6.5:1. Further, we are in compliance with the requirement that adjusted EBITDA per the credit agreement be in excess of $25.0 million. Capital Expenditures and Outlook January 29, 2007 Period from Year Ended Year Ended (Inception) January 1, 2007 December 31, December 31, through December 31, through April 11, (Dollars in millions) 2009 2008 2007 2007 Pre-publication costs $ 2.4 $ 2.2 $ 2.7 $ 0.4 Fixed capital Total expenditures for property, equipment, and pre-publication costs Capital spending in 2010 will increase relative to 2009 due to the VLCY acquisition. VLCY historically spent more on capital items and in house development as compared to Cambium. The 2010 expenditures are expected to range between $10.0 million and $13.0 million. Capital expenditures for 2010 will be concentrated primarily on ongoing and new product development, which management believes will generate future sales growth. Additionally, 2010 will include capitalized items related to expenditures which will facilitate the integration of VLCY and the Company. We believe that current cash, cash equivalents and short term investment balances, expected income tax refunds, and cash generated from operations will be adequate to fund the working capital and capital expenditures necessary to support our currently expected sales for the foreseeable future. Commitments and Contractual Obligations We have various contractual obligations which are recorded as liabilities in our Consolidated Financial Statements. Other items, such as certain purchase commitments and other executory contracts, are not recognized as liabilities in our Consolidated Financial Statements but are required to be disclosed. The following table summarizes our significant operational and contractual obligations and commercial commitments at December 31, 2009 showing the future periods in which such obligations are expected to be settled in cash: (in millions) Total 2010 2011 & 2012 2013 & 2014 After 2014 Senior secured revolving credit as of December 31, 2009 $ 5.0 $ 5.0 $ — $ — $ — Senior secured notes as of December 31, 2009 126.4 10.3 20.3 95.8 — Senior unsecured notes as of December 31, 2009 64.2 — — 64.2 — Build-to-suit lease obligations as of December 31, 2009 Other capital lease obligations as of December 31, 2009 0.2 0.1 0.1 — — Operating lease obligations as of December 31, 2009 Contingent value rights as of December 31, 2009 As of December 31, 2009, we also have $11.7 million in obligations with respect to our pension plan. For further information, see Note 15 to our Consolidated Financial Statements included herein. We have letters of credit outstanding as of December 31, 2009 in the amount of $2.3 million to support workers’ compensation insurance coverage, certain of our credit card programs, the build-to-suit lease, and performance bonds for certain contracts. We maintain a $1.1 million certificate of deposit as collateral for the workers’ compensation insurance and credit card program letters of credit and for our Automated Clearinghouse (ACH) programs. The certificate of deposit is recorded in other assets. As of December 31, 2009, we had approximately $1.3 million of long-term income tax liabilities that have a high degree of uncertainty regarding the timing of the future cash outflows. We are unable to reasonably estimate the years when settlement will occur with the respective tax authorities. We incurred $3.0 million to an affiliate of VSS at the closing of the mergers in consideration of providing advisory services with respect to the transaction. One million dollars of this fee was paid in cash at closing, and the balance becomes payable if and when Cambium Learning’s ratio of total outstanding debt to adjusted EBITDA drops below 3.0:1. Three-quarters of this remaining balance will be allocated pro rata among VSS and certain of the members of VSS-Cambium Holdings III, LLC. For purposes of determining when this fee is to be paid, adjusted EBITDA is calculated in the same manner as that measure is calculated under Cambium Learning’s senior unsecured credit agreement. The Company has no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on the Company’s financial condition, changes in financial conditions, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. Our Consolidated Financial Statements are prepared in accordance with accounting principles generally accepted in the U.S., which require management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenue, expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates including those related to accounting for revenue recognition, impairment, capitalization and depreciation, allowances for doubtful accounts and sales returns, inventory reserves, income taxes, and other contingencies. We base our estimates on historical experience and other assumptions we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that may not be readily available from other sources. Actual results may differ from these estimates, which could have a material impact on our financial statements. Certain accounting policies require higher degrees of judgment than others in their application. We consider the following to be critical accounting policies due to the judgment involved in each. For a detail discussion of our significant accounting policies see Note 2 to our Consolidated Financial Statements included herein. Revenue Recognition. Revenues are derived from sales of reading, math and science, and professional development solutions to school districts primarily in the United States Sales include printed materials and often online access to educational materials for individual students, teachers, and classrooms. Revenue from the sale of printed materials for reading and math products is recognized when the product is shipped to or received by the customer. Revenue for product support, training and implementation services, and online subscriptions is recognized over the period services are delivered. Revenue for our professional development courses, which include an Internet delivery component, is recognized over the contractual delivery period, typically nine to twelve months. ExploreLearning and Learning A-Z derive revenue exclusively from sales of online subscriptions to their reading, math and science teaching websites. Typically, the subscriptions are for a twelve month period and the revenue is recognized ratably over the period the online access is available to the customer. The division of revenue between shipped materials, online materials, and ongoing support and services is determined in accordance with applicable accounting guidance for revenue arrangements with multiple deliverables. Revenue for the online content sold separately or included with certain curriculum materials is recognized ratably over the subscription period, typically a school year. Revenues related to maintenance and support are recognized on a straight-line basis over the period that maintenance and support are provided. In certain instances, telephone support and software repairs are provided for free within the first year of licensing the software. The cost of providing this service is insignificant, and is accrued at the time of revenue recognition. Maintenance and support services include telephone support, bug fixes, and for certain products, rights to upgrades and enhancements on a when-and-if available basis. Revenues under multiple-element software license arrangements, which may include several different software products and services sold together, including training and maintenance and support, is allocated to each element based on the residual method in accordance with accounting guidance for software revenue recognition. We enter into agreements to license certain book publishing rights and content. We recognize the revenue from these agreements when the license amount is fixed and determinable, collection is reasonably assured, and the license period has commenced. For those license agreements that require us to deliver additional materials as part of the license agreement, the revenue is recognized when the product is received by the customer. Shipments to school book depositories are on consignment and revenue is recognized based on shipments from the depositories to the schools. Impairment of Goodwill. We review the carrying value of goodwill for impairment at least annually. The annual analysis is performed as of December 1 or when certain triggering events occur. The applicable accounting guidance requires that a two-step impairment test be performed on goodwill. In the first step, the fair value of each reporting unit is compared to its carrying value. If the fair value of a reporting unit exceeds the carrying value of that unit, goodwill is not impaired and no further testing is required. If the carrying value of the reporting unit exceeds the fair value of that unit, then a second step must be performed to determine the implied fair value of the reporting entity’s goodwill. If the carrying value of a reporting unit’s goodwill exceeds its implied fair value, then an impairment loss equal to the difference is recorded. Determining the fair value of a reporting unit is judgmental in nature, and involves the use of significant estimates and assumptions. These estimates and assumptions may include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions, and determination of appropriate market comparables. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to determine the carrying values of our reporting units. 2009 Quarterly Impairment Reviews. In June 2009 we determined that the signing of the merger agreement was a triggering event requiring us to review goodwill for impairment. At the time of this review, we had two reporting units: Published Products and Learning Technologies. In the first step of the impairment test for the second quarter of 2009, the fair market value of each reporting unit was determined using an income approach and was dependent on multiple assumptions and estimates, including future cash flow projections with a terminal value multiple and the discount rate used to determine the expected present value of the estimated future cash flows. Future cash flow projections were based on management’s best estimates of economic and market conditions over the projected period including industry fundamentals such as the state of educational funding, revenue growth rates, future costs and operating margins, working capital needs, capital and other expenditures, and tax rates. The discount rate applied to the future cash flows was a weighted-average cost of capital and took into consideration market and industry conditions, returns for comparable companies, the rate of return an outside investor would expect to earn, and other relevant factors. The first step of impairment testing as of June 30, 2009 showed that the carrying value of our Published Products unit exceeded its fair value and that the second step of testing was required for this unit. The second step of the goodwill impairment analysis requires the allocation of the fair value of the reporting unit to all of the assets and liabilities of that reporting unit as if the reporting unit had been acquired in a business combination. The fair values included in the second step of the second quarter 2009 goodwill impairment analysis were dependent on multiple assumptions and estimates, including the projected cash flows and discount rate used for the first step of the analysis, as well as the percentage of future revenues and cash flows attributable to the intangible assets, asset lives used to generate future cash flows, royalty relief savings attributable to our trademarks, normal profit margins applicable to deferred revenues, and other assumptions used in determining the fair value of assets and liabilities in a hypothetical purchase accounting allocation. As a result of the second step of the second quarter 2009 impairment test, the goodwill balance for the reporting unit as of the measurement date was determined to be partially impaired, and an impairment charge of $9.1 million was recorded as of June 30, 2009. We also reviewed goodwill for impairment as of September 30, 2009. For that review, the first step in the impairment test showed that the fair value of each reporting unit exceeded its carrying value and goodwill was therefore not impaired. Year End Impairment Review. We currently have three reporting units for purposes of the annual goodwill impairment review: Voyager, Sopris and Cambium Learning Technologies. In the first step of the impairment test for fiscal year 2009, the fair market value of each reporting unit was determined using an income approach and was dependent on multiple assumptions and estimates, including future cash flow projections with a terminal value multiple and the discount rate used to determine the expected present value of the estimated future cash flows. Future cash flow projections were based on management’s best estimates of economic and market conditions over the projected period including industry fundamentals such as the state of educational funding, revenue growth rates, future costs and operating margins, working capital needs, capital and other expenditures, and tax rates. The discount rate applied to the future cash flows was a weighted-average cost of capital and took into consideration market and industry conditions, returns for comparable companies, the rate of return an outside investor would expect to earn, and other relevant factors. The first step of impairment testing for fiscal 2009 showed that the fair value of each reporting unit exceeded its carrying value; therefore, no second step of testing was required. The adverse developments in the education funding environment that affected our operations during fiscal year 2008 and 2009 may continue to have an impact, and potentially increase the impact, on our future sales, profits, cash flows and carrying value of assets. Although management has included its best estimates of the impact of these and other factors in our cash flow projections, the projection of future cash flows is inherently uncertain and requires a significant amount of judgment. Actual results that are significantly different than these cash flow projections or a change in the discount rate could significantly affect the fair value estimates used to value our reporting units in step one of the goodwill analysis or the fair values of our other asset and liability balances used in step two of the goodwill analysis, and could result in future goodwill impairments. Impairment of Long Lived Assets. We review the carrying value of long lived assets for impairment whenever events or changes in circumstances indicate net book value may not be recoverable from the estimated undiscounted future cash flows. If our review indicates any assets are impaired, the impairment of those assets is measured as the amount by which the carrying amount exceeds the fair value as estimated by discounted cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost of disposal. For fiscal year 2009, no impairment was indicated. The determination whether our definite-lived intangible assets are impaired involves significant assumptions and estimates, including projections of future cash flows, the percentage of future revenues and cash flows attributable to the intangible assets, asset lives used to generate future cash flows, and royalty charges attributable to trademarks. The impairment calculations are most sensitive to the future cash flow assumptions. Future cash flow projections are based on management’s best estimates of economic and market conditions over the projected period including industry fundamentals such as the state of educational funding, revenue growth rates, future costs and operating margins, working capital needs, and capital and other expenditures. Adverse developments in the education funding environment, including the reductions in Reading First funding that occurred in 2008 and reductions in available state and local funds as property taxes decline have affected our operations during 2009 and may continue to have an impact, and potentially increase the impact, on our future sales, profits, cash flows and carrying value of assets. However, we have seen recent improvements in the funding environment and management expects that the impact of these adverse developments will stabilize in 2010. Pre-Publication Costs. We capitalize certain pre-publication costs of our curriculum, including art, prepress, editorial, and other costs incurred in the creation of the master copy of our curriculum products. Pre-publication costs are amortized over the expected life of the education program, generally on an accelerated basis over a period of five years. The amortization methods and periods chosen reflect the expected sales generated by the education programs. We periodically review the recoverability of the capitalized costs based on expected net realizable value. Royalty Advances. Royalty advances to authors are capitalized and represent amounts paid in advance of the sale of an author’s product. These costs are then amortized as the related publication is sold. We evaluate advances periodically to determine if they are expected to be recovered and reserve any portion of a royalty advance that is not expected to be recovered. Accounts Receivable. Accounts receivable are stated net of allowances for doubtful accounts and estimated sales returns. The allowance for doubtful accounts is based on a review of the outstanding balances and historical collection experience. The reserve for sales returns is based on historical rates of returns as well as other factors that in our judgment could reasonably be expected to cause sales returns to differ from historical experience. Actual returns could differ from our estimates. Inventory. Inventory is stated at the lower of cost, determined using the first-in, first-out (FIFO) method, or market, and consists of finished goods. We reduce slow-moving or obsolete inventory to net realizable value. Inventory values are maintained at an amount that management considers appropriate based on factors such as the inventory aging, historical usage of the product, future sales forecasts, and product development plans. These factors involve management’s judgment and changes in estimates could result in increases or decreases to the inventory values. Inventory values are reviewed on a periodic basis. Derivative Instruments. We use an interest rate derivative instrument to hedge our exposure to interest rate volatility resulting from the senior secured credit agreement. We are required to report all derivative instruments on our balance sheet at fair value. Applicable FASB accounting guidance sets forth the criteria for designation and effectiveness of hedging relationships, and provides generally that all designations must be made at the inception of each instrument. As we did not make such initial designations at inception, we are required to recognize changes in the fair value of the derivative instrument in the current period as other income or expense. We determine the fair value of the interest rate swap from a third-party quote. This value represents the estimated amount that we would receive or pay to terminate the swap agreement taking into consideration current interest rates. Income Taxes. Provision is made for the expense, or benefit, associated with taxes based on income. The provision for income taxes is based on laws currently enacted in every jurisdiction in which we do business and considers laws mitigating the taxation of the same income by more than one jurisdiction. Significant judgment is required in determining income tax expense, current tax receivables and payables, deferred tax assets and liabilities, and valuation allowance recorded against the net deferred tax assets. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income in prior carryback years, loss carryforward limitations, and tax planning strategies in assessing whether deferred tax assets will be realized in future periods. If, after consideration of these factors, management believes it is more likely than not that a portion of the deferred tax assets will not be realized, a valuation allowance is established. The amount of the deferred tax asset considered realizable could be reduced if estimates of future taxable income during the carryforward period are reduced. We recognize liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if available evidence indicates that it is more likely than not that the position will be sustained on audit. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. It is inherently difficult and subjective to estimate these amounts, since this requires management to determine the probability of various possible outcomes. We reevaluate our uncertain tax positions on a periodic basis, based on factors such as changes in facts and circumstances, changes in tax law, effectively settled issues under audit and new audit activity. Contingent Value Rights (CVRs). CVRs were issued to VLCY stockholders as part of the merger. Each CVR represents the right to receive a cash amount equal to the sum of the following amounts (minus specified agreed-upon liabilities, including agreed contingencies, potential working capital adjustments and expenses of the stockholders’ representative) under the merger agreement: • specified VLCY tax refunds received after the effective time of the merger, plus • the lesser of $4.0 million or the amount of specified post-signing tax refunds of VLCY received after the date of the merger agreement and on or prior to the date of the closing, which was $1.6 million, plus • any portion of the 280G Escrow Account (as defined in the merger agreement) which is not paid to its beneficiary, plus • other amounts specified in the escrow agreement, divided by the total number of shares of VLCY common stock outstanding as of the effective time of the mergers. The ultimate value of the CVRs is not known at this time; however it is not expected to be more than $11 million and could be as low as zero. As of the merger date, a fair value of $9.6 million has been recorded as a liability for the CVR payments. The determination of fair value of the CVRs involves significant assumptions and estimates regarding the likelihood, amount and timing of cash flows related to the elements of the CVRs. Future changes in the estimate of the fair value of the CVRs will impact results of operations and could be material. As of December 31, 2009, restricted assets in an escrow account for the benefit of the CVR were $7.9 million. Other Contingencies. Other contingencies are recorded when it is probable that a liability exists and the value can be reasonably estimated. We have a potential indemnification liability related to state income taxes that have been assessed against a former subsidiary of VLCY sold in 2007. Management believes that it is likely that our position will be upheld and we do not have a liability accrued. This contingency was identified as an agreed contingency for the CVR and, as such, any amount paid would potentially offset payments due under the CVR in accordance with the merger agreement terms. As of yearend 2009, the fair value of the CVR includes a reduction of $0.9 million related to this state income tax issue, calculated using management assumptions related to the likelihood, amount and timing of any cash outflows for this agreed-upon contingency. If the former subsidiary’s tax position is not upheld, we could incur significant indemnification expense in future periods to our Statements of Operations and amounts payable to prior VLCY stockholders for the CVR could be materially reduced from our estimate as of December 31, 2009. The former subsidiary has appealed the assessment and is awaiting an administrative decision by the state taxing authority. If the administrative decision by the state taxing authority is unfavorable, the former subsidiary plans to appeal the decision. We expect the final resolution of any tax litigation or potential settlement could range from zero to approximately $17.5 million (including interest). To the extent funds are available in the CVR escrow account, our cash exposure could be reduced by up to fifty percent. Recently Issued Financial Accounting Standards Information regarding recently issued accounting standards is included in Note 2 to the Consolidated Financial Statements, which is included in Item 8 of this Annual Report on Form 10-K. Item 7A. Quantitative and Qualitative Disclosures About Market Risk. We have outstanding at year end $102.2 million of indebtedness under Cambium Learning’s senior secured credit facility (including $5.0 million in revolving credit outstanding but not including $2.3 million in outstanding letters of credit) and have outstanding at year end $54.6 million of the senior unsecured notes due on April 11, 2014, which were issued on April 12, 2007. Cambium Learning will have $63.2 million of its debt under Cambium Learning’s senior secured credit facility bearing interest at variable rates. Assuming that Cambium Learning does not have in effect any interest rate swaps or cap agreements applicable to its variable rate facilities, an increase in the variable component used in determining the interest rates on Cambium Learning’s variable rate facilities would result in the interest rates under these facilities being limited by the maximum interest rate applicable to the facilities. Giving effect to the foregoing assumptions and assumed applicable tax rate of 38.5%, we expect that our annual earnings would decrease by approximately $0.4 million for each one percentage point increase in the rates applicable to Cambium Learning’s variable debt, and by $3.9 million for a ten percent increase in the variable component used in determining the interest rates applicable to Cambium Learning’s variable debt. At present, Cambium Learning has in place an interest rate swap agreement that hedges against the risk on $39 million of its credit agreement debt, that the three-month LIBOR will exceed 5.417% per annum. Cambium Learning makes payments to the counterparty under the swap agreement to the extent that the three-month LIBOR is below 5.417% and is entitled to receive payments from the counterparty to the extent that the three-month LIBOR exceeds 5.417%. The three-month LIBOR was 0.26% at December 31, 2009. Giving effect to the foregoing assumptions and assumed applicable tax rate of 38.5%, Cambium Learning expects that its annual earnings would decrease by approximately $0.2 million for each one percentage point decrease in the three-month LIBOR rate below the 5.417% fixed maximum rate and expects that its annual earnings would increase by approximately $0.2 million for each one percentage point increase in the three-month LIBOR rate above the 5.417% fixed maximum rate. Foreign Currency Risk We do not have material exposure to changes in foreign currency rates. As of December 31, 2009, we do not have any outstanding foreign currency forwards or option contracts. Item 8. Financial Statements and Supplementary Data. To the Board of Directors and Stockholders of We have audited the accompanying consolidated balance sheet of Cambium Learning Group, Inc. and subsidiaries (the “Company”), as of December 31, 2009, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for the year then ended. In connection with our audit of the consolidated financial statements, we have also audited financial statement schedule II. The Company’s management is responsible for these financial statements and financial statement schedule. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements and financial statement schedule referred to above present fairly, in all material respects, the financial position of the Company, as of December 31, 2009, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. /s/ Whitley Penn LLP To the Board of Managers and Members of VSS-Cambium Holdings, LLC: We have audited the accompanying consolidated balance sheet of VSS-Cambium Holdings, LLC (a Delaware limited liability company) and subsidiaries (the “Company”) as of December 31, 2008, and the related consolidated statements of operations, members’ equity, and cash flows for the year then ended. Our audit of the basic financial statements included the financial statement schedule, Schedule II: Valuation and Qualifying Accounts for the year ended December 31, 2008 appearing under Item 15(a) 2. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of VSS-Cambium Holdings, LLC and subsidiaries as of December 31, 2008, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule for the year ended December 30, 2008, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein. /s/ Grant Thornton LLP October 8, 2009 except for Note 21, as to which the date is October 29, 2009 and except for Note 1 (Segments), as to which the date is March 26, 2010 The Board of Managers and Members of VSS-Cambium Holdings, LLC We have audited the accompanying consolidated statements of operations, stockholders’/members’ equity, and cash flows of VSS-Cambium Holdings, LLC for the period from January 29, 2007 (inception) through December 31, 2007 (Successor basis), and the period from January 1, 2007 to April 11, 2007 (Predecessor basis). In connection with our audits of the consolidated financial statements, we have also audited financial statement schedule II for the period from January 29, 2007 (inception) through December 31, 2007 (Successor basis), and the period from January 1, 2007 to April 11, 2007 (Predecessor basis). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated results of VSS-Cambium Holdings, LLC’s operations and its cash flows for the period from January 29, 2007 (inception) through December 31, 2007 (Successor basis), and the period from January 1, 2007 to April 11, 2007 (Predecessor basis), in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. /s/ Ernst & Young LLP Except for Notes 5 and 21, relating to 2006 and 2007, as to which the date is October 8, 2009 Cambium Learning Group, Inc. and Subsidiaries (Successor) Cambium Learning, Inc. (Predecessor) Successor Period Predecessor From January 29, Period From For the Year For the Year 2007 through January 1, 2007 Ended December 31, Ended December 31, December 31, through April 11, (In thousands, except per share data) 2009 2008 2007 2007 101,048 99,731 80,847 18,414 9,723 11,453 9,338 732 — — 890 — 9,105 75,966 — — 129 7,254 5,732 1,000 Total costs and expenses 124,342 187,868 87,927 33,179 (23,294 ) (88,137 ) (7,080 ) (14,765 ) Net interest income (expense): (19,487 ) (18,520 ) (13,276 ) (766 ) — 30,202 — — — (5,632 ) — — (698 ) (981 ) (1,557 ) 1 Loss before income taxes (43,469 ) (82,982 ) (21,769 ) (15,506 ) 7,704 13,422 7,838 3,694 $ (35,765 ) $ (69,560 ) $ (13,931 ) $ (11,812 ) Net loss per common share: Basic net loss per common share $ (1.63 ) $ (3.39 ) $ (0.68 ) $ (4.34 ) Diluted net loss per common share Average number of common shares and equivalents outstanding: The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements. As of December 31, 2009 and December 31, 2008 (In thousands, except per share data) 2009 2008 $ 13,345 $ 2,418 Restricted assets, current 9,755 — Property, equipment and software at cost Accumulated depreciation and amortization Net property, equipment and software Acquired curriculum and technology intangibles, net Acquired publishing rights, net Pre-publication costs, net Restricted assets, less current portion LIABILITIES AND STOCKHOLDERS’/MEMBERS’ EQUITY Notes payable — line of credit Current portion of long-term debt Current portion of capital lease obligations Contingent value rights, current Accrued expenses Deferred revenue, current Long-term debt, less current portion Capital lease obligations, less current portion Deferred revenue, less current portion Contingent value rights, less current portion Commitments and contingencies (See Note 19) Stockholders’ and members’ equity: Preferred stock ($.001 par value, 15,000 shares authorized, zero shares issued and outstanding at December 31, 2009) Common stock ($.001 par value, 150,000 shares authorized, 43,859 shares issued and outstanding at December 31, 2009) 258,789 — Members’ interest — 151,707 (119,268 ) (83,503 ) Pension and postretirement plans Net unrealized gain on securities Accumulated other comprehensive income (loss) Total stockholders’ and members’ equity Total liabilities and stockholders’/members’ equity Successor Period from January Predecessor 29, 2007 Period from (in thousands) 2009 2008 2007 2007 Operating activities: Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Inventory step-up — (30,202 ) — — Gain from recovery of property held for sale Loss on extinguishment of debt — unamortized debt issuance costs — 4,594 — — Non-cash interest expense 2,309 1,701 642 — Amortization of deferred financing costs — 604 679 — Loss (gain) on derivative instruments (1,390 ) 848 1,534 — Loss on disposal of assets 2 — — — Stock-based compensation — employee awards 37 (618 ) — (69 ) Stock-based compensation — subscription rights 2,222 — — — (7,975 ) (13,526 ) (8,365 ) (4,553 ) 2,306 (1,041 ) 306 (769 ) 4,725 (3,152 ) (867 ) (499 ) 3,022 (355 ) 488 1,732 1,579 (15 ) 724 40 (7,948 ) — — — (1,812 ) (2,941 ) (1,183 ) 3,856 4,980 (2,651 ) (8,162 ) 4,049 (1,115 ) 172 (369 ) (4 ) Other, net (95 ) — (469 ) 20 1,934 (13,855 ) (3,234 ) (3,732 ) Cash paid for acquisitions, net of cash acquired (9,697 ) (112 ) (303,236 ) — Expenditures for property, equipment, and pre-publication costs (3,395 ) (3,201 ) (3,370 ) (1,100 ) Settlement proceeds from previous stockholders Net cash provided by (used in) investing activities (13,092 ) 26,889 (306,606 ) (1,100 ) Proceeds from debt — — 172,105 — Repayment of debt (5,585 ) (24,280 ) (960 ) — Principal payments under capital lease obligations (289 ) (226 ) (195 ) (26 ) Borrowings under revolving credit agreement Payment of revolving credit facility (10,000 ) — (4,500 ) — Proceeds from capital contributions 2,959 684 140,108 — Proceeds from issuance of common stock in connection with the merger 25,000 — — — Borrowings from affiliates Distribution to members — — (12 ) — 22,085 (11,822 ) 311,046 3,574 Increase (decrease) in cash and cash equivalents 10,927 1,212 1,206 (1,258 ) Cash and cash equivalents, beginning of year 2,418 1,206 — 1,642 Cash and cash equivalents, end of year $ 13,345 $ 2,418 $ 1,206 $ 384 Supplemental disclosure of cash flow information: Income taxes paid (refunded) $ (3,080 ) $ 742 $ (337 ) $ 278 16,936 16,215 11,983 799 Supplemental disclosure of noncash investing and financing activities: Non-cash acquisition costs paid Rollover in capital contribution — — 3,915 — Conversion of unsecured notes payable — affiliates Assets received in settlement — property held for sale Consolidated Statements of Stockholders’ and Members’ Equity and Comprehensive Income (Loss) Series A Convertible Additional Preferred Stock Common Stock Paid in Accumulated (in thousands) Shares Value Shares Par Value Capital Deficit Total Predecessor Period Balance at December 31, 2006 84,700 $ 84,655 2,721 $ 27 $ 6,895 $ (12,682 ) $ 78,895 — — — — (69 ) — (69 ) Conversion of preferred stock to common stock (84,700 ) (84,655 ) 84,700 85 84,570 — — Balance at April 11, 2007 — $ — 87,421 $ 112 $ 91,396 $ (24,494 ) $ 67,014 Additional Accumulated Other Common Stock Paid in Members’ Comprehensive Accumulated (Dollars and shares in thousands) Shares Par Value Capital Interest Income Deficit Total Balance at January 29, 2007 (inception): — $ — $ — $ — $ — $ — $ — Capital contribution by members — — — — — (12 ) (12 ) — — — 144,023 — (13,943 ) 130,080 — — — 7,684 — — 7,684 — — — 151,707 — (83,503 ) 68,204 Conversion of members’ interests to common shares in connection with the merger (a) 20,493 20 154,646 (154,666 ) — — — Issuance of common stock to members in exchange for a $25 million capital contribution in connection with the merger 3,846 4 24,996 — — — 25,000 Issuance of common stock to Voyager stockholders in connection with the merger 19,520 20 76,888 — — — 76,908 Issuance of subscription rights in connection with the merger — — 2,222 — — — 2,222 — — 37 — — — 37 Comprehensive income (loss): — — — — 206 — 206 Unrealized gain on securities — — — — 1 — 1 Total comprehensive income (loss) 43,859 $ 44 $ 258,789 $ — $ 207 $ (119,268 ) $ 139,772 (a) As the previous members are also majority stockholders in Cambium Learning Group, Inc., the common shares issued on December 8, 2009 in connection with the merger will be considered outstanding for all successor periods presented for purposes of calculating earnings per share. Note 1 — Basis of Presentation Cambium Learning Group, Inc. (Successor). Cambium Learning Group, Inc. (the “Company”) was incorporated under the laws of the State of Delaware in June 2009. On December 8, 2009, the Company completed the mergers of Voyager Learning Company (“VLCY”) and VSS-Cambium Holdings II Corp. (“Cambium”) into two of our wholly-owned subsidiaries, resulting in VLCY and Cambium becoming wholly-owned subsidiaries. Following the completion of the mergers, all of the outstanding capital stock of VLCY’s operating subsidiaries, Voyager Expanded Learning, Inc. and LAZEL, Inc., were transferred to Cambium Learning, Inc., Cambium’s operating subsidiary (“Cambium Learning”). The results of VLCY are included in the Company’s operations beginning with the December 8, 2009 merger date; therefore the 2009 financials include VLCY for the last 23 days of the year and the results of the Company for the full year. The transaction was accounted for as an “acquisition” of VLCY by Cambium, as that term is used under U.S. GAAP, for accounting and financial reporting purposes under the applicable accounting guidance for business combinations. In making this determination, management considered that (a) the newly developed entity did not have any significant pre-combination activity and, therefore, did not qualify to be the accounting acquirer and (b) the former sole stockholder of Cambium is the majority holder of the combined entity, while the prior owners of VLCY became minority holders in the combined entity. As a result, the historical financial statements of Cambium have become the historical financial statements of the Company. Cambium Learning, Inc. (Predecessor). VSS-Cambium Holdings, LLC was formed on January 29, 2007. VSS-Cambium Holdings, LLC was formed to enter into a stock purchase agreement, dated as of January 29, 2007, by and among Cambium Learning, the former stockholders of Cambium Learning and VSS-Cambium Holdings, LLC, and to acquire all of the capital stock of Cambium Learning. On February 7, 2007, VSS-Cambium Management, LLC was formed. VSS-Cambium Management, LLC was formed for the purpose of providing selected key employees of Cambium Learning with an equity participation in the future appreciation in the value of Cambium Learning. VSS-Cambium Management, LLC is a member of VSS-Cambium Holdings, LLC and holds an equity interest in VSS-Cambium Holdings, LLC. On April 12, 2007, VSS-Cambium Holdings, LLC acquired 100% of the capital stock of Cambium Learning. The operating results of VSS-Cambium Holdings, LLC include Cambium Learning’s operating results from the acquisition date. In accordance with the requirements of purchase accounting, the assets and liabilities of Cambium Learning were adjusted to their estimated fair values and the resulting goodwill computed as of the acquisition date. Accordingly, and because of other effects of purchase accounting, the accompanying consolidated financial statements as of and for the period prior to the VSS-Cambium Holdings, LLC acquisition are not comparable. Therefore, the consolidated financial statements present the Company as of December 31, 2007 (Successor basis reflecting activity of the Company from January 29, 2007 and including the results of Cambium Learning from April 12, 2007) and the period January 1, 2007 through April 11, 2007 (Predecessor basis for the period prior to the Company’s acquiring Cambium Learning). Fiscal Year. The consolidated financial statements present the Company as of a calendar year ending on December 31. Nature of Operations. The Company currently operates in three business segments: Voyager, a comprehensive intervention business; Sopris, a supplemental solutions business; and Cambium Learning Technologies, a technology based education product business. Prior to the merger transaction completed on December 8, 2009, the Company had two reportable segments: Published Products and Learning Technologies. The reading programs in the Voyager business unit consist of: Voyager Passport; Voyager Universal Literacy System; Ticket to Read; Passport Reading Journeys; TimeWarp Plus; Voyager Pasaporte; LANGUAGE!; Read Well and We Can!. The math programs in the Voyager business unit consist of: Vmath; Vmath Summer Adventure; TransMath; Algebra Rescue and Voyages. The Voyager business unit also includes professional development programs. The Sopris business unit comprises products making up the supplemental solutions business. Sopris’ primary products consist of Step Up to Writing, Rewards, Dynamic Indicators of Basic Early Literacy Skills (DIBELS/IDEL), Language Essentials for Teachers of Reading and Spelling (LETRS), The Six Minute Solution, and Algebra Ready. Cambium Learning Technologies offers products under four different brands. Learning A-Z is a group of related websites known as Reading A-Z, Raz-Kids, Reading-Tutors, Vocabulary A-Z and Writing A-Z, which provide online supplemental reading, writing and vocabulary lessons, books, and other resources for students and teachers. Science A-Z, a Learning A-Z website, is aimed at the supplemental science market. ExploreLearning is a subscription-based online library of interactive simulations in math and science for grades 3-12. ExploreLearning supplies online simulations in math and science. Kurzweil Educational Systems is a program that primarily targets students in middle school through higher education struggling with reading and writing, specifically those students with ADHD, dyslexia and visual impairments. IntelliTools offers hardware products that target students with physical, visual and cognitive disabilities that make using a standard keyboard and mouse difficult. IntelliTools also offers software products that target elementary and middle school special education students struggling with reading and math. Reclassifications. Certain reclassifications to the Consolidated Financial Statements for all prior periods presented have been made to conform to the 2009 presentation. Such reclassifications include the following adjustments from the Statements of Operations presented in previous reports: (1) amortization expense related to tradenames and trademarks has been re-allocated from cost of sales and included as a component of the line item depreciation and amortization expense (See Note 2); (2) research and development expense, previously included with cost of sales, is now a separate line item within operating expenses; and (3) previously reported selling, general and administrative expense is now presented as four separate line items including sales and marketing expense, general and administrative expense, shipping costs, and depreciation and amortization expense. Segments. Prior to the merger transaction completed on December 8, 2009, the Company had two reportable segments: Published Products and Learning Technologies. Subsequent to the merger transaction, the Company operates as three reportable segments with separate management teams and infrastructures that offer various products and services: Voyager, our comprehensive intervention business; Sopris, our supplemental solutions business; and Cambium Learning Technologies, our technology based education product business. The Company’s historical segment reporting results have been re-allocated for comparative purposes to reflect the current organizational structure. These reclassifications required certain assumptions and estimates. See Note 21 to the financial statements for further information on the Company’s reportable segments. Note 2 — Significant Accounting Policies Use of Estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting periods. Subsequent actual results may differ from those estimates. Principles of Consolidation. The Successor consolidated financial statements of the Company include the accounts of the Company and its wholly owned subsidiaries: Voyager Learning Company, Voyager Expanded Learning, Inc., LAZEL, Inc., Cambium Learning, Inc., Cambium Learning (New York), Inc., Sopris West Educational Services, Inc., Kurzweil Educational Systems, Inc., and IntelliTools, Inc. All inter-company accounts and transactions are eliminated in consolidation. The Predecessor consolidated financial statements for the period from January 1, 2007 through April 11, 2007 include the accounts of Cambium Learning and its wholly owned subsidiaries. All inter-company accounts and transactions have been eliminated in consolidation. Revenue Recognition. Revenues are derived from sales of reading, math and science, and professional development solutions to school districts primarily in the United States. Sales include printed materials and often online access to educational materials for individual students, teachers, and classrooms. Revenue from the sale of printed materials for reading and math products is recognized when the product is shipped to or received by the customer based on shipping terms. Revenue for product support, training and implementation services, and online subscriptions is recognized over the period services are delivered. Revenue for our professional development courses, which include an Internet delivery component, is recognized over the contractual delivery period, typically nine to twelve months. ExploreLearning and Learning A-Z derive revenue exclusively from sales of online subscriptions to their reading, math and science teaching websites. Typically, the subscriptions are for a twelve-month period and the revenue is recognized ratably over the period the online access is available to the customer. The Company enters into agreements to license certain book publishing rights and content. Revenue from these agreements is recognized when the license amount is fixed and determinable, collection is reasonably assured, and the license period has commenced. For those license agreements that require us to deliver additional materials as part of the license agreement, the revenue is recognized when the product is received by the customer. Shipments to school book depositories are on consignment and revenue is recognized based on shipments from the depositories to the schools. Accounts Receivable. Accounts receivable are stated net of allowances for doubtful accounts and estimated sales returns. The allowance for doubtful accounts and estimated sales returns totaled $0.3 million and $0.7 million at year end 2009 and 2008, respectively. The allowance for doubtful accounts is based on a review of the outstanding balances and historical collection experience. The reserve for sales returns is based on historical rates of returns as well as other factors that in our judgment could reasonably be expected to cause sales returns to differ from historical experience. Net Earnings (Loss) per Common Share. Basic net earnings (loss) per common share is computed by dividing net earnings (loss) by the weighted average number of common shares outstanding during the period. Diluted net earnings (loss) per common share is computed by dividing net earnings (loss) by the weighted average number of common shares outstanding during the period, including the potential dilution that could occur if all of our outstanding stock awards that are in-the-money were exercised, using the treasury stock method. A reconciliation of the weighted average number of common shares and equivalents outstanding used in the calculation of basic and diluted net earnings per common share are shown in the table below for the periods indicated: Successor Period Predecessor Period From January 29, From January 1, For the Year Ended For the Year Ended 2007 through 2007 through December 31, December 31, December 31, April 11, Dilutive effect of awards The following were not included in the computation of diluted net income per share because their effect would have been antidilutive: options to purchase shares of 2.3 million, zero, zero, and 5.9 million for the year ended December 31, 2009, the year ended December 31, 2008, for the period from January 29, 2007 to December 31, 2007 and for the period from January 1, 2007 to April 11, 2007, respectively; subscription rights to purchase shares of 4.7 million for the year ended December 31, 2009; and a warrant to purchase shares of 0.1 million for the year ended December 31, 2009. As the previous members of VSS-Cambium Holdings, LLC are also majority stockholders in Cambium Learning Group, Inc., 20.5 million of common shares issued on December 8, 2009 in connection with the merger will be considered outstanding for the periods from January 1, 2009 to the merger date, the year ended December 31, 2008 and the period from January 29, 2007 to December 31, 2007. The 20.5 million shares reflect the number of shares issued to the sole stockholder of Cambium at the merger date in consideration of its pre-merger equity interest. The weighted-average shares outstanding for the year ended December 31, 2009 includes an additional 3.8 million shares issued to the sole stockholder in exchange for a $25 million contribution made at the time of the merger and 19.5 million shares issued to VLCY stockholders, as well as 0.4 million shares related to a warrant issued to the sole stockholder for which all contingencies have been resolved and that requires little consideration to exercise. Cash and Cash Equivalents. The Company considers all highly liquid investments with maturities of three months or less (when purchased) to be cash equivalents. The carrying amount reported in the Consolidated Balance Sheets approximates fair value. Inventory. Inventory is stated at the lower of cost, determined using the first-in, first-out (FIFO) method, or market, and consists of finished goods. The Company reduces slow-moving or obsolete inventory to net realizable value. Restricted Assets. Restricted assets consist of funds placed in a rabbi trust pursuant to the merger agreement for the purpose of funding certain obligations acquired in the VLCY merger, mostly deferred compensation, pension, and severance obligations, and an escrow of funds subject to the Contingent Value Rights (“CVRs”) described in Note 4. Property and Equipment. Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed over the assets’ estimated useful lives using the straight-line method. Estimated lives are as follows. Estimated Useful Life Land improvements Computer equipment and software Leasehold improvements Lesser of useful life or lease term Expenditures for maintenance and repairs, as well as minor renewals, are charged to operations as incurred, while improvements and major renewals are capitalized. Purchased and Developed Software. Purchased and developed software includes the costs to purchase third party software and to develop internal-use software. The Company follows applicable guidance for the costs of computer software developed or obtained for internal use for capitalizing software projects. Software costs are amortized over the expected economic life of the product, generally three to five years. At December 31, 2009 and 2008, unamortized capitalized software was $3.4 million and $1.8 million, respectively, which included amounts of software under development of $0.6 million and $0.1 million, respectively. Acquired Curriculum and Technology. Acquired curriculum and technology represents curriculum and developed technology acquired in the acquisitions of VLCY in 2009, certain assets of Tobii Assistive Technology, Inc. in 2008 and Cambium Learning in 2007 and is the initial purchase accounting value placed on the past development and refinement of the core methodologies, processes, measurement techniques, and technologies by which the Company structures curriculum. Acquired curriculum and technology is being amortized using an accelerated method over six to seven years, as it has an economic benefit declining over the estimated useful life. Acquired curriculum and technology is presented net of accumulated amortization of $4.3 million and $2.5 million as of yearend 2009 and 2008, respectively. Acquired Publishing Rights. A publishing right allows the Company to publish and republish existing and future works, as well as transform, adapt, or create new works based on previously published materials. The Company determines the fair market value of the publishing rights arising from business combinations by discounting the after-tax cash flows projected to be derived from the publishing rights and titles to their net present value using a rate of return that accounts for the time value of money and the appropriate degree of risk. The useful life of the publishing rights is based on the lives of the various titles involved, which is generally ten years. The Company calculates amortization using either the straight-line method or the percentage of the projected discounted cash flows derived from the titles in the current year as a percentage of the total estimated discounted cash flows over the remaining useful life. The Company periodically reviews the recoverability of the publishing rights based on expected net realizable value, and generally retire the assets once fully depreciated. Acquired publishing rights are presented net of accumulated amortization of $38.0 million and $24.0 million as of yearend 2009 and 2008, respectively. Pre-Publication Costs. The Company capitalizes certain pre-publication costs of its curriculum including art, prepress, editorial, and other costs incurred in the creation of the master copy of its curriculum products. Pre-publication costs are amortized over the expected life of the education program, generally on accelerated basis over a period of five years. The amortization methods and periods chosen reflect the expected sales generated by of the education programs. The Company periodically reviews the recoverability of the capitalized costs based on expected net realizable value, and generally retires the assets once fully depreciated. Pre-publication costs are presented net of accumulated amortization of $2.9 million and $1.2 million as of yearend 2009 and 2008, respectively. Goodwill and Other Intangible Assets. Goodwill and other intangible assets are related to the acquisitions of VLCY in 2009, certain assets of Tobii Assistive Technology, Inc. in 2008 and Cambium Learning in 2007. Other intangible assets include tradenames/trademarks, reseller networks, customer relationships/lists, and conference attendee relationships, which are being amortized on a straight-line basis over estimated lives ranging from six to sixteen years, and non-compete agreements and contracts, which are being amortized on a straight-line basis over their contractual lives of three to four years. Other intangible assets are presented net of accumulated amortization of $26.2 million and $18.3 million as of year end 2009 and 2008, respectively. See Note 8 herein for further discussion of our review of goodwill and the related impairment charges recognized in the years ended December 31, 2009 and December 31, 2008. Depreciation and Amortization. Depreciation and amortization for the year ended December 31, 2009, for the year ended December 31, 2008, for the period from January 29, 2007 to December 31, 2007 and for the period from January 1, 2007 to April 11, 2007 was broken out as follows: For the Period From January 31, 2007 For the Period From For the Year Ended For the Year Ended through January 1, 2007 through (in thousands) December 31, 2009 December 31, 2008 December 31, 2007 April 11, 2007 Acquired publishing rights $ 13,949 $ 13,566 $ 10,473 $ 2,283 Acquired curriculum and technology 1,707 1,072 100 488 Internally developed software related to product 19 — — — Total amortization included in cost of sales Tradenames and trademarks Property, equipment and software Total depreciation and amortization included in operating expenses Total depreciation and amortization Impairment of Long Lived Assets. The Company reviews the carrying value of long lived assets for impairment whenever events or changes in circumstances indicate net book value may not be recoverable from the estimated undiscounted future cash flows. If the review indicates any assets are impaired, the impairment of those assets is measured as the amount by which the carrying amount exceeds the fair value as estimated by either quoted market prices or discounted cash flows. Assets to be disposed of are reported at the lower of the carrying amount or fair value less cost of disposal. The determination whether our definite-lived intangible assets are impaired involves significant assumptions and estimates, including projections of future cash flows, the percentage of future revenues and cash flows attributable to the intangible assets, asset lives used to generate future cash flows, and royalty relief savings attributable to trademarks. For the year ended December 31, 2009, the year ended December 31, 2008, for the period from January 29, 2007 to December 21, 2007 and for the period from January 1, 2007 to April 11, 2007, no impairment was indicated. Deferred Costs. Certain up-front costs associated with completing the sale of the Company’s products are deferred and recognized as the related revenue is recognized. Advertising Costs. The Company, from time to time, ships products to prospective customers as samples. Samples costs are expensed to sales and marketing expense upon shipment and totaled $1.5 million, $1.6 million, $1.0 million and $0.3 million for the year ended December 31, 2009, the year ended December 31, 2008, for the period from January 29, 2007 to December 21, 2007 and for the period from January 1, 2007 to April 11, 2007, respectively. Other costs of advertising, which include advertising, print, and photography expenses, are expensed as incurred and totaled $2.9 million, $4.5 million, $2.5 million and $2.4 million for the year ended December 31, 2009, the year ended December 31, 2008, for the period from January 29, 2007 to December 21, 2007 and for the period from January 1, 2007 to April 11, 2007, respectively. The Company recognizes catalog expense when the catalog is mailed to potential customers. The cost to print the catalog is recorded in prepaid expenses on the Consolidated Balance Sheet until such time that the catalog is mailed. Income Taxes. Provision is made for the expense, or benefit, associated with taxes based on income. The provision for income taxes is based on laws currently enacted in every jurisdiction in which the Company does business and considers laws mitigating the taxation of the same income by more than one jurisdiction. Significant judgment is required in determining income tax expense, current tax receivables and payables, deferred tax assets and liabilities, and valuation allowance recorded against the net deferred tax assets. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, taxable income in prior carryback years, loss carryforward limitations, and tax planning strategies in assessing whether deferred tax assets will be realized in future periods. If, after consideration of these factors, management believes it is more likely than not that a portion of the deferred tax assets will not be realized, a valuation allowance is established. The amount of the deferred tax asset considered realizable could be reduced if estimates of future taxable income during the carryforward period are reduced. The Company recognizes liabilities for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if available evidence indicates that it is more likely than not that the position will be sustained on audit. The second step requires the Company to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement. The Company reevaluates its uncertain tax positions on a periodic basis, based on factors such as changes in facts and circumstances, changes in tax law, effectively settled issues under audit and new audit activity. The Company accrues interest and penalties, if any, related to unrecognized tax benefits as a component of income tax expense. Royalty Advances. Royalty advances to authors are capitalized and represent amounts paid in advance of the sale of an author’s product. These costs are then expensed as the related publication is sold. The Company evaluates advances periodically to determine if they are expected to be utilized and reserves any portion of a royalty advance that is not expected to be recovered. Sales Taxes. The Company reports sales taxes collected from customers and remitted to governmental authorities on a net basis. Sales tax collected from customers is excluded from revenues. Collected but unremitted sales tax is included as part of accrued expenses in the accompanying consolidated balance sheets. Derivative Instruments and Hedging Activities. The Company uses an interest rate derivative instrument to hedge its exposure to interest rate volatility resulting from its senior credit facility. Accounting guidance for derivatives and hedging requires that all derivative instruments be reported on the balance sheet at fair value, and establishes criteria for designation and effectiveness of hedging relationships, including a requirement that all designations must be made at the inception of each instrument. As such initial designations were not made by the Company at inception, changes in the fair value of the derivative instrument are required to be recognized in the current period Statement of Operations as other income or expense. Derivative financial instruments involve, to a varying degree, elements of market and credit risk not recognized in the consolidated financial statements. The market risk associated with these instruments resulting from interest rate movements is expected to offset the market risk of the underlying transactions, assets and liabilities being hedged. The counterparty to the agreement relating to the Company’s interest rate instrument is a major financial institution. The Company does not believe that there is significant risk of nonperformance by this counterparty. While the contract or notional amounts of the derivative financial instrument provide one measure of the volume of these transactions, they do not represent the amount of the Company’s exposure to credit risk. The amounts potentially subject to credit risk (arising from the possible inability of counterparties to meet the terms of their contracts) are generally limited to the amounts, if any, by which the counterparties’ obligations under the contracts exceed the obligations of the Company to the counterparties. The Company does not hold or use any derivative financial instruments for trading purposes. The fair value of the interest rate swap is obtained from a third-party quote. This value represents the estimated amount the Company would receive or pay to terminate the agreement taking into consideration current interest rates. Stock-Based Compensation. The Company accounts for its stock based compensation in accordance with applicable accounting guidance for share based payments. This guidance requires all share-based payments to be recognized in the income statement based on their fair values. Compensation costs for awards with graded vesting are recognized on a straight-line basis over the anticipated vesting period. Recently Issued Financial Accounting Standards. In December 2007, the Financial Accounting Standards Board, or FASB, issued new accounting guidance on business combinations. This guidance establishes principles and requirements for how an acquirer accounts for business combinations. This issuance includes guidance for the recognition and measurement of the identifiable assets acquired, the liabilities assumed, and any noncontrolling or minority interest in the acquiree. It also provides guidance for the measurement of goodwill, the recognition of contingent consideration, the accounting for pre-acquisition gain and loss contingencies and acquisition- related transaction costs, and the recognition of changes in the acquirer’s income tax valuation allowance. This accounting guidance applies prospectively and is effective for business combinations made by the Company beginning January 1, 2009. The provisions are effective as of the Company’s first quarter ended March 31, 2009. The Company followed this guidance in accounting for the VLCY acquisition described in Note 4. In April 2008, the FASB issued new accounting guidance on the determination of the useful life of intangible assets. The new guidance amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under previous guidance for goodwill and other intangible assets. This issuance is effective for fiscal years beginning after December 15, 2008. The provisions are effective as of the Company’s first quarter ended March 31, 2009. The Company followed this guidance in determining the useful lives of the intangibles recognized as a result of the VLCY acquisition described in Note 4. In April 2009, the FASB issued new accounting guidance on interim disclosures about fair value of financial instruments, which amends previous guidance on disclosures about fair value of financial instruments to require disclosure about fair value of financial instruments in interim financial statements. This new guidance is effective for interim and annual periods ending after June 15, 2009. The provisions were effective as of the Company’s second quarter ended June 30, 2009. The Company will make these interim disclosures as appropriate. In October 2009, new guidance was issued regarding multiple-deliverable revenue arrangements and certain arrangements that include software elements. This guidance requires entities to allocate revenue in an arrangement using estimated selling prices of the delivered goods and services based on a selling price hierarchy. The guidance eliminates the residual method of revenue allocation and requires revenue to be allocated using the relative selling price method. It also removes tangible products from the scope of software revenue guidance and provides guidance on determining whether software deliverables in an arrangement that includes a tangible product are covered by the scope of the software revenue guidance. This guidance will be applied on a prospective basis for revenue arrangements entered into or materially modified in fiscal years beginning on or after June 15, 2010 with early adoption permitted. The Company is currently evaluating the impact of this standard on its consolidated financial condition, results of operations and cash flows. Note 3 — Embezzlement On April 26, 2008, the Company began an internal investigation that revealed irregularities over the control and use of cash and certain other general ledger accounts of the Company, revealing a misappropriation of assets (the “Embezzlement Matter”). These irregularities were perpetrated by a former employee over more than a three-year period beginning in 2004 and continuing through April 2008. The embezzlement loss incurred in each year, before the effect of income taxes, is as follows: Year/Period Amount January 1, 2007 — April 11, 2007 Total — Predecessor April 12, 2007 — December 31, 2007 Total — Successor Total Embezzlement Loss In addition to these losses, the Company has incurred fees and expenses as a result of the embezzlement totaling $5.5 million in 2008, net of recoveries. In 2008, the Company took possession of five boats which were purchased by the former employee using the embezzled funds. As of December 31, 2008, the boats had an appraised value of $1.6 million and were netted against the fees and expenses incurred as a result of the embezzlement and are included in other assets on the Consolidated Balance Sheet. In the year ended December 31, 2009, the Company has incurred fees and expenses as a result of the embezzlement totaling $0.1 million, net of recoveries. As more fully described in Note 4, $20.0 million of the purchase price of Cambium Learning was held in escrow. Pursuant to an agreement dated July 10, 2008 by and between the former stockholders of the predecessor company and the members of the successor company, the remaining escrow amount was distributed in its entirety to VSS-Cambium Settlement Fund, LLC (Settlement Fund), acting as an agent for Cambium Learning. Also, the former stockholders of the predecessor company agreed to contribute an additional $9.3 million to the Settlement Fund. The total settlement of $30.2 million, including interest income of $0.9 million, was distributed to Cambium Learning and used to cover costs and pay down a portion of the senior credit facility. Since the embezzlement was discovered after the initial purchase allocation, the entire settlement amount was recorded as a gain from settlement with previous stockholders on the accompanying Consolidated Statements of Operations. The former stockholders also agreed to forego any claims or rights to any amount held in escrow in exchange for which the members of VSS-Cambium Holdings, LLC indemnified the former stockholders from any claims in connection with the Embezzlement Matter. Acquisition of VLCY On December 8, 2009, the Company acquired VLCY and its subsidiaries. The Company determined that the merger could capitalize upon potential strategic, operational and financial synergies to generate significant cash flow and strengthen the leadership position of Cambium and VLCY in education solutions for the pre-K-12 market. In reaching its decision to acquire VLCY, which resulted in the recognition of $44.6 million of goodwill, there were a number of reasons why the Company believed the acquisition would be beneficial. These potential benefits include: • Capitalizing on the complementary nature of the companies’ products to enhance certain products with minimal development costs, achieve critical mass in certain markets, facilitate the cross-selling of each other’s products to established customers, and expand sales and marketing reach. • Leveraging the companies’ combined implementation services and robust technological capabilities. • Combining two experienced management teams to spread “best practices”, attract leading authors and programs, and acquire additional product lines and business as opportunities arise. • Increasing sales into existing and new markets of certain products through complementary sales channels. The acquisition was accounted for as a purchase transaction. The consolidated financial statements of the Company include the results of VLCY from December 8, 2009, the date of acquisition. The purchase price was allocated among tangible and intangible assets acquired and liabilities assumed based on fair values at the transaction date. The excess of the purchase price over the acquired tangible and intangible assets and liabilities was recorded as goodwill. The Company acquired the stock of VLCY and, therefore, the additional goodwill resulting from this transaction is not expected to be tax deductible. Acquisition costs of $13.6 million and $26,000 are included in general and administrative expenses in the Consolidated Statements of Operations for the years ended December 31, 2009 and 2008, respectively. Consideration to the VLCY shareholders consisted of: • at the election of the stockholder, either, • one share of Company common stock, or • $6.50 in cash, limited to a maximum of $67.5 million in the aggregate and prorated in accordance with the merger agreement; • plus, regardless of the election made, • an amount in cash equal to the amount of certain tax refunds specified in the merger agreement and received by VLCY prior to the closing of the mergers (reduced by the amount of the VLCY tax refunds contractually required to be placed in escrow at closing), divided by the total number of shares of VLCY common stock outstanding immediately prior to the effective time of the mergers; plus • a Contingent Value Right (“CVR”) to receive cash in an amount equal to the aggregate amount of specified tax refunds received after the closing of the mergers and various other amounts deposited in escrow on or after the closing date, reduced by any payments to be made under the escrow agreement entered into in connection with the mergers, with respect to agreed contingencies, a potential working capital adjustment and allowed expenses, divided by the total number of shares of VLCY common stock outstanding immediately prior to the effective time of the mergers. The ultimate value of the CVRs is not known at this time; however, it is not expected to be more than $11 million and could be as low as zero. As of the merger date and as of December 31, 2009, a fair value of $9.6 million has been recorded as a liability for the CVR payments. The determination of fair value of the CVRs involves significant assumptions and estimates regarding the likelihood, amount and timing of cash flows related to the elements of the CVRs. Future changes in the estimate of the fair value of the CVRs will impact results of operations and could be material. CVR payments will be made in accordance with the escrow agreement on the nine and eighteen month anniversaries of the effective date of the merger, with a final payment, if any, to be made in October 2013 that is related to certain potential 280G tax gross up indemnity obligations placed in escrow. The amounts that will be paid at these dates could vary materially from the amounts recorded in the Company’s financial statements at December 31, 2009. As of December 31, 2009, restricted assets in an escrow account for the benefit of the CVR were $7.9 million. Additionally, under the merger agreement, share-based awards held by employees of VLCY were required to be converted into rights or options for shares of the Company with the same terms and conditions that were applicable to the rights or options for VLCY shares. Therefore, in accordance with applicable accounting guidance for business combinations, the fair value, prior to conversion, of replacement equity awards issued for pre-combination services at the date of acquisition is included in the calculation of the purchase price. The following represents the components of the purchase price: Cash paid to shareholders making the cash election Cash paid to shareholders for specified tax refunds Fair value of shares of Company issued to shareholders Fair value of equity awards converted at acquisition Fair value of the Contingent Value Rights Total consideration The following represents the allocation of the purchase price: Income tax receivable Curriculum in development Accounts payable and accrued expenses Capital lease obligations Total net assets acquired Other identified intangibles acquired consist of the following: Voyager Technologies Useful Life Curriculum and technology $ 23,700 $ 19,000 7 years 3,880 1,500 7 years 1,610 559 15 years Goodwill purchased in the acquisition has been allocated to the Company’s Voyager and Cambium Learning Technologies reporting units as $24.9 million and $19.7 million, respectively. Valuations were established giving consideration to the three basic approaches to value with the method or methods applied for each asset depending on the nature of the asset and the type and reliability of information available for the analysis and were based upon the Company’s projected revenue growth assumptions through each asset’s estimated useful life. Discounted cash flows were based upon the Company’s weighted-average cost of capital of 25% and an estimated effective tax rate of 38%. Curriculum and technology and customer relationships were valued using a form of the income approach known as the excess earnings method. Tradenames and trademarks were valued using a form of the income approach known as the relief-from-royalty method. Supplemental Pro Forma Information Since the December 8, 2009 acquisition date, the VLCY acquisition has contributed $4.5 million of net sales and a pretax loss of $1.5 million to the Company’s consolidated results. The following unaudited supplemental pro forma information presents the results of operations as if the VLCY acquisition had occurred at the beginning of the respective reporting periods: Years Ended December 31, (in thousands) (unaudited) 2009 2008 Net loss per share — basic and diluted $ (1.34 ) $ (3.55 ) The supplemental pro forma information has been adjusted to include: • the pro forma impact of the amortization of intangible assets and the reduction in deferred revenue and related deferred costs based on the purchase price allocation; • the pro forma impact of reduced interest income lost as a result of the $58.0 million of cash used in the purchase price consideration (net of $25.0 million contributed by the sole stockholder of the Company at the time of the merger); • the pro forma impact of certain employment agreements and stock option grants entered into on the effective date of the merger; • the elimination of merger transaction costs incurred by the Company and VLCY; and • the pro forma tax effect of the merger, which was estimated using a combined company effective tax rate of 0% for 2009 and 7.6% for 2008. Basic and diluted loss per share is calculated using share equivalents outstanding at the merger date of 44.3 million. The supplemental pro forma information does not include an adjustment for certain contractual obligations, severance, retention, and other payments that became payable as a result of the merger. The majority of such payments are recorded in the historical financial statements of the Company or VLCY. Approximately $1.6 million of such payments subject to subsequent service requirements will be recorded as expense in 2010. The pro forma results are presented for illustrative purposes only and do not reflect the realization of potential cost savings, or any integration costs. Certain cost savings may result from the acquisition; however, there can be no assurance that these cost savings will be achieved. These pro forma results do not purport to be indicative of the results that would have actually been obtained if the acquisition occurred at the beginning of the respective reporting periods, nor is the pro forma data intended to be a projection of future results. Acquisition of Cambium Learning, Inc. On April 12, 2007, the Company acquired Cambium Learning and its subsidiaries: Cambium Learning (New York), Inc., Sopris West Educational Services, Inc. (Sopris West), Kurzweil Educational Systems, Inc., and IntelliTools, Inc. The Company determined that combining their media expertise and capital with the strong growth potential that existed in the pre-K – 12 educational marketplace for the types of products and services provided by Cambium would create a more competitive company. In reaching its decision to acquire Cambium, which resulted in the recognition of $192.3 million of goodwill, there were a number of reasons why the Company believed the acquisition would be beneficial. These potential benefits include: • Capitalizing on a growing market and the need for accountability. • Increasing program penetration by expanding sales from current customers. • Exploring acquisition opportunities in a fragmented market. The acquisition was funded through a combination of $140.1 million of cash, $3.9 million of executive rollover shares, and $172.1 million of debt, net of issuance costs. The aggregate purchase price, net of cash acquired and executive rollover shares, was $303.2 million, of which $21.0 million was held in escrow. The $21.0 million held in escrow consisted of $1.0 million held in a Purchase Price Escrow and $20.0 million held in an Indemnity Escrow. The Purchase Price Escrow fund was established to support a post-closing working capital adjustment. The Indemnity Escrow was established to support any deficiencies in the Purchase Price Escrow and to secure the payment of any indemnification claims made by the purchaser pursuant to the acquisition agreement. The acquisition agreement contained customary general indemnification protection for breaches of representations and warranties during a specified post-closing survival period. At the time of closing, the purchaser had no reason to believe that any such representations or warranties would prove to be inaccurate, and, consequently, no reason to believe it would assert any claims against the Indemnity Escrow. The accounting guidance that was in effect at the time of closing prescribes the accounting treatment for escrows such as the Indemnity Escrow. It requires certain future contingent consideration to be included in the purchase price of an acquisition only after the contingency has occurred and the consideration has been delivered to the sellers, and pending occurrence of the contingency, the amount of such consideration is to be recorded on the balance sheet as a liability and not included in purchase price. However, where the expectation of making the future payment is beyond a reasonable doubt, then it is not deemed contingent. A release of consideration from an indemnity escrow which secured claims for breaches of representations and warranties is deemed to be beyond a reasonable doubt, based upon the assumption that representations and warranties are accurate when made. Escrowed amounts which secured such breaches, like the Indemnity Escrow, are, therefore, not deemed to be contingent, absent a pre-acquisition contingency that was subject to the escrow. Thus, the amount of consideration placed in the Indemnity Escrow at closing was included in the purchase price. In 2007, $1.0 million of the Purchase Price Escrow was released for a purchase price adjustment related to net working capital. As disclosed in Note 3, Cambium Learning suffered a loss resulting from an embezzlement that was discovered in late April 2008. The purchaser asserted indemnity claims against the sellers with respect to that loss, and settled those claims in July 2008. The settlement negotiations were memorialized in an agreement dated July 10, 2008 by and between the former stockholders of the predecessor company and the members of the successor company, and resulted in the remaining Indemnity Escrow being distributed in its entirety to VSS-Cambium Settlement Fund, LLC (Settlement Fund), acting as an agent for Cambium Learning. Also, the former stockholders of the predecessor company agreed to contribute an additional $9.3 million to the Settlement Fund. The total settlement of $30.2 million, including interest income of $0.9 million, was distributed by the Settlement Fund to Cambium Learning and used to cover costs and pay down a portion of the senior credit facility and is reflected in gain from settlement with previous stockholders in the Consolidated Statements of Operations. The Settlement Fund was designated as the agent to act as a receiving and paying agent, since the settlement monies had to be received from the several sellers and then distributed to several parties, consisting of the various lenders and professional advisors; having the Settlement Fund act as agent facilitated this flow of funds at a time when the Company was concluding its internal investigation. Despite these escrow releases, the expected accuracy of the representations and warranties provided a reasonable basis to find sufficient certainty with respect to the sellers’ entitlement to the escrows and, consequently, to include them in the purchase price at closing. The acquisition was accounted for as a purchase transaction. The consolidated financial statements of the Company include the results of Cambium Learning from the date of acquisition. The purchase price was allocated among tangible and intangible assets acquired and liabilities assumed based on fair values at the transaction date. The excess of the purchase price over the acquired tangible and intangible assets and liabilities was recorded as goodwill. The Company acquired the stock and, therefore, the additional goodwill resulting from this transaction is not expected to be tax deductible. The Company has established deferred taxes on the other nondeductible intangible assets as part of the purchase price. In connection with the acquisition, certain executives carried over a portion of their investment to the Company. The rollover shares were valued at $3.9 million based on the fair value of their equity interest in Cambium at the time of the acquisition. This amount was converted into a membership interest which was based on the percentage of $3.9 million to the total $144.0 million of contributed capital. Other long-term assets Other identified intangible assets Long-term deferred tax liabilities In-process research and development (in thousands) Fair Value Useful Life $ 90,300 11 years Developed technology 6,300 6 years 15,580 16 years Reseller networks 13,700 6 – 11 years Noncompetes Conference attendee relationships 500 8 years Total other identified intangibles Goodwill purchased in the acquisition was allocated to the Company’s Publishing and Learning Technologies reporting units as $153.5 million and $38.8 million, respectively, based on their relative fair values. Valuations were established giving consideration to the three basic approaches to value with the method or methods applied for each asset depending on the nature of the asset and the type and reliability of information available for the analysis and were based upon the Company’s projected revenue growth assumptions through each asset’s estimated useful life. Discounted cash flows were based upon the Company’s weighted-average cost of capital of 12% and an estimated effective tax rate of 40%. Publishing rights were valued using a form of the income approach known as the excess earnings method. Trademarks and developed technology were valued using a form of the income approach known as the relief-from-royalty method. Customer relationships, conference attendees and reseller networks were valued using the residual cash flow method and customer contracts were valued using various forms of the income approach depending on the nature of the individual contract. Non-compete agreements were valued using a form of the income approach known as the profit differential method. Acquisition of Certain Assets of Tobii Assistive Technology, Inc. On July 25, 2008, Cambium acquired certain intellectual property rights and an inventory of titles with related author agreements of Tobii Assistive Technology, Inc., a Massachusetts corporation, for $112,003. The cash used to fund this acquisition came from the Company’s general working capital. The purchase price was allocated as follows: $52,003 to goodwill (deductible for tax purposes), $39,000 to customer lists and $21,000 to developed technology. The customer lists and developed technology will be amortized on a straight-line basis over their useful lives of two years and three years, respectively. Note 5 — Income Taxes Losses before income taxes for the year ended December 31, 2009, for the year ended December 31, 2008, for the period from January 29, 2007 to December 31, 2007, and for the period from January 1, 2007 to April 11, 2007 were all attributable to the U.S. Income tax benefit attributable to income included the following: Current income tax expense (benefit): United States federal $ — $ — $ 18 $ 501 Current income tax expense Deferred income tax benefit (2,405 ) (1,574 ) (1,254 ) (243 ) $ (7,704 ) $ (13,422 ) $ (7,838 ) $ (3,694 ) Reconciliation of income tax benefit and the domestic federal statutory income tax benefit is as follows: Statutory federal income tax benefit $ (15,214 ) $ (29,044 ) $ (7,624 ) $ (5,427 ) Increase (reduction) from: State taxes (net of federal benefit) (1,378 ) (1,057 ) (484 ) (428 ) Purchase price adjustment Merger transaction expenses 4,745 — — 1,674 Change in valuation allowance 625 122 — 373 Deferred income taxes are primarily provided for temporary differences between the financial reporting basis and the tax basis of our assets and liabilities. The tax effects of each type of temporary difference and carryforward that give rise to a significant portion of deferred tax assets (liabilities) at the end of fiscal 2009 and 2008 were as follows: (in thousands) 2009 2008 Deferred tax assets are attributable to: Net operating loss carryforwards Tax credit carryforwards Deferred financing costs Embezzlement loss Total gross deferred tax assets Valuation allowance (14,312 ) (2,858 ) Net deferred tax assets Deferred tax liabilities are attributable to: — (880 ) (4,403 ) — Total gross deferred tax liabilities Net deferred tax liability: $ (1,889 ) $ (10,549 ) The deferred tax asset (liability) is classified as follows: Short-term deferred tax asset Long-term deferred tax liability Net deferred tax asset (liability) The net increase in the valuation allowance in 2008 was $1.8 million. The valuation allowance increased during 2008 primarily related to state net operating loss carryforwards that are not expected to be realized. As of December 31, 2009, there is not any amount of the valuation allowance for which subsequently recognized benefits will be allocated to reduce goodwill or other intangible assets. The net increase in the valuation allowance in 2009 was $11.5 million. The valuation allowance increased during 2008 primarily because of the acquisition of VLCY. VLCY had established a valuation allowance of $12.1 million as of the date of acquisition against all of its Federal and unitary state net deferred tax assets. The inclusion of Cambium’s net deferred tax liabilities decreased VLCY’s valuation allowance approximately $1.8 million. Post acquisition, increases in the Company’s deferred tax assets were offset by increases in the valuation allowance. As of December 31, 2009, there is not any amount of the valuation allowance for which subsequently recognized benefits will be allocated to reduce goodwill or other intangible assets. At December 31, 2009, the amounts and expiration dates of loss and tax credit carryforwards were as follows: Amount as of Expire or start expiring (in thousands) year ended 2009 at the end of: U.S. net operating loss (1) $ 62,791 2028 State net operating loss carryforward (net): State tax net operating losses (2) 4,441 2012 – 2028 Tax credits: Minimum tax credit 7,254 Carry forward indefinitely 416 2014 – 2021 Total tax credits (1) $38.3 million of the U.S. net operating loss (NOL) above is related to the VLCY acquisition. The utilization of this NOL is subject to an annual limitation of $7.1 million. (2) $2.9 million of the state NOL above are expected to expire unutilized. These NOLs are associated with specific legal entities that are not expected to generate taxable income within the statute of limitation period. The Company has established a valuation allowance against these deferred tax assets. Income taxes refunded, net of tax payments, were $3.1 million for fiscal year 2009. $3.4 million of the income taxes received were deposited into escrow pursuant to the CVR obligation in connection with the merger agreement. Income taxes paid, net of refunds, for fiscal year 2008 were $0.7 million. Income taxes refunded, net of tax payments, were $0.3 million for the period from January 29, 2007 to December 31, 2007. Income taxes paid, net of tax refunds, were $0.3 million for the period from January 1, 2007 to April 11, 2007. The Company has refunds receivable from taxing authorities of $1.3 million as of fiscal year end 2009. Approximately $1.0 million of this receivable will be deposited into escrow when it is received as part of the CVR obligation. VLCY was formerly known as ProQuest Company. Under sale agreements with Snap-On Incorporated and Cambridge Scientific Abstracts, LP (“CSA”), the Company is liable to indemnify Snap-On Incorporated or CSA for any income taxes assessed against ProQuest Business Solutions (“PQBS”) or ProQuest Information and Learning (“PQIL”) for periods prior to the sale of PQBS or PQIL. The Company has established a contingent liability for those matters where it is not probable that the position will be sustained. The amount of the liability is based on management’s best estimate given the Company’s history with similar matters and interpretations of current laws and regulations. The Company recognizes the financial statement effects of a tax return position when it is more likely than not, based on the technical merits, that the position will ultimately be sustained. For tax positions that meet this recognition threshold, we apply our judgment, taking into account applicable tax laws, our experience in managing tax audits and relevant GAAP, to determine the amount of tax benefits to recognize in our financial statements. For each position, the difference between the benefit realized on our tax return and the benefit reflected in our financial statements is recorded on our balance sheet as an unrecognized tax benefit (“UTB”). We update our unrecognized tax benefits at each financial statement date to reflect the impacts of audit settlements and other resolution of audit issues, expiration of statutes of limitation, developments in tax law and ongoing discussions with taxing authorities. A reconciliation of the change in the UTB balance from January 1, 2009 to December 31, 2009, and January 1, 2008 to December 31, 2008, is as follows: Balance at the beginning of the year $ — $ — Increases for acquisitions during the period Increases for tax positions taken during the period Decreases relating to settlements Balance at the end of the year $ 15,437 $ — The Company estimates it is reasonably possible that approximately $6.1 million in unrecognized tax benefits will be recognized in 2010 due to the statute of limitations expiring. Of this amount and included in the balance of unrecognized tax benefits at December 31, 2009 are approximately $1.1 million of tax benefits that, if recognized, would affect the effective tax rate. The recognition of the remaining uncertain tax positions would not affect the effective tax rate, but would instead increase or would have increased available tax attributes. However, the recognition of the tax attribute would be offset by an increase in the deferred tax asset valuation allowance resulting in no net impact in the effective tax rate. The Company recognizes interest accrued related to unrecognized tax benefits and penalties as income tax expense. Related to the unrecognized tax benefits noted above, the Company recognized penalties of zero and immaterial amounts for interest (gross) during 2009 and, as of December 31, 2009, has a liability for penalties of zero and interest (gross) of approximately $0.1 million. The Company files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. All U.S. tax years prior to 2008 related to the VLCY acquired entities have been audited by the Internal Revenue Service. Cambium and its subsidiaries have been examined by the Internal Revenue Service through the end of 2006. Various state tax authorities are in the process of examining income tax returns for various tax years through 2007. Note 6 — Performance Share Plan At the time of the acquisition of Cambium Learning, the Company agreed to pay for a long-term incentive plan for Sopris West employees. The Company recorded a liability at fair value on the date of acquisition due to the commitment being fixed. The aggregate amount accrued as of April 11, 2007 and paid on June 30, 2007 under this plan was $7.6 million. No further amounts were due at December 31, 2009 or December 31, 2008. Note 7 — Property, Equipment and Software Balances of major classes of assets and accumulated depreciation and amortization consist of the following: Land and building Machinery, computers and equipment Less accumulated depreciation and amortization Property, equipment and software, net Note 8 — Goodwill and Other Intangible Assets The changes in the carrying amount of goodwill for the years ended December 31, 2009 and December 31, 2008 are as follows: (in thousands) Publishing Voyager Sopris CLT Total Balance as of December 31, 2007 $ 153,533 $ — $ — $ 38,754 $ 192,287 Accumulated impairment losses 153,533 — — 38,754 192,287 Goodwill from acquisitions — — — 52 52 (75,966 ) — — — (75,966 ) 77,567 — — 38,806 116,373 (9,105 ) — — — (9,105 ) Allocation of Publishing goodwill among Voyager and Sopris segments (68,462 ) 51,162 17,300 — — — 24,923 — 19,724 44,647 — 161,156 17,300 58,530 236,986 — (85,071 ) — — (85,071 ) $ — $ 76,085 $ 17,300 $ 58,530 $ 151,915 In accordance with applicable accounting guidance, goodwill and other indefinite-lived intangible assets are no longer amortized but are instead reviewed for impairment at least annually and if a triggering event is determined to have occurred in an interim period. The Company’s annual impairment testing is performed as of December 1 of each year. In June 2009, we determined that the signing of the merger agreement was a triggering event requiring us to review goodwill for impairment. At the time of this review, the Company had two reporting units: Published Products and Learning Technologies. The first step of impairment testing as of June 30, 2009 showed that the carrying value of the Published Products unit exceeded its fair value and that the second step of testing was required for this unit. The second step requires the allocation of fair value of a reporting unit to all of the assets and liabilities of that reporting unit as if the reporting unit had been acquired in a business combination. The fair value was determined using an income approach based on forecasted operating results. As a result of the second step of our second quarter 2009 impairment test, the goodwill balance for the reporting unit as of the measurement date was determined to be partially impaired, and an impairment charge of $9.1 million was recorded as of June 30, 2009. As of second quarter 2009, the estimated fair market value of the reporting unit was estimated to have fallen below the book value as a result of worsening and prolonged adverse developments in the overall education funding environment, including the reductions in Reading First funding effective 2008 and the reductions in available state and local funds. In conducting our annual goodwill impairment testing for fiscal 2008, we compared the book value of goodwill attributed to the Published Products and Learning Technologies segments with the estimated fair market values of these segments. As of yearend 2008, the estimated fair market value of the Published Products segment was estimated to be less than the book value as a result of lower future cash flow projections, driven by adverse developments in the education funding environment at the federal and local level. An impairment charge of $76.0 million related to Published Products was recorded in 2008 as a result of these factors. These estimates of fair market are dependent on multiple assumptions and inputs, including industry fundamentals such as the state of educational funding and the actual performance and future projections of the Company. Our definite lived intangible assets and related accumulated amortization at the end of fiscal 2009 and 2008 consist of the following: December 31, Impairment Balance at (in thousands) 2007 Additions Charge 2008 Additions Charge 2009 $ 192,287 $ 52 $ (75,966 ) $ 116,373 $ 44,647 $ (9,105 ) $ 151,915 Other intangible assets — gross book value: 90,300 — — 90,300 — — 90,300 15,580 — — 15,580 2,169 — 17,749 13,700 39 — 13,739 5,380 — 19,119 2,100 — — 2,100 — — 2,100 6,300 21 — 6,321 42,700 — 49,021 Reseller network Conference attendees 500 — — 500 — — 500 Total other intangibles — gross book value 143,380 60 — 143,440 50,249 — 193,689 Other intangible assets — accumulated amortization: (10,473 ) (13,566 ) — (24,039 ) (13,949 ) — (37,988 ) (1,130 ) (1,330 ) — (2,460 ) (1,349 ) — (3,809 ) (3,371 ) (3,804 ) — (7,175 ) (2,915 ) — (10,090 ) (440 ) (1,047 ) — (1,487 ) (555 ) — (2,042 ) (151 ) (142 ) — (293 ) (86 ) — (379 ) (624 ) (866 ) — (1,490 ) (867 ) — (2,357 ) Total other intangibles — accumulated amortization $ 123,409 $ (24,813 ) $ — $ 98,596 $ 26,544 $ — $ 125,140 Estimated aggregate amortization expense expected for each of the next five years related to intangibles subject to amortization is as follows: Amortization - Amortization - Total (in thousands) Cost of Sales Operating Expense Amortization $ 25,238 $ 6,000 $ 31,238 $ 97,009 $ 28,131 $ 125,140 Note 9 — Other Current Assets Other current assets at the end of fiscal 2009 and 2008 consist of the following: Settlement receivable $ 2,400 $ — Prepaid expenses Deferred costs The settlement receivable amount relates to an amount due from a subsidiary sold by VLCY in the years prior to the merger with Cambium. The receivable was allocated a portion of the purchase price at the acquisition date and is also included in the CVRs obligation created in the merger with Cambium, as described in Note 4. Note 10 — Accrued Expenses Accrued expenses at the end of fiscal 2009 and 2008 consist of the following: Salaries, bonuses and benefits Accrued royalties Pension and post-retirement medical benefits Interest rate swap Deferred compensation Salaries, bonuses and benefits accrued as of December 31, 2009 include severance and other amounts owed to employees and former employees that are related to the merger agreement between the Company and VLCY. As of the merger date, funds related to these obligations, as well as obligations related to certain deferred compensation and pension liabilities, were placed in a rabbi trust pursuant to the merger agreement. As of December 31, 2009, the funds in this rabbi trust totaled $16.7 million. See Note 15 for further description of our pension benefits. Note 11 — Other Liabilities Other liabilities at the end of fiscal 2009 and 2008 consist of the following: Pension and post-retirement medical benefits, long-term portion Long-term income tax payable Long-term deferred compensation See Note 15 for further description of our pension benefits. Note 12 — Leases The Company leases certain facilities and equipment for selling and administrative purposes under capital lease agreements with original lease terms up to 10 years. Capital leases that exist as of year-end 2009 expire no later than 2016. The Company has a build-to-suit lease for warehouse space in Frederick, Colorado. The lease requires minimum monthly rents that expire on October 31, 2016. The lease is renewable at the Company’s option for two additional periods of five years each. The Company has an outstanding letter of credit in the amount of $1.0 million to secure the lease. The Company evaluated the provisions of the accounting guidance relating to the effect of a lessee’s involvement in an asset construction and concluded that due to the Company’s collateral to the landlord, in the form of the $1.0 million letter of credit, that it is deemed the owner of the land and building for accounting purposes. As a result, the related capitalized costs for the warehouse space in Frederick, Colorado are classified as “land, land improvements, and building” and are included in property, plant and equipment, net, in the accompanying Consolidated Balance Sheets. A liability for the same amount is included in the current portion of capital lease obligations and capital lease obligations, less current portion, representing the short- and long-term components. Due to the acquisition of Cambium, the Company recorded an increase of $4.8 million in purchase accounting related to the fair market value of land, land improvements, and building for the warehouse space on the date of acquisition. The related liability has been adjusted accordingly. The cost of the building is being depreciated over a 35-year useful life. The amount of the depreciation expense was $0.4 million, $0.4 million, $0.2 million and $0.1 million for the year ended December 31, 2009, the year ended December 31, 2008, for the period of January 29, 2007 through December 31, 2007 and for the period of January 1, 2007 through April 11, 2007, respectively. Additionally, the obligation will be reduced over the life of the lease at an interest rate of 5.54%. At the end of the original lease term, the land and building, net of accumulated depreciation, will be equal to the remaining liability. The gross value of other leased capital assets was $0.4 million and zero at December 31, 2009 and December 31, 2008, respectively, which are included in the Machinery, computers and equipment category in Property, Equipment and Software. The accumulated amortization of leased capital assets was $0.1 million and zero at December 31, 2009 and December 31, 2008, respectively. Amortization of capital lease assets is recognized over the term of the lease on a straight line basis and included in depreciation expense. The Company leases certain facilities and equipment for production, selling and administrative purposes under agreements with original lease periods up to 10 years. Leases generally include provisions requiring payment of taxes, insurance, and maintenance on the leased property. Some leases include renewal options and rent escalation clauses, and certain leases include options to purchase the leased property during or at the end of the lease term. Rent holidays and rent escalation provisions are considered in determining straight-line rent expense to be recorded over the lease term. The lease term begins on the date of initial term of the lease. Lease renewal periods are considered on a lease-by-lease basis and are generally not included in the initial lease term. Operating rent expense was $1.1 million, $1.2 million, $0.9 million and $0.4 million for the year ended December 31, 2009, for the year ended December 31, 2008, for the period from January 29, 2007 to December 31, 2007 and for the period from January 1, 2007 to April 11, 2007, respectively. Future minimum build-to-suit and capital lease payments under long-term non-cancelable leases, and the related present value of capital lease payments at December 31, 2009 are as follows: Total minimum lease payments Less: Amount representing interest (4,409 ) Present value of net minimum lease payments Less: Current portion Add: Remaining liability at end of build-to-suit lease Capital leases obligations, less current portion Future minimum payments under all remaining non-cancelable operating leases are payable as follows: Note 13 — Fair Value of Financial Instruments Effective January 1, 2008, the Company adopted the accounting guidance for fair value measurements and disclosures for its financial assets and liabilities. The new guidance establishes a new framework for measuring fair value and expands disclosure requirements. In addition, the new guidance defines fair value as the price that would be received to sell an asset, or paid to transfer a liability (exit price), in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Under the new guidance, valuation techniques are based on observable or unobservable inputs. Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect the Company’s market assumptions. These two types of inputs have created the following fair value hierarchy: • Level 1 — Quoted prices for identical instruments in active markets. • Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which significant value drivers are observable. • Level 3 — Valuations derived from valuation techniques in which significant value drivers are unobservable. The guidance requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. As of December 31, 2009, financial instruments include $13.3 million of cash and cash equivalents, restricted assets of $24.7 million, the $5.0 million revolver, the $97.2 million senior secured credit facility, the $54.6 million senior unsecured notes, $0.3 million of warrants, $9.6 million in CVRs, and the $1.0 million interest rate swap contract. As of December 31, 2008, the financial instruments include $2.4 million of cash and cash equivalents, the $5.0 million revolver, the $102.8 million senior secured credit facility, the $52.3 million senior unsecured notes and the $2.4 million interest rate swap contract. The fair market values of cash equivalents and the restricted assets are equal to their carrying value as these investments are recorded based on quoted market prices and/or other market data for the same or comparable instruments and transactions as of the end of the reporting period. The fair value of the revolver is equal to its carrying value due to the short-term nature of the instrument and the interest rate being variable. The fair market value of the senior credit facility and senior unsecured notes are subject to market conditions; however, a limited trading market restricts the ability to freely trade the debt. The senior credit facility bears interest at a variable rate and management believes that the carrying value of the senior credit facility approximates its fair value. The fair value of the interest rate swap is obtained from a third-party valuation. This value represents the estimated amount the Company would receive or pay to terminate the agreement taking into consideration current interest rates. This estimate was determined using a discounted cash flows model predicated upon observable market inputs, primarily forward LIBOR rates from a yield curve derived from market data. Assets and liabilities measured at fair value on a recurring basis are as follows: Fair Value at Reporting Date Using Quoted Prices in Active Significant Markets for Other Significant Year Ended Identical Observable Unobservable Total (in thousands) December 31, Assets Inputs Inputs Gains Description 2009 (Level 1) (Level 2) (Level 3) (Losses) Restricted Assets Money Market $ 24,686 $ 24,686 $ — $ — $ — 280 — 280 — 1 992 — 992 — 1,390 CVRs 9,617 — — 9,617 — $ 2,382 $ — $ 2,382 $ — $ (848 ) The fair value of the interest rate swap is obtained from a third-party valuation. This value represents the estimated amount the Company would receive or pay to terminate the agreement taking into consideration current interest rates. This estimate was determined using a discounted cash flows model predicated upon observable market inputs, primarily forward LIBOR rates from a yield curve derived from market data. The warrant was valued as described in Note 17 below. The CVRs were valued as described in Note 4 above. Assets and liabilities measured at fair value on a non-recurring basis are as follows: Quoted Prices in Significant Year Ended Active Markets for Significant Other Unobservable (in thousands) December 31, Identical Assets Observable Inputs Inputs Total Gains $ 151,915 $ 151,915 $ (9,105 ) $ 116,373 $ — $ — $ 116,373 $ (75,966 ) In accordance with the provisions in the accounting guidance for intangibles—goodwill and other, for the year ended December 31, 2009, goodwill with a carrying amount of $161.0 million was written down to its implied fair value of $151.9 million, resulting in an impairment charge of $9.1 million, which was included in earnings for the period. Also, for the year ended December 31, 2008, goodwill with a carrying amount of $192.3 million was written down to its implied fair value of $116.3 million, resulting in an impairment charge of $76.0 million, which was included in earnings for the period. The table below sets forth a summary of changes in the estimated fair value of the Company’s Level 3 financial assets and liabilities measured on a recurring basis as of December 31, 2009. Fair Value Measurements Using Inputs (Level 3) (in thousands) CVRs Beginning balance Initial valuation of obligation Gains(losses) for the period included in earnings attributable to the change in unrealized gains or losses related to liabilities still held as of December 31, 2009 Note 14 — Debt Long-term debt consists of the following: $128.0 million of floating rate senior secured notes due April 11, 2013, interest payable quarterly $ 97,169 $ 102,760 $64.2 million of 13.75% senior unsecured notes due April 11, 2014, interest payable quarterly Less: Current portion of long-term debt Total long-term debt Permanent Waiver As a result of the Embezzlement Matter and the relevant investigation, the Company was unable to issue its 2007 financial statements until after April 14, 2008, causing a financial reporting default under the senior secured credit facility (the “Senior Facility”) and Senior Unsecured Notes Agreement. Pursuant to waivers entered into among the Company, the administrative agent under the Senior Facility, and the required lenders, and waivers entered into among the Company, the administrative agent under the Senior Unsecured Notes Agreement, and the required noteholders on May 20, 2008, the required lenders under the Senior Facility and the required noteholders under the Senior Unsecured Note Agreement each temporarily waived the financial reporting defaults, and extended the date upon which the Company was required to deliver the relevant financial reports until August 15, 2008. During the period of temporary waiver, interest on the senior secured loans made pursuant to the Senior Facility and Senior Unsecured Notes was calculated at 2% higher than the original rate, as called for in the agreements. The additional interest for the Senior Unsecured Notes was added to the principal of the notes and is payable at maturity. While in default, including the period of temporary waiver, the Company was prohibited from borrowing against the revolving loans made pursuant to the Senior Facility. In order to assist the Company in meeting its seasonal, short-term financing requirements, three members of the Company made unsecured loans to the Company totaling $7.0 million, payable October 11, 2014, with interest at 14% per year, payable quarterly beginning June 30, 2008. On August 22, 2008, the Company entered into a Permanent Waiver and Amendment (“Permanent Waiver”) with its Senior Facility and Senior Unsecured Notes lenders. Under the terms and conditions of the Permanent Waiver, the lenders waived the default arising from the embezzlement and resulting financial reporting default, and agreed to other terms and conditions further described in this note. The EBITDA definition in the credit agreement, as amended, was modified to include adjustments related to losses and expenses incurred as a result of the Embezzlement Matter. The Permanent Waiver required the Company to pay an amendment fee and increased the interest rate on the Senior Facility and Senior Unsecured Notes. In connection with the Permanent Waiver, the $7.0 million in unsecured loans described above were converted to capital stock on June 30, 2008. Deferred financing costs were capitalized in other assets, net of accumulated amortization, and were amortized over the term of the related debt using the effective interest method. In connection with the successor financings above, the Company incurred $5.9 million in financing costs. Capitalized deferred financing costs at August 22, 2008 (date of Permanent Waiver) and at December 31, 2007 were $4.6 million and $5.2 million, respectively. In accordance with the accounting guidance for modifications or exchanges of debt instruments, the modifications to the Senior Facility and Senior Unsecured Notes resulting from the Permanent Waiver were analyzed to determine whether the refinancing would be recorded as an extinguishment of debt or a modification of debt. Based upon this analysis, it was determined that the modification qualified as extinguishment of debt, with associated unamortized deferred financing costs and amendment fees included in debt extinguishment gain or loss. The Company recognized a total pre-tax charge of $5.6 million consisting of deferred financing costs of $4.6 million and amendment fees of $1.0 million, recorded as loss on extinguishment of debt in the accompanying Consolidated Statement of Operations. Senior Secured Credit Facility On April 12, 2007, Cambium Learning entered into the $158 million Senior Facility with several banks for which the Company is a guarantor. The Senior Facility was comprised of a $30 million revolving credit agreement (the “Revolver”) and a $128 million loan agreement. The Senior Facility, including the Revolver for which Cambium pays annual commitment fees, expires on April 11, 2013. The Senior Facility is collateralized by all of Cambium’s personal property. Under the original agreement, the interest rate on the Senior Facility was based upon either the one-, three- or six-month LIBOR rate plus 2.75%. The loan agreement requires quarterly principal payments of $0.3 million. Due to the Permanent Waiver, the interest rate on the Senior Facility is now based on one-, three- or six-month LIBOR or ABR rate plus a spread as determined by the Company’s credit ratings. Based on ratings as of year end 2009, the spread is LIBOR plus 6.50%. The Permanent Waiver also places a floor on the two rates. The LIBOR rate will not be less than 3.00%, and the ABR rate will not be less than 4.00%. As of December 31, 2009, the interest rate on the Senior Facility was 9.5%. As of December 31, 2009, Cambium had borrowings of $5.0 million under the Revolver, and subject to certain borrowing base capacity limitations for outstanding letters of credit, had $23.5 million available to borrow. At December 31, 2009, the interest rate on the Revolver was 9.5%. On August 27, 2008, in accordance with the terms of the Permanent Waiver, $23.0 million was used to prepay the Tranche B Loans of the Senior Facility. In addition, proceeds from the recovery of the embezzled funds have been and will be used to make prepayments on the Senior Facility. In the first quarter of 2010, the Company’s credit ratings were upgraded by Standard & Poor’s and Moody’s Investor Services. As a result of the credit rating upgrades, the spread for LIBOR decreased from 6.5% to 5.0%, with a continued LIBOR floor of 3.0%, and the effective interest rate became 8.0%. Senior Unsecured Notes On April 12, 2007, Cambium Learning entered into a Note Purchase Agreement and sold 11.75% notes due April 11, 2014 (the “Senior Unsecured Notes”), generating gross proceeds of $50 million, in a private placement. The Senior Unsecured Notes are guaranteed by the Company and pay cash interest equal to 10.0% on a quarterly basis. Any additional interest beyond the 10% rate is added to the principal of the notes and is not payable until April 11, 2014. The initial interest rate on the senior unsecured notes was 11.75% per annum. That rate was increased by 200 basis points in connection with the negotiation of the Permanent Waiver and credit agreement amendments in 2008 and was increased by an additional 50 basis points as of March 31, 2009 by virtue of Cambium’s total leverage ratio (as defined under the senior unsecured notes) exceeding 5.5 to 1 as of March 31, 2009; however, as a result of the merger with VLCY, the total leverage ratio fell below 5.5 to 1 and the rate was decreased by 50 basis points. Thus, as of December 31, 2009, the interest rate on the subordinated notes was 13.75% per annum. Assuming the all-in interest rate on the senior unsecured notes remains at 13.75% until April 11, 2014, the value of these notes, including accrued interest, will be $64.2 million. Covenants under the Senior Facility and Senior Unsecured Notes The Senior Facility includes a financial covenant which is a total leverage ratio. The ratio is calculated quarterly using an adjusted EBITDA, which is defined as earnings before interest paid, taxes, depreciation, and amortization, and other adjustments allowed under the terms of the agreement, on a rolling 12-month basis. It also contains customary covenants, including limitations on Cambium Learning’s ability to incur debt, and events of default as defined by the agreement. The Senior Facility also limits Cambium Learning’s ability to pay dividends, to make advances, and otherwise engage in

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QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended October 30, 2021 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Ollie’s Bargain Outlet Holdings, Inc. (State or other jurisdiction of incorporation) (IRS Employer Identification No.) 6295 Allentown Boulevard (Registrant’s telephone number, including area code) Trading Symbol Common Stock, $0.001 par value The NASDAQ Stock Market LLC Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☒ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☐ Emerging growth company ☐ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ The number of shares of the registrant’s common stock, $0.001 par value, outstanding as of December 2, 2021 was 63,125,090. PART I - FINANCIAL INFORMATION Condensed Consolidated Financial Statements (unaudited) Unaudited Condensed Consolidated Statements of Income for the thirteen and thirty-nine weeks ended October 30, 2021 and October 31, 2020 Unaudited Condensed Consolidated Balance Sheets as of October 30, 2021, October 31, 2020 and January 30, 2021 Unaudited Condensed Consolidated Statements of Stockholders’ Equity for the thirteen and thirty-nine weeks ended October 30, 2021 and October 31, 2020 Unaudited Condensed Consolidated Statements of Cash Flows for the thirty-nine weeks ended October 30, 2021 and October 31, 2020 Notes to Unaudited Condensed Consolidated Financial Statements Management’s Discussion and Analysis of Financial Condition and Results of Operations PART II - OTHER INFORMATION Item 1A. Unregistered Sales of Equity Securities and Use of Proceeds Defaults Upon Senior Securities ITEM 1 – CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) OLLIE’S BARGAIN OUTLET HOLDINGS, INC. AND SUBSIDIARIES Condensed Consolidated Statements of Income (In thousands, except per share amounts) Thirteen weeks ended Thirty-nine weeks ended Depreciation and amortization expenses Pre-opening expenses Interest expense (income), net Earnings per common share: Weighted average common shares outstanding: See accompanying notes to the condensed consolidated financial statements. Prepaid expenses and other assets Property and equipment, net of accumulated depreciation of $116,088, $93,361 and $98,627, respectively Income taxes payable Current portion of operating lease liabilities Accrued expenses and other Long-term operating lease liabilities Preferred stock - 50,000 shares authorized at $0.001 par value; no shares issued Common stock - 500,000 shares authorized at $0.001 par value; 66,454, 66,117 and 66,165 shares issued, respectively Treasury - common stock, at cost; 3,382, 698 and 702 shares, respectively Condensed Consolidated Statements of Stockholders’ Equity Thirteen weeks ended October 30, 2021 and October 31, 2020 paid-in Retained stockholders’ Balance as of July 31, 2021 Proceeds from stock options exercised Vesting of restricted stock Common shares withheld for taxes Shares repurchased Balance as of October 30, 2021 Balance as of August 1, 2020 Thirty-nine weeks ended October 30, 2021 and October 31, 2020 Balance as of January 30, 2021 Balance as of February 1, 2020 Depreciation and amortization of property and equipment Amortization of debt issuance costs (Gain) loss on sale of assets Deferred income tax provision Accrued expenses and other liabilities Proceeds from sale of property and equipment Repayments on finance leases Proceeds from stock option exercises Payment for shares repurchased Net cash (used in) provided by financing activities Cash and cash equivalents at the beginning of the period Cash and cash equivalents at the end of the period Supplemental disclosure of cash flow information: Cash paid during the period for: Non-cash investing activities: Accrued purchases of property and equipment Notes to Condensed Consolidated Financial Statements October 30, 2021 and October 31, 2020 Organization and Summary of Significant Accounting Policies Description of Business Ollie’s Bargain Outlet Holdings, Inc. and subsidiaries (collectively referred to as the “Company” or “Ollie’s”) principally buys overproduced, overstocked, and closeout merchandise from manufacturers, wholesalers and other retailers. In addition, the Company augments its name-brand closeout deals with directly sourced private label products featuring names exclusive to Ollie’s in order to provide consistently value-priced goods in select key merchandise categories. Since its first store opened in 1982, the Company has grown to 426 retail locations in 29 states as of October 30, 2021. Ollie’s Bargain Outlet retail locations are located in Alabama, Arkansas, Connecticut, Delaware, Florida, Georgia, Illinois, Indiana, Kansas, Kentucky, Louisiana, Maryland, Massachusetts, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Ohio, Oklahoma, Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Vermont, Virginia and West Virginia. Ollie’s follows a 52/53-week fiscal year, which ends on the Saturday nearer to January 31 of the following calendar year. References to the thirteen weeks ended October 30, 2021 and October 31, 2020 refer to the thirteen weeks from August 1, 2021 to October 30, 2021 and from August 2, 2020 to October 31, 2020, respectively. References to year-to-date periods ended October 30, 2021 and October 31, 2020 refer to the thirty-nine weeks from January 31, 2021 to October 30, 2021 and from February 2, 2020 to October 31, 2020, respectively. References to “2020” refer to the fiscal year ended January 30, 2021 and references to “2021” refer to the fiscal year ending January 29, 2022. Both periods consist of 52 weeks. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and applicable rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. The condensed consolidated financial statements reflect all normal recurring adjustments which management believes are necessary to present fairly the Company’s results of operations, financial condition, and cash flows for all periods presented. The condensed consolidated balance sheets as of October 30, 2021 and October 31, 2020, and the condensed consolidated statements of income and stockholders’ equity for the thirteen and thirty-nine weeks ended October 30, 2021 and October 31, 2020, and the condensed consolidated statements of cash flows for the thirty-nine weeks ended October 30, 2021 and October 31, 2020 have been prepared by the Company and are unaudited. The Company’s business is seasonal in nature and results of operations for the interim periods presented are not necessarily indicative of operating results for 2021 or any other period. All intercompany accounts, transactions, and balances have been eliminated in consolidation. The Company’s balance sheet as of January 30, 2021, presented herein, has been derived from the audited balance sheet included in the Company’s Annual Report on Form 10-K filed with the SEC on March 24, 2021 (“Annual Report”), but does not include all disclosures required by GAAP. These financial statements should be read in conjunction with the financial statements for 2020 and footnotes thereto included in the Annual Report. For purposes of the disclosure requirements for segments of a business enterprise, it has been determined that the Company is comprised of one operating segment. Use of Estimates The preparation of condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Fair Value Disclosures Fair value is defined as the price which the Company would receive to sell an asset or pay to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. In determining fair value, GAAP establishes a three-level hierarchy used in measuring fair value, as follows: Level 1 inputs are quoted prices available for identical assets and liabilities in active markets. Level 2 inputs are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets and liabilities in active markets or other inputs which are observable or can be corroborated by observable market data. Level 3 inputs are less observable and reflect the Company’s assumptions. The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable and its credit facilities. The carrying amount of cash and cash equivalents, accounts receivable and accounts payable approximates fair value because of their short maturities. The carrying amount of the Company’s credit facilities approximates its fair value because the interest rates are adjusted regularly based on current market conditions. Impact of the Novel Coronavirus (“COVID-19”) The outbreak of the novel coronavirus COVID-19, which was declared a global pandemic by the World Health Organization on March 11, 2020, has led to adverse impacts on the U.S. and global economies. The outbreak of COVID-19 and related measures to quell the outbreak have impacted the Company’s inventory supply chain, operations and customer demand. The Company is continuing to experience labor pressures in its stores and distribution centers as well as supply chain disruptions due to the ongoing impacts of COVID-19 and related measures. The COVID-19 pandemic could further affect the Company’s operations and the operations of its suppliers and vendors as a result of continuing or renewed restrictions and limitations on travel, limitations on store or facility operations up to and including closures, and other governmental, business or consumer actions. The extent to which the COVID-19 pandemic will impact the Company’s operations, liquidity or financial results in subsequent periods is uncertain, but such impact could be material. Ollie’s recognizes retail sales in its stores when merchandise is sold and the customer takes possession of merchandise. Also included in net sales is revenue allocated to certain redeemed discounts earned via the Ollie’s Army loyalty program and gift card breakage. Net sales are presented net of returns and sales tax. The Company provides an allowance for estimated retail merchandise returns based on prior experience. Revenue is deferred for the Ollie’s Army loyalty program where members accumulate points that can be redeemed for discounts on future purchases. The Company has determined it has an additional performance obligation to Ollie’s Army members at the time of the initial transaction. The Company allocates the transaction price to the initial transaction and the discount awards based upon its relative standalone selling price, which considers historical redemption patterns for the award. Revenue is recognized as those discount awards are redeemed. Discount awards issued upon the achievement of specified point levels are subject to expiration. Unless temporarily extended, the maximum redemption period is 45 days. At the end of each fiscal period, unredeemed discount awards and accumulated points to earn a future discount award are reflected as a liability. Discount awards are combined in one homogeneous pool and are not separately identifiable. Therefore, the revenue recognized consists of discount awards redeemed that were included in the deferred revenue balance at the beginning of the period as well as discount awards issued during the current period. The following table is a reconciliation of the liability related to this program (in thousands): Beginning balance Revenue deferred Revenue recognized Gift card breakage for gift card liabilities not subject to escheatment is recognized as revenue in proportion to the redemption of gift cards. Gift cards do not expire. The rate applied to redemptions is based upon a historical breakage rate. Gift cards are combined in one homogenous pool and are not separately identifiable. Therefore, the revenue recognized consists of gift cards that were included in the liability at the beginning of the period as well as gift cards that were issued during the period. The following table is a reconciliation of the gift card liability (in thousands): Gift card issuances Gift card redemption and breakage Earnings per Common Share Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding. Diluted earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding after giving effect to the potential dilution, if applicable, from the assumed exercise of stock options into shares of common stock as if those stock options were exercised and the assumed lapse of restrictions on restricted stock units. The following table summarizes those effects for the diluted earnings per common share calculation (in thousands, except per share amounts): Weighted average number of common shares outstanding - Basic Incremental shares from the assumed exercise of outstanding stock options and vesting of restricted stock units Weighted average number of common shares outstanding - Diluted Earnings per common share - Basic Earnings per common share - Diluted The effect of the weighted average assumed exercise of stock options outstanding totaling 408,514 and 186,270 for the thirteen weeks ended October 30, 2021 and October 31, 2020, respectively, and 379,657 and 368,237 for the thirty-nine weeks ended October 30, 2021 and October 31, 2020, respectively, were excluded from the calculation of diluted weighted average common shares outstanding because the effect would have been antidilutive. The effect of weighted average non-vested restricted stock units outstanding totaling 43,159 and 394 for the thirteen weeks ended October 30, 2021 and October 31, 2020, respectively and 14,386 and 16,062 for the thirty-nine weeks ended October 30, 2021 and October 31, 2020, respectively, were excluded from the calculation of diluted weighted average common shares outstanding because the effect would have been antidilutive. The Company accounts for leases in accordance with Accounting Standards Update (“ASU”) 2016-02, Leases, which was adopted as of February 3, 2019. Pursuant to the adoption of the new standard, the Company elected the practical expedients upon transition that did not require it to reassess existing contracts to determine if they contain leases under the new definition of a lease, or to reassess historical lease classification or initial direct costs. The Company also adopted the practical expedient to not separate lease and non-lease components for new leases after adoption of the new standard. In addition, the Company applied a policy election to exclude leases with an initial term of 12 months or less from balance sheet recognition. The Company did not adopt the hindsight practical expedient and, therefore, will continue to utilize lease terms determined under previous lease guidance for leases existing at the date of adoption that are not subsequently modified. Ollie’s generally leases its stores, offices and distribution facilities under operating leases that expire at various dates through 2034. These leases generally provide for fixed annual rentals; however, several provide for minimum annual rentals plus contingent rentals based on a percentage of annual sales. A majority of the Company’s leases also require a payment for all or a portion of common-area maintenance, insurance, real estate taxes, water and sewer costs and repairs, on a fixed or variable payment basis, the cost of which, for leases existing as of the adoption of ASU 2016-02, is charged to the related expense category rather than being accounted for as rent expense. For leases entered into after the adoption of ASU 2016-02, the Company accounts for lease components together with non-lease components as a single component for all classes of underlying assets. Most of the leases contain options to renew for three to five successive five-year periods. The Company is generally not reasonably certain to exercise renewal options; therefore, the options are not considered in determining the lease term, and associated potential option payments are excluded from the lease payments. Ollie’s lease agreements generally do not contain any material residual value guarantees or material restrictive covenants. Store and office lease costs are classified in selling, general and administrative expenses and distribution center lease costs are classified in cost of sales on the condensed consolidated statements of income. The following table summarizes the maturity of the Company’s operating lease liabilities by fiscal year as of October 30, 2021 (in thousands): Thereafter Total undiscounted lease payments (1) Less: Imputed interest Total lease obligations Less: Current obligations under leases Long-term lease obligations Lease obligations exclude $36.0 million of minimum lease payments for leases signed, but not commenced. The following table summarizes other information related to the Company’s operating leases as of and for the respective periods (dollars in thousands): Cash paid for operating leases Operating lease cost Variable lease cost Non-cash right-of-use assets obtained in exchange for lease obligations Weighted-average remaining lease term Weighted-average discount rate Marketing Commitment The Company has entered into an agreement with Valassis Communications, Inc. for marketing services. This agreement has a guaranteed spend commitment of $23.0 million over a two-year period ending May 28, 2022. Related Party Leases The Company has entered into five non-cancelable operating leases with related parties for office and store locations that expire at various dates through 2033. Ollie’s made $1.2 million in rent payments to such related parties during each of the thirty-nine weeks ended October 30, 2021 and October 31, 2020. The lease payments are included in the operating lease disclosures stated above. From time to time the Company may be involved in claims and legal actions that arise in the ordinary course of its business. The Company cannot predict the outcome of any litigation or suit to which it is a party. However, the Company does not believe that an unfavorable decision of any of the current claims or legal actions against it, individually or in the aggregate, will have a material adverse effect on its financial position, results of operations, liquidity or capital resources. Accrued expenses and other consists of the following (in thousands): Sales and use taxes Debt Obligations and Financing Arrangements Long-term debt consists of finance leases as of October 30, 2021, October 31, 2020 and January 30, 2021. The Company’s credit facility (the “Credit Facility”) provides for a five-year $100.0 million revolving credit facility, which includes a $45.0 million sub-facility for letters of credit and a $25.0 million sub-facility for swingline loans (the “Revolving Credit Facility”). Loans under the Revolving Credit Facility mature on May 22, 2024. In addition, the Company may at any time add term loan facilities or additional revolving commitments up to $150.0 million pursuant to terms and conditions set out in the Credit Facility. The interest rates for the Credit Facility are calculated as follows: for Base Rate Loans, the higher of the Prime Rate, the Federal Funds Effective Rate plus 0.50% or the Eurodollar Rate plus 1.0%, plus the Applicable Margin, or, for Eurodollar Loans, the Eurodollar Rate plus the Applicable Margin. The Applicable Margin will vary from 0.00% to 0.50% for a Base Rate Loan and 1.00% to 1.50% for a Eurodollar Loan, based on availability under the Credit Facility. The Eurodollar Rate is subject to a 0% floor. Under the terms of the Revolving Credit Facility, as of October 30, 2021, the Company could borrow up to 90.0% of the most recent appraised value (valued at cost, discounted for the current net orderly liquidation value) of its eligible inventory, as defined, up to $100.0 million. As of October 30, 2021, the Company had no outstanding borrowings under the Revolving Credit Facility, with $86.4 million of borrowing availability, outstanding letters of credit commitments of $13.4 million and $0.2 million of rent reserves. The Revolving Credit Facility also contains a variable unused line fee ranging from 0.125% to 0.250% per annum. The Credit Facility is collateralized by the Company’s assets and equity and contains a financial covenant, as well as certain business covenants, including restrictions on dividend payments, which the Company must comply with during the term of the agreement. The financial covenant is a consolidated fixed charge coverage ratio test of at least 1.0 to 1.0 applicable during a covenant period, based on reference to availability. The Company was in compliance with all terms of the Credit Facility during the thirty-nine weeks ended October 30, 2021. The provisions of the Credit Facility restrict all of the net assets of the Company’s consolidated subsidiaries, which constitutes all of the net assets on the Company’s condensed consolidated balance sheet as of October 30, 2021, from being used to pay any dividends or make other restricted payments to the Company without prior written consent from the financial institutions that are a party to the Credit Facility, subject to material exceptions including proforma compliance with the applicable conditions described in the Credit Facility. The provision for income taxes is based on the current estimate of the annual effective tax rate and is adjusted as necessary for discrete events occurring in a particular period. The effective tax rates for the thirteen weeks and thirty-nine weeks ended October 30, 2021 were 23.1% and 23.3%, respectively. The effective tax rates during the thirteen and thirty-nine weeks ended October 31, 2020 were 21.9% and 7.8%, respectively. The effective tax rates during the thirteen and thirty-nine weeks ended October 30, 2021 were affected by excess tax benefits related to stock-based compensation of $1.0 million and $3.4 million, respectively. The thirteen and thirty-nine weeks ended October 31, 2020 included a similar discrete tax benefit of $2.0 million and $33.8 million, respectively. The tax benefit during the thirty-nine weeks ended October 31, 2020 is primarily due to the exercise of stock options by the estate of a former executive of the Company. Equity Incentive Plans During 2012, Ollie’s established an equity incentive plan (the “2012 Plan”), under which stock options were granted to executive officers and key employees as deemed appropriate under the provisions of the 2012 Plan, with an exercise price at the fair value of the underlying stock on the date of grant. The vesting period for options granted under the 2012 Plan is five years (20% ratably per year). Options granted under the 2012 Plan are subject to employment for vesting, expire 10 years from the date of grant and are not transferable other than upon death. As of July 15, 2015, the date of the pricing of the Company’s initial public offering, no additional equity grants will be made under the 2012 Plan. In connection with its initial public offering, the Company adopted the 2015 equity incentive plan (the “2015 Plan”) pursuant to which the Company’s Board of Directors may grant stock options, restricted shares or other awards to employees, directors and consultants. The 2015 Plan allows for the issuance of up to 5,250,000 shares. Awards will be made pursuant to agreements and may be subject to vesting and other restrictions as determined by the Board of Directors or the Compensation Committee of the Board. The Company uses authorized and unissued shares to satisfy share award exercises. As of October 30, 2021, there were 2,636,926 shares available for grant under the 2015 Plan. The exercise price for stock options is determined at the fair value of the underlying stock on the date of grant. The vesting period for awards granted under the 2015 Plan is generally set at four years (25% ratably per year). Awards are subject to employment for vesting, expire 10 years from the date of grant, and are not transferable other than upon death. A summary of the Company’s stock option activity and related information for the thirty-nine weeks ended October 30, 2021 follows: of options Outstanding at January 30, 2021 Forfeited Exercised Outstanding at October 30, 2021 Exercisable at October 30, 2021 The weighted average grant date fair value per option for options granted during the thirty-nine weeks ended October 30, 2021 and October 31, 2020 was $33.80 and $13.13, respectively. The fair value of each option award is estimated on the date of grant using the Black-Scholes option-pricing model that used the weighted average assumptions in the following table: Risk-free interest rate Expected dividend yield Expected life (years) Expected volatility The expected life of stock options is estimated using the “simplified method,” as the Company does not have sufficient historical information to develop reasonable expectations about future exercise patterns and post-vesting employment termination behavior for its stock option grants. The simplified method is based on the average of the vesting tranches and the contractual life of each grant. For stock price volatility, the Company uses its historical information since its initial public offering as well as comparable public companies as a basis for its expected volatility to calculate the fair value of option grants. The risk-free interest rate is based on U.S. Treasury notes with a term approximating the expected life of the option. Restricted Stock Units Restricted stock units (“RSUs”) are issued at a value not less than the fair value of the common stock on the date of the grant. RSUs outstanding vest ratably over four years or cliff vest in one or four years. Awards are subject to employment for vesting and are not transferable other than upon death. A summary of the Company’s RSU activity and related information for the thirty-nine weeks ended October 30, 2021 is as follows: of shares grant date fair value Non-vested balance at January 30, 2021 Non-vested balance at October 30, 2021 The compensation cost for stock options and RSUs which have been recorded within selling, general and administrative expenses related to the Company’s equity incentive plans was $1.6 million and $1.7 million for the thirteen weeks ended October 30, 2021 and October 31, 2020, respectively, and $6.0 million and $4.8 million for the thirty-nine weeks ended October 30, 2021 and October 31, 2020, respectively. As of October 30, 2021, there was $18.9 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements. That cost is expected to be recognized over a weighted average period of 2.8 years. Compensation costs related to awards are recognized using the straight-line method. The Company’s capital structure consists of a single class of common stock with one vote per share. The Company has authorized 500,000,000 shares at $0.001 par value per share. Additionally, the Company has authorized 50,000,000 shares of preferred stock at $0.001 par value per share; to date, however, no preferred shares have been issued. Treasury stock, which consists of the Company’s common stock, is accounted for using the cost method. Share Repurchase Program On December 15, 2020, the Board of Directors of the Company authorized the repurchase of up to $100.0 million of shares of the Company’s common stock. On March 16, 2021, the Board of Directors of the Company authorized an increase of $100.0 million in the Company’s share repurchase program. Both of these authorizations are authorized to be executed through January 2023. Shares under both authorizations may be purchased from time to time in open market transactions (including blocks), privately negotiated transactions, accelerated share repurchase programs or other derivative transactions, issuer self-tender offers or any combination of the foregoing. The timing of repurchases and the actual amount purchased will depend on a variety of factors, including the market price of the Company’s shares, general market, economic and business conditions, and other corporate considerations. In addition, the authorizations are subject to extension or earlier termination by the Board of Directors at any time. During the thirty-nine weeks ended October 30, 2021, the Company repurchased 2,679,507 shares of its common stock for $200.0 million, inclusive of transaction costs, pursuant to its share repurchase program. These expenditures were funded by cash generated from operations. As of October 30, 2021, the Company had $33,000 remaining under its share repurchase authorization. There can be no assurance that any additional repurchases will be completed, or as to the timing or amount of any repurchases. The share repurchase program may be discontinued at any time. See Note 10 for additional information. Subsequent Event On November 30, 2021, the Board of Directors of the Company authorized an additional $200.0 million to repurchase stock pursuant to the Company’s share repurchase program, expiring on December 15, 2023, subject to extension or earlier termination by the Board of Directors at any time. See Note 9 for additional information. The following discussion and analysis of the financial condition and results of our operations should be read together with the financial statements and related notes of Ollie’s Bargain Outlet Holdings, Inc. included in Item 1 of this Quarterly Report on Form 10-Q and with our audited financial statements and the related notes included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on March 24, 2021 (“Annual Report”). As used in this Quarterly Report on Form 10-Q, except where the context otherwise requires or where otherwise indicated, the terms “Ollie’s,” the “Company,” “we,” “our” and “us” refer to Ollie’s Bargain Outlet Holdings, Inc. and subsidiaries. We operate on a fiscal calendar widely used by the retail industry that results in a fiscal year consisting of a 52- or 53-week period ending on the Saturday nearer to January 31 of the following year. References to “2021” refer to the 52-week period of January 31, 2021 to January 29, 2022. References to “2020” refer to the 52-week period of February 2, 2020 to January 30, 2021. References to the “third quarter of fiscal 2021” and the “third quarter of fiscal 2020” refer to the thirteen weeks of August 1, 2021 to October 30, 2021 and August 2, 2020 to October 31, 2020, respectively. Year-to-date periods ended October 30, 2021 and October 31, 2020 refer to the thirty-nine weeks of January 31, 2021 to October 30, 2021 and February 2, 2020 to October 31, 2020, respectively. Historical results are not necessarily indicative of the results to be expected for any future period and results for any interim period may not necessarily be indicative of the results that may be expected for a full year. This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as “could,” “may,” “might,” “will,” “likely,” “anticipates,” “intends,” “plans,” “seeks,” “believes,” “estimates,” “expects,” “continues,” “projects” and similar references to future periods, prospects, financial performance and industry outlook. Forward-looking statements are based on our current expectations and assumptions regarding our business, the economy and other future conditions. Because forward-looking statements relate to the future, by their nature, they are subject to inherent uncertainties, risks and changes in circumstances that are difficult to predict. As a result, our actual results may differ materially from those contemplated by the forward-looking statements. Important factors that could cause actual results to differ materially from those in the forward-looking statements include regional, national or global political, economic, business, competitive, market and regulatory conditions, including, but not limited to, legislation, national trade policy, and the following: our failure to adequately procure and manage our inventory or anticipate consumer demand; changes in consumer confidence and spending; risks associated with our status as a “brick and mortar” only retailer; risks associated with intense competition; our failure to open new profitable stores, or successfully enter new markets, on a timely basis or at all; the risks associated with doing business with international manufacturers and suppliers including, but not limited to, transportation and shipping challenges, and potential increases in tariffs on imported goods; outbreak of viruses or widespread illness, including the continued impact of COVID-19 and continuing or renewed regulatory responses thereto; our inability to operate our stores due to civil unrest and related protests or disturbances; our failure to properly hire and to retain key personnel and other qualified personnel; our inability to obtain favorable lease terms for our properties; the failure to timely acquire, develop and open, the loss of, or disruption or interruption in the operations of, our centralized distribution centers; fluctuations in comparable store sales and results of operations, including on a quarterly basis; risks associated with our lack of operations in the growing online retail marketplace; risks associated with litigation, the expense of defense, and potential for adverse outcomes; our inability to successfully develop or implement our marketing, advertising and promotional efforts; the seasonal nature of our business; risks associated with the timely and effective deployment, protection, and defense of computer networks and other electronic systems, including e-mail; changes in government regulations, procedures and requirements; risks associated with natural disasters, whether or not caused by climate change; and our ability to service indebtedness and to comply with our financial covenants together with each of the other factors set forth under “Item 1A - Risk Factors” contained herein and in our filings with the SEC, including our Annual Report. Any forward-looking statement made by us in this Quarterly Report on Form 10-Q speaks only as of the date on which such statement is made. Factors or events that could cause our actual results to differ may emerge from time to time, and it is not possible for us to predict all of them. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future developments or otherwise, except as may be required by law. You are advised, however, to consult any further disclosures we make on related subjects in our public announcements and SEC filings. Ollie’s is a highly differentiated and fast-growing, extreme value retailer of brand name merchandise at drastically reduced prices. Known for our assortment of products offered as “Good Stuff Cheap,” we offer customers a broad selection of brand name products, including housewares, food, books and stationery, bed and bath, flooring, toys and hardware. Our differentiated go-to market strategy is characterized by a unique, fun and engaging treasure hunt shopping experience, compelling customer value proposition and witty, humorous in-store signage and advertising campaigns. The COVID-19 pandemic has significantly impacted the U.S. and global economies, resulting in business slowdowns or shutdowns, reduced economic activity, changes in consumer behavior, and changes in the mindset and availability of the labor force. We continue to monitor the impact of the pandemic on our business, including on our associates, customers, business partners and supply chain. We continue to take measures to protect the health and safety of our associates and customers, a primary concern of our management team. We have also taken measures to support the communities that we serve to address the challenges posed by the pandemic. Following the onset of the pandemic, our net sales initially benefited from increased consumer spending associated with federal stimulus funds for said pandemic. At this time, there is uncertainty with regard to the continuation of these stimulus measures and, as a result, there may be potential changes in consumer spending behavior or demand. In addition, we are experiencing labor pressures at both our stores and distribution centers, higher import and trucking costs, and supply chain disruptions due to the impacts of COVID-19 and related measures. We are increasing our hiring efforts in certain impacted markets and working closely with our suppliers and transportation partners to mitigate the impact of the supply chain challenges. The significance and duration of these and other potential elevated costs is uncertain, and we will continue to assess and respond to current and evolving conditions. As we continue to monitor the COVID-19 pandemic and potentially take actions based on the requirements and recommendations of federal, state and local authorities, we intend to focus on managing the business for future, long-term growth. In certain circumstances, there may be developments outside our control, including resurgences of COVID-19 and, in particular, new and more contagious or vaccine resistant variants, requiring us to refine our operations. As such, given the evolving nature of the pandemic, we cannot reasonably estimate its impact on our financial condition, results of operations or cash flows in the future. Refer to Part II, Item 1A. Risk Factors of this Form 10-Q and Part I, Item 1A. Risk Factors of our 2020 Form 10-K for a full discussion of the risks associated with the COVID-19 pandemic. Since the founding of Ollie’s in 1982, we have grown organically by backfilling existing markets and leveraging our brand awareness, marketing and infrastructure to expand into new markets in contiguous states. We have expanded to 426 stores located in 29 states as of October 30, 2021. Our stores are supported by three distribution centers, one each in York, PA, Commerce, GA and Lancaster, TX. We believe our distribution capabilities can support a range of 500 to 600 stores over the next several years. We have invested in our associates, infrastructure, distribution network and information systems to allow us to continue to rapidly grow our store footprint, including: growing our merchant buying team to increase our access to brand name/closeout merchandise; adding members to our senior management team; expanding the capacity of our distribution centers to their current 2.2 million square feet; and investing in information technology, accounting, and warehouse management systems. Our business model has produced consistent and predictable store growth over the past several years, during both strong and weaker economic cycles. We plan to continue to enhance our competitive positioning and drive growth in sales and profitability by executing on the following strategies: growing our store base; increasing our offerings of great bargains; and leveraging and expanding Ollie’s Army, our customer loyalty program. We have a proven portable, flexible and highly profitable store model that has produced consistent financial results and returns. Our new store model targets a store size between 25,000 to 35,000 square feet and an average initial cash investment of approximately $1.0 million, which includes store fixtures and equipment, store-level and distribution center inventory (net of payables) and pre-opening expenses. We target new store sales of approximately $4 million in their first full year of operations. While we are focused on driving comparable store sales and managing our expenses, our revenue and profitability growth will primarily come from opening new stores. The core elements of our business model are procuring great deals, offering extreme values to our customers and creating consistent, predictable store growth and margins. In addition, our new stores generally open strong, contributing to the growth in net sales and profitability of our business. We plan to achieve continued net sales growth, including comparable stores sales, by adding stores to our store base and by continuing to provide quality merchandise at a value for our customers as we scale and gain more access to purchase directly from major manufacturers. We also plan to leverage and expand our Ollie’s Army database marketing strategies. In addition, we plan to continue to manage our selling, general and administrative expenses (“SG&A”) by continuing to make process improvements and by maintaining our standard policy of reviewing our operating costs. Our ability to grow and our results of operations may be impacted by additional factors and uncertainties, such as consumer spending habits, which are subject to macroeconomic conditions and changes in discretionary income. Our customers’ discretionary income is primarily impacted by gas prices, wages and consumer trends and preferences, which fluctuate depending on the environment. The potential consolidation of our competitors or other changes in our competitive landscape could also impact our results of operations or our ability to grow, even though we compete with a broad range of retailers. Our key competitive advantage is our direct buying relationships with many major manufacturers, wholesalers, distributors, brokers and retailers for our brand name and closeout products and unbranded goods. We also augment our product mix with private label brands. As we continue to grow, we believe our increased scale will provide us with even greater access to brand name and closeout products as major manufacturers seek a single buyer to acquire an entire deal. How We Assess the Performance of Our Business and Key Line Items We consider a variety of financial and operating measures in assessing the performance of our business. The key measures we use are number of new stores, net sales, comparable store sales, gross profit and gross margin, SG&A, pre-opening expenses, operating income, EBITDA and Adjusted EBITDA. Number of New Stores The number of new stores reflects the number of stores opened during a particular reporting period. Before we open new stores, we incur pre-opening expenses described below under “Pre-Opening Expenses” and we make an initial investment in inventory. We also make initial capital investments in fixtures and equipment, which we amortize over time. We expect new store growth to be the primary driver of our sales growth. Our initial lease terms are approximately seven years with options to renew for three to five successive five-year periods. Our portable and predictable real estate model focuses on backfilling existing markets and entering new markets in contiguous states. Our new stores often open with higher sales levels as a result of greater advertising and promotional spend in connection with grand opening events, but decline shortly thereafter to our new store model levels. Ollie’s recognizes retail sales in its stores when merchandise is sold and the customer takes possession of the merchandise. Also included in net sales is revenue allocated to certain redeemed discounts earned via the Ollie’s Army loyalty program and gift card breakage. Net sales are presented net of returns and sales tax. Net sales consist of sales from comparable stores and non-comparable stores, described below under “Comparable Store Sales.” Growth of our net sales is primarily driven by expansion of our store base in existing and new markets. As we continue to grow, we believe we will have greater access to brand name and closeout merchandise and an increased deal selection, resulting in more potential offerings for our customers. Net sales are impacted by product mix, merchandise mix and availability, as well as promotional activities and the spending habits of our customers. Our broad selection of offerings across diverse product categories supports growth in net sales by attracting new customers, which results in higher spending levels and frequency of shopping visits from our customers, including Ollie’s Army members. The spending habits of our customers are subject to macroeconomic conditions and changes in discretionary income. Our customers’ discretionary income is primarily impacted by gas prices, wages, and consumer trends and preferences, which fluctuate depending on the environment. However, because we offer a broad selection of merchandise at extreme values, we believe we are generally less impacted than other retailers by economic cycles that correspond with declines in general consumer spending habits. We believe we also benefit from periods of increased consumer spending. Comparable store sales measure performance of a store during the current reporting period against the performance of the same store in the corresponding period of the previous year. Comparable store sales consist of net sales from our stores beginning on the first day of the sixteenth full fiscal month following the store’s opening, which is when we believe comparability is achieved. Comparable store sales are impacted by the same factors that impact net sales. We define comparable stores to be stores that: have been remodeled while remaining open; are closed for five or fewer days in any fiscal month; are closed temporarily and relocated within their respective trade areas; and have expanded, but are not significantly different in size, within their current locations. Non-comparable store sales consist of new store sales and sales for stores not open for a full 15 months. Stores which are closed temporarily, but for more than five days in any fiscal month, are included in non-comparable store sales beginning in the fiscal month in which the temporary closure begins until the first full month of operation once the store re-opens, at which time they are included in comparable store sales. Opening new stores is the primary component of our growth strategy and as we continue to execute on our growth strategy, we expect a significant portion of our sales growth will be attributable to non-comparable store sales. Accordingly, comparable store sales are only one measure we use to assess the success of our growth strategy. Gross Profit and Gross Margin Gross profit is equal to our net sales less our cost of sales. Cost of sales includes merchandise costs, inventory markdowns, shrinkage and transportation, distribution and warehousing costs, including depreciation and amortization. Gross margin is gross profit as a percentage of our net sales. Gross margin is a measure used by management to indicate whether we are selling merchandise at an appropriate gross profit. In addition, our gross margin is impacted by product mix, as some products generally provide higher gross margins, by our merchandise mix and availability, and by our merchandise cost, which can vary. Our gross profit is variable in nature and generally follows changes in net sales. We regularly analyze the components of gross profit, as well as gross margin. Specifically, our product margin and merchandise mix is reviewed by our merchant team and senior management, ensuring strict adherence to internal margin goals. Our disciplined buying approach has produced consistent gross margins and we believe helps to mitigate adverse impacts on gross profit and results of operations. The components of our cost of sales may not be comparable to the components of cost of sales or similar measures of our competitors and other retailers. As a result, our gross profit and gross margin may not be comparable to similar data made available by our competitors and other retailers. SG&A are comprised of payroll and benefits for store, field support and support center associates. SG&A also include marketing and advertising expense, occupancy costs for stores and the store support center, insurance, corporate infrastructure and other general expenses. The components of our SG&A remain relatively consistent per store and for each new store opening. The components of our SG&A may not be comparable to the components of similar measures of other retailers. Consolidated SG&A generally increase as we grow our store base and as our net sales increase. A significant portion of our expenses is primarily fixed in nature, and we expect to continue to maintain strict discipline while carefully monitoring SG&A as a percentage of net sales. We expect that our SG&A will continue to increase in future periods with future growth. Property and equipment are stated at original cost less accumulated depreciation and amortization. Depreciation and amortization expenses are calculated over the estimated useful lives of the related assets, or in the case of leasehold improvements, the lesser of the useful lives or the remaining term of the lease. Expenditures for additions, renewals, and betterments are capitalized; expenditures for maintenance and repairs are charged to expense as incurred. Depreciation and amortization are computed on the straight-line method for financial reporting purposes. Depreciation and amortization as it relates to our distribution centers is included within cost of sales on the condensed consolidated statements of income. Pre-opening expenses consist of expenses of opening new stores and distribution centers, as well as store closing costs. For opening new stores, pre-opening expenses include grand opening advertising costs, payroll expenses, travel expenses, employee training costs, rent expenses and store setup costs. Pre-opening expenses for new stores are expensed as they are incurred, which is typically within 30 to 45 days of opening a new store. For opening distribution centers, pre-opening expenses primarily include inventory transportation costs, employee travel expenses and occupancy costs. Store closing costs primarily consist of insurance deductibles, rent and store payroll. Operating income is gross profit less SG&A, depreciation and amortization and pre-opening expenses. Operating income excludes net interest income or expense and income tax expense. We use operating income as an indicator of the productivity of our business and our ability to manage expenses. EBITDA and Adjusted EBITDA EBITDA and Adjusted EBITDA are key metrics used by management and our Board to assess our financial performance. EBITDA and Adjusted EBITDA are also frequently used by analysts, investors and other interested parties to evaluate companies in our industry. We use Adjusted EBITDA to supplement U.S. generally accepted accounting principles (“GAAP”) measures of performance to evaluate the effectiveness of our business strategies, to make budgeting decisions, to evaluate our performance in connection with compensation decisions and to compare our performance against that of other peer companies using similar measures. Management believes it is useful to investors and analysts to evaluate these non-GAAP measures on the same basis as management uses to evaluate the Company’s operating results. We believe that excluding items from operating income, net income and net income per diluted share that may not be indicative of, or are unrelated to, our core operating results, and that may vary in frequency or magnitude, enhances the comparability of our results and provides a better baseline for analyzing trends in our business. We define EBITDA as net income before net interest income or expense, depreciation and amortization expenses and income taxes. Adjusted EBITDA represents EBITDA as further adjusted for non-cash stock-based compensation expense and the gain from an insurance settlement. EBITDA and Adjusted EBITDA are non-GAAP measures and may not be comparable to similar measures reported by other companies. EBITDA and Adjusted EBITDA have limitations as analytical tools, and you should not consider them in isolation or as a substitute for analysis of our results as reported under GAAP. In the future we may incur expenses or charges such as those added back to calculate Adjusted EBITDA. Our presentation of Adjusted EBITDA should not be construed as an inference that our future results will be unaffected by these items. For further discussion of EBITDA and Adjusted EBITDA and for reconciliations of net income, the most directly comparable GAAP measure, to EBITDA and Adjusted EBITDA, see “Results of Operations.” Factors Affecting the Comparability of our Results of Operations Our results over the past two years have been affected by the following factors, which must be understood in order to assess the comparability of our period-to-period financial performance and condition. Historical results are not necessarily indicative of the results to be expected for any future period. Store Openings and Closings We opened 18 new stores and temporarily closed one store due to weather-related events in the third quarter of fiscal 2021. We opened 19 new stores, including one relocated store, and re-opened a temporarily closed store in the third quarter of fiscal 2020. In connection with these store openings, relocations and closings, we incurred expenses of $3.3 million and $3.7 million for the third quarters of fiscal 2021 and fiscal 2020, respectively. We opened 41 new stores, including two relocated stores, and temporarily closed one additional store due to weather-related events in the thirty-nine weeks ended October 30, 2021. We opened 42 new stores, including one relocated store, and closed two additional stores in the thirty-nine weeks ended October 31, 2020. In connection with these store openings, relocations and closings, we incurred expenses of $8.4 million and $8.9 million for the thirty-nine weeks ended October 30, 2021 and October 31, 2020, respectively. Our business is seasonal in nature and demand is generally the highest in our fourth fiscal quarter due to the holiday sales season. To prepare for the holiday sales season, we must order and keep in stock more merchandise than we carry during other times of the year and generally engage in additional marketing efforts. We expect inventory levels, along with accounts payable and accrued expenses, to reach their highest levels in our third and fourth fiscal quarters in anticipation of increased net sales during the holiday sales season. As a result of this seasonality, and generally because of variation in consumer spending habits, we experience fluctuations in net sales and working capital requirements during the year. Because we offer a broad selection of merchandise at extreme values, we believe we are generally less impacted than other retailers by economic cycles which correspond with declines in general consumer spending habits and we believe we still benefit from periods of increased consumer spending. The following tables summarize key components of our results of operations for the periods indicated, both in dollars and as a percentage of our net sales. We derived the condensed consolidated statements of income for the thirteen and thirty-nine weeks ended October 30, 2021 and October 31, 2020 from our unaudited condensed consolidated financial statements and related notes. Our historical results are not necessarily indicative of the results that may be expected in the future. ( dollars in thousands) Condensed consolidated statements of income data: Percentage of net sales (1): Select operating data: Number of closed stores Number of stores re-opened Number of stores open at end of period Average net sales per store (2) Comparable stores sales change (15.5 Components may not add to totals due to rounding. Average net sales per store represents the weighted average of total net weekly sales divided by the number of stores open at the end of each week for the respective periods presented. The following table provides a reconciliation of our net income to Adjusted EBITDA for the periods presented: Depreciation and amortization expenses (1)

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Appreciation Week Entire SiteAP & P2PAR & O2CWebinarsWhitepapersTools & TemplatesExpert AnswersArticlesPodcasts Browse below for definitions. Click on a letter of the alphabet to jump to that section. Got a term not found here that you need defined? Tell us and we'll define it and add it to the glossary. IRS Forms 1099 are used for reporting income other than wages, tips and salaries for one calendar year to the IRS; Form 1099-MISC as it relates to accounts payable activity most commonly reports payments for services, and payments to independent contractors. See these related articles: Form 1099-MISC, Request Forms for 1099 Reporting, 1099 Planning Calendar A reduction or cancellation of an assessed tax, penalties or interest. Abatement Letter A letter written to the IRS proposing that all penalties or interest be waived. 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A fiscal year is any 12-month accounting period that a business chooses to adopt as opposed to the calendar year, which runs from January 1 to December 31. A type of short-term debt, accounts payable are amounts a business owes - bills from suppliers for goods or services purchased on credit. Accounts Payable is classified as a Current Liability because the obligation is generally due within 12 months from the initial transaction date. Amounts owed to a business that it expects to receive; includes sales made on credit. Accrual accounting has to do with the timing of recording income and expenses. In accrual accounting, income is recognized when a sale occurs and expenses are recognized when incurred (goods or services are received), rather than when cash is actually received or payment actually made (cash accounting). By recording income when it is truly earned and expenses when truly incurred, the income of a period is accurately matched to expenses of the period, giving a more accurate picture of net profits for the period than cash accounting. Accrual Basis of Accounting The opposite of cash basis of accounting; an accrual basis of accounting reports income when it is earned, rather than when it is actually received, and matches any related expenses to that same reporting timeframe. Association of Certified Fraud Examiners. A professional organization that provides anti-fraud training and education; more than 75,000 members worldwide. The ACFE certifies and governs Certified Fraud Examiners, which investigate business fraud around the world. Automated Clearing House (ACH) is a secure payment transfer system that connects all U.S. financial institutions. The ACH network acts as the central clearing facility for all Electronic Fund Transfer (EFT) transactions that occur nationwide, representing a crucial link in the national banking system. ACH payment is a type of electronic funds transfer (EFT). ACH is faster than a check but slower than wire. ACH cost is typically between $0.10 - $0.25 per transaction (compared to typically $10.00 - $30.00 for wire). Acid test ratio An indicator of a company's short-term liquidity that measures a company's ability to meet its short term obligations. Also called quick ratio and quick assets ratio. Information obtained from a company's balance sheet is used to calculate the ratio. Subtract inventories from current assets and divide the number by current liabilities. Activity-based management (ABM) A system wide, integrated approach that focuses management's attention on activities by refining and expressing an organization's resources on the activities it supports - not on what it spends. 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An aging report sorts accounts into categories based on how long they have been outstanding, e.g., 1 to 30 days, 31 to 60 days, etc. The American Institute of Certified Public Accountants is a national association for the accounting industry where part of its mission is to provide accounting professionals with uniform certification and licensing standards, establishing professional standards, and enforcing current requirements. See www.aicpa.org for further information. An allocation of money between contractual partners as a reimbursement for expenses from one to the other. American Banking Association (ABA) Founded in 1875, the American Bankers Association represents banks of all sizes and charters and is the voice for the nation's $13 trillion banking industry and its 2 million employees. For more information see About the ABA. An organization dedicated to research and education on matters related to insolvency. American National Standards Institute (ANSI) American National Standards Institute. A non-profit organization which coordinates the development and use of voluntary standards for products, services, processes, systems and personnel in the United States. ANSI developed the standards for EDI. American SAP Users Group (ASUG) A non-profit association of business and technology professionals who are SAP users. For more information see the Americas SAP Users Group The process of gradually reducing any amount in regular installments over a period of time, such as write-down of bond premium, the cost of intangible assets or periodic payment of mortgage or other debt. Analogous Article An article that is not found in freight classification but is comparable to an article that is in the classification. An attached note or graphic on an imaged document made after scanning. ANSI X12 Standards The American National Standards Institute Accredited Standards Committee’s EDI standards for the United States. AP On-Hold Instance when an invoice has been received and entered but further processing for payment is delayed until an issue is resolved. A term used to reference Additional Paid In Capital. Accredited Payables Manager. Title awarded to accounts payable managers who have completed certification exams provided by Accounts Payable & Procure-to-Pay Network and The Institute of Management & Administration. Accredited Payables Managers certification demonstrates that the individual has mastered the basics of accounts payable and has the skills required to manage an AP department. Accredited Payables Specialist. Title awarded to accounts payable employees who have completed certification exams provided by Accounts Payable & Procure-to-Pay Network and The Institute of Management & Administration. Accredited Payables Specialist certification states that the individual has demonstrated the knowledge and skill to excel in accounts payable. Imaged documents on magnetic or optical media in long-term storage for possible future access. Arms Export Control Act (AECA) Debarred List A list published by the State Department. It contains the names of individuals and entities convicted of violating or conspiring to violate the Arms Export Control Act (AECA). They are barred from directly or indirectly exporting defense articles, including technical data and defense services. Click here to access the AECA Debarred List Notification by a carrier to the consignee of the arrival of a shipment. American Standard Code for Information Interchange. ASCII is character encoding technology based on the English Alphabet. ASCII is capable of understanding and communicating letters, numbers and some symbols between digital devices; it is a commonly used system in entering data into a computer system for accounting software, document management, audit and other purposes. Advanced Shipping Notice. A notice of a pending delivery sent by the shipper of a supply to the recipient. The ASN is based on information in the purchase order or a contract. When using an ASN, the price of the goods has already been determined. Application Service Provider. A business that provides computer-based services to customers over the Internet. Customers can access the services, which can include Web invoicing, automatic purchasing and expense management applications, online any time. ASPs are often referred to as on-demand software. An economic resource belonging to a company or entity, an item owned by the company or entity; an asset has future economic benefit and is the result of past financial transaction. Asset-Based Lending (ABL) A loan that is secured by an organization's assets: inventory, accounts receivable, equipment, etc. Association of Certified Fraud Examiners (ACFE) A professional organization that provides anti-fraud training and education; more than 37,000 members worldwide. The ACFE certifies and governs Certified Fraud Examiners, which investigate business fraud around the world. An internal or external examination of financial accounts and records in order to assure compliance with accounting rules and regulations, catch fraudulent activity and to review efficiency of financial operations. A report that provides an opinion and analysis of a company's financial state; usually prepared by an outside or external auditor. A process of confirming a computer, system or program user's identity by validating it against a user database; usually requires a unique user name and password. The granting of access rights to a computer system's data based on a user's identity. Authorization generally follows immediately after authentication; together they comprise a two-part process. Automated Clearing House (ACH) An electronic method used to process transfers between banks via the Federal Reserve system and other AHC operators, such as automated payroll deposits and debit card purchases. ACH is more efficient and cost-effective than paper checks and transactions are usually processed and settled within one or two days. B-Notice Notification from the IRS that a payee name and TIN combination are incorrect. Backup withholding must be done on any further payments until a corrected Form W-9 from the payee or a TIN validation form from the IRS has been received. A term used in reference to 'business-to-business'; generally used when referring to a business which sells its products or services to another business. A term used in reference to 'business-to-consumer'; generally used when referring a business which sells its products or services to a consumer. Back Office Conversion The ability of retailers or billers to convert a physical check collected at a point-of-sale or manned bill payment location into a single-entry ACH debit. Back-end Imaging Imaging invoices for archival purposes once they have been processed on paper, allowing for fast document retrieval and requiring no physical storage space. A percentage that is withheld from any payment made to a payee that has not provided a correct TIN or where the IRS has issued a notice to backup withhold on payments to that individual. Backup withholding is also required on payments made to nonresident aliens without a signed Form W-8 or W-8BEN certifying foreign status. An account receivable, loan or note that is deemed uncollectible by the company and is written off. This usually occurs when a customer is unwilling to pay for services rendered to them. The listing of assets (items owned), liabilities (obligations owed), and owners' equity (the difference between assets and liabilities), prepared at a specific point in time. Bank Administration Institute (BAI) An organization geared towards improving the functionality of financial service companies through the offering of solutions, education and training. Bank Administration Institute (BAI) Standards The quality standards to which most cash management service providers and banks are held. Each year, the survey done by the BAI researching the quality of processing by financial institutions, is often used to formulate the quality standards for the upcoming year. A commitment by a bank to be answerable for payment to a specified beneficiary (seller) in the event of the failure of the bank's client (the buyer) to pay. A nine-digit number printed across the bottom of a check that identifies the financial institution it is drawn upon. A legal declaration of the inability of an individual or an organization to pay their creditors. An organization will request for the reorganization of its debts (under chapter 11) or a liquidation of its assets (under chapter 7). Bankruptcy can be initiated by the debtor or by the creditors, in an effort to recoup a portion of what is owed to them. Debts of an insolvent person or organization are liquidated after being satisfied to the greatest extent possible by debtor's assets. Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) BAPCPA is a disclosure of rules regarding bankruptcy and debt counseling that apply to debtors, creditors, lawyers, debt relief agencies and petition preparers. This act helped to amend the 1968 Truth in Lending act. Base Rating Table (BRT) A rate table published by a carrier for LTL shipments. An operation where related transactions are grouped together and submitted for processing at least once a day; usually used by merchants who do not have a real time verification system. The process of improving performance by continuously identifying, understanding, and adapting best practices and processes found inside and outside your organization. A business technique that has been proven most effective in producing desired results, including regulatory compliance. Codes assigned to identify banks in the Single Euro Payment Area (SEPA). Bilateral contract A contract where both parties have promised obligations to each other. Bill Consolidator In EIPP, a Bill Service Provider that consolidates bills from other Bill Service Providers or Billers and delivers them for presentment to the Customer Service Provider Bill Detail Information provided to a customer from a biller that includes specific billing information. Also called invoice detail."" Bill of Lading (B/L) A contractual document stating the terms between the shipper of goods and the transportation company. A bill of lading also serves as a receipt for goods. Bill of Lading (BOL) A document issued by a carrier to a shipper acknowledging receipt of goods for transport and specifying terms of delivery, the contract for transport services. A written, legal document that transfers title to personal property. An invoice summary sent to the customer explaining what is owed. Information on the summary may include: Amount owed, due date, biller name and account number, etc. Bill to Address The address to which the freight bill is to be sent. Bill/Invoice A request for payment for products or services rendered, typically comprising an itemized list of charges, including prices, quantity, tax if applicable, and shipping charges. A company or organization that issues a bill or invoice requesting payment for a product or service rendered to a customer or client. Billing Quality Index (BQI) A benchmark used to gauge the accuracy of invoices processed. Blanket Purchase Order Long-term agreement between a company and its supplier; often contains predetermined delivery dates. A "distributed ledger" technology that is decentralized to a great number of computer nodes; transactions, financial or otherwise, must be validated by all the nodes to be authorized, making blockchain extremely secure. A group of transactions is created as a "block," which is then written to all the nodes and is unchangeable, thus forming the "blockchain" over time. Potential applications of the technology include cryptocurrencies that do not require banks (e.g. Bitcoin), and more efficient business transactions. A group of individuals elected by a public corporation's or non-profit's shareholders; it is their responsibility to govern and set policy for the organization. The task of recording amounts, dates and sources of all business revenue, gain, expense and loss transactions; the starting point of the accounting process. A resource that constrains the flow of production, inventory movement or data in a system. Business Process Outsourcing - hiring a vendor to take responsibility for a business process. BSP (Biller Service Provider) An agent that provides an electronic payment service for the biller. Call Campaign A series of calls made by collectors to contact a debtor by telephone. An area within an organization that handles inbound and outbound customer service calls, technical support and many other customer-related responsibilities. A company's expense for long-term fixed assets like property or equipment. The expense is amortized or depreciated over the life of the asset, or "capitalized." The aggregate of a company's common and preferred stock authorized for issue by the corporate charter. It is reported on the balance sheet as "stockholder equity." A policy to protect part or all of the freight in a shipment. A company that offers services to transport freight. Carrier Discount A reduction off the base rate that a carrier offers a shipper. Cash Application The process of applying payments, credit memos, and adjustments to customers' accounts. Cash Basis Accounting A method of accounting where expenses and revenue are recorded when cash is actually received or spent, as opposed to an accrual accounting basis. Cash Discount A deduction that a vendor allows on the invoice amount to encourage prompt payment. For example, terms of sale might include 2/10, n/30, meaning that the customer can pay 2% less than the invoice amount if the bill is paid within 10 days. The full amount must be paid within 30 days. The amount of cash that is coming into a company compared to how much is leaving the company. A healthy financial condition entails a higher inflow of cash than outflow.It's an analytical tool used to determine a company's short-term viability, including ability to pay bills. (Also known as statement of cash flows or funds flow statement.) Summary of a company's cash receipts and cash disbursements over a period of time; Lists cash to and cash from operating, investing, and financing activities, along with the net increase or decrease in cash for the period. Cash In Advance (CIA) Companies often ask new customers or customers with little, no or poor credit histories to pay in advance. The shipper requests the carrier of the goods to collect the payment for the delivery from the consignee. Money received by a business from its customers, such as payments on accounts receivable. Cash Concentration or Disbursement. One of three formats used to make business-to-business automated clearing house payments. Since the CCD format cannot carry remittance data about the payment, it is often only used to pay a single invoice. CCD+ Cash Concentration or Disbursement Plus. One of three formats used to make business-to-business automated clearing house payments. Unlike CCD, CCD+ can transmit up to 80 characters of remittance data entered in an ANSI ASC X12 data segment along with payments. CCD+ can also be used to pay multiple invoices. CEBP The Council for Electronic Billing and Payment (CEBP) promotes the adoption and usage of electronic consumer, business and government billing and payment programs and services across any delivery channel. Certificate of Weight A statement of authority of the weight of a shipment of freight prepared by a weigh master. A designation (CPA) certifying that an accounting professional practicing in the United States has obtained a license to practice as a public accountant in their state. When an organization files bankruptcy and requests to reorganize its debts. See bankruptcy and Chapter 7.> When an organization files bankruptcy and requests to liquidate its assets. See bankruptcy and Chapter 11.> Term that refers to deductions AR thinks are invalid and are charged back to the customer. A listing of Accounts in a financial system generally using alpha numeric characters to designate the transactions that comprise the Balance Sheet and Income Statement. The chart of accounts is used as the basis for preparing financial reports from an accounting system. The equivalent designation in Canada and United Kingdom of an accounting professional who has obtained their CPA. Chattel paper A record or records that evidence both a monetary obligation and a security interest in specific goods. Check Clearing for the 21st Century Act of 2004 Legislation that created a new negotiable instrument called a substitute check or image replacement document (IRD), which has the full legal force of the original check of which it is a copy. Also referred to as Check 21. Check Kiting A form of check fraud in which bank "float" is manipulated to fund bogus checks. This process can be perpetuated between bank accounts indefinitely, creating an interest-free loan: a bogus check is deposited into account A, and a check is written against that to deposit nonexistent funds into account B, which is then used to deposit nonexistent funds back into account A. However, many banks now place a hold on funds from check deposits until they clear, and float time is much less that it was previously, making this a less viable scam. Clearing House Inter-Bank Payment System. The main privately held clearing house for large-value transactions in the United States. Along with government-owned Fedwire, CHIPS is the primary network for large-value domestic and international bank transactions. COD Fees A service charge made to the shipper ("prepaid") or consignee ("collect") by the carrier for collecting the consignee's payment for the goods delivered. An asset or property used as assurance that a debt will be repaid. The asset will be given to the creditor in the event of a default. The consignee is responsible for payment for the freight or delivery charges. Collect on Delivery(COD) The act of pursuing debtors who are delinquent on payments due. Fees added to accounts receivable for outside collection efforts, including administration costs, penalties and interest. Collection Intensity Matrix A strategy where accounts receivables are segmented by balance size and collectors tailor approaches to manage each segment. For example, collectors would spend more time and effort on accounts with balances greater than $10,000 that control 67 percent of the portfolio than accounts with balances that range from $5,000 to $9,999 that contribute 28 percent to the AR portfolio. Commercial Law League of America (CLLA) An organization of attorneys and other experts in credit and finance actively engaged in the field of commercial law, bankruptcy and insolvency. Description of type of goods shipped, used to determine LTL classification. A class of contributed capital in the equity section of the balance sheet that represents the residual ownership interest in a company by a person or organization. Often referred to as 'ordinary shares', common stock shares are ownership units issued in the form of a stock certificate(s) to a person in exchange for the certificate gave the company cash or other consideration. Conformity with legislation governing a particular practice or process; e.g., tax laws, unclaimed property laws, or such governing legislation as the Sarbanes-Oxley Act of 2002, which mandates transparency and ethics for public companies. Computer Readable Data Data in a format — such as ASCII — that a computer can understand. Confirmed irrevocable letter of credit (L/C) A letter of credit that may not be amended or cancelled without the consent of the issuing bank, the confirming bank, if any, and the beneficiary. The bank guarantees the payment if the beneficiary complies with credit terms and conditions. The receiver of the shipment. A transaction, in which a business delivers goods to a merchant for the purpose of sale and the transaction does not create a security interest that secures an obligation. Consolidation (Freight) Putting together several consignments that are headed in the same direction. Consolidator An interface between multiple buyers and sellers that simplifies invoice presentment allowing trading partners to interact through one party. Contra-Accounts A general ledger account that offsets the balance in a related account; e.g., an accumulated depreciation account that offsets the fixed asset account. Combined, they report the net value of the assets remaining. Another example of such a pair is allowance for doubtful accounts and accounts receivable. Contributed Capital Contributed Capital is the value of funds or other consideration contributed to a company in return for an ownership interest. For instance, contributed capital increases when a person invests money in a company and receives a stock certificate recognizing their right to share in the profits and losses of a company and increases or decreases in the equity value of the company. Owners of a company are often referred to as stockholders. Contributed capital is located in the stockholders equity section of the balance sheet. A credit card issued to an individual under a corporate account, used for business expenses; the individual cardholder is the liable party. A corporate card simplifies processing of expense reports, as most items are noted on the card statement. The statement can serve as the report and most cards offer online processing capabilities. Corporate or Parent Company Guarantee When the customer's parent company guarantees payment in the event the customer defaults. Corporate Trade Payments (CTX) An ACH format that allows B2B electronic payments that include remittance information, up to 9,999 addenda that contain trade payment details. A legal business entity that has its own rights, including issuance of freely transferable stock, perpetual life and limitation of owner's liability. Committee of Sponsoring Organizations of the Treadway Commission, a joint initiative created to combat corporate fraud. : Council on State Taxation. A non-profit trade association of about 570 multi-state corporations active in interstate and international business. COST seeks to establish favorable state and local taxes for businesses that deal in multiple jurisdictions. The aggregate cost of materials, components, labor, distribution costs and overhead to produce goods sold by a company. COGS is reported on an income statement and is deducted from revenue to arrive at net income. Sometimes called "cost of sales." See "Cost of Goods Sold." Course of conduct Refers to a proven and accepted history or performance and actions that transpired between two parties, which allegedly created a verbal contract. Credit Balance A balance that represents a liability or income to the company. In accounts payable general ledger account, a credit balance represents money owed to the company's vendors. Credit bid When a secured lender uses the value of their assets in lieu of cash to bid for their collateral in a bankruptcy sale. An agency that collects information from collection agencies and creditors and reports that to a consumer reporting organization, which in turns supplies quantifiable information to banks, lenders and financing companies about borrowing and payment behaviors. Credit Group A gathering of credit managers within an industry who meet periodically to share information about customers' credit status and credit worthiness. Credit Memo A credit memo is a document issued by a company to a customer to offset all or part of an invoice, to correct accounts receivable and make good to the customer for such issues as damaged or return goods, lack of delivery, incorrect prices or freight charges, or other such problems. The company usually applies the credit memo against the customer’s outstanding balance, or issues a check to the customer. A numerical expression calculated to determine the creditworthiness of a company or person. Credit departments use credit scores to ascertain how much credit to extend a new customer. An individual or organization to whom money is owed. Cross-Aging In accounts receivable, deeming an entire account to be delinquent when a certain percentage of receivables become overdue, typically 10 percent. A strictly digital currency in which cryptography is used to record and control transactions; e.g., bitcoin, ethereum. Corporate Trade Exchange. One of three formats used to make business-to-business automated clearing house payments. Unlike CCD and CCD+, CTX is capable of transmitting extensive remittance data along with transactions. CTX payments can include up to 9,999 individual records made up of up to 80 characters each formatted either as an ANSI ASC X12 data segment or as a payment-related UN/EDIFACT transaction. Cubic Capacity Rule If an LTL shipment exceeds a designated number of cubic feet in a trailer (typically 750 cubic feet), it triggers a rate increase. An asset expected to provide an economic benefit to the company within 12 months from the date of the initial transaction that generated the asset. Current Liability An amount owed by a company as an obligation expected to be settled within 12 months from the date of the initial transaction that resulted in the liability. A ratio calculated by dividing a company's current assets by its current liabilities. The ratio indicates whether a company has the ability to pay off its short-term liabilities with its short-term assets. (Also known as liquidity ratio, cash asset ratio and cash ratio.). Customer Master File A central database that contains all pertinent information about customers, such as names (legal entity and DBA name); tax ID; billing address; delivery address; contract terms; credit limit; contact information; order. Abbreviation for "per 100 pounds weight" Cycle Billing An accounting method where invoices are prepared and divided into cycles and dispatched throughout the accounting period, rather than billing all customers on the same day each month, thus spreading work evenly over time. A reporting tool that organizes and presents key information or metrics to provide the status or condition of a project, process or business. A piece of information contained in a segment of an EDI transaction set. Converting important information into scrambled text to prevent unauthorized use and to protect confidentiality of the information. This process makes the data unreadable until it is decrypted. (DPO) A number representing the number of days on average that a business takes to settle its trade payables. Abbreviation for “Doing Business As” when using a trade name, i.e. a name that is less or other than the full legal business name. Typically, the DBA name is the name seen by the public. In the U.S., a company must register its DBA at the county or sometimes state level. In the U.K., the similar term is T/A - trading as. Any benefit given to an employee that is so low in value that accounting for it would be unreasonable. Cash benefits are never excludable as a de minimis benefit. Benefits that may be excluded as de minimis include: transportation fare, meals, copy machine use, holiday gifts with a low fair market value, occasional parties and entertainment. Debit Balance A balance that represents an asset or an expense of the company. In accounts payable general ledger account, a debit balance represents an amount owed by the vendor to the company; it can occur as a result of product returns, allowances, rebates, and chargebacks. Debit Transaction An electronic payment transaction that results in a debit to a cardholder's account and a credit to the merchant account. Debt Buyer A purchaser of accounts receivable or portfolios. Unlike a factor, if collection attempts are unsuccessful, a debt buyer will either place receivables with an external collection agency or resell all or portions of the receivables to other debt buyers. Defined as a collection agency" under the Fair Debt Collection Practices Act. Also called "bad debt buyers."" Debt Collection Improvement Act of 1996 (DCIA) The U.S government's response to the increasing amount of delinquent non-tax debt owed to the U.S. The act centralized the collection of debts to the Treasury and the Financial Management Service (FMS). Also under the act, federal agencies are required to turn over all non-tax debt to FMS for collection. Collection of delinquent tax debt was added in 1999. For more on this act, click here. Debt to Equity Ratio Total debt divided by total equity. A high debt-to-equity ratio may indicate that a company might not be able to generate sufficient cash to satisfy its obligations. A party that owes a creditor and has the obligation to pay off the debt. Deficit Weight Weight that is added to a shipment to bring the weight up to the "bill-as" weight, to reduce the total charge (taking advantage of rate reductions for higher weights). A written document from the seller to the buyer that accompanies a delivery of goods and specifies type of goods and quantity. Delivery Receipt Document dated and signed by consignee or its agent at the time of delivery stating the condition of the goods at delivery. Denied Persons List A list published by the Department of Commerce’s Bureau of Industry and Security. It contains the names, addresses and countries of individuals and companies whose export and re-export privileges were revoked by the U.S. government. Click here to access the Denied Persons List A reduction in the value of a tangible asset over time due to wear, age or obsolescence; the allocation of the cost of an asset over time for accounting and tax purposes - an annual depreciation charge in accounts represents the amount of capital assets used up in the accounting period; also, a decrease in the value of a currency in relation to the value of another. A method of collection where a debtor authorizes a creditor to debit their account to collect payment. Paying out in the discharge of a debt or expense; actual payment made for product or service to a contractor or vendor. Disputed Stop Payment A stop payment initiated by the writer of a check due to a dispute over goods or services. Dividends are generally payments made to owners of a company. These payments can be in the form of cash or the issuance of additional Stock. Dividends are generally used as a way to allow the owners to participate in the profits generated by the company. Generic term for any piece of paper with important data such as an invoice, inventory sheet, application, etc. The Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in 2010 as a response to the financial crisis of 2008. It places regulation of the financial industry in the hands of the federal government. Days payable outstanding. A number representing the number of days on average that a business takes to settle its trade payables. When one company makes the sale and is in charge of the accounts receivable, but a separate wholesale or manufacturing company actually fulfills the order and ships it to the customer. DSO is Days Sales Outstanding, a measurement of the average number of days that a company takes to collect revenue after a sale has been made. DSO = [(Total Receivables / Total Credit Sales for the Period) X (# Days in Period)]. For more information see Understanding Your DSO. DSO, Countback Countback DSO is a method of calculating DSO that seeks to provide a more precise figure than the standard DSO calculation, by accounting for month-to-month changes in sales and past due receivables, and using actual number of days in the month. The calculation gives more weight to the current month’s sales, since most of the AR balance should be from current rather than previous sales. DSO, Sales Weighted Sales Weighted DSO is a method of calculating DSO that takes into account credit sales and terms of sale. Sales Weighted DSO = [($ in Current Age Bucket / Credit Sales of Current Period) + ($ in 1-30 Day Age Bucket / Credit Sales one month prior) + ($ in 31-60 Day Age Bucket / Credit Sales two months prior) + (etc.)] x 30. In AP, typically refers to efforts made by a business to find the owner of unclaimed property. Performing due diligence usually includes sending a search letter to the owner’s last known address within 60 to 120 days before the end of the dormancy period. However, rules tend to vary by state. Due diligence can also refer to efforts to verify vendor legitimacy when doing business with a new vendor. Dunning Letter A collection letter with defined language sent to a customer with an outstanding account, and part of a series of escalating collection letters. Dunning Letter Service A service that distributes dunning letters. Duplicate Invoice More than one invoice issued for the same transaction. Duplicate invoices can result in duplicate payments, and may be issued as a method of fraud, or may be due to inadequate internal controls, such as duplicate vendors within the vendor master file. Earnings is the sum of all revenues, gains, expenses and losses during a specified period of time. It most often referred to when a company makes a profit and, therefore, the sum of all revenues and gains exceeds the sum of all expenses and losses. Earnings before interest, taxes, depreciation and amortization. This measurement provides insight into a company's operating profitability, although it is not regulated by GAAP. EBPP Electronic Bill Presentment and Payment generally refers to the billing and payment process for consumers or B2C applications. Electronic Benefit Transfer. A form of electronic funds transfer in which state governments credit money to a pseudo account belonging to a low-income individual, who is given a plastic EBT debit card. EBT funds can only be used to purchase specific items, such as food and other necessities. Electronic Data Interchange - computer-to-computer transmission of information between two companies, including such documents as purchase orders and invoices. Electronic Document Management refers to software that allows specific imaged documents to be retrieved based on queries about data on the images. Electronic Funds Transfer: Any process of electronically transferring funds to or from an account; EFT does not involve the exchanging of hard currency. A Federal law to allow the transfer of funds electronically was passed in the United States in 1978. In the U.S., common forms of EFT are ACH and Wire transactions. Employer Identification Number: A nine digit number assigned to all business entities by the IRS for taxation purposes. An EIN is required on all business tax returns, documents and statements. EIPP Electronic Invoice Presentment and Payment (EIPP). EIPP refers to the invoicing and payment process between businesses, or B2B applications, over the Internet and typically via a third-party EIPP vendor. See EIPP under Technology in the Main Topics section. The use of computers and other technology to handle banking transactions and to access bank accounts. Financial institutions usually issue a PIN (Personal Identification Number) and/or ATM or debit cards for this purpose. Electronic Bill Delivery A system that sends customer bills via computer or telephone. Electronic Bill Presentment and Payment (EBPP) A system that sends bills and other information electronically to customers and provides a way for them to make the payment. Electronic Check Clearing House Organization (ECCHO) A non-profit organization that is a national clearinghouse for its member institutions. It provides the rules for check image exchange for member financial institutions that exchange and settle check payments. For more information visit the homepage: ECCHO A system that makes possible the electronic exchange of documents such as purchase orders, invoices and other business transactions. A computerized system that electronically transfers funds from one account to another. EFT eliminates the need for paper checks. Electronic Invoice Presentment and Payment (EIPP) EIPP refers to the invoicing and payment process between businesses, or B2B applications, over the Internet and typically via a third-party EIPP vendor. Electronic Payment An alternative payment method to the paper check that is made electronically via computer, telephone or ATM. Electronic Signatures in Global and National Commerce Act (ESIGN) A federal law designed to facilitate the use of electronic records and signatures in interstate and foreign commerce. Financial fraud involving misappropriation of funds placed in one's care. Similar to larceny, except in the case of embezzlement, the criminal gains access to the funds rightfully before appropriating them wrongfully. A process by which readable text is translated into unreadable code during Internet transmission from one trading partner to another, and then retranslated into readable text according to an encryption key. Enterprise Resource Plan (ERP) Software that integrates departments and functions across a company into one computer system. ERP runs off a single database, enabling various departments to share information and communicate with each other. Entity List A list published by the Department of Commerce’s Bureau of Industry and Security. It contains the names of foreign nationals, businesses and organizations subject to special licensing requirements or policies for the export, re-export or transfer of selected items. Click here to view Frequently Asked Questions About the Entity List The ownership interest in the assets of a company or entity; funds from owners or creditors provided for acquiring assets; the difference between the amount owned (Asset) and the amount owed (Liability) by a company or entity. Electronic Records Management. A company's strategy for maintaining digital copies of important documents and information. An ERM might include scanning and indexing invoices, receipts and purchase orders into a computer system. Enterprise Resource Plan - software that integrates departments and functions across a company into one computer system. ERP runs off a single database, enabling various departments to share information and communicate with each other. ERP systems comprise function-specific modules designed to interact with the other modules, e.g. Accounts Receivable, Accounts Payable, Purchasing, etc. Evaluated Receipt Settlement. ERS eliminates the supplier invoice from the procurement and disbursement process. It determines disbursement based on Purchase Orders and Receiving information. Price information is found in the PO, and quantity information in the Receipt. Escheatment Remittance of unclaimed property to the state in compliance with unclaimed property law. Abandoned or unclaimed property (of all kinds) becomes the property of the state, which protects the property on behalf of the owner. For AP departments, this would be, for instance, a check never cashed. Unclaimed property laws in each state set dormancy periods, requirements for due diligence in seeking the owner, and reporting and escheat requirements for the state. Owners can claim escheated property held by the state, though only a small percentage ultimately do. Escheatment priority rules Rules that determine which state is entitled to abandoned property in the event of disputes. First priority is given to the state of the last known address of the owner - i.e. the customer to whom the credit belongs; if the customer's address is unknown, the state of incorporation of the holder of the credit takes precedence. (See Texas v. New Jersey.) America's oldest nonprofit organization devoted to independent research and the advancement of high ethical standards. An automatic renewal/extension clause in a contract that keeps it in force until either party formally cancels it. The price of the currency of one nation in terms of that of another nation; the rate at which one currency is traded for another. A tax levied on the manufacture, sale, or consumption of certain (particular) non-essential goods or services, e.g. airline tickets, gasoline, alcohol, tobacco, etc. An excise tax is levied on a particular product in contrast to sales and use taxes, which are levied because sales occurred, rather than on the product purchased. A term often referred to when a person decides to purchase their company's stock through the contractual right granted to them in a stock option. A person 'exercises' their right to purchase company stock from the right granted in a stock option. Generally refers to the fixed price documented in a stock option from which a person can exercise their right to purchase a company's stock. Decreases in economic resources or assets resulting from activities undertaken to generate revenue. Expenses decrease Equity. Extensible Mark-up Language (XML) A flexible language standard, administered by the World Wide Web Consortium (W3C), which provides a set of grammatical rules for exchanging information and eliminates rigid format standards. A private system that is part of an organization's internal computer network that is made available to outside users such as suppliers, vendors, partners or other businesses. The system allows the organization to share information through various levels of accessibility. Eyeball Test A clear, readily perceived indication that a payee is exempt from Form 1099 reporting. Such indications can be: an incorporated entity ("Corp." "Inc.") as seen on an invoice, a signed W-9 stating the company is a domestic corporation or the payee is a government organization. F.O.B. "Free on Board," a term of sale which in general means the seller provides for loading goods onto the shipment vessel (shipping point), at which ownership transfers to the buyer; sellerdoes not cover cost of shipment unless otherwise specified (see below). F.O.B. Delivered/ Freight Collect A term of sale in which the buyer takes ownership of the goods on delivery and pays the freight charges, and the seller files any claims. F.O.B. Delivered/ Freight Collect and Allowed A term of sale in which the buyer takes ownership of the goods on delivery and pays the freight charges but then deducts them from the seller's invoice, and the seller files any claims. F.O.B. Delivered/ Freight Prepaid A term of sale in which the buyer takes ownership of the goods on delivery, and the seller pays the freight charges and files any claims. F.O.B. Origin/ Freight Collect A term of sale in which the buyer takes ownership of the goods at the shipping point, pays the freight charges, and files any claims. F.O.B. Origin/ Freight Prepaid A term of sale in which the buyer takes ownership of the goods at the shipping point and seller pays the freight charges and files any claims. F.O.B. Origin/ Freight Prepaid and Add A term of sale in which the buyer takes ownership of the goods at the shipping point and files any claims, and the seller pays the freight charges but is then reimbursed by the buyer. A company that purchases accounts receivable from a client, then collects payment for the invoices. Factor, factoring A factor is one who acts or transacts business for another. Typically, a factor buys a company's accounts receivable at a percentage of face value. Recourse factoring means the bad debt risk remains with the company. Non-recourse factoring is when the bad debt risk is transferred to the factor, protecting you from companies that don't pay. Non-recourse factoring fees are therefore higher than recourse factoring. A financial transaction whereby a business sells its accounts receivable at a discount. The purchasing organization assumes the responsibility of collecting the invoices Factoring Rate Percentage of invoice amount a factor charges for advancing on an invoice. Fair and Accurate Credit Transactions Act (FACTA) A federal law enacted in December 2003 to reduce identity theft and help victim recovery by providing ways for consumers to obtain their credit report and credit score. For more information on this act, click here Fair Credit Billing Act of 1974 (FCBA) An act that helped amend the 1968 Truth in Lending Act and applies to open end" credit accounts A federal consumer protection law that ensures that credit reporting agencies act fairly and establishes procedures on how to correct mistakes that appear on credit reports. To read the full act, click here. A federal consumer protection law that ensures that collection agencies do not use abusive or deceptive debt collection practices. To read the full act, click here. Financial Accounting Standards Board. A private, non-profit organization whose primary purpose is to develop Generally Accepted Accounting Principles (GAAP) in the United States. The standards established by FASB are intended to educate issuers, auditors and users of financial information as well as the general public. An interagency body established in March 1979 to prescribe uniform principles, standards, and report forms to promote uniformity in the supervision of financial institutions. The central banking system in the United States. Twelve banks belong to the Federal Reserve and serve twelve districts. The functions of the Federal Reserve include enforcing good banking practices, ensuring compliance with federal regulations, providing loans and money to banks and determining interest rates. "First-in, first-out." A method of inventory costing in which the oldest inventory items are considered to be sold first. Generally used when selling perishable items, but may also figure into tax liability. See "LIFO." Financial Electronic Data Interchange (FEDI) The electronic exchange of payment and related information from one computer application to another in a standardized, structured format. An asset, usually tangible, that is not intended to be consumed or sold for at least a year, and is needed to conduct business, e.g., land, buildings, machinery and equipment, vehicles, etc. Tangible, relatively long-lived resources. The business has acquired these assets ordinarily in order to use them in the production of other goods and services. These assets will wear out and be replaced over the long run; therefore, each year they are depreciated (a paper loss in the value of fixed assets). Sometimes known as overhead costs, these costs are part of the operating expense of a business and not dependent on the amount of goods or services produced. A period of time in which the same funds appear on the books of two different financial institutions due to inefficiencies in the clearing system, e.g., "check float." Also refers to the time between issuance of a check and the time that the check clears the bank account on which it is drawn. A diagram that illustrates the flow of data, processes and operations within an organization or business management system. Fair Labor Standards Act. Enacted by Congress in 1938, the act established rules in the United States governing workplace practices, including establishing a national minimum wage, guaranteed time-and-a-half overtime pay for certain jobs and outlawed most child labor. In addition, the FLSA also protects employees' rights to make workplace complaints without fear of reprisal. A clause that appears in many supplier contracts that excuses non-performance for forces beyond the suppliers' control, like acts of God, wars, riots, etc. A legal forced sale of a property due to failure of a mortgager to comply with the terms and conditions of the mortgage. The property is sold to pay off the debt of the defaulting borrower. Foreign Corrupt Practices Act of 1977 (FPCA) A federal law with key provisions that address anti-bribery and accounting transparency. The act of deliberately altering or creating a fraudulent document or financial instrument, such as a check, to falsely authorize or change it. The ability for software to "read" a scanned document and extract the data into computer-readable format, eliminating the need to enter the data manually. Any dishonest and illegal activity perpetrated in the course of business to give an advantage to an individual or company. Freight All Kinds (FAK) When shipped products are classified as single freight class despite comprising various commodities. Front-end Imaging Imaging invoices once they arrive in accounts payable and using an automated workflow solution to process. It eliminates the need for paper documents at the start of the process. Full Cost Accounting An accounting method that seeks to identify, quantify and allocate all costs associated with a process or product, including environmental and other social costs. It typically includes direct costs, hidden costs, contingent liability costs and less tangible costs. The term may be used to refer to full private or bottom line costs to an enterprise, which is common, or include the full social costs including externalities that are difficult to quantify. Full-Service Collections A third party collection service that uses several collection tactics throughout the collection cycle. Tactics include written debtor contacts and calls from professional collectors. A collection of EDI transaction sets of the same type transmitted together (e.g., a group of invoices). Fungible Goods Goods, like nails, where each unit is the equivalent of any other like unit. Generally Accepted Accounting Principles are accounting guidelines accepted by accounting professionals and businesses on a set of practices that provide guidance for preparing and reporting financial information. There are also two other sources that provide the basis for establishing accounting standards: 1) APB Opinions are accounting guidelines issued by the AICPA Accounting Principles Board and 2) ETIF abstracts are issued by FASB Emerging Task Force for guidance on new accounting issues. GAAP helps to create conformity when reporting financial results across all businesses and industries in the United States. Financial Reporting methodologies in accordance with GAAP provides comparable data and common principles when a company prepares and reports financial information. Increase in equity as a result of business activities not a part of normal operations (e.g. a cruise company selling an asset such as its dining room chairs); reported on a net basis. General Ledger (G/L) A record of business transactions by account. General Ledger (GL) A list of numbered accounts with an organization used to prepare financial statements. The GL contains a credit and corresponding debit for every transaction, called a "double entry accounting system." Generally Accepted Accounting Principles (GAAP) Accounting guidelines accepted by accounting professionals and businesses on a set of practices that provide guidance for preparing and reporting financial information. There are also two other sources that provide the basis for establishing accounting standards: 1) APB Opinions are accounting guidelines issued by the AICPA Accounting Principles Board and 2) ETIF abstracts are issued by FASB Emerging Task Force for guidance on new accounting issues. GAAP helps to create conformity when reporting financial results across all businesses and industries in the United States. Financial Reporting methodologies in accordance with GAAP provides comparable data and common principles when a company prepares and reports financial information. Ghost Card or Supplier Card The ghost card refers to a single account number that is assigned to an entity and typically resides with the entity's vendor for high volume purchases. The ghost "card" can be used by multiple users, typically for a single vendor or limited number of specific vendors. No actual card is produced. Responsibility for monitoring and reconciliation of the account usually rests with the department using the account, rather than with AP or p-card administrator. A ghost card account resembles a charge account. A value-added tax (VAT) imposed in some countries for goods and services. The items taxed and the amounts vary by type and nation. GR or Goods Receipt Confirmation documentation by receiving department or requisitioner that ordered goods were received. Used, along with a purchase order (PO) in the "three-way match" to authorize invoice payment. Total revenue minus cost of goods sold. Hash Total A number calculated or arbitrarily assigned to verify records or documents; for example, the check numbers of a batch may be added together to produce a value that may be used later to ensure that all were deposited. It is not a significant number in and of itself, but rather a verification method. Hazardous Material (HazMat) Any substance that represents a health or safety risk to people, property or the environment as determined by the U.S. Department of Transportation; a HazMat shipment requires special handling and documentation. Health Insurance Portability & Accountability Act (HIPAA) A federal act that protects American workers by improving portability and continuity of health insurance coverage. To see the full act, click here. Hell or high water clause A clause in a contract, usually a lease, that says the lessee must make payments during the contract's life come hell or high water Heuristic Credit Score Determining a customer's credit worthiness using intuition, educated guesses, common sense, industry trends, etc. Health Insurance Portability and Accountability Act. Enacted by Congress in 1996, the act protects health insurance coverage for workers and their families when they change or lose their jobs and creates standards for health care transactions. The law also protects patient privacy records. Household Goods Carriers Bureau (HGCB or HGB) Part of the American Moving and Storage Association and the authority behind tariffs and The Official Transportation Mileage Guide (published by Rand McNally). International Bank Account Number; used for international payments, primarily in Europe. Intelligent Character Recognition refers to the ability of software to recognize hand-printed characters from a scanned document and turn them into computer-readable data. Interactive Financial Exchange - A standard for the exchange of financial data and instructions independent of a particular platform or technology. See http://www.ifxforum.org IFX (Interactive Financial Exchange) A standard set for the exchange of financial data and instructions. Image Cash Letter (ICL) An electronic file that is the standard for formatting and transmitting remotely deposited checks. ICL's contain check images and MICR data. Also known as an X file. Turning human-readable images — documents, invoices, photos, etc. — into computer-readable images such as TIFF, JPG or MPEG files. A collection of hardware and software that work together to capture, store and retrieve images. A sample system includes a scanner, management software and a storage device such as a CD, hard drive, etc. Inbound Freight Direction of freight concerning the consignee. Inbound freight is traveling to the consignee from the shipper. The direction of freight plays a part in carrier contracts. Inbound contracts typically mean the consignee is paying for the shipment. A term used to refer to the calculated result of adding the revenue, gain, expense and loss transactions generated by a company. If revenue plus gains less expenses and losses results in a positive number, then the company has generated income during the specified period. Also Statement of Earnings or Statement of Operations - Listing of sources and monetary amounts of a company's revenues and expenses, gains and losses for a particular period, e.g. quarter or year. A company's profitability is calculated from revenues and gains less expenses and losses. Standard definitions and rules for common commercial terms clarifying buyer and seller tasks, costs and risks in international trade; created and maintained by the International Chamber of Commerce (ICC). A clause contained with a legal contract in which one party agrees to assume liability and compensate the other for issues related to the contract. For example, if a manufacturing company supplied faulty products to its customer and the customer were sued, the manufacturer might contractually indemnify its customer by assuming costs issuing from the lawsuit. A descriptive piece of data associated with an image for retrieving that specific image from storage. A situation in which an organization can no longer meet its financial obligations. Institute of Internal Auditors (IIA) The internal audit profession's recognized authority, acknowledged leader, chief advocate, and principal educator. A non-physical asset, including intellectual property, trademarks and patents, brand recognition, etc. Two examples of intangible assets are goodwill and the value of patents. Intangible Property Property that a person or company can own, but has no physical substance. Intangibleproperty represents value, but is not itself valuable. Examples include stocks, bonds andcopyrights. Interactive Voice Response (IVR) A system to automatically manage incoming calls, IVR can link phone callers (voice and/or touchtone) with a computer database. It can accept a question, access the company's database and provide a caller with the information they are seeking. It can also take information from the caller, convert it to data and input that data to the database. Interactive Web Response (IWR) Similar to IVR, IWR is a Web-based system that allows customers or vendors to find information online, such as invoice status or scheduled payment date. It also can allow data input to a database, or send e-mail via the site. A fee paid for the privilege of borrowing money, usually a percentage of the loaned amount (principal). Intermediate-term liabilities Claims of outsiders that come due in one to ten years. International Association of Commercial Administrators (IACA) A professional association for government administrators of business organization and secured transaction record systems at the state, provincial, territorial, and national level. International Standby Practices 1998 (ISP98) Rules that incorporate generally accepted practices, customs and uses of standby letters of credit maintained and published by the International Chamber of Commerce. Interval measure A calculation used to estimate the number of days a company could operate with its cash on hand. Like the current ratio and quick ratio, it shows how quickly a company could cover its obligations. Finished goods, work-in-progress and raw materials that comprise a sizeable portion of a business's assets. Investment-to-value Ratio A measurement of a creditor's position and the likelihood that a foreclosure would occur. A formal request for payment; a written record of a transaction submitted to customer or client when requesting payment for services or goods delivered; includes taxes where applicable; also called bill, and sometimes statement, though the term "statement" has a different meaning that does not include a formal request for payment. IOCR Intelligent Optical Character Recognition. The ability, like standard OCR, of software to recognize machine-printed (or typed) alphanumerics and turn them into computer-readable data. IOCR software, however, can recognize most common text fonts without needing to be trained to read them. Image Replacement Document. Also referred to as substitute checks, IRDs are paper copies of checks that have been scanned to produce digital images (truncated) to facilitate electronic transmission between banks. An IRD is produced when a party involved in the transaction requires physical documentation. The image of the paper check in an IRD is smaller than the original check and contains some different information. IRD: Image Replacement Document Also referred to as substitute checks, IRDs are paper copies of checks that have been scanned to produce digital images (truncated) to facilitate electronic transmission between banks. An IRD is produced when a party involved in the transaction requires physical documentation. The image of the paper check in an IRD is smaller than the original check and contains some different information (See Check 21) Internal Revenue Service. The United States government agency that collects taxes and enforces internal revenue laws. The IRS is a bureau of the Department of Treasury. Individual Taxpayer Identification Number. A nine digit taxpayer identification number given to nonresident aliens who are not eligible for a social security number. This includes nonresident spouses and dependents listed on a U.S. tax return. A chronological record of daily transactions of a business. For each transaction, the journal shows the debits and credits to be entered in specific ledger accounts and a description of the transaction. Japanese for continuous improvement. A business methodology that developed in Japan after World War II. Every employee is encouraged to regularly offer improvement suggestions. Ideas are shared, discussed and frequently implemented. A short list of important financial or operational metrics that provide a measurement forresults. Knocked Down(KD) Indicates a disassembled article, which facilitates packing and shipping. The cost of goods including freight charges, taxes and all other applicable fees. Lapping Scheme A form of payment fraud facilitated by inadequate separation of duties. An employee steals a payment, then diverts a second payment to cover up the theft of the first, then a third to cover the misapplication of the second, and so on, often continuing until the perpetrator is caught. Letter of Credit. A document issued by a bank or other financial institution on behalf of one of its clients, called the "applicant." The letter is effectively a guarantee of payment to another party, called the "beneficiary," which is named in the LC. A collection of related financial information such as revenues, expenses, accounts receivable and accounts payable. Less-than-Truckload(LTL) A shipment that does not qualify for full (lower) truckload rate because it does not require the full use of a trailer; a shipment that weighs less than the full truckload weight, typically 10,000 lbs. Letter of Credit (LOC) A document issued by a bank or other financial institution on behalf of one of its clients, called the applicant." The letter is effectively a guarantee of payment to another party Letter of Credit, Standby A document that assures payment will occur for a transaction, such as the timely construction of a building. Standby letters of credit are not limited to the sale of goods, but are used to guarantee performance or repayment of a financial obligation. The ability to control property of greater value than the amount of capital invested, in an effort to increase return on equity. An amount owed; an obligation of a company or entity that must be settled in the future by transfer of assets, provision of services, or assignment of future economic benefit, it is the result of a past transaction. A legal claim by one person on the real or personal property of another as security for a debt; a lien blocks the sale of the property until the lien is paid. "Last-in, first-out." A method of inventory valuation where the last goods purchased are assumed to be the first sold or used. The choice of whether to use this method or FIFO is a decision generally made to control tax liability, since the cost of the inventory may vary over time, and thus may be higher or lower relative to the selling price and will affect taxable income. A form of business structure designed to combine the best of corporate and partnership attributes into one entity; members have limited liability and are taxed like a partnership, avoiding double taxation. Rules vary by state. Business structure consisting of at least one general partner and one limited partner; limited partners have limited liability and are not involved in management. It serves as a tax shelter, but does not constitute a separate legal entity from the owners, as does a corporation. Linear Foot Rule If an LTL shipment exceeds a designated number of floor feet in a trailer, it triggers a rate increase. When a company becomes insolvent and its assets are divided among creditors and shareholders, per Chapter 7 of the U.S. Bankruptcy Code. The ability of assets to meet liabilities. Also refers to an organization's ability to quickly access cash. Liquidity Ratio The relationship of cash and marketable assets to outstanding debt. A high ratio indicates a company unlikely to default on its obligations. Loan-to-value Ratio The ratio of the money borrowed on a property to the property's fair market value. A third party collection service, often a bank, to which clients have customers send payment. This provides the client with faster deposits and better control of cash. Long-term liabilities Mortgages and other liabilities that are expected to be held on the books for more than ten years. Decrease in equity as a result of business activities not a part of normal operations; reported on a net basis. A business transaction conducted by using a mobile electronic device, such as a cell phone. Manifest Bill of Lading A summary list of the bills of lading for goods being transported by a LTL or parcel services carrier. Master Bill of Lading A summary list of bills of lading aggregated for a multiple-stopoff truckload carrier. Matched Payment When the amount paid matches" or equals the amount owed. Also called a "full payment."" Merchant Category Code. A universal four-digit classification code describing whether a particular business predominantly provides goods or predominantly provides services. P-card providers furnish these codes to businesses as a way to help them know which p-card purchases should be reported on a 1099. Purchases made to vendors with MCCs labeling them service providers are reportable while purchases made to goods providers are not. Magnetic Ink Character Recognition. A technology developed by the American banking industry to facilitate timely processing of checks. MICR characters on the bottoms of checks are made with specially designed ink with a magnetic signature that makes it easy for quick scanning and processing. MICR (Magnetic Ink Character Recognition) A character recognition technology adopted by the banking industry to facilitate check processing, includes magnetic ink or toner and unique fonts on the bottom of checks. The encoding contains the account number, the routing number, the serial number and the amount of the check. MICR Number Method A procedure that authorizes a check using the bank routing number, the account number and the check number located at the bottom of the check. MICR Reader An instrument used to read the encoded information in the magnetic ink on the check. Method of transportation, e.g., rail, highway, air, and water. A not-for-profit association that represents more than 11,000 financial institutions through memberships, a network of regional payments associations and 585 organizations through its industry councils and establishes standards and procedures that enable the exchange of ACH payments on a national basis. North American Industry Classification System. A numbering system used by businesses and governments to measure economic activity in Mexico, Canada and the United States. Knowing a vendor's NAICS code can help AP departments verify that business' authenticity in their own vendor master file. NAICS is replacing the Standard Industry Classification (SIC) system that was initially established in the 1930s. National Association of Unclaimed Property Administrators (NAUPA) A non-profit organization whose members administer state unclaimed property and compliance laws. National Automated Clearing House Association (NACHA) A non-profit organization that creates rules for moving electronic payments through the ACH (Automated Clearing House) network. National Motor Freight Classification (NMFC) A publication that categorizes goods into freight classifications used along with weight and distance to determine shipping charge. Net (income, loss, profit, sales, worth) The amount that remains after related items have been deducted. E.g., net income is revenue minus the costs of doing business. Sales tax term describing a seller’s physical connection to a particular state. If a seller has nexus in a particular state, then they must collect sales taxes from all purchases made from buyers in that state. Examples of common activities creating sufficient nexus are physicalpresence, established bank accounts, collection activities, trade show attendance, certain drop shipment arrangements, consigned inventory, and contracted service agents. In fact, having a single salesperson located in a state constitutes nexus. Under the Fair Labor Standards Act (FLSA), employees who are not exempt from earning overtime pay. Non-PO Accrual Unpaid expenses for goods and services that have already been received and were purchased without a purchase order. See Accrual for further definition. Non-recourse Factoring A factoring agreement where the factor assumes all the debt risks and all rights to pursue a customer for payment. The client is not responsible for refunding the advance if the debt is not paid. NSF (Non-Sufficient Funds) Indicates that a demand for payment (a check) cannot be honored because there are not enough funds to cover the check. Optical Character Recognition refers to the ability of software to recognize machine-printed (or typed) alphanumeric characters from a scanned document and turn them into computer-readable data. Software that electronically converts scanned images into text. The Treasury Department's Office of Foreign Assets Control. OFAC publishes the Specially Designated Nationals and Blocked Persons List (SDN). U.S. businesses are prohibited from doing business with individuals and countries contained on the list. Open Financial Exchange - Open Financial Exchange is a specification for the electronic exchange of financial data between financial institutions, business and consumers via the Internet. Created by CheckFree, Intuit and Microsoft in early 1997, Open Financial Exchange supports a wide range of financial activities including consumer and small business banking, consumer and small business bill payment, bill presentment, and investments tracking, including stocks, bonds, mutual funds, and 401(k) account details. Since 2000, with the 2.0 specification, OFX has become XML 1.0 compliant and has added 1098, 1099 and W2 tax form download capabilities. OFX (Open Financial Exchange) A data format used by financial institutions to exchange financial information over the Internet. On-time payment percentage The percentage of the time that a customer pays its vendor's within the agreed 'payment terms.' A single credit card used both for small amount purchases and for travel and entertainment expenses. Eliminates the need for multiple cards for different uses; the company or entity, rather than the individual user, is the liable party for charges to the card. Costs associated with operation of a business, e.g., cost of goods sold (COGS), selling, general and administrative expense (SG&A). Order to Cash (OTC or O2C) The cycle or steps in a process that starts with credit extension and receipt of the sales order and ends when payment (cash) is received. Any individual, corporation or financial institution that initiates an ACH transfer. Other Receivables Amounts usually owed by employees Outbound Freight Direction of freight concerning the shipper. Outbound freight is traveling from the shipper to the consignee. The direction of freight plays a role in carrier contracts. Outbound contracts typically mean the shipper is paying for the shipment. Contracting to move an in-house work function to an external service provider that specializes in the function, e.g., freight bill auditing, processing and payment; objectives typically include cost reduction and access to required expertise. The process of hiring a third-party firm to handle internal company functions. Outsourcing often leads to cost-savings and better efficiency. A debit or check written for an amount that exceeds the amount of funds available in the bank account. Financial institutions often will charge a fee for each overdraft made to the account. A document that accompanies product shipped and lists quantity shipped versus amounts ordered; should be checked by Receiving to verify agreement with actual product received; used in a three-way match for payment approval with a Purchase Order and Invoice. Paper Hanging A form of check fraud involving intentionally writing checks on a closed account. The fraudster makes no physical changes to the checks, but the account information is no longer valid. Perpetrators only have access to a small number of remaining checks, meaning paperhanging is usually a short-term fraud, but often involves large-dollar purchases. Paperhanging Par Value Par value is the term used to represent how much of the contributed capital will be allocated to the Common Stock classification and how much will be allocated to the APIC classification in the equity section of the balance sheet. The company generally sets par value at the time of its incorporation when authorizing the number of shares available to issue. The par value does not necessarily (and usually does not) have any relationship to the value of the Common Stock. A single shippable item less than 75 pounds. Parent Company Guarantee When a customer's parent company guarantees repayment of the customer's loan. The individual or organization to whom a check is made payable. Also known as the receiver of payments. A method to effect the transfer of value; the transfer of funds between bank depositories or to or from a debt instrument. Payment Card Industry Data Security Standards (PCI DSS) Standards developed by the Payment Card Industry Security Standards Council to assist organizations that process credit card payments with preventing fraud. provisions, typically set by the vendor, regarding settlement of a transaction. May benegotiated between vendor and buyer as part of a contract. Example: payment terms 2/10 net 30, ( or 2 percent, 10 days, net 30 ) means if the customer pays the bill within 10 days of invoice date (some use receipt date), then the customer can deduct 2 percent of the value of the bill (usually excluding freight as part of the discount). Otherwise the customer has 30 days from invoice date or receipt date to pay the full value of the bill, after which interest charges may be applied. Actual assessment of penalty charges typically depends on the nature of the vendor/customer relationship. Payor or Payer The individual or organization that makes a payment. Payment Card Industry Data Security Standard. Created in 2004 by major card brands Visa, MasterCard, American Express and Discover, the PCI DSS is a set of widely accepted standards for card transactions of all types. When a borrower or third party guarantees a loan with personal assets. The lender may take control of the guarantors' assets if the borrower defaults. Personal Property Security Act (PPSA) Canadian statutes that regulate the creation and registration of security interests. A list of financial assets, investments and securities owned by an individual or an entity. A best-practice deterrent to check fraud, positive pay involves daily reconciliation of a company's issued checks to checks presented for payment to the company's bank. The company sends a daily data file of issued checks to the bank. The information in the data file includes check number, amount and date, bank and account information. It may also include payee information, as payee positive pay is becoming more common (ensuring that the correct payee is on the presented check). Checks presented for payment are compared to the checks-issued file; those that fail to match are rejected and a list of the exceptions is sent to the company, which makes the decision whether to pay or not. Power Dialer A high-speed telephone system that rapidly dials numbers in succession. Practical Highway Miles The number of actual miles a truck or semi-trailer must travel between origin and destination. Carriers may charge based on practical miles or shortest miles, which is the shortest possible route between the origin and destination, regardless of what route the driver traveled. Pre-Arranged Payment and Deposit A type of ACH transaction (ACH Standard Entry Class code PPD) that a transfer of funds by way of direct access to a consumer's checking or savings account, e.g., direct payroll deposit (credit), or consumer bill payment (debit). A new, high-speed telephone system that automatically dials batches of telephone numbers simultaneously until one number is answered and also monitors the length of each call to determine an average call length. Preference Payment A payment made during the preference period A class of contributed capital in the equity section of the balance sheet that represents the residual ownership interest in a company by a person or organization but it has a priority over Common Stock in the payment of dividends and usually the distribution of assets. Freight and charges are the responsibility of the shipper and are paid prior to receipt of the bill of lading. Prepaid Expense An asset that has a future value and it is expensed as the asset's value is used over the time you expect to receive the benefit. An example is the payment of an insurance premium which covers a 12 month calendar period. The company has an initial asset of the value of the prepaid premium which is then expensed at a rate of 1/12th per month during the policy period the company benefits from having the insurance. Prepaid Liability A liability incurred when a payment is received prior to a company providing the full benefit of the product or service to be rendered. An example is a deposit payment from a customer who will receive a product or service at a later date sometimes referred to as a customer deposit liability account. Price-to-Earnings Ratio A method of determining the value of a company to investors; it is arrived at by the formula: (market value per share / earnings per share). PRO Number A carrier number used to identify freight for billing, tracing, etc. Generally, procurement is the act of purchasing items for your organization. Many companies also refer to their purchasing departments as the procurement department. Procurement performs activities associated with documenting and placing orders with supplier of goods or services. They also develop purchasing policies and negotiate supplier contracts. A company generates a profit when its revenues and gains are greater than its expenses and losses. Profits increase a company's retained earnings and generally an owner's equity value. An invoice typically sent prior to shipment and represents an estimate. It is not the actual bill. Companies do not pay from these invoices. A commercial invoice should follow with the final price. Proft and Loss Statement Often called simply "P&L." A financial statement reporting activity for a certain specified period: quarter or year, for example. Also called "income statement" or "statement of earnings." A legal document between a lender and a borrower where the borrower promises to repay the loan by a given date. The promissory note also contains information about the terms and conditions of the loan. Short for proximo, from the Latin "proximo mense," which means the next month. Proximo terms are terms that specify payment in the month following the shipment, invoice or receipt. The number identifies the day of the following month on which the payment is due. For example, "Net 10th Prox." means payment is due on the 10th of the month following the month the invoice is dated or goods received. "Net 15th Prox." means payment is due on the 15th of the next month following the month of the invoice date. Purchase Card (P-Card) Multi-purpose bank card aimed at streamlining the traditional purchase order and payment processes for lower-dollar transactions, typically not exceeding $5,000, but often much smaller. Purchase Money Security Interest (PMSI) A lien trade creditors can use to obtain first priority on goods or equipment they sell in the event their debtor defaults. Purchase Order (PO) Information sent to a vendor to request product or service; typically includes item, quantity, price, discounts, vendor information, and ship-to information. Activities associated with documenting and placing an order with a supplier of goods or services; buying/obtaining goods and services; also the department responsible for those activities. Purchasing Card (P-Card) A measurement of a business's liquidity. It compares the company's cash and cash equivalents, such as marketable securities and accounts receivables with current liabilities. Also called an acid test. Process of extending a formal offer to a prospective buyer for a product or service. What a carrier charges for the shipment of goods by the weight, volume or type of goods. Real estate and buildings. Real property is also called immovable property. A written or electronic record of a transaction verifying payment. Location where a company receives shipments from suppliers; also the set of activities surrounding acknowledging the receipt of goods and transfer of ownership. Reconsignment A change made to a bill of lading in regards to the name of the consignee or the location of delivery of a shipment that is still in transit. Record Retention Schedule Also "record retention period." The prescribed length of time to keep certain historical business records, often specified by type; the reason for keeping it; and its final disposition, whether to archive or dispose of it. Recourse Factoring A factoring agreement where the factor has the right to reclaim their advance to the client if the customer does not pay the debt. Remittance Information The information needed by the biller to accurately post customer bill payments. Remittance Method The method used to deliver remittance information. Remotely Created Check (RCC) A check drawn on a bank account that is created by a person other than the account holder and does not bear the physical signature of the person on whose account the check is drawn. An RCC may contain a statement of customer authorization, the account holder's printed or typed name on the check, or the statement "No signature required" or "Signature on file." Also called a "telecheck", "demand draft", or "preauthorized draft." Requisition A request for service or product initiated by the user or consumer. The sum of the company's income from inception, less dividends declared. Retained earnings are one part of the owners' Equity section of a Balance Sheet, the other is Contributed Capital. Retained Earnings Statement Explains the change of retained earnings over a period of time. Increases or decreases in Retained Earnings is generally the result of a Loss, Gain, or Profit generated from a company's financial transactions. A financial ratio used to value or ascertain a company's return or gain on an investment. Gross income from business operations from which no costs have been subtracted. Also called the "top line." Increases in economic resources or assets; monetary amounts received for goods or services provided in normal operations for a given period, typically in the form of cash or accounts receivable. Revenues increase equity. RosettaNet A non-profit organization (www.rosettanet.org) that seeks to develop and implement standard electronic commercial interfaces for supply-chain (manager-supplier) transactions on the Internet. Created in 1998, the self-funded group includes companies like American Express, Microsoft, Netscape, and IBM. It is working to standardize labels for elements like product descriptions, part numbers, pricing data, and inventory status. The group hopes to implement many of its goals through XML, a mark-up language that lets programmers classify information with tags. The means and the path by which a shipment of goods moves. Routing Instructions Delivered by the shipper, directs the carrier to use on a shipment. Routing Transit Number (RTN) A nine-digit number that designates a specific financial institution used to process transactions. The number appears on the bottom of financial instruments, like checks, and indicates the bank on which the check is drawn. Software-as-a-Service or “software on demand.” Software that users subscribe to and access via the internet whenever they need it opposed to software that must be installed, updated and maintained on a company’s internal computers. A tax on gross receipts from retail sales of products and services and is calculated as a percentage of the sales prices. Sarbanes-Oxley Act of 2002 A United States law passed in response to a series of corporate scandals including Enron, WorldCom, and Tyco International. Provisions require the CEO and CFO of all publicly traded companies attest that they have strict internal controls within the company's policies and procedures. SOX is intended to deter and punish accounting fraud and corruption The Specially Designated Nationals and Blocked Persons list prepared by the Treasury Department’s Office of Foreign Assets Control. U.S. businesses are prohibited from doing business with the individuals, organizations, and countries on the SDN. The list includes terrorists, drug and weapon dealers and other prohibited individuals and organizations. Click here for OFA’s SDN List The section of the bill of lading where the shipper assigns to the carrier the collection of freight charges from the consignee, without recourse to the shipper. When Section 7 is signed, the carrier is at risk for collection of freight payment. Secured Transactions (lien)(SLAs) A security interest granted over an item of property, such as a home, business, or equipment to secure the payment of a debt. An agency of the U.S. federal government created to prevent fraud in securities transactions and mutual fund trading. A grouping of information within an EDI transaction set (e.g., name and address). Segment Identifier The code that introduces a new segment in an EDI transaction set. Segment Separator The code that terminates a segment in an EDI transaction set. Single Euro Payment Area. An initiative to streamline electronic and international payments in Europe. Electronic payments within or between the 31 member states are accepted in euros, with each country adopting similar business, legal and technical requirements. SEPA will govern all European payments by 2011. Service Level Agreements (SLAs) A contract that defines levels of service in measurable terms. The complete assembly of an item. The resolution of a legal matter without having to dispute the case in court. The standardization, re-engineering, and consolidation of a non-core function within a company. It generally involves the centralization of administrative functions. Shares is a term referred to the units of ownership interest provided to the stockholder or owner of a company. The term is often used in connection with the number of units issued to an owner of Common Stock or Preferred Stock. The person whose commodities are being moved by a carrier on contractual terms. Short pays When a customer pays less than the total amount due on an invoice; the deduction is usually taken for a real or perceived error, such as damaged goods. Single Euro Payment Area (SEPA) A geographical area where electronic payments within or between 32 European member states are accepted in euros; each member country adopts similar business, legal and technical requirements. A method or set of techniques, Six Sigma has also become a movement focused on business process improvement. It is a quality measurement and improvement program originally developed by Motorola that focuses on the control of a process to the point of ± six sigma (standard deviations) from a centerline, or put another way, 3.4 defects per million items. A Six Sigma systematic quality program provides businesses with the tools to improve the capability of their business processes. It includes identifying factors critical to quality as determined by the customer, reducing process variation and improving capabilities, increasing stability and designing systems to support the six sigma goal. 1) Stealing money from cash receipts for personal use and not reporting them in a deposit. 2) Stealing the information from payment cards and using it for fraudulent purchases. The process of finding the whereabouts of persons, often hard-to-locate debtors, known as skips."" Subject matter expert. A business that is owned and operated by one individual. The sole owner assumes all financial and legal liability for the business. The process of identifying, negotiating, and creating supply agreements with vendors of goods and services. A critical part of spend management, it's an in-depth analysis of an organization's expenditures data; includes what you spend, with whom you spend it, and how you spend. A payment that is applied to the wrong account. Also refers to a payment that is divided or split" among several invoices." Spot Rate Quotation A carrier price offer to a shipper applicable to a single, specific shipment; a negotiated one-off price. Short-paid un-reconciled deduction; received payment that is less than the amount invoiced. Standard Carrier Alpha (SCAC) An industry-wide code issued by the National Motor Freight Traffic Association (NMFTA) to identify all carrier companies. A written record of an account; also a summary of outstanding (unpaid) invoices. Unlike an invoice or bill, a statement is not generally used as a formal request for payment but rather as a reminder of amounts owed by a customer. Statement/Notice A periodic report that states all transactions on a single account. A statement can also be an itemized list of charges showing due dates and amounts owed. Stem Time The amount of time required for a truck or semi-trailer to travel between origin and destination. Another term used to describe the ownership interest in a company. Often used interchangeably with contributed capital, common stock and preferred stock. Stock Certificate A document providing evidence of a person or organizations' ownership interest in a company. A stock certificate is issued to a an owner of Common Stock or Preferred Stock. The unit of measurement used to record products on a stock record and manage inventory. Stock Option Generally, a stock option is a contractual right granted by a company to the named holder of the option the right to purchase the company's stock at a fixed price stated on the stock option within a specified period of time. If the stock option is not exercised within the specified period of time, then the contractual right lapses. Stockholder Refers to the owner of a company who has contributed cash or some other form of consideration in exchange for an ownership interest. Another term used interchangeably with Equity. It is the section of the balance sheet that provides information about the amount of contributed capital and amount of earnings retained in the company. This section is generally the sum of: Common Stock + APIC + Retained Earnings. Stopoff The pickups or deliveries between the initial pickup and the last delivery. Straight Through Processing A method of electronic payment processing where funds are transferred and settled without the need for manually re-keying the data. Streamlined Sales Tax (SST) A cooperative agreement among U.S. states intended to simplify and standardize sales tax collection and administration between states. A main goal is to promote parity between brick-and-mortar merchants and remote / internet sellers from a sales tax standpoint. Strike Price Another term used for describing the fixed price documented in a stock option. See Exercise Price. Acknowledgement that a debt owed is inferior to another debt owed by the same debtor. Successful Effort Accounting Used in extraction industries, e.g. oil & gas or mining, this accounting method carries forward only successful exploration and evaluation costs--costs are only capitalized if they can be associated directly with future production; costs of unsuccessful efforts are written off as expense at the time they are incurred. A model in economics that states that when the supply of a commodity is high but the demand low, the price drops; when supply is low but demand is high, the price rises. Over time in a competitive market, a price equilibrium will be reached; for example, if prices become too high, demand will drop, which will force prices down. An agency of the Department of Transportation that was created to take over the ICC's duties after the latter's termination in 1995. The Society for Worldwide Interbank Financial Telecommunication is a private consortium of member banks that maintains a worldwide network for exchange financial information; SWIFT is a messaging system transferring information about money transactions, not the actual money. Money and assets that physically exist. To be considered tangible, a piece of property must be movable. Real Estate, which is immovable, is not considered tangible personal property. Texas v. New Jersey The landmark case in which the U.S. Supreme Court's rulings established escheatment priority rules that determine which state is entitled to abandoned property in the event of disputes. First priority is given to the state of the last known address of the owner - i.e. the customer to whom the credit belongs; if the customer's address is unknown, the state of incorporation of the holder of the credit takes precedence. Three-way match Validation of an invoice by matching it to a purchase order and a receiving document. If all three match or agree, the invoice is approved for payment. Time Value of Money The principle that money received in the present is worth more than money invested in the future. Taxpayer Identification Number. A nine digit number assigned by the IRS to individuals (SSN), employers (EIN) and nonresident aliens (ITIN). TIN Matching Program An IRS online database and batch process program where payers can search payee name and TIN combinations. The system informs the payer if the name and the TIN are a valid match or not. Companies and other institutions exchanging information via EDI with one another. Activity between two parties. A transaction can be financial or commercial. Transaction Set In ANSI X12, the electronic equivalent of a paper form (e.g., invoice, purchase order). The shipper's policy guidelines, including routing instructions, pertaining to the transport of their goods. Travel and Entertainment (T&E) Expenses Expenses employees incur for business travel and entertainment that may be tax deductible. Travel and Entertainment Expenses (T&E) Trial Balance An accounting worksheet in which all general ledger transactions are listed in debit and credit columns for a certain period, and verified to see that they match. The quantity of freight that fills a trailer, usually over 10,000 pounds, and to which truckload rates apply. The process of removing a paper check from its processing flow. TWIST is a not-for-profit international industry group focusing on end-to-end connectivity of financial processes, seeking development and adoption of standards for straight-through processing (STP) of wholesale trade transactions, working capital management and corporate payments. TWIST emphasises market collaboration and has taken a proactive role in developing standards in conjunction with other standards such as ISO / SWIFT, IFX, FpML, RosettaNet, MDDL market data standards and CRG-Edifact. U.S. Source Income In the case of accounts payable, income to an nonresident alien for services performed in the United States; U.S Source income must be reported to the IRS on IRS Form 1042S. UB-92 The standard billing format for submitting hospital claims, developed by the AHA's National Uniform Billing Committee. Uniform Commercial Code -The laws that govern commercial transactions in the United States. UN Joint European and North American Working Party (UN-JEDI) The international EDI standards developed by the UN-JEDI (defined below) committee; EDIFACT stands for Electronic Data Interchange For Administration, Commerce and Transport. UN/EDIFACT Standards Unbilled Receivables Receivables for which services or products have been delivered and revenue recognized but no invoice has been issued; unbilled receivables are a metric to watch, since timely billing is critical to cash flow. Tangible or intangible property that is considered lost or abandoned by the rightful owner after that owner cannot be located for a specific period of time. Intangible unclaimed property typically includes money, checks, drafts, deposits, interest, dividends and income, credit balances, customer overpayment, gift certificates, security deposits, refunds, credit memos, unpaid wages, unused airline tickets, and unidentified remittances. Such property must be reported and escheated (remitted) to the states after a dormancy period and a due diligence effort to locate the owner. See Escheatment. Unclaimed Property Professionals Organization (UPPO) An organization created to ease the burden of reporting unclaimed property and simplifying compliance issues. It works closely with the National Association of Unclaimed Property Administrators. Uncollected Funds Checks that have been deposited into an account but have not yet been paid by the bank(s) on which the checks were drawn. Uniform Commercial Code (UCC) A set of statutes and laws adopted by most states to govern commercial transactions uniformly. Click on The Uniform Commercial Code for more information. Uniform Customs and Practice for Documentary Credits (UCP) A set of rules regarding the issuance and use of letters of credit developed, maintained and published by the International Chamber of Commerce. The most recent version, UPC 600, took effect on July 1, 2007. Uniform Law Commission The Uniform Law Commission is also known as the National Conference of Commissioners on Uniform State Laws. The commission was established in 1892 and provides states with non-partisan, well-conceived and well-drafted legislation that brings clarity and stability to critical areas of state statutory law. Unmatched Payments Payments made that differ from the amounts that are due. Unprocessed Non-PO Invoice Instance when an invoice received for goods purchased without a PO has not been approved and/or entered into the accounting records. A debt that has had very few, if any, payments made on it. Unverified List A list published by the Department of Commerce’s Bureau of Industry and Security. It contains the names of foreign individuals whose participation in transactions may have failed to follow U.S. export control regulations. The Bureau has not been able to conduct pre-license checks or post-shipment verifications of the transactions. Click here for the Unverified List Use Tax A tax on the use or consumption of a taxable product or service and was devised to capture revenue that slips through the cracks of the sales tax law. (See Sales and Use Tax Concepts) VAT is a consumption tax levied on goods and services at each step of the production/distribution cycle. An indirect tax, VAT is paid by manufacturers, distributors and retailers when they receive goods in their inventories. Businesses are able to recover VAT payments through tax deductions, with the cost of the tax ultimately paid by the end-consumer. More than 100 countries worldwide have VAT systems in place, including Canada, New Zealand, Japan, Australia and the European Union. VAT rates can vary from 3.6 percent to 25 percent of a good's total value. Value-Added Network (VAN) A large communication network that facilitates EDI between companies. Value added tax. VAT is a consumption tax levied on goods and services at each step of the production/distribution cycle. An indirect tax, VAT is paid by manufacturers, distributors andretailers when they receive goods in their inventories. Businesses are able to recover VAT payments through tax deductions, with the cost of the tax ultimately paid by the end-consumer. More than 100 countries worldwide have VAT systems in place, including Canada, New Zealand, Japan, Australia and the European Union. VAT rates can vary from 3.6 percent to 25 percent of a good’s total value. Vendor Master File A central, comprehensive data base file generally maintained by the Accounts Payable Department that contains information about vendors used to facilitate financial transactions between companies. The information includes payment terms, address, names, credit limit, and payment or purchase transaction history. Vendor-bridging When a company has been cut off from one supplier and turns to a new vendor to purchase products and/or services. Value not to exceed. A document that can serve as an authorization for payment and/or entry to the accounts payable system of a vendor invoice; usually indicates how the invoiced amount should be charged in the companies general ledger. Waybill In essence, a waybill is a bill of lading for air shipments; has much of the same information, but is not a document of title. Weight Break The weight where less-than-truckload rate equals truckload rate at the minimum weight. Weight Group Refers to weight limits used to determine the mode of carrier for the shipment. Wholesale Lockbox A third party collection service that collects business-to-business payments from a lockbox dedicated to receiving payments from these businesses. This is typically a high-dollar, low volume payment lockbox. Method of payment in the form of an electronic transfer of funds (EFT) between the payer (the company) and recipient (the vendor). A wire transfer costs approximately $10 -$30 per transaction. A Wire transfer is faster than ACH but more expensive. Wire Transfer or Wire Fund Payment A method of payment in the form of an electronic transfer of funds (EFT) between the payer (the company) and recipient (the vendor). A wire transfer costs approximately $10 - $30 per transaction. A Wire transfer is faster than ACH but more expensive. WNX Weight not to exceed. Refers to the technology which uses electronic systems to manage and monitor business processes, allowing the flow of work between individuals to be defined and tracked; moving information in document form according to defined processes; tracking the process of creating, reviewing and distributing documents for action. In a payables or source-to-pay context, refers to the technology which uses electronic systems to manage and monitor business processes, allowing the flow of work between individuals to be defined and tracked; moving information in document form according to defined processes; tracking the process of creating, reviewing and distributing documents for action. The available short-term liquidity (excluding loans like line of credit) a business has for day-to-day operations; calculated by subtracting current liabilities from current assets. The body responsible for managing Internet standards development. XBRL (eXtensible Business Reporting Language) is a royalty-free, open specification for software that uses XML data tags to describe financial information for public and private companies and other organizations. Z-Scores A family of statistical models used to calculate the probability a company will file for bankruptcy. The original Z-Score model only sampled publically-traded manufacturing companies. Z' (Z Prime) included manufacturing and privately-held organizations. Z?'s (Z Double Prime) samples were compiled from manufacturing and non-manufacturing firms, such as retailers and wholesalers, and companies located outside the U.S. Zombie Debt Bad debt that is so old the borrower may have forgotten he or she owed it. It may have been given up on by the company to which it was owed. Zombie debt can haunt a debtor if a debt collector buys the debt for a low price from the company in attempt to recover the owed funds. Accounts Payable & Procure-to-Pay › Accounts Receivable & Order-to-Cash › About IOFM AR Connect 2019 DSAR Requests Events, Products & Services © 2020 Diversified Communications. All rights reserved.

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Discuss the Uses and Limitation of Cash Flow Statement 2021 | Advantages and Disadvantages of Cash Flow Statement Class 12 Education E-BOOKS Finance Welcome to latestnews-24.com. During this article, you’ll discover the What is the Limitation of Cash Flow Statement: An accounting statement that summarizes the amount of cash and cash equivalents entering and leaving a business is called a cash flow statement. So if you like our post then please you’ll share the post along with your friends also. Read our Trending Topics What are the Limitations of Statistics Importance of Forest Essay Value of Discipline Essay 200 Words Essay on Autobiography of a Newspaper Types of Plastic Money Plastic Money Merits and Demerits Child Labour Essay Women Empowerment Essay Learn in detail about the Explain the Importance and Limitation of Cash Flow Statement class 12 Notes in English by reading this well-described Article. and if you want to read this article About the Limitation of Cash Flow Statement Class 12 Notes in Hindi then use our translator plugin on the top left corner of the screen. Essentially, the cash flow statement measures how well a company manages its cash, which means its ability to generate cash to manage its debt obligations and fund operations. A cash flow statement is included as part of a company’s financial reports since 1987, alongside the balance sheet and income statement. The purpose of this article is to demonstrate how the CFS is structured, as well as how you can use it to analyze a company. What Is Cash Flow Statement? Limitations of Cash Flow Statements Advantages of Cash Flow Statement How Cash Flow Statements Work How to Use a Cash Flow Statement The Structure of the Cash Flow Statement Cash Flows from Operations Cash Flows from Investing Cash Flows from Financing Why the Cash Flow Statement is required Negative Cash Flow vs. Positive Cash Flow How Cash Flow Is Calculated Cash Flow Statement Direct Method Cash Flow Statement Indirect Method Accounts Receivable and Cash Flow Inventory Value and Cash Flow How the cash flow statement works with the income statement and the balance sheet How to Track Cash Flow using the Indirect Method 7 Major Limitations of Cash Flow Statement Disadvantages of Cash Flow Statement Difference between Cash Flow and Fund Flow Statement How to prepare Cash Flow Statement Cash Flow Statement Format (Indirect Method) Importance of Cash Flow Statement List of cash flow statement formula Cash Flow Statement format PDF Cash Flow Statement format in excel Some questions about Limitation of Cash Flow Statement How are cash flow and net income differentiated? Why is cash flow necessary for business? How to maximize your cash flow? How to analyze cash flow? What happens when cash flow is negative? What is free cash flow? How to analyse if cash flow statements are correct? Can cash flow be negative? How to calculate Free Cash Flow (FCF) from a cash flow statement? What is levered free cash flow? An income statement depicts all cash inflows and outflows made by an organization from its ongoing operations and external investments. Cash outflows include all payments for business activities and investments during a particular time period. Investors and analysts can view a company’s financial statements as they provide a snapshot of all the items that make up that organization, where every item contributes to its success. Cash flow statements are viewed as the most intuitive financial statements because they provide information on how cash is generated by a business through its operations, investments, and financing. The total of these three components is the business’ net cash flow. Investors can determine the value of a stock or the company as a whole by studying the three different sections of the cash flow statement. Analyzing financial statements with cash flow statements can provide useful insights. Yet there are some limitations to the cash flow statement. Listed below are such limitations. In a cash flow statement, cash inflow and outflow are the only items listed. Nevertheless, the cash balance reported by the statement does not reflect how liquid the business really is. In fact, net income is determined by taking into account both cash items and non-cash items, which means that the Cash Flow Statement does not necessarily represent the net income of a business. The Cash Flow Statement does not portray the business’s full financial picture. Preparing the cash flow statement is just a post-mortem exercise. No projections about future cash flow are included in this process. Instead, an income statement should be used. An income statement can be used as an indicator of the accuracy of a cash flow statement. The income statement and the cash flow statement are both inaccurate if the balance sheet is. It hasn’t been prepared to reflect accrual accounting principles. Consequently, the accuracy of cash flow statement should be questioned. A cash flow from operating activities calculation does not include non-cash items, making it unsuitable for gauging a firm’s profitability. Assess the Liquidity Status of Company: With the help of the Cash Flow Statement, an individual can find out the liquidity or actual cash position of the company, which is something that profit and loss and fund flow statements fail to provide. With the knowledge of the liquidity status, external sources of funds can be searched for and raised, and if there are surpluses, they can be used for the business’ growth. By analyzing a cash flow statement, you can determine whether there is a discrepancy in cash position. In order to figure out how the firm’s cash position can be optimally managed, the Cash Flow statement is used. With the determination of the optimum cash balance, the company can determine whether it has too much or too little cash. With an understanding of the firm’s cash position, funds can decide how much to borrow and invest. Assist in Planning, Budgeting, and Controlling: By using the cash flow statement, financial planning and analysis can be carried out. Managing financial operations properly has become easier thanks to the cash flow statement. By preparing cash flow statements, it becomes possible to manage cash. By doing so, the management will be able to make an estimation of various inflows and outflows of cash in order to take necessary actions in the near future. Performance Appraisal: A comparison of the actual cash flow statement and projected cash flow statement can help management evaluate performances regarding cash. Should any variances be discovered, they ought to be corrected accordingly. Movement of Cash: The cash flow statement shows how the cash is incoming and going out, thus allowing us to estimate future cash flows. The Securities and Exchange Commission (SEC) requires every company that sells and offers its stock to the public to file financial reports and statements. The balance sheet and income statement are the two main financial statements. In addition to opening interested parties’ eyes to all the transactions that occur within a company, a cash flow statement provides an insight into the workings of the business. A company’s accounting system has two distinct areas-this is accrual accounting. The income statement of most public companies differs from the cash position, as accrual accounting is used to report earnings. Cash flow statements, however, are more concerned with cash accounts. Cash flow statements are critical tools for companies, analysts, and investors because profitable companies can stumble when it comes to managing cash flow. Three different cash flow activities are accounted for in a cash flow statement: operations, investing, and financing. Consider a company that sells its customers a product and extends them a credit line for that purchase. However, the company may not receive cash for that sale until a later date, even though it recognizes it as revenue. Profits from the business appear on the income statement, but it may generate more or less cash than it shows on the income statement. Investors can use the CFS to determine how an organization manages its operations, where the money is coming from, and where the money is going. In addition to providing investors with valuable information, the CFS also provides valuable insights into a company’s financial position. As for creditors, the CFS can be used to determine how much cash is available for the company (referred to as liquidity) to cover its operating costs and pay its debts. limitations of cash flow statement class 12 Cash flow statement includes the following components: Cash from operating activities Cash from investing activities Cash from financing activities This statement is different from both the income statement and balance sheet in that it does not include as items future cash inflows and outflows recorded on credit. So cash and net income are not the same things because cash sales are reflected on the income statement while credit sales are reflected on the balance sheet. A cash flow statement’s first section includes the cash from operating activities (CFO) as well as the transactions from operating activities. Detailed cash flows from operations are calculated by starting with net income, then reconciling all noncash items to cash items representing operational activities. It is, in other words, the net income of the company expressed in cash. Directly associated with a company’s main business operations, this section reports cash flows and outlays. Purchasing and selling inventory and supplies, along with paying its employees, are among these activities. In addition to the inflows and outflows discussed here, any other forms of inflows and outflows are excluded. Businesses have the ability to generate positive cash flow for their operations. For expansion, the company may need to secure financing from external sources if they do not generate enough. An accounts receivable account, for example, is not a cash account. During a period where accounts receivable increase, it means there were more sales but no cash was received. Due to the fact that receivables are not cash, they are deducted from net income in the cash flow statement. In addition, accounts payable, depreciation, amortization, and numerous pre-paid items can also generate cash flows from the operations section, but often without cash associated with them. Investing gains and losses are the results of the cash flow from investing (CFI) section of the cash flow statement. Investing gains and losses are also reflected here for purchases of property, plant, and equipment. The capital expenditures (Capex) section is where analysts check how spending has changed. It is generally true that Capex increases mean less cash flow. In some cases, that can actually be a good thing, as it indicates that a company is making investments in its future. Growth companies are typically those that invest heavily in equipment. Cash flow, however good, needed to be generated from business operations, not investments and financing activities in order for investors to be satisfied. Sales of property and equipment can provide cash flow for businesses within this section. This section of the cash flow statement summarizes the cash flows from financing (CFF). Cash in the form of operating expenses is presented in the section. This measure measures the flow of cash from the income of a company to its owners and creditors, and its sources are normally debt or equity. A company’s 10-K report to shareholders generally includes these figures. Analysts use the cash flows from the financing section to determine how much money the company has paid out via dividends or share buybacks. It is also useful to help determine how a company raises cash for operational growth. Cash obtained or paid back from capital fundraising efforts, such as equity or debt, is listed here, as are loans taken out or paid back. When the cash flow from financing is a positive number, it means there is more money coming into the company than flowing out. When the number is negative, it may mean the company is paying off debt, or is making dividend payments and/or stock buybacks. Accounting professionals realize that just studying one or two financial statements isn’t enough to gain complete knowledge of a company’s finances and operations. A statement of cash flows must therefore be included in a set of financial statements distributed outside the company in accordance with generally accepted accounting principles (GAAP, US GAAP). The following are the five financial statements and notes to the financial statements that make up a complete set of financial statements: Statement of comprehensive income Statement of stockholders’ equity Notes to the financial statements Income statements provide the news to the media, but they are actually derived from the accrual basis of accounting. Accounting techniques such as this best measure how a company’s revenues, expenses, and earnings change during a short time period. Nevertheless, the income statement does not include information on how much cash a company had in it and out of it. An income statement does not disclose, for instance, whether the company had: Cash collected from sales. (The cash might be collected from customers 45 days after the sale.) Cash paid for goods sold. (Payment may have been made many months prior to their sale.) Cash paid for buildings and equipment that will be expensed over the next 5 to 30 years. Cash received from the sale of long-term assets Cash received from bank loans Cash payments to reduce a loan’s principal balance Cash withdrawn by owners or cash dividends paid to stockholders It is important for corporations to fully understand their cash inflows and outflows so that they can meet their short- and long-term obligations. In addition to creditors and investors, the company’s cash flows also interest current and prospective lenders and investors. Cash flows from operating activities is the first section of the cash flow statement that financial analysts will pay close attention to. This section is reviewed by comparing the net cash provided by operating activities (described by this section as net cash generated from the operation of the company) with its net income. It’s necessary to evaluate the income statement to determine whether the revenue, expenses, and net income reported are in accordance with the company’s cash balance. When there is inconsistency, they may seek to uncover the reason for the differences. There is the possibility that the company’s inventory no longer sells or that customers are returning it. There could also be a problem with receivables. Lastly, the SCF provides the cash amounts needed in some financial models. The analyst’s view is that “Cash is king”. While some leeway can be exercised when applying accounting principles, there is no leeway when it comes to reporting the cash amount. which of the following is not a limitation of cash flow statement Negative Cash Flow Positive Cash Flow During your accounting period, you lost cash – that is what you mean by negative cash flow on your cash flow statement. Cash flow that is negative over time does not always mean there is a negative trend. When a business is just starting out, it is critical for it to track its burn rate as it grows and becomes profitable. When you see a positive number at the bottom of the statement, this indicates that your cash flow for the month was positive. You should keep in mind that positive cash flows aren’t always beneficial in the long run. Having that money now might help you, but you may also need it to bail out your failing business if you took on a large loan. Overall, a positive cash flow is not always the best or even the most effective. To calculate net cash flow, one makes certain adjustments to net income by adding and subtracting on the balance sheet and income statement the differences between revenue and expenses for the period, as well as adjusting for credit transactions. In addition to non-cash items, total assets and liabilities also include non-cash items (income statement). The reason is that since not all transactions involve cash items, calculating cash flow from operations requires re-evaluating many items. Consequently, there are two ways to calculate cash flow: the direct way and the indirect way. By adding up all cash payments and receipts, including remittances to suppliers, cash receipts from customers, and salary payments, the direct method determined the cash earnings of the company. The balances in the accounts are calculated by using the starting and ending balances of different business accounts and analyzing the net decrease or increase. A company’s net income is first removed from its income statement to calculate cash flow from operating activities using the indirect method. Revenue is only recognized when earnings are earned rather than when a company receives them because a company’s income statement is prepared on an accrual basis. Earnings before interest and taxes (EBIT) are not an accurate reflection of net cash flow from operating activities, therefore it is necessary to adjust the EBIT for items that affect the net income even though no cash has yet been received or paid against them. As part of the indirect method, non-operating activities are also added back that do not impact cash flow from operations. When it comes to depreciation, an amount that is deducted from an asset’s value is considered a cash expense; it is not an actual cash expense. As a result, it is included in net earnings to calculate cash flow. Changing accounts receivables (AR) on the balance sheet should also be reflected on the cash flow statement. In a falling AR environment, this suggests that more cash has entered the company from customers paying off their credit balances, with the reduced AR amount being added to net earnings. It is mandatory to deduct the amount of accounts receivable increase from net earnings when AR increases from one account period to the next because, although these amounts represent revenue, they are not cash. Conversely, the presence of increased inventory signifies that the company has invested more money in purchasing more raw materials. Cash-paid inventory increases in value are deducted from net earnings when the inventory is paid with cash. Inventory decreases would increase net earnings. A balance sheet increase in accounts payable will occur if inventory is purchased on credit, and this amount will be added to net income the following year. The same logic applies in regards to taxes payable, prepaid insurance, and salaries payable. In the case of a paid-off item, the difference between one year and the next owed on the item has to be subtracted from net income. The net earnings will be adjusted to include any differences if there is still an amount owed. Creating a cash flow statement requires you to carefully examine your income statement and balance sheet. The income statement indicates how much money has entered your business and left, while the balance sheet shows the impact that money has had on your business accounts such as accounts receivable, inventory, and accounts payable. As a business, the process of creating financial statements is as follows: Income Statement + Balance Sheet = Cash Flow Statement You can create a cash flow statement by keeping a few simple rules in mind: A decrease in cash flow is the result of transactions that increase assets. Increased cash flow is a result of transactions resulting in a decrease in assets. Cash flow is increased in transactions that increase liabilities. When liabilities decrease, cash flow decreases as well. Limitation of Cash Flow Statement Keeping a cash flow statement is limited by 7 limitations! (1) Fails to Present Net Income: An income statement has the advantage of being able to present the financial data of a company in the form of net income since it takes into account the non-cash items that are easily apparent in the cash flow statement. The Income Statement can be supplemented by this report. (2) Fails to Assess the Liquidity and Solvency Position: A cash flow statement does not provide much help when it comes to assessing a firm’s solvency or liquidity. In the cash flow statement, which shows only how much cash was available at the end of the period, the appropriate liquidity position cannot be determined. The statement is only useful for determining the number of obligations that can be met since the liquidity position indicated by the cash flow statement is not an accurate representation of the situation. (3) Neither a Substitute of Funds Flow Statement nor Income Statement: Cash Flow Statements cannot be substituted for Fund Flow Statements nor for Income Statements. An Income Statement or Funds Flow Statement cannot fulfill all the functions of these statements. (4) Not to Assess Profitability: As a result, cash flows from operations cannot be used to determine whether a firm is profitable since it does not consider costs and revenues. (5) Does not Conform with the Companies Act: According to the Companies Act, the Profit and Loss Account and Balance Sheet are in conformity with the Profit and Loss Account, however, the Cash Flow Statement prepared per AS 3 is not in conformity with the Companies Act. (6) Does not Assess Future Cash Flows: Due to the fact that Cash Flow Statements are prepared using historical costs, knowing future/projected cash flows is not helpful. (7) Inter-Industry Comparison not Possible: The cash flow statement is unable to measure a firm’s economic efficiency in comparison with another firm in the same industry. For example, a firm with a lower level of capital investment will have a lower level of cash flow than a firm with a greater level of capital investment. Several aspects of the cash flow statement are deficient, including the following: Non-Cash Transactions are Overlooked: An individual’s focus on the Cash Flow Statement is entirely on the ‘Inflow’ and ‘Outflow’ of cash. The TCPA is not involved in non-cash transactions, such as the sale of buildings through the issuance of stock/debentures, or the issuance of bonus shares. Not a Substitute for an Income Statement: This form of the statement reveals both ‘Cash’ and ‘Non-Cash’ items of a business organization as well as it’s Net Income’. ‘Cash Flow Statements, on the other hand, only consider the cash flow aspect of the business and as such can only display the inflows or outflows of ‘Net Cash Flows’. It is not permitted to disclose the organization’s ‘Net Profit/Loss. Limited Use: ‘Cash Flow Statements’ are very limited in their application when taken separately. A balanced sheet and profit and loss account are necessary to obtain meaningful results. The income statement alone does not stand alone in figuring out a business’s financial position. Historical in Nature: Creating the cash flow statement requires rearranging other financial statements, such as the income statement. Accounting terms such as ‘balance sheet’ and ‘profit & loss account’ relate to historical data. The presentation would have been more effective and useful if it had been accompanied by a ‘Projected Cash Flow Statement’. Ignoring the Accrual Concept: Cash flow statement is totally oblivious to the concept of accrual, one of the basis of accounting. Basis of Difference Fund Flow Statement Cash Flow Statement Nature of Statement Working capital is expressed as a change. The statement summarizes changes to the cash position. Object The purpose of preparing a fund flow statement is to gather information regarding the ability of an organization to meet its long-term obligations. An enterprise’s ability to meet its short-term liabilities is the purpose of preparing cash flow statements. Opening Balance In preparation for a fund flow statement, there is an opening balance of cash on hand. With the cash opening balance in hand, the document is prepared. Period It takes longer to prepare a statement of fund flow. It takes a short amount of time to prepare a cash flow statement. Planning An enterprise’s long-term plan is facilitated by its fund flow statement. An enterprise’s short-term planning is facilitated by a cash flow statement. Dependence In addition to the cash flow statement, Fund Flow Statement can also be drafted. Taking only the fund flow statement into consideration is not sufficient to prepare the cash flow statement. The schedule of working capital changes must also accompany the fund’s flow statement if the cash flow statement is to be prepared. Additional Statement An additional statement, viz. A fund flow statement must be prepared after the preparation of the fund flow statement. Workflow schedule, to be prepared after preparation of the fund flow statement. Describes the cash flow for the period. No other statements are prepared after the cash flow statement. Difference of Sides Working capital is either increased or decreased on both sides of the fund flow statement. The closing balance of cash is the difference between both sides of the cash flow statement. The following two methods can be used to prepare a cash flow statement: Preparation of ‘Cash Flow Statement’ under “Traditional Method”: In order to prepare a Cash Flow Statement, one uses the “Traditional Method.” This method is simple and straightforward. A standard format is not stipulated as to how to describe ‘Inflows’ and ‘Outflows’ separately. Furthermore, ‘Operating Activities’, ‘Investment Activities’, and ‘Financing Activities’ are not broken down separately. Preparation of “Cash Flow Statement’ under AS-3: Reporting and presentation of the Cash Flow Statement differ fundamentally between the standard AS-3 cash flow statement and the conventional cash flow statement. From the operating activities perspective, ‘Cash Flow’ can be reported in two ways: Direct Method. Indirect Method. (For the period ended 31st March…..) Particulars Rs. Net Profit as per P&L A/c Add: Non-Operating Items: Depreciation on Building Depreciation on Machinery Depreciation on Machinery sold Increase in Provision for doubtful debts Transfer to Reserves Goodwill has written off Preliminary Expenses written-off Other tangible assets written-off Loss on sale or disposable of fixed Less: Profit on sale of investment Profit on sale of machinery Operating Profit before Working Capital Changes Add: Increase in Current liabilities Decrease in Current assets Less: Increase in Current assets Decrease in Current liabilities Cash Generated from Operating Activities Less: Income tax Paid Net Cash Flows from Operating Activities (A) Cash Flows from Investing Activities: Add: Sale of Investments Sale of Machine Less: Purchase of Buildings Less: Purchase of Machinery Net Cash Flows from Investing Activities (B) Add: Issue of Share Add: Issue of Debenture Less: Redemption of Debentures Less: Interim Dividend Paid Less: Dividend Paid Net Cash Flows from Financing Activities (C) Net Increase/Decrease in Cash & Cash Equivalents (A + B+C) Cash& Cash Equivalents at the Beginning of the Year Cash &Cash Equivalents at End of the Year – Note: In order to judge the accuracy of the cash flow statement (indirect method), one must ensure that (A+B+C) the amount of cash and cash equivalents at the beginning and at the end of the year are the same. This can be written as, Cash & Cash Equivalents at the end of the year = Net Increase/Decrease in Cash & Cash Equivalents + Cash & Cash Equivalents at the beginning of the year. Short Term Planning Cash Flow Statements are regarded as valuable and vital tools for a company’s management for a variety of reasons, including short-term planning and cash management. In order to be able to meet various obligations as and when they arise, each business entity needs to maintain a sufficient level of liquid funds. By comparing past data of cash inflows and outflows to the projected cash flow in the near future, the cash flow statement assists the financial manager in forecasting future cash flows. Provides the Details where the Money is Spent In addition, the Cash Flow statement is also of importance because there are various payments made by the company that is not included in the profit and loss statement of the company, whereas they are mentioned in the Cash Flow statement. Therefore, the cash flow statement provides a detailed breakdown of how the company spends its money. Creating Excess Cash Profits are the motive behind every business enterprise. While the profit helps create the cash, there are other ways that also contribute to the creation of cash. Identifying and implementing these methods can be done by focusing on your cash flow statement. Conversely, focusing exclusively on the P&L account prevents a company from focusing on creating cash. Revealing the Cash Planning Results Another benefit of a cash flow statement is that it can be used to determine how successful a company’s cash planning has been because the actual results can be compared with the projections included in the cash flow statement. Taking the appropriate measures will be made possible by the results. Thus, it provides the company with a means of comparing past assessments’ cash budgets with the current budgets in order to assess what will be the company’s cash requirements in the future. One of the other important aspects of the cash flow statement is that it aids management in planning the long-term position of the cash flow. Having a long-term financial plan is crucial for the success of a company, as it determines how far the company will advance. Therefore, it identifies important changes that have to be made for the financial positioning of a company and allows the management to prioritize the strategic activities. Knowing the Optimum Level of Cash Balance As a result of the Cash Flow Statement, a company is able to determine what the most optimal level of cash balance is. This helps the firm to determine if there is an excess of cash, a shortage of cash or if the funds are idle. If the firm can assess its Cash Balance, it can determine more efficiently whether the funds are idle, insufficient, or surplus. With the knowledge of the actual cash position of the company, the management can make appropriate decisions. Helps in Analyzing the Working Capital Operating cash flow comprises the component of a company’s income from operations that can affect its cash flow. In order to know how working capital movements in the firm impact cash flow, investors should be aware. cash flow statement formula Free Cash Flow = Net income + Depreciation/Amortization – Change in Working Capital – Capital Expenditure Operating Cash Flow = Operating Income + Depreciation – Taxes + Change in Working Capital Cash Flow Forecast = Beginning Cash + Projected Inflows – Projected Outflows = Ending Cash Operating Cash Flow Ratio = Cash Flows From Operations/Current Liabilities Cash flow from operating cash flows/Net sales = _____% Current Ratio = Current Assets/Current Liabilities Quick Ratio = Current Assets – Inventory/Current Liabilities Formula for Direct Method of Calculating the Cash Flows from Operating Activities Particulars Amount Cash Receipts from Customers xxx Cash Paid to suppliers and employees (xxx) Cash generated from Operations xxx Income Tax Paid (xxx) Cash Flow before Extra-ordinary Items xxx Extra-ordinary items xxx Net Cash from Operating Activities (Direct Method) xxx The indirect method of cash flow calculation for operating activities Net Profit before Tax and Extra-ordinary items xxx Adjustments for – Depreciation xxx – Foreign Exchange xxx – Investments xxx – Gain or Loss on Sale of Fixed Assets xxx – Interest Dividend xxx Operating Profit before Working Capital Changes xxx – Trade and Other Receivables xxx – Inventories xxx – Trade Payable xxx – Interest Paid (xxx) – Direct Taxes (xxx) Cash before Extra-Ordinary Items xxx Deferred Revenue xxx Net Cash Flow from Operating Activities (Indirect Method) xxx Investing activities’ cash flows in various formats:- Purchase of Fixed Assets (xxx) (Add) Proceeds from Sale of Fixed Assets xxx (Add) Interest received xxx (Add) Dividend received xxx Net Cash Flow from Investing Activities xxx Flows from financing activities in different formats:- Proceeds from Issue of Share Capital xxx Proceeds from Long Term Borrowings xxx Repayment of Long Term Borrowings (xxx) Interest Paid (xxx) Dividend Paid (xxx) Net Cash Flows from Financing Activities xxx As shown below, the entire Cash Flow Statement can be formatted in the following manner:- Cash flow from Operating Activities (Direct Method/ Indirect Method) xxx (Add) Cash Flow from Investing Activities xxx (Add) Cash Flow from Financing Activities xxx (=)Net Increase/Decrease in Cash xxx (Add) Opening Balance of Cash & Cash Equivalents xxx (=) Closing Balance of Cash & Cash Equivalents xxx In addition to showing a company’s strength, profitability, and long-term future outlook, cash flow statements also help to gauge the company’s financial health. In order to determine whether a company has sufficient liquidity for paying its expenses, the CFS can be used. In addition to helping companies budget for the future, cash flow statements can be used to predict future cash flow. As a means of assessing a company’s financial health, the cash flow statement is critical since it indicates the availability of cash for business operations. However, this rule of thumb should not be taken literally. It’s not uncommon for a company to experience negative cash flow after expanding operations as part of its growth strategy. An investor can assess the financial health of a company by analyzing the cash flow statement. In addition, the cash flow statement provides a clear picture of how much cash the company generates. Usually, cash flow is calculated by comparing changes in cash balance between accounting periods. An accounting period’s net income is equal to gross income minus the associated expenses. It is crucial for businesses to have a steady cash flow since this is what delivers money for paying bills, buying supplies, and paying employees. In order to increase cash flow, you will need to increase the speed at which your receivables arrive. It may be necessary to reduce the amount of time you reward customers for paying on time or to increase customer service efforts. A cash flow statement shows the money that comes into and leaves your business, and you need one to analyze cash flow. From there, you can analyze your investors, operating expenses, financing costs, and so on. Negative cash flow prevents businesses from paying their bills. Borrowing money, paying interest, and hurting the bottom line is what they have to do. After considering capital consumptions, free cash flow (FCF) measures how much money a business is able to generate. You need to do a line-by-line analysis and verify that the information you enter in your cash flow statements is accurate before you submit them. It is possible to have negative cash flow. Negative cash flow occurs when your expenses surpass your income. As a result of poorly managed receivables and a lack of understanding of credit, a company gets into financial trouble. It is acceptable for a business to have negative cash flow in the beginning. However, repeated negative cash flow can lead to bankruptcy. FCF can be calculated by subtracting the previous taxes, interest, and depreciation from your previous-year earnings then adding the depreciation and amortization. Cash on hand after all obligations have been met is what is known as levered free cash flow. These funds do not have any creditors. If you have shareholders or investors, they will also have access to it. We also write about 21 Best Happy Birthday Bhabhi Ji Quotes and Essay on Deforestation in 250 Words Wish this article helped you with your Speech on the limitations of cash flow forecast in English for Students. Much obliged to you for visiting our site. We trust you like our post advantages and disadvantages of cash flow statement ppt in English for Students Details 2021 in the event that you like our post, at that point please like and offer it to your loved ones moreover. here we covered all topics If you like our article, please share it with your friends and family to get detailed information about this topic. Limitation of Cash Flow Statement: An accounting statement that summarizes the amount of cash and cash equivalents entering and leaving a business. Course Provider: Organization Course Provider Name: Latestnews-24.com Tags: advantages and disadvantages of cash flow statement ppt, advantages of cash flow statement, Cash Flow Statement, cash flow statement analysis, cash flow statement form, cash flow statement format, cash flow statement format in excel, cash flow statement format pdf, cash flow statement formula, cash flow statement indirect method, discuss the uses and limitations of cash flow statement, how to prepare cash flow statement, importance of cash flow statement, Limitation of Cash Flow Statement, limitations of cash flow forecast, limitations of cash flow statement class 12, limitations of cash flow statement pdf, what is cash flow statement, which of the following is not a limitation of cash flow statement What are the Limitations of Statistics Class 11 2021 | Explain the Importance and Limitations of Statistics PDF in English Important Money and Credit Class 10 Notes Extra Questions 2021 | Money and Credit Class 10 MCQ and PPT in English

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FORM 10-K ☒ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended June 30, 2018 ☐ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number: 001-33522 SYNTHESIS ENERGY SYSTEMS, INC. Delaware 20-2110031 (State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.) Three Riverway, Suite 300, Houston, Texas 77056 Registrant’s telephone number, including area code (713) 579-0600 Securities registered pursuant to Section 12(b) of the Exchange Act: Common Stock, $.01 par value NASDAQ Stock Market (Title of Class) (Name of Exchange on Which Registered) Securities registered pursuant to Section 12(g) of the Exchange Act: None Indicate by check mark whether the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes ☐ No ☒ Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 of 15(d) of the Exchange Act. Yes ☐ No ☒ Indicate by check mark whether the registrant (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ☒ No ☐ Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ☒ No ☐ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ☒ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ Accelerated filer ☐ Non-accelerated filer ☐ Smaller reporting company ☒ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ☐ No ☒ The aggregate market value of the voting stock held by non-affiliates of the registrant was approximately $24.6 million on December 31, 2017. The registrant had 11,022,283 shares of common stock outstanding on November 1, 2018. DOCUMENTS INCORPORATED BY REFERENCE Item 1. Description of Business 4 Item 1A. Risk Factors 19 Item 1B. Unresolved Staff Comments 36 Item 2. Properties 36 Item 3. Legal Proceedings 36 Item 4. Mine Safety Disclosures 36 Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 37 Item 6. Selected Financial Data 38 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 39 Item 7A. Quantitative and Qualitative Disclosure About Market Risk 45 Item 8. Financial Statements and Supplementary Data 45 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures 75 Item 9A. Controls and Procedures 75 Item 9B. Other Information 76 Item 10. Directors, Executive Officers and Corporate Governance 77 Item 11. Executive Compensation 80 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 89 Item 13. Certain Relationships and Related Transactions, and Director Independence 91 Item 14. Principal Accounting Fees and Services 92 Item 15. Exhibits and Financial Statement Schedules 93 This Annual Report on Form 10-K includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. All statements other than statements of historical fact are forward-looking statements and are subject to certain risks, trends and uncertainties that could cause actual results to differ materially from those projected. Among those risks, trends and uncertainties are the ability of Batchfire Resources Pty Ltd (“BFR”) and Australian Future Energy Pty Ltd (“AFE”) management to successfully grow and develop their Australian assets and operations, including Callide, Pentland and the Gladstone Energy and Ammonia Project; the ability of BFR to produce earnings and pay dividends; the ability of SES EnCoal Energy sp. z o. o. (“SEE”) management to successfully grow and develop projects, assets and operations in Poland; our ability to raise additional capital; our indebtedness and the amount of cash required to service our indebtedness; our ability to find a partner for our technology business; our ability to develop and expand business of the Tianwo-SES Joint Venture in the joint venture territory; our ability to develop our business verticals, including DRI steel, through our marketing arrangement with Midrex Technologies; our ability to successfully develop our licensing business; the ability of our project with Yima to produce earnings and pay dividends; the economic conditions of countries where we are operating; events or circumstances which result in an impairment of our assets; our ability to reduce operating costs; our ability to make distributions and repatriate earnings from our Chinese operations; our ability to maintain our listing on the NASDAQ Stock Market; our ability to successfully commercialize our technology at a larger scale and higher pressures; commodity prices, including in particular natural gas, crude oil, methanol and power, the availability and terms of financing; our customers’ and/or our ability to obtain the necessary approvals and permits for future projects; our ability to estimate the sufficiency of existing capital resources; the sufficiency of internal controls and procedures; and our results of operations in countries outside of the U.S., where we are continuing to pursue and develop projects. Although we believe that in making such forward-looking statements our expectations are based upon reasonable assumptions, such statements may be influenced by factors that could cause actual outcomes and results to be materially different from those projected by us. We cannot assure you that the assumptions upon which such forward-looking statements are based will prove to be correct. When used in this Form 10-K, the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. Because these forward-looking statements involve risks and uncertainties, actual results could differ materially from those expressed or implied by these forward-looking statements for a number of important reasons, including those discussed under “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and elsewhere in this Form 10-K. You should read these statements carefully because they discuss our expectations about our future performance, contain projections of our future operating results or our future financial condition, or state other “forward-looking” information. You should be aware that the occurrence of certain events described in this Form 10-K could substantially harm our business, results of operations and financial condition and that upon the occurrence of any of these events, the trading price of our common stock could decline, and you could lose all or part of your investment. We cannot guarantee any future results, levels of activity, performance or achievements. Except as required by law, we undertake no obligation to update any of the forward-looking statements in this Form 10-K after the date hereof. Item 1. Description of Business Synthesis Energy Systems, Inc. (referred to herein as “we”, “us” and “our”), together with its wholly-owned and majority-owned controlled subsidiaries is a global clean energy company that owns proprietary technology, SES Gasification Technology (“SGT”), for the low-cost and environmentally responsible production of synthesis gas (referred to as the “syngas”). Syngas produced from SGT is a mixture of primarily hydrogen, carbon monoxide and methane, and is used for the production of a wide variety of high-value clean energy and chemical products, such as substitute natural gas, power, methanol and fertilizer. Our current focus has been primarily on commercializing our technology outside China through the regional business platforms we have created with partners in Australia, Australian Future Energy Pty Ltd (“AFE”), and in Poland, SES EnCoal Energy sp. zo. o (“SEE”). Through AFE and SEE we believe we are developing energy and resource projects with the necessary commercial and financing structures to deliver attractive financial results. Our business model is to create value growth through AFE and SEE via the generation of earnings, from the licensing of our proprietary technology and the sale of proprietary equipment into those project developments, and through income from earned or carried equity ownership in resource and clean energy production facilities that utilize our technology. AFE and SEE endeavor to link long-term access to low-cost coal or renewable resources to the projects they develop as well as secure long-term contracts for product off-take thereby establishing the commercial and financing foundation for those projects. Through AFE and SEE, we have established local expertise with knowledge of the markets and government influences in those regions and who have the expertise required for project development, project financing, and fundraising to deliver financial results for the platforms. We believe our business proposition is compelling due to our ability to generate lower cost syngas in a clean and responsible manner utilizing coal, coal wastes, renewable biomass and municipal wastes for the production of clean energy and chemicals. We operate our business from our headquarters located in Houston, Texas and our offices in Shanghai, China. Additionally, our partnership companies AFE and SEE have independent operations in Brisbane, Australia and Warsaw, Poland respectively. Syngas as an Alternative to Conventional Energy Sources Our syngas can provide a competitive alternative to other forms of energy such as natural gas, LNG, crude oil and conventional utilization of coal in boilers for power generation. Such competing technologies include reforming of natural gas for chemicals and hydrogen production, oil refining for fuels production, petroleum byproducts for plastics, precursors such as olefins and conventional natural gas, fuel oil and coal combustion in power generation equipment and other industrial applications. The competitive advantage of our syngas is primarily driven by the price and lack of availability of natural gas, LNG and crude oil. As such, our syngas can provide a lower cost energy source in markets where coal, low quality coal, coal wastes, biomass and municipal wastes are available and where natural gas, LNG and crude oil are expensive or constrained due to lack of infrastructure such as distribution pipelines and power transmission lines, such as Asia, Eastern Europe, and parts of South America, while conversely in markets with relatively inexpensive natural gas, LNG and crude oil, we do not anticipate new syngas capacity additions. In addition to economic advantages, we believe our syngas also provides an environmentally responsible option for manufacturing chemicals, hydrogen, industrial fuel gas and can provide a cleaner option for the generation of power from coal as it minimizes both air and solid environmental emissions, in addition to utilizing less water. World population is expected to increase by 1.7 billion reaching 9.2 billion by 2040 and global GDP is projected to average around 3.25% per year, broadly in line with growth over the past 25 years. The main driver of economic growth is increasing productivity which accounts for three-quarters of global expansion and lifts more than 2.5 billion people from low incomes. This places a large demand on energy. The stronger growth reflects the more limited scope for efficiency gains when oil, gas and coal used as a feedstock rather than as a source of energy, according to the BP Energy Outlook 2018 edition. While assessing target markets in relation to the deployment of our gasification technology into global projects, we believe our ability to produce a competitively priced and environmentally responsible syngas as an alternative to natural gas and LNG positions us as a syngas energy alternative that bridges between coal markets based on traditional coal burning and the growing natural gas and LNG markets. Thus, while coal is expected to decline as part of global energy consumption, natural gas and LNG are expected to dramatically rise over the same time period. We believe this shift from coal burning offers a compelling opportunity for our technology to utilize the lowest cost coals to produce a clean syngas which can be economically advantaged over LNG in markets where LNG imports are expected to rise such as Asia/ China and Europe. Our syngas technology provides project owners with what we believe can be a very small environmental footprint related to harmful pollutants such as nitrous oxides, sulfur oxides, particulate matter, airborne mercury and heavy metals and is an efficient and responsible user of water resources. However, we face challenges with the growing anti-coal sentiment primarily in the western world where we are doing business in Australia and the European Union. New government regulatory concepts under discussion and review in these regions have the potential of halting all know forms of coal to energy utilization due to caps and penalties related to CO2 generation. We believe we address this new challenge through utilizing our technology’s ability to blend renewable solid feedstocks with coal or by using only renewable solid feedstocks. We also work to educate the market place regarding our syngas technology’s ability to separate and capture significant amounts of CO2 for utilization in other processes. Against this market backdrop, we believe there is potential for increasing demand for new global syngas capacity from coal conversion technologies such as ours. We can see the acceleration of interest in syngas as an energy source by examining the number of global projects either under construction or planned through 2019 While traditional uses of gasification technology have predominantly been driven by the chemicals industry, we believe new growth will be within the chemicals industry but will also come from utilization of syngas as a source of industrial fuel gas, SNG and power generation. For example, the global share of energy for power generation is expected to rise to 47% by 2035, according to the BP Energy Outlook 2017 edition, as consumer preference shift towards electricity. Our technological ability to utilize coal in a clean manner to produce syngas for either power generation or a replacement alternative for natural gas and LNG affords us the opportunity to be part of meeting these global energy needs. We believe that our technology is well positioned to be an important solution that addresses the market needs of the changing global energy landscape. Our gasification technology is unique in its ability to provide an economic, efficient and environmentally responsible alternative to many energy and chemical products normally derived from natural gas, LNG, crude oil, and oil derivatives. Our target markets focus primarily on lower quality coals, biomass and municipal waste where our gasification technology allows energy in the widest range of feedstocks to be unlocked and converted into flexible and valuable syngas. We offer a compelling advantage because of our ability to use such a wide range of solid fuel natural resources. Without our technology, regions where lignite coal, high moisture coal, high ash coal and/or high fines coals exist may face technology barriers which will prevent those resources from being used in energy production. Our technology can transform most of these natural resources into a valuable and flexible syngas product. This clean syngas product can then be used in place of natural gas and oil for making most energy and chemical products. Our primary focus is on the Australia and Eastern Europe markets through AFE and SEE where each have unique market dynamics where we believe we can deploy our technology into projects and provide the investment returns critical to our future success and growth. Because of these market dynamics, we believe our gasification technology has broad strategic importance to: 1) Countries and regions with developing economies which have their own low cost domestic coal resources or easy access to imported low cost coal. Such countries and regions need access to low cost clean energy and chemical products to grow and, in some cases, to provide basic necessities that improve the health and well-being of their populations. These regions have limited access to affordable alternate energy sources like natural gas and oil and can benefit from economic growth by using the lowest cost energy resources such as low cost domestic or imported coal for the production of vital products. Many Asian countries expect to see a surge in expensive imported LNG and a need to utilize their domestic coal to meet their energy product demand increase. 2) Countries which possess significant low-cost coal resources such as Australia and those in South America and Eastern Europe which also have a strategic need and desire to produce clean and affordable energy and chemicals from their own domestic resources. 3) Existing operating companies which deploy their own technologies for energy and/or chemicals production or who rely upon oil and natural gas for their industrial applications. These technologies have been well established for use with oil and natural gas resources but are constrained from growing in parts of the world where the oil and natural gas feedstocks are either not readily available due to missing infrastructure and/or very expensive such as LNG in much of Asia. Integrating those established technologies with our technology opens these technologies to a new low cost natural resource in low quality coals thereby transforming the economic opportunity. Such is the case for example in producing power, methanol, DRI steel product, ammonia and urea for fertilizers and many transportation fuels such as gasoline, diesel and jet fuel. 4) Developed countries such as the United States and Western Europe who are searching for a viable solution for growing biomass and municipal solid waste disposal issues and could also benefit from additional renewable resources. Our technology offers an economical and cleaner approach for conversion of coal into energy and chemicals through our ability to economically gasify a wide range of solid-form natural resources including biomass, low quality coals, high quality coals, and coal wastes. We are not aware of commercially available gasifiers with such a wide range of feedstock flexibility. Our gasification technology operates efficiently with high ash and high moisture coals without coal rejection due to particle size and without the formation of tars and oils present in the technology of our competitors. While our technology has been proven to be commercially viable, we are continually seeking to advance and improve our gasification technology, such as through our new XL3000 gasification system. We are continuing to work with our prospective customers to determine the suitability of their low rank coals for our technology through proprietary coal characterization testing and bench scale gasification tests. During the current year we received an additional patent for processes which were a result of our continued development of SGT. We have several additional patent applications pending relating to these technology improvements in addition to a number of other improvements to increase the gasifier availability and to lower the costs of the gasifier installation and subsequent operations. Historically, the most predominant commercially deployed gasification technology providers have been: GE, Shell, Siemens, CB&I and Lurgi. Shell’s technology is now owned by U.S. based company Air Products. With the exception of Lurgi, these competitors utilized entrained flow slagging gasification technologies. The entrained flow technologies operate on more expensive high grade bituminous and some sub-bituminous coals as feedstocks, but lack capability with the more difficult low heating value, high ash and high moisture coals and with biomass or other renewable waste materials. We have seen what we believe are significant changes in the competitive landscape for gasification over the past few years. Primarily this has been reflected in the inability of these long standing traditional entrained flow technologies to meet the needs of the many of the new projects now in development because many of these projects owners are faced with the need to use much lower quality coals or renewable feedstocks. We believe this change in the competitive landscape is pushing SGT and other fluidized bed and moving/fixed bed technologies into the forefront for consideration for future projects. The Lurgi gasification technology, a moving bed gasification technology, is capable of gasifying the lower grade coals, but has more restrictive requirements on feedstock particle size. The Lurgi gasification technology also generates tars and oils in the syngas that have to be removed prior to downstream processing. Several types of simple fluid bed technologies are available. ThyssenKrupp (Uhde division) offers the High Temperature Winkler (“HTW”) technology and there are several versions of very simple, low pressure fluid bed gasifiers offered in Asia. While a number of HTW plants were built and operated, we are not aware of any in current commercial operation. All of these simple fluid bed technologies have more operating temperature limits than SGT, and none have managed to achieve the high conversions which SGT has demonstrated in commercial plants. In addition to these, there are several Chinese gasification technologies that have been commercialized such as East China University and China Aerospace. The Chinese technologies commercialized thus far are derivatives of the historically commercialized western technologies mentioned above and generally fall into the category of entrained flow slagging gasification. To date, commercialization of these technologies has been primarily inside China. The following chart details our view of the current competitive landscape and details the current technologies available on the marketplace, along with their competitive advantages and disadvantages. SES Gasification Technology Competitive Comparison Biomass & Peat Lignite Sub Bituminous Bituminous & Anthracite Comments SES Advanced Fluidized Bed Good Economics Good Efficiency Low Capex Low water use Good for high ash Good for high moisture Includes fine coal Best Economics SES Advanced Fluidized gasification maintains its efficiency across all feedstock qualities, has lower water usage and low Capex and Opex. This leads to attractive economics on most of the world’s solid-form natural resources. Simple Fluid Beds Low Conversion/high feed cost Very Low Conversion/high feed cost Simple fluid beds cannot achieve high conversion and are more limited in range of acceptable ash fusion temperatures. Entrained Flow Excluded due to technology capability or to poor economics Reduced Economics Some are Efficient Low to High Capex Med to high water use Not suitable for high ash Not suitable for high moisture Some have moisture or ash limits Entrained flow technologies have been the most widely deployed over the past 4 decades. These technologies tend to perform well and are best suited for highest quality coal resources. They can be large water consumers depending on coal feed type and syngas cooling systems used. Low to high Capex due mainly to variations in gasification heat recovery and integration designs. Moving Bed Acceptable Economics due to lower coal pricing High Capex High water use Environmental issues due to tars and oils Lump coal only Excludes fine coal Large installed base in South Africa and China. Prior to SES technology, this was the High Capex alternative for low quality coal where entrained flow technologies were uneconomic. Transport Reactor & Other Non- Commercial Non- Commercial Non- Commercial Non- Commercial Emerging technologies have very limited commercial plants in operation such as the transport reactor which is best suited for low ash lignite coals. Many other emerging technologies attempting to gasify biomass and municipal wastes. Barriers to New Competition Historically gasification technologies have required many years and development costs on the order of hundreds of millions of dollars to reach credible commercial deployment. Because of the costs surrounding such development, gasification technology developed has been historically funded by users with strategic interests and significant economic resources such as major international oil companies or governmental entities looking at alternative clean energy solutions. Most, if not all, gasification technologies have received significant government subsidies in the early research and development stages. Our technology has been highly developed by both GTI and us over the past 40+ years where the technology has been enhanced and commercially deployed. More than $700 million dollars have been spent in the development and commercialization of our SGT technology, including ~$200 million for the research and development required to develop the U-GAS® technology at GTI, ~$200 million of additional funding by us to further technology development and early commercialization, and over $300 million dollars from our Chinese partners and customers providing equity and debt guarantees for the commercial systems now up and running in China. We believe that the current range of available technologies leaves little incentive for development of new technologies, and emerging competition for everyone in the industry will focus on imitation and adaptation. GTI Agreement In November 2009, we entered into an Amended and Restated License Agreement, (the “GTI Agreement”), with the Gas Technology Institute, (“GTI”), replacing the Amended and Restated License Agreement between us and GTI dated August 31, 2006, as amended. Under the GTI Agreement, we maintain our exclusive worldwide right to license the U-GAS® technology for all types of coals and coal/biomass mixtures with coal content exceeding 60%, as well as the non-exclusive right to license the U-GAS® technology for 100% biomass and coal/biomass blends exceeding 40% biomass. We have the right to grant sublicenses, with the approval from GTI, for which we would then owe royalty payments to GTI based on an agreed upon rate schedule. Royalty payments to GTI consist of a minimum annual payment or variable rate payments per the rate schedules dependent upon license agreements, invested equity or carried interests, whichever is higher. The initial term of the contract was for 10 years with two 10-year extensions executable upon notice to GTI. In May 2016, we exercised the first of our two 10-year extensions available and now maintain the exclusive license through 2026. Through 2026, we and GTI are restricted from disclosing any confidential information (as defined in the GTI Agreement) to any person other than employees of affiliates or contractors who are required to deal with such information, and such persons will be bound by the confidentiality provisions of the GTI Agreement. We have further indemnified GTI and its affiliates from any liability or loss resulting from unauthorized disclosure or use of any confidential information that we receive. While the core of our technology is the U-GAS® system, we have continued to innovate and modify the process to a point where we maintain certain intellectual property rights over SGT. Since the original licensing in 2004, we have maintained a strong relationship with GTI and continue to benefit from the resources and collaborative work environment that GTI provides us. Relationships with Strategic Partners and Business Verticals As part of our overall strategy, we intend primarily to (i) work with our existing, AFE and SEE partnership companies to secure new SGT technology and equipment orders and develop energy, chemicals and resource projects where we would own an earned or carried equity interest in the project, (ii) monitor, support and facilitate our minority ownership interest in BFR in order to realize the financial value through dividend income or other means, (iii) work to recover cash and monetize our joint venture operations, Yima and Tianwo-SES, (iv) continue to seek value accretive partnerships to help us grow through strengthening our SGT delivery capability and through creation of new project opportunities and (v) taking necessary steps to utilize our existing cash reserves in the most financially productive means possible. In July 2015, we entered into a Project Alliance Agreement that expands our exclusive relationship with Midrex Technologies for integration and optimization of DRI technology using coal gasification. Midrex has taken the lead in marketing, sales, proposal development, and project execution for coal gasification DRI projects as part of the new project alliance. Midrex may also lead the construction of the fully integrated solution for customers who desire such an execution strategy. We will provide the DRI gasification technology for each project including engineering, key equipment, and technical services. The agreement includes finalization of an engineering package for the optimized coal gasification DRI solution. Prior to the Project Alliance Agreement, we also entered into an exclusive agreement with Tianwo-SES and Midrex for the joint marketing of coal gasification-based DRI facilities in China. These facilities will combine our gasification technology with the Direct Reduction Process of Midrex to create syngas from low quality coals in order to convert iron ore into high-purity DRI. Tianwo-SES Joint Venture will aid in the marketing of these DRI facilities in China and will supply the gasification equipment and licensing of the technology. Current Operations and Projects Australian Future Energy Pty Ltd In February 2014, we established AFE together with an Australian company, Ambre Investments PTY Limited (“Ambre”). AFE is an independently managed Australian business platform established for the purpose of building a large-scale, vertically integrated business in Australia based on developing, building and owning equity interests in financially attractive and environmentally responsible projects that produce low cost syngas as a competitive alternative to expensive local natural gas and LNG. On June 9, 2015, we entered into a Master Technology Agreement (the “MTA”) with AFE which was later revised on May 10, 2017 (as described below). Pursuant to the MTA, we have conveyed certain exclusive access rights to our gasification technology in Australia focusing on promotion and use of our technology in projects. AFE is the exclusive operational entity for business relating to our technology in Australia and AFE owns no rights to sub-license our technology. AFE will work with us on project license agreements for use of our technology as projects are developed in Australia. In return for its work, AFE will receive a share of any license fee we receive for project licenses in Australia. On May 10, 2017, we entered into a project technology license agreement with AFE in connection with a project being developed by AFE in Queensland Australia. AFE intends to form a subsidiary project company and assign the project technology license agreement to that company and that company will assume all of the obligations of AFE thereunder. Pursuant to the project technology license agreement, we granted a non-exclusive, license to use our technology at the project to manufacture syngas and to use our technology in the design of the facility. In consideration, the project technology license agreement calls for a license fee to be finalized based on the finalized plant capacity and a separate fee of $2.0 million for the delivery of a process design package. License fees shall be paid as project milestones are reached throughout the planning, construction and first five years of plant operations. The success and timing of the project being developed by AFE will affect if and/or when we will be able to receive all of the payments from this license agreement. However, there can be no assurance that AFE will be successful in developing this or any other project. If AFE makes, whether patentable or not, improvements relating to our technology, they grant to us and our affiliates, an irrevocable royalty free right to use or license such improvements and agrees to make such improvements available free of charge. AFE provides indemnity to us for damages resulting from the use of the technology in a manner other than as contemplated by the license, while we indemnify AFE to the extent that the intellectual property associated with the technology is found to infringe on the rights of a third party. Either party may terminate the license in connection with a material breach by the other party or the other party’s bankruptcy. AFE may also terminate if we fail to diligently commence the process design package as contemplated by the license. We also provide a guarantee of all obligations under the license. If we are unable to fulfil our obligations under this agreement, AFE may terminate the agreement and be entitled to a full, irrevocable, and unencumbered license for the duration of its project to use without any further payment to us. AFE has evaluated multiple project opportunities and is currently focused on three projects, all in the state of Queensland, targeted to produce a combination of syngas and methane for industrial fuel gas plus ammonia and electric power. In 2016, AFE completed the creation and spin-off of Batchfire Resources Pty Ltd (“BFR”) (as discussed below) as a separate standalone company which acquired and operates the Callide thermal coal mine in Queensland. In August 2017, AFE completed the acquisition of a mine development lease related to the 266-million-ton resource near Pentland, Queensland through AFE’s wholly owned subsidiary, Great Northern Energy Pty Ltd (“GNE”). GNE has a 100% ownership interest in the Pentland Coal Mine. GNE is currently finalizing the preparation of its Initial Advice Statement of the Pentland Coal Mine project to the Queensland Government for the development of the project for an initial 6.0 million metric tons per annum (mtpa) ROM coal operation, with allowance for expansion of the project for up to 9.0 million mtpa ROM coal operation. In its first phase of operation, 4.5 million mtpa of coal is planned for export to Asian markets with the balance of 1.5 million mtpa for feedstock to a future proposed coal gasification project. It is anticipated, based on current planning, for the project to be operational in 2022. A drilling program is planned to commence in late 2018 to expand the size and overall quality and understanding of the Pentland resource. In September 2018, AFE’s Gladstone Energy and Ammonia Project (“GEAP”) was formally announced in Queensland Parliament by Minister for State Development, Manufacturing, Innovation and Planning, Mr. Cameron Dick and was declared by the Queensland Co-Ordinator General as a Co-Ordinated Project. A coordinated project approach also means that all the potential impacts and benefits of the project are considered in an integrated and comprehensive manner and the Coordinator-General’s decision to declare this project a Coordinated Project is expected to help streamline approvals and fast-track delivery of the project. The project will be located in the State Development Area in Gladstone, Queensland and is planned to process 1.5 million mtpa of low-quality coal using SGT, to produce up to 330,000 mpta of ammonia product, and up to 8 petajoules of pipeline quality gas for the east coast domestic gas market. In addition, the proposed project will generate approximately 90 MW of electrical power, with approximately 25 MW of this being available for export to the local domestic grid. The ammonia and gas produced is to be used by major industrial users, including those focusing on agriculture, the mining industry and advanced manufacturing. The project is estimated by AFE to commence construction by mid-2020, with the first ammonia production proposed in mid-2022. For our ownership interest in AFE, we have been contributing cash and engineering support for AFE’s business development while Ambre contributed cash and services. Additional ownership in AFE has been granted to the AFE management team and staff individuals providing services to AFE. In January 2017, we elected to increase our ownership interest in AFE by contributing approximately $0.4 million of cash. In August 2017 and March 2018, we elected to make additional contributions of $0.47 million and $0.16 million respectively to assist AFE with developing its business in Australia. Batchfire Resources Pty Ltd As a result of AFE’s early stage business development efforts associated with the Callide coal mine in Central Queensland, Australia, AFE created BFR. BFR was a spin-off company for which ownership interest was distributed to the existing shareholders of AFE and to the new BFR management team in December 2015. BFR is registered in Australia and was formed for the purpose of purchasing the Callide thermal coal mine from Anglo-American plc (“Anglo-American”). The Callide mine is one of the largest thermal coal mines in Australia and has been in operation for more than 20 years. In October 2016, BFR stated that it had received investment support for the acquisition from Singapore-based Lindenfels Pte Ltd, a subsidiary of commodity traders Avra Commodities. The acquisition of the Callide thermal coal mine from Anglo-American was completed in October 2016. In January 2018, the Minister of Natural Resources, Mines and Energy approved BFR’s mining lease application through to 2043 for Callide coal mine’s Boundary Hill South Project. The Callide mining tenure extends across 180 square kilometers and contains an estimated coal resource of up to 1.7 billion metric tons and saleable coal production averages 10 million metric tons per year. BFR is implementing its mining plan at Callide intended to lower the per unit mining costs and deliver profitable financial results. SES EnCoal Energy sp. z o.o In October 2017, we entered into agreements with Warsaw-based EnInvestments sp. z o.o. Under the terms of the agreements, we and EnInvestments are equal shareholders of SEE and SEE will exclusively market, develop, and commercialize projects in Poland which utilize our technology, services, and proprietary equipment and we share with SEE a portion of the technology license payments, net of fees, we receive from Poland. The goal of SEE is to establish efficient clean energy projects that provide Polish industries superior economic benefits as compared to the use of expensive, imported natural gas and LNG, while providing energy independence through our technological capabilities to convert the wide range of Poland’s indigenous coals, coal waste, biomass and municipal waste to valuable syngas products. SEE has developed a pipeline of projects and together with us is actively working with Polish customers and partners to complete necessary project feasibility, permitting, and SGT technology agreement steps required prior to starting construction on the projects. Tauron Wytwarzanie S.A., (“Tauron”), has contracted Poland’s Institute of Coal Chemistry (“IChPW”) to complete a detailed preliminary design assessment and economic study for the conversion of its 200MW conventional power boilers to clean syngas which would be Poland’s first SGT facility. The project feasibility study concluded in March 2018 with positive results. The results presented by IChPW to Tauron have shown that the conversion of Tauron’s 200 MW power boiler utilizing SGT can be both economically attractive and environmentally beneficial. We believe that SGT power boiler conversions are an ideal solution capable of meeting EU and IED targets. For our ownership interest in SEE, we have been contributing cash and assisting in the development of SEE. SEE was initially funded in January 2018 with a cash contribution of approximately $6,000 and an additional funding in March 2018 of approximately $76,000. Yima Joint Venture In August 2009, we entered into joint venture contracts and related agreements with Yima Coal Industry Group Company (“Yima”), replacing the prior joint venture contracts entered in October 2008 and April 2009. The joint ventures were formed for each of the gasification, methanol/methanol protein production, and utility island components of the plant (collectively the “Yima Joint Venture”). The joint venture contracts provided that we and Yima contribute equity of 25% and 75%, respectively, to the Yima Joint Venture. The remaining capital for the project construction has been funded with project debt obtained by the Yima Joint Venture. Yima agreed to guarantee the project debt in order to secure debt financing from domestic Chinese banking sources. We agreed to pledge to Yima our ownership interests in the joint ventures as security for our obligations. In the event that the necessary additional debt financing is not obtained, Yima agreed to provide a loan to the joint venture to satisfy the remaining capital needs of the project with terms comparable to current market rates at the time of the loan. Yima also agreed to provide coal to the project at preferential pricing under a side-letter agreement related to the JV contracts. To date, Yima has not provided coal at preferential price to the project and we do not believe Yima will do so in the future. The term of the joint venture commenced June 9, 2009 at the time each joint venture company obtained its business operating license and shall end 30 years after the business license issue date, June 8, 2039. As discussed below, in November 2016, as part of an overall corporate restructuring plan, these joint ventures were combined into a single joint venture. We continue to own a 25% interest in the Yima Joint Venture and Yima owns a 75% interest. Notwithstanding this, in connection with an expansion of the project, we have the option to contribute a greater percentage of capital for the expansion, such that as a result, we could expand through contributions, at our election, up to a 49% ownership interest in the Yima Joint Venture. Despite initiating methanol production in December 2012, the Yima Joint Venture’s plant continued its construction through the beginning of 2016. In March 2016, the Yima Joint Venture completed the required performance testing of the SGT systems and successfully issued its Performance Test Certificate, which is the point that we considered the plant to be completed. In 2016, the plant faced increasing regulatory scrutiny from the environmental and safety bureaus as the plant was not built in full compliance with its original submitted designs. In June 2016, the local environmental bureau requested that the plant temporarily halt operations to address certain issues identified by the environmental bureau. These issues affected the joint venture’s ability to receive its final operating and safety permits and were related to the original approval for methanol protein production and the original three JV business structure. This has been addressed and fully resolved and the three joints ventures were combined into one in November 2016. The Yima Joint Venture returned to operations in late November 2016 and in November 2017, the Yima Joint Venture completed the required safety testing and successfully received its safety production permit from the Henan government and it subsequently received the Industry Products License in May 2018, allowing for its products to be sold on the open market and an updated business license was successfully obtained in January 2018. Since the plant restored operations in November 2016, it has had periods of running at full design capacity and periods of operations at lower levels of production. The primary operational issues have been related to operational errors, equipment quality that has caused increased downtime and the failure to secure coal supply. The plant experienced a 90-day period in which it operated at full capacity ending in August 2017. For the fiscal year ending June 30, 2018, the plant produced 185,761 tons of pure methanol, its best fiscal year performance to date. We continue to see signs of overall improvement in operations, resulting in longer periods of production at design capacity. In December 2017 and January 2018, on-going development cooperation and discussions with the Yima Joint Venture management resulted in the joint venture agreeing to pay various costs incurred by us during the construction and commissioning period of the facility in the amount of approximately 16 million Chinese Renminbi yuan, (“RMB”). As of June 30, 2018, we have received 6.15 million RMB (approximately $0.9 million) of payments from the Yima Joint Venture related to these costs. Additional payments may be forthcoming. Due to uncertainty, revenues will be recorded upon receipt of payment. Tianwo-SES Clean Energy Technologies Limited Joint Venture Contract In February 2014, SES Asia Technologies Limited, one of our wholly owned subsidiaries, entered into a Joint Venture Contract (the “JV Contract”) with Zhangjiagang Chemical Machinery Co., Ltd., which subsequently changed its legal name to Suzhou Thvow Technology Co. Ltd. (“STT”), to form Tianwo-SES Clean Energy Technologies Limited, (“Tianwo-SES Joint Venture”). The purpose of the Tianwo-SES Joint Venture is to establish our gasification technology as the leading gasification technology in the Tianwo-SES Joint Venture territory (which is China, Indonesia, the Philippines, Vietnam, Mongolia and Malaysia) by becoming a leading provider of proprietary equipment and engineering services for the technology. The scope of the Tianwo-SES Joint Venture is to market and license our gasification technology via project sublicenses; procurement and sale of proprietary equipment and services; coal testing; and engineering, procurement and research and development related to the technology. STT contributed 53.8 million RMB (approximately $8.0 million) in April 2014 and was required to contribute an additional 46.2 million RMB (approximately $6.8 million) within two years of such date for a total contribution of 100 million RMB (approximately $14.8 million) in cash to the Tianwo-SES Joint Venture in return for a 65% ownership interest in the Tianwo-SES Joint Venture. The second capital contribution from STT of 46.2 million RMB (approximately $6.8 million) was not paid by STT in April 2016 as required by the initial JV Contract. As part of a restructuring of the agreement described below, the obligation for payment of additional registered capital was removed. We have contributed certain exclusive technology sub-licensing rights into the Tianwo-SES Joint Venture for the territory pursuant to the terms of a Technology Usage and Contribution Agreement (the “TUCA”) entered into among the Tianwo-SES Joint Venture, STT and us on the same date and further described in more detail below. This resulted in an original ownership of 35% of the Tianwo-SES Joint Venture by SES. Under the JV Contract, neither party may transfer their interests in the Tianwo-SES Joint Venture without first offering such interests to the other party. In August 2017, we entered into a restructuring agreement of the Tianwo-SES Joint Venture (“Restructuring Agreement”). The agreed change in share ownership, reduction in the registered capital of the joint venture, and the final transfer of shares with local government authorities was completed in December 2017. In this restructuring, an additional party was added to the JV Contract, upon receipt of final government approvals, The Innovative Coal Chemical Design Institute (“ICCDI”) has become a 25% owner of the Tianwo-SES Joint Venture, we have decreased our ownership to 25% and STT has decreased its ownership to 50%. ICCDI previously served as general contractor and engineered and constructed all three projects which utilize SGT in seven gasification systems. Equipment orders related to these projects were secured by our joint venture partner, Zhangjiangang Chemical Machinery Co., Ltd. The projects are located in the provinces of Shandong, Henan, and Shanxi, have been completed and are currently operating for the Aluminum Corporation of China. We received 11.15 million RMB (approximately $1.7 million) from ICCDI as a result of this restructuring. In conjunction with the joint venture restructuring, we also received 1.2 million RMB (approximately $180,000) related to outstanding invoices for services we had provided to the Tianwo SES Joint Venture. The inclusion of ICCDI as an owner has the potential to enhance the joint venture’s bidding ability and we believe the joint venture will focus on securing larger coal to chemical projects as well as continue to pursue projects in the industrial fuels segment. In addition to the ownership changes described above, the Tianwo-SES Joint Venture board of directors (the “Board”) was changed to consist of eight directors, four appointed by STT, two appointed by ICCDI and two appointed by us. All significant acts as described in the JV Contract require the unanimous approval of the Board. The JV Contract also includes a non-competition provision which requires that the Tianwo-SES Joint Venture be the exclusive legal entity within the Tianwo-SES Joint Venture territory for the marketing and sale of any gasification technology or related equipment that utilizes low quality coal feedstock. Notwithstanding this, STT retained the right to manufacture and sell gasification equipment outside the scope of the Tianwo-SES Joint Venture within the Tianwo-SES Joint Venture territory. In addition, we retained the right to develop and invest equity in projects outside of the Tianwo-SES Joint Venture within the Tianwo-SES Joint Venture territory. As a result of the Restructuring Agreement, we have further retained the right to provide gasification technology licenses and to sell proprietary equipment directly into projects in the joint venture territory provided we have an equity interest in the project. After the termination of the Tianwo-SES Joint Venture, STT and ICCDI must obtain written consent from us to market development of any gasification technology that utilizes low quality coal feedstock in the Tianwo-SES Joint Venture territory. The JV Contract may be terminated upon, among other things: (i) a material breach of the JV Contract which is not cured, (ii) a violation of the TUCA, (iii) the failure to obtain positive net income within 24 months of establishing the Tianwo-SES Joint Venture or (iv) mutual agreement of the parties. TUCA Pursuant to the TUCA, we have contributed to the Tianwo-SES Joint Venture certain exclusive rights to our gasification technology in the Tianwo-SES Joint Venture territory, including the right to: (i) grant site specific project sub-licenses to third parties; (ii) use our marks for proprietary equipment and services; (iii) engineer and/or design processes that utilize our technology or our other intellectual property; (iv) provide engineering and design services for joint venture projects and (v) take over the development of projects in the Tianwo-SES Joint Venture territory that have previously been developed by us and our affiliates. As a result of the Restructuring Agreement, ICCDI was added as a party to the TUCA, but all other material terms remained the same. The Tianwo-SES Joint Venture will be the exclusive operational entity for business relating to our technology in the Tianwo-SES Joint Venture territory, except for projects in which SES has an equity ownership position. For these projects, as a result of the Restructuring Agreement, we can provide technology and equipment directly, with no obligation to the joint venture. If the Tianwo-SES Joint Venture loses exclusivity due to a breach by us, STT and ICCDI are to be compensated for direct losses and all lost project profits. We were also required to provide training for technical personnel of the Tianwo-SES Joint Venture through the second anniversary of the establishment of the Tianwo-SES Joint Venture, which has now passed. We will also provide a review of engineering works for the Tianwo-SES Joint Venture. If modifications are suggested by us and not made, the Tianwo-SES Joint Venture bears the liability resulting from such failure. If we suggest modifications and there is still liability resulting from the engineering work, it is our liability. Any party making improvements, whether patentable or not, relating to our technology after the establishment of the Tianwo-SES Joint Venture, grants to the other party an irrevocable, non-exclusive, royalty free right to use or license such improvements and agrees to make such improvements available to us free of charge. All such improvements shall become part of our technology and all parties shall have the same rights, licenses and obligations with respect to the improvement as contemplated by the TUCA. The Tianwo-SES Joint Venture is required to establish an Intellectual Property Committee, with two representatives from the Tianwo-SES Joint Venture and two from SES. This Committee shall review all improvements and protection measures and recommend actions to be taken by the Tianwo-SES Joint Venture in furtherance thereof. Notwithstanding this, each party is entitled to take actions on its own to protect intellectual property rights. As of June 30, 2018, that committee was yet to be formed. Any breach of or default under the TUCA which is not cured on notice entitles the non-breaching party to terminate. The Tianwo-SES Joint Venture indemnifies us for misuse of our technology or infringement of our technology upon rights of any third party. Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd. In July 2006, we entered into a cooperative joint venture contract with Shandong Hai Hua Xuecheng Energy Co. Ltd. (“Xuecheng Energy”) which established Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd. (“ZZ Joint Venture”). The ZZ Joint Venture’s primary purpose was to develop, construct and operate a syngas production plant utilizing SGT in Zao Zhuang City, Shandong Province, China and producing and selling syngas and the various byproducts of the plant. We initially owned 97.6% of the ZZ Joint Venture and Xuecheng Energy owned the remaining 2.4%. In June 2015, we entered into a Share Purchase and Investment Agreement, (the “SPA”), with Rui Feng Enterprises Limited (“Rui Feng”), whereby Rui Feng would acquire a controlling interest in Synthesis Energy Systems Investments Inc. (“SESI”), and a wholly owned subsidiary, which owns our interest in the ZZ Joint Venture. Under the terms of the SPA, SESI originally agreed to sell an approximately 61% equity interest to Rui Feng in exchange for $10.0 million. This amount was to be paid in four installments through December 2016, with the first installment of approximately $1.6 million paid on June 26, 2015. However, Rui Feng did not make any subsequent payments. This resulted in our majority ownership (approximately 88.1%) until we eventually restructured our ownership with Xuecheng Energy. In August 2016, we announced that we and Xuecheng Energy entered into a definitive agreement to restructure the ZZ Joint Venture. Due to the Chinese government’s widespread initiative to move industry into larger scale, commercial and environmentally beneficial industrial parks, it became clear that the plant was no longer going to be allowed to operate in its current location. As a result, we retain an approximate nine percent ownership in the ZZ Joint Venture asset, and Xuecheng Energy assumed all outstanding liabilities of the ZZ Joint Venture, including payables related to the Cooperation Agreement with Xuecheng Energy signed in 2013. The definitive agreement took full effect when the registration with the government was completed on October 31, 2016. With the closure of this transaction, SES does not anticipate any future liabilities related to the ZZ Joint Venture. The ZZ Joint Venture was a very successful demonstration of our technology and its operational history and commercial operations helped provide the foundation for our technology, SGT. During the second quarter of fiscal 2017, we deconsolidated the ZZ Joint Venture and began accounting for our nine percent investment in the ZZ Joint Venture under the cost method. The carrying value of our investment in the ZZ Joint Venture was zero at both June 30, 2018 and 2017. Business Development, Engineering and Project Management Management and Business Development Staff We currently employ a staff of experienced management and business development professionals in both the U.S. and China that are focused on opportunities in our target markets. The management and business development team are focused on the disciplined development of new business for gasification projects, licensing opportunities and other technology products and services which maximize the advantages of our gasification technology. Members of the team have either led or participated in the development of multiple coal and natural gas power projects, coal gasification projects, chemical and gasification licensing transactions globally over the past three decades. In addition, we utilize consultants and our relationships with our strategic partners to further supplement our staff in developing relationships with potential customers. Technology, Engineering and Project Management Staff We have a capable and seasoned technology team, with skill sets ranging from detailed design engineering, project management and plant commissioning experience. Our engineers leverage their gasification and process industry knowledge to continuously improve SGT using data collected from our commercial licensees and test platforms. These improvements increase overall plant reliability, while reducing the capital and operating costs for our project partners, as well as develop core intellectual property for the company. The team is engaged during the earliest stages of project development, allowing for more precise planning and optimization of the integrated technologies. This provides a further competitive edge with respect to cost and project development cycle times. In addition to our technology engineering team, we leverage our resource capability through partnering with international engineering and procurement companies with significant gasification experience. Business Concentration Our assets in China accounted for approximately 52% of our total assets as of June 30, 2018, which includes our investment in the Yima Joint Venture and other miscellaneous assets. While our balance sheet shows a significant business concentration in China, we are primarily focused on developing our assets outside of China which we believe will be responsible for a large percentage of our financial results going forward. China has rapidly expanded its industrial manufacturing and construction capabilities. This has reduced the cost and build time of traditional sources of supply. In China, through our strategic relationships, we have been successful in locating and contracting with a number of key suppliers of major equipment and services. For projects outside of China, we plan to continue to leverage our strong ties and partnerships in China to provide low cost equipment and engineering into our projects. In locations where local sourcing is of value, we expect to be able to develop supply chain capabilities for our equipment utilizing experienced industrial manufacturing capabilities and low-cost sources of labor and materials that will benefit our technology. We currently hold multiple U.S. and international patents and a number of pending patent applications, primarily relating to new technology developments that we have made to the U-GAS® technology, known as SGT. This includes our gasification process, the integration of our gasification process with downstream uses and the equipment design for our gasification facilities. Although in the aggregate our patents are important to us, we do not regard any individual patent as critical or essential to our business. Prior to us entering into the GTI Agreement, U-GAS® had not been commercially deployed on coal above approximately 150 tons per day per gasification system nor had it been commercially deployed on coal using pure oxygen as a reactant or at elevated pressures. Today, we have commercially deployed the technology at a scale of 1,200 tons per day of coal feed using pure oxygen as a reactant and at pressures of up to 10 bar. In addition, we also have new designs completed, with more in process today, and we are quoting gasification systems for customers that would increase our gasification capacity to approximately 3,000 tons per day of coal using pure oxygen as a reactant at pressures up to 55 bar. We have made improvements to the U-GAS technology which have either been patented, are in the process of patenting, or are held by us as trade secrets. In addition, we have several new improvements which are currently in development associated with designs of our higher pressure and higher capacity systems that will further enhance the efficiency of the gasification process or reduce capital or operating expenses. Project and Technical Development We may incur internal and third-party project and technical development costs related to the advancement of our gasification technology and related processes. We plan to continue certain development initiatives that support our strategies and project development activities with a goal of offering our customers the best and most efficient clean coal solutions. Our operations are subject to stringent national, provincial state and local laws and regulations governing the discharge of materials into the environment or otherwise relating to environmental protection. Numerous governmental agencies, including various Chinese and Australian authorities, issue regulations to implement and enforce such laws, which often require difficult and costly compliance measures that carry substantial administrative, civil and criminal penalties or may result in injunctive relief for failure to comply. These laws and regulations may require the acquisition of a permit before construction or operation at a facility commences, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with such activities, limit or prohibit construction activities on certain lands lying within wilderness, wetlands, ecologically sensitive and other protected areas, and impose substantial liabilities for pollution. Our facilities may require permits for or be constrained by permit conditions in relation to acceptable air emissions and wastewater discharges, as well as other authorizations, some of which must be issued before construction commences. Issuance of these permits could be subject to unpredictable delays, contests and even, in some cases, denial or refusal. Although we believe that there will be support for our projects, the permitting process could be complex and time consuming and the issuance of permits may be subject to the potential for contest and other regulatory uncertainties that may result in unpredictable delays. We are in substantial compliance with current applicable environmental laws and regulations and have not experienced any material adverse effect from compliance with these environmental requirements. In addition, some recent scientific studies have suggested that emissions of certain gases, commonly referred to as “greenhouse gases,” may be contributing to the warming of the Earth’s atmosphere. In response to such studies, many countries are actively considering legislation, or have already taken legal measures, to reduce emissions of greenhouse gases. Examples of such legislation and new legal measures include new environmental laws and regulations that could impose a carbon tax, a cap and trade program requiring us to purchase carbon credits, or measures that would require reductions in emissions or require modification of raw materials, fuel use or production rates. In China, the Environmental Protection Tax Law entered into force on January 1, 2018, pursuant to which enterprises that directly discharge taxable pollutants within the territory of China and maritime space under its justification shall pay environmental protection tax. This legislation includes two appendices, one of which provides for the tax rate of different pollutants and the other lists taxable pollutants and pollution equivalent. According to this legislation, the environmental protection tax has replaced the pollutant discharge fee since January 1, 2018. Carbon dioxide, (CO2), a byproduct of burning fossil fuels such as coal, is an example of a greenhouse gas. Regardless of technology used in gasification facilities, there is carbon dioxide released whenever the syngas is cleaned and prepared for energy or chemicals production. We believe that gasification is currently the most desirable technology for processing coal if CO2 emissions become regulated. This is because gasification and the adjacent syngas cleaning technologies separate the CO2 produced from the final products and thereby create a rich CO2 stream that can be captured, sequestered and/or sold. However, greenhouse gas regulations can add production and capital cost to all fossil fuel technologies and may require us or our customers to obtain additional permits, meet additional control requirements, install additional environmental mitigation equipment, or take other as yet unknown steps to comply with such potential regulations, which could adversely affect our financial performance. In 2013, the U.S. and a number of international development banks, including the World Bank, the European Investment Bank and the European Bank for Reconstruction and Development, announced that they would no longer provide financing for the development of new coal-fueled power plants or would do so only in narrowly defined circumstances. Other international development banks, such as the Asian Development Bank and the Japanese Bank for International Cooperation, have continued to provide such financing. The Kyoto Protocol, adopted in December 1997 by the signatories to the 1992 United Nations Framework Convention on Climate Change (UNFCCC), established a binding set of greenhouse gas emission targets for developed nations. The U.S. signed the Kyoto Protocol, but it has never been ratified by the U.S. Senate. Australia ratified the Kyoto Protocol in December 2007 and became a full member in March 2008. There were discussions to develop a treaty to replace the Kyoto Protocol after the expiration of its commitment period in 2012, including at the UNFCCC conferences in Copenhagen (2009), Cancun (2010), Durban (2011), Doha (2012) and Paris (2015). At the Durban conference, an ad hoc working group was established to develop a protocol, another legal instrument or an agreed outcome with legal force under the UNFCCC, applicable to all parties. At the Doha meeting, an amendment to the Kyoto Protocol was adopted, which included new commitments for certain parties in a second commitment period, from 2013 to 2020. In December 2012, Australia signed on to the second commitment period. During the UNFCCC conference in Paris, France in late 2015, an agreement was adopted calling for voluntary emissions reductions contributions after the second commitment period ends in 2020. The agreement was entered into force on November 4, 2016 after ratification and execution by more than 55 countries that account for at least 55% of global greenhouse gas emissions. Both Australia and the United States ratified the agreement. On August 4, 2017 the United States formally signaled its intention to withdraw from the agreement (although it has not yet withdrawn). Enactment of laws or passage of regulations regarding emissions from the combustion of coal by the U.S., some of its states or other countries, or other actions to limit such emissions, could result in electricity generators switching from coal to other fuel sources. Further, policies limiting available financing for the development of new coal-fueled power stations could adversely impact the global demand for coal in the future. The potential financial impact on us of future laws, regulations or other policies will depend upon the degree to which any such laws or regulations force electricity generators to diminish their reliance on coal as a fuel source. That, in turn, will depend on a number of factors, including the specific requirements imposed by any such laws, regulations or other policies, the time periods over which those laws, regulations or other policies would be phased in, the state of commercial development and deployment of CCUS technologies and the alternative uses for coal. From time to time, we attempt to analyze the potential impact on the Company of as-yet-unadopted, potential laws, regulations and policies. Such analysis require that we make significant assumptions as to the specific provisions of such potential laws, regulations and policies. These analyses sometimes show that certain potential laws, regulations and policies, if implemented in the manner assumed by the analyses, could result in material adverse impacts on our operations, financial condition or cash flow, in view of the significant uncertainty surrounding each of these potential laws, regulations and policies. We do not believe that such analyses reasonably predict the quantitative impact that future laws, regulations or other policies may have on our results of operations, financial condition or cash flows. Australian Regulatory Matters Native Title and Cultural Heritage. Since 1992, the Australian courts have recognized that native title to lands, as recognized under the laws and customs of the Aboriginal inhabitants of Australia, may have survived the process of European settlement. These developments are supported by Native Title Act 1993 (Cth) which recognizes and protects native title, and under which a national register of native title claims and determinations has been established. Native title rights do not extend to minerals; however, native title rights can be affected by the mining process unless those rights have previously been extinguished thereby requiring negotiation with the registered native title claimants or determined native title holders (as applicable) (and potentially the payment of compensation) prior to the grant of certain mining tenements. There is also federal and state legislation to prevent damage to and manage Aboriginal cultural heritage and archaeological sites. Mining Tenements and Environmental. In Queensland and New South Wales, the development of a mine requires both the grant of a right to extract the resource and an approval which authorizes the environmental impact. These approvals are obtained under separate legislation from separate government authorities. The application processes can run concurrently and are also concurrent with any native title or cultural heritage process that is required. The environmental impacts of mining projects are regulated by state and federal governments. Federal regulation will only apply if the particular project will, or is likely to, significantly impact a matter of national environmental significance (for example, a water resource, an endangered species or particular protected places). Environmental approvals processes involve complex issues that, on occasion, require lengthy studies and documentation. Typically mining proponents must also reach agreement with the owners of land underlying proposed mining tenements prior to the grant and/or conduct of mining activities or otherwise acquire the land. These arrangements generally involve the payment of compensation in lieu of the impacts of mining on the land. Australian mining operations are generally subject to local, state and federal laws and regulations. At the federal level, these legislative acts include, but are not limited to, the Environment Protection and Biodiversity Conservation Act 1999 (Cth), Native Title Act 1993 (Cth), Fair Work Act 2009 (Cth), Foreign Acquisitions and Takeovers Act 1975 (Cth) and the Aboriginal and Torres Strait Islander Heritage Protection Act 1984 (Cth). Foreign investors into Australia may also require approval of the Foreign Investment Review Board. In Queensland, laws and regulations related to mining include, but are not limited to, the Mineral Resources Act 1989 (Qld), Mineral and Energy Resources (Common Provisions) Act 2014 (Qld) (MERCP Act), Environmental Protection Act 1994 (Qld) (EP Act), Environmental Protection Regulation 2008 (Qld), potentially the Planning Act 2016 (Qld), Building Act 1975 (Qld), Explosives Act 1999 (Qld), Aboriginal Cultural Heritage Act 2003 (Qld), Native Title (Queensland) Act 1993 (Qld), Water Act 2000 (Qld), State Development and Public Works Organization Act 1971 (Qld), Queensland Heritage Act 1992 (Qld), Transport Infrastructure Act 1994 (Qld), Nature Conservation Act 1992 (Qld), Vegetation Management Act 1999 (Qld), Land Act 1994 (Qld), Regional Planning Interests Act 2014 (Qld), Fisheries Act 1994 (Qld) and the Forestry Act 1959 (Qld). Under the EP Act, policies have been developed to achieve the objectives of the law and provide guidance on specific areas of the environment, including air, noise, water and waste management. Increased emphasis has recently been placed on topics including, but not limited to, hazardous dams assessment, the protection of strategic cropping land, the assessment and provision of financial assurance and undertaking rehabilitation of mining activities. The MERCP Act commenced on September 27, 2016 and included significant reforms to the management of overlapping coal and coal seam gas tenements and the coordination of activities and access to private and public land. In November 2016, amendments to the EP Act and the Water Act 2000 (Qld) became effective and facilitate regulatory scrutiny of the environmental impacts of underground water extraction during the operational phase of resource projects for all tenements yet to commence mineral extraction. The ‘Chain of Responsibility’ provisions of the EP Act, effective in April 2016, allow the regulator to issue an environmental protection order (EPO) to a related person of a company in two circumstances; (a) if an EPO has been issued to the company, an EPO can also be issued to a related person of the company (at the same time or later); or (b) if the company is a high risk company (as defined in the EP Act), an EPO can be issued to a related person of the company (whether or not an EPO has also been issued to the company). A guideline has been issued to provide more certainty to industry on the circumstances when an EPO may be issued. In New South Wales, laws and regulations related to mining include, but are not limited to, the Mining Act 1992 (NSW), Work Health and Safety (Mines and Petroleum Sites) Act 2013 (NSW), Mine Subsidence Compensation Act 1961 (NSW), Environmental Planning and Assessment Act 1979 (NSW) (EP&A Act), Environmental Planning and Assessment Regulations 2000 (NSW), Protection of the Environment Operations Act 1997 (NSW), Contaminated Land Management Act 1997 (NSW), Explosives Act 2003 (NSW), Water Management Act 2000 (NSW), Water Act 1912 (NSW), Radiation Control Act 1990 (NSW), Heritage Act 1977 (NSW), Aboriginal Land Rights Act 1983 (NSW), Crown Lands Act 1989 (NSW), Dangerous Goods (Road and Rail Transport) Act 2008 (NSW), Fisheries Management Act 1994 (NSW), Forestry Act 2012 (NSW), Native Title (New South Wales) Act 1994 (NSW), Roads Act 1993 (NSW) and National Parks & Wildlife Act 1974 (NSW). Under the EP&A Act, environmental planning instruments must be considered when approving a mining project development application. There are multiple State Environmental Planning Policies (SEPPs) relevant to coal projects in New South Wales. Amendments to the SEPPs that cover mining have occurred in the past two years and are aimed at protecting agriculture, water resources and critical industry clusters. One SEPP, referred to as the “Mining SEPP”, was amended in late 2013 to make it mandatory for decision makers to consider the economic significance of coal resources when determining a development application for a mine and to give primacy to that consideration. While this amendment was repealed in 2015, decision makers still have regard to the significance of a resource and the State and regional economic benefits of a proposed coal mine when considering a development application on the basis that it is an element of the “public interest” head of consideration contained in the legislation. Mining Rehabilitation (Reclamation). Mine reclamation is regulated by state specific legislation. As a condition of approval for mining operations, companies are required to progressively rehabilitate mined land and provide appropriate security to the relevant state government as a safeguard to cover the costs of rehabilitation in circumstances where mine operators are unable to do so. Self-bonding is not permitted. BFR has provided security to the relevant authorities which are calculated in accordance with current regulatory requirements. BFR operate in both the Queensland and New South Wales state jurisdictions. New South Wales reclamation. The Mining Act 1992 (NSW) (Mining Act) is administered by the Department of Planning and Environment and authorizes the holder of a mining tenement to extract a mineral subject to obtaining consent under the EP&A and other auxiliary approvals and licenses. Through the Mining Act, environmental protection and rehabilitation are regulated by conditions in all mining leases and environmental authorities including requirements for the submission of a Mining Operations Plan (MOP) prior to the commencement of operations. All mining operations must be carried out in accordance with the MOP which describes site activities and the progress toward environmental and rehabilitation outcomes and are updated on a regular basis or if mine plans change. The mines publicly report their reclamation performance on an annual basis. In support of the MOP process, a rehabilitation cost estimate is calculated periodically to determine the amount of bond support required to cover the cost of rehabilitation based on extent of disturbance during the MOP period. Queensland rehabilitation. The EP Act is administered by the Department of Environment and Science which authorizes environmentally relevant activities such as mining activities relating to a mining lease through an Environmental Authority (EA). Environmental protection and rehabilitation activities are regulated by conditions in the EA, including the requirement for the submission of a Plan of Operations (PO) prior to the commencement of operations. Currently, all mining operations must be carried out in accordance with the PO which describes site activities and the progress toward environmental and rehabilitation outcomes and are updated on a regular basis or if mine plans change. The mines submit an annual return reporting on their EA compliance including rehabilitation performance. The Queensland Government is in the process of reviewing the requirement of a PO for mining activities. Legislation (in the form of a Bill) was introduced in the Queensland parliament in February 2018 that instead requires entities undertaking mining activities to prepare a ‘life of mine’ progressive rehabilitation and closure plan (PRCP) which will be binding in the undertaking of a mining activity and include annual reporting and regular auditing requirements. The Bill requires EA holders to prepare a detailed PRCP which is to include information detailing how mining activities will be undertaken to maximize progressive rehabilitation of the land to a stable condition. The PRCP will provide for specific rehabilitation milestones and non-compliance will be an offence. As a condition of the EA, financial security requirements are calculated to determine the amount of bonding required to cover the cost of rehabilitation based on extent of disturbance during the PO period. The Bill will also amend the way in which financial security is calculated and provided. The new regime is to consider the risk profile of the EA holder for the mining activity and the risk profile of the particular mining project so that security is either provided by way of a contribution to a fund or by other surety. At this stage, it is expected that the Bill is likely to be passed by the Queensland parliament in October 2018 with commencement to occur by the end of 2018 or in early 2019. Occupational Health and Safety. Broadly, State legislation requires persons conducting a business or undertaking to provide and maintain a safe workplace by providing safe systems of work, safety equipment and appropriate information, instruction, training and supervision. Specific occupational health and safety obligations have been mandated under state legislation to account for the specialized nature of the coal mining industry. The concepts are typically similar to the general occupational health and safety legislation however, there are some differences in the terminology, the application and detail of the laws. The most noteworthy difference being that coal mining safety laws are more prescriptive when compared to general occupational health and safety laws. Further, mining operators, executive officers (including directors and other officers of a corporate entity), employees with statutory appointments (e.g. site senior executives) and all other persons (including coal mine workers and all other persons at a mine) are subject to the obligations under this legislation. A small number of coal mine workers in Queensland and New South Wales have been diagnosed with coal workers’ pneumoconiosis (CWP, also known as black lung) following decades of assumed eradication of the disease. This led to a Parliamentary inquiry into CWP with a report tabled before the Queensland parliament in May 2017. The report made a series of recommendations regarding the detection and monitoring of CWP as well as recommending the relevant legislation better support these initiatives. The report also noted that the government authority (the Department of Natural Resources, Mines and Energy) responsible for regulating CWP (amongst broader occupational health and safety issues pertaining to the resources and mining sector) failed to properly administer the relevant legislation. The Queensland Government released its formal response to the recommendations tabled before Parliament. Following the recommendations, and a consultation process, the Queensland Government made a number of changes to the coal mining legislation, specifically with a view to prevent and monitor issues contributing to CWP. Following the report, the Queensland Government’s initial response was to release a draft Bill establishing a mine health and safety regulatory body that is independent from the Department of Natural Resources, Mines and Energy. This Bill has not been passed by Parliament and further amendments to the Bill have been tabled. Industrial Relations. A national industrial relations system administered by the federal government applies to all private sector employers and employees. The matters regulated under the national system include employment conditions, unfair dismissal, enterprise bargaining, bullying claims, industrial action and resolution of workplace disputes. Many of the workers employed or to be employed by AFE and BFR are covered by enterprise agreements approved under the national system. Greenhouse Gases. In 2007, a single, national reporting system relating to greenhouse gas emissions, energy use and energy production was introduced. The National Greenhouse and Energy Reporting Act 2007 (Cth) (NGER Act) imposes requirements for corporations meeting a certain threshold to register and report greenhouse gas emissions and abatement actions, as well as energy production and consumption. The Clean Energy Regulator administers the NGER Act. The Commonwealth Department of Environment is responsible for NGER Act-related policy developments and review. Both foreign and local corporations that meet the prescribed carbon dioxide and energy production or consumption limits in Australia (Controlling Corporations) must comply with the NGER Act. On July 1, 2016, amendments to the NGER Act implemented the Emission Reduction Fund Safeguard Mechanism. From that date, large designated facilities such as coal mines were issued with a baseline for their covered emissions and must take steps to keep their emissions below the baseline, comply with their statutory obligations by some other means (for example, by purchasing and surrendering Australian carbon credit units to offset emissions over the baseline) or face penalties. Queensland Royalty. As a general rule, royalties are payable to the State of Queensland for extracted coal. Statutory formulas under the Mineral Resources Regulation 2013 (Qld) are used to calculate the royalty rates (expressed as a percentage) for coal sold, disposed of, or used, where the average price per metric ton is either between $100 and $150 Australian dollars, or greater than $150 Australian dollars. The rate is 7% for coal sold, disposed of, or used below $100 Australian dollars per metric ton. The periodic impact of these royalty rates is dependent upon the volume of metric tons produced at Queensland mining locations and coal prices received for those metric tons. The Queensland Office of State Revenue issues determinations setting out its interpretation of the laws that impose royalties and provide guidance on how royalty rates should be calculated. New South Wales Royalty. In New South Wales, the royalty applicable to coal is charged as a percentage of the value of production (total revenue less allowable deductions). This is equal to 6.2% for deep underground mines (coal extracted at depths greater than 400 meters below ground surface), 7.2% for underground mines and 8.2% for open-cut mines. Chinese Foreign Investment and Business Regulations We operate our business in China under a legal regime consisting of the State Council, which is the highest authority of the executive branch of the Chinese central government, and several ministries and agencies under its authority, including the State Administration for Industry and Commerce (“SAIC”), the Ministry of Commerce (“MOFCOM”), the State Administration of Foreign Exchange (“SAFE”) and their respective authorized local counterparts. The Chinese government imposes restrictions on the convertibility of the Chinese Renminbi yuan and on the collection and use of foreign currency by Chinese entities. Under current regulations, the Chinese Renminbi yuan is generally convertible for current account transactions, which include dividend distributions, and the import and export of goods and services subject to review and approval by SAFE or its designated foreign exchange bank. However, conversion of Chinese Renminbi yuan into foreign currency and foreign currency into Chinese Renminbi yuan for capital account transactions is under the strict scrutiny of SAFE. According to SAFE Circular [2015] 19 (Circular on Reforming the Administration of Foreign Exchange Capital Settlement of Foreign-invested Enterprise) and SAFE Circular [2016] 16 (Circular on Reforming the Administration of Foreign Exchange Settlement under the Capital Account), foreign-invested enterprise whose main business is investment may convert foreign currency in a capital account into Chinese Renminbi yuan for equity investment. Other types of foreign-invested enterprises may convert foreign currency in a capital account into Chinese Renminbi yuan for equity investment provided that the enterprise being invested into makes relevant registration with SAFE (or a designated bank) and establishes a settlement payment account. Under current Chinese regulations, foreign-invested enterprises such as our Chinese subsidiaries are required to apply to banks authorized to conduct foreign exchange business by SAFE for a Foreign Exchange Registration Certificate for Foreign-Invested Enterprise. With such registration (which is subject to remaining rights and interests, registration with SAFE), a foreign-invested enterprise may open foreign exchange bank accounts at banks authorized to conduct foreign exchange business by SAFE and may buy, sell and remit foreign exchange through such banks, subject to documentation and approval requirements. Foreign-invested enterprises are required to open and maintain separate foreign exchange accounts for capital account transactions and current account transactions. In addition, there are restrictions on the amount of foreign currency that foreign-invested enterprises may retain in such accounts, except that foreign-invested enterprises may retain foreign exchange income under current account transactions in its sole discretion. Also at the time of applying for SAFE registration (including any change registration), foreign-invested enterprises that do not constitute round tripping investment enterprises will be required to represent that its foreign shareholder is not directly or indirectly held by any Chinese residents; foreign-invested enterprises that constitute round tripping investment enterprises will be required to disclose the actual controlling person of its foreign shareholder. Any false or misleading representations may result in administrative liabilities imposed on the onshore entities and their legal representatives. If Chinese residents who are beneficial holders of our shares, make, or have previously made, direct or indirect round tripping investments through a SPV which falls within the scope of the registration under the SAFE Circular [2014] 37 (SAFE Circular [2014] 37 Relating to Foreign Exchange Administration of Offshore Investment, Financing and Round tripping Investment by Domestic Residents utilizing Special Purpose Vehicles), the Chinese residents must make foreign exchange registration for their offshore investments, failing which, the Chinese residents may be ordered to return the capital to China and be imposed a fine by SAFE for such misconduct. Failure to comply with the registration procedures, including failure to update its own foreign exchange registration, may result in restrictions on the relevant onshore entity, including restrictions on the payment of dividends and other distributions to its offshore parent or affiliate and restrictions on the capital inflow from the offshore entity, and may also subject relevant Chinese residents to penalties under the Chinese foreign exchange administration regulations. Also, at the time of applying for SAFE registration (including any change registration), the onshore entities that do not constitute round tripping investment enterprises will be required to represents that its foreign shareholder is not directly or indirectly held by any Chinese residents; the onshore entities that constitute round tripping investment enterprises will be required to disclose the actual controlling person of its foreign shareholder. Any false or misleading representations may result in administrative liabilities imposed on the onshore entities and their legal representatives. Under Chinese regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in China may pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. The foreign invested company may not distribute profits until the losses of the previous fiscal years have been made up. Additionally, the foreign invested company shall make allocations of after-tax profits to a reserve fund and a bonus and welfare fund for their employees. In the case of a Sino-foreign equity joint venture, in addition to the reserve fund and the bonus and welfare fund, the company shall also make allocations to a venture expansion fund. In the case of a wholly foreign-owned enterprise, the amount to be contributed to the reserve fund shall be no less than 10% of the after-tax profits unless the aggregate amount reaches 50% of the registered capital of the company, at which time the company may stop making allocations to the reserve fund. The amount to be contributed to other funds of a wholly foreign-owned enterprise or any of the above funds of a Sino-foreign equity joint venture may be determined by the board of the company in accordance with the applicable laws. Any amounts to be contributed to such funds shall be set aside prior to distribution of after-tax profit. As of June 30, 2018, we had approximately 13 full time employees. None of our employees are represented by any collective bargaining unit. We have not experienced any work stoppages, work slowdowns or other labor unrest. We believe that our relations with our employees are good. Available Information We make available free of charge, or through the “Investor Center – Financials & Filings” section of our website at www.synthesisenergy.com, access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after such material is filed, or furnished to the Securities and Exchange Commission. Our Code of Business and Ethical Conduct and the charters of our Audit, Compensation and Nominating and Corporate Governance Committees are also available through the “Investor Center - Corporate Governance” section of our website or in print to any stockholder who requests them. Our business is subject to a number of risks which may negatively impact our business interests on a go-forward basis. These risks should be carefully considered prior to, or continuing, investment in our Company. To assist in the understanding of these risks, we have broken down the risks into four main categories all of which could materially impact our financial operations or our financial position: Risks Related to Our Business We will require substantial additional funding, and our failure to raise additional capital necessary to support and expand our operations could reduce our ability to compete and could harm our business. As of June 30, 2018, we had $7.1 million in cash and cash equivalents and $6.4 million of working capital. As of November 14, 2018, we had $4.0 million in cash and cash equivalents. In addition to the cash and cash equivalents we have approximately another $0.3 million in Chinese bank acceptance notes, which are similar to certificates of deposits, and have maturity dates greater than 90 days but less than one year. Of the $4.0 million in cash and cash equivalents, $2.6 million resides in the United States or easily accessed foreign countries and approximately $1.4 million resides in China. We are seeking to strengthen our financial position through new strategic partnering opportunities and we consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. If we cannot raise required funds on acceptable terms, we may further reduce our expenses. We believe that with the strategies above, we can continue to operate for the next twelve months, assuming we can successfully transfer the funds currently in China to the U.S. Based on the historical negative cash flows that the Company has incurred, the continued limited cash inflows in the period subsequent to year end and the uncertain nature of the ability to transfer the cash that resides in China, there is substantial doubt about the Company’s ability to continue as a going concern. We currently plan to use our available cash for: (i) securing orders and tasks associated with our overall business strategy described above; (ii) additional working capital investments or shareholder loans into AFE or SEE to support the growth of those strategic businesses; (iii) growing our technology IP portfolio and securing technology partners or collaborations that help us improve our ability to commercialize and implement SGT; (iv) paying the interest related to the Senior Secured Debentures (“Debentures”); (v) general and administrative expenses; and (vi) working capital and other general corporate purposes. The actual allocation and timing of these expenditures will be dependent on various factors, including changes in our strategic relationships, commodity prices and industry conditions, and other factors that we cannot currently predict. We currently have very limited financial and human resources to fully develop and execute on all of our business opportunities. We can make no assurances that AFE, SEE and our other business operations including our expected share of dividends from BFR will provide us with sufficient and timely cash flows to continue our operations. We are seeking to strengthen our financial position through new strategic partnering opportunities and we may choose to raise additional capital through equity and debt financing to strengthen our balance sheet to support our delivery of potential new orders for our technology and for our corporate general and administrative expenses. We may consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. We cannot provide any assurance that any financing will be available to us in the future on acceptable terms or at all. Any such financing could be dilutive to our existing stockholders. If we cannot raise required funds on acceptable terms, we may further reduce our expenses and we may not be able to, among other things, (i) maintain our general and administrative expenses at current levels including retention of key personnel and consultants; (ii) successfully implement our business strategy, including continuing to deliver our technology to customers and partners pursuant to licenses; (iii) make additional capital contributions to our joint ventures; (iv) fund certain obligations as they become due; (v) respond to competitive pressures or unanticipated capital requirements; or (vi) repay our indebtedness. In addition, we may elect to sell certain investments as a source of cash to develop additional projects or for general corporate purposes. Our ability to generate cash to service our indebtedness depends on many factors beyond our control, and any failure to meet our debt obligations could harm our business, financial condition and results of operations. Our ability to make payments on and to refinance our indebtedness, including our recently issued Debentures, and to fund planned capital expenditures will depend on our ability to generate sufficient cash flow from operations in the future. To a certain extent, this is subject to general economic, financial, competitive, legislative and regulatory conditions and other factors that are beyond our control. We cannot assure you that our business will generate sufficient cash flow from operations in an amount sufficient to enable us to pay principal and interest on our indebtedness, including our recently issued Debentures, or to fund our other liquidity needs. If our cash flow and capital resources are insufficient to fund our debt obligations, we may be forced to sell assets, seek additional equity or debt capital or restructure our debt. We cannot assure you that any of these remedies could, if necessary, be affected on commercially reasonable terms, or at all. Our cash flow and capital resources may be insufficient for payment of interest on and principal of our debt in the future, including payments on our recently issued Debentures, and any such alternative measures may be unsuccessful or may not permit us to meet scheduled debt service obligations, which could cause us to default on our obligations and could impair our liquidity. We may not be successful in developing our business platform in Australia. All of our business in Australia is currently being conducted by AFE and as such, we are dependent on the ability of AFE to grow and develop its pending and contemplated projects, and to secure debt and equity financing for projects. We will only receive fees for projects with AFE when agreed milestones across the development, design, construction, start-up and operations of the project are achieved. These projects will have a number of risks and could present unexpected challenges, including the existence of unknown potential disputes, liabilities or contingencies that arise during or after the development of the project. We cannot assure you that AFE will be able to complete the necessary financings, or once completed satisfy the conditions required to achieve these milestones or be able to enter into relationships with partners which can finance and develop the projects to completion. In addition, we can make no assurances that AFE will have sufficient and timely cash flows to continue its operations in the absence of a financing. The failure to complete the financings and, achieve the milestones or for the projects to be fully developed would have a material adverse effect on our business and results of operation. Our size and lack of operating history could inhibit the development of our third-party licensing business. SGT license and equipment supply agreements will typically provide a guarantee of the performance of the SGT systems used in a project. Due to our limited history and lack of financial strength, we may not be able to provide adequate financial support required to guarantee our technology performance in a project. As a result, this can impact the ability to complete equity and debt financing of projects and prevent us from securing orders. This outcome would hinder the development of our third-party licensing business and, as a result, have a material adverse effect on our financial condition and results of operations. We may not be successful developing opportunities to license our technology. Although we have identified potential opportunities in Australia, Eastern Europe, South America, the Caribbean, China and other parts of Asia, our licensing and related service business are based on our ability to secure contractual commitments from our potential customers to utilize our technology in their projects. These projects are generally capital intensive, require government approvals and can take two to five years or more to complete their development and construction. Our ability to secure orders for our technology is subject to many uncertainties associated with our customers completing a go or no-go decision to develop and invest in these projects. Additionally, successfully developing global licensing opportunities for our technology is subject to the uncertainty of global markets as well as our continued capability to deliver technology licenses, components and services, as well as the capability of regional platform companies that we develop, like AFE, to fund, develop and complete both equity and debt financing for the projects that will use our technology and related services. In addition, as with our other projects, we will be exposed to the risk of financial non-performance by our customers. Although we anticipate that we can generate revenues through engineering and technical service fees, as well as licensing fees and royalties on products sold by our licensees that incorporate our proprietary technology, there can be no assurances that we will be able to do so and our inability to do so could have a material adverse effect on our business and results of operation. We are dependent on our relationships with our strategic partners for project development. We are dependent on our relationships with our strategic partners to accelerate our expansion, fund our development efforts, better understand market practices and regulatory issues and more effectively handle challenges that may arise. Through the Tianwo-SES Joint Venture, we have partnered a significant portion of our China business with STT, a Chinese company which desires to invest into the growth of China’s clean energy space and ICCDI previously served as general contractor and engineered and constructed all three projects for the Aluminum Corporation of China, which recognizes the opportunity afforded by our technology capability and business model. We have committed to execute all of our business in Australia through AFE and in Poland through SEE. We believe partnering with companies such as STT and ICCDI and setting up companies like AFE and SEE with strong local partners, can increase the acceptance of our technology on a global basis and will enable us to reduce our capital requirements to achieve this acceleration. We may also seek additional partners in the future for our technology platforms. Our future success will depend on these relationships and any other strategic relationships that we may enter into. We cannot assure you that we will satisfy the conditions required to maintain these relationships under existing agreements or that we can prevent the termination of these agreements. We also cannot assure you that we will be able to enter into relationships with future strategic partners on acceptable terms. Further, we cannot assure you that our joint venture partners, including STT and ICCDI, AFE, and SEE will grow effectively meet their development objectives. We may not be successful developing our technology and licensing business. The development of our licensing and technology business depends, in part, on our ability to form strategic relationships with other partners which can extend our global sales reach for our technology and licensing business and retaining key technical personnel to work on that business for us. We cannot provide assurance that we will be able to successfully develop our strategic partnerships or successfully grow the Tianwo-SES Joint Venture, our exclusive provider of technology and licensing in China, Mongolia, Indonesia, Vietnam, The Philippines, and Malaysia, which depends upon several factors, including the strength of global energy and chemical markets, commodity prices and the ability of our strategic partners to timely perform their obligations. There can be no assurances that we will be able to succeed in developing or sustaining these relationships, or continue to retain the necessary employees, and our inability to do so could result in ending our licensing business which would have a material adverse effect on our business and results of operation. Joint ventures, partnerships, and companies that we enter into present a number of challenges that could have a material adverse effect on our business and results of operations and cash flows. We have developed projects in China with the ZZ Joint Venture, the Yima Joint Venture, and our Tianwo-SES Joint Venture. In addition, as part of our business strategy, we plan to enter into other joint ventures or similar transactions, including as part of our business verticals some of which may be material. These transactions typically involve a number of risks and present financial, managerial and operational challenges, including the existence of unknown potential disputes, liabilities or contingencies that arise after entering into the joint venture related to the counterparties to such joint ventures, with whom we share control. We could experience financial or other setbacks if transactions encounter unanticipated problems due to challenges, including problems related to execution or integration. In some cases, our joint venture partner may have a contractual commitment to provide funding to the joint venture, although we do not have assurances that they will satisfy such obligations. Economic uncertainty in China, Eastern Europe, Australia, or other parts of the world in which we plan to do business, could also cause delays or make financing of operations more difficult. Any of these risks could reduce our revenues or increase our expenses, which could adversely affect our results of operations and cash flows. All of our business in Australia is currently being conducted through AFE and as such, we are dependent on the ability of AFE to grow and develop its pending and contemplated projects. AFE will need to raise additional funds to move their project development efforts forward. We will only receive fees for projects with AFE, if they are successful in their fundraising efforts, and when agreed milestones across the development, design, construction, start-up and operations of the project are achieved. These projects will have a number of risks and could present unexpected challenges, including the existence of unknown potential disputes, liabilities or contingencies that arise during or after the development of the project. We cannot assure you that AFE will satisfy the conditions required to achieve these milestones or that AFE will be able to enter into relationships with partners which can finance and develop the projects to completion. The failure to achieve the milestones or for the projects to be fully developed would have a material adverse effect on our business and results of operations. All of our business in Poland is currently being conducted through SEE and as such, we are dependent on the ability of SEE to grow and develop its pending and contemplated projects. SEE will need to raise additional funds to move their project development efforts forward. We will only receive fees for projects with SEE if they are successful in their fundraising efforts and when agreed milestones across the development, design, construction, start-up and operations of the project are achieved. These projects will have a number of risks and could present unexpected challenges, including the existence of unknown potential disputes, liabilities or contingencies that arise during or after the development of the project. We cannot assure you that SEE will satisfy the conditions required to achieve these milestones or that SEE will be able to enter into relationships with partners which can finance and develop the projects to completion. The failure to achieve the milestones or for the projects to be fully developed would have a material adverse effect on our business and results of operations. Additionally, we are a minority owner in the Yima Joint Venture. We have failed to demonstrate that we can significantly influence the decision making of the joint venture. Therefore, we rely on our joint venture partner to provide management and operational support for the joint venture. Accordingly, the Yima Joint Venture investment’s success is completely dependent upon the Yima management. We have relied, and will continue to rely, upon personnel in China to compile this information and deliver it to us in a timely fashion so that the information can be incorporated into our consolidated financial statements prior to the due dates for our annual and quarterly reports. Any difficulties or delays in receiving this information or incorporating it into our consolidated financial statements in the future could impair our ability to timely file our annual and quarterly reports. Dependence on owners of future projects in which we have a minority interest, or extended negotiations regarding the scope of the projects, could delay or prevent the realization of targeted returns on our capital invested in these projects. We may be subject to future impairment losses due to potential declines in the fair value of our assets. We evaluated the conditions of the Yima Joint Venture to determine whether other-than-temporary decrease in value had occurred as of June 30, 2018 and 2017. As of each date, management determined that there were applicable triggering events related to its investment in the Yima Joint Venture. Management determined these events in these years were other-than-temporary in nature and therefore conducted an impairment analysis utilizing a discounted cash flow fair market valuation and a Black-Scholes Model-Fair Value of Optionality used in valuing companies with substantial amounts of debt where a discounted cash flow valuation may be inadequate for estimating fair value with the assistance of a third-party valuation expert. In the valuations, significant unobservable inputs were used to calculate the fair value of the investment. These inputs included forecasted methanol and coal prices, calculated discount rates and discount for lack of marketability as the majority owner is a state-owned entity in China, volatility analysis and information received from the joint venture. These valuations led to the conclusion that the investment in the Yima Joint Venture were impaired as of June 30, 2018 and 2017, and accordingly, we recorded a $3.5 million impairment for the year ended June 30, 2018, and a $17.7 million impairment for the year ended June 30, 2017. The carrying value of our Yima investment as of June 30, 2018 and 2017 was approximately $5.0 million and $8.5 million respectively. Should general economic, market or business conditions decline further, and continue to have a negative impact on our revenues or other aspects of our business, we may be required to record impairment charges in the future, which could materially and adversely affect financial condition and results of operation. Economic uncertainty could negatively impact our business, limit our access to the credit and equity markets, increase the cost of capital, and may have other negative consequences that we cannot predict. Global economic uncertainty and the underlying access to credit and equity markets could create financial challenges for us and the economy as a whole. Our internally generated cash flow and cash on hand historically have not been sufficient to fund all of our expenditures, and we have relied on, among other things, bank financings and private equity to provide us with additional capital. Our ability to access capital may be restricted at a time when we would like, or need, to raise capital. If our cash flow from operations is less than anticipated and our access to capital is restricted, we may be required to reduce our operating and capital budget, which could have a material adverse effect on our results and future operations. Ongoing uncertainty may also reduce the values we are able to realize in asset sales or other transactions we may engage in to raise capital, thus making these transactions more difficult and less economic to consummate. Our results of operations and cash flows may fluctuate. Our operating results and cash flows may fluctuate significantly as a result of a variety of factors, many of which are outside our control. Factors that may affect our operating results and cash flows include but are not limited to: (i) the ability of our Australian and Polish businesses, through AFE, SEE and BFR, to develop and provide the contemplated returns on our investment; (ii) the success of the Yima Joint Venture and their ability to improve operations and overcome the current cash flow concerns of their operations; (iii) our ability to obtain new customers and retain existing customers; (iv) the success and acceptance of our technology; (v) our ability to successfully distribute cash out of China; (vi) our ability to successfully develop additional regional platforms similar to AFE and SEE in other parts of the world, and our ability to successfully develop our licensing business verticals , as well as execute on our projects; (vii) the ability to obtain financing for our projects; (viii) the cost of coal, electricity, and natural gas; (ix) shortages of equipment, raw materials or feedstock; (x) approvals by various government agencies; and (xi) general economic conditions as well as economic conditions specific to the energy industry. An inability to attract and retain qualified personnel could harm our business, financial condition and results of operations. We do not currently have all of the personnel to fully develop and execute on all of our business opportunities, including our various business verticals and other partnering arrangements. Also, our technology design and implementation capability rely on years of gasification specific and U-GAS® specific experience and expertise in key staff members. Our future success depends, in part, on our ability, as well as the ability of our joint ventures, to identify, attract and retain highly skilled technical personnel. We face intense competition for qualified individuals from numerous other companies, some of which have far greater resources than we do. We may be unable to identify, attract and retain suitably qualified individuals, or we may be required to pay increased compensation in order to do so. If we were to be unable to attract and retain the qualified personnel we need to succeed, our business, financial condition and results of operations could suffer. Our success will depend in part on our ability to grow and diversify, which in turn will require that we manage and control our growth effectively. Our business strategy contemplates growth and diversification. As we add to our services, our number of customers, and our marketing and sales efforts, operating expenses and capital requirements will increase. Our ability to manage growth effectively will require that we continue to expend funds to improve our operational, financial and management controls, as well as reporting systems and procedures. In addition, we must effectively recruit new employees, and once hired, train and manage them. From time to time, we may also have discussions with respect to potential acquisitions, some of which may be material, in order to further grow and diversify our business. However, acquisitions are subject to a number of risks and challenges, including difficulty of integrating the businesses, adverse effects on our earnings, existence of unknown liabilities or contingencies and potential disputes with counterparties. We will be unable to manage our business effectively if we are unable to alleviate the strain on resources caused by growth in a timely and successful manner. We cannot assure you that we will be able to manage our growth and a failure to do so could have a material adverse effect on our business. We or our partners will manage the design, procurement and construction of our plants. If our or their management of these issues fail, our business and operating results could suffer. Previously for our ZZ Joint Venture, and possibly for other projects we may work on in the future, we have or expect to manage plant design as it relates to the gasification systems. Some of this work has been or will be subcontracted to third parties. We are and will be coordinating and supervising these tasks. Although we believe that this is the most time and cost-effective way to build gasification plants, we bear the risk of cost and schedule overruns and quality control. If we do not properly manage the design, procurement and construction of our plants, our business and operating results could be seriously harmed. Furthermore, as we continue to improve our technology, we may decide to make changes to our equipment that could further delay the construction of our plants. Additionally, for certain of our projects, including projects for which we provide a license or related service, we will rely on our partners to manage the design, procurement and construction of the plant. The success and timing of work on these projects by others will depend upon a number of factors that will be largely outside of our control. We can provide no assurances that the work will be completed timely or at all, or that the work will be performed at standards to our satisfaction. Continued disruption in U.S. and international economic conditions and in the commodity and credit markets may adversely affect our business, financial condition and results of operation. The global economy may experience another significant contraction, which could impeded our ability and the ability of our partners to obtain financing for our projects. This could significantly and adversely affect our results of operations and financial condition in a number of other ways. Any decline in economic conditions may reduce the demand or prices for the production from our plants. Our industry partners and potential customers and suppliers may also experience insolvencies, bankruptcies or similar events. As a direct result of these trends, our ability to finance and develop our existing projects, commence any new projects and sell our products may continue to be adversely impacted. In addition, the increased currency volatility could significantly and adversely affect our results of operations and financial condition. Any of the above factors could also adversely affect our ability to access credit or raise capital even if the capital markets improve. Our lack of operating history precludes us from forecasting operating results and our business strategies may not be accepted in the marketplace and may not help us to achieve profitability. Our lack of operating history or meaningful revenue precludes us from forecasting operating results based on historical results. Our proposed business strategies described in this annual report incorporate our senior management’s current best analysis of potential markets, opportunities and difficulties that face us. No assurance can be given that the underlying assumptions accurately reflect current trends in our industry, terms of possible project investments or our customers’ reaction to our products and services or that such products or services will be successful. Our business strategies may and likely will change substantially from time to time as our senior management reassesses its opportunities and reallocates its resources, and any such strategies may be changed or abandoned at any time. If we are unable to develop or implement these strategies through our projects and our technology, we may never achieve profitability which could impair our ability to continue as a going concern. Even if we do achieve profitability, it may not be sustainable, and we cannot predict the level of such profitability. We face the potential inability to protect our intellectual property rights which could have a material adverse effect on our business. We rely on the proprietary SGT technology originally based on U-GAS® technology licensed from GTI. All of the original patents granted around U-GAS® technology have expired and we are improving SGT technology, received some new patents and we have applied for other new patents for these improvements and new technologies. Proprietary rights relating to our technology are protected from unauthorized use by third parties only to the extent that they are covered by valid and enforceable patents, maintained within trade secrets or maintained in confidence through legally binding agreements. There can be no assurance that patents will be issued from any pending or future patent applications owned by or licensed to us or that the claims allowed under any issued patents will be sufficiently broad to protect our technology. In the absence of patent protection, we may be vulnerable to competitors who attempt to copy our technology or gain access to our proprietary information and technical know-how and we may be especially vulnerable to Chinese entities in their attempts to copy all or part of our technology. In addition, we rely on proprietary information and technical know-how that we seek to protect, in part, by entering into confidentiality agreements with our collaborators, employees, and consultants. In the case of the Tianwo-SES Joint Venture, to which we have transferred the exclusive right to our technology within the joint venture territory, we are relying on the covenants and protections included in the TUCA. We cannot assure you that these agreements will not be breached, that we would have adequate remedies for any breach or that our trade secrets will not otherwise become known or be independently developed by competitors. Proceedings initiated by us to protect our proprietary rights could result in substantial costs to us. We cannot assure you that our competitors will not initiate litigation to challenge the validity of our patents, or that they will not use their resources to design comparable products that do not infringe upon our patents. Pending or issued patents held by parties not affiliated with us may relate to our products or technologies. We may need to acquire licenses to, or contest the validity of, any such patents. We cannot assure you that any license required under any such patent would be made available on acceptable terms or that we would prevail in any such contest. We could incur substantial costs in defending ourselves in suits brought against us or in suits in which we may assert our patent rights against others. If the outcome of any such litigation is unfavorable to us, our business and results of operations could be materially and adversely affected. We are dependent on the availability and cost of low rank coal and coal waste and our inability to obtain a low-cost source could have an impact on our business. We believe that we have the greatest competitive advantage using our technology in situations where there is a ready source of low rank, low cost coal, coal waste or biomass to utilize as a feedstock. We intend to locate projects in areas where low cost coal and coal waste are available or where it can be moved to a project site easily without transportation issues and we are working to develop structured transactions that include securing options to feedstock resources including coal and biomass. The success of our projects and those of our customers will depend on the supply of low rank coal and coal waste. If a source of low cost coal or coal waste for these projects cannot be obtained effectively, our business and operating results could be seriously affected. Decreased cost or increased availability for natural gas in Australia, Poland, China and other regions where we develop projects could have an impact on our business and results of operation. We compete with producers of other low-cost fuels used for electricity generation, such as natural gas. Declines in the price of natural gas, or continued low natural gas prices, could cause demand for coal-based energy to decrease and adversely affect the price of syngas and related projects. Sustained periods of low natural gas prices or other fuels may also cause utilities to phase out or close existing coal-fired power plants or reduce construction of new coal-fired power plants. In addition, competition provided by new methods of extracting natural gas could hurt our business in Australia, China and elsewhere around the world. All of this could materially and adversely affect our business and results of operations. The termination of our license agreement with GTI or any of our joint venture agreements or licensing agreements may materially adversely affect our business and results of operations. The GTI Agreement, our joint ventures in China, our licensing and related service business and our business verticals are essential to us and our future development. With the exercise of our first extension of our agreement in May 2016, the GTI Agreement terminates on August 31, 2026, but may be terminated by GTI upon certain events of default if not cured by us within specified time periods. In addition, after the second ten-year extension period provided under the GTI Agreement, which is exercisable at our option, we cannot assure you that we will succeed in obtaining an extension of the term of the license at a royalty rate that we believe to be reasonable or at all. Our joint venture agreements do not terminate for many years, but, may be terminated earlier due to certain events of bankruptcy or default, and, in the case of the Tianwo-SES Joint Venture, if the joint venture does not establish positive net income within 24 months of formation. Termination of any of our joint ventures or other key business relationships would require us to seek another collaborative relationship in that territory. We cannot assure you that a suitable alternative third party would be identified, and even if identified, we cannot assure you that the terms of any new relationship would be commercially acceptable to us. In addition, any of our license agreements could be terminated by our customer if we default under the terms of the agreement and any such termination could have a material adverse effect on our business and results of operations. A portion of our revenues will be derived from the merchant sales of commodities and our inability to obtain satisfactory prices could have a material adverse effect on our business. In certain circumstances, we or our partners plan to sell methanol, glycol, DME, synthetic gasoline, SNG, ammonia, hydrogen, nitrogen, elemental sulphur, ash, acetic acid, propionic acid and other commodities into the merchant market. These sales may not be subject to long term offtake agreements and the price will be dictated by the then prevailing market price. Revenues from such sales may fluctuate and may not be consistent or predictable. In particular, the market for commodities such as methanol is currently under significant pressure and we are unsure of how much longer this will continue. Our business and financial condition would be materially adversely affected if we are unable to obtain satisfactory prices for these commodities or if prospective buyers do not purchase these commodities. We are dependent on key personnel who would be difficult to replace. Our performance is substantially dependent on the continued services and on the performance of our senior management and other key personnel. Our performance also depends on our ability to retain and motivate our officers, directors and key employees. The loss of the services of any of our executive officers or other key employees could have a material adverse effect on our business, results of operations and financial condition. Although we have employment and consulting arrangements, with other members of senior management, and third parties, as a practical matter, those agreements will not assure the retention of those resources and we may not be able to enforce all of the provisions in any such agreements, including the non-competition provisions. We are also dependent on our joint ventures and platform companies having the necessary senior management to maintain operations. Our future success also depends on our ability to identify, attract, hire, train, retain and motivate other highly skilled technical, managerial, marketing and customer service personnel. Competition for personnel in jurisdictions where we operate is intense, and we cannot assure you that we will be able to successfully attract, integrate or retain sufficiently qualified personnel. In addition, because substantially all of our operations are currently outside the U.S., we will be required to retain personnel, particularly our key technical personnel, who are willing to travel, sometimes for long periods of time, to foreign locations. Payment of severance benefits could strain our cash flow. Certain members of our senior management have employment agreements that provide for substantial severance payments. In the event we terminate the employment of any of these employees, or in certain cases, if such employees terminate their employment with us, such employees will be entitled to receive certain severance and related payments. The need to pay these severance payments could put a strain on our financial resources. We face intense competition. If we cannot gain market share among our competition, we may not earn revenues and our business may be harmed. The business of providing clean energy is highly competitive. In the gasification market, large multi-national industrial corporations that are better capitalized, such as General Electric, Shell, CB&I, Siemens (with entrained flow technologies); Lurgi (with moving bed technology); and smaller Chinese firms offer coal gasification equipment and services which compete with our technology. While our technology can provide superior economics than these technologies in most cases, our size, our availability to the capital markets and the lack of commercial operating experience can make it difficult for us to win orders. In addition, new competitors, some of whom may have extensive experience in related fields or greater financial resources, may enter the market. Increased competition could result in a loss of contracts and market share. Either of these results could seriously harm our business and operating results. In addition, there are a number of gasification and conventional, non-gasification, coal-based alternatives for producing heat and power that could compete with our technology in specific situations. If we are unable to effectively compete with other sources of energy, our business and operating results could be seriously harmed. Our information technology systems and those of our service providers are subject to our ability to maintain them to avoid cyber security risks and threats. We depend on information technology systems that we manage, and others that are managed by our third-party service and equipment providers, to conduct our operations, and these systems are subject to risks associated with cyber incidents or attacks. It has been reported that unknown entities or groups have mounted cyber-attacks on businesses and other organizations solely to disable or disrupt computer systems, disrupt operations and, in some cases, steal data. Due to the nature of cyber-attacks, breaches to our or our service or equipment providers’ systems could go unnoticed for a prolonged period of time. These cyber security risks could disrupt our operations and result in disruption of our operations, loss of critical data as well as result in higher costs to correct and remedy the effects of such incidents. If our or our service or equipment providers’ systems for protecting against cyber incidents or attacks prove to be insufficient and an incident were to occur, it could have a material adverse effect on our business, financial condition, results of operations or cash flows. Currently, we do not carry insurance for losses related to cyber security attacks and may elect to not obtain such insurance in the future. We may incur substantial liabilities to comply with climate control legislation and regulatory initiatives. Recent scientific studies have suggested that emissions of certain gases, commonly referred to as “greenhouse gases,” may be contributing to the warming of the Earth’s atmosphere. In response to such studies, many countries are actively considering legislation, or have already taken legal measures, to reduce emissions of greenhouse gases. Carbon dioxide, a byproduct of burning fossil fuels such as coal, is an example of a greenhouse gas. Plants using our technology may release a significant amount of carbon dioxide. Methane is another greenhouse gas. New legislation or regulatory programs that restrict emissions of greenhouse gases in areas in which we conduct business may require us or our customers to obtain additional permits, meet additional control requirements, install additional environmental mitigation equipment, or take other as yet unknown steps to comply with these potential regulations, which could adversely affect our financial performance. Although we plan to use advanced technologies to actively utilize or sequester any greenhouse gas emissions, compliance with any future regulation of greenhouse gases, if it occurs, could be costly and may delay our development of projects. Even if we or our customers obtain all necessary permits, the air quality standards or the interpretation of those standards may change, thus requiring additional control equipment, more stringent permitting requirements, or other measures. Such requirements could significantly increase the operating costs and capital costs associated with any future development, expansion or modification of a plant. Our controls and procedures may fail or be circumvented. Our management regularly reviews and updates our internal control over financial reporting, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls and procedures, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of our controls and procedures, or failure to comply with regulations related to controls and procedures, could have a material adverse effect on our business, results of operations and financial condition. In fiscal years ending June 30, 2018 and 2017, we did not maintain effective internal controls over financial reporting. Specifically, we identified material weaknesses over management’s review controls over significant accounting estimates and review controls over accounting for non-routine and complex accounting transactions. A material weakness was identified relating to the impairment evaluation of our cost method investments. We did not effectively operate controls over management’s review of the impairment assessment, including its review of certain elements related to the valuation of our cost basis investments. Additionally, management’s assessment identified an additional material weakness in management’s review controls over non-routine and complex accounting transactions that were caused by a lack of segregation of duties over these types of transactions. We are subject to the requirements of Section 404 of the Sarbanes-Oxley Act. If we are unable to maintain compliance with Section 404 or if the costs related to compliance are significant, our profitability, stock price and results of operations and financial condition could be materially adversely affected. We are required to comply with the provisions of Section 404 of the Sarbanes-Oxley Act of 2002. Section 404 and the related Securities and Exchange Commission’s implementing rules, require that management disclose whether the principal executive officer and principal financial officer maintained internal control over financial reporting that, among other things, provides reasonable assurance that material errors in our external financial reports will be prevented or detected on a timely basis, and that we maintain support for that disclosure that includes evidence of our evaluation of the design and operation of our internal control. We are a small company with international operations, limited financial resources and our finance and accounting staff is very limited. We cannot be certain that we will be able to successfully maintain the procedures, certification and attestation requirements of Section 404 or that we or our auditors will not identify material weaknesses in internal control over financial reporting in the future. If we are unable to maintain compliance with Section 404, investors could lose confidence in our financial statements, which in turn could harm our business and negatively impact the trading price of our common stock. Risks Related to International Operations International operations have uncertain political, economic, and other risks. The majority of our operations are located in China and Australia, and we are looking at development opportunities in other countries as well. As a result, a significant portion of our revenue is subject to the increased political and economic risks and other factors associated with international operations including, but not limited to: • general strikes and civil unrest; • other changes in political climate and energy-related policy and laws; • the risk of war, acts of terrorism, expropriation and resource nationalization, forced renegotiation or modification of existing contracts; • import and export regulations (including in respect of gas); • taxation policies, including royalty and tax increases and retroactive tax claims, and investment restrictions; • price control; • transportation regulations and tariffs; • constrained methanol markets dependent on demand in a single or limited geographical area; • exchange controls, currency fluctuations, devaluation, or other activities that limit or disrupt markets and restrict payments or the movement of funds; • laws and policies of the United States affecting foreign trade, including trade sanctions; • the possibility of being subject to exclusive jurisdiction of foreign courts in connection with legal disputes relating to licenses to operate and concession rights in countries where we currently operate; • the possible inability to subject foreign persons, especially foreign oil ministries and national oil companies, to the jurisdiction of courts in the United States; and • difficulties in enforcing our rights against a governmental agency because of the doctrine of sovereign immunity and foreign sovereignty over international operations. Foreign countries have occasionally asserted rights to assets held by foreign entities. If a country claims superior rights to our assets, our interests could decrease in value or be lost. Various regions of the world in which we operate have a history of political and economic instability. This instability could result in new governments or the adoption of new policies that might result in a substantially more hostile attitude toward foreign investments such as ours. In an extreme case, such a change could result in termination of contract rights and expropriation of our assets. This could adversely affect our interests and our future profitability. The impact that future terrorist attacks or regional hostilities may have on our industry in general, and on our operations in particular, is not known at this time. Uncertainty surrounding military strikes or a sustained military campaign may affect operations in unpredictable ways, including disruptions of feedstock supplies and markets, and the possibility that infrastructure facilities, including production facilities, could be direct targets of, or indirect casualties of, an act of terror or war. We may be required to incur significant costs in the future to safeguard our assets against terrorist activities. Foreign investment regulations could adversely impact our company and subject us to fines. Many nations, both developing and developed countries, have stringent laws which are related to the investment and re-patriotization of funds from profits within their respective countries and which may inhibit or prevent us from removing funds from the country in which the investment was made and could potentially impact our liquidity. For example, Chinese regulations relating to outbound investment activities, in particular, round-tripping investments by Chinese residents may increase our administrative burden, restrict our overseas and cross-border investment activity or otherwise adversely affect the implementation of our acquisition strategy. If Chinese residents, who are beneficial holders of our shares, make or have previously made direct or indirect round tripping investments through a SPV which falls within the scope of the registration under the SAFE Circular [2014] 37 (SAFE Circular [2014] 37 Relating to Foreign Exchange Administration of Offshore Investment, Financing and Round tripping Investment by Domestic Residents utilizing Special Purpose Vehicles), the Chinese residents must make foreign exchange registration for their offshore investments, otherwise, the Chinese residents may be ordered to return the capital to China and be imposed a fine by SAFE for such misconduct. At the time of applying for SAFE registration (including any change registration), the foreign-invested enterprises that do not constitute round tripping investment enterprises will be required to represent that its foreign shareholder is not directly or indirectly held by any Chinese residents; the foreign-invested enterprises that constitute round tripping investment enterprises will be required to disclose the actual controlling person of its foreign shareholder. Any false or misleading representations may result in administrative liabilities imposed on the onshore entities and their legal representatives. We cannot provide any assurances that all of our stockholders who are Chinese residents will make or obtain any applicable registrations or approvals required by these SAFE regulations. The failure or inability of our Chinese resident stockholders to comply with the registration procedures set forth in the SAFE regulations may subject our Chinese subsidiaries to fines and legal sanctions, restrict our cross-border investment activities, or limit the ability to distribute dividends to or obtain foreign-exchange dominated loans from our company. Given that SAFE [2014] Circular 37 is a newly issued regulation, certain aspects therein still remain in uncertainty. As it is uncertain how the SAFE regulations will be interpreted or implemented, we cannot predict how these regulations will affect our business operations or future strategy. For example, we may be subject to a more stringent review and approval process with respect to our foreign exchange activities, such as remittance of dividends and obtaining foreign currency denominated borrowings, which may harm our results of operations and financial condition. In addition, if we decide to acquire a Chinese domestic company, we cannot assure you that we or the owners of such company, as the case may be, will be able to obtain the necessary approvals or complete the necessary filings and registrations required by the SAFE regulations. This may restrict our ability to implement our acquisition strategy and could adversely affect our business and prospects. In relation to our Australian operations, the Australian Government regulates investments by foreign persons in certain companies, trusts, businesses and land under the Foreign Acquisitions and Takeovers Act (“FATA”). This regime requires notification of the proposed acquisition to the Australian Treasurer, through the Foreign Investment Review Board (“FIRB”) and obtaining a no objections notification (“FIRB approval”) in respect of certain investments made by foreign persons. Under the FATA, we are considered a foreign person. Similarly, due to our ownership position in AFE, AFE will also be considered a foreign person under the FATA. This means that if we or AFE decide to acquire an Australian company, trust, business or interest in Australian land (which includes an interest in mining and production tenements), such an acquisition may require FIRB approval if it meets the relevant FATA thresholds. Also, due to the Australia - United States Free Trade Agreement, United States investors are considered "agreement country investors" under the FATA. The “agreement country investors” are subject to much higher FATA thresholds which means that United States investors can make significantly larger investments without needing to seek FIRB approval. However, we can only benefit from these higher FATA thresholds if we use entities incorporated or established in United States to directly make the proposed investment. The Treasurer will only grant FIRB approval if he can be satisfied that the proposed investment is not contrary to the Australian national interest. We cannot provide any assurances that we or AFE, as the case may be, will be able to obtain the necessary FIRB approvals in relation to proposed acquisitions that meet the FATA thresholds. However, rejections of proposed investments are rare. Furthermore, depending on the proportion of our shares that are beneficially held by government-related entities at any one time, we, and in turn AFE, may be considered a foreign government investor under the FATA. Foreign government investors are subject to lower FATA thresholds and greater scrutiny by FIRB in relation to their proposed acquisitions. We cannot assure you that we will always be able to accurately identify whether we are a foreign government investor under the FATA. Failure to obtain FIRB approval when required or otherwise comply with the FATA may subject us to fines and a range of legal sanctions, including orders requiring us to dispose of the relevant interest (in relation to interests that have been acquired without FIRB approval). This may restrict our ability to implement our acquisition strategy and could adversely affect our business and prospects. In our areas of operation, the projects we and our customers intend to build are subject to rigorous environmental regulations, review and approval. We cannot assure you that such approvals will be obtained, applicable requirements will be satisfied or approvals, once granted, will be maintained. Our operations are subject to stringent laws and regulations governing the discharge of materials into the environment, remediation of contaminated soil and groundwater, sitting of facilities or otherwise relating to environmental protection. Numerous governmental agencies, such as various Chinese, Polish and Australian authorities at the municipal, state/provincial or central government level and similar regulatory bodies in other countries, issue regulations to implement and enforce such laws, which often require difficult and costly compliance measures that carry substantial potential administrative, civil and criminal penalties or may result in injunctive relief for failure to comply. These laws and regulations may require the acquisition of a permit before construction and/or operations at a facility commence, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with such activities, limit or prohibit construction activities on certain lands lying within wilderness, wetlands, ecologically sensitive and other protected areas and impose substantial liabilities for pollution. We believe that we are in substantial compliance with current applicable environmental laws and regulations. Although to date we have not experienced any material adverse effect from compliance with existing environmental requirements, we cannot assure you that we will not suffer such effects in the future or that projects developed by our partners or customers will not suffer such effects. Although we have been successful in obtaining the permits in China, any retroactive change in policy guidelines or regulations, or an opinion that the approvals that have been obtained are inadequate, could require us to obtain additional or new permits, spend considerable resources on complying with such requirements or delay commencement of construction. Other developments, such as the enactment of more stringent environmental laws, regulations or policy guidelines or more rigorous enforcement procedures, or newly discovered conditions, could require us to incur significant capital expenditures. Our projects and projects of our customers are subject to an extensive governmental approval process which could delay the implementation of our business strategy. Selling syngas, methanol, glycol and other commodities is highly regulated in many markets around the world, as will be projects in our business verticals. We believe these projects will be supported by the governmental agencies in the areas where the projects will operate because coal-based technologies, which are less burdensome on the environment, are generally encouraged by most governments. However, the regulatory environment is often uncertain and can change quickly, often with contradictory regulations or policy guidelines being issued. In some cases, government officials have different interpretations of such regulations and policy guidelines and project approvals that are obtained could later be deemed to be inadequate. Furthermore, new policy guidelines or regulations could alter applicable requirements or require that additional levels of approval be obtained. If we or our customers and partners are unable to effectively complete the government approval process in China, Poland, Australia, and other markets in which we intend to operate, our business prospects and operating results could be seriously harmed. Foreign laws may not afford us sufficient protections for our intellectual property, and we may not be able to obtain patent protection outside of the United States. Certain nations that we operate in may not grant us certain intellectual property rights that are customarily granted in more developed legal systems. Patent law reform in the United States and other countries may also weaken our ability to enforce our patent rights or make such enforcement financially unattractive. For example, Australia has enacted the Intellectual Property Laws Amendment (Raising the Bar) Act, which provides higher standards for obtaining patents. These reforms could result in increased costs to protect our intellectual property or limit our ability to patent our products in these jurisdictions. In addition, despite continuing international pressure on the Chinese government, intellectual property rights protection continues to present significant challenges to foreign investors and, increasingly, Chinese companies. Chinese commercial law is relatively undeveloped compared to the commercial law in our other major markets and only limited protection of intellectual property is available in China as a practical matter. Although we have taken precautions in the operations of our Chinese subsidiaries and in our joint venture agreements (including as to the Tianwo-SES Joint Venture to which we have transferred the exclusive right to our technology within the joint venture territory) to protect our intellectual property, any local design or manufacture of products that we undertake in China could subject us to an increased risk that unauthorized parties will be able to copy or otherwise obtain or use our intellectual property, which could harm our business. We may also have limited legal recourse in the event we encounter patent or trademark infringement. Uncertainties with respect to the Chinese legal system may adversely affect the operations of our Chinese subsidiaries. China has put in place a comprehensive system of intellectual property laws however, incidents of infringement are common and enforcement of rights can, in practice, be difficult. If we are unable to manage our intellectual property rights, our business and operating results may be seriously harmed. We could be adversely affected by violations of the FCPA and similar laws in connection with our foreign operations. The U.S. Foreign Corrupt Practices Act (“FCPA”) and similar other corruption laws generally prohibit companies and their intermediaries from making improper payments to government officials for the purpose of obtaining or retaining business. Our corporate policies mandate compliance with these laws. We operate in many parts of the world that have experienced governmental corruption to some degree and, in certain circumstances, strict compliance with anti-bribery laws may conflict with local customs and practices. Despite our training and compliance program, we cannot assure you that our internal control policies and procedures always will protect us from reckless or negligent acts committed by our employees or our respective agents. Violations of these laws, or allegations of such violations, could disrupt our business and result in a material adverse effect on our business and operations. We may be subject to competitive disadvantages to the extent that our competitors are able to secure business, licenses or other preferential treatment by making payments to government officials and others in positions of influence or using other methods that United States or other corruption laws and regulations prohibit us from using. In order to effectively compete in some foreign jurisdictions, we utilize local agents and seek to establish joint ventures with local operators or strategic partners. Although we have procedures and controls in place to monitor internal and external compliance, if we are found to be liable for FCPA violations (either due to our own acts or our inadvertence, or due to the acts or inadvertence of others, including actions taken by our agents and our strategic or local partners, even though our agents and partners are not subject to the FCPA), we could suffer from civil and criminal penalties or other sanctions, which could have a material adverse effect on our business, financial position, results of operations and cash flows. Our results of operations would be negatively affected by potential currency fluctuations in exchange rates with foreign countries. Currency fluctuations, devaluations and exchange restrictions may adversely affect our liquidity and results of operations. Exchange rates are influenced by political or economic developments the United States, China or elsewhere and by macroeconomic factors and speculative actions. In some countries, local currencies may not be readily converted into U.S. dollars or other hard currencies or may only be converted at government-controlled rates, and, in some countries, the transfer of hard currencies offshore has been restricted from time to time. Very limited hedging transactions are available in China to reduce our exposure to exchange rate fluctuations. To date, we have not entered into any hedging transactions in an effort to reduce our exposure to foreign currency exchange risk. While we may decide to enter into hedging transactions in the future, the availability and effectiveness of these hedges may be limited may not be able to successfully hedge our exposure. Fluctuations in exchange rates can have a material impact on our costs of construction, our operating expenses and the realization of revenue from the sale of commodities. We cannot assure you that we will be able to offset any such fluctuations and any failure to do so could have a material adverse effect on our business, financial condition and results of operations. In addition, our financial statements are expressed in U.S. dollars and will be negatively affected if foreign currencies, such as the RMB, or the Australian dollar (“AUD”), or the Polish Zloty (“PLN”) depreciate relative to the U.S. dollar. In addition, our currency exchange losses may be magnified by exchange control regulations in China or other countries that restrict our ability to convert into U.S. dollars. Risks related to our Australian Platform Estimating the quantity and quality of mineral resources is an inherently uncertain process. Estimating the quantity and quality of mineral resources is an inherently uncertain process and any reserve estimates that we may receive from AFE related to the Pentland resource or from BFR in the future are and will be estimates and may not prove to be an accurate indication of the quantity and/or grade of mineralization that AFE or BFR has identified or that they will be able to extract, process and sell. Mineral reserve estimates are expressions of judgement based on knowledge, experience and industry practice. Mineral reserve estimates are necessarily imprecise and depend to some extent on interpretations and geological assumptions, the application of sampling techniques, estimates of commodity prices, cost assumptions, and statistical inferences which may ultimately prove to have been unreliable. The inclusion of mineral reserve estimates should not be regarded as a representation that these amounts can be economically exploited and investors are cautioned not to place undue reliance on mineral reserve estimates, particularly inferred resource estimates, which are highly uncertain. Consequently, mineral reserve estimates are often regularly revised based on actual production experience or new information and are therefore expected to change. Furthermore, should AFE or BFR encounter mineralization or formations different from those predicted by past drilling, sampling and similar examinations, their mineral reserve estimates may have to be adjusted and mining plans, processing and infrastructure may have to be altered in a way that might adversely affect their operations. Moreover, a decline in the price of commodities, increases in production costs, decreases in recovery rates or changes in applicable laws and regulations, including environment, permitting, title or tax regulations, that are adverse to AFE or BFR, may mean the volumes of mineralization that AFE or BFR can feasibly extract may be significantly lower than the original mineral reserve estimates. If it is determined that mining of certain of resources and the reserves derived from them have become uneconomic, this may ultimately lead to a reduction in the quantity of the aggregate resources of AFE and BFR being mined or result in AFE or BFR deciding not to proceed with the project. Mining exploration and operations are subject to a number of factors which could adversely affect AFE and BFR. The current and future operations of AFE and BFR, including exploration, appraisal, development and possible production activities may be affected by a range of exploration and operating factors, including: · Geological conditions; · Limitations on activities due to seasonal or adverse weather patterns; · Alterations to program and budgets; · Unanticipated operational and technical difficulties encountered in geophysical surveys, drilling, metallurgical laboratory work and production activities; · Mechanical failure of operating plant and equipment, industrial and environmental accidents, acts of terrorism or political or civil unrest and other force majeure events; · Industrial action, disputation or disruptions; · Unavailability of transport or drilling equipment to allow access and geological and geophysical investigations; · Unavailability of suitable laboratory facilities to complete metallurgical test work investigations; · Failure of metallurgical testing to determine a commercial viable product; · Shortages or unavailability of manpower or appropriately skilled manpower; · Unexpected shortages or increases in the costs of consumables, spare parts, plant and equipment; and / or · Prevention or restriction of access by reason of inability to obtain consents or approvals. Both AFE and BFR have minimal operating history which could have an adverse effect on the success of their business operations. Prior to the completion of the Callide acquisition, neither AFE or BFR had developed or managed a fully operational mining or processing facility and neither of them has any direct or demonstrated experience in building or operating mining or processing facilities. While their directors and management have substantial experience in the mining and resources industries, there can be no assurance that their projects will experience results similar to those achieved by other companies or projects in which their directors and management have been involved in the past. The financial condition of AFE and BFR will depend upon the commercial viability and profitability of their projects. Neither AFE or BFR can provide any assurance that it will be able to commission or sustain the successful operation of its projects or that they will achieve commercial viability. Our Australian operations are subject to a number of operating risks which could have a material adverse effect on our results of operations. The future operations of AFE and BFR will be subject to operating risks that could result in decreased production which could reduce its revenues. Operational difficulties may impact production volumes, delay or increase the cost of operating for a varying length of time. Such difficulties include (but are not limited to) unexpected maintenance or technical problems; failure of key equipment; depletion of mineral resources; increased or unexpected reclamation costs; interruptions due to transportation delays; industrial and environmental accidents; industrial disputes; unexpected shortages or increases in the costs of consumables and spare parts; availability of water; availability and cost of power and other utilities; fires; adverse weather conditions and other natural disasters. Other difficulties may arise as a result of variations in mining or operating conditions from those projected from drilling, such as geotechnical issues, variations in the amount of waste material, variations in geological conditions and the actions of potential contractors engaged to operate projects including any breach of contract or other action outside the control of AFE or BFR. Unforeseen geological, geotechnical or operational difficulties could also cause a loss of revenue due to lower production than expected, higher operating and maintenance costs and/ or ongoing unplanned capital expenditure to meet production targets. Any such geological conditions may adversely affect the financial performance of AFE and BFR. A failure to obtain access, whether under a contractual arrangement or otherwise, to an adequate supply of capital equipment or consumables for use in their operations could result in delays to the commencement of operations at projects for AFE and BFR, reduced production rates and increased costs. AFE and BFR may consider opportunities for expansion and/or opportunities to acquire other mining and processing rights in the future. There can be no certainty that any expenditures made by them towards the search for, acquisition of or evaluation of mineral deposits or rights will result in commercial discoveries or acquisitions. Failure to obtain necessary licenses or permits could delay or restrict our projects being developed in Australia. Both AFE and BFR are required under applicable local laws and regulations to seek governmental concessions, permits, authorizations, licenses and other approvals, including in connection with its operating, producing, exploration and development activities. We cannot predict whether they will be able to obtain all required permits or other authorizations for its current and future operations. Obtaining, retaining or renewing the necessary governmental concessions, permits, authorizations, licenses (including with respect to environment and water use) and approvals can be a complex and time-consuming process and may involve substantial costs or the imposition of unfavorable conditions. There can be considerable delay in obtaining the necessary permits and other authorizations and in certain cases the relevant government agency may be unable to issue a required permit or other authorization in a timely manner. The duration and success of permit applications are contingent on many factors that are outside of the control of AFE and BFR including objections from local communities, non-government organizations or special interest groups. Failure to obtain a material license or permit in connection with a specific project would adversely impact AFE and BFR. Mineral exploration involves significant risks which could have an adverse effect on our results of operations. The exploration of mineral deposits involves significant risks which even a combination of careful evaluation, experience and knowledge will not fully eliminate. While the discovery of a mineral deposit may result in substantial rewards, few properties which are explored are ultimately developed into producing mines. Major expenses may be required to locate and establish ore reserves and to construct mining and processing facilities at a particular site. Whether a mineral deposit will be commercially viable depends on a number of factors, some of which include the particular attributes of the deposit, such as size, quality and proximity to infrastructure; commodity prices which are highly cyclical; and government regulations, including regulations relating to prices, taxes, royalties, land tenure, land use, importing and exporting of minerals and environmental protection. The exact effect of these factors cannot be accurately predicted, but the combination of these factors may result in AFE or BFR not receiving an adequate, or any, return on invested capital for any exploration activities that may be undertaken in the future. Government regulation or policy could impose a significant cost on our Australian operations. Government regulations will impose significant costs on the mining and processing operations of AFE and BFR, and future regulations could increase those costs or limit their ability to operate and produce. The mining and processing industries are subject to increasingly strict regulation with respect to matters such as limitations on land use, employee health and safety, mine permitting and licensing requirements, reclamation and restoration of mining properties, air quality standards, water pollution, protection of human health, plant life and wildlife, the discharge of materials into the environment, surface subsidence from underground mining and the effects of mining on groundwater quality and availability. The possibility exists that new legislation and/or regulations and orders may be adopted that may materially adversely affect the mining operations of AFE and BFR, cost structure and/or their ability of to sell (or, if applicable, export) their products. New legislation or administrative regulations (or new judicial interpretations or administrative enforcement of existing laws and regulations or changes in respect policy or the enactment of policy-related decisions), including proposals related energy policy or to the protection of the environment that would further regulate and tax the industry, may also require AFE, BFR or its customers to change operations significantly or incur increased costs. Environmental regulations impacting the mining industry may adversely affect AFE and BFR. The operations of AFE and BFR are subject to or affected by a wide array of regulations in the jurisdictions where they operate, including those directly impacting mining activities and those indirectly affecting their businesses, such as applicable environmental laws. In addition, new environmental legislation or administrative regulations relating to mining or affecting demand for mined materials, or more stringent interpretations of existing laws and regulations, may require AFE or BFR to significantly change or curtail their operations. The high cost of compliance with environmental regulations may discourage them from expanding existing mines or developing new mines and may also cause customers to limit or even discontinue their mining operations. As a result of these factors, our Australian projects could be adversely affected by environmental regulations directly or indirectly impacting the mining industry. Any reduction in demand as a result of environmental regulations could have a material adverse effect on the business, financial condition or results of operations of AFE and BFR. Failure to obtain necessary native title or Aboriginal cultural heritage consents and approvals could delay or restrict our projects being developed in Australia. Both AFE and BFR are required under applicable local laws and regulations to seek authorizations and consents from Aboriginal and Torres Strait Islander Peoples in relation to native title (where it has not been extinguished) and Aboriginal cultural heritage, including in connection with its operating, producing, exploration and development activities. We cannot predict whether they will be able to obtain all required authorizations and consents for its current and future operations. Obtaining, retaining or renewing the necessary authorizations and consents can be a complex and time-consuming process and may involve substantial costs or the imposition of unfavorable conditions. There can be considerable delay in obtaining the necessary authorizations and consents. However, where consents and authorizations are not provided by agreement, there are fallback options available under the native title “right to negotiate” process and the statutory process for development of cultural heritage management plans. The duration and success of authorization and consent processes are contingent on many factors that are outside of the control of AFE and BFR. Failure to obtain an authorization or consent in connection with a specific project would adversely impact AFE and BFR. Uncertainty or weaknesses in global economic conditions could adversely impact coal pricing. The world prices of coal are strongly influenced by international demand and global economic conditions. Uncertainties or weaknesses in global economic conditions could adversely affect our business and negatively impact our financial results. In addition, if another global economic downturn were to occur, we would likely see decreased demand and decreased prices with respect to our Australian projects, resulting in lower revenue levels and decreasing margins. We are not able to predict whether the global economic conditions will continue or worsen and the impact it may have on our operations and the industry in general going forward. Taxation of dividends paid by AFE and BFR could have a negative impact on our shareholders. Australian resident companies are liable for Australian income tax on their taxable income at a corporate tax rate (which is currently 30%). The payment of Australian income tax by an Australian company generates a “franking credit” which, when the company pays a dividend to shareholders, generally flows through to the company’s shareholders. Dividends, to the extent that they are paid by AFE and BFR, may potentially be franked up to 100%. The rate of franking depends on the Australian company’s level of available franking credits. The level of franking may vary over time and dividends may be partially or fully franked or not franked at all. Non-Australian tax resident shareholders who hold shares in an Australian tax resident company may be subject to Australian dividend withholding tax on the ‘unfranked’ component of any dividends paid by the company (unless those shares are held at or through a permanent establishment in Australia). Dividend withholding tax should not apply to non-Australian tax resident shareholders to the extent that the dividend is franked. Where it applies, Australian dividend withholding tax is generally imposed at the rate of 30%, but the rate may be reduced under a double tax treaty between Australia and the jurisdiction where the shareholder is resident. Under the double tax treaty between the United States of America and Australia, the dividend withholding tax rate applicable to dividends paid to US tax residents is reduced to 5% of the gross amount of the unfranked dividend provided the shareholder holds 10% or more of the voting power in the company paying the dividends (where the US tax resident holds less than 10% of the voting power in the company paying the dividends, the dividend withholding tax rate is reduced to 15%). Risks Related to Our Chinese Operations Economic conditions in China could have an adverse impact on the performance of our joint venture partners and, as a result, our results of operations. We may be adversely affected by economic uncertainty in China or the United States, such as may result from the current trade tariff discussions between the U.S. and China or other political tensions, which could create further financial challenges for us and make our Chinese businesses less economic and more difficult to consummate new business. We may have difficulty establishing adequate management, legal and financial controls in China. China historically has been deficient in Western-style management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. We have limited influence in decision making in our Chinese joint ventures. For example, we changed from the equity method of accounting for our investment in the Yima Joint Venture to the cost method of accounting because we concluded that we are unable to exercise significant influence over the Yima Joint Venture due to, among other things, our limited participation in operating and financial policymaking processes and our limited ability to influence technological decisions. We may have difficulty in hiring and retaining a sufficient number of employees who are qualified to assist us in application of such concepts and practices to work in China. As a result of these factors, we may experience difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards. This situation can be more challenging in cost method investments where we do not experience significant influence and could have an adverse impact on our results of operations. China’s anti-corruption campaign may adversely impact our Chinese partners and our Chinese joint ventures. The Chinese government initiated a nationwide anti-corruption campaign to improve governance in China. The primary focus of this campaign was largely on state-owned enterprises (“SOE”). Certain of our joint ventures are majority owned by an SOE. If one or more of the senior executives of our SOE joint venture partner or related entities are questioned or come under investigation, this could limit our participation in the on-going operations of the facilities and could adversely affect our realization of our investment in such joint ventures and facilities. This would materially affect our financial condition and results of operations. We may have difficulty making distributions and repatriating earnings from our Chinese operations. Under Chinese regulations, wholly foreign-owned enterprises and Sino-foreign equity joint ventures in China may pay dividends only out of their accumulated profits, if any, determined in accordance with Chinese accounting standards and regulations. The foreign invested company may not distribute profits until the losses of the previous fiscal years have been made up. Additionally, the foreign invested company shall make allocations of after-tax profits to a reserve fund and a bonus and welfare fund for their employees. In the case of a Sino-foreign equity joint venture, in addition to the reserve fund and the bonus and welfare fund, the company shall also make allocations to a venture expansion fund. In the case of a wholly foreign-owned enterprise, the amount to be contributed to the reserve fund shall be no less than 10% of the after-tax profits unless the aggregate amount reaches 50% of the registered capital of the company, at which time the company may stop making allocations to the reserve fund. The amount to be contributed to other funds of a wholly foreign-owned enterprise or any of the above funds of a Sino-foreign equity joint venture may be determined by the board of the company in accordance with the applicable Chinese laws. Any amounts to be contributed to such funds shall be set aside prior to distribution of after-tax profit. If we are unable to make distributions and repatriate earnings from our Chinese operations, it could have a materially adverse effect on our financial condition and results of operation. Increased development of shale gas in China could have an adverse effect on our business. According to a 2014 study published by the EIA, China has the world’s largest technically recoverable shale gas reserve resource, representing approximately 9.2% of the world’s total recoverable shale gas resources. However, given the variation across the world's shale formations in both geology and above-the-ground conditions, the extent to which global technically recoverable shale resources will prove to be economically recoverable is not yet clear. The market effect of shale resources outside the United States will depend on the associated production costs, volumes, and market prices. For example, a potential shale well that costs twice as much and produces half the output of a typical U.S. well would not likely be developed. An increase in the development of shale gas would be a competitive alternative to syngas which is produced by our technology and could have a material adverse effect on our business and results of operation if successful. Our operations in China may be adversely affected by evolving economic, political and social conditions. Our operations are subject to risks inherent in doing business internationally. Such risks include the adverse effects on operations from war, international terrorism, civil disturbances, political instability, governmental activities and deprivation of contract and property rights. In particular, since 1978, the Chinese government has been reforming its economic and political systems, and we expect this to continue. Although we believe that these reforms have had a positive effect on the economic development of China and have improved our ability to do business in China, we cannot assure you that these reforms will continue or that the Chinese government will not take actions that impair our operations or assets in China. In addition, periods of international unrest may impede our ability to do business in other countries and could have a material adverse effect on our business and results of operations. Furthermore, changes in China’s economic or political situations could impact the exchange rate of the Chinese Renminbi yuan, which could materially impact our financial positions and our results of operations in China. Chinese regulations of loans and direct investment by offshore entities to Chinese entities may delay or prevent us from utilizing proceeds of funds to make loans or additional capital contributions to our operations in China, which could materially and adversely affect our liquidity and our ability to fund and expand our business. We may make loans or additional capital contributions to our operations in China. Any loans to our Chinese operations are subject to Chinese regulations and approvals. Such loans by us cannot exceed statutory limits and must be registered with the Chinese State Administration of Foreign Exchange or its local counterpart. We may also decide to finance our Chinese operations by means of capital contributions. This capital contribution must be approved by the Chinese Ministry of Commerce or its local counterpart. We cannot assure you that we will be able to obtain these government registrations or approvals on a timely basis, if at all, with respect to future loans or capital contributions by us to our Chinese operations or any of their subsidiaries. If we fail to receive such registrations or approvals, our ability to capitalize our Chinese operations may be negatively affected, which could adversely and materially affect our liquidity and ability to fund and expand our business. The Chinese government exerts substantial influence over the manner in which we must conduct our business activities. The Chinese government has exercised and continues to exercise substantial control over virtually every sector of the Chinese economy through regulation and state ownership. Our ability to operate in China may be harmed by changes in its laws and regulations, including those relating to taxation, import and export tariffs, environmental regulations, land use rights, property and other matters. We believe that our operations in China are in material compliance with all applicable legal and regulatory requirements. However, the central or local governments of the jurisdictions in which we operate may impose new, stricter regulations or interpretations of existing regulations that would require additional expenditures and efforts on our part to ensure our compliance with such regulations or interpretations. Accordingly, government actions in the future, including any decision not to continue to support recent economic reforms and to return to a more centrally planned economy or regional or local variations in the implementation of economic policies, could have a significant effect on economic conditions in China or particular regions thereof and could require us to divest ourselves of any interest we then hold in Chinese properties or joint ventures. We face risks related to natural disasters and health epidemics in China, which could have a material adverse effect on our business and results of operations. Our business could be materially adversely affected by natural disasters or the outbreak of health epidemics in China. For example, in May 2008, Sichuan Province suffered a strong earthquake measuring approximately 8.0 on the Richter scale that caused widespread damage and casualties. In addition, in the last decade, China has suffered health epidemics related to the outbreak of avian influenza and severe acute respiratory syndrome, or SARS. Any future natural disasters or health epidemics in China could also have a material adverse effect on our business and results of operations. Uncertainties with respect to the Chinese legal system could limit the legal protections available to you and us. We conduct substantially all of our current business through our operating subsidiaries in China. Our operating subsidiaries are generally subject to Chinese laws and regulations including those applicable to foreign investments in China and, in particular, laws applicable to foreign-invested enterprises. The Chinese legal system is a civil law system based on written statutes. Unlike common law systems, decided legal cases have little precedential value in China. In 1979, the Chinese government began to promulgate a comprehensive system of laws and regulations governing economic matters in general. The overall effect of legislation since 1979 has significantly enhanced the protections afforded to various forms of foreign investment in China. However, Chinese laws and regulations change frequently, and the interpretation of laws and regulations is not always uniform, and enforcement thereof can involve uncertainties. For instance, we may have to resort to administrative and court proceedings to enforce the legal protection that we are entitled to by law or contract. However, since Chinese administrative and court authorities have significant discretion in interpreting statutory and contractual terms, it may be difficult to evaluate the outcome of administrative court proceedings and the level of law enforcement that we would receive in more developed legal systems. Such uncertainties, including the potential inability to enforce our contracts, could limit legal protections available to you and us and could affect our business and operations. In addition, intellectual property rights and confidentiality protections in China may not be as effective as in the United States or other countries. Accordingly, we cannot predict the effect of future developments in the Chinese legal system, particularly with regard to the industries in which we operate, including the promulgation of new laws. This may include changes to existing laws or the interpretation or enforcement thereof, or the preemption of local regulations by national laws. These uncertainties could limit the availability of law enforcement, including our ability to enforce our agreements with Chinese government entities and other foreign investors. Risks Related to our Common Stock Our historic stock price has been volatile and the future market price for our common stock is likely to continue to be volatile. The public market for our common stock has historically been very volatile. Any future market price for our shares is likely to continue to be very volatile. This price volatility may make it more difficult for our stockholders to sell shares when they want at prices that they find attractive. We do not know of any one particular factor that has caused volatility in our stock price. However, the stock market in general has experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance of companies. Broad market factors and the investing public’s negative perception of our business may reduce our stock price, regardless of our operating performance. Our common stock is thinly traded on The NASDAQ Stock Market. Although our common stock is traded on The NASDAQ Stock Market, the trading volume has historically been low. We cannot assure investors that trading volume will increase or the volatility of the trading price of our common stock will decrease. We cannot assure investors that a more active trading market will develop even if we issue more equity in the future. The market valuation of our business may fluctuate due to factors beyond our control and the value of the investment of our stockholders may fluctuate correspondingly. The market valuation of clean energy companies, such as us, frequently fluctuate due to factors unrelated to the past or present operating performance of such companies. Our market valuation may fluctuate significantly in response to a number of factors, many of which are beyond our control, including: • Changes in securities analysts’ estimates of our financial performance; • Fluctuations in stock market prices and volumes, particularly among securities of energy companies; • Changes in market valuations of similar companies; • Announcements by us or our competitors of significant contracts, new technologies, acquisitions, commercial relationships, joint ventures or capital commitments; • Variations in our quarterly operating results; • Fluctuations in coal, oil, natural gas, methanol and ammonia prices; • Loss of a major customer of failure to complete significant commercial contracts; • Loss of a relationship with a partner; and • Additions or departures of key personnel. As a result, the value of your investment in us may fluctuate. Investors should not look to dividends as a source of income. We do not intend to pay cash dividends in the foreseeable future. Consequently, any economic return will initially be derived, if at all, from appreciation in the fair market value of our stock, and not as a result of dividend payments. Item 1B. Unresolved Staff Comments Item 2. Properties Our corporate office occupies approximately 7,300 square feet of leased office space in Houston, Texas as of June 30, 2018. Over time, additional properties may be required if we develop new projects and add personnel to advance our commercial and technical efforts. Item 4. Mine Safety Disclosures Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Market Price for Common Stock and Stockholders On December 4, 2017, we enacted a 1 for 8 reverse stock split as approved by a special shareholder meeting in November 2017. All share and per share amounts below have been retroactively restated to reflect the impact of the reverse stock split. Our common stock is traded on The NASDAQ Global Market under the symbol SES. The following table sets forth the range of the high and low sale prices for our common stock for the periods indicated. Sales Price Year Ending June 30, 2018: First Quarter $ 5.44 $ 2.68 Second Quarter $ 4.32 $ 2.51 Third Quarter $ 3.87 $ 2.00 Fourth Quarter $ 3.40 $ 2.67 First Quarter $ 11.60 $ 7.76 Fourth Quarter $ 10.24 $ 4.40 As of September 13, 2018, our authorized capital stock consisted of 200,000,000 shares of common stock and 20,000,000 shares of preferred stock, of which 11,022,283 shares of common stock and no preferred stock were issued and outstanding. As of such date, there were 72 holders of record of our common stock. We have not paid dividends on our common stock and do not anticipate paying cash dividends in the immediate future as we contemplate that our cash flows will be used for continued growth of our operations. The payment of future dividends, if any, will be determined by our Board of Directors based on conditions then existing including our earnings, financial condition, capital requirements, restrictions in financing agreements, business conditions and other factors. Recent Sales of Unregistered Securities In July 2015, we agreed with a holder of a warrant exercisable for 173,612 shares of our common stock at $17.28 per share to remit his exercise of the warrant as to 125,000 shares at a reduced exercise price of $8.00 per share. We also issued him a new warrant for 125,000 shares at the original exercise price of $17.28. The warrant holder is an accredited investor and the issuances were made pursuant to exemptions under the Securities Act and the rules and regulations promulgated thereunder, including pursuant to Section 4(2). The proceeds of $1.0 million received in August 2015 were used for general corporate purposes. In July 2018, we agreed with a consulting firm to issue restricted shares for services rendered in connection with their consulting agreement with a total aggregate value of $70,500. We issued 22,890 shares of our common stock at $3.08 in relation to the consulting agreement. The issuance was made pursuant to exemptions under the Securities Act and the rules and regulations promulgated thereunder, including pursuant to Section 4(2). Securities Authorized for Issuance Under Equity Compensation Plans The following table sets forth information regarding our existing equity compensation plans as of June 30, 2018. Equity Compensation Plan Information Plan Category Number of securities to be issued upon exercise of outstanding options, warrants and rights Weighted average exercise price of outstanding options, warrants and rights Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) Equity compensation plans approved by security holders (1) 1,730,569 (2) $ 7.07 342,808 Equity compensation plans not approved by security holders 606,021 (3) $ 10.03 — Total as of June 30, 2018 2,336,590 $ 7.84 342,808 (1) Consists of the 2015 Long-term Incentive Plan and the Amended and Restated 2005 Incentive Plan. (2) Of the total 2,625,000 shares under 2015 Long-term Incentive Plan and the Amended and Restated 2005 Incentive Plan, options to acquire 1,720,732 shares of commons stock and 9,837 shares of unvested restricted stock were outstanding at June 30, 2018. (3) As of June 30, 2018, warrants to acquire up to 606,021 shares of our common stock were outstanding to third-party companies working with the company in different capacities (Market Development Consulting Group, Inc. and ILL-Sino Development). Item 6. Selected Financial Data Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes and other financial information included elsewhere in this annual report. Some of the information contained in this discussion and analysis or set forth elsewhere in this annual report, including information with respect to our plans and strategy for our business and related financing, includes forward-looking statements that involve risks and uncertainties. You should review the “Risk Factors” section of this annual report for a discussion of important factors that could cause actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. On December 4, 2017, we enacted a 1 for 8 reverse stock split as approved by a special shareholder meeting in November 2017. All share and per share amounts in the consolidated financial statements and this discussion and analysis have been retroactively restated to reflect the reverse stock split. We are a global clean energy company that owns proprietary technology, SES Gasification Technology (“SGT”), for the low-cost and environmentally responsible production of synthesis gas (referred to as the “syngas”). Syngas produced from SGT is a mixture of primarily hydrogen, carbon monoxide and methane, and is used for the production of a wide variety of high-value clean energy and chemical products, such as substitute natural gas, power, methanol and fertilizer. Our current focus has been primarily on commercializing our technology outside China through the regional business platforms we have created with partners in Australia, Australian Future Energy Pty Ltd (“AFE”), and in Poland, SES EnCoal Energy sp. zo. o (“SEE”). Through AFE and SEE we believe we are developing energy and resource projects with the necessary commercial and financing structures to deliver attractive financial results. Our business model is to create value growth through AFE and SEE via the generation of earnings, from the licensing of our proprietary technology and the sale of proprietary equipment into those project developments, and through income from earned or carried equity ownership in resource and clean energy production facilities that utilize our technology. AFE and SEE endeavor to link long-term access to low-cost coal or renewable resources to the projects they develop as well as secure long-term contracts for product off-take thereby establishing the commercial and financing foundation for those projects. Through AFE and SEE we have established local expertise with knowledge of the markets and government influences in those regions and who have the expertise required for project development, project financing, and fundraising to deliver financial results for the platforms. Results of Operations Year Ended June 30, 2018 (“Current Year”) Compared to the Year Ended June 30, 2017 (“Prior Year”) Unless noted below, the results of operations are comparing Current Year results of continuing operations with the Prior Year results from continuing operations. Revenue. Total revenue was $1.5 million for the Current Year as compared to $0.2 million for the Prior Year. The increase was primarily due to $0.9 million of payments of past due invoices related to technical consulting and engineering services provided to our Yima Joint Venture during the construction and commissioning period, due to uncertainty of receipts from the Yima Joint Venture, we only record revenues upon receipt of payment, $0.2 million related to our collection of past due invoices from our Tianwo-SES Joint Venture in conjunction with our transfer of ownership, $0.1 million related to services provided to AFE and $0.3 million from a third-party paid feasibility study. Prior Year revenue related to a third-party paid engineering study. Related party consulting revenue was $1.2 million for the Current Year as compared to $0.1 million for the Prior Year, which primarily resulted from technical consulting and engineering services provided to AFE, and the past due invoices collected during the Current Year from our Yima and Tianwo-SES joint ventures. Costs of sales and operating expenses. Costs of sales and operating expenses was $0.4 million during the Current Year compared to $0.1 million costs of sales and operating expenses for the Prior Year, which resulted from costs incurred for engineering services provided to customers. General and administrative expenses. General and administrative expenses was $6.5 million during the Current Year as compared to $8.6 million during the Prior Year. The decrease of $2.1 million was due primarily to the reduction of employee related compensation costs, professional fees and other general and administrative expenses. Stock-based expense. Stock-based expense decreased by $0.4 million to $1.3 million for the Current Year compared to $1.7 million for the Prior Year. This decrease is primarily due to a lower stock price effect on the stock warrants and options issued during the Current Year as compared with the Prior Year. Depreciation and amortization expense. Depreciation and amortization expense was $37,000 for the Current Year compared with $66,000 for the Prior Year. Which primarily relates to the amortization of our global patents. Impairments. Impairment was $3.5 million for the Current Year as compared to $17.7 million for the Prior Year. We evaluated the conditions of the Yima Joint Venture to determine whether other-than-temporary decrease in value had occurred in the Current Year. We determined that there were triggering events that were other-than-temporary in the Current Year as production levels in the fourth quarter reduced the annual production below expectations which resulted in a net increase in the working capital deficit and the debt levels of the joint venture. An impairment analysis led to the conclusion that the investment in the Yima Joint Venture was impaired in the Current Year and, therefore, we recorded a $3.5 million impairment in the Current Year. In the Prior Year, management determined there were triggering events, such as the lower than expected production levels and the increased debt levels as compared to the previous year, which indicated a continued cash flow concern for the joint venture. During the Prior Year, management determined that these triggering events related to its Yima Joint Venture investment were other-than-temporary in nature and therefore management conducted an impairment analysis. The impairment analysis led to the conclusion that our investment in the Yima Joint Venture was impaired and therefore we recorded a $17.7 million impairment in the Prior Year. Equity in losses of joint venture. The equity in losses of joint venture was $0.7 million during the Current Year as compared to $0.3 million in the Prior Year, which primarily relates to our 39% share of the start -up losses incurred by AFE. Gain on fair value adjustments of derivative liabilities. The net gain on fair value adjustments of derivative liabilities was approximately $0.1 million for the Current Year compared with zero for the Prior Year, which resulted from the lower fair market value for our warrants issued to the debentures investors and the placement agent as of June 30, 2018 versus the fair market value as of the issuance date of October 24, 2017. The change in the derivative liability was primarily due to movements in the Company’s stock price. Other changes in the assumptions related to the passage of time, interest rate fluctuations and stock market volatility. Foreign currency gain (losses). Foreign currency gain was $143,000 for the Current Year as compared to foreign currency loss of $71,000 for the Prior Year. The Current Year gain of $143,000 foreign currency gain resulted from the 2% appreciation of the Chinese Renminbi yuan (“RMB”) to the U.S. dollar during the Current Year. Other gain: The other gain was $1.7 million for the Current Year as compared to zero for the Prior Year, which was primarily due to the restructuring of the Tianwo-SES Joint Venture. The Tianwo-SES Joint Venture is accounted for under the equity method. The Company’s contribution in the formation of the venture was the TUCA, which is an intangible asset granting certain exclusive rights to our gasification technology. As such, the Company did not record a carrying value of the investment in the Tianwo-SES Joint Venture at the inception of the venture. In August 2017, the Company entered into a Restructuring Agreement and received $1.7 million related to its transfer of ownership, reducing its ownership from 35% to 25% and final transfer and registration of shares with local government authorities was completed in December 2017. The $1.7 million gain was deferred in August and recognized upon the completed registration process in December 2017, as the joint venture has no carrying value and therefore the $1.7 million received related to the transfer of ownership resulted in a gain. Income (Loss) from discontinued operations. Gain from discontinued operations was zero for the Current Year as compared to a gain from discontinued operations of $1.9 million for the Prior Year and related to our deconsolidation of the ZZ Joint Venture. Liquidity and Capital Resources As of June 30, 2018, we had $7.1 million in cash and cash equivalents and $6.4 million of working capital. As of November 14, 2018, we had $4.0 million in cash and cash equivalents. In addition to the cash and cash equivalents, we have approximately another $0.3 million in Chinese bank acceptance notes, which are similar to certificates of deposits, and have maturity dates greater than 90 days but less than one year. Of the $4.0 million in cash and cash equivalents, $2.6 million resides in the United States or easily accessed foreign countries and approximately $1.4 million resides in China. We are seeking to strengthen our financial position through new strategic partnering opportunities and we may consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. If we cannot raise required funds on acceptable terms, we may further reduce our expenses. We believe that with the strategies above, we can continue to operate for the next twelve months, assuming we can successfully transfer the funds currently in China to the U.S. Based on the historical negative cash flows that the Company has incurred, the continued limited cash inflows in the period subsequent to year end and the uncertain nature of the ability to transfer the cash that resides in China, there is substantial doubt about the Company’s ability to continue as a going concern. We currently plan to use our available cash for: (i) securing orders and tasks associated with our overall business strategy; (ii) additional working capital investments or shareholder loans into AFE or SEE to support the growth of those strategic businesses; (iii) growing our technology IP portfolio and securing technology partners or collaborations that help us improve our ability to commercialize and implement SGT; (iv) paying the interest related to the Debentures; (v) general and administrative expenses; and (vi) working capital and other general corporate purposes. On October 24, 2017, we entered into a securities purchase agreement (the “Purchase Agreement”) with certain accredited investors (the “Purchasers”) for the purchase of $8.0 million in principal amount of Senior Secured Debentures (“Debentures”). The Debentures have a term of 5 years with an interest rate of 11% that adjusts to 18% per annum in the event the Company defaults on an interest payment. The Debentures require that dividends received from BFR are used to pay down the principal amounts of outstanding debentures. Additionally, we issued warrants to purchase 1,000,000 shares of common stock at $4.00 per common share. The Purchase Agreement and the Debentures contain certain customary representations, warranties and covenants. There are no financial metric covenants related to the Debentures. The transaction was approved by a special committee of our board of directors due to the fact that certain board members were Purchasers. Interest on the outstanding balance of Debentures is payable quarterly commencing on January 1, 2018 (or next business day) and all unpaid principal and interest on the Debentures will be due on October 23, 2022. The net offering proceeds to the Company from the sale of the Debentures and warrants, after deducting the placement agent’s fee and associated costs and expenses, was approximately $7.4 million, not including the proceeds, if any, from the exercise of the warrants issued in this the offering. As compensation for its services, we paid T.R. Winston & Company, LLC (the “Placement Agent”): (i) a cash fee of $0.56 million (representing an aggregate fee equal to 7% of the face amount of the Debentures); and (ii) a warrant to purchase 70,000 shares of common stock, 7% of the shares issued to the Purchasers (the “Placement Agent Warrant”). We also reimbursed certain expenses of the Placement Agent. The warrants and the Placement Agent Warrants are exercisable into shares of the Company’s common stock at any time at an exercise price of $4.00 per common share (subject to adjustment). The warrants and the Placement Agent Warrants will terminate five years after they become exercisable. The warrants and the Placement Agent Warrants contain provisions providing for the adjustment of the purchase price and number of shares into which the securities are exercisable in certain events. The Debentures are guaranteed by the U.S. subsidiaries of the Company, as well as the Company’s British Virgin Islands subsidiary, pursuant to a Subsidiary Guarantee, in favor of the holders of the Debentures by the subsidiary guarantors, party thereto, as well as any future subsidiaries which the Company forms or acquires. The Debentures are secured by a lien on substantially all the assets of the Company and the subsidiary guarantors, other than their equity ownership interest in the Company’s foreign subsidiaries, pursuant to the terms of the Purchase Agreement among the Company, the subsidiary guarantors and the holders of the Debentures. On May 13, 2016, we entered into an At The Market Offering Agreement (the “Offering Agreement”) with T.R. Winston & Company (“T.R. Winston”) to sell, from time to time, shares of our common stock having an aggregate sales price of up to $20.0 million through an “at the marketing offering” program under which T.R. Winston would act as sales agent, which we refer to as the ATM Offering. The shares that may be sold under the Offering Agreement, if any, would be issued and sold pursuant to the Company’s $75.0 million universal shelf registration statement on Form S-3 that was declared effective by the Securities and Exchange Commission on April 21, 2016. We had no obligation to sell any of our common stock under the Offering Agreement. The Offering Agreement expired in April 2018. Notwithstanding the above, we have very limited financial and human resources necessary to fully develop and execute on all of our business opportunities. We can make no assurances that AFE, SEE and our other business operations including our expected share of dividends from BFR will provide us with sufficient and timely cash flows to continue our operations. We are seeking to strengthen our financial position through new strategic partnering activities and we may choose to raise additional capital through equity and debt financing to strengthen our balance sheet to support our delivery of potential new orders for our technology and for our corporate general and administrative expenses. We may consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. We cannot provide any assurance that any financing will be available to us in the future on acceptable terms or at all. Any such financing could be dilutive to our existing stockholders. If we cannot raise required funds on acceptable terms, we may further reduce our expenses and we may not be able to, among other things, (i) maintain our general and administrative expenses at current levels including retention of key personnel and consultants; (ii) successfully implement our business strategy, including continuing to deliver our technology to customers and partners pursuant to licenses; (iii) make additional capital contributions to our joint ventures; (iv) fund certain obligations as they become due; (v) respond to competitive pressures or unanticipated capital requirements; or (vi) repay our indebtedness. In addition, the Company may elect to sell certain of its investments as a source of cash to develop additional projects or for its general corporate purposes. The following summarized the sources and uses of cash during the Current Year: • Operating Activities: During the Current Year, we used $6.1 million in cash for operating activities compared to $8.5 million during the Prior Year. These funds were utilized to develop our technical licensing and related services and our general and administrative expenses. • Investing Activities: During the Current Year, we had a net source of cash of $1.1 million in investing activities, which included $1.7 million proceeds from the Tianwo-SES Joint Venture share transfer, and $0.6 million additional investment in AFE and SEE. During the Prior Year, we used $0.4 million in investing activities for investing in AFE; used $5,000 for capital expenditures; and used $12,000 related to our ZZ Joint Venture restructuring. • Financing Activities: For the Current Year, we had a net source of cash of $7.2 million as compared to a net source of cash of $0.1 million in the Prior Year. During the Current Year, we received net proceeds of $7.4 million from issuance of the debentures and paid legal fees of $0.2 million related to issuance costs of our Debentures. During the Prior Year, we received proceeds of $0.1 million from the exercise of stock options. We account for our investment in AFE under the equity method. Our ownership of 38% makes us the second largest shareholder. We also maintain a seat on the board of directors which allows us to have significant influence on the operations and financial decisions, but not control, of the company. On June 30, 2018, we owned approximately 38% of AFE and the carrying value of our investment in AFE was approximately zero and $39,000 as of June 30, 2018 and June 30, 2017 respectively. We account for our investment in BFR under the cost method due to our limited investment and lack of significant influence. At the time of the spin-off, the carrying amount of our investment in AFE was reduced to zero through equity losses. As such, the value of the investment in BFR post spin-off was also zero. On June 30, 2018, our ownership in BFR was approximately 11% and the carrying value of our investment in BFR was zero as of June 30, 2018 and June 30, 2017. SES EnCoal Energy sp. z o. o. We account for our investment in SEE under the equity method. Our ownership of 50% makes us an equal shareholder and we also maintain two of the four seats on the board of directors which allows us to have significant influence on the operations and financial decisions, but not control, of the company. On June 30, 2018, as an equal shareholder, our ownership was 50% of SEE and the carrying value of our investment in SEE was approximately $36,000 and zero as of June 30, 2018 and June 30, 2017, respectively. The Yima Joint Venture is accounted for under the cost method of accounting. Our conclusion to account for this joint venture under this methodology is based upon our historical lack of significant influence in the Yima Joint Venture. The lack of significant influence was determined based upon our interactions with the Yima Joint Venture related to our limited participation in operating and financial policymaking processes coupled with our limited ability to influence decisions which contribute to the financial success of the Yima Joint Venture. The carrying value of our Yima Joint Venture investment as of June 30, 2018 and June 30, 2017 was approximately $5.0 million and $8.5 million respectively. The Tianwo-SES Joint Venture is accounted for under the equity method. Our initial capital contribution in the formation of the venture was the TUCA, which is an intangible asset. As such, we did not record a carrying value at the inception of the venture. The carrying value of our investment in the Tianwo-SES Joint Venture was zero as of both June 30, 2018 and 2017. As such in December 2017, the proceeds related to the transfer of shares, 11.15 million RMB (approximately $1.7 million) was recorded as a gain when the final transfer of shares with local government authorities was completed. Under the equity method of accounting, losses in the venture are not recorded if the losses cause the carrying value to be negative and there is no requirement of the Company to contribute additional capital. As we are not required to contribute additional capital, we have not recognized losses in the venture, as this would cause the carrying value to be negative. Had we recognized our share of the losses related to the venture, we would have recognized losses of approximately $0.5 million and $1.5 million for the years ended June 30, 2018 and 2017, respectively, and $3.4 million from inception to date. Critical Accounting Policies The preparation of financial statements in accordance with U.S. generally accepted accounting principles, or “GAAP”, requires our management to make certain estimates and assumptions which are inherently imprecise and may differ significantly from actual results achieved. We believe the following are our critical accounting policies due to the significance, subjectivity and judgment involved in determining our estimates used in preparing our consolidated financial statements. We evaluate our estimates and assumptions used in preparing our consolidated financial statements on an ongoing basis utilizing historic experience, anticipated future events or trends and on various other assumptions that are believed to be reasonable under the circumstances. The resulting effects of changes in our estimates are recorded in our consolidated financial statements in the period in which the facts and circumstances that give rise to the change in estimate become known. We believe the following describes significant judgments and estimates used in the preparation of our consolidated financial statements: Revenue from sales of products and sales of equipment are recognized when the following elements are satisfied: (i) there are no uncertainties regarding customer acceptance; (ii) there is persuasive evidence that an agreement exists; (iii) performance or delivery has occurred; (iv) the sales price is fixed or determinable; and (v) collectability is reasonably assured. Technology licensing revenue is typically received over the course of a project’s development as milestones are met. We may receive upfront licensing fee payments when a license agreement is entered into. Typically, the majority of a license fee is due once project financing and equipment installation occur. We recognize license fees as revenue when the license fees become due and payable under the license agreement, subject to the deferral of the amount of the performance guarantee. Fees earned for engineering services, such as services that relate to integrating our technology to a customer’s project, are recognized using the percentage-of-completion method. Accounting for Variable Interest Entities and Financial Statement Consolidation Criteria The joint ventures which we have entered into may be considered a variable interest entity, (“VIE”). We consolidate all VIEs where we are the primary beneficiary. This determination is made at the inception of our involvement with the VIE and is continuously assessed. We consider qualitative factors and form a conclusion that we, or another interest holder, has a controlling financial interest in the VIE and, if so, whether it is the primary beneficiary. In order to determine the primary beneficiary, we consider who has the power to direct activities of the VIE most significantly impacts the VIE’s performance and has the obligation to absorb losses from or receive benefits of the VIE that could be significant to the VIE. We do not consolidate VIEs where we are not the primary beneficiary. We account for these unconsolidated VIEs using either the equity method if we have significant influence but not control, or cost method and include our net investment on our consolidated balance sheet. Under the equity method, our equity interest in the net income or loss from our unconsolidated VIEs is recorded in non-operating income/expense on a net basis on our consolidated statements of operations. In the event of a change in ownership, any gain or loss resulting from an investee share issuance is recorded in earnings. Controlling interest is determined by majority ownership interest and the ability to unilaterally direct or cause the direction of management and policies of an entity after considering any third-party participation rights. Investment in Joint Ventures. We have equity investments in various privately held entities. We account for these investments either under the equity method or cost method of accounting depending on our ownership interest and level of influence in each joint venture. Investments accounted for under the equity method are recorded based upon the amount of our investment and adjusted each period for our share of the investee's income or loss. Investments are reviewed for changes in circumstance or the occurrence of events that suggests other-than-temporary event where our investment may not be recoverable. Impairment Evaluation of Long-Lived Assets We evaluate our long-lived assets and specifically identified intangibles, when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. When we believe an impairment condition or "triggering event" may have occurred, we are required to estimate the undiscounted future cash flows associated with a long-lived asset or group of long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities for long-lived assets that are expected to be held and used. If we determine that the undiscounted cash flows from an asset to be held and used are less than the carrying amount of the asset, or if we have classified an asset as held for sale, we estimate fair value to determine the amount of any impairment charge. The following summarizes some of the most significant estimates and assumptions used in evaluating if we have an impairment charge. Undiscounted Expected Future Cash Flows. In order to estimate future cash flows, we consider historical cash flows and changes in the market environment and other factors that may affect future cash flows. To the extent applicable, the assumptions we use are consistent with forecasts that we are otherwise required to make (for example, in preparing our other earnings forecasts). The use of this method involves inherent uncertainty. We use our best estimates in making these evaluations and consider various factors, including forward price curves for energy, feedstock costs, and other operating costs. However, actual future market prices and project costs could vary from the assumptions used in our estimates, and the impact of such variations could be material. Fair Value. Generally, fair value will be determined using valuation techniques such as the present value of expected future cash flows. We will also discount the estimated future cash flows associated with the asset using a single interest rate representative of the risk involved with such an investment. We may also use different valuation models, such as Black-Scholes, to assist in the determining the value of certain options or in valuing the optionality of investments in equity. We may also consider prices of similar assets, consult with brokers, or employ other valuation techniques. We use our best estimates in making these evaluations; however, actual future market prices and project costs could vary from the assumptions used in our estimates, and the impact of such variations could be material. Off Balance Sheet Arrangements In October 2017, we amended and extended the lease agreement for our corporate offices in Houston, Texas which now expires on January 31, 2019. Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, which creates Accounting Standards Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers,” and supersedes most existing U.S. GAAP revenue recognition guidance. In summary, the core principle of Topic 606 provides a single principles-based, five-step model to be applied to all contracts with customers. The five steps are to identify the contract(s) with the customer, to identify the performance obligations in the contract, to determine the transaction price, to allocate the transaction price to the performance obligations in the contract and to recognize revenue when performance obligations are satisfied. Revenue will be recognized when promised goods or services are transferred to the customer in an amount that reflects the consideration expected in exchange for those goods and services. Companies are allowed to select between two transition methods: (1) a full retrospective transition method with the application of the new guidance to each prior reporting period presented, or (2) a retrospective transition method that recognizes the cumulative effect on prior periods at the date of adoption together with additional footnote disclosures. The amendments in ASU No. 2014-09 are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period, and early application is not permitted. In March 2016 and April 2016, the FASB issued ASU No. 2016-08 and ASU No. 2016-10, respectively. The amendments in ASU No. 2016-08 and ASU No. 2016-10 do not change the core principle of ASU No. 2014-09, but instead clarify the implementation guidance on principle versus agent considerations and identify performance obligations and the licensing implementation guidance, respectively. We have decided to use modified retrospective basis as our method of adoption and will adopt the standard on July 1, 2018. The new ASU will have no impact on our historically reported consolidated financial statements as the Company’s revenue recorded in the comparison periods have been analyzed and would be recorded similarly under the new standard. Timing of revenues related to license fees in the future will be affected as receipt and the satisfying of the performance obligations may differ. There were no license revenues for the comparison years. In January 2016, the FASB issued ASU No. 2016-01, which requires an entity to: (i) measure equity investments at fair value through net income, with certain exceptions for those accounted for under the equity method, those that result in consolidation and certain other investments; (ii) present in OCI the changes in instrument-specific credit risk for financial liabilities measured using the fair value option: (iii) present financial assets and financial liabilities by measurement category and form of financial asset; (iv) calculate the fair value of financial instruments for disclosure purposes based on an exit price and : (v) assess a valuation allowance on deferred tax assets related to unrealized losses of AFS debt securities in combination with other deferred tax assets. The update provides an election to subsequently measure certain nonmarketable equity investments at cost less any impairment and adjusted for certain observable price changes. This guidance is effective for interim and annual periods beginning after December 15, 2017. We are evaluating what impact the adoption of this guidance will have on our financial statements and financial disclosures. In February 2016, the FASB issued ASU No. 2016-02, which creates ASC Topic 842, “Leases.” This update increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2018. We are evaluating what impact, if any, the adoption of this guidance will have on our financial condition, results of operations, cash flows or financial disclosures. In August 2016, the FASB issued ASU No. 2016-15, which provides additional clarity on the classification of specific events on the statement of cash flows. These events include: debt prepayment and extinguishment costs, settlement of zero-coupon debt instruments, contingent consideration payments made after a business combination, proceeds from settlement of insurance claims, distributions received from equity method investees, and beneficial interests in securitization transactions. The update is effective for annual reporting periods beginning after December 15, 2017, including interim periods within those annual reporting periods, with early application permitted. The new accounting standard addresses presentation in the statement of cash flows only and we do not expect the standard to have a material effect on our financial condition, results of operations, cash flows or financial disclosures. In February 2017, the FASB issued ASU No. 2017-05 which to clarify the scope and application of Subtopic 610-20, “Other Income– Gains and Losses from the Derecognition of Nonfinancial Assets”. The standard clarifies that a parent transferring its ownership interest in a consolidated subsidiary is within the scope of the accounting standard if substantially all the fair value of the assets within that subsidiary are nonfinancial assets. The standard also clarifies that the derecognition of all businesses and nonprofit activities should be accounted for in accordance with the derecognition and deconsolidation guidance. The standard also eliminates the exception in the financial asset guidance for transfers of investments (including equity method investments) in real estate entities. An entity is required to apply the amendments in this update at the same time that it applies the amendments in revenues from contracts with customers. The standard is effective beginning after December 15, 2017 and may be applied retrospectively to each period presented or through a cumulative effect adjustment to retained earnings at the date of adoption. We do not expect the standard to have a material effect on our financial condition, results of operations, cash flows or financial disclosures. In May 2017, the FASB issued ASU No. 2017-09, which amends ASC Topic 718, “Compensation – Stock Compensation”. This amendment provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting. The standard is effective for annual periods beginning after December 15, 2017, with early adoption permitted, including adoption for interim periods. This standard must be applied prospectively upon adoption. We do not expect the standard to have a material effect on our financial condition, results of operations, cash flows or financial disclosures. In June 2018, the FASB issued ASU No. 2018-07, which expands the scope of Topic 718, “Compensation – Stock Compensation”, to include share-based payment transactions for acquiring goods and services from non-employees. An entity should apply the requirements of Topic 718 to non-employee awards except for specific guidance on inputs to an option pricing model and the attribution of cost. This amendment specify that Topic 718 applies to all share-based payment transactions in which a grantor acquires goods or services to be used or consumed in a grantor's own operations by issuing share-based payment awards. This amendment also clarifies that Topic 718 does not apply to share-based payments used to effectively provide (1) financing to the issuer or (2) awards granted in conjunction with selling goods or services to customers as part of a contract accounted for under Topic 606, Revenue from Contracts with Customers. The standard is effective for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year. We do not expect the standard to have a material effect on our financial condition, results of operations, cash flows or financial disclosures. Item 7A. Quantitative and Qualitative Disclosure About Market Risk Item 8. Financial Statements and Supplementary Data INDEX TO FINANCIAL STATEMENTS Report of Independent Registered Public Accounting Firm 46 Consolidated Balance Sheets as of June 30, 2018 and 2017 48 Consolidated Statements of Operations for the years ended June 30, 2018 and 2017 49 Consolidated Statements of Other Comprehensive Loss for the years ended June 30, 2018 and 2017 50 Consolidated Statement of Equity for the years ended June 30, 2018 and 2017 51 Consolidated Statements of Cash Flows for the years ended June 30, 2018 and 2017 52 Notes to the Consolidated Financial Statements 53 Report of Independent Registered Public Accounting Firm To the Board of Directors and Stockholders of Opinion on the Financial Statements We have audited the accompanying consolidated balance sheets of Synthesis Energy Systems, Inc. and its subsidiaries (the Company) as of June 30, 2018, the related consolidated statements of operations, other comprehensive income, stockholders' equity and cash flows for the year then ended, and the related notes to the consolidated financial statements (collectively, the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of June 30, 2018, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. Emphasis of a Matter The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has limited cash resources. This raises substantial doubt about the Company's ability to continue as a going concern. Management's plans in regard to these matters also are described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. Basis for Opinion These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the Company’s financial statements based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB. We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audit, we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. Our audit included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audit provides a reasonable basis for our opinion. /s/ RSM US LLP We have served as the Company's auditor since 2017. To Board of Directors and Stockholders We have audited the accompanying consolidated balance sheet of Synthesis Energy Systems, Inc. (the “Company”) as of June 30, 2017, and the related consolidated statements of operations, other comprehensive loss, equity and cash flows for the year then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts of disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Synthesis Energy Systems, Inc. as of June 30, 2017, and the results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. /s/ BDO USA, LLP October 25, 2017, except for the effects of the reverse stock split discussed in Note 2(a), as to which the date is November 14, 2018. (In thousands, except par value amounts) 2018 June 30, Accounts receivable – related party, net 287 167 Prepaid expenses and other currents assets 719 539 Inventory — 42 Property, plant and equipment, net 10 24 Intangible asset, net 1,038 984 Investment in joint ventures 5,036 8,539 Other long-term assets 153 43 Accrued expenses and accounts payable $ 1,681 $ 1,765 Senior secured debenture principal 8,000 — Less unamortized discount and debt issuance costs (2,610 ) — Total senior secured debenture 5,390 — Derivative liabilities 1,964 — Total long-term liabilities 7,354 — Total liabilities $ 9,035 $ 1,765 Commitment and contingencies (Note 14) Stockholders’ equity: Preferred stock, $0.01 par value- 20,000 shares authorized – no shares issued and outstanding — — Common stock, $0.01 par value: 200,000 shares authorized: 10,999 and 10,930 shares issued and outstanding, respectively 110 109 Accumulated deficit (260,068 ) (250,464 ) Accumulated other comprehensive income 244 831 Total stockholders’ equity to SES stockholders Noncontrolling interests in subsidiaries ) (724 ) Total stockholders’ equity Total liabilities and equity $ 14,314 $ 15,326 See accompanying notes to the consolidated financial statements. Year Ended June 30, Technology licensing and related services $ 269 $ 51 Related party consulting services 1,238 100 Total revenue 1,507 151 Costs and Expenses: Costs of sales 413 142 General and administrative expenses 6,450 8,622 Stock-based expense 1,258 1,701 Depreciation and amortization 37 66 Impairments Total costs and expenses Operating loss (10,151 ) (28,080 ) Non-operating income (expense): Equity in losses of joint ventures (715 ) (342 ) Gain on fair value adjustments of derivative liabilities 126 — Foreign currency gain (losses), net 143 (71 ) Interest expense (869 ) — Interest income 43 13 Other gain 1,689 — Net loss before income tax provision (9,734 ) (28,480 ) Income tax benefit/(provision) 129 — Net loss from continuing operations (9,605 ) (28,480 ) Income/(loss) from discontinued operations — 1,929 Net Loss (9,605 ) (26,551 ) Less: net loss attributable to non-controlling interests (1 ) Net loss attributable to SES stockholders $ (9,604 ) $ (26,523 ) Net income/(loss) attributable to SES stockholders: From continuing operations (9,604 ) (28,461 ) From discontinued operations — 1,938 Net income/(loss) per share (Basic and diluted): From continuing operations $ (0.88 ) $ (2.61 ) From discontinued operations — 0.18 Net loss per share attributable to SES stockholders $ (0.88 ) $ (2.43 ) Weighted average common shares outstanding: Basic and diluted 10,964 10,893 Consolidated Statements of Other Comprehensive Loss Net loss $ (9,605 ) $ (26,551 ) Cumulative translation adjustment (189 ) (245 ) Gain on disposition of investment in subsidiary 254 — Deconsolidation of ZZ Joint Venture — (1,655 ) Comprehensive loss (9,540 ) (28,451 ) Less: Comprehensive gain attributable to noncontrolling interests Comprehensive loss attributable to the Company $ (10,191 ) $ (29,091 ) Non- Paid-in Capital Balance at June 30, 2016 10,873 $ 105 $ 261,990 $ (223,941 ) $ 3,399 $ (1,364 ) $ 40,189 Net loss — — — (26,523 ) — Currency translation adjustment from continued Operations — — — — (245 ) — (245 ) Deconsolidation of ZZ Joint Venture — — — — (2,323 ) 668 (1,655 ) Stock-based expense 34 2 1,699 — — — 1,701 Exercise of stock options 23 2 120 — — — 122 Balance at June 30, 2017 10,930 $ 109 $ 263,809 $ (250,464 ) $ 831 $ (724 ) $ 13,561 Net loss — — — (9,604 ) — ) (9,605 ) Gain on disposition of investment in subsidiary — — — — (398 ) 652 254 Exercise of stock options — — — — — — — Balance at June 30, 2018 10,999 $ 110 $ 265,066 $ (260,068 ) $ 244 $ ) $ Adjustments to reconcile net loss to net cash used in operating activities: Depreciation of property, plant and equipment 15 15 Amortization of debenture issuance cost 265 — Amortization of intangible and other assets 22 51 Gain on fair value adjustment of derivative (126 ) — Net gain on discontinued operations — (1,929 ) Gain on investment (311 ) — Other gains (1,689 ) — Equity in losses of joint ventures 715 342 Changes in operating assets and liabilities: Accounts receivable - related party, net (272 ) (140 ) Prepaid expenses and other current assets (172 ) 279 Inventory 43 1 Other long-term assets (185 ) (100 ) Accrued expenses and payables 422 118 Net cash used in operating activities (6,120 ) (8,513 ) Capital expenditures — (5 ) Proceeds from Tianwo-SES Joint Venture share transfer 1,689 — Cash transferred in connection with deconsolidation — (12 ) Equity investment in joint ventures (562 ) (380 ) Net cash used in investing activities 1,127 (397 ) Gross proceeds from issuance of debenture 8,000 — Payments on debenture issuance cost (786 ) — Proceeds from exercise of stock options, net — 122 Net cash provided by financing activities 7,214 122 Net increase/(decrease) in cash and cash equivalents 2,221 (8,788 ) Cash and cash equivalents, beginning of year 4,988 13,807 Effect of exchange rates on cash (138 ) (31 ) Cash and cash equivalents, end of year $ 7,071 $ 4,988 Supplemental Disclosures: Cash paid for interest expense during the year: $ 384 $ — Non-cash investing activities during the year ended June 30, 2018 The company exchanged $150,000 of accounts receivable for $150,000 additional investment in AFE for the year ended June 30, 2018. The company issued a total of 1,000,000 shares of warrants as discount to the debenture with a total fair value of approximately $2.0 million on the date of issuance. The company issued a total of 70,000 shares of warrants to the placement agency with a total fair value of approximately $0.1 million on the date of issuance. • There were no non-cash investing activities related to the year ended June 30, 2017. Note 1 — Business and Liquidity (a) Organization and description of business Synthesis Energy Systems, Inc. (referred to herein as “we”, “us” and “our”), together with its wholly-owned and majority-owned controlled subsidiaries is a global clean energy company that owns proprietary technology, SES Gasification Technology (“SGT”), for the low-cost and environmentally responsible production of synthesis gas (referred to as the “syngas”). Syngas produced from SGT is a mixture of primarily hydrogen, carbon monoxide and methane and is used for the production of a wide variety of high-value clean energy and chemical projects such as substitute natural gas, power, methanol, and fertilizer. Our current focus has been primarily on commercializing our technology outside China through the regional business platforms we have created with partners in Australia, Australia Future Energy Pty Ltd (“AFE”), and in Poland, SES EnCoal Energy sp. zo. o (“SEE”). Through AFE and SEE we believe we are developing energy and resource projects with the necessary commercial and financing structures to deliver attractive financial results. Our business model is to create value growth through AFE and SEE via the generation of earnings, from the licensing of our proprietary technology and the sale of proprietary equipment into those project developments, and through income from earned or carried equity ownership in resource and clean energy production facilities that utilize our technology. AFE and SEE endeavor to link long-term access to low-cost coal or renewable resources to the projects they develop as well as secure long-term contracts for product off-take thereby establishing the commercial and financing foundation for those projects. (b) Liquidity and Management’s Plan As of June 30, 2018, we had $7.1 million in cash and cash equivalents and $6.4 million of working capital. On October 24, 2017, we received net proceeds of approximately $7.4 million related to the sale of $8.0 million of Senior Secured Debentures (“Debentures”). The Debentures have a term of 5 years with an interest rate of 11% that adjusts to 18% per annum in the event the Company defaults on an interest payment. The Debentures require that dividends received from Batchfire Resources Pty Ltd (“BFR”) are used to pay down the principal amounts of outstanding Debentures. Additionally, we issued warrants to purchase 1,000,000 shares of common stock at $4.00 per common share (shares and price adjusted for 1 for 8 reverse stock split effective December 4, 2017, see Note 2 Summary of Significant Accounting Policies – (a) Reverse Stock Split). The Debentures transaction is discussed further in Note 6 – Senior Secured Debentures. As of November 14, 2018, we had $4.0 million in cash and cash equivalents. In addition to the cash and cash equivalents, we have approximately another $0.3 million in Chinese bank acceptance notes, which are similar to certificates of deposits, and have maturity dates greater than 90 days but less than one year. Of the $4.0 million in cash and cash equivalents, $2.6 million resides in the United States or easily access foreign countries and approximately $1.4 million resides in China. We are seeking to strengthen our financial position through new strategic partnering opportunities and we consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. If we cannot raise required funds on acceptable terms, we may further reduce our expenses. We believe that with the strategies above, we can continue to operate for the next twelve months, assuming we can successfully transfer the funds currently in China to the U.S. Based on the historical negative cash flows that the Company has incurred, the continued limited cash inflows in the period subsequent to year end and the uncertain nature of the ability to transfer the cash that resides in China, there is substantial doubt about the Company’s ability to continue as a going concern. We currently have very limited financial and human resources to fully develop and execute on all of our business opportunities. We can make no assurances that AFE, SEE and our other business operations including our expected share of dividends from BFR will provide us with sufficient and timely cash flows to continue our operations. We are seeking to strengthen our financial position through new strategic partnering activities and we may choose to raise additional capital through equity and debt financing to strengthen our balance sheet to support our delivery of potential new orders for our technology and for our corporate general and administrative expenses. We may consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. We cannot provide any assurance that any financing will be available to us in the future on acceptable terms or at all. Any such financing could be dilutive to our existing stockholders. If we cannot raise required funds on acceptable terms, we may further reduce our expenses and we may not be able to, among other things, (i) maintain our general and administrative expenses at current levels including retention of key personnel and consultants; (ii) successfully implement our business strategy, including continuing to deliver our technology to customers and partners pursuant to licenses; (iii) make additional capital contributions to our joint ventures; (iv) fund certain obligations as they become due; (v) respond to competitive pressures or unanticipated capital requirements; or (vi) repay our indebtedness. In addition, we may elect to sell certain investments as a source of cash to develop additional projects or for general corporate purposes. See “Note 8 – Risks and Uncertainties.” Note 2 — Summary of Significant Accounting Policies (a) Reverse Stock Split On December 4, 2017, we enacted a 1 to 8 reverse stock split as approved by a special stockholder meeting in November 2017. All share and per share amounts in the consolidated financial statements have been retroactively restated to reflect the reverse stock split. (b) Basis of presentation and principles of consolidation, prior period corrections, deconsolidation of ZZ Joint Venture Basis of presentation and principles of consolidation. The consolidated financial statements are in U.S. dollars. Non-controlling interests in consolidated subsidiaries in the consolidated balance sheets represents minority stockholders’ proportionate share of the equity in such subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Immaterial prior period corrections. During the preparation of the consolidated financial statements as of and for the year ended June 30, 2018, we identified certain errors in our historical financial statements. These errors relate to (in thousands): (i) The conversion of our Yima Joint Venture investment from the equity method to the cost method in 2013 should have included the reclassification of the related accumulated comprehensive income to the basis of our investment. This reclassification would have resulted in a reduction of impairments of the investment recorded in periods prior to our 2017 financial statements by $3,187. We decreased the balance of accumulated deficit and accumulated other comprehensive income at June 30, 2017 and 2016 by $3,187 to correct for this error. (ii) The allocation of losses to the noncontrolling interests in our subsidiary Synthesis Energy Systems Investments, Inc. (“SESI”), should have excluded certain charges contractually agreed to with the noncontrolling interest shareholder. At June 30, 2016, we increased accumulated deficit and noncontrolling interest by $190; at June 30, 2017, we increased accumulated deficit and noncontrolling interest by $477 and for the year ended June 30, 2017, we increased losses attributable to SES stockholders and decreased losses allocated to the noncontrolling interest by $287. We have assessed these misstatements and concluded that they were not material to any of the previously issued consolidated financial statements, however, these adjustments would be material to the current year financial statements if corrected in the current year. These prior period error corrections have been corrected in the consolidated financial statements reported herein as of and for the year ended June 30, 2017. Deconsolidation of ZZ Joint Venture. As discussed in Note 4-Current Projects, in August 2016, the Company announced that it and Shandong Hai Hua Xuecheng Energy Co. Ltd. (“Xuecheng Energy”) entered into a Definitive Agreement to restructure the ZZ Joint Venture. The agreement took full effect when the registration with the government was completed on October 31, 2016. During the second quarter of fiscal 2017, the Company deconsolidated the ZZ Joint Venture and began accounting for its investment in the ZZ Joint Venture under the cost method. For purposes of these financials, the Company has classified all operations related to the ZZ Joint Venture as discontinued operations for all periods presented and have classified all assets and liabilities related to the ZZ Joint Venture as assets/liabilities of discontinued operations as of June 30, 2016. Disposition of investment in subsidiary. In November 2017, we received the authority registration change notice for the share transfer of all of our interest in our Golden Concord Limited Joint Venture. This joint venture has essentially been dormant since June 2013. Upon receiving the approved share transfer, we recognized the elimination of all remaining balances outstanding related to this investment which resulted in a gain of $0.3 million. (c) Accounting for Variable Interest Entities and Financial Statement Consolidation Criteria We have equity investments in various privately held entities. We account for these investments either under the equity method or cost method of accounting depending on our ownership interest and the level of our influence in each joint venture. Investments accounted for under the equity method are recorded based upon the amount of our investment and adjusted each period for our share of the investee's income or loss. Cost method investments are recorded at cost less any impairments. All investments are reviewed for changes in circumstance or the occurrence of events that suggest an other than temporary event where our investment may not be recoverable. The joint ventures which we have entered into may be considered a variable interest entity, (“VIE”). We consolidate all VIEs where we are the primary beneficiary. This determination is made at the inception of our involvement with the VIE and is continuously assessed. We consider qualitative factors and form a conclusion that we, or another interest holder, has a controlling financial interest in the VIE and, if so, whether it is the primary beneficiary. In order to determine the primary beneficiary, we consider who has the power to direct activities of the VIE that most significantly impacts the VIE’s performance and has the obligation to absorb losses from or the right to receive benefits of the VIE that could be significant to the VIE. We do not consolidate VIEs where we are not the primary beneficiary. We account for these unconsolidated VIEs using either the equity method if we have significant influence but not control, or the cost method and include our net investment on our consolidated balance sheet. Under the equity method, our equity interest in the net income or loss from our investments are recorded in non-operating income/expense on a net basis on its consolidated statements of operations. In the event of a change in ownership, any gain or loss resulting from an investee share issuance is recorded in earnings. Controlling interest is determined by majority ownership interest and the ability to unilaterally direct or cause the direction of management and policies of an entity after considering any third-party participatory rights. Our investments are as follows: We have determined that AFE (as defined in Note 4 – Current Projects – Australian Future Energy Pty Ltd) is a VIE that we are not the primary beneficiary as other shareholders have a 62% ownership interest and we are not the largest shareholder or have the power to direct the activities of the VIE. We account for our investment in AFE under the equity method. The carrying value of our investment in AFE at June 30, 2018 was zero and approximately $39,000 at June 30, 2017. We have determined that BFR (as defined in Note 4 – Current Projects – Batchfire Resources Pty Ltd) is a VIE that we are not the primary beneficiary as other shareholders have more than an 89% ownership interest nor do we have the power to direct the activities of the VIE. We account for our investment in BFR under the cost method. At the time of the spin-off from AFE, the carrying value of our investment in AFE was reduced to zero through equity losses. As such, the value of our investment in BFR was also zero. The carrying value of our investment in BFR at both June 30, 2018 and 2017 was zero. We have determined that SEE (as defined in Note 4 – Current Projects – SES EnCoal Energy sp. z o. o) is a VIE that we are not the primary beneficiary as the ownership of the company is split between two equal shareholders, each with a 50% ownership interest. We have the power to influence but not direct the activities of the VIE. We account for our investment in SEE under the equity method. The initial capitalization of the company was funded in January 2018 with additional funding in March 2018. The carrying value of our investment in SEE at June 30, 2018 and 2017 was approximately $35,000 and zero respectively. We have determined that the Yima Joint Venture (as defined in Note 4 – Current Projects – Yima Joint Venture) is a VIE of which Yima, our joint venture partner, is the primary beneficiary since they have a 75% ownership interest in the Yima Joint Venture and the power to direct the activities of the VIE that most significantly influence the VIE’s performance. We have also determined that our 25% ownership interest does not allow us to influence the activities of the VIE. We account for our investment in the Yima Joint Venture under the cost method. The carrying value of our investment in Yima Joint Venture at June 30, 2018 and June 30, 2017 was approximately $5.0 million and $8.5 million respectively. See Note 4 – Current Projects – Yima Joint Venture for a further discussion of our accounting method. We have determined that the Tianwo-SES Joint Venture (as defined in Note 4- Current Projects – Tianwo-SES Clean Energy Technologies Limited) is a VIE of which STT, the largest joint venture partner, is the primary beneficiary since SST has a 50% ownership interest in the Tianwo-SES Joint Venture and has the power to direct the activities of the Tianwo-SES Joint Venture that most significantly influence its performance. We account for our investment in the Tianwo-SES Joint Venture under the equity method. Because of losses sustained by the Tianwo-SES Joint Venture, the carrying value of this joint venture is zero at both June 30, 2018 and 2017. See Note 4 – Current Projects - Tianwo-SES Clean Energy Technologies Limited for a further discussion of our accounting method. Prior to August 2016, we determined that the ZZ Joint Venture (as defined in Note 4 – Current Projects – Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd. was a VIE and determined that the Company was the primary beneficiary. As noted in Note 5, in August 2016, the Company announced that it and Xuecheng Energy entered into a Definitive Agreement to restructure the ZZ Joint Venture. The agreement took full effect when the registration with the government was completed on October 31, 2016. During the second quarter of fiscal 2017, the Company deconsolidated the ZZ Joint Venture and began accounting for our investment in the ZZ Joint Venture under the cost method. The carrying value of this investment is zero at both June 30, 2018 and 2017. (d) Revenue Recognition Revenue from sales of services, products, and equipment are recognized when the following elements are satisfied: (i) there are no uncertainties regarding customer acceptance; (ii) there is persuasive evidence that an agreement exists; (iii) performance or delivery has occurred; (iv) the sales price is fixed or determinable; and (v) collectability is reasonably assured. The Company records revenue net of any applicable value-added taxes. We may receive upfront licensing fee payments when a license agreement is entered into. Typically, the majority of a license fee is due once project financing and equipment installation occur. We recognize license fees for the use of our gasification systems as revenue when the license fees become due and payable under the license agreement, subject to the deferral of the amount of the performance guarantee. No license fee revenue was recorded in the fiscal year ending June 30, 2018. Fees earned for engineering services, such as services that relate to integrating our technology to a customer’s project, are recognized using the percentage-of-completion method or as services are provided. Estimates are used in calculating the performance guarantees and also used in the percentage-of-completion method calculations as discussed in (e) Use of estimates below. Revenues of $250,000 related to percentage of completion projects and $1,257,000 related to services provided or due to uncertainty when collected were recorded in the fiscal year ending June 30, 2018. (e) Use of estimates The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States (“U.S. GAAP”) requires management to make estimates that affect the amounts reported in the financial statements and accompanying notes. Management considers many factors in selecting appropriate operational and financial accounting policies and controls, and in developing the assumptions that are used in the preparation of these consolidated financial statements. Management must apply significant judgment in this process. Among the factors, but not fully inclusive of all factors that may be considered by management in these processes are: the range of accounting policies permitted by U.S. GAAP; management’s understanding of the Company’s business for both historical results and expected future results; the extent to which operational controls exist that provide high degrees of assurance that all desired information to assist in the estimation is available and reliable or whether there is greater uncertainty in the information that is available upon which to base the estimate; expectations of the future performance of the economy, both domestically, and globally, within various areas that serve the Company’s principal customers and suppliers of goods and services; expected rates of exchange, sensitivity and volatility associated with the assumptions used in developing estimates; and whether historical trends are expected to be representative of future trends. The estimation process at times may yield a range of potentially reasonable estimates of the ultimate future outcomes and management must select an amount that lies within that range of reasonable estimates based upon the risks associated with the variability that might be expected from the future outcome and the factors considered in developing the estimate. Management attempts to use its business and financial accounting judgment in selecting the most appropriate estimate, however, actual amounts could and will differ from those estimates. (f) Fair value measurements Accounting standards require that fair value measurements be classified and disclosed in one of the following categories: Level 1 Unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities; Level 2 Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; and Level 3 Prices or valuation techniques that require inputs that are both significant to the fair value measurement and unobservable (i.e., supported by little or no market activity). The Company’s financial assets and liabilities are classified based on the lowest level of input that is significant for the fair value measurement. The following table summarizes the assets of the Company measured at fair value as of June 30, 2018 and June 30, 2017 (in thousands): Level 1 Level 2 Level 3 Total Certificates of Deposit $ — $ 50 (1) $ — $ 50 Money Market Funds 4,345 (2) — — 4,345 Non-recurring Investment in Yima Joint Venture — — 5,000 5,000 Derivative liabilities $ — $ — $ 1,964 $ 1,964 (1) Amount included in current assets on the Company’s consolidated balance sheets. (2) Amount included in cash and cash equivalents on the Company’s consolidated balance sheets. There were no liabilities measured at fair value on a recurring basis as of June 30, 2017. The following table sets forth the changes in the estimated fair value for our Level 3 classified derivative liabilities (in thousands): Derivative liabilities balance - June 30, 2017 $ — Issuance of warrants - debenture 1,837 Down round protection provision 253 Change in fair value (126 ) Derivative liabilities balance – June 30, 2018 $ 1,964 The carrying values of the certificates of deposit and money market funds approximate fair value, which were estimated using quoted market prices for those or similar investments. The carrying value of other financial instruments, including accounts receivable and accounts payable approximate their fair values due to the short maturities on those instruments. Our Debentures are recorded at face value of $8.0 million and fair value is unable to be determined. The derivative liabilities are measured at fair value using a Monte Carlo simulation valuation methodology (See also Note 7 – Derivative Liabilities for more details related to valuation and assumptions of the Company’s derivative liabilities). (g) Derivative Instruments We currently do not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks. We account for derivatives in accordance with ASC 815, which establishes accounting and reporting for derivative instruments and hedging activities, including certain derivative instruments embedded in other financial instruments or contracts and requires recognition of all derivatives on the balance sheet at fair value, regardless of hedging relationship designation. (h) Cash and cash equivalents The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents. (i) Accounts receivable and allowance for doubtful accounts Accounts receivable are stated at historical carrying amounts net of allowance for doubtful accounts. We establish provisions for losses on accounts receivable if it is determined that collection of all or part of an outstanding balance is not probable. Collectability is reviewed regularly, an allowance is established or adjusted, as necessary. As of the fiscal year ending June 30, 2018 and 2017, no allowance for doubtful accounts was necessary. (j) Property, plant, and equipment Property, plant and equipment are stated at cost, net of accumulated depreciation. Depreciation is computed by using the straight-line method at rates based on the estimated useful lives of the various classes of property, plant and equipment. Estimates of useful lives are based upon a variety of factors including durability of the asset, the amount of usage that is expected from the asset, the rate of technological change and the Company’s business plans for the asset. Leasehold improvements are amortized on a straight-line basis over the shorter of the lease term or estimated useful life of the asset. Should the Company change its plans with respect to the use and productivity of property, plant and equipment, it may require a change in the useful life of the asset or incur a charge to reflect the difference between the carrying value of the asset and the proceeds expected to be realized upon the asset’s sale or abandonment. Expenditures for maintenance and repairs are expensed as incurred and significant major improvements are capitalized and depreciated over the estimated useful life of the asset. (k) Intangible assets Intangible assets with indefinite useful lives are not amortized but instead are tested annually for impairment, or immediately if conditions indicate that impairment could exist. Intangible assets with definite useful lives are amortized over their estimated useful lives and reviewed for impairment when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Substantial judgment is necessary in the determination as to whether an event or circumstance has occurred that may trigger an impairment analysis and in the determination of the related cash flows from the asset. Estimating cash flows related to long-lived assets is a difficult and subjective process that applies historical experience and future business expectations to revenues and related operating costs of assets. Should impairment appear to be necessary, subjective judgment must be applied to estimate the fair value of the asset, for which there may be no ready market, which often times results in the use of discounted cash flow analysis and judgmental selection of discount rates to be used in the discounting process. If the Company determines an asset has been impaired based on the projected undiscounted cash flows of the related asset or the business unit, and if the cash flow analysis indicates that the carrying amount of an asset exceeds related undiscounted cash flows, the carrying value is reduced to the estimated fair value of the asset. We evaluated such intangibles for impairments and did not record an impairment for the year ended June 30, 2018. (l) Impairment of long-lived assets We evaluate our long-lived assets, such as property, plant and equipment, construction-in-progress, and specifically identified intangibles, when events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. When we believe an impairment condition may have occurred, it is required to estimate the undiscounted future cash flows associated with a long-lived asset or group of long-lived assets at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities for long-lived assets that are expected to be held and used. If we determine that the undiscounted cash flows from an asset to be held and used are less than the carrying amount of the asset, or if we have classified an asset as held for sale, we estimate fair value to determine the amount of any impairment charge. We evaluated the conditions of the Yima Joint Venture to determine whether other-than-temporary decrease in value had occurred as of June 30, 2018 and 2017. As of June 30, 2018, management determined there was a triggering event related to the value of its investment in the Yima Joint Venture. Lower production levels in the fourth quarter reduced the annual production below expectations which resulted in a net increase in the working capital deficit and the debt levels of the joint venture. At June 30, 2017, management determined that there were triggering events related to the value of its investment and these were the lower than expected production levels and the increased debt levels as compared to the previous year, which indicated a continued cash flow concern for the joint venture. Management determined these events in both years were other-than-temporary in nature and therefore conducted an impairment analysis utilizing a discounted cash flow fair market valuation and a Black-Scholes Model-Fair Value of Optionality used in valuing companies with substantial amount of debt where a discounted cash flow valuation may be inadequate for estimating fair value with the assistance of a third-party valuation expert. In this valuation, significant unobservable inputs were used to calculate the fair value of the investment. These inputs included forecasted methanol and coal prices, calculated discount rates and discount for lack of marketability as the majority owner is a state-owned entity in China, volatility analysis and information received from the joint venture. The valuation led to the conclusion that the investment in the Yima Joint Venture was impaired as of June 30, 2018 and, therefore, we recorded a $3.5 million impairment for the year ended June 30, 2018. The previous valuation concluded there was an impairment which resulted in a $17.7 million impairment for the year ended June 30, 2017. The carrying value of our Yima investment as of June 30, 2018 and June 30, 2017 was approximately $5.0 million and $8.5 million respectively. We continue to monitor the Yima Joint Venture and could record an additional impairment in the future if operating conditions deteriorate or if the cash flow situation worsens. (m) Income taxes Deferred tax liabilities and assets are determined based on temporary differences between the basis of assets and liabilities for income tax and financial reporting purposes. The deferred tax assets and liabilities are classified as long-term asset or long-term liability. Valuation allowances are established when necessary based upon the judgment of management to reduce deferred tax assets to the amount expected to be realized and could be necessary based upon estimates of future profitability and expenditure levels over specific time horizons in tax jurisdictions. We recognize the tax benefits from an uncertain tax position when, based on technical merits, it is more likely than not the position will be sustained on examination by the taxing authorities. On December 22, 2017, the Tax Cuts and Jobs Act (the “Act”) was signed into law. The Act provides for numerous significant tax law changes and modifications with varying effective dates, which include reducing the corporate income tax rate from 35% to 21%, creating a territorial tax system, broadening the tax base, and allowing for immediate capital expensing of certain qualified property. Due to losses recorded in past years and the fact we have offset our net deferred tax assets with a valuation allowance, the Act will have a minimal effect. The Act however does allow for Alternative Minimum Tax (“AMT”) to be refundable over subsequent periods. The tax benefit of approximately $129,000 was recorded for the fiscal year ending June 30, 2018 includes previously paid AMT tax amounts we paid in past years which are refundable under the Act. (n) Foreign currency translation Certain of the Company’s foreign subsidiaries utilize the local currency as their functional currency. Assets and liabilities of these foreign subsidiaries are translated into U.S. dollars at period-end rates of exchange, and income and expenses are translated at average exchange rates during the period. Adjustments resulting from translating financial statements into U.S. dollars are reported as cumulative translation adjustments and are shown as a separate component of other comprehensive loss. Gains and losses from foreign currency transactions are included in the calculation of net loss. (o) Stock-based expense The Company has a stock-based compensation plan under which stock-based awards have been granted to employees and non-employees. Stock-based expense is accounted for in accordance with ASC 718, “Compensation – Stock Compensation.” We establish fair values for our equity awards to determine its cost and recognize the related expense over the appropriate vesting periods. We recognize expense for stock options, stock warrants, and restricted stock awards. The fair value of restricted stock awards is based on the market value as of the date of the awards, and for stock-based awards vesting based on service period, the value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service period on a straight-line basis for each separately vesting portion of the award as if the award was, in substance, multiple awards. See Note 15 – Equity – Stock-Based Awards for additional information related to stock-based expense. Note 3 — Recently Issued Accounting Standards In May 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-09, which creates Accounting Standards Codification (“ASC”) Topic 606, “Revenue from Contracts with Customers,” and supersedes most existing U.S. GAAP revenue recognition guidance. In summary, the core principle of Topic 606 provides a single principles-based, five-step model to be applied to all contracts with customers. The five steps are to identify the contract(s) with the customer, to identify the performance obligations in the contract, to determine the transaction price, to allocate the transaction price to the performance obligations in the contract and to recognize revenue when performance obligations are satisfied. Revenue will be recognized when promised goods or services are transferred to the customer in an amount that reflects the consideration expected in exchange for those goods and services. Companies are allowed to select between two transition methods: (1) a full retrospective transition method with the application of the new guidance to each prior reporting period presented, or (2) a retrospective transition method that recognizes the cumulative effect on prior periods at the date of adoption together with additional footnote disclosures. The amendments in ASU No. 2014-09 are effective for annual reporting periods beginning after December 15, 2017, including interim periods within that reporting period, and early application is not permitted. In March 2016 and April 2016, the FASB issued ASU No. 2016-08 and ASU No. 2016-10, respectively. The amendments in ASU No. 2016-08 and ASU No. 2016-10 do not change the core principle of ASU No. 2014-09, but instead clarify the implementation guidance on principle versus agent considerations and identify performance obligations and the licensing implementation guidance, respectively. We have decided to use modified retrospective basis as our method of adoption and will adopt the standard on July 1, 2018. The new ASU will have no impact on our historically reported consolidated financial statements as the Company’s revenue recorded in the comparison periods have been analyzed and would be recorded similarly under the new standard. Timing of revenues related to license fees in the future will be affected as receipt and the satisfying of the performance obligations may differ. There were no license fee revenues for the comparison years. See also Note 2 (e) Revenue Recognition for current revenue recognition policy. In February 2016, the FASB issued ASU No. 2016-02, which creates ASC Topic 842, “Leases.” This update increases transparency and comparability among organizations by recognizing lease assets and lease liabilities on the balance sheet and disclosing key information about leasing arrangements. This guidance is effective for interim and annual reporting periods beginning after December 15, 2018. We are currently evaluating what impact, if any, the adoption of this guidance will have on our financial condition, results of operations, cash flows or financial disclosures. Note 4 — Current Projects In 2016, AFE completed the creation and spin-off of BFR (as discussed below) as a separate standalone company which acquired and operates the Callide thermal coal mine in Queensland. In August 2017, AFE completed the acquisition of a mine development lease related to the 266-million-ton resource near Pentland, Queensland through AFE’s wholly owned subsidiary, Great Northern Energy Pty Ltd. We account for our investment in AFE under the equity method. Our ownership of 38% makes us the second largest shareholder. We also maintain a seat on the board of directors which allows us to have significant influence on the operations and financial decisions, but not control, of the company. On June 30, 2018, we owned approximately 38% of AFE and the carrying value of our investment in AFE was zero as of June 30, 2018 and approximately $39,000 as of June 30, 2017. The following summarizes unaudited condensed financial information of AFE as of and for the years ended June 30, 2018 and 2017 (in thousands): Total assets $ 421 $ 525 Total equity (158 ) (130 ) Net loss (1,777 ) (870 ) In October 2016, BFR stated that it had received investment support for the acquisition from Singapore-based Lindenfels Pte, Ltd, a subsidiary of commodity traders Avra Commodities. The acquisition of the Callide thermal coal mine from Anglo-America was completed in October 2016. In January 2018, the Minister of Natural Resources, Mines and Energy approved BFR’s mining lease application through to 2043 for Callide coal mine’s Boundary Hill South Project. BFR is implementing its mining plan at Callide intended to lower the per unit mining costs and deliver profitable financial results. Tauron Wytwarzanie S.A. (“Tauron”), has contracted Poland’s Institute of Coal Chemistry (“IChPW”) to complete a detailed preliminary design assessment and economic study for the conversion of its 200MW conventional power boilers to clean syngas which would be Poland’s first SGT facility. During the quarter ended June 30, 2016, the Yima Joint Venture commenced an organizational restructuring to better streamline the operations. This restructuring effort the included combining the three joint ventures into a single operating entity and obtaining a business operating license and was completed in November 2016. Since 2014, we have accounted for this joint venture under the cost method of accounting. Our conclusion to account for this joint venture under this methodology is based upon our historical lack of significant influence in the Yima Joint Venture. The lack of significant influence was determined based upon our interactions with the Yima Joint Venture related to our limited participation in operating and financial policymaking processes coupled with our limited ability to influence decisions which contribute to the financial success of the Yima Joint Venture. Under the terms of the joint venture agreement, the Yima Joint Venture is to be governed by a board of directors consisting of eight directors, two of whom were appointed by us and six of whom were appointed by Yima. Although we maintain two seats on the board of directors, the board does not meet on a regular basis and management, who has been appointed by Yima has acted alone without board approval in many cases. In 2016, the board began holding periodic meetings beginning in April 2016 and again in July 2016 with the last meeting being held in January 2017. Discussions at these meetings generally have not included policy decisions, but rather served a more ceremonial function. Yima’s parent company, Henan Energy Chemistry Group Company (“Henan Energy”) restructured the management of the Yima Joint Venture under the direction of the Henan Coal Gasification Company (“Henan Gasification”), which is an affiliated company reporting directly to Henan Energy. Henan Gasification currently has full authority of day to day operational and personnel decisions at the Yima Joint Venture. Therefore, we concluded, and continue to believe, that we do not have significant influence in the matters of the Yima Joint Venture and the cost method is the appropriate accounting method. This consideration has been and continues to be monitored on a quarterly basis to assess whether that conclusion remains appropriate. The Yima Joint Venture experienced certain cash flow concerns resulting primarily from a series of third-party bank loans due during calendar year 2016, an extended shutdown of the plant, and a need for interim shareholder loans from Yima, the 75% shareholder of the Yima Joint Venture. Yima successfully refinanced amounts which were due in October 2016. In addition to this refinancing, Yima completed an internal restructuring of its third-party loans in 2017. As of June 30, 2018, the Yima Joint Venture’s third-party loans balance was approximately 91.9 million RMB, approximately $13.8 million with $3.8 million due in October 2018 and $3.0 million due in March 2019, $5.1 million due in April 2019 and $1.9 million due in April 2020. The $3.8 million which came due in October 2018 is currently being negotiated for extension and final outcome is unknown at this time. We evaluated the conditions of the Yima Joint Venture to determine whether other-than-temporary decrease in value had occurred as of June 30, 2018 and 2017. At June 30, 2018, management determined there was a triggering event related to the value of its investment. Lower production levels in the fourth quarter reduced the annual production below expectations which resulted in a net increase in the working capital deficit and the debt level of the joint venture. At June 30, 2017, management determined that there were triggering events related to the value of its investment and these were the lower than expected production levels and the increased debt levels as compared to the previous year, which indicated a continued cash flow concern for the joint venture. Management determined these events in both years were other than temporary in nature and therefore conducted an impairment analysis utilizing a discounted cash flow fair market valuation and a Black-Sholes Model-Fair Value of Optionality used in valuing companies with substantial amounts of debt where a discounted cash flow valuation may be inadequate for estimating fair value with the assistance of a third-party valuation expert. In this valuation, significant unobservable inputs were used to calculate the fair value of the investment (see Note 2 – (f) Use of Estimates). These inputs included forecasted methanol and coal prices, calculated discount rates and discount for lack of marketability as the majority owner is a state-owned entity in China, volatility analysis and information received from the joint venture. The valuation led to the conclusion that the investment in the Yima Joint Venture was impaired as of June 30, 2018 and, therefore, we recorded a $3.5 million impairment for the year ended June 30, 2018. The previous valuation concluded there was an impairment which resulted in a $17.7 million impairment for the year ended June 30, 2017. The carrying value of our Yima Joint Venture investment as of June 30, 2018 and June 30, 2017 was approximately $5.0 million and $8.5 million respectively. We continue to monitor the Yima Joint Venture and could record additional impairments in the future if operating conditions deteriorate or if the cash flow situation worsens. In February 2014, SES Asia Technologies Limited, one of our wholly owned subsidiaries, entered into a Joint Venture Contract (the “JV Contract”) with Zhangjiagang Chemical Machinery Co., Ltd., which subsequently changed its legal name to Suzhou Thvow Technology Co. Ltd. (“STT”), to form Tianwo-SES Clean Energy Technologies Limited, (“Tianwo-SES Joint Venture”). The purpose of the Tianwo-SES Joint Venture is to establish the Company’s gasification technology as the leading gasification technology in the Tianwo-SES Joint Venture territory (which is China, Indonesia, the Philippines, Vietnam, Mongolia and Malaysia) by becoming a leading provider of proprietary equipment and engineering services for the technology. The scope of the Tianwo-SES Joint Venture is to market and license our gasification technology via project sublicenses; procurement and sale of proprietary equipment and services; coal testing; and engineering, procurement and research and development related to the technology. STT contributed 53.8 million RMB (approximately $8.0 million) in April 2014 and was required to contribute an additional 46.2 million RMB (approximately $6.8 million) within two years of such date for a total contribution of 100 million RMB (approximately $14.8 million) in cash to the Tianwo-SES Joint Venture in return for a 65% ownership interest in the Tianwo-SES Joint Venture. The second capital contribution from STT of 46.2 million RMB (approximately $6.8 million) was not paid by STT in April 2016 as required by the initial JV Contract. As part of a restructuring of the agreement described below, the obligation for payment of additional registered capital was removed. In August 2017, we entered into a restructuring agreement of the Tianwo-SES Joint Venture (“Restructuring Agreement”). The agreed change in share ownership, reduction in the registered capital of the joint venture, and the final transfer of shares with local government authorities was completed in December 2017. In this restructuring, an additional party was added to the JV Contract, upon receipt of final government approvals, The Innovative Coal Chemical Design Institute (“ICCDI”) has become a 25% owner of Tianwo-SES, we have decreased our ownership to 25% and STT has decreased its ownership to 50%. ICCDI previously served as general contractor and engineered and constructed all three projects for the Aluminum Corporation of China. We received 11.15 million RMB (approximately $1.7 million) from ICCDI as a result of this restructuring. In conjunction with the joint venture restructuring, we also received 1.2 million RMB (approximately $180,000) related to outstanding invoices for services we had provided to the Tianwo SES Joint Venture. In addition to the ownership changes described above, Tianwo-SES is now managed by a board of directors (the “Board”) consisting of eight directors, four appointed by STT, two appointed by ICCDI and two appointed by us. All significant acts as described in the JV Contract require the unanimous approval of the Board. Tianwo-SES Joint Venture unaudited financial data The following table presents summarizes unaudited financial information for the Tianwo-SES Joint Venture (in thousands): Income Statement data: 2018 2017 Revenue $ 109 $ 3,709 Operating loss (1,686 ) (3,470 ) Net loss (1,686 ) (4,303 ) As of June 30, Balance sheet data: 2018 2017 Current assets $ 5,151 $ 6,016 Noncurrent assets 1,376 5,565 Current liabilities 4,011 3,696 Noncurrent liabilities — — Equity 2,516 7,885 The Tianwo-SES Joint Venture will be the exclusive operational entity for business relating to our technology in the Tianwo-SES Joint Venture territory, except for projects in which SES has an equity ownership position. For these projects, as a result of the Restructuring Agreement, SES can provide technology and equipment directly with no obligation to the joint venture. If the Tianwo-SES Joint Venture loses exclusivity due to a breach by us, STT and ICCDI are to be compensated for direct losses and all lost project profits. We were also required to provide training for technical personnel of the Tianwo-SES Joint Venture through the second anniversary of the establishment of the Tianwo-SES Joint Venture, which has now passed. We will also provide a review of engineering works for the Tianwo-SES Joint Venture. If modifications are suggested by us and not made, the Tianwo-SES Joint Venture bears the liability resulting from such failure. If we suggest modifications and there is still liability resulting from the engineering work, it is our liability. Any party making improvements, whether patentable or not, relating to our technology after the establishment of the Tianwo-SES Joint Venture, grants to the other party an irrevocable, non-exclusive, royalty free right to use or license such improvements and agrees to make such improvements available to us free of charge. All such improvements shall become part of our technology and both parties shall have the same rights, licenses and obligations with respect to the improvement as contemplated by the TUCA. In July 2006, we entered into a cooperative joint venture contract with Shandong Hai Hua Xuecheng Energy Co. Ltd. (“Xuecheng Energy”) which established Synthesis Energy Systems (Zao Zhuang) New Gas Company Ltd., (“the ZZ Joint Venture”). The ZZ Joint Venture’s primary purpose was to develop, construct and operate a syngas production plant utilizing SGT in Zao Zhuang City, Shandong Province, China and producing and selling syngas and the various byproducts of the plant. We initially owned 97.6% of the ZZ Joint Venture and Xuecheng Energy owned the remaining 2.4%. In June 2015, we entered into a Share Purchase and Investment Agreement, (the “SPA”), with Rui Feng Enterprises Limited (“Rui Feng”), whereby Rui Feng would acquire a controlling interest in Synthesis Energy Systems Investments Inc. (“SESI”), and a wholly owned subsidiary, which owns our interest in the ZZ Joint Venture. Under the terms of the SPA, SESI originally agreed to sell an approximately 61% equity interest to Rui Feng in exchange for $10 million. This amount was to be paid in four installments through December 2016, with the first installment of approximately $1.6 million paid on June 26, 2015. However, Rui Feng did not make any subsequent payments. This resulted in our majority ownership (approximately 88.1%) until we eventually restructured our ownership with Xuecheng Energy. In August 2016, we announced that we and Xuecheng Energy had entered into a definitive agreement to restructure the ZZ Joint Venture. Due to the Chinese government’s widespread initiative to move industry into larger scale, commercial and environmentally beneficial industrial parks, it became clear that the plant was no longer going to be allowed to operate in its current location. As a result, we retain an approximate nine percent ownership in the ZZ Joint Venture asset, and Xuecheng Energy assumed all outstanding liabilities of the ZZ Joint Venture, including payables related to the Cooperation Agreement with Xuecheng Energy signed in 2013. The definitive agreement took full effect when the registration with the government was completed on October 31, 2016. With the closure of this transaction, SES does not anticipate any future liabilities related to the ZZ Joint Venture. During the second quarter of fiscal 2017, we deconsolidated the ZZ Joint Venture and began accounting for our investment in ZZ Joint Venture under the cost method. The carrying value of our investment in the ZZ Joint Venture was zero at both June 30, 2018 and 2017. Note 5 — Discontinued Operations As discussed in Note 4, in August 2016, the Company reached a definitive agreement with Xuecheng Energy to reduce its ownership in the ZZ Joint Venture to approximately 9%. The definitive agreement took full effect in October 2016, when the government approved our transfer. The ZZ Joint Venture was deconsolidated during the quarter ended December 31, 2016. The following table provides the results of operations from discontinued operation, the ZZ Joint Venture, for the year ended June 30, 2018, and 2017. Revenue: 2018 2017 Product sales and other –related parties $ — $ — Technology licensing and related services — 168 Total revenue from discontinued operations $ — $ 168 From discontinued operations $ — $ (380 ) From Gain on deconsolidation — 2,318 Total Net income/(loss) from discontinued operations: $ — $ 1,938 The following table provides the major categories of cash flows from discontinued operations, our ZZ Joint Venture, for the years ended June 30, 2018 and 2017. Cash flow from operating activities $ — $ — Cash flow from investing activities — (16 ) Cash flow from financing activities — — There are no significant non-cash transactions related to discontinued operations for the year ended June 30, 2018 and 2017. Note 6 — Senior Secured Debentures On October 24, 2017, the Company entered into a securities purchase agreement (the “Purchase Agreement”) with certain accredited investors (the “Purchasers”) for the purchase of $8.0 million in principal amount of Debentures. The Debentures have a term of 5 years with an interest rate of 11% that adjusts to 18% in the event the Company defaults on an interest payment. The Debentures require that dividends received from BFR are used to pay down the principal amounts of outstanding Debentures. Additionally, we issued warrants to purchase 1,000,000 shares of common stock at $4.00 per common share. The Purchase Agreement and the Debentures contain certain customary representations, warranties and covenants. There are no financial metric covenants related to the Debentures. The transaction was approved by a special committee of our board of directors due to the fact that certain board members were Purchasers. Interest on the outstanding balance of Debentures is payable quarterly commencing on January 2, 2018, all unpaid principal and interests on the Debentures will be due on October 23, 2022. The net offering proceeds to the Company from the sale of the Debentures and warrants, after deducting the placement agent’s fee and associated costs and expenses, was approximately $7.4 million, not including the proceeds, if any, from the exercise of the warrants issued in this offering. As compensation for its services, we paid T.R. Winston & Company, LLC (the “Placement Agent”): (i) a cash fee of $0.56 million (representing an aggregate fee equal to 7% of the face amount of the Debentures); and (ii) a warrant to purchase 70,000 shares of common stock, 7% of the shares issued to the Purchasers (the “Placement Agent Warrants”). We also reimbursed certain expenses of the Placement Agent. The fair market value of the warrants was approximately $137,000 at the time of issuance and recorded as debt issuance cost. A total of approximately $1.0 million debt issuance cost was recorded as a result and is being amortized to interest expense over the term of the Debentures by using effective interest method beginning in October 2017. The warrants and Placement Agent Warrants contain provisions providing for the adjustment of the purchase price and number of shares into which the securities are exercisable in the certain events. Also, under certain events, the Company shall, at the holder’s option, purchase the warrants from the holder by paying the holder an amount in cash based on a Black Scholes Option Pricing Model for remaining unexercised warrants. Under U.S. GAAP, this potential cash transaction requires the Company to record the fair market value of the warrants as a liability as opposed to equity. Management used a Monte Carlo Simulation method to value the warrants with Anti-Dilution Protection with the assistance of a third-party valuation expert. To execute the model and value the warrants, certain assumptions were needed as noted below: Valuation Date: October 24, 2017 Warrant Expiration Date: October 31, 2022 Total Number of Warrants Issued: 1,000,000 Contracted Conversion Ratio: 1:1 Warrant Exercise Price (USD) 4.00 Next Capital Raise Date: October 31, 2018 Threshold exercise price post Capital raise: 2.51 Spot Price (USD): 3.28 Expected Life (Years): 5.0 Volatility: 66.0% Volatility (Per-period Equivalent): 19.1% Risk Free Interest Rate: 2.04% Risk Free Rate (Per-period Equivalent): 0.17% Nominal Value (USD Mn): 4.0 No of Shares on conversion (Mn): 8.0 The results of the valuation exercise valued the warrants issued at $1.9528 per share, or $2.0 million in total. The total proceeds received are first allocated to the fair value of all the derivative instruments, the remaining proceeds, are then allocated to the Debentures, resulting in the Debentures being recorded at a discount from the face value. The Company recorded $8.0 million as the face value of the debentures and a total of $1.9 million as discount of Debentures and $0.1 million as debt issuance cost for warrants issued to investors and placement agent, which will be amortized to interest expense over the term of the debenture beginning October 2017, this resulted in a charge to interest expense of $0.3 million for the year ended June 30, 2018. The effective annual interest rate of the debentures is approximately 18% after considering this $1.9 million discount related to the Debentures. The warrants and the Placement Agent Warrants are exercisable into shares of the Company’s common stock at any time at an exercise price of $4.00 per common share (subject to adjustment). The warrants and the Placement Agent Warrants will terminate five years after they become exercisable. The warrants and the Placement Agent Warrants contain provisions providing for the adjustment of the purchase price and number of shares into which the securities are exercisable in the certain events. The Debentures are guaranteed by the U.S. subsidiaries of the Company, as well as the Company’s British Virgin Islands subsidiary, pursuant to a Subsidiary Guarantee, in favor of the holders of the Debentures by the subsidiary guarantors, party thereto, as well as any future subsidiaries which the Company forms or acquires. The Debentures are secured by a lien on substantially all of the assets of the Company and the subsidiary guarantors, other than their equity ownership interest in the Company’s foreign subsidiaries, pursuant to the terms of the Purchase Agreement among the Company, the subsidiary guarantors and the holders of the Debentures. Note 7 — Derivative Liabilities The warrants issued to the Debenture investors and the Placement Agent contain provisions providing for the adjustment of the purchase price and number of shares into which the securities are exercisable under certain events. Under certain events, the Company shall, at the holder’s option, purchase the warrants from the holder by paying the holder an amount in cash based on a Black Scholes Option Pricing Model for remaining unexercised warrants. ASC 815, which establishes accounting and reporting standards for derivative instruments including certain derivative instruments embedded in other financial instruments or contracts and requires recognition of all derivatives on the balance sheet at fair value. Management used a Monte Carlo Simulation method to value the warrants with Anti-Dilution Protection with the assistance of a third-party valuation expert to initially record the fair value of these derivatives. The third-party valuation expert also assisted management in valuing the derivatives as of December 31, 2017, March 31, 2018 and June 30, 2018 with the changes in the fair value reported as non-operating income or expense. To execute the model and value the derivatives, certain assumptions were needed as noted below: At Issuance Warrant Issue Date: October 24, 2017 October 24, 2017 Valuation Date: October 24, 2017 June 30, 2018 Warrant Expiration Date: October 31, 2022 October 31, 2022 Total Number of Warrants Issued: 1,070,000 1,070,000 Warrant Exercise Price (USD): 4.00 4.00 Next Capital Raise Date:(1) October 31, 2018 June 30, 2019 Threshold Exercise Price Post Capital Raise:(2) 2.51 2.15 Spot Price (USD): 3.28 3.28 Expected Life (Years): 5.0 4.3 Volatility: 66.0% 65.0% Volatility (Per-period Equivalent): 19.1% 18.8% Risk Free Interest Rate: 2.04% 2.71% Risk Free Rate (Per-period Equivalent): 0.17% 0.22% Nominal Value (USD Mn): 4.3 4.3 No. of Shares on Conversion (Mn): 1.1 1.1 Contracted Conversion Ratio: 1:1 1:1 Fair Values (in thousands) Fair Value without Anti-Dilution Protection: $ 1,837 $ 1,704 Fair Value of Embedded Derivative: 253 260 Fair Value of the Warrants Issued: $ 2,090 $ 1,964 Gain/(Loss) on Fair Value Adjustments to Derivative Liabilities Not Applicable 126 (1) Next Capital Raise Date was assumed to be within a year of the debt offering and each valuation date. This was assumed as the Company has registered some type of capital raise in every year for the past 3 years. The Company may not have executed the capital raise but did register. (2) Threshold Exercise Price Post Capital Raise is assumed to be the 52-week low closing price, not to be confused with the 52-week low of the stock price. The change in the derivative liability was mostly due to the Company’s stock price movements. Other changes in assumptions are listed above, some change with the passage time, interest rate fluctuations and stock market volatility. Note 8 — Risks and Uncertainties As discussed in Note 1 – Business and Liquidity - (b) Liquidity, we currently have very limited financial and human resources to fully develop and execute on all of our business opportunities. We are seeking to strengthen our financial position through new strategic partnering opportunities and we consider a full range of financing options to create the most value for us which may include divestiture of assets such as our Yima Joint Venture, our Tianwo-SES Joint Venture and our technology. If we cannot raise required funds on acceptable terms, we may further reduce our expenses. We believe that with the strategies above, we can continue to operate for the next twelve months, assuming we can successfully transfer the funds currently in China to the U.S. Based on the historical negative cash flows that the Company has incurred, the continued limited cash inflows in the period subsequent to year end and the uncertain nature of the ability to transfer the cash that resides in China, there is substantial doubt about the Company’s ability to continue as a going concern. Other than AFE and our Yima Joint Venture, all of our other development opportunities are in the early stages of development and/or contract negotiations. We continue to evaluate the conditions of the Yima Joint Venture to monitor for any impairments in our investment. Yima had lower production levels in the fourth quarter reduced the annual production below expectations which resulted in a net increase in the working capital deficit and the debt level of the joint venture which caused the Company to evaluate its investment for impairment for the year-ended June 30, 2018. Our analysis of our investment in the Yima Joint Venture did result in a further impairment as of June 30, 2018. Our operations are subject to stringent laws and regulations governing the discharge of materials into the environment, remediation of contaminated soil and groundwater, sitting of facilities or otherwise relating to environmental protection. Numerous governmental agencies, such as various Chinese, Australian and European Union authorities at the municipal, provincial or central government level and similar regulatory bodies in other countries, issue regulations to implement and enforce such laws, which often require difficult and costly compliance measures that carry substantial potential administrative, civil and criminal penalties or may result in injunctive relief for failure to comply. These laws and regulations may require the acquisition of a permit before construction and/or operations at a facility commence, restrict the types, quantities and concentrations of various substances that can be released into the environment in connection with such activities, limit or prohibit construction activities on certain lands lying within wilderness, wetlands, ecologically sensitive and other protected areas and impose substantial liabilities for pollution. Although to date we have not experienced any material adverse effect from compliance with existing environmental requirements, we cannot assure you that we will not suffer such effects in the future or that projects developed by our partners or customers will not suffer such effects. For example, in China, developing, constructing and operating gasification facilities is highly regulated. In the development stage of a project, the key government approvals are the project’s environmental impact assessment report, or EIA, feasibility study (also known as the project application report). Approvals in China are required at the municipal, provincial and/or central government levels depending on the total size of the investment in the project. Prior to commencing full commercial operations, we also need additional environmental approvals to ensure that the facility will comply with standards adopted in the EIA. Although we have been successful in obtaining the permits that are required at this stage of our development, any retroactive change in policy guidelines or regulations, or an opinion that the approvals that have been obtained are inadequate, could require us to obtain additional or new permits, spend considerable resources on complying with such requirements or delay commencement of construction. Other developments, such as the enactment of more stringent environmental laws, regulations or policy guidelines or more rigorous enforcement procedures, or newly discovered conditions, could require us to incur significant capital expenditures. Selling syngas, methanol, glycol and other commodities is highly regulated in many markets around the world, as will be projects in our business verticals. We believe these projects will be supported by the governmental agencies in the areas where the projects will operate because coal-based technologies, which are less burdensome on the environment, are generally encouraged by most governments. However, in China and other developing markets, the regulatory environment is often uncertain and can change quickly, often with contradictory regulations or policy guidelines being issued. In some cases, government officials have different interpretations of such regulations and policy guidelines and project approvals that are obtained could later be deemed to be inadequate. Furthermore, new policy guidelines or regulations could alter applicable requirements or require that additional levels of approvals be obtained. In addition, the European Union continues to promote clean energy and climate policies and encouraging a shift away from facilities powered by coal. The Chinese government also continues to encourage newer technologies that can cleanly process coal. Although we do not believe that China’s project approval requirements and slowing of approvals for new coal to methanol and DME projects will invalidate any of our existing permits, our future joint ventures will have to abide by these guidelines. If we or our customers and partners are unable to effectively complete the government approval process in China, Australia, Poland and other markets in which we intend to operate, our business prospects and operating results could be seriously harmed. The Company is subject to concentration of credit risk with respect to our cash and cash equivalents, which it attempts to minimize by maintaining cash and cash equivalents with major high credit quality financial institutions. At times, the Company’s cash balances in a particular financial institution exceed limits that are insured by the U.S. Federal Deposit Insurance Corporation or equivalent agencies in foreign countries and jurisdictions such as Hong Kong. As of June 30, 2018, the Company had $7.1 million in cash and cash equivalents (of which $4.9 million is located in the United States). Note 9 — Property, Plant and Equipment Property, plant and equipment consisted of the following (in thousands): Estimated June 30, useful lives 2018 2017 Furniture and fixtures 2 to 3 years $ 243 $ 243 Leasehold improvements Lease term 23 23 Computer hardware 3 years 336 336 Computer software 3 years 875 875 Office equipment 3 years 149 148 Motor vehicles 5 years 39 38 Less: Accumulated depreciation (1,655 ) (1,639 ) Net carrying value $ 10 $ 24 Note 10 — Detail of Selected Balance Sheet Accounts Accrued expenses and other payables consisted of the following (in thousands): Accounts payable — trade $ 496 $ 455 Accrued payroll, vacation and bonuses 80 107 Technical consulting, engineering and design services — 114 Deferred revenue 206 50 GTI royalty expenses due to GTI 250 250 Interest payable 220 — Other 429 789 Note 11 — Intangible Assets GTI License Agreement In November 2009, we entered into an Amended and Restated License Agreement, (the “GTI Agreement”), with the Gas Technology Institute, (“GTI”), replacing the Amended and Restated License Agreement between us and GTI dated August 31, 2006, as amended. Under the GTI Agreement, we maintain our exclusive worldwide right to license the U-GAS® technology for all types of coals and coal/biomass mixtures with coal content exceeding 60%, as well as the non-exclusive right to license the U-GAS® technology for 100% biomass and coal/biomass blends exceeding 40% biomass. We have the right to grant sublicenses, with the approval from GTI, for which we would then owe royalty payments to GTI based on an agreed upon rate schedule. Royalty payments to GTI consist of a minimum annual payment or variable rate payments per the rate schedules dependent upon license agreements, invested equity or carried interests, whichever is higher. The initial term of the contract was for 10 years with two 10-year extensions executable upon notice to GTI. In May 2016, we exercised the first of our 10-year extensions and now maintain the exclusive license through 2026. The cost and accumulated amortization of intangible assets were as follows (in thousands): Use rights of U-GAS® $ 1,886 $ 1,886 $ — $ 1,886 $ 1,886 $ — Other intangible assets 1,149 111 1,038 1,072 88 984 Total $ 3,035 $ 1,997 $ 1,038 $ 2,958 $ 1,974 $ 984 The use rights of U-GAS® have an amortization period of ten years. Amortization expense was zero for the year ended June 30, 2018 as it was fully amortized as of August 2016 and approximately $28,000 for the year ended June 30, 2017. Other intangible assets are primarily patents. Note 12 — Income Taxes For financial reporting purposes, net loss showing domestic and foreign sources was as follows (in thousands): Domestic $ (5,174 ) $ (6,238 ) Foreign (4,560 ) (22,242 ) The effective income tax rate was 2.1% and 0.0% for the years ended June 30, 2018 and 2017 respectively. The following table reconciles the income tax benefit with income tax expense that would result from application of the statutory federal tax rate, 28% and 35% for the years ended June 30, 2018 and 2017, respectively, to loss before income tax expense (benefit) recorded (in thousands): Net loss before income tax $ (9,734 ) $ (28,480 ) Computed tax benefit at statutory rate (2,726 ) (9,968 ) Taxes in foreign jurisdictions with rates different than US 1,210 (810 ) Impact of U.S. tax reform 11,633 — Deferred Tax Adjustments (1) 10,988 Valuation allowance (22,129 ) 9,813 Income tax expense/(benefit) $ (129 ) $ — (1) Adjustments of $11.0 million relate primarily to prior years in connection with the (i) Yima Joint Venture investment impairment of $8.0 million due to the change to the Mauritius tax rate of 3%; (ii) provisions related to AFE and Tianwo-SES Joint Venture totaling $2.0 million; and (iii) Stock option forfeitures in the amount of $0.6 million. The impact of these changes on the prior year would have resulted in a similar change to the valuation allowance and therefore the net income tax expense/(benefit) recognized in the prior year would not have changed. Net deferred tax assets of continuing operations consisted of the following (in thousands): Deferred tax assets (liabilities): Net operating loss carry forward $ 10,594 $ 16,429 Warrant FMV Change (26 ) — Depreciation and amortization 1 63 Investment in joint ventures 1,381 13,281 Accruals 129 255 AMT credit — 138 Subtotal 16,585 38,715 Valuation allowance (16,585 ) (38,715 ) Net deferred assets $ — $ — At June 30, 2018, the Company had approximately $47.5 million of U.S. federal net operating loss (“NOL”) carry forwards, and $2.4 million of China NOL carry forwards. The China NOL carry forwards have expiration dates through 2023 and the U.S. NOL carry forwards begin expiring in 2029. The Company’s tax returns are subject to periodic audit by the various taxing jurisdictions in which the Company operates, which can result in adjustments to its NOLs. There are no significant audits underway at this time. In assessing the Company’s ability to utilize its deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. Based on the level of historical taxable income and projections for future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that the Company will not realize the benefits of these deductible differences. Future changes in estimates of taxable income or in tax laws may change the need for the valuation allowance. The Company and two of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various states and foreign jurisdictions. Generally, the Company will inventory tax positions related to tax items for all years where the statute of limitations for the assessment of income taxes has not expired. The Company’s open tax years are from June 30, 2009 forward through and including June 30, 2017. Since these periods all have NOL carryforwards, the normal statute of limitations will technically not expire unless and until the NOLs expire or are utilized. As of June 30, 2018, the domestic and foreign tax authorities have not proposed any adjustments to the Company’s material tax positions. The Company establishes reserves for positions taken on tax matters which, although considered appropriate under the regulations, could potentially be successfully challenged by authorities during a tax audit or review. The Company did not have any liability for uncertain tax positions as of June 30, 2018 or 2017. Note 13 — Net Loss Per Share Data Historical net loss per share of common stock is computed using the weighted average number of shares of common stock outstanding. Basic loss per share excludes dilution and is computed by dividing net loss available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Stock options, warrants and unvested restricted stock are the only potential dilutive share equivalents the Company had outstanding for the periods presented. For the years ended June 30, 2018 and 2017, options and warrants to purchase common stock excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive as the Company incurred net losses during those periods. The total number of shares excluded from diluted earnings per share equivalents amounted to approximately 3.4 million for the year ended June 30, 2018 and 2.8 million for the year ended June 30, 2017. Note 14 — Commitments and Contingencies The Company is currently not a party to any legal proceedings. In October 2017, the Company extended its corporate office lease term for an additional 13 months ending January 31, 2019 with rental payments of approximately $18,000 per month (monthly rent changes depending on actual utility usage each month). Consolidated rental expense incurred under operating leases was $0.2 million for the year ended June 30, 2018 and $0.4 million for the year ended June 30, 2017. Note 15 — Equity At the Annual Meeting of Stockholders of the Company on June 30, 2015, the Company’s stockholders approved an amendment to the Company’s certificate of incorporation to authorize a class of preferred stock, consisting of 20,000,000 authorized shares, which may be issued in one or more series, with such rights, preferences, privileges and restrictions as shall be fixed by the Company’s board of directors. No shares of preferred stock have been issued or outstanding since approved by the stockholders. In July 2015, the Company received proceeds of $1 million in connection with a warrant holder’s offer to amend and exercise his warrants. The warrant holder elected to exercise a total of 125,000 shares of his warrant with exercise price of $17.28 per share at a reduced exercise price of $8.00 per share, providing a total of $1 million in gross proceeds to the Company. On November 10, 2017 and January 1, 2017, we issued 17,046 shares of common stock and 7,066 shares of common stock respectively to Market Development Consulting Group, Inc. (“MDC”), our investor relations advisor, pursuant to the term of the consulting agreement, as amended on October 28, 2016. The shares were fully vested and non-forfeitable at the time of issuance. The fair value of the common stock was $3.52 per share and $8.48 per share on the date of issuance respectively, and we recorded $60,000 of expense for both the years ended June 30, 2018 and 2017 related to issuance of these shares. Stock-Based Awards As of June 30, 2018, the Company has outstanding stock option and restricted stock awards granted under the Company’s 2015 Long Term Incentive Plan (the “2015 Incentive Plan”) and Amended and Restated 2005 Incentive Plan (the “2005 Incentive Plan”), under which the Company’s stockholders have authorized a total of 2,625,000 shares of common stock for awards under the 2015 and 2005 Incentive Plan. The 2005 Incentive Plan expired as of November 7, 2015 and no future awards will be made thereunder. As of June 30, 2018, there were approximately 342,808 shares authorized for future issuance pursuant to the 2015 Incentive Plan. Under the 2015 Incentive Plan, we may grant incentive and non-qualified stock options, stock appreciation rights, restricted stock units and other stock-based awards to officers, directors, employees and non-employees. Stock option awards generally vest ratably over a one to four-year period and expire ten years after the date of grant. On April 1, 2017, the Company authorized the issuance of 13,236 shares of restricted stock under the 2015 Incentive Plan to ILL-Sino Development (“ILL-Sino”) according to the term of Amended and Restated Consulting Service Agreement dated April 1, 2014 between the Company and ILL-Sino. The fair value of the restricted stock was approximately $0.1 million based on the market value as of the date of the awards for the year ended June 30, 2017. There were no restricted shares issued to ILL-Sino for the year ended June 30, 2018. Restricted stock activity during the two years ended June 30, 2018 and 2017 was as follows: Restricted stock Unvested shares outstanding at June 30, 2016 34,387 Granted 36,729 Vested (26,256 ) Forfeited (14,373 ) Forfeited — Unvested shares outstanding at June 30, 2018 9,837 The fair values for the stock options granted during the years ended June 30, 2018 and 2017 were estimated at the date of grant using a Black-Scholes-Morton option-pricing model with the following weighted-average assumptions. Risk-free rate of return 2.60 % 2.07 % Expected life of award (in years) 5.0 5.0 Expected dividend yield 0.00 % 0.00 % Expected volatility of stock 86 % 84 % Weighted-average grant date fair value $ 2.34 $ 4.48 The expected volatility of stock assumption was derived by referring to changes in the historical volatility of the company. We used the “simplified” method for “plain vanilla” options to estimate the expected term of options granted during the years ended June 30, 2018 and 2017. Stock option activity during the two years ended June 30, 2018 and 2017 were as follows: Outstanding at June 30, 2016 1,276,957 $ 8.26 Granted 218,942 6.70 Exercised (23,000 ) 5.28 Cancelled/forfeited (10,865 ) 11.36 Outstanding at June 30, 2017 1,462,034 8.05 5.5 $ 0.1 Exercised — — Cancelled/forfeited (84,390 ) 8.33 Outstanding at June 30, 2018 1,720,732 7.11 5.4 $ 0.02 Exercisable at June 30, 2018 1,552,147 7.48 4.9 $ 0.02 As discussed in Note 6, on October 24, 2017, in connection with the issuance of the Debentures, the Company issued warrants to purchase 1,000,000 shares of common stock at exercise price of $4.00 per share to the investors and issued to the Placement Agent, for the Debenture offering, warrants to purchase 70,000 shares of common stock at exercise price of $4.00 per share. On each of November 1, 2017 and October 28, 2016, the Company issued a warrant to MDC to acquire 50,000 shares of the Company’s common stock each at an exercise price of $3.52 and $7.60 per share respectively according to the term of the consulting agreement, as amended on October 28, 2016, between the Company and MDC. The fair value of each warrant was estimated to be approximately $0.2 million and 0.3 million respectively. The fair values of the warrants issued to MDC were estimated using a Black-Scholes-Morton option-pricing, and the following weighted-average assumptions for the years ended June 30, 2018 and 2017: Expected life of award (in years) 10 10 Stock warrants activity during the two years ended June 30, 2018 and 2017 were as follows: Stock Warrants Outstanding at June 30, 2016 1,239,355 $ 14.08 Granted 50,000 7.60 Cancelled/forfeited — — Outstanding at June 30, 2017 1,289,355 13.84 Granted 1,120,000 3.98 Cancelled/forfeited (733,334 ) 16.26 Outstanding at June 30, 2018 1,676,021 6.18 Exercisable at June 30, 2018 1,676,021 6.18 The Company recognizes the stock-based expense related to the Incentive Plans awards and warrants over the requisite service period. The following table presents stock- based expense attributable to stock option awards issued under the Incentive Plans and attributable to warrants and common stocks issued to consulting firms (in thousands): Incentive Plans $ 1,045 $ 1,187 Common Stock and Warrants 213 514 Total stock-based compensation expense $ 1,258 $ 1,701 In May 2017, the Company granted stock options exercisable for 30,074 shares and issued 5,538 restricted shares to employees in connection with salary reduction agreements for a six months period from May to October 2017. The fair value of these options and restricted shares was approximately $132,000 and $36,000 at the date of grant. In January 2018, the Company granted additional stock options exercisable for 47,133 shares to employees in connection with salary reduction agreements for a six months period of January to June 2018. The fair value of these options was approximately $92,000 at the date of grant. These options and restricted shares vest ratably over the six-month service period. As of June 30, 2018, approximately $0.2 million of estimated expense with respect to non-vested stock option and restricted shares awards have yet to be recognized and will be recognized in expense over the remaining weighted average period of approximately 7 months. Note 16 – Segment Information The Company’s reportable operating segments have been determined in accordance with its internal management reporting structure and include SES Foreign Operating, Technology Licensing and Related Services, and Corporate. The SES Foreign Operating reporting segment includes all of the assets, operations and related administrative costs for China and our equity positions and earnings related to our joint ventures including AFE, BFR, the Yima Joint Venture and the Tianwo-SES Joint Venture. The Technology Licensing and Related Services reporting segment includes all of our current operating activities related to our technology group. The Corporate reporting segment includes the executive and administrative expenses of the corporate office in Houston. The Company evaluates performance based upon several factors, of which a primary financial measure is segment operating income or loss. The following table presents statements of operations data and assets by segment (in thousands): SES Foreign Operating $ 894 $ — Technology licensing and related services 613 151 Corporate — — Total revenue $ 1,507 $ 151 SES Foreign Operating $ 10 $ 10 Technology licensing and related services — — Corporate 27 56 Total depreciation and amortization $ 37 $ 66 Impairment loss: SES Foreign Operating 3,500 17,700 Total impairment loss $ 3,500 $ 17,700 Operating loss: SES Foreign Operating (3,682 ) $ (19,339 ) Technology licensing and related services (1,138 ) (2,273 ) Corporate (5,331 ) (6,468 ) Total operating loss $ (10,151 ) $ (28,080 ) Equity in losses of joint ventures: SES Foreign Operating $ 715 $ 342 Total equity in losses of joint ventures $ 715 $ 342 SES Foreign Operating $ 7,402 $ 8,123 Corporate 5,928 6,274 Note 17 — Subsequent Events On November 5, 2018, a default occurred related to the Purchase Agreement and the Debentures due to the Company failing to timely file this Annual Report on Form 10-K. If the default is not waived by the holders of the Debentures, the holders may have the option to accelerate the principal and interest outstanding and other mandatory charges on the Debentures. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures Effective November 20, 2017, the Audit Committee of our Board of Directors approved the dismissal of BDO USA, LLP (“BDO”) as our independent registered public accounting firm, and engaged RSM US, LLP (“RSM”) as our independent registered public accounting firm for our fiscal year ended June 30, 2018 and related interim periods. The decision to engage RSM as our independent registered public accounting firm was approved by Audit Committee of our Board of Directors. BDO’s audit reports on the consolidated financial statements of us and our subsidiaries as of June 30, 2017 and 2016 and for each of the years in the two-year period ended June 30, 2017 did not contain any adverse opinion or disclaimer of opinion and were not qualified or modified as to uncertainty, audit scope, or accounting principles. During the fiscal years ended June 30, 2017 and 2016 and the subsequent interim period through November 20, 2017, there were no disagreements with BDO on any matter of accounting principles or practices, financial statement disclosure, or auditing scope or procedure, which, if not resolved to the satisfaction of BDO, would have caused BDO to make reference to the subject matter of the disagreement(s) in connection with its reports. During the year ended June 30, 2017, there was a “reportable event” as defined in Regulation S-K, Item 304(a)(1)(v). The Company reported the existence of a material weakness in our internal control over financial reporting relating to the preparation and review of the impairment evaluation of its cost method investments, as more fully described in Item 9A of the Company’s Annual Report on Form 10-K for the year ended June 30, 2017, and its Quarterly Reports on Form 10-Q for the periods ended September 30, 2016, December 31, 2016 and March 31, 2017, and September 30, 2017. The Audit Committee of our Board of Directors, and our Board of Directors, discussed this material weakness with BDO and authorized BDO to respond fully to the inquiries of RSM concerning the material weakness. During the fiscal years ended June 30, 2017 and 2016 and the subsequent interim period prior to the engagement of RSM, we did not consult with RSM regarding either (i) the application of accounting principles to a specific completed or contemplated transaction, or the type of audit opinion that might be rendered on our consolidated financial statements and neither a written report was provided to us or oral advice was provided that RSM concluded was an important factor considered by us in reaching a decision as to the accounting, auditing or financial reporting issue or (ii) any matter that was either the subject of a disagreement as defined in (a)(1)(iv) of Item 304 of Regulation S-K and the related instructions to Item 304 of Regulation S-K or a reportable event as that term is defined in (a)(1)(v) of Item 304 of Regulation S-K. Item 9A. Controls and Procedures In accordance with Exchange Act Rule 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Accounting Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Accounting Officer, as appropriate, to allow timely decisions regarding required disclosure. Based upon that evaluation, the Chief Executive Officer and Chief Accounting Officer concluded that our disclosure controls and procedures were not effective as of June 30, 2018. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Management’s Annual Report on Internal Control Over Financial Reporting Our management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act. We have performed an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of our internal control over financial reporting. Our management assessed the effectiveness of our internal control over financial reporting as of June 30, 2018. Because of its inherent limitations, internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collision or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions or that the degree of compliance with established policies or procedures may deteriorate. Our management used the criteria set forth in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) to perform its assessment. Based on this assessment, our management, including our Chief Executive Officer and our Chief Accounting Officer, concluded, that as of June 30, 2018, our internal controls over financial reporting were not effective as of June 30, 2018. Material Weaknesses. We did not maintain effective internal controls over financial reporting. Specifically, we identified material weaknesses over management’s review controls over significant accounting estimates and review controls over accounting for non-routine and complex accounting transactions. Changes in Internal Control Over Financial Reporting There have been no changes in our internal control over financial reporting during the three months ended June 30, 2018 that have materially affected, or that are reasonably likely to materially affect, our internal control over financial reporting. Item 9B. Other Information Item 10. Directors, Executive Officers and Corporate Governance. Directors, Executive Officers and Significant Employees The following table sets forth information concerning our directors, executive officers and significant employees as of June 30, 2018: Name Age Position Lorenzo Lamadrid (1) (2) 67 Chairman of the Board Robert Rigdon 60 Vice Chairman of the Board Denis Slavich (1) (2) (3) 78 Director Harry Rubin (1) (2) (3) 65 Director Ziwang Xu (3) 61 Director Brown, Charles (2) (3) 59 Director Anderson, Robert F.(1)(2) 61 Director DeLome Fair 55 President, Chief Executive Officer and Director David Hiscocks 54 Corporate Controller and Corporate Secretary Wade Taber 43 Vice President of Engineering (1) Member of the Compensation Committee of the Board (the “Compensation Committee”). (2) Member of the Nominating and Corporate Governance Committee. (3) Member of the Audit Committee. Lorenzo Lamadrid. Mr. Lamadrid has been the Chairman of the Board since April 2005. Since 2001, Mr. Lamadrid has been the Managing Director of Globe Development Group, LLC, a firm that specializes in the development of large scale energy, power generation, transportation and infrastructure projects in China and provides business advisory services and investments with a particular focus on China. Mr. Lamadrid was also a director of Flow International Corporation from 2006 until its sale in 2014. He previously served as President and Chief Executive Officer of Arthur D. Little, a management and consulting company, from 1999 to 2001, as President of Western Resources International, Inc. from 1996 through 1999 and as Managing Director of The Wing Group from 1993 through 1999. The Wing Group was a leading international electric power project-development company that was sold to Western Resources in 1999. Prior to that, he was with General Electric from 1984 to 1993 serving as corporate officer, Vice President and General Manager at GE Aerospace for Marketing and International Operations, and as General Manager of Strategic Planning and Business Development of GE’s International Sector. Prior to joining GE, Mr. Lamadrid was a senior Manager at the Boston Consulting Group where he worked from 1975 to 1984. Mr. Lamadrid’s experience in business development and management is a key attribute for us, and his background in overseas markets has provided him with valuable insights into our international focus. Education: Mr. Lamadrid holds a dual bachelor’s degree in Chemical Engineering and Administrative Sciences from Yale University, an M.S. in Chemical Engineering from the Massachusetts Institute of Technology and an M.B.A. in Marketing and International Business from the Harvard Business School. Directorships in the past five years: Flow International (2006 to 2014). Robert Rigdon. Mr. Rigdon has been the Vice Chairman of the Board since February 2016. Mr. Rigdon joined us as a director in August 2009, and previously served as President and Chief Executive Officer from March 2009 to February 2016. Prior to that, he served as Chief Operating Officer since November 2008 and as Senior Vice President of Global Development since May 2008, where he was responsible for overseeing all aspects of our current and future coal gasification projects worldwide. From June 2004 until joining us, Mr. Rigdon worked for GE Energy in a variety of capacities, including Manager—Gasification Engineering, Director—IGCC Commercialization, and Director—Gasification Industrials and Chemicals Business. For the 20 years previous to this, Mr. Rigdon worked for Texaco, and later ChevronTexaco, as an engineer and in the Worldwide Power & Gasification group, where he ultimately became Vice President—Gasification Technology for the group. As a result of his three decades working on gasification, Mr. Rigdon is experienced in the operational and marketing strategies that are key to our development and success. Education: Mr. Rigdon is a mechanical engineer with a B.S. from Lamar University. Directorships in the past five years: None, other than our Board. Denis Slavich. Mr. Slavich has served as a director since November 2005. Mr. Slavich has over 35 years of experience in large scale power generation development. He is currently the Group Strategic Director-Finance of Astrata Group Pte Ltd, a privately held global telematics company headquartered in Singapore, and an international consultant, as well as an advisor and board member for a number of additional firms. He served as a director of China Advanced Construction Materials Group, Inc., a company traded on the NASDAQ, from September 2009 until May 2011. From 1998 to 2000, Mr. Slavich was the CFO and director of KMR Power Corporation and was responsible for the development of this international IPP Company that developed projects in Columbia as well as other areas. From 2000 until 2002, he served as Vice President and CFO of Big Machines Inc., a software company. Mr. Slavich also served as acting President for Kellogg Development Corporation, a division of M.W. Kellogg, during 1997. From 1991 to 1995, Mr. Slavich was also a Vice President of Marketing for Fluor Daniel. From 1971 to 1991, Mr. Slavich served in various executive positions at Bechtel Group including Sr. VP, CFO, and director and Sr. VP and division manager of the International Power Division. In addition to his experience in power generation development, Mr. Slavich is experienced in finance and accounting matters and has extensive experience with financial statements. Education: Mr. Slavich received his Ph.D. from Massachusetts Institute of Technology, his M.B.A. from the University of Pittsburgh and his B.S. in Electrical Engineering from the University of California at Berkeley. Directorships in the past five years: Astrata Group (2011 to present) and Leading Edge Technologies (2001 to 2014). Harry Rubin. Mr. Rubin has served as a director since August 2006. Mr. Rubin is currently Chairman of Henmead Enterprises, in which capacity he advises various companies regarding strategy, acquisitions and divestitures. He held board positions at a number of private and public companies such as the A&E Network, RCA/Columbia Pictures Home Video, the Genisco Technology Corporation and Image-Metrics Plc. He was a founding partner of the Boston Beer Company. In the 12 years prior to 2006, Mr. Rubin held various senior management roles in the computer software industry, including Senior Executive Vice President and Chief Operating Officer of Atari, and President of International Operations and Chief Financial Officer for GT Interactive Software. Mr. Rubin entered the computer software business in 1993 when he became Executive VP for GT Interactive Software as a start-up company, played a leadership role in GT’s progression as the company went public in 1995 and became one of the largest industry players. Prior to 1993, he held various senior financial and general management positions at RCA, GE and NBC. Through his various management roles, Mr. Rubin has developed an in-depth knowledge and experience in strategic development that is key to our growth. Education: He is a graduate of Stanford University and Harvard Business School. Directorships in the past five years: 784 Park Avenue Realty, Inc. (December 2005 to present) and Henmead Enterprises, Inc. (1991 to present). Ziwang Xu. Mr. Xu has served as a director since February 2010. Mr. Xu is currently the Chairman of CXC Capital, Inc. and CXC China Sustainable Growth Fund, companies which he founded in March of 2008 and which are based in Shanghai, China. From November of 2005 until founding CXC, he was a private investor in Shanghai and worked on the development of residential real estate projects. During this same time, he was an Advisory Director for Goldman Sachs in Beijing, China. From 1997 through 2005, he served as a Managing Director and Partner for Goldman Sachs in Hong Kong. He is also currently an Advisor with Clayton, Dubilier & Rice, a member of the Board of Overseers of the Fletcher School of Law and Diplomacy at Tufts University, and Vice Chairman, Alumni Association of Economics and Finance, of Fudan University in Shanghai, China. Additionally, he is a member of the Shanghai Comprehensive Economy Studies Council and the Shanghai International Cultural Council. Mr. Xu’s background in overseas markets and his experience in finance matters have provided him with valuable insights into our strategy. Education: He holds a B.A. from East China Normal University and an M.A. in Economics from Fudan University and an M.A. in International Business from the Fletcher School of Law and Diplomacy at Tufts University. Directorships in the past five years: Shanghai Ruibo New Energy Automobile Technology Company (2010 to present), CXC Capital, Inc. (2008 to present), and Lubao New Energy Company (2007 to present). Charles Brown. Mr. Brown has served as a director since July 2014. Since October 2014, he has served as President and Chief Executive Officer, and a member of the board of directors, of Specified Air Solutions. Mr. Brown served as President and Chief Executive Officer of Flow International, Inc., and as a member of its board of directors, from July 2007 through January 2014, when Flow International was merged with and into Waterjet Holdings, Inc. Previously, Mr. Brown was the President and Chief Operating Officer of the Pump, Pool and Spa Divisions at Pentair, Inc. from April 2005 through October 2006. From August 2003 to February 2005, Mr. Brown was the President and Chief Operating Officer of the Pentair Tools Group (which was acquired by Black & Decker Corporation in 2004). Prior to that, Mr. Brown was the President/General Manager of Aqua Glass Corporation, a Masco Corporation company, from 1996 to August 2003. Mr. Brown brings a broad business and management experience to our Board. Education: He holds a B.A. from Cornell University in Economics and Government and an M.B.A. from J.L. Kellogg Graduate School of Management at Northwestern University. Directorships in the past five years: Specified Air Solutions (October 2014 to present), Flow International (2007-2014) and Waterjet Holdings, Inc. (January 2014 to August 2015). Robert F. Anderson. Mr. Anderson has served as a director since March 2018. Mr. Anderson is a seasoned commercial executive with over 35 years of leading global sales teams for General Electric Corporation and Stewart & Stevenson. Most recently, he served as Vice President, General Electric Packaged Power Inc. and General Manager Fast Power Americas for General Electric from February 2014 to June 2017. Prior to that, he served as General Manager, Global Sales with strategic responsibilities for a worldwide products and services team for GE Aero Energy in their aeroderivative gas turbine product line. In 2010, GE Aero became part of GE Distributed Power and he added General Manager, North America to his responsibilities. Throughout his GE career, he held progressively responsible positions with assignments in Houston, Texas, west Texas and Venezuela. Mr. Anderson brings vast amount of commercial and leadership experience to our Board. Education: He holds a BBA in International Business from the University of Texas and has a Diploma in Spanish Studies from the Universidad Complutense in Madrid, Spain. DeLome Fair. Ms. Fair has served as a director since February 2016. Ms. Fair is also our President and Chief Executive Officer, a position she has held since February 2016 and has also acted in the capacity of the Company’s principal financial officer since May 2017. Ms. Fair joined our executive team in December 2014, as Senior Vice President, Gasification Technology, and in March 2015 was additionally named President of SES Technologies, LLC. Ms. Fair has over 25 years of experience in gasification which spans leadership positions with GE Energy and Chevron/Texaco. Prior to joining us, Ms. Fair led GE Energy’s global team of 135 engineers in the U.S., India and China as General Manager, Gasification & Process Systems Technology. In that post, she was responsible for engineering to GE’s global gasification business, including business development support, execution of customer orders, new product development, services, and project management. Previously, Ms. Fair’s expertise in gasification and IGCC technology led to her appointment as GE’s Chief Consulting Engineer for gasification. Her career has also included serving as Product Line Leader, Licensing Manager, and Technology Manager for gasification in both GE and Chevron/Texaco. Education: Ms. Fair received her M.S. and B.S. in Chemical Engineering from the University of Kansas. Executive Officers and Significant Employees David Hiscocks. Mr. Hiscocks is our Corporate Controller and Corporate Secretary, a position he has held since May 2017. Prior to joining us, he served as Regional Controller-Eastern Hemisphere and Senior Manager of Finance & Administration-New Markets from 2012 to 2016 at Noble Corporation, a worldwide offshore drilling contractor. Prior to Noble, Mr. Hiscocks served in various accounting positions from 1993 to 2012 with Transocean, Inc., a worldwide drilling contractor, and its prior merged companies of GlobalSantaFe Corp. and Santa Fe International Corp. During his tenure there, Mr. Hiscocks served as Country Controller based in Malaysia, Vietnam, Canada, Angola and the various accounting positions in the corporate offices in Dallas and Houston, Texas. Mr. Hiscocks holds a B.A. in Accounting from the University of Northern Iowa. He is a certified public accountant in the State of Texas. Wade Taber. Mr. Taber is our Vice President of Engineering, a position he has held since January 2016 and is responsible for all of our Engineering, Equipment Sourcing and Operations Support for the Company. From 2007 to 2015, Mr. Taber served as Senior Engineering Manager – Components/Technology Innovation for General Electric, where his accomplishments included more than a dozen patented and trade secret innovations in gasification technology. Mr. Taber received GE’s Corporate Engineering Award for his development and commercialization of GE’s Advanced Chromia Refractory, which doubled refractory life for solid feedstock gasification. His previous positions include Senior Application Engineer – Energy Systems/Gasification with Saint-Gobain Ceramics from 1998 to 2007, where he helped to grow Saint-Gobain’s refractories business by over $5 million in a three-year period. Mr. Taber holds a B.S. degree in Ceramic Engineering/Materials Science from the University of Illinois and has completed several advanced leadership programs at The Browne Centre - University of New Hampshire. Section 16(a) Beneficial Ownership Reporting Compliance Section 16(a) of the Exchange Act requires our directors and executive officers, and persons who own more than 5% of our equity securities, to file initial reports of ownership and reports of changes in ownership of our common stock with the SEC and to furnish us a copy of each filed report. To our knowledge, based solely on review of the copies of such reports furnished to us and written representations that no other reports were required, during the fiscal year ended June 30, 2018, our officers, directors and greater than 10% beneficial owners timely filed all required Section 16(a) reports. Material Changes in Director Nominations Process There have not been any material changes to the procedures by which shareholders may recommend nominees to our Board. During the year ended June 30, 2018, the members of the Audit Committee were Ziwang Xu, Harry Rubin, Charles Brown and Denis Slavich who serves as Chairman. The Board has determined that Denis Slavich is an audit committee financial expert under Item 407(d) of Regulation S-K of the SEC. All of the members of the Audit Committee were and are independent within the meaning of Rule 5605 of the NASDAQ Listing Rules. The Audit Committee operates under a written charter adopted by the Board which is available under “Corporate Governance” at the “Investor Center” section of our website at www.synthesisenergy.com. The Audit Committee met eight times during the year ended June 30, 2018. The primary purpose of the Audit Committee is to assist the Board in overseeing: (a) the integrity of our financial statements, (b) our compliance with legal and regulatory requirements, (c) the qualifications and independence of the independent registered public accountants and (d) the performance of our internal auditors (or other personnel responsible for the internal audit function). We have adopted a Code of Business and Ethical Conduct that applies to all of our employees, as well as each member of our Board. The Code of Business and Ethical Conduct is available under “Corporate Governance” at the “Investor Center” section of our website at www.synthesisenergy.com. We intend to post amendments to or waivers from the Code of Business and Ethical Conduct (to the extent applicable to our principal executive officer, principal financial officer or principal accounting officer) at this location on our website. The charters for our Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee and our Code of Business and Ethical Conduct are available under “Corporate Governance” at the “Investor Center” section of our website at www.synthesisenergy.com. Copies of these documents are also available in print form at no charge by sending a request to David Hiscocks, our Corporate Controller and Corporate Secretary, Synthesis Energy Systems, Inc., Three Riverway, Suite 300, Houston, Texas 77056, telephone (713) 579-0600. Item 11. Executive Compensation. Summary Compensation Table The following table provides information concerning compensation paid or accrued during the fiscal years ended June 30, 2018 and 2017 to each person who served as our principal executive officer during the year ended June 30, 2018, and our principal financial officer, to whom we sometimes refer together as our “named executive officers.” Name and Principal Position Year Salary Bonus Non-Equity Incentive Plan Compensation All Other Compensation Total DeLome Fair 2018 $ 266,667 $ — $ — $ 57,500 $ — $ — $ 324,167 President and CEO (2) 2017 $ 333,333 $ 30,750 $ — $ 57,500 $ — $ — $ 421,583 (principal executive and principal financial officer) Chris Raczkowsk 2018 $ 126,044 $ — $ — $ — $ — $ — $ 126,044 President – Asia (3) 2017 $ 54,667 $ — $ — $ 232,833 $ — $ — $ 287,500 David Hiscocks 2018 $ 138,000 $ — $ — $ 13,800 $ — $ — $ 151,800 Corporate Controller (principal 2017 $ 21,635 $ — $ — $ 23,589 $ — $ — $ 45,224 accounting officer)(4) Scott Davis 2018 $ — $ — $ — $ — $ — $ — $ — Former Chief Accounting 2017 $ 171,554 $ — $ 1,386 $ — $ — $ — $ 172,940 Officer and principal financial officer(5) Roger Ondreko 2018 $ — $ — $ — $ — $ — $ — $ — Former Chief Financial Officer 2017 $ 118,173

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SLM Corp - FORM 10-Q - July 24, 2018 EX-32.2 - EXHIBIT 32.2 - SLM Corp slm20180630ex322.htm For the quarterly period ended June 30, 2018 SLM Corporation 300 Continental Drive, Newark, Delaware Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act. (Do not check if a smaller reporting company) If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Outstanding at June 30, 2018 Common Stock, $0.20 par value Defaults Upon Senior Securities Mine Safety Disclosures Available-for-sale investments at fair value (cost of $185,749 and $247,607, respectively) Loans held for investment (net of allowance for losses of $295,277 and $251,475, respectively) Restricted cash Other interest-earning assets Accrued interest receivable Premises and equipment, net Tax indemnification receivable Income taxes payable, net Upromise member accounts Preferred stock, par value $0.20 per share, 20 million shares authorized: Series B: 4 million and 4 million shares issued, respectively, at stated value of $100 per share Common stock, par value $0.20 per share, 1.125 billion shares authorized: 449.4 million and 443.5 million shares issued, respectively Accumulated other comprehensive income (net of tax expense of $7,448 and $1,696, respectively) Total SLM Corporation stockholders’ equity before treasury stock Less: Common stock held in treasury at cost: 14.0 million and 11.1 million shares, respectively See accompanying notes to consolidated financial statements. Interest income: Total interest income Interest expense: Interest expense on short-term borrowings Interest expense on long-term borrowings Total interest expense Less: provisions for credit losses Net interest income after provisions for credit losses Non-interest income: Gains on sales of loans, net Losses on sales of securities, net Losses on derivatives and hedging activities, net Total non-interest income Non-interest expenses: FDIC assessment fees Other operating expenses Acquired intangible asset amortization expense Total non-interest expenses Income before income tax expense Net income attributable to SLM Corporation common stock Basic earnings per common share attributable to SLM Corporation Average common shares outstanding Diluted earnings per common share attributable to SLM Corporation Average common and common equivalent shares outstanding CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Other comprehensive income (loss): Unrealized gains (losses) on investments Unrealized gains (losses) on cash flow hedges Total unrealized gains (losses) Income tax (expense) benefit Other comprehensive income (loss), net of tax (expense) benefit Total comprehensive income CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY Common Stock Shares Preferred Stock Shares Cumulative effect of the adoption of the stock compensation standard amendment Cash dividends: Preferred Stock, Series A ($1.74 per share) Preferred Stock, Series B ($1.39 per share) Redemption of Series A Preferred Stock Dividend equivalent units related to employee stock-based compensation plans Issuance of common shares Stock-based compensation expense Shares repurchased related to employee stock-based compensation plans Reclassification resulting from the adoption of ASU No. 2018-02 Adjustments to reconcile net income to net cash (used in) provided by operating activities: Provisions for credit losses Amortization of brokered deposit placement fee Amortization of ABCP Facility upfront fee Amortization of deferred loan origination costs and loan premium/(discounts), net Net amortization of discount on investments Income on tax indemnification receivable Depreciation of premises and equipment Amortization of acquired intangibles Unrealized losses on derivatives and hedging activities, net Other adjustments to net income, net Increase in accrued interest receivable (Increase) decrease in other interest-earning assets Decrease in tax indemnification receivable Increase in other assets Decrease in income taxes payable, net Increase in accrued interest payable Decrease in payable due to entity that is a subsidiary of Navient Decrease in other liabilities Total adjustments Total net cash used in operating activities Loans acquired and originated Net proceeds from sales of loans held for investment Proceeds from claim payments Net decrease in loans held for investment Purchases of available-for-sale securities Proceeds from sales and maturities of available-for-sale securities Total net cash used in investing activities Brokered deposit placement fee Net increase in certificates of deposit Net increase in other deposits Borrowings collateralized by loans in securitization trusts - issued Borrowings collateralized by loans in securitization trusts - repaid Issuance costs for unsecured debt offering Unsecured debt issued Borrowings under ABCP Facility Repayment of borrowings under ABCP Facility Fees paid on ABCP Facility Redemption of Preferred Stock Series A Preferred stock dividends paid Net increase (decrease) in cash, cash equivalents and restricted cash Cash, cash equivalents and restricted cash at beginning of period Cash, cash equivalents and restricted cash at end of period Cash disbursements made for: Income taxes refunded Reconciliation of the Consolidated Statements of Cash Flows to the Consolidated Balance Sheets: Total cash, cash equivalents and restricted cash NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Dollars in thousands, unless otherwise noted) 1. Significant Accounting Policies The accompanying unaudited, consolidated financial statements of SLM Corporation (“Sallie Mae,” “SLM,” the “Company,” “we,” or “us”) have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) for interim financial information. Accordingly, they do not include all the information and footnotes required by GAAP for complete consolidated financial statements. The consolidated financial statements include the accounts of SLM Corporation and its majority-owned and controlled subsidiaries after eliminating the effects of intercompany accounts and transactions. In the opinion of management, all adjustments considered necessary for a fair statement of the results for the interim periods have been included. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Operating results for the three and six months ended June 30, 2018 are not necessarily indicative of the results for the year ending December 31, 2018 or for any other period. These unaudited financial statements should be read in conjunction with the audited financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2017 (the “2017 Form 10-K”). The consolidated financial statements include the accounts of the Company and its majority-owned and controlled subsidiaries after eliminating the effects of intercompany accounts and transactions. We consolidate any variable interest entity (“VIE”) where we have determined we are the primary beneficiary. The primary beneficiary is the entity which has both: (1) the power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (2) the obligation to absorb losses or receive benefits of the entity that could potentially be significant to the VIE. Recently Issued and Adopted Accounting Pronouncements In November 2016, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2016-18, “Statement of Cash Flows (Topic 230): Restricted Cash.” Whereas restricted cash balances have traditionally been excluded from the statement of cash flows, this ASU requires restricted cash and restricted cash equivalents to be included within the beginning and ending totals of cash, cash equivalents and restricted cash presented on the statement of cash flows for all periods presented. Restricted cash and restricted cash equivalent inflows and outflows with external parties are required to be classified within the operating, investing, and/or financing activity sections of the statement of cash flows, whereas transfers between cash and cash equivalents and restricted cash and restricted cash equivalents should no longer be presented on the statement of cash flows. ASU No. 2016-18 also requires (a) the nature of the restrictions to be disclosed to help provide information about the sources and uses of these balances during a reporting period and (b) a reconciliation of the cash, cash equivalents and restricted cash totals on the statement of cash flows to the related balance sheet line items when cash, cash equivalents, and restricted cash are presented in more than one line item on the balance sheet. The reconciliation can be presented either on the face of the statement of cash flows or in the notes to the financial statements and must be provided for each period that a balance sheet is presented. We adopted the new accounting pronouncement on January 1, 2018, and the adoption did not have a material impact to our statement of cash flows. In February 2018, the FASB issued ASU No. 2018-02, “Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income,” which allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the tax law and tax rate changes under the Tax Cuts and Jobs Act of 2017 (the “Tax Act”) enacted on December 22, 2017. Under the Tax Act, deferred taxes were adjusted to reflect the reduction of the historical corporate income tax rate to the newly enacted corporate income tax rate, which left the tax effects on items within accumulated other comprehensive income stranded at an NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) Significant Accounting Policies (Continued) inappropriate tax rate. This guidance is effective for fiscal years beginning after December 15, 2018, and for interim periods within those fiscal years, with early adoption permitted. We adopted this standard effective January 1, 2018 and recorded a $0.6 million reclass from accumulated other comprehensive income to retained earnings in the first quarter of 2018. The amortized cost and fair value of securities available for sale are as follows: Amortized Cost Estimated Fair Value Available for sale: Utah Housing Corporation bonds Investments (Continued) The following table summarizes the amount of gross unrealized losses for our mortgage-backed securities and Utah Housing Corporation bonds and the estimated fair value for securities having gross unrealized losses, categorized by length of time the securities have been in an unrealized loss position: Less than 12 months 12 months or more As of June 30, 2018: As of December 31, 2017: Our investment portfolio is comprised primarily of mortgage-backed securities issued by Ginnie Mae, Fannie Mae and Freddie Mac, with amortized costs of $72 million, $49 million, and $46 million, respectively, at June 30, 2018. We own these securities to meet our requirements under the Community Reinvestment Act. In the second quarter of 2018, we elected to sell nine securities totaling $41 million to better align the portfolio with the Community Reinvestment Act requirements, and we recognized a $2 million loss upon the sale of those securities. As of June 30, 2018, 75 of the 84 separate mortgage-backed securities in our investment portfolio had unrealized losses, and 35 of the 75 securities in a net loss position were issued under Ginnie Mae programs that carry a full faith and credit guarantee from the U.S. Government. The remaining securities in a net loss position carry a principal and interest guarantee by Fannie Mae or Freddie Mac, respectively. We have the ability and the intent to hold these securities for a period of time sufficient for the market price to recover to at least the adjusted amortized cost of the security. As of December 31, 2017, 62 of the 92 separate mortgage-backed securities in our investment portfolio had unrealized losses, and 31 of the 62 securities in a net loss position were issued under Ginnie Mae programs that carry a full faith and credit guarantee from the U.S. Government. The remainder carried a principal and interest guarantee by Fannie Mae or Freddie Mac, respectively. We also invest in Utah Housing Corporation bonds for the purpose of complying with the Community Reinvestment Act. These bonds are Aa3 rated by Moody’s Investors Service. The amortized cost of the investment on the consolidated balance sheet at June 30, 2018 and December 31, 2017 was $19 million and $20 million, respectively. We have the intent and ability to hold these bonds for a period of time sufficient for the market price to recover to at least the adjusted amortized cost of the security. As of June 30, 2018, the amortized cost and fair value of securities, by contractual maturities, are summarized below. Contractual maturities versus actual maturities may differ due to the effect of prepayments. Year of Maturity The mortgage-backed securities have been pledged to the Federal Reserve Bank (the “FRB”) as collateral against any advances and accrued interest under the Primary Credit lending program sponsored by the FRB. We had $161 million and $218 million par value of mortgage-backed securities pledged to this borrowing facility at June 30, 2018 and December 31, 2017, respectively, as discussed further in Note 6, “Borrowings.” 3. Loans Held for Investment Loans held for investment consist of Private Education Loans, FFELP Loans and Personal Loans. We use “Private Education Loans” to mean education loans to students or their families that are not made, insured or guaranteed by any state or federal government. Private Education Loans do not include loans insured or guaranteed under the previously existing Federal Family Education Loan Program (“FFELP”). We use “Personal Loans” to mean those unsecured loans to individuals that may be used for non-educational purposes. We began acquiring Personal Loans from third parties in the fourth quarter of 2016 and originating Personal Loans in the first quarter of 2018. Our Private Education Loans are made largely to bridge the gap between the cost of higher education and the amount funded through financial aid, government loans and customers’ resources. Private Education Loans bear the full credit risk of the customer. We manage this risk through risk-performance underwriting strategies and qualified cosigners. Private Education Loans may be fixed rate or may carry a variable interest rate indexed to LIBOR. As of June 30, 2018, and December 31, 2017, 73 percent and 77 percent, respectively, of all of our Private Education Loans were indexed to LIBOR. We provide incentives for customers to include a cosigner on the loan, and the vast majority of loans in our portfolio are cosigned. We also encourage customers to make payments while in school. In connection with the separation of Navient Corporation (“Navient”) from SLM (the “Spin-Off”), we retained the right to require Navient to purchase delinquent loans (at fair value) when the borrower has a lending relationship with both us and Navient (“Split Loans”). In the second quarter of 2018, we sold our remaining $43 million portfolio of Split Loans (both current and non-current loans) to Navient and recognized a net gain of $2 million. FFELP Loans are insured as to their principal and accrued interest in the event of default, subject to a risk-sharing level based on the date of loan disbursement. These insurance obligations are supported by contractual rights against the United States. For loans disbursed on or after July 1, 2006, we receive 97 percent reimbursement on all qualifying claims. For loans disbursed after October 1, 1993, and before July 1, 2006, we receive 98 percent reimbursement on all qualifying claims. For loans disbursed prior to October 1, 1993, we receive 100 percent reimbursement on all qualifying claims. Loans Held for Investment (Continued) Loans held for investment are summarized as follows: Private Education Loans: Total Private Education Loans, gross Deferred origination costs and unamortized premium/(discount) Allowance for loan losses Total Private Education Loans, net FFELP Loans Total FFELP Loans, net Personal Loans (fixed rate) Total Personal Loans, net Loans held for investment, net The estimated weighted average life of education loans in our portfolio was approximately 5.3 years and 5.5 years at June 30, 2018 and December 31, 2017, respectively. The average balance and the respective weighted average interest rates of loans in our portfolio are summarized as follows: Average Balance Weighted Average Interest Rate Private Education Loans Total portfolio 4. Allowance for Loan Losses Our provision for credit losses represents the periodic expense of maintaining an allowance sufficient to absorb incurred probable losses in the held-for-investment loan portfolios. The evaluation of the allowance for loan losses is inherently subjective, as it requires material estimates that may be susceptible to significant changes. We believe the allowance for loan losses is appropriate to cover probable losses incurred in the loan portfolios. Allowance for Loan Losses Metrics Three Months Ended June 30, 2018 FFELP Beginning balance Total provision Net charge-offs: Net charge-offs Loan sales(1) Allowance: Ending balance: individually evaluated for impairment Ending balance: collectively evaluated for impairment Loans: Net charge-offs as a percentage of average loans in repayment (annualized)(2) Allowance as a percentage of the ending total loan balance Allowance as a percentage of the ending loans in repayment(2) Allowance coverage of net charge-offs (annualized) Ending total loans, gross Average loans in repayment(2) Ending loans in repayment(2) (1) Represents fair value adjustments on loans sold. (2) Loans in repayment include loans on which borrowers are making interest only or fixed payments, as well as loans that have entered full principal and interest repayment status after any applicable grace period. Allowance for Loan Losses (Continued) Six Months Ended June 30, 2018

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professional_accounting

As of November 05, 2008, there were 34,092,164 shares of our common stock, par value $0.001, outstanding. The Company will continue to focus on projects in the oil and gas industry primarily based in the Rocky Mountains and specifically the Williston Basin Bakken Shale formation. The Company has begun to develop its substantial leasehold in the Bakken play and will continue to do so as well as target additional opportunities in emerging plays utilizing its first mover leasing advantage. We participate on a heads up basis in the drilling of wells on our leasehold. We own working interest in wells, and do not lease land to operators. To this point we have participated only in wells operated by others but have a substantial inventory of high working interest locations that we will likely drill in 2009 and beyond. We believe the advantage gained by participating as a non-operating partner in the 60-70 gross oil wells we will drill in 2008 and early 2009 will give us valuable data on completions and help to control well costs as we begin to develop our high working interest sections in mid-2009. The Company participates on a heads up basis proportionate to its working interest in a declared drilling unit. Although to this point we have participated with only minority interests ranging from 1% to 37%, we expect to participate in the drilling of incrementally higher working interest drilling units, eventually operating our substantial inventory of high working interest drilling units with a range of 40% to 100% ownership. We control approximately 65,000 net acres in the growing North Dakota Bakken Play. This exposes us to 101 net wells based on 640 acre spacing units. To be more specific, if we drill a well and participate with a 25% working interest, this counts towards this total as a quarter of one well. Down spacing in the field will potentially expose us to significantly more wells as development continues on “held by production” acreage. As an independent oil and gas producer, the Company’s revenue, profitability and future rate of growth are substantially dependent on prevailing prices of natural gas and oil. Historically, the energy markets have been very volatile and it is likely that oil and gas prices will continue to be subject to wide fluctuations in the future. A substantial or extended decline in natural gas and oil prices could have a material adverse effect on the Company’s financial position, results of operations, cash flows and access to capital, and on the quantities of natural gas and oil reserves that can be economically produced. As of September 30, 2008 the substantial decline in oil prices has not affected the Company’s financial position in a material amount. this Form 10-Q pursuant to certain rules and regulations of the Securities and Exchange Commission. These financial statements should be read in conjunction with the audited financial statements and notes for the year ended December 31, 2007, which are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. In December 2007, the FASB issued SFAS No. 160 “Noncontrolling Interest in Consolidated Financial Statements – an Amendment of ARB 51” (SFAS 160). SFAS 160 clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. It also requires consolidated net income to be reported at amounts that include the amounts attributable to both the parent and the noncontrolling interest, and requires disclosure, on the face of the consolidated statement of income, of the amounts of consolidated net income attributable to the parent and to the noncontrolling interest. SAFS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. We do not anticipate a material impact upon adoption. In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair value Measurements.” SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. SFAS 157 applies under other accounting pronouncements that require or permit fair value measurements and does not require any new fair value measurements. The provisions of SFAS 157 were originally to be effective beginning January 1, 2008. Subsequently, the FASB provided for a one-year deferral of the provisions of SFAS 157 for non-financial assets and liabilities that are recognized or disclosed at fair value in consolidated financial statements on a non-recurring basis. We are currently evaluating the impact of adopting the provisions of SFAS 157 for non-financial assets and liabilities that are recognized or disclosed on a non-recurring basis. The Company follows the full cost method of accounting for oil and gas operations whereby all costs related to the exploration and development of oil and gas properties are initially capitalized into a single cost center (“full cost pool”). Such costs include land acquisition costs, geological and geophysical evaluation expenses, carrying charges on non-producing properties, costs of drilling directly related to acquisition, and exploration activities. As of September 30, 2008, we controlled approximately 21,354 net acres of leaseholds in Sheridan County, Montana with primary targets including the Red River and Mission Canyon formations, approximately 65,000 net acres, primarily in Mountrail County, North Dakota, targeting the Bakken Shale and 10,000 net acres in Yates County, New York that is prospective for Marcellus Shale and Trenton-Black River natural gas production. See Note 6 for an explanation of activities on these properties. Proceeds from property sales generally will be credited to the full cost pool, with no gain or loss recognized, unless such a sale would significantly alter the relationship between capitalized costs and the proved reserves attributable to these costs. A significant alteration would typically involve a sale of 25% or more of the proved reserves related to a single full cost pool. Capitalized costs of oil and gas properties (net of related deferred income taxes) may not exceed an amount equal to the present value, discounted at 10% per annum, of the estimated future net cash flows from proved oil and gas reserves plus the cost of unevaluated properties (adjusted for related income tax effects). Should capitalized costs exceed this ceiling, impairment is recognized. The present value of estimated future net cash flows is computed by applying period-end prices of oil and natural gas to estimated future production of proved oil and gas reserves as of period-end, less estimated future expenditures to be incurred in developing and producing the proved reserves and assuming continuation of existing economic conditions. Such present value of proved reserves’ future net cash flows excludes future cash outflows associated with settling asset retirement obligations that have been accrued on the Balance Sheet (following SEC Staff Accounting Bulletin No. 106). Should this comparison indicate an excess carrying value, the excess is charged to earnings as an impairment expense. The unamortized cost of the Company’s oil and gas properties did not exceed the ceiling limit as of September 30, 2008. Therefore, the Company was not required to writedown the net capitalized costs of its oil and gas properties at September 30, 2008. Property and equipment that are not oil and gas property are recorded at cost and depreciated using the straight-line method over their estimated useful lives of three to five years. Expenditures for replacements, renewals, and betterments are capitalized. Maintenance and repairs are charged to operations as incurred. Long-lived assets, other than oil and gas properties, are evaluated for impairment to determine if current circumstances and market conditions indicate the carrying amount may not be recoverable. We have not recognized any impairment losses on non oil and gas long-lived assets. Depreciation expense was $33,713 for the nine months ended September 30, 2008. Our cash positions represent assets held in checking and money market accounts. These assets are generally available to us on a daily or weekly basis and are highly liquid in nature. Due to the balances being greater than $250,000, we do not have FDIC coverage on the entire amount of bank deposits. The Company believes this risk is minimal. In addition we are subject to SIPC protection on a vast majority of our financial assets, specifically $6,717,245 of cash and cash equivalents and all of our long-term investments. The Company uses derivative instruments from time to time to manage market risks resulting from fluctuations in the prices of oil and natural gas. The Company may periodically enter into derivative contracts, including price swaps, caps and floors, which require payments to (or receipts from) counterparties based on the differential between a fixed price and a variable price for a fixed quantity of oil or natural gas without the exchange of underlying volumes. The notional amounts of these financial instruments would be based on expected production from existing wells. The Company has, and may continue to use exchange traded futures contracts and option contracts to hedge the delivery price of oil at a future date. flow hedge transactions in which the Company is hedging the variability of cash flows related to a forecasted transaction. Period to period changes in the fair value of derivative instruments designated as cash flow hedges are reported in other comprehensive income and reclassified to earnings in the periods in which the contracts are settled. The ineffective portion of the cash flow hedges is recognized in current period earnings as income or loss from derivative. Gains and losses on derivative instruments that do not qualify for hedge accounting are included in income or loss from derivative in the period in which they occur. The resulting cash flows from derivatives are reported as cash flows from operating activities. The Company accounts for income taxes under FASB Statement No. 109, Accounting for Income Taxes. Deferred income tax assets and liabilities are determined based upon differences between the financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. FASB Statement No. 109 requires the consideration of a valuation allowance for deferred tax assets if it is “more likely than not” that some component or all of the benefits of deferred tax assets will not be realized. As of September 30, 2008, the Company maintains a full valuation allowance for all deferred tax assets. We recognize oil and gas revenues from our interests in producing wells when production is delivered to, and title has transferred to, the purchaser and to the extent the selling price is reasonably determinable. We use the sales method of accounting for gas balancing of gas production and would recognize a liability if the existing proven reserves were not adequate to cover the current imbalance situation. As of September 30, 2008 and December 31, 2007, our gas production was in balance, i.e., our cumulative portion of gas production taken and sold from wells in which we have an interest equaled our entitled interest in gas production from those wells. Diluted earnings per share is computed using the weighted average number of common shares plus dilutive common share equivalents outstanding during the period using the treasury stock method. they continue to pay interest at various rates. We also have the ability to borrow up to 75% of the loan-to-market value of eligible auction rate securities on a no-net cost basis. In September 2007, we commenced a continuous lease program with South Fork Exploration, LLC. (“SFE”) to acquire acreage in and around Burke and Divide Counties of North Dakota. As of September 30, 2008, the Company has paid SFE $615,600 for all acreage secured under the program. SFE’s president is J.R. Reger, brother of Michael Reger, the Company’s Chief Executive Officer. J.R. Reger is also a shareholder in the Company. On January 18, 2008, Montana Oil Properties, Inc. (“MOP”) assigned to the Company leases covering approximately 1,600 net acres in Mountrail County, North Dakota. The total purchase price for this assignment is $800,000 in cash and 30,000 shares of restricted common stock. As of June 30, 2008, MOP delivered an additional 885 acres. The total purchase price for this assignment was $442,291 in cash and 16,587 shares of restricted stock. The principals of MOP are Mr. Steven Reger and Mr. Tom Ryan, both are relatives of our Chief Executive Officer, Michael Reger. On February 15, 2008, the Company entered into an agreement to acquire from Antares Exploration Fund, L.P. (“Antares”), leasehold interests covering up to 5,700 net acres in Mountrail County, North Dakota for an aggregate purchase price of $5,700,000. On April 14, 2008, we entered into an Agreement setting forth a land bank arrangement with Deephaven MCF Acquisition, LLC (“Deephaven”), an affiliate of Deephaven Capital Management, LLC. On April 14, 2008, pursuant to the land bank arrangement, Deephaven closed on the acquisition from Antares of leases covering 5,132 net acres for the Company's benefit, which leases can then be acquired by the Company at any time during the initial year that Deephaven owns such leases. On April 14, 2008 and June 26, 2008, the Company closed on the purchase directly from Antares of an additional 277 net acres and 223 net acres in Mountrail County, North Dakota, respectively. The foregoing transactions have resulted in the Company controlling an aggregate of 5,632.99 net acres purchased from Antares pursuant to the February 15, 2008 agreement. On September 26, 2008, the Company negotiated an amendment of certain terms of the February 15, 2008 land bank agreement altering the structure of the agreement in the Company’s favor. On May 21, 2008, the Company entered into an agreement to acquire from Ritter, Laber & Associates, Inc. leasehold interest on approximately 3,209 net acres in Mountrail and Burke Counties, North Dakota. On July 1, 2008, the Company closed on this acquisition. The total purchase price for this assignment was $3,049,367 in cash. On June 13, 2008, the Company entered into an agreement to acquire from Woodstone Resources, LLC leasehold interests on approximately 23,210 net acres in Dunn County, North Dakota. On July 10, 2008, the Company closed on this acquisition. The total purchase price for this assignment was $9,284,000 in cash. In April, June, and July 2008 4,818,186 shares were issued related to the exercise of warrants issued in 2007. In March 2008, the Company issued 20,000 shares of restricted common stock to employee James Sankovitz pursuant to a written employment agreement. The issuance of restricted stock is intended to retain and motivate the employee. The fair value of the award was $140,500 or $7.03 per share, the average market value of a share of Common Stock on the date the stock was issued. The fair value will be expensed over the one-year term of the award. The Company expensed $35,125 related to this award in the quarter ended September 30, 2008. Vesting of the shares is contingent on the employee maintaining employment with the Company and other restrictions included in the employment agreement. materially affect the fair value estimate. The total fair value of the options will be recognized as compensation over the service period (see Note 2 for calculation of fair value). The Company received no cash consideration for these option grants. There have be no stock options granted in 2008 under the 2006 Stock Option Plan, and all exercises of options during 2008 related to prior period grants. 260,000 options were exercised in the nine months ended September 30, 2008. No options were forfeited or granted during the nine months ended September 30, 2008. 400,000 options are exercisable and outstanding as of September 30, 2008. The Company recorded compensation expense related to these options of $2,366,417 for the year ended December 31, 2007. There is no further compensation expense that will be recognized in future years relating to options that had been granted as of September 30, 2008, because the entire fair value compensation has been recognized. The Company held derivative positions in the form of written call options that were not designated as hedges. These positions were entered into as investment vehicles. Also, futures contracts that cannot be matched with production for cash flow hedges were included as investment vehicles. The following table reflects open commodity derivative contracts at September 30, 2008, the associated volumes and the corresponding weighted average NYMEX reference price. The following schedule summarizes the valuation of financial instruments measured at fair value on a recurring basis in the balance sheet as of September 30, 2008. The current asset amounts represent the fair values expected to be included in the results of operations in December 2008. Level 3 assets consist of municipal bonds and floating rate preferred stock (see Note 4) with an auction reset feature (“auction rate securities” or ARS). The underlying assets for the municipal bonds are student loans which are substantially backed by the federal government. Auction-rate securities are long-term floating rate bonds or floating rate perpetual preferred stock tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates based on mathematical formulas in accordance with each security's prospectus. In February 2008, auctions began to fail for these securities and each auction since then has failed. Consequently, the investments are not currently liquid. In the event the Company needed to access these funds, they are not expected to be accessible until one of the following occurs: a successful auction occurs, the issuer redeems the issue, a buyer is found outside of the auction process or the underlying securities mature. In October 2008, the Company received an offer (the “Offer”) from UBS AG (“UBS”), one of its investment providers, to sell at par value auction-rate securities originally purchased from UBS ($3,550,524) at anytime during a two-year period beginning June 30, 2010. The Offer is non-transferable and expires on November 14, 2008. On October 28, the Company elected to participate in the Offer. Based on this, along with the underlying maturities of the securities, a portion of which is greater than 30 years, we have classified auction rate securities as long-term assets on our balance sheet. In addition to the Offer, UBS is providing no net cost loans up to 75% of the loan-to-market value of eligible auction rate securities until June 30, 2010. Typically, the fair value of ARS investments approximates par value due to the frequent resets through the auction process. While the Company continues to earn interest on its ARS investments at the contractual rate, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated fair value of the ARS no longer approximates par value. At September 30, 2008, the Company’s investment advisors provided a valuation based on Level 3 inputs for the ARS investments. The investment advisors utilized a discounted cash flow approach to arrive at this valuation. The assumptions used in preparing the discounted cash flow model include estimates of, based on data available as of September 30, 2008, interest rates, timing and amount of cash flows, credit and liquidity premiums, and expected holding periods of the ARS. These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change. Based on this Level 3 valuation, the Company valued the ARS investments at $3,320,975, which represents a decline in value of $229,549 from par. Based on the cash balance of $6,772,167, the expected positive operating cash flows, and the Company’s ability to obtain no net cost loans up to 75% of the loan-to-market value, as determined by UBS, on eligible auction rate securities, the Company does not anticipate the current inability to liquidate the auction rate securities to adversely affect the Company’s ability to conduct its business. In October 2008, the Company received an Offer from UBS, one of its investment providers, to sell at par value auction-rate securities originally purchased from UBS ($3,550,524) at anytime during a two-year period beginning June 30, 2010. The Offer is non-transferable and expires on November 14, 2008. On October 28, the Company elected to participate in the Offer. The following updates information as to our financial condition and plan of operation provided in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007. The following also analyzes our results of operations for nine month periods ended September 30, 2008 and September 30, 2007. We are a growth-oriented independent energy company engaged in the acquisition, exploration, exploitation and development of oil and natural gas properties, and have focused our activities primarily on projects based in the Rocky Mountain Region of the United States, specifically the Williston Basin. We have targeted specific prospects and began drilling for oil in the Williston Basin region in the fourth fiscal quarter of 2007. As of November 4, 2008, we have completed 28 successful discoveries, consisting of 26 targeting the Bakken formation and 2 targeting a Red River Structure. As of November 6, 2008, we are participating in the drilling of 15 Bakken and Three Fork/Sanish wells. As of November 6, 2008, approximately 170 sections containing Northern’s acreage has been included in permitted or docketed-for-permit drilling locations. The Company participates on a heads up basis proportionate to its working interest in a declared drilling unit. More specifically, we pay for the drilling costs based on our working interest percentage and receive revenue from the oil and gas production based on the working interest percentage, minus landowner royalties, which typically range from 12% to 20%. Although to this point we have participated with only minority interests ranging from 1% to 37%, we expect to participate in the drilling of incrementally higher working interest drilling units, eventually operating our substantial inventory of high working interest drilling units with a range of 40% to 100% ownership. We control approximately 65,000 net acres in the growing North Dakota Bakken Play. This exposes us to 101 net drilling locations based on 640 acre spacing units. To be more specific, if we drill a well and participate with a 25% working interest, this counts towards the total as a quarter of one well. We control approximately 68 spacing units where we own in excess of 40% of the acreage, this gives us a substantial inventory of potential drilling locations that we could drill and operate on our own timing. To drill our complete inventory of 101 net drilling locations we expect to participate in approximately 450 gross wells. As of November 6, 2008, we have developed approximately 2% of our North Dakota Bakken position. We expect to participate in approximately 60 gross oil wells in 2008 and very early 2009 with an average working interest of 8% yielding approximately four net wells. Based on the current pace of development, we expect to fully hold our Bakken acreage by production by 2011. Subsequent to this, we expect down spacing to yield significantly more net oil wells. We expect our position to have the potential to yield approximately 50 million gross barrels of oil. This is based on assumptions of 101 net wells and 500,000 barrels of recoverable oil per well. Operators have stated a range of approximately 250,000 to 900,000 barrels of recoverable oil. Our assumption of 500,000 barrels of recoverable oil per well was derived from reported results from our operating partners and reservoir engineering data from our producing wells. The pace of development and our assumptions are subject to change and it is possible that results may not be as favorable as we expect. However we may also experience substantially higher reserves due to secondary recovery and enhanced completion techniques. Based on currently planned wells, we expect to exit 2008 at a run rate of approximately 1,100 gross barrels of daily oil production. After paying landowner royalties ranging from 12% to 20% this equates to approximately 900 barrels of daily production net to us. At $65 dollar oil prices, our target exit rate of 900 barrels per day will produce a run rate of approximately $21 million in annualized cash flows entering 2009 if we were to stop drilling. We expect this number to grow substantially through 2009 as we continue to add production. Any fluctuation in the per barrel price of oil, the actual daily production from our wells or the number of wells in production entering 2009 would correspondingly increase or decrease our actual annualized cash flow at any point in time. For instance, in the event that the price of oil decreases by ten percent from $65 per barrel, our annualized cash flows entering 2009 would equal approximately $19.2 million. Conversely, in the event that the price of oil increases by ten percent from $65 per barrel, our annualized cash flows entering 2009 would equal approximately $23.4 million. We have also completed other miscellaneous, non material, acreage acquisitions in North Dakota and Montana. Results of Operations for the fiscal year ended December 31, 2007 and the nine months ended September 30, 2008. The Company is in the early stage of developing its properties in Montana, North Dakota and New York. During the fiscal year ended December 31, 2007, our operations were limited primarily to technical evaluation of the properties and the design of development plans to exploit the oil and gas resources on those properties, as well as seeking opportunities to acquire additional oil and gas properties. Accordingly, we had minimal production due to our wells commencing production near the end of the fourth quarter of 2007. We completed drilling of our first wells and began selling limited quantities of oil and gas in the fourth quarter of 2007. In the first three quarters of 2008, we increased production and expect to continue to grow production consistently throughout the remainder of 2008. As of September 30, 2008, we recognized production revenues from 23 wells, of which twelve wells are located in Mountrail County, North Dakota, nine wells are located in Dunn County, North Dakota and two wells are located in Sheridan County, Montana. Subsequent to quarter end, we added production from an additional five wells in the Bakken formation. Our third quarter revenue has increased approximately 80 % over the second quarter of 2008. We did not recognize any oil and gas revenues for the twelve months ended December 31, 2007. We realized our first meaningful revenues from production late in the quarter ended March 31, 2008, as we were able to establish commercial production in connection with new drilling activities commenced in 2007. Revenues from oil and gas sales in the quarter ended September 30, 2008 were $1,362,655, compared to $764,528 in the quarter ended June 30, 2008. Our average realized sales price for oil produced during the quarter ended September 30, 2008 was approximately $103.50 per barrel, compared to approximately $120.12 per barrel in the quarter ended June 30, 2008. We expect that our revenues will continue to increase quarter-over-quarter for the fourth quarter of 2008 as we continue to drill new wells and establish commercial production from our existing and new wells. Each fiscal quarter we continue to realize increased oil and natural gas volumes from wells put into production in prior fiscal quarters as well as additional wells drilled or completed in the current quarter. expect operating costs to continue to increase as we proceed with our development plans. In the future we expect to incur increased geologic, geophysical, engineering and other personnel related costs. We realized net income of $871,819 for the quarter ended September 30, 2008 and net income of $968,007 for the nine months ended September 30, 2008, compared to a net loss of $4,305,293 for the fiscal year ended December 31, 2007, a net loss of $187,277 for the quarter ended March 31, 2008, net income of $283,465 for the quarter ended June 30, 2008 and net income of $96,188 for the six months ended June 30, 2008. Approximately $500,000 of the loss experienced during the fiscal year ended December 31, 2007 consisted of a cash expense, and the balance was related to share issuance costs which are expected to decrease substantially in 2008. Approximately $125,546 of the loss experienced during the quarter ended March 31, 2008 consisted of cash expenses, and the balance was related to share issuance costs. We expect the cash general and administrative expenses to run approximately $500,000 per quarter going forward, excluding any one-time charges. In the quarter ended March 31, 2008, we began selling meaningful amounts of oil from wells that became operational in the fourth quarter of 2007. In the quarter ended June 30, 2008, we continued to realize additional sales of oil from wells that were productive during the prior fiscal quarter and began selling meaningful amounts of oil from additional wells that became operational during the second fiscal quarter. We continued that trend during the quarter ended September 30, 2008, as evidenced by a quarter-over-quarter increase in our net income. We expect our revenue to continue to increase along with our oil production as we continue to participate in additional wells during the fourth quarter of 2008. We realized production revenues totaling $1,029,892 from 21 wells in North Dakota during the quarter ended September 30, 2008, of which 13 wells came into production during the third fiscal quarter of 2008. As of September 30, 2008, we capitalized approximately $6,438,437 in acreage, drilling and future drilling costs for these wells. We realized production revenues totaling $332,763 from 2 wells in Montana during the quarter ended September 30, 2008. Both of these wells were productive throughout the third quarter of 2008. As of September 30, 2008, we capitalized approximately $707,743 in acreage, drilling and future drilling costs for these wells. The following table illustrates selected operational data for the quarter ended September 30, 2008 compared to the quarter ended June 30, 2008. Our depletion expense is driven by many factors including certain exploration costs involved in the development of producing reserves, production levels and estimates of proved reserve quantities and future developmental costs at the end of the first three fiscal quarters of 2008. During the fourth quarter of the fiscal year ended December 31, 2007, we commenced in earnest the development of our oil and gas properties in conjunction with our drilling partners. These activities continued to build in the first three quarters of fiscal year 2008, and are anticipated to continue to grow throughout the fourth quarter of 2008 and beyond. The Company has several projects that are in various stages of discussions and is continually evaluating oil and gas opportunities in the Continental United States. We will continue to participate on a heads-up basis in the continuing development of our substantial Bakken acreage holdings. We do not typically lease land to operators or dilute working interest. We own our proportionate share of wells and we will continue to develop higher working interest sections going forward. We will continue to acquire acreage in the play as it may become available as well as continually evaluate additional opportunities both in the Bakken and beyond. As of September 30, 2008, we had completed 23 successful discoveries, compared to ten successful discoveries completed as of June 30, 2008 and six successful discoveries completed as of March 31, 2008. As of November 6, 2008, we have completed an additional five wells, for a total of 28 successful discoveries. As of November 6, 2008, we are participating in the drilling of 15 additional wells, all of which are expected to commence production in the fourth calendar quarter of 2008. Approximately 170 sections containing NOG acreage have been permitted or docketed for permit as of November 6, 2008. We expect most, if not all, of these wells and potentially more will be drilled throughout 2009, although we have no control over the timing of such wells in our position as a non-operator in these particular wells. In addition to the proposed drilling locations, we are making preparations to drill wells on some of our high working interest locations, potentially ranging up to 100% working interest. Upon full development of our North Dakota acreage position, we anticipate that we will be able to drill up to 101 net wells based on 640-acre spacing. In the event the Bakken field continues to be down spaced to 320-acre units, we could control as many as 203 net Bakken wells. EOG Resources previously announced calculations of 9 million barrels of oil in place per 640-acre section in the Parshall Field, of which they believe they will recover 900,000 barrels with a single lateral well. Based on a number of 500,000 barrels of recoverable oil per well, conservative relative to the EOG estimates, we may be exposed to approximately 50 million gross barrels of oil based on 640 acre spacing, excluding the Brigham joint venture acreage. On continued down spacing to 320 acre drilling units, we could be exposed up to a potential 100 million barrels of oil. In addition we believe significant amounts of oil may be recoverable from a second producing reservoir in the Three Forks/Sanish formation, this formation has the potential to increase reserves and productivity significantly. We are currently participating in four wells operated by Continental Resources and have several planned that will be targeting this formation. With the addition of the Three Forks/Sanish formation, our potential reserves may increase substantially. Brigham continues to drill on it. Should Brigham let 120 days pass without the spud of a new well the joint venture shall terminate. On April 23, 2007 we entered into a joint venture agreement with Brigham Exploration. Under the terms of the agreement, we contributed 3,000 net acres of our approximate 65,000 net acres located in North Dakota and approximately 21,350 net acres of our Sheridan County, Montana acreage. On the Sheridan County, Montana acreage, we successfully completed the Richardson #25, a Red River test well that went on production at a consistent rate of approximately 300 barrels of oil per day. The Company participated for a 10% working interest that converts to 37% working interest at payout, which occurred in the third fiscal quarter of 2008. We did not recognize any revenue from these wells in 2007. We also completed the Richardson #30 in late June 2008, an offset to the productive Richardson #25 Red River Well. The Richardson #30 began production at a rate of approximately 175 barrels of oil per day. The Company participated for a 12.5% working interest that converts to 21.25% working interest at payout as well as retaining a 1% over-riding royalty interest. Commencing in 2008, Brigham is subject to a 120 day continuous drilling provision requiring Brigham to drill every 120 days to retain future drilling opportunity. Under the joint venture acreage in Mountrail County North Dakota, Brigham expects to operate a third Bakken well that will spud in late December 2008. On the Sheridan county acreage, Brigham expects to drill a third conventional well expected to spud in early 2009. In the second quarter of 2008, our acreage was included in the Rick Clair 25-36H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 1400 gross barrels of oil per day. In the second quarter of 2008, we participated with Whiting Oil & Gas in the Braaflat 11-11H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 1600 gross barrels of oil per day. In the third quarter of 2008, we participated with Whiting Oil & Gas in the Federal 11-9H, a horizontal Bakken well in Mountrail County North Dakota. In the second quarter of 2008, we participated with Sinclair Oil in the Nelson 1-26H a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 750 gross barrels of oil per day. In the second quarter of 2008, we participated with Slawson Exploration in the Pathfinder 1-9H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 1,500 gross barrels of oil per day. In the third quarter of 2008, we participated with Slawson Exploration in the Prowler 1-16H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 950 gross barrels of oil per day. We participated in the Payara 1-21H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 622 gross barrels of oil per day. We participated in the Voyager 1-18H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 929 gross barrels of oil per day. On October 30, 2008, we executed a drilling agreement with Slawson Exploration covering certain of our acreage in Mountrail County, North Dakota for a one-well drilling arrangement. Under that agreement, we agreed to sell 120 net acres in Section 5, Township 151 North, Range 92 West for $3,000 per net acre. Once the transaction is complete, we will control a 42% working interest in the section. The Jericho 1-5H well, expected to be drilled pursuant to the agreement, will be a horizontal Bakken well drilled in the 640 acre section. The agreement is conditioned on Slawson commencing drilling by March 1, 2009. In the fourth quarter of 2007, we participated with Marathon Oil for a 3% working interest in the Reiss 34 20H, a horizontal Bakken well in Dunn County North Dakota that produced at an early rate of 700 gross barrels of oil per day. In the second quarter of 2008, we participated with Marathon Oil in the Kent Carlson 24-36H , a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 450 gross barrels of oil per day. We participated in the Clive Pelton 34-23H, a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 650 gross barrels of oil per day. We participated in the Eckelberg 41-26H, a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 650 gross barrels of oil per day. In the third quarter of 2008, we participated with Marathon Oil in the Strommen 14-8H , a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 632 gross barrels of oil per day. We participated in the Voigt 11-15H, a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 550 gross barrels of oil per day. We participated with Marathon Oil in the Willard Kovaloff 21-1H, a horizontal Bakken well located in Dunn County North Dakota that produced at an early rate of 695 gross barrels of oil per day. The Marathon Oil program is an excellent example of how we attempt to participate in wells with a small working interest in order to accumulate data as the completion techniques continue to evolve. In the second quarter of 2008, we participated with Burlington Resources in the Bonney 34-3H, a horizontal Bakken well in Dunn County North Dakota that produced at an early rate of 400 gross barrels of oil per day. In the third quarter of 2008, we participated with Hess in the EN-Person 1102H-1, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 950 gross barrels of oil per day. We participated with Hess in the RS-Agribank 1102-H1, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 950 gross barrels of oil per day. We participated with Hess in the EN-Neset 0706H-1, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 550 gross barrels of oil per day. We participated with Hess in the BL-Blanchard 155-96, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 650 gross barrels of oil per day. In the third quarter of 2008, we participated with EOG Resources in the Wayzetta 1-13H, a horizontal Bakken well in Mountrail County North Dakota that produced at an early rate of 1,355 gross barrels of oil per day. In the third quarter of 2008, we participated with Continental Resources in the Shonna 1-15H, a horizontal Bakken well in Divide County North Dakota that produced at an early rate of 403 gross barrels of oil per day. We participated with Continental Resources in the Arvid 1-35H, a horizontal Bakken well in Divide County North Dakota. Liquidity is a measure of a company’s ability to meet potential cash requirements. We have historically met our capital requirements through the issuance of common stock and by short term borrowings. In the future, we anticipate we will be able to provide the necessary liquidity by the revenues generated from the sales of our oil and gas reserves in our existing properties. The following table summarizes total current assets, total current liabilities and working capital at March 31, 2008, June 30, 2008 and September 30, 2008. In addition to our September 30, 2008 working capital amount of $4,164,086, we have the ability to borrow, on a no-net cost basis, up to 75% of the market value of our auction rate securities. We continued to participate in the drilling of our acreage at an accelerated pace in the quarter ended September 30, 2008, and expect that trend to continue into 2009. If drilling activities accelerate at a rate that exceeds our receipt of revenues from producing wells, we will require additional capital to finance future drilling activities through equity and/or debt financings. We are presently pursuing potential debt financing arrangements to address this potential need, but cannot be certain that such arrangements will be available on terms acceptable to the Company. The recent financial and banking crisis in the United States has limited access to capital for many companies, but we cannot be certain the extent to which those conditions will impact our future financing activities. In the event that we are not able to obtain debt or equity financing on terms acceptable to us, we may utilize “farm-out” and other arrangements that will allow us to generate additional capital through sales or leases of select portions of our acreage. In any event, however, we would at a minimum retain an overriding royalty interest that would ensure the Company realizes revenues from any properties sold or leased using such arrangements. We do expect to have access to the necessary capital to continue to drill our locations in the manner we have to this point. We currently are funded to meet our minimum drilling commitments and expected general and administrative expenses for the next 12 months. However, we anticipate accelerating the drilling of higher working interest units which will require additional capital. On April 14, 2008, we entered into an Agreement setting forth a land bank arrangement with Deephaven MCF Acquisition, LLC (“Deephaven”), an affiliate of Deephaven Capital Management LLC, pursuant to which the Company could acquire leases having an aggregate value of up to $8.1 million. Under the arrangement, Deephaven acquired certain qualifying leases in the Bakken Shale formation in Mountrail County, North Dakota, which leases could be acquired by the Company at any time during the initial year that Deephaven owns such leases. cash, capital stock or other consideration of any form will be due from the Company to Deephaven following Deephaven’s receipt of the agreed-upon cash payment and shares of common stock. The Second Amendment also terminated the Registration Rights Agreement By and Among Northern Oil and Gas, Inc. and Deephaven MCF Acquisition LLC dated April 14, 2008 and a prior Amendment extending the initial option period under the Agreement. The Second Amendment provides, however, that the Company is required to file a registration statement on Form S-3 registering the shares of common stock issued to Deephaven no later than December 25, 2008. As of September 30, 2008, we received gross proceeds of approximately $25,982,072.75 from the exercise of outstanding warrants previously issued in connection with the Company’s September 2007 institutional private placement. The warrants resulted in the issuance of an aggregate of 4,818,187 shares of the Company’s common stock, par value $0.001. In or around September 2007, we began purchasing municipal bonds and floating rate preferred stock with an auction reset feature (“auction rate securities” or ARS). The underlying assets for the municipal bonds are student loans which are substantially backed by the federal government. Auction-rate securities are long-term floating rate bonds or floating rate perpetual preferred stock tied to short-term interest rates. After the initial issuance of the securities, the interest rate on the securities is reset periodically, at intervals established at the time of issuance (primarily every twenty-eight days), based on market demand for a reset period. Auction-rate securities are bought and sold in the marketplace through a competitive bidding process often referred to as a “Dutch auction”. If there is insufficient interest in the securities at the time of an auction, the auction may not be completed and the rates may be reset to predetermined “penalty” or “maximum” rates based on mathematical formulas in accordance with each security's prospectus. In February 2008, auctions began to fail for these securities and each auction since then has failed. Consequently, the investments are not currently liquid. In the event the Company needed to access these funds, they are not expected to be accessible until one of the following occurs: a successful auction occurs, the issuer redeems the issue, a buyer is found outside of the auction process or the underlying securities mature. In October 2008, the Company received an offer (the “Offer”) from UBS AG (“UBS”), one of its investment providers, to sell at par value auction-rate securities originally purchased from UBS for $3,550,524 at anytime during a two-year period beginning June 30, 2010. The Offer is non-transferable and expires on November 14, 2008. On October 28, the Company elected to participate in the Offer. Based on that decision, along with the underlying maturities of the securities, a portion of which is greater than 30 years, we have classified auction rate securities as long-term assets on our balance sheet. In addition to the Offer, UBS is providing no net cost loans of up to 75% of the loan-to-market value of eligible auction rate securities until June 30, 2010. UBS has agreed to allow the Company to borrow, on a no net cost basis up to 75% of the loan-to-market value, as determined by UBS. Typically, the fair value of ARS investments approximates par value due to the frequent resets through the auction process. While the Company continues to earn interest on its ARS investments at the contractual rate, these investments are not currently trading and therefore do not have a readily determinable market value. Accordingly, the estimated fair value of the ARS no longer approximates par value. At September 30, 2008, the Company’s investment advisors provided a valuation based on certain inputs for the ARS investments. The investment advisors utilized a discounted cash flow approach to arrive at this valuation. The assumptions used in preparing the discounted cash flow model include estimates of, based on data available as of September 30, 2008, interest rates, timing and amount of cash flows, credit and liquidity premiums, and expected holding periods of the ARS. These assumptions are volatile and subject to change as the underlying sources of these assumptions and market conditions change. Based on this valuation, the Company valued the ARS investments at $3,320,975, which represents a decline in value of $229,549 from par. terms, the underlying securities have matured or the Company accepts the investment manager’s offer to redeem the securities. As of September 30, 2008, we had four executive-level full-time employees and one administrative employee. As drilling production activities commence, we may hire additional technical, operational and administrative personnel as appropriate. We do not expect a significant change in the number of full time executive employees over the next 12 months. We are using, and will continue to use, extensively the services of independent consultants and contractors to perform various professional services, particularly in the area of land services, reservoir engineering, drilling, water hauling, pipeline construction, well design, well-site monitoring and surveillance, permitting and environmental assessment. We believe that this use of third-party service providers may enhance our ability to contain general and administrative expenses. defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) pursuant to Rule 13a-15(b) under the Exchange Act. Based upon and as of the date of the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that information required to be disclosed is recorded, processed, summarized and reported within the specified periods and is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, to allow for timely decisions regarding required disclosure of material information required to be included in our periodic SEC reports. Based on the foregoing, our management determined that our disclosure controls and procedures were effective as of September 30, 2008. There were no changes in our internal control over financial reporting that occurred during the three months ended September 30, 2008, that materially affected or are reasonably likely to materially affect our internal control over financial reporting. From time to time we may be engaged in certain legal proceedings and claims arising in the ordinary course of our business. The ultimate liabilities, if any, which may result from these or other pending or threatened legal actions against us cannot be determined at this time. However, in the opinion of management, the facts known at the present time do not indicate that such litigation will have a material effect on our consolidated financial position or results of operations. On June 30, 2008, we provided notice to all holders of the remaining outstanding warrants to purchase shares of our common stock exercisable for $6.00 per share indicating that the Company determined to call such warrants for cancellation pursuant to the terms of such warrants. Between July 1, 2008 and July 21, 2008, the Company received additional gross proceeds of $10,400,004 from the exercise of such warrants, which had been issued in connection with the Company’s September 2007 institutional private placement. The warrants resulted in the issuance of an aggregate of 1,733,334 shares of the Company’s common stock. The Company believes the issuance of the shares upon exercise of the warrants was exempt from the registration and prospectus delivery requirements of the Securities Act by virtue of Section 4(2) and Rule 506 of Regulation D promulgated by the United States Securities and Exchange Commission (the “SEC”). As of September 30, 2008, all outstanding warrants to purchase shares of the Company’s common stock had been exercised by the holders thereof, and no outstanding warrants remained available for exercise. On September 26, 2008, we issued 2,558 shares of restricted common stock to MOP as partial consideration for our acquisition of leases covering acreage in Mountrail County, North Dakota pursuant to an agreement dated January 17, 2008. The shares were issued pursuant to the exemption from registration provided in Section 4(2) of the Securities Act. The principals of MOP are Mr. Steven Reger and Mr. Tom Ryan, both are uncles of our Chief Executive Officer, Michael Reger. The issuance of the foregoing shares of common stock was approved by our Audit Committee, which consists of independent directors having no relation to the principals of MOP. We did not receive any proceed from the issuance of the foregoing securities. On September 26, 2008, we issued 7,675 shares of restricted common stock to Missouri River Royalty Corporation as consideration for our acquisition of well interests in certain wells proposed for drilling in McKenzie County and Mountrail County of North Dakota pursuant to an agreement dated June 19, 2008. The shares were issued pursuant to the exemption from registration provided in Section 4(2) of the Securities Act. We did not receive any proceed from the issuance of the foregoing securities. provided in Section 4(2) of the Securities Act. We did not receive any proceed from the issuance of the foregoing securities.

{'timestamp': '2019-04-23T22:18:02Z', 'url': 'https://ir.northernoil.com/sec-filings/all-sec-filings/content/0001104485-08-000052/form10q_093008.htm', 'language': 'en', 'source': 'c4'}

professional_accounting

Levi Strauss & Co. Announces Fourth-Quarter & Fiscal-Year 2016 Financial Results Full Year Revenue up 1% Reported and 3% Constant Currency Full Year Net Income up 40%; Operating Cash Flow up 41%; Free Cash Flow Doubles February 09, 2017 03:00 PM Eastern Standard Time SAN FRANCISCO--(BUSINESS WIRE)--Levi Strauss & Co. (LS&Co.) announced financial results today for the fourth quarter and fiscal year ended November 27, 2016. Three Months Ended Fiscal Year Ended ($ millions) November 27, 2016 November 29, 2015 November 27, 2016 November 29, 2015 Net revenues $ 1,299 $ 1,285 $ 4,553 $ 4,495 Net income attributable to LS&Co. $ 96 $ 101 $ 291 $ 209 Adjusted EBIT $ 146 $ 168 $ 480 $ 479 Net revenues grew one percent on a reported basis in the fourth quarter and grew two percent excluding $6 million in unfavorable currency translation. For the full year, reported revenue grew one percent and grew three percent excluding $77 million in unfavorable currency translation. On a constant-currency basis, direct-to-consumer sales grew eleven percent for the fourth quarter and twelve percent for the full year, reflecting performance and expansion of the retail network and ecommerce across all regions; wholesale revenues declined one percent for the fourth quarter and was flat for the full year. Fourth quarter net income declined five percent primarily reflecting investments associated with the expansion of our company-operated stores network and ecommerce. Full-year net income grew forty percent primarily reflecting higher gross margins, lower restructuring and related charges, prior year debt extinguishment, partially offset by increased investments in retail and ecommerce. Adjusted EBIT declined thirteen percent in the fourth quarter on a reported and constant-currency basis, primarily reflecting investments related to the expansion of the company's direct-to-consumer business, the unfavorable transactional impact of the devaluation of the British pound and lower gross margin. For the full year, Adjusted EBIT was flat on a reported basis but grew two percent on a constant-currency basis, primarily reflecting higher gross margins, partially offset by increased investments in the company's direct-to-consumer business. A reconciliation of Adjusted EBIT is provided at the end of this press release. "We are pleased to report our fourth consecutive year of profitable constant currency revenue growth behind the strength of the Levi’s® brand and our global direct-to-consumer business," said Chip Bergh, president and chief executive officer. "Looking ahead, although it remains a very challenging environment, given our diversified portfolio we remain optimistic about our long term prospects for growth." On a reported basis, gross profit in the fourth quarter was $659 million compared with $658 million for the same quarter of 2015, despite unfavorable currency translation effects of approximately $2 million. Gross margin for the fourth quarter was 50.7 percent of revenues compared with 51.2 percent of revenues in the same quarter of 2015 primarily reflecting the unfavorable transactional impact of currency, partially offset by direct-to-consumer sales growth. Selling, general and administrative (SG&A) expenses for the fourth quarter were $518 million compared with $494 million in the same quarter of 2015. Currency favorably impacted SG&A by $4 million. Excluding currency, higher costs were primarily related to the expansion of the company's direct-to-consumer business. The company had 41 net new company-operated stores at the end of 2016 than it did at the end of 2015. Operating income of $143 million in the fourth quarter was down from $161 million in the same quarter of 2015, primarily due to investments related to the expansion of the company's direct-to-consumer business. Reported regional net revenues and operating income for the fourth quarter were as follows: Net Revenues Operating Income* % Increase (Decrease) ($ millions) November 27, Americas $799 $817 (2)% $162 $174 (7)% Europe $292 $258 13% $41 $42 (2)% Asia $209 $209 —% $23 $34 (31)% * Note: Regional operating income is equal to regional Adjusted EBIT. In the Americas, excluding unfavorable currency effects of $8 million, net revenues decreased one percent, as direct-to-consumer growth was offset by declines at wholesale. Operating income declined primarily due to lower revenues. In Europe, net revenues grew thirteen percent reflecting strong double-digit growth across both wholesale and direct-to-consumer channels. Operating income declined due to investments in direct-to-consumer business and unfavorable transactional impact of the devaluation of the British pound. In Asia, excluding favorable currency effects of $3 million, net revenues declined one percent, as a decline in the franchise channel offset strong growth from company-operated stores and ecommerce. Operating income declined primarily due to an increase in franchisee support in Mainland China and direct-to-consumer expansion. Fiscal Year 2016 Highlights On a reported basis, gross profit for the fiscal year grew to $2,329 million compared with $2,269 million in 2015, despite unfavorable currency translation effects of approximately $36 million. Gross margin for the fiscal year grew to 51.2 percent of revenues compared with 50.5 percent of revenues in 2015, primarily reflecting lower negotiated product costs and streamlined supply chain operations as well as international retail growth, partially offset by the unfavorable transaction impact of currency. SG&A expenses for the fiscal year were $1,867 million compared with $1,824 million in 2015. Currency favorably impacted SG&A by $26 million. Higher costs primarily reflected expansion of the company's retail network and investment in its ecommerce business. The company had 41 net new company-operated stores at the end of the 2016 than it did at the end of 2015. Operating income of $462 million for the fiscal year was up from $431 million in 2015, primarily due to higher gross margins, lower restructuring and related charges, partially offset by investments related to the expansion of the company's direct-to-consumer business. Reported regional net revenues and operating income for the fiscal year were as follows: Year Ended Americas $2,683 $2,727 (2)% $482 $524 (8)% Europe $1,091 $1,016 7% $197 $184 7% Asia $778 $752 4% $105 $122 (14)% In the Americas, excluding unfavorable currency effects of $35 million, net revenues remained relatively flat, as direct-to-consumer growth was offset by declines at wholesale. Excluding unfavorable currency effects of $8 million, lower operating income primarily reflected lower revenues, lower gross margin and higher investment in retail. These were partially offset by the recognition of approximately $7.0 million of benefit resulting from the resolution of a vendor dispute in the third quarter. In Europe, excluding unfavorable currency effects of $24 million, net revenues grew ten percent reflecting single-digit growth in wholesale and double-digit growth in direct-to-consumer channels resulting from the expansion and performance of our company-operated retail network. Operating income increased primarily due to higher net revenues, partially offset by increased investment in retail and unfavorable transactional impact of the devaluation of the British pound. In Asia, excluding unfavorable currency effects of $18 million, net revenues grew six percent, reflecting growth in company-operated retail, ecommerce and traditional wholesale, partially offset by a decline in the franchise channel as a result of weakened performance. Excluding unfavorable currency effects of $5 million, lower operating income primarily reflected direct-to-consumer expansion and an increase in franchisee support. Cash Flow and Balance Sheet At November 27, 2016, cash and cash equivalents of $376 million were complemented by $784 million available under the company's revolving credit facility, resulting in a total liquidity position of approximately $1.2 billion. Net debt declined to $670 million at the end of 2016, compared to $834 million at the end of 2015, reflecting lower gross debt and higher cash. Cash flow from operations for 2016 was $307 million, up from $218 million. Free cash flow for 2016 was $161 million, up from $81 million in 2015, reflecting more cash received from customers, lower restructuring and related payments, partially offset by payments for higher inventory. Subsequent to the fiscal year end, on February 1, 2017, our Board of Directors declared a cash dividend for $70 million, payable in two $35 million installments. The company expects to pay the first installment in the first quarter of 2017, and the second installment in the fourth quarter of 2017. Investor Conference Call The company's fourth-quarter and full-year 2016 investor conference call will be available through a live audio webcast at https://engage.vevent.com/rt/levistraussao~50968087 today, February 9, 2017, at 1 p.m. Pacific / 4 p.m. Eastern or via the following phone numbers: 800-891-4735 in the United States and Canada, or +1-973-200-3066 internationally; I.D. No. 31527451. A replay is available the same day on http://www.levistrauss.com/investors/earnings-webcast and will be archived for one week. A telephone replay is also available through February 16, 2017, at 855-859-2056 in the United States and Canada, or +1-404-537-3406 internationally; I.D. No. 31527451. Please see http://www.levistrauss.com/investors/earnings-webcast for a discussion and reconciliation of non-GAAP measures referenced on the investor conference call. About Levi Strauss & Co. Levi Strauss & Co. is one of the world's largest brand-name apparel companies and a global leader in jeanswear. The company designs and markets jeans, casual wear and related accessories for men, women and children under the Levi's®, Dockers®, Signature by Levi Strauss & Co.™, and Denizen® brands. Its products are sold in more than 110 countries worldwide through a combination of chain retailers, department stores, online sites, and a global footprint of approximately 2,900 retail stores and shop-in-shops. Levi Strauss & Co.'s reported fiscal 2016 net revenues were $4.6 billion. For more information, go to http://levistrauss.com. This news release and related conference call contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements related to: inventory levels, including year-end levels; full year gross margin; SG&A and advertising costs; capital expenditures; profitable revenue and gross margin growth; growing the U.S. business; and new store openings. We have based these forward-looking statements on our current assumptions, expectations and projections about future events. We use words like “believe,” “will,” “so we can,” “when,” “anticipate,” “intend,” “estimate,” “expect,” “project” and similar expressions to identify forward-looking statements, although not all forward-looking statements contain these words. These forward-looking statements are necessarily estimates reflecting the best judgment of our senior management and involve a number of risks and uncertainties that could cause actual results to differ materially from those suggested by the forward-looking statements. Investors should consider the information contained in our filings with the U.S. Securities and Exchange Commission (the “SEC”), including our Annual Report on Form 10-K for the fiscal year 2016, especially in the “Management's Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors” sections. Other unknown or unpredictable factors also could have material adverse effects on our future results, performance or achievements. In light of these risks, uncertainties, assumptions and factors, the forward-looking events discussed in this news release and related conference call may not occur. You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date stated, or if no date is stated, as of the date of this news release and related conference call. We are not under any obligation and do not intend to update or revise any of the forward-looking statements contained in this news release and related conference call to reflect circumstances existing after the date of this news release and related conference call or to reflect the occurrence of future events even if experience or future events make it clear that any expected results expressed or implied by those forward-looking statements will not be realized. The company reports its financial results in conformity with generally accepted accounting principles in the United States (“GAAP”) and the rules of the SEC. However, management believes that certain non-GAAP financial measures, such as Free Cash Flow, Net Debt and Adjusted EBIT, provide users of the company’s financial information with additional useful information. The tables found below include Free Cash Flow, Net Debt and Adjusted EBIT and corresponding reconciliations to the most comparable GAAP financial measures. These non-GAAP financial measures should be viewed as supplementing, and not as an alternative or substitute for, the company’s financial results prepared in accordance with GAAP. Certain of these items that may be excluded or included in non-GAAP financial measures may be significant items that could impact the company’s financial position, results of operations and cash flows and should therefore be considered in assessing the company’s actual financial condition and performance. Non-GAAP financial measures are subject to inherent limitations as they reflect the exercise of judgment by management in determining how they are formulated. Some specific limitations, include but are not limited to, the fact that such non-GAAP financial measures: (a) do not reflect cash outlays for capital expenditures, contractual commitments or liabilities including pension obligations, post-retirement health benefit obligations and income tax liabilities, (b) do not reflect changes in, or cash requirements for, working capital requirements; and (c) they do not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on indebtedness. Additionally, the methods used by the company to calculate its non-GAAP financial measures may differ significantly from methods used by other companies to compute similar measures. As a result, any non-GAAP financial measures presented herein may not be comparable to similar measures provided by other companies, limiting the usefulness of these measures. The company urges investors to review the reconciliation of these non-GAAP financial measures to the comparable GAAP financial measures included in this press release, and not to rely on any single financial measure to evaluate its business. The company presents non-GAAP financial measures, such as Free Cash Flow, Net Debt and Adjusted EBIT, because it believes they provide investors, financial analysts and the public with additional information to measure performance and evaluate the company’s ability to service its debt and may be useful for comparing its operating performance with the performance of other companies that have different financing and capital structures and tax rates. The company further believes these measures may be useful for period-over-period comparisons of underlying business trends and its ongoing operations. See “RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES FOR THE FOURTH QUARTER OF 2016” below for reconciliation to the most comparable GAAP financial measures. Constant currency Constant-currency comparisons are based on translating local currency amounts in the prior-year period at actual foreign exchange rates for the current year. The company routinely evaluates its financial performance on a constant-currency basis in order to facilitate period-to-period comparisons without regard to the impact of changing foreign currency exchange rates. LEVI STRAUSS & CO. AND SUBSIDIARIES November 27, November 29, (Dollars in thousands) Cash and cash equivalents $ 375,563 $ 318,571 Trade receivables, net of allowance for doubtful accounts of $11,974 and $11,025 479,018 498,196 Inventories: Raw materials 2,454 3,368 Work-in-process 3,074 3,031 Finished goods 710,653 600,460 Total inventories 716,181 606,859 Other current assets 115,385 104,523 Total current assets 1,686,147 1,528,149 Property, plant and equipment, net of accumulated depreciation of $856,588 and $811,013 393,605 390,829 Goodwill 234,280 235,041 Other intangible assets, net 42,946 43,350 Deferred tax assets, net 523,101 580,640 Other non-current assets 107,017 106,386 Total assets $ 2,987,096 $ 2,884,395 LIABILITIES, TEMPORARY EQUITY AND STOCKHOLDERS’ EQUITY Short-term debt $ 38,922 $ 114,978 Current maturities of long-term debt — 32,625 Accounts payable 270,293 238,309 Accrued salaries, wages and employee benefits 180,740 182,430 Restructuring liabilities 4,878 20,141 Accrued interest payable 5,098 5,510 Accrued income taxes 9,652 6,567 Other accrued liabilities 252,160 245,607 Total current liabilities 761,743 846,167 Long-term debt 1,006,256 1,004,938 Long-term capital leases 15,360 12,320 Postretirement medical benefits 100,966 105,240 Pension liability 354,461 358,443 Long-term employee related benefits 73,243 73,342 Long-term income tax liabilities 20,150 26,312 Other long-term liabilities 63,796 56,987 Total liabilities 2,395,975 2,483,749 Temporary equity 79,346 68,783 Stockholders’ Equity: Levi Strauss & Co. stockholders’ equity Common stock — $.01 par value; 270,000,000 shares authorized; 37,470,158 shares and 37,460,145 shares issued and outstanding 375 375 Additional paid-in capital 1,445 3,291 Retained earnings 935,049 705,668 Accumulated other comprehensive loss (427,314 ) (379,066 ) Total Levi Strauss & Co. stockholders’ equity 509,555 330,268 Noncontrolling interest 2,220 1,595 Total liabilities, temporary equity and stockholders’ equity $ 2,987,096 $ 2,884,395 The notes accompanying our consolidated financial statements in our Form 10-K are an integral part of these consolidated financial statements. CONSOLIDATED STATEMENTS OF INCOME Net revenues $ 4,552,739 $ 4,494,493 $ 4,753,992 Cost of goods sold 2,223,727 2,225,512 2,405,552 Gross profit 2,329,012 2,268,981 2,348,440 Selling, general and administrative expenses 1,866,493 1,823,863 1,906,164 Restructuring, net 312 14,071 128,425 Operating income 462,207 431,047 313,851 Interest expense (73,170 ) (81,214 ) (117,597 ) Loss on early extinguishment of debt — (14,002 ) (20,343 ) Other income (expense), net 18,223 (25,433 ) (22,057 ) Income before income taxes 407,260 310,398 153,854 Income tax expense 116,051 100,507 49,545 Net income 291,209 209,891 104,309 Net (income) loss attributable to noncontrolling interest (157 ) (455 ) 1,769 Net income attributable to Levi Strauss & Co. $ 291,052 $ 209,436 $ 106,078 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME Net income $ 291,209 $ 209,891 $ 104,309 Other comprehensive (loss) income, before related income taxes: Pension and postretirement benefits (22,925 ) 38,785 (53,323 ) Net investment hedge (losses) gains (829 ) 385 13,404 Foreign currency translation (losses) gains (30,380 ) (28,791 ) (36,201 ) Unrealized gains (losses) on marketable securities 143 (575 ) 1,577 Total other comprehensive (loss) income, before related income taxes (53,991 ) 9,804 (74,543 ) Income tax benefit (expense) related to items of other comprehensive (loss) income 6,211 (13,602 ) 10,903 Comprehensive income, net of income taxes 243,429 206,093 40,669 Comprehensive (income) loss attributable to noncontrolling interest (625 ) (383 ) 2,098 Comprehensive income attributable to Levi Strauss & Co. $ 242,804 $ 205,710 $ 42,767 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Levi Strauss & Co. Stockholders Additional Other Total Common Paid-In Retained Comprehensive Noncontrolling Stockholders' Stock Capital Earnings Loss Interest Equity Balance at November 24, 2013 $ 374 $ 7,361 $ 475,960 $ (312,029 ) $ 3,310 $ 174,976 Net income (loss) — — 106,078 — (1,769 ) 104,309 Other comprehensive loss, net of tax — — — (63,311 ) (329 ) (63,640 ) Stock-based compensation and dividends, net — 13,290 (23 ) — — 13,267 Reclassification to temporary equity — (19,298 ) (19,842 ) — — (39,140 ) Repurchase of common stock — (1,353 ) (3,961 ) — — (5,314 ) Cash dividends paid — — (30,003 ) — — (30,003 ) Balance at November 30, 2014 374 — 528,209 (375,340 ) 1,212 154,455 Net income — — 209,436 — 455 209,891 Other comprehensive loss, net of tax — — — (3,726 ) (72 ) (3,798 ) Stock-based compensation and dividends, net 1 16,674 (66 ) — — 16,609 Reclassification to temporary equity — (10,961 ) 19,842 — — 8,881 Balance at November 29, 2015 375 3,291 705,668 (379,066 ) 1,595 331,863 Other comprehensive (loss) income, net of tax — — — (48,248 ) 468 (47,780 ) Stock-based compensation and dividends, net — 9,649 (40 ) — — 9,609 Reclassification to temporary equity — (10,563 ) — — — (10,563 ) Repurchase of common stock — (932 ) (1,631 ) — — (2,563 ) Cash Flows from Operating Activities: Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 103,878 102,044 109,474 Asset impairments 4,100 2,616 6,531 Gain on disposal of assets (6,058 ) (8,626 ) (197 ) Unrealized foreign exchange (gains) losses (5,853 ) (371 ) 5,392 Realized (gain) loss on settlement of forward foreign exchange contracts not designated for hedge accounting (17,175 ) (14,720 ) 6,184 Employee benefit plans’ amortization from accumulated other comprehensive loss and settlement losses 14,991 16,983 45,787 Noncash loss on extinguishment of debt, net of write-off of unamortized debt issuance costs — 3,448 5,103 Noncash restructuring charges — 658 3,347 Amortization of premium, discount and debt issuance costs 2,576 2,150 2,331 Stock-based compensation 9,333 15,137 12,441 Allowance for doubtful accounts 2,195 1,875 662 Deferred income taxes 66,078 58,386 (28,177 ) Change in operating assets and liabilities: Trade receivables 6,150 4,060 (51,367 ) Inventories (121,379 ) 28,566 (6,184 ) Other current assets (22,944 ) (3,061 ) 5,377 Other non-current assets (9,103 ) (21,375 ) 1,509 Accounts payable and other accrued liabilities 43,040 (80,224 ) (28,871 ) Restructuring liabilities (17,290 ) (36,711 ) 66,574 Income tax liabilities 7,653 (9,680 ) 19,224 Accrued salaries, wages and employee benefits and long-term employee related benefits (49,880 ) (44,714 ) (42,878 ) Other long-term liabilities 5,029 (10,902 ) (3,740 ) Other, net — 2,902 78 Net cash provided by operating activities 306,550 218,332 232,909 Cash Flows from Investing Activities: Purchases of property, plant and equipment (102,950 ) (102,308 ) (73,396 ) Proceeds from sale of assets 17,427 9,026 8,049 Proceeds (payments) on settlement of forward foreign exchange contracts not designated for hedge accounting 17,175 14,720 (6,184 ) Acquisitions, net of cash acquired — (2,271 ) (318 ) Net cash used for investing activities (68,348 ) (80,833 ) (71,849 ) Cash Flows from Financing Activities: Proceeds from issuance of long-term debt — 500,000 — Repayments of long-term debt and capital leases (39,641 ) (528,104 ) (395,853 ) Proceeds from senior revolving credit facility 180,000 345,000 265,000 Repayments of senior revolving credit facility (279,000 ) (346,000 ) (165,000 ) Proceeds from short-term credit facilities 29,154 23,936 24,372 Repayments of short-term credit facilities (18,219 ) (21,114 ) (24,000 ) Other short-term borrowings, net 13,475 (12,919 ) (10,080 ) Debt issuance costs — (4,605 ) (2,684 ) Change in restricted cash, net 2,967 1,615 1,060 Repurchase of common stock (2,563 ) (4,175 ) (5,314 ) Excess tax benefits from stock-based compensation 278 1,471 826 Dividend to stockholders (60,000 ) (50,000 ) (30,003 ) Net cash used for financing activities (173,549 ) (94,895 ) (341,676 ) Effect of exchange rate changes on cash and cash equivalents (7,661 ) (22,288 ) (10,387 ) Net increase (decrease) in cash and cash equivalents 56,992 20,316 (191,003 ) Beginning cash and cash equivalents 318,571 298,255 489,258 Ending cash and cash equivalents $ 375,563 $ 318,571 $ 298,255 Noncash Investing Activity: Purchases of property, plant and equipment not yet paid at end of period $ 19,903 $ 23,958 $ 19,728 Cash paid for interest during the period $ 67,052 $ 77,907 $ 110,029 Cash paid for income taxes during the period, net of refunds 57,148 61,456 60,525 RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES FOR THE FOURTH QUARTER OF 2016 The following information relates to non-GAAP financial measures, and should be read in conjunction with the investor call held on February 9, 2017, discussing the company’s financial condition and results of operations as of and for the quarter and year ended November 27, 2016. Free cash flow, Net debt and Adjusted EBIT are not financial measures prepared in accordance with U.S. generally accepted accounting principles, or GAAP. As used in this press release: (1) Free cash flow represents cash from operating activities less purchases of property, plant and equipment, payments (proceeds) on settlement of forward foreign exchange contracts not designated for hedge accounting, and cash dividends to stockholders; (2) Net debt represents total long-term and short-term debt less cash and cash equivalents; and (3) Adjusted EBIT represents net income plus income tax expense, interest expense, loss on early extinguishment of debt, other (income) expense, net, restructuring and related charges, severance and asset impairment charges, net, and pension and postretirement benefit plan curtailment and net settlement (gains) losses, net. Free cash flow: (Dollars in millions) Most comparable GAAP measure: Net cash provided by operating activities $ 306.6 $ 218.3 Non-GAAP measure: Purchases of property, plant and equipment (103.0 ) (102.3 ) Proceeds on settlement of forward foreign exchange contracts not designated for hedge accounting 17.2 14.7 Dividend to stockholders (60.0 ) (50.0 ) Free cash flow $ 160.8 $ 80.7 Net debt: Total long-term and short-term debt $ 1,045.2 $ 1,152.5 Cash and cash equivalents (375.6 ) (318.6 ) Net debt $ 669.6 $ 833.9 Adjusted EBIT: (Dollars in millions) (unaudited) Net income $ 96.2 $ 101.7 $ 291.2 $ 209.9 Income tax expense 39.3 41.9 116.1 100.5 Interest expense 18.7 18.9 73.2 81.2 Loss on early extinguishment of debt — — — 14.0 Other (income) expense, net (11.5 ) (1.3 ) (18.2 ) 25.4 Restructuring and related charges, severance and asset impairment charges, net 3.3 6.1 17.6 47.0 Pension and postretirement benefit plan curtailment and net settlement (gains) losses, net 0.2 0.4 (0.1 ) 0.6 Adjusted EBIT $ 146.2 $ 167.7 $ 479.8 $ 478.6 Edelita Tichepco, 415-501-1953 [email protected] Amber Rensen, 415-501-7777 [email protected] Levi Strauss & Co. announced financial results today for the fourth quarter and fiscal year ended November 27, 2016.

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Equinix Reports Third Quarter 2019 Results Interconnection and Data Center Leader Delivers 67th Consecutive Quarter of Revenue Growth REDWOOD CITY, Calif., Oct. 30, 2019 /PRNewswire/ -- Quarterly revenues increased 9% year-over-year to $1.397 billion, which includes $8 million of negative foreign currency impact when compared to prior guidance rates. This reflects an 8% year-over-year increase on a normalized and constant currency basis Delivered one of the strongest interconnection quarters in the company's history Recognized by the U.S. Environmental Protection Agency (EPA) for leading green power use, ranking number four on the EPA's National Top 100 Partners list Delivered record channel bookings, accounting for more than 30% of total bookings Equinix, Inc. (Nasdaq: EQIX), the global interconnection and data center company, today reported results for the quarter ended September 30, 2019. Equinix uses certain non-GAAP financial measures, which are described further below and reconciled to the most comparable GAAP financial measures after the presentation of our GAAP financial statements. All per share results are presented on a fully diluted basis. Third Quarter 2019 Results Summary $1.397 billion, a 1% increase over the previous quarter Includes $8 million of negative foreign currency impact when compared to prior guidance rates $285 million, a 2% decrease from the previous quarter, and an operating margin of 20% $675 million, a 48% adjusted EBITDA margin Includes $2 million of integration costs Net Income and Net Income per Share attributable to Equinix $121 million, a 16% decrease from the previous quarter including a $16 million increased income tax expense attributable to FX hedge gains $1.41 per share, a 17% decrease from the previous quarter including a per share reduction of $0.19 related to increased income tax expense attributable to FX hedge gains, a significant portion of which is expected to reverse in Q4 AFFO and AFFO per Share $473 million, a 5% decrease from the previous quarter $5.52 per share including a per share reduction of $0.19 related to increased income tax expense attributable to FX hedge gains, a significant portion of which is expected to reverse in Q4 2019 Annual Guidance Summary $5.554 - $5.564 billion, a normalized and constant currency increase of approximately 9% over the previous year Includes a $21 million negative foreign currency impact when compared to prior guidance rates $2.666 - $2.676 billion, a 48% adjusted EBITDA margin Assumes $9 million of integration costs $1.913 - $1.923 billion, a normalized and constant currency increase of 13 - 14% over the previous year $22.56 - $22.68 per share, a normalized and constant currency increase of approximately 8% over the previous year Includes $10 million of increased income tax expense attributable to FX hedge gains, a per share impact of $0.12 Equinix does not provide forward-looking guidance for certain financial data, such as depreciation, amortization, accretion, stock-based compensation, net income (loss) from operations, cash generated from operating activities and cash used in investing activities, and as a result, is not able to provide a reconciliation of GAAP to non-GAAP financial measures for forward-looking data without unreasonable effort. The impact of such adjustments could be significant. Charles Meyers, President and CEO, Equinix: "We had another great quarter, building on our market leadership and unlocking the power of Platform Equinix by expanding our geographic reach, enhancing our market-leading interconnection portfolio and launching new offerings that respond to the evolving needs of our customers. We have a clear view of our strategy and are actively building new capabilities that will enable us to achieve our vision for the future of Platform Equinix, allowing customers to reach everywhere, interconnect everyone and integrate everything on their digital transformation journey." Business Highlights Equinix continued to invest in building out its global platform in response to strong customer demand and a high level of inventory utilization: On October 4, Equinix announced a US$175 million definitive agreement to acquire three Axtel data centers that serve two new strategic technology metros in Mexico. This acquisition, when combined with the previous acquisitions of key traffic hubs in Dallas (Infomart) and Miami (NAP of the Americas), will further strengthen Equinix's global platform by increasing interconnection between North, Central and South America. On October 9, Equinix announced the completion of the formation of the greater than US$1.0 billion joint venture in the form of a limited liability partnership with GIC, Singapore's sovereign wealth fund, to develop and operate xScale™ data centers in Europe. This was a strategic milestone for Equinix, enhancing its ability to respond to the rapidly expanding needs of the world's largest cloud and hyperscale companies while strengthening leadership in the cloud ecosystem. Equinix continues its investment in organic growth and expansion activities with 28 major expansion projects underway across 21 markets and 16 countries. Among them are four xScale data centers and four newly announced projects, including phased expansions in Chicago and Toronto, and two new builds in Washington, D.C. Additionally, Equinix completed six new phased expansions or openings this quarter, including two new International Business Exchange™ (IBX®) data centers in Helsinki and Seoul. Equinix achieved its best-ever third quarter bookings with strong performance across all three regions (Americas, EMEA and Asia-Pacific) with notable momentum in EMEA. Bookings this quarter spanned across more than 3,100 customers, with the majority of bookings composed of small to mid-sized multi-metro deals. Equinix continues to lead in cloud connectivity, with over three times as many metros with multicloud on-ramps as its nearest competitor. Equinix continues the growth of its indirect selling initiatives, as the company pursues high-value strategic channel partnerships. In Q3, Equinix delivered record channel bookings, accounting for more than 30% of total bookings, with 60% of this activity going into the enterprise vertical. New channel wins this quarter spanned across all end-user types including insurance, federal government, banking, public utilities and pharmaceutical, with network optimization and hybrid multicloud as key use cases. Interconnection growth again outpaced colocation revenues, growing 13% year-over-year on a normalized and constant currency basis, driven by solid traction across all interconnection products. Today, Equinix has the most comprehensive global interconnection platform, comprising over 356,000 physical and virtual interconnections. In Q3, Equinix added 8,500 interconnections, more per quarter than our top 10 competitors combined. In the quarter, Equinix surpassed 20,000 virtual connections enabled by Equinix Cloud Exchange Fabric™ (ECX Fabric™), which accounted for more than 5% of total interconnections and serves more than 1,800 customers. Equinix is advancing the company's sustainability agenda with meaningful progress across environmental, social and governance initiatives. Equinix is progressing on its commitment to 100% sustainable energy, and over 90% of its energy consumption is now covered by clean and renewable energy sources. In Q3, the U.S. EPA recognized Equinix for leading in green power use, ranking the company number four on the EPA's National Top 100 Partners list, and Equinix received the EPA's Green Power Leadership Award for the 3rd consecutive year, recognizing the company's contribution to advancing the development of the nation's voluntary green power market. Equinix added key leadership positions with the appointments of Sandra Rivera to its Board of Directors and Justin Dustzadeh as its Chief Technology Officer. For the fourth quarter of 2019, the Company expects revenues to range between $1.409 and $1.419 billion, an increase of 1% quarter-over-quarter, or a normalized and constant currency increase of approximately 2%. This guidance includes a negative foreign currency impact of $7 million when compared to the average FX rates in Q3 2019. Adjusted EBITDA is expected to range between $654 and $664 million, including the impact of timing of spend, a $3 million negative foreign currency impact when compared to the average FX rates in Q3 2019 and $3 million of integration costs from acquisitions. Recurring capital expenditures are expected to range between $65 and $75 million. For the full year of 2019, total revenues are expected to range between $5.554 and $5.564 billion, a 10% increase over the previous year, or a normalized and constant currency increase of 9% at the mid-point. This updated guidance maintains prior full year revenue guidance, offset by a negative foreign currency impact of $21 million when compared to prior guidance rates. Adjusted EBITDA is expected to range between $2.666 and $2.676 billion, an adjusted EBITDA margin of 48%. This updated guidance raises full year adjusted EBITDA by $6 million, offset by a negative foreign currency impact of $10 million when compared to prior guidance rates, and includes an expected $9 million of integration costs. AFFO is expected to range between $1.913 and $1.923 billion, an approximate 16% increase over the previous year, or a normalized and constant currency increase of 13 - 14%. This updated guidance raises full year underlying AFFO by $8 million due to strong business performance, offset by $10 million of increased income tax expense attributed to FX hedge gains and a negative foreign currency impact. AFFO per share is expected to range between $22.56 - $22.68, an increase of approximately 8% over the previous year, on a normalized and constant currency basis. Non-recurring capital expenditures are expected to range between $1.730 and $1.920 billion, and recurring capital expenditures are expected to range between $170 and $180 million. The U.S. dollar exchange rates used for 2019 guidance, taking into consideration the impact of our current foreign currency hedges, have been updated to $1.15 to the Euro, $1.31 to the Pound, S$1.38 to the U.S. dollar, ¥108 to the U.S. dollar, and R$4.14 to the U.S. dollar. The Q3 2019 global revenue breakdown by currency for the Euro, British Pound, Singapore Dollar, Japanese Yen and Brazilian Real is 20%, 9%, 7%, 6% and 3%, respectively. The adjusted EBITDA guidance is based on the revenue guidance less our expectations of cash cost of revenues and cash operating expenses. The AFFO guidance is based on the adjusted EBITDA guidance less our expectations of net interest expense, an installation revenue adjustment, a straight-line rent expense adjustment, a contract cost adjustment, amortization of deferred financing costs and debt discounts and premiums, income tax expense, an income tax expense adjustment, recurring capital expenditures, other income (expense), (gains) losses on disposition of real estate property and adjustments for unconsolidated joint ventures' and non-controlling interests' share of these items. Q3 2019 Results Conference Call and Replay Information Equinix will discuss its quarterly results for the period ended September 30, 2019, along with its future outlook, in its quarterly conference call on Wednesday, October 30, 2019, at 5:30 p.m. ET (2:30 p.m. PT). A simultaneous live webcast of the call will be available on the Company's Investor Relations website at www.equinix.com/investors. To hear the conference call live, please dial 1-517-308-9482 (domestic and international) and reference the passcode EQIX. A replay of the call will be available one hour after the call through Wednesday, February 12, 2020, by dialing 1-203-369-2048 and referencing the passcode 2019. In addition, the webcast will be available at www.equinix.com/investors (no password required). Investor Presentation and Supplemental Financial Information Equinix has made available on its website a presentation designed to accompany the discussion of Equinix's results and future outlook, along with certain supplemental financial information and other data. Interested parties may access this information through the Equinix Investor Relations website at www.equinix.com/investors. Equinix Investor Relations Resources Equinix, Inc. (Nasdaq: EQIX) connects the world's leading businesses to their customers, employees and partners inside the most-interconnected data centers. On this global platform for digital business, companies come together across more than 50 markets on five continents to reach everywhere, interconnect everyone and integrate everything they need to create their digital futures. Equinix provides all information required in accordance with generally accepted accounting principles ("GAAP"), but it believes that evaluating its ongoing operating results may be difficult if limited to reviewing only GAAP financial measures. Accordingly, Equinix uses non-GAAP financial measures to evaluate its operations. Equinix provides normalized and constant currency growth rates, which are calculated to adjust for acquisitions, dispositions, integration costs, changes in accounting principles and foreign currency. Equinix presents adjusted EBITDA, which is a non-GAAP financial measure. Adjusted EBITDA represents income or loss from operations excluding depreciation, amortization, accretion, stock-based compensation expense, restructuring charges, impairment charges, transaction costs and gain or loss on asset sales. In presenting non-GAAP financial measures, such as adjusted EBITDA, cash cost of revenues, cash gross margins, cash operating expenses (also known as cash selling, general and administrative expenses or cash SG&A), adjusted EBITDA margins, free cash flow and adjusted free cash flow, Equinix excludes certain items that it believes are not good indicators of Equinix's current or future operating performance. These items are depreciation, amortization, accretion of asset retirement obligations and accrued restructuring charges, stock-based compensation, restructuring charges, impairment charges, transaction costs and gain or loss on asset sales. Equinix excludes these items in order for its lenders, investors and the industry analysts who review and report on Equinix to better evaluate Equinix's operating performance and cash spending levels relative to its industry sector and competitors. Equinix excludes depreciation expense as these charges primarily relate to the initial construction costs of an IBX data center, and do not reflect its current or future cash spending levels to support its business. Its IBX data centers are long-lived assets, and have an economic life greater than 10 years. The construction costs of an IBX data center do not recur with respect to such data center, although Equinix may incur initial construction costs in future periods with respect to additional IBX data centers, and future capital expenditures remain minor relative to the initial investment. This is a trend it expects to continue. In addition, depreciation is also based on the estimated useful lives of the IBX data centers. These estimates could vary from actual performance of the asset, are based on historic costs incurred to build out our IBX data centers and are not indicative of current or expected future capital expenditures. Therefore, Equinix excludes depreciation from its operating results when evaluating its operations. In addition, in presenting the non-GAAP financial measures, Equinix also excludes amortization expense related to acquired intangible assets. Amortization expense is significantly affected by the timing and magnitude of acquisitions and these charges may vary in amount from period to period. We exclude amortization expense to facilitate a more meaningful evaluation of our current operating performance and comparisons to our prior periods. Equinix excludes accretion expense, both as it relates to its asset retirement obligations as well as its accrued restructuring charges, as these expenses represent costs which Equinix also believes are not meaningful in evaluating Equinix's current operations. Equinix excludes stock-based compensation expense, as it can vary significantly from period to period based on share price and the timing, size and nature of equity awards. As such, Equinix and many investors and analysts exclude stock-based compensation expense to compare its operating results with those of other companies. Equinix excludes restructuring charges from its non-GAAP financial measures. The restructuring charges relate to Equinix's decision to exit leases for excess space adjacent to several of its IBX data centers, which it did not intend to build out, or its decision to reverse such restructuring charges. Equinix also excludes impairment charges related to certain long-lived assets. The impairment charges are related to expense recognized whenever events or changes in circumstances indicate that the carrying amount of long-lived assets are not recoverable. Equinix also excludes gain or loss on asset sales as it represents profit or loss that is not meaningful in evaluating the current or future operating performance. Finally, Equinix excludes transaction costs from its non-GAAP financial measures to allow more comparable comparisons of the financial results to the historical operations. The transaction costs relate to costs Equinix incurs in connection with business combinations and formation of joint ventures, including advisory, legal, accounting, valuation and other professional or consulting fees. Such charges generally are not relevant to assessing the long-term performance of Equinix. In addition, the frequency and amount of such charges vary significantly based on the size and timing of the transactions. Management believes items such as restructuring charges, impairment charges, transaction costs and gain or loss on asset sales are non-core transactions; however, these types of costs may occur in future periods. Equinix also presents funds from operations ("FFO") and adjusted funds from operations ("AFFO"), both commonly used in the REIT industry, as supplemental performance measures. FFO is calculated in accordance with the definition established by the National Association of Real Estate Investment Trusts ("NAREIT"). FFO represents net income or loss, excluding gain or loss from the disposition of real estate assets, depreciation and amortization on real estate assets and adjustments for unconsolidated joint ventures' and non-controlling interests' share of these items. AFFO represents FFO, excluding depreciation and amortization expense on non-real estate assets, accretion, stock-based compensation, restructuring charges, impairment charges, transaction costs, an installation revenue adjustment, a straight-line rent expense adjustment, a contract cost adjustment, amortization of deferred financing costs and debt discounts and premiums, gain or loss on debt extinguishment, an income tax expense adjustment, recurring capital expenditures, net income or loss from discontinued operations, net of tax and adjustments from FFO to AFFO for unconsolidated joint ventures' and non-controlling interests' share of these items. Equinix excludes depreciation expense, amortization expense, accretion, stock-based compensation, restructuring charges, impairment charges and transaction costs for the same reasons that they are excluded from the other non-GAAP financial measures mentioned above. Equinix includes an adjustment for revenues from installation fees, since installation fees are deferred and recognized ratably over the period of contract term, although the fees are generally paid in a lump sum upon installation. Equinix includes an adjustment for straight-line rent expense on its operating leases, since the total minimum lease payments are recognized ratably over the lease term, although the lease payments generally increase over the lease term. Equinix also includes an adjustment to contract costs incurred to obtain contracts, since contract costs are capitalized and amortized over the estimated period of benefit on a straight-line basis, although costs of obtaining contracts are generally incurred and paid during the period of obtaining the contracts. The adjustments for installation revenues, straight-line rent expense and contract costs are intended to isolate the cash activity included within the straight-lined or amortized results in the consolidated statement of operations. Equinix excludes the amortization of deferred financing costs and debt discounts and premiums as these expenses relate to the initial costs incurred in connection with its debt financings that have no current or future cash obligations. Equinix excludes gain or loss on debt extinguishment since it represents a cost that is not a good indicator of Equinix's current or future operating performance. Equinix includes an income tax expense adjustment, which represents the non-cash tax impact due to changes in valuation allowances and uncertain tax positions that do not relate to the current period's operations. Equinix excludes recurring capital expenditures, which represent expenditures to extend the useful life of its IBX data centers or other assets that are required to support current revenues. Equinix also excludes net income or loss from discontinued operations, net of tax, which represents results that are not a good indicator of our current or future operating performance. Equinix presents constant currency results of operations, which is a non-GAAP financial measure and is not meant to be considered in isolation or as an alternative to GAAP results of operations. However, Equinix has presented this non-GAAP financial measure to provide investors with an additional tool to evaluate its operating results without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons of Equinix's business performance. To present this information, Equinix's current and comparative prior period revenues and certain operating expenses from entities with functional currencies other than the U.S. dollar are converted into U.S. dollars at a consistent exchange rate for purposes of each result being compared. Non-GAAP financial measures are not a substitute for financial information prepared in accordance with GAAP. Non-GAAP financial measures should not be considered in isolation, but should be considered together with the most directly comparable GAAP financial measures and the reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures. Equinix presents such non-GAAP financial measures to provide investors with an additional tool to evaluate its operating results in a manner that focuses on what management believes to be its core, ongoing business operations. Management believes that the inclusion of these non-GAAP financial measures provides consistency and comparability with past reports and provides a better understanding of the overall performance of the business and its ability to perform in subsequent periods. Equinix believes that if it did not provide such non-GAAP financial information, investors would not have all the necessary data to analyze Equinix effectively. Investors should note that the non-GAAP financial measures used by Equinix may not be the same non-GAAP financial measures, and may not be calculated in the same manner, as those of other companies. Investors should, therefore, exercise caution when comparing non-GAAP financial measures used by us to similarly titled non-GAAP financial measures of other companies. Equinix does not provide forward-looking guidance for certain financial data, such as depreciation, amortization, accretion, stock-based compensation, net income or loss from operations, cash generated from operating activities and cash used in investing activities, and as a result, is not able to provide a reconciliation of GAAP to non-GAAP financial measures for forward-looking data without unreasonable effort. The impact of such adjustments could be significant. Equinix intends to calculate the various non-GAAP financial measures in future periods consistent with how they were calculated for the periods presented within this press release. This press release contains forward-looking statements that involve risks and uncertainties. Actual results may differ materially from expectations discussed in such forward-looking statements. Factors that might cause such differences include, but are not limited to, the challenges of acquiring, operating and constructing IBX data centers and developing, deploying and delivering Equinix products and solutions; unanticipated costs or difficulties relating to the integration of companies we have acquired or will acquire into Equinix; a failure to receive significant revenues from customers in recently built out or acquired data centers; failure to complete any financing arrangements contemplated from time to time; competition from existing and new competitors; the ability to generate sufficient cash flow or otherwise obtain funds to repay new or outstanding indebtedness; the loss or decline in business from our key customers; risks related to our taxation as a REIT; and other risks described from time to time in Equinix filings with the Securities and Exchange Commission. In particular, see recent Equinix quarterly and annual reports filed with the Securities and Exchange Commission, copies of which are available upon request from Equinix. Equinix does not assume any obligation to update the forward-looking information contained in this press release. EQUINIX, INC. (in thousands, except per share data) Nine Months Ended June 30, Recurring revenues Non-recurring revenues Cost of revenues Transaction costs Impairment charges Gain on asset sales Total operating expenses Income from operations Interest and other income (expense): Gain (loss) on debt extinguishment Total interest and other, net Net (income) loss attributable to non-controlling interests Net income attributable to Equinix Net income per share attributable to Equinix: Basic net income per share Diluted net income per share Shares used in computing basic net income per share Shares used in computing diluted net income per share Condensed Consolidated Statements of Comprehensive Income Other comprehensive loss, net of tax: Foreign currency translation adjustment ("CTA") gain (loss) Net investment hedge CTA gain (loss) Unrealized gain (loss) on cash flow hedges Net actuarial gain (loss) on defined benefit plans Total other comprehensive loss, net of tax Comprehensive income, net of tax Other comprehensive loss attributable to non-controlling interests Comprehensive income attributable to Equinix Accounts receivable, net Assets held for sale Property, plant and equipment, net Intangible assets, net Accounts payable and accrued expenses Accrued property, plant and equipment Current portion of operating lease liabilities Current portion of finance lease liabilities Current portion of mortgage and loans payable Current portion of senior notes Liabilities held for sale Operating lease liabilities, less current portion Finance lease liabilities, less current portion Mortgage and loans payable, less current portion Senior notes, less current portion Other liabilities Accumulated dividends Total Equinix stockholders' equity Total stockholders' equity Ending headcount by geographic region is as follows: Americas headcount EMEA headcount Asia-Pacific headcount Total headcount Summary of Debt Principal Outstanding Finance lease liabilities Mortgage payable and other loans payable Plus: debt discount and issuance costs, net Total mortgage and loans payable principal Plus: debt issuance costs Less: debt premium Total senior notes principal Total debt principal outstanding Adjustments to reconcile net income to net cash provided by operating activities: Depreciation, amortization and accretion Amortization of debt issuance costs and debt discounts and premiums (Gain) loss on debt extinguishment Changes in operating assets and liabilities: Income taxes, net Operating lease liabilities Other assets and liabilities Purchases, sales and maturities of investments, net Business acquisitions, net of cash and restricted cash acquired Purchases of real estate Purchases of other property, plant and equipment Proceeds from asset sales Proceeds from employee equity awards Payment of dividend distributions Proceeds from public offering of common stock, net of offering costs Proceeds from loans payable Proceeds from senior notes Repayment of finance lease liabilities Repayment of mortgage and loans payable Repayment of senior notes Debt extinguishment costs Debt issuance costs Net cash provided by (used in) financing activities Effect of foreign currency exchange rates on cash, cash equivalents and restricted cash Net increase (decrease) in cash, cash equivalents and restricted cash Cash, cash equivalents and restricted cash at beginning of period Cash, cash equivalents and restricted cash at end of period Cash paid for taxes Cash paid for interest Free cash flow (negative free cash flow) (1) Adjusted free cash flow (adjusted negative free cash flow) (2) We define free cash flow (negative free cash flow) as net cash provided by operating activities plus net cash provided by (used in) investing activities (excluding the net purchases, sales and maturities of investments) as presented below: Net cash provided by operating activities as presented above Net cash used in investing activities as presented above Free cash flow (negative free cash flow) We define adjusted free cash flow (adjusted negative free cash flow) as free cash flow (negative free cash flow) as defined above, excluding any purchases of real estate and business acquisitions, net of cash and restricted cash acquired as presented below: Free cash flow (negative free cash flow) as defined above Less business acquisitions, net of cash and restricted cash acquired Less purchases of real estate Adjusted free cash flow (adjusted negative free cash flow) Non-GAAP Measures and Other Supplemental Data Revenues (1) Cash cost of revenues (2) Cash gross profit (3) Cash operating expenses (4)(7): Cash sales and marketing expenses(5) Cash general and administrative expenses (6) Total cash operating expenses (4)(7) Adjusted EBITDA (8) Cash gross margins (9) Adjusted EBITDA margins (10) Adjusted EBITDA flow-through rate (11) FFO (12) AFFO (13)(14) Basic FFO per share (15) Diluted FFO per share(15) Basic AFFO per share (15) Diluted AFFO per share(15) The geographic split of our revenues on a services basis is presented below: Americas Revenues: Managed infrastructure EMEA Revenues: Asia-Pacific Revenues: Worldwide Revenues: We define cash cost of revenues as cost of revenues less depreciation, amortization, accretion and stock-based compensation as presented below: Depreciation, amortization and accretion expense Stock-based compensation expense Cash cost of revenues The geographic split of our cash cost of revenues is presented below: Americas cash cost of revenues EMEA cash cost of revenues Asia-Pacific cash cost of revenues We define cash gross profit as revenues less cash cost of revenues (as defined above). We define cash operating expense as selling, general, and administrative expense less depreciation, amortization, and stock-based compensation. We also refer to cash operating expense as cash selling, general and administrative expense or "cash SG&A". Selling, general, and administrative expense Depreciation and amortization expense Cash operating expense We define cash sales and marketing expense as sales and marketing expense less depreciation, amortization and stock-based compensation as presented below: Sales and marketing expense Cash sales and marketing expense We define cash general and administrative expense as general and administrative expense less depreciation, amortization and stock-based compensation as presented below: General and administrative expense Cash general and administrative expense The geographic split of our cash operating expense, or cash SG&A, as defined above, is presented below: Americas cash SG&A EMEA cash SG&A Asia-Pacific cash SG&A Cash SG&A We define adjusted EBITDA as income from operations excluding depreciation, amortization, accretion, stock-based compensation, restructuring charges, impairment charges, transaction costs and gain or loss on asset sales as presented below: The geographic split of our adjusted EBITDA is presented below: Americas income from operations Americas depreciation, amortization and accretion expense

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Download XBRL Form 10-Q For the quarterly period ended March 31, 2017 Commission File Numbers: 333-72440 Mediacom Broadband LLC Mediacom Broadband Corporation* (Exact names of Registrants as specified in their charters) Delaware 06-1615412 (State or other jurisdiction of incorporation or organization) Identification Numbers) 1 Mediacom Way Mediacom Park, NY 10918 (Registrants’ telephone number) Indicate by check mark whether the Registrants (1) have filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrants were required to file such reports), and (2) have been subject to such filing requirements for the past 90 days. ☐ Yes ☒ No Note: As voluntary filers, not subject to the filing requirements, the Registrants have filed all reports under Section 13 or 15(d) of the Exchange Act during the preceding 12 months. Indicate by check mark whether the Registrants have submitted electronically and posted on their corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrants were required to submit and post such files). ☒ Yes ☐ No Indicate by check mark whether the Registrants are large accelerated filers, accelerated filers, non-accelerated filers or smaller reporting companies. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filers ☐ Accelerated filers ☐ Non-accelerated filers ☒ (Do not check if a smaller reporting company) Smaller reporting companies ☐ Emerging growth companies ☐ If emerging growth companies, indicate by check mark if the registrants have elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐ Indicate by check mark whether the Registrants are shell companies (as defined in Rule 12b-2 of the Exchange Act). ☐ Yes ☒ No Indicate the number of shares outstanding of the Registrants’ common stock: Not Applicable * Mediacom Broadband Corporation meets the conditions set forth in General Instruction H (1) (a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format. MEDIACOM BROADBAND LLC AND SUBSIDIARIES FOR THE PERIOD ENDED MARCH 31, 2017 Item 1. Financial Statements Consolidated Balance Sheets (unaudited) March 31, 2017 and December 31, 2016 Consolidated Statements of Operations (unaudited) Three Months Ended March 31, 2017 and 2016 Consolidated Statements of Cash Flows (unaudited) Three Months Ended March 31, 2017 and 2016 Notes to Consolidated Financial Statements (unaudited) Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations Item 3. Quantitative and Qualitative Disclosures about Market Risk Item 4. Controls and Procedures Item 1. Legal Proceedings Item 1A. Risk Factors Item 6. Exhibits This Quarterly Report on Form 10-Q is for the three months ended March 31, 2017. Any statement contained in a prior periodic report shall be deemed to be modified or superseded for purposes of this Quarterly Report to the extent that a statement herein modifies or supersedes such statement. The Securities and Exchange Commission allows us to “incorporate by reference” information that we file with them, which means that we can disclose important information by referring you directly to those documents. Information incorporated by reference is considered to be part of this Quarterly Report. Mediacom Broadband LLC is a Delaware limited liability company and a wholly-owned subsidiary of Mediacom Communications Corporation, a Delaware corporation. Mediacom Broadband Corporation is a Delaware corporation and a wholly-owned subsidiary of Mediacom Broadband LLC. Mediacom Broadband Corporation was formed for the sole purpose of acting as co-issuer with Mediacom Broadband LLC of debt securities and does not conduct operations of its own. References in this Quarterly Report to “we,” “us,” or “our” are to Mediacom Broadband LLC and its direct and indirect subsidiaries (including Mediacom Broadband Corporation), unless the context specifies or requires otherwise. References in this Quarterly Report to “Mediacom” or “MCC” are to Mediacom Communications Corporation. You should carefully review the information contained in this Quarterly Report and in other reports or documents that we file from time to time with the SEC. In this Quarterly Report, we state our beliefs of future events and of our future financial performance. In some cases, you can identify those so-called “forward-looking statements” by words such as “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “potential,” “predicts,” “should” or “will,” or the negative of those and other comparable words. These forward-looking statements are not guarantees of future performance or results, and are subject to risks and uncertainties that could cause actual results to differ materially from historical results or those we anticipate as a result of various factors, many of which are beyond our control. Factors that may cause such differences to occur include, but are not limited to: • increased levels of competition from direct broadcast satellite operators, local phone companies, other cable providers, wireless communications companies, providers of over-the-top video, and other services that compete for our customers; • lower demand for our services from existing and potential residential and business customers due to increased competition, weakened economic conditions or other factors; • our ability to contain the continued increases in video programming costs, or to raise video rates to offset, in whole or in part, the effects of such costs, including retransmission consent fees; • an acceleration in bandwidth consumption by high-speed data customers at rates greater than current expectations, which could require unplanned network investments and meaningfully increase our capital expenditures; • our ability to continue to grow our business services customer base, and associated revenues, which has continued to make increasing contributions to our results of operations; • our ability to realize the anticipated benefits from the major initiatives under MCC’s plan for approximately $1 billion in total capital expenditures during the three years ending December 31, 2018, as further described in our Annual Report for the year ended December 31, 2016; • our ability to successfully adopt new technologies and introduce new products and services, or enhance existing ones, to meet customer demands and preferences; • our ability to secure hardware, software and operational support for the delivery of products and services to consumers; • disruptions or failures of our network and information systems, including those caused by “cyber-attacks,” natural disasters or other events outside our control; • our reliance on certain intellectual property rights, and not infringing on the intellectual property rights of others; • our ability to generate sufficient cash flows from operations to meet our debt service obligations; • our ability to refinance future debt maturities on favorable terms, if at all; • changes in assumptions underlying our critical accounting policies; • changes in legislative and regulatory matters that may cause us to incur additional costs and expenses; and • other risks and uncertainties discussed in our Annual Report for the year ended December 31, 2016 and other reports or documents that we file from time to time with the SEC. Statements included in this Quarterly Report are based upon information known to us as of the date that this Quarterly Report is filed with the SEC, and we assume no obligation to update or alter our forward-looking statements made in this Quarterly Report, whether as a result of new information, future events or otherwise, except as required by applicable federal securities laws. March 31, December 31, $ 9,502 $ 14,208 Accounts receivable, net of allowance for doubtful accounts of $3,022 and $3,857 Property, plant and equipment, net of accumulated depreciation of $1,640,182 and $1,619,301 Franchise rights Other assets, net of accumulated amortization of $4,273 and $4,101 $ 2,297,941 $ 2,292,154 LIABILITIES, PREFERRED MEMBERS’ INTEREST AND MEMBER’S EQUITY Accounts payable, accrued expenses and other current liabilities Accounts payable—affiliates Long-term debt, net (less current portion) Other non-current liabilities Commitments and contingencies (Note 10) PREFERRED MEMBERS’ INTEREST (Note 7) MEMBER’S EQUITY Capital distributions (38,115 ) (37,348 ) Total member’s equity Total liabilities, preferred members’ interest and member’s equity The accompanying notes to the unaudited financial statements are an integral part of these statements. Costs and expenses: Service costs (exclusive of depreciation and amortization) Selling, general and administrative expenses Management fee expense Gain (loss) on derivatives, net 1,265 (7,260 ) (318 ) (469 ) Dividend to preferred members (Note 7) (4,500 ) (4,500 ) Net income applicable to member CASH FLOWS FROM OPERATING ACTIVITIES: Adjustments to reconcile net income to net cash flows provided by operating activities: (Gain) loss on derivatives, net (1,265 ) 7,260 Changes in assets and liabilities: Prepaid expenses and other assets (43 ) (23 ) Net cash flows provided by operating activities CASH FLOWS FROM INVESTING ACTIVITIES: $ (46,037 ) $ (42,345 ) Change in accrued property, plant and equipment Proceeds from sale of assets Net cash flows used in investing activities CASH FLOWS FROM FINANCING ACTIVITIES: New borrowings of bank debt Repayment of bank debt (115,000 ) (74,269 ) Dividend payments on preferred members’ interest (Note 7) Capital distributions to parent (Note 8) (800 ) — Other financing activities (850 ) 709 Net cash flows used in financing activities (4,706 ) (331 ) CASH, beginning of period CASH, end of period SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the period for interest, net of amounts capitalized NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Basis of Preparation of Unaudited Consolidated Financial Statements Mediacom Broadband LLC (“Mediacom Broadband,” and collectively with its subsidiaries, “we,” “our” or “us”) is a Delaware limited liability company wholly-owned by Mediacom Communications Corporation (“MCC”). MCC is involved in the acquisition and operation of cable systems serving smaller cities and towns in the United States, and its cable systems are owned and operated through our operating subsidiaries and those of Mediacom LLC, a New York limited liability company wholly-owned by MCC. As limited liability companies, we and Mediacom LLC are not subject to income taxes and, as such, are included in the consolidated federal and state income tax returns of MCC, a C corporation. Our principal operating subsidiaries conduct all of our consolidated operations and own substantially all of our consolidated assets. Our operating subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to make funds available to us. We rely on our parent, MCC, for various services such as corporate and administrative support. Our financial position, results of operations and cash flows could differ from those that would have resulted had we operated autonomously or as an entity independent of MCC. See Notes 8 and 9. We have prepared these unaudited consolidated financial statements in accordance with the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of management, such statements include all adjustments, consisting of normal recurring accruals and adjustments, necessary for a fair statement of our consolidated results of operations, financial position, and cash flows for the interim periods presented. The accounting policies followed during such interim periods reported are in conformity with generally accepted accounting principles in the United States of America and are consistent with those applied during annual periods. For a summary of our accounting policies and other information, refer to our Annual Report on Form 10-K for the year ended December 31, 2016. The results of operations for the interim periods are not necessarily indicative of the results that might be expected for future interim periods or for the full year ending December 31, 2017. Mediacom Broadband Corporation (“Broadband Corporation”), a Delaware corporation wholly-owned by us, co-issued, jointly and severally with us, public debt securities. Broadband Corporation has no operations, revenues or cash flows and has no assets, liabilities or stockholders’ equity on its balance sheet, other than a one-hundred dollar receivable from an affiliate and the same dollar amount of common stock. Therefore, separate financial statements have not been presented for this entity. Franchise fees imposed by local governmental authorities are collected on a monthly basis from our customers and are periodically remitted to the local governmental authorities. Because franchise fees are our obligation, we present them on a gross basis within revenues with a corresponding operating expense. Franchise fees reported on a gross basis amounted to $5.5 million and $6.0 million for the three months ended March 31, 2017 and 2016, respectively. 2. RECENT ACCOUNTING PRONOUNCEMENTS In May 2014, the FASB issued ASU No. 2014-09 (“ASU 2014-09”) – Revenue from Contracts with Customers. The guidance states that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. An entity should also disclose sufficient information to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. This guidance supersedes most industry-specific guidance, including Statement of Financial Accounting Standards No. 51 – Financial Reporting by Cable Television Companies. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers, which deferred by one year the effective date of ASU 2014-09 until reporting periods beginning after December 15, 2017, including interim periods within the reporting periods. The FASB is permitting early adoption of the updated accounting guidance, but not before the original effective date of December 15, 2016. Based on a preliminary assessment of certain revenue transactions performed to date, we expect that the new guidance will impact the timing of the recognition of installation revenue and commission expenses. Under the new guidance, these amounts will be recognized as revenue and expenses, respectively, over a period of time instead of immediately, as is being done under current practice. Installation revenues and commission expenses recorded in the year ended December 31, 2016 are each less than 2% of total revenues recorded in the same period. We are currently in the process of evaluating which method of transition will be utilized at adoption. We continue to assess all of the potential impacts that the adoption of ASU 2014-09 will have on our consolidated financial statements, including the development of new accounting policies, procedures and internal controls associated with the adoption of the standard. In February 2016, the FASB issued ASU 2016-02—Leases (Topic 842) (“ASU 2016-02”). The objective of ASU 2016-02 is to address the concerns to increase the transparency around lease obligations. To address these concerns, previously unrecorded off-balance sheet obligations will now be brought more prominently to light by presenting lease liabilities on the face of the balance sheet. Accompanied by enhanced qualitative and quantitative disclosures in the notes to the financial statements, financial statement users will be able to more accurately compare information from one company to another. This guidance is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2018. We have not completed our evaluation of this new guidance. In August 2016, the FASB issued ASU 2016-15 – Statement of Cash Flows – Clarification of Certain Cash Receipts and Cash Payments. (“ASU 2016-15”). Stakeholders indicated that there is diversity in practice in how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other topics. ASU 2016-15 addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The amendments in ASU 2016-15 are effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those fiscal years. We do not expect ASU 2016-15 will have a material impact on our financial position, operations or cash flows upon adoption. 3. FAIR VALUE The tables below set forth our financial assets and liabilities measured at fair value on a recurring basis using a market-based approach. Our financial assets and liabilities, all of which represent interest rate exchange agreements (which we refer to as “interest rate swaps”) have been categorized according to the three-level fair value hierarchy established by Accounting Standards Codification (“ASC”) No. 820 — Fair Value Measurement, which prioritizes the inputs used in measuring fair value, as follows (dollars in thousands): • Level 1 — Quoted market prices in active markets for identical assets or liabilities. • Level 2 — Observable market based inputs or unobservable inputs that are corroborated by market data. • Level 3 — Unobservable inputs that are not corroborated by market data. Fair Value as of March 31, 2017 Level 1 Level 2 Level 3 Total Interest rate exchange agreements $ — $ 591 $ — $ 591 $ — $ — $ — $ — Fair Value as of December 31, 2016 $ — $ 1,089 $ — $ 1,089 The fair value of our interest rate swaps represents the estimated amount that we would receive or pay to terminate such agreements, taking into account projected interest rates, based on quoted London Interbank Offered Rate (“LIBOR”) futures and the remaining time to maturity. While our interest rate swaps are subject to contractual terms that provide for the net settlement of transactions with counterparties, we do not offset assets and liabilities under these agreements for financial statement presentation purposes, and assets and liabilities are reported on a gross basis. As of March 31, 2017, we recorded a current asset and a long-term asset of $0.1 million and $0.5 million, respectively, and no current or long-term liability. As of December 31, 2016, we recorded a long-term asset of $1.1 million, a current liability in accounts payable, accrued expenses and other current liabilities of $1.8 million, and no current assets or long-term liabilities. As a result of the changes in the mark-to-market valuations on our interest rate swaps, we recorded a net gain on derivatives of $1.3 million and a net loss on derivatives of $7.3 million for the three months ended March 31, 2017 and 2016, respectively. 4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consisted of the following (dollars in thousands): Cable systems, equipment and customer devices Buildings and leasehold improvements Furniture, fixtures and office equipment Land and land improvements Property, plant and equipment, gross (1,640,182 ) (1,619,301 ) 5. ACCOUNTS PAYABLE, ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES Accounts payable, accrued expenses and other current liabilities consisted of the following (dollars in thousands): Accounts payable—trade Accrued programming costs Accrued taxes and fees Advance customer payments Accrued payroll and benefits Accrued property, plant and equipment Accrued service costs Bank overdrafts (1) Accrued administrative costs Accrued marketing costs Accrued telecommunications costs Liabilities under interest rate exchange agreements Other accrued expenses (1) Bank overdrafts represent outstanding checks in excess of funds on deposit at our disbursement accounts. We transfer funds from our depository accounts to our disbursement accounts upon daily notification of checks presented for payment. Changes in bank overdrafts are reported in “other financing activities” in our Consolidated Statements of Cash Flows. Outstanding debt consisted of the following (dollars in thousands): Bank credit facility 5 1⁄2% senior notes due 2021 Less: current portion Total long-term debt, gross (less current portion) Less: deferred financing costs, net Total long-term debt, net (less current portion) As of March 31, 2017, we maintained a $1.380 billion bank credit facility (the “credit facility”), comprising: • $368.5 million of revolving credit commitments, which expire on October 10, 2019; • $142.0 million of outstanding borrowings under Term Loan A, which mature on January 15, 2021; • $577.5 million of outstanding borrowings under Term Loan H, which mature on January 29, 2021; • $291.8 million of outstanding borrowings under Term Loan J, which mature on June 30, 2021. As of March 31, 2017, we had $279.1 million of unused revolving credit commitments, all of which were available to be borrowed and used for general corporate purposes, after giving effect to approximately $79.7 million of outstanding loans and $9.7 million of letters of credit issued thereunder to various parties as collateral. The credit facility is collateralized by our ownership interests in our operating subsidiaries and is guaranteed by us on a limited recourse basis to the extent of such ownership interests. As of March 31, 2017, the credit agreement governing the credit facility (the “credit agreement”) required our operating subsidiaries to maintain a total leverage ratio (as defined in the credit agreement) of no more than 5.0 to 1.0 and an interest coverage ratio (as defined in the credit agreement) of no less than 2.0 to 1.0. For all periods through March 31, 2017, our operating subsidiaries were in compliance with all covenants under the credit agreement. As of the same date, the credit agreement allowed for the full or partial repayment of any outstanding debt under the credit facility at par value at any time prior to maturity. Interest Rate Swaps We have entered into several interest rate exchange agreements (which we refer to as “interest rate swaps”) with various banks to fix the variable rate on a portion of our borrowings under the credit facility to reduce the potential volatility in our interest expense that may result from changes in market interest rates. Our interest rate swaps have not been designated as hedges for accounting purposes, and have been accounted for on a mark-to-market basis as of, and for the three months ended, March 31, 2017 and 2016. As of March 31, 2017, we had interest rate swaps that fixed the variable portion of $600 million of borrowings at a rate of 1.5%, all of which are scheduled to expire during December 2018. As of March 31, 2017, the weighted average interest rate on outstanding borrowings under the credit facility, including the effect of our interest rate swaps, was 3.6%. As of March 31, 2017, we had $500 million of outstanding senior notes, comprising $200 million of 5 1⁄2% senior notes due April 2021 and $300 million of 6 3⁄8% senior notes due April 2023. Our senior notes are unsecured obligations, and the indentures governing our senior notes (the “indentures”) limit the incurrence of additional indebtedness based upon a maximum debt to operating cash flow ratio (as defined in the indentures) of 8.5 to 1.0. For all periods through March 31, 2017, we were in compliance with all covenants under the indentures. As of the same date, the indentures allowed for the full or partial repayment of any of our senior notes at any time prior to maturity, subject to certain prices and conditions specified in the indentures. Debt Ratings MCC’s corporate credit ratings are currently Ba3 by Moody’s, with a positive outlook, and BB by Standard and Poor’s (“S&P”), with a stable outlook, and our senior unsecured ratings are currently B2 by Moody’s, with a positive outlook, and B+ by S&P, with a stable outlook. There are no covenants, events of default, borrowing conditions or other terms in the credit agreement or indentures that are based on changes in our credit rating assigned by any rating agency. The fair values of our senior notes and outstanding debt under the credit facility (which were calculated based upon unobservable inputs that are corroborated by market data that we determine to be Level 2), were as follows (dollars in thousands): Total senior notes 7. PREFERRED MEMBERS’ INTEREST In July 2001, we received a $150.0 million preferred membership investment (“PMI”) from the operating subsidiaries of Mediacom LLC, which has a 12% annual dividend, payable quarterly in cash. We may voluntarily repay the PMI any time at par, and the operating subsidiaries of Mediacom LLC have the option to call for the redemption of the PMI upon the repayment of all of our outstanding senior notes. We paid $4.5 million in cash dividends on the PMI during each of the three months ended March 31, 2017 and 2016. 8. MEMBER’S EQUITY As a wholly-owned subsidiary of MCC, our business affairs, including our financing decisions, are directed by MCC. See Note 9. Capital distributions to parent and capital contributions from parent are reported on a gross basis in the Consolidated Statements of Cash Flows. We made capital distributions to parent in cash of $0.8 million and $0 for the three months ended March 31, 2017 and 2016, respectively. We received no capital contributions from parent for the three months ended March 31, 2017 and 2016. 9. RELATED PARTY TRANSACTIONS MCC manages us pursuant to management agreements with our operating subsidiaries. Under such agreements, MCC has full and exclusive authority to manage our day-to-day operations and conduct our business. We remain responsible for all expenses and liabilities relating to the construction, development, operation, maintenance, repair and ownership of our systems. As compensation for the performance of its services, subject to certain restrictions, MCC is entitled under each management agreement to receive management fees in an amount not to exceed 4.0% of the annual gross operating revenues of our operating subsidiaries. MCC is also entitled to the reimbursement of all expenses necessarily incurred in its capacity as manager. MCC charged us management fees of $5.7 million and $5.4 million for the three months ended March 31, 2017 and 2016, respectively. Mediacom LLC is a preferred equity investor in us. See Note 7. 10. COMMITMENTS AND CONTINGENCIES We are involved in various legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial position, results of operations, cash flows or business. 11. GOODWILL AND OTHER INTANGIBLE ASSETS In accordance with the FASB’s ASC No. 350 — Intangibles — Goodwill and Other (“ASC 350”), the amortization of goodwill and indefinite-lived intangible assets is prohibited and requires such assets to be tested annually for impairment, or more frequently if impairment indicators arise. We have determined that our goodwill and franchise rights are indefinite-lived assets and therefore not amortizable. We last evaluated the factors surrounding our Mediacom Broadband reporting unit as of October 1, 2016 and did not believe that it was “more likely than not” that a goodwill impairment existed at that time. As such, we did not perform Step 2 of the goodwill impairment test. We last evaluated our other intangible assets as of October 1, 2016 and did not believe that it was “more likely than not” that an impairment existed at that time. Because we believe there has not been a meaningful change in the long-term fundamentals of our business during the first three months of 2017, we determined that there has been no triggering event under ASC 350 and, as such, no interim impairment test was required for our goodwill and other intangible assets as of March 31, 2017. The following discussion should be read in conjunction with our unaudited consolidated financial statements as of, and for the three months ended, March 31, 2017 and 2016, and with our Annual Report on Form 10-K for the year ended December 31, 2016. Mediacom Communications Corporation We are a wholly-owned subsidiary of Mediacom Communications Corporation (“MCC”), the nation’s fifth largest cable company based on the number of customers who purchase one or more video services, or video customers. MCC offers a wide array of information, communications and entertainment services to households and businesses, including video, high-speed data (“HSD”), phone, and home security and automation. Through Mediacom Business, MCC provides scalable broadband communications solutions to commercial and public sector customers of all sizes, and sells advertising and production services under the OnMedia brand. MCC’s cable systems are owned and operated through our operating subsidiaries and those of Mediacom LLC, another wholly-owned subsidiary of MCC. As of March 31, 2017, MCC’s cable systems passed an estimated 2.8 million homes and served approximately 832,000 video customers, 1,179,000 HSD customers and 495,000 phone customers, aggregating 2.5 million primary service units (“PSUs”). The following discussion of financial condition and results of operations relates only to Mediacom Broadband LLC and not to the consolidated financial condition and results of operations of MCC. We are a wholly-owned subsidiary of MCC. As of March 31, 2017, we served approximately 461,000 video customers, 652,000 HSD customers and 273,000 phone customers, aggregating 1.39 million PSUs. As of the same date, we served 757,000 residential and business customer relationships. We offer video, HSD and phone services individually and in bundled packages to residential and small- to medium-sized business (“SMB”) customers over our hybrid fiber and coaxial cable (“HFC”) network, and provide fiber-based network and transport services to medium- and large-sized businesses, governments and educational institutions. We also sell advertising to local, regional and national advertisers on television and digital platforms, and offer home security and automation services to residential customers. Our services are typically offered on a subscription basis, with installation fees, monthly rates and related charges associated with the services, equipment and features customers choose. We offer discounted packages for new customers and those who take multiple services, and our Xtream packages include video with digital video recorder (“DVR”) service and set-tops with the TiVo guide, HSD with a wireless gateway, and phone service. We believe the simplified pricing and value proposition of our Xtream bundles has positively influenced the market’s perception of our products and services, and has driven higher levels of sales activity. Over the past several years, revenues from residential services have increased mainly due to residential HSD customer growth. We expect to continue to grow revenues from residential services through HSD customer growth and increased revenue per customer relationship as more customers take faster HSD tiers and advanced video services, including our next-generation set-top and DVR service. Our business services revenues have grown at a faster rate than our residential revenues as we have rapidly expanded our SMB and, to a lesser extent, enterprise customer base. In an effort to sustain or accelerate our rate of growth in business services revenues, we have commenced “Project Open Road,” where we plan to extend our network to a meaningful number of new commercial locations that contain multiple businesses that represent potential customers. Our residential video service principally competes with direct broadcast satellite (“DBS”) providers that offer video programming substantially similar to ours. Over the past several years, we have experienced meaningful video customer losses, as DBS competitors have deployed aggressive marketing campaigns, including deeply discounted promotional packages, more advanced customer premise equipment and exclusive sports programming. We have placed a greater emphasis on higher quality residential customer relationships, as we have generally eliminated or reduced tactical discounts for customers not likely to purchase two or more services or to stay with us for an extended period, which may further contribute to video customer declines. To appeal to such higher-quality residential consumers, we have deployed a next-generation Internet Protocol (“IP”) set-top that offers a cloud-based, graphically-rich TiVo guide with access and integrated search functionality to certain third-party Internet-based video applications (“video apps”), such as Netflix, Hulu, and YouTube, along with a multi-room DVR service and the ability to download certain content to personal devices. In 2017, we also plan to introduce a new, lower-cost, IP set-top that offers the TiVo guide and video apps, but without the required equipment for DVR service. We believe our video strategy has enabled us to reduce the rate of video customer losses and regain market share of new video connects. If we are unsuccessful with this strategy and cannot offset video customer losses through higher average unit pricing and greater penetration of our advanced video services, we may experience future declines in annual video revenues. Our residential HSD service competes primarily with digital subscriber line (“DSL”) services offered by local phone companies, and we have continued to grow our HSD customer base over the last several years. We believe our HSD service is generally superior to DSL offerings in our service areas as our minimum downstream speed of 60 megabits per second (“Mbps”) is faster than the highest speed offered by substantially all our DSL competition. As consumers’ bandwidth requirements have dramatically risen in recent years, we have dedicated increasing levels of capital expenditures to allow for faster speeds and greater levels of consumption. Through “Project Gigabit,” we have installed the necessary equipment to transition substantially all our homes passed to the DOCSIS 3.1 platform, which will allow us to introduce packages offering speeds of up to 1 gigabit per second (“Gbps”) across most of our markets in 2017. We expect to continue to grow HSD revenues as we further take market share and our HSD customers choose higher speed tiers. Our residential phone service mainly competes with substantially comparable phone services offered by local phone companies and cellular phone services offered by national wireless providers. We believe we will continue to grow residential phone customers, but may experience modest declines in phone revenues due to unit pricing pressure. Our business services primarily compete for SMB customers with local phone companies, many of which have had a historical advantage given long-term relationships with such customers, a nation-wide footprint that allows them to more effectively serve multiple locations, and existing networks built in certain commercial areas that we do not currently serve. Our cell tower backhaul and enterprise-level services also face competition from these local phone companies as well as other carriers, including metro and regional fiber-based carriers. In recent years, we have aggressively marketed our business services and expanded our network into additional commercial areas, which has allowed us to gain meaningful market share and led to strong growth rates of business services revenues in the past several years. We believe the introduction of “Project Open Road” will allow us to continue to gain market share and grow business services revenues. We compete for advertising revenues principally against local broadcast stations, national cable and broadcast networks, radio, newspapers, magazines, outdoor display and Internet companies. Competition will likely elevate as new formats for advertising are introduced into our markets. Historically, video programming has been our single largest expense, and we have experienced substantial increases in programming costs per video customer, particularly for sports and local broadcast programming, well in excess of the inflation rate or the change in the consumer price index. We believe these expenses will continue to grow at a high single- to low double-digit rate because of the demands of large media conglomerates or other owners of most of the popular cable networks and major market local broadcast stations, and of large independent television broadcast groups, who own or control a significant number of local broadcast stations across the country and, in some cases, own, control or otherwise represent multiple stations in the same market. Moreover, many of those powerful owners of programming require us to purchase their networks and stations in bundles and effectively dictate how we offer them to our customers, given the contractual economic penalties if we fail to comply. Consequently, we have little or no ability to individually or selectively negotiate for networks or stations, to forego purchasing networks or stations that generate low customer interest, to offer sports programming services, such as ESPN and regional sports networks, on one or more separate tiers, or to offer networks or stations on an a la carte basis to give our customers more choice and potentially lower their costs. In many instances, such programmers have created additional networks and migrated popular programming, particularly sports programming, to these new networks, which has contributed to the increases in our programming costs. Additionally, we believe certain programmers may also demand higher fees from us in an effort to partially offset declines in their advertising revenue as more advertisers allocate a greater portion of their spending to Internet advertising. While such growth in programming expenses can be offset, in whole or in part, by rate increases, we expect our video gross margins will continue to decline if increases in programming costs outpace any growth in video revenues. Video revenues primarily represent monthly subscription fees charged to residential customers, which vary according to the level of service and the type and amount of equipment taken. Video revenues also include the sale of VOD content and pay-per-view events, installation, reconnection and wire maintenance fees, franchise and late payment fees, and other ancillary revenues. HSD revenues primarily represent monthly subscription fees charged to residential customers, which vary according to the level of service and type of equipment taken. Phone revenues primarily represent monthly subscription and equipment fees charged to residential customers for our phone service. Business services revenues primarily represent monthly fees charged to SMBs for video, HSD and phone services, which vary according to the level of service taken, and fees charged to large businesses, including revenues from cell tower backhaul and enterprise class services. Advertising revenues primarily represent revenues received from selling advertising time we receive under programming license agreements to local, regional and national advertisers for the placement of commercials on channels offered on our video services. Costs and Expenses Service Costs Service costs consist of the costs related to providing and maintaining services to our customers. Significant service costs comprise: video programming; HSD service, including bandwidth connectivity; phone service, including leased circuits and long distance; our enterprise networks business, including leased access; technical personnel who maintain the cable network, perform customer installation activities and provide customer support; network operations center; utilities, including pole rental; and field operations, including outside contractors, vehicle fuel and maintenance and leased fiber for regional connectivity. Video programming costs, which are generally paid on a per-video customer basis, have historically represented our single largest expense. In recent years, we have experienced substantial increases in the per-unit cost of programming, which we believe will continue to grow due to the increasing contractual rates and retransmission consent fees demanded by large programmers and independent broadcasters. Our HSD costs fluctuate depending on customers’ bandwidth consumption and customer growth. Phone service costs are mainly determined by network configuration, customers’ long distance usage and net termination payments to other carriers. Our other service costs generally rise as a result of customer growth and inflationary cost increases for personnel, outside vendors and other expenses. Personnel and related support costs may increase as the percentage of expenses that we capitalize declines due to lower levels of new service installations. We anticipate that service costs, with the exception of programming expenses, will remain fairly consistent as a percentage of our revenues. Significant selling, general and administrative expenses comprise: call center, customer service, marketing, business services, support and administrative personnel; franchise fees and other taxes; bad debt; billing; marketing; advertising; and general office administration. These expenses generally rise due to customer growth and inflationary cost increases for personnel, outside vendors and other expenses. We anticipate that selling, general and administrative expenses will remain fairly consistent as a percentage of our revenues. Service costs and selling, general and administrative expenses exclude depreciation and amortization, which we present separately. Management fee expense reflects compensation paid to MCC for the performance of services it provides our operating subsidiaries in accordance with management agreements between MCC and our operating subsidiaries. Capital expenditures are categorized in accordance with the National Cable and Telecommunications Association (“NCTA”) disclosure guidelines, which are intended to provide more consistency in the reporting of capital expenditures among peer companies in the cable industry. These disclosure guidelines are not required under GAAP, nor do they impact our accounting for capital expenditures under GAAP. Our capital expenditures comprise: • Customer premise equipment, which include equipment and labor costs incurred in the purchase and installation of equipment that resides at a residential or commercial customer’s premise; • Enterprise networks, which include costs associated with furnishing custom fiber solutions for medium- to large-sized business customers, including for cell tower backhaul; • Scalable infrastructure, which include costs incurred in the purchase and installation of equipment at our facilities associated with network-wide distribution of services; • Line extensions, which include costs associated with the extension of our network into new service areas; • Upgrade / rebuild, which include costs to modify or replace existing components of our network; and • Support capital, which include vehicles and all other capital purchases required to support our customers and general business operations. Use of Non-GAAP Financial Measures “OIBDA” is not a financial measure calculated in accordance with generally accepted accounting principles (“GAAP”) in the United States. We define OIBDA as operating income before depreciation and amortization. OIBDA has inherent limitations as discussed below. OIBDA is one of the primary measures used by management to evaluate our performance and to forecast future results. We believe OIBDA is useful for investors because it enables them to assess our performance in a manner similar to the methods used by management, and provides a measure that can be used to analyze our value and evaluate our performance compared to other companies in the cable industry. A limitation of OIBDA, however, is that it excludes depreciation and amortization, which represents the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in our business. Management uses a separate process to budget, measure and evaluate capital expenditures. In addition, OIBDA may not be comparable to similarly titled measures used by other companies, which may have different depreciation and amortization policies. OIBDA should not be regarded as an alternative to operating income or net income as an indicator of operating performance, or to the statement of cash flows as a measure of liquidity, nor should it be considered in isolation or as a substitute for financial measures prepared in accordance with GAAP. We believe that operating income is the most directly comparable GAAP financial measure to OIBDA. Actual Results of Operations Three Months Ended March 31, 2017 Compared to Three Months Ended March 31, 2016 The table below sets forth our consolidated statements of operations and OIBDA (dollars in thousands and percentage changes that are not meaningful are marked NM): 2017 2016 % Change $ 261,508 $ 255,218 2.5 % 109,062 104,475 4.4 % 47,517 46,968 1.2 % 5,650 5,350 5.6 % 62,700 63,097 (0.6 %) (17,793 ) (20,667 ) (13.9 %) 1,265 (7,260 ) NM (318 ) (469 ) NM $ 45,854 $ 34,701 32.1 % OIBDA $ 99,279 $ 98,425 0.9 % The table below represents a reconciliation of OIBDA to operating income (dollars in thousands): (36,579 ) (35,328 ) 3.5 % $ 62,700 $ 63,097 (0.6 %) The tables below set forth our revenues and selected customer and average total monthly revenue statistics (dollars in thousands, except per unit data): $ 111,304 $ 112,702 (1.2 %) 89,532 80,037 11.9 % 9,737 13,883 (29.9 %) Total revenues Video customers 461,000 479,000 (3.8 %) HSD customers Phone customers 273,000 245,000 11.4 % Primary service units (PSUs) 1,386,000 1,345,000 3.0 % Average total monthly revenue per customer relationship (1) $ 115.38 $ 115.59 (0.2 %) (1) Represents average total monthly revenues for the period divided by average customer relationships for the period. Revenues increased 2.5% for the three months ended March 31, 2017, primarily due to greater HSD and, to a lesser extent, business services revenues, offset in part by lower advertising revenues. Video revenues decreased 1.2% for the three months ended March 31, 2017, mainly due to a lower residential video customer base compared to the prior year period, offset in part by rate adjustments, including the pass-through of higher programming costs for retransmission consent fees, and more customers taking our advanced video services. We lost 2,000 video customers during the three months ended March 31, 2017, compared to a decrease of 1,000 video customers in the comparable prior year period. As of March 31, 2017, we served 461,000 video customers, or 30.6% of estimated homes passed, and 42.3% of our residential video customers took our DVR service, which represents a large component of revenues from advanced video services. HSD revenues rose 11.9% for the three months ended March 31, 2017, largely due to rate adjustments and more customers paying higher rates for faster speed tiers and a greater residential HSD customer base compared to the prior year period. We gained 9,000 HSD customers during the three months ended March 31, 2017, compared to an increase of 16,000 HSD customers in the comparable prior year period. As of March 31, 2017, we served 652,000 HSD customers, or 43.3% of estimated homes passed, and 52.0% of our residential HSD customers took our wireless home gateway service. Phone revenues declined 2.0% for the three months ended March 31, 2017, primarily due to greater levels of discounting within the bundled packaging of our services, offset in part by a greater residential phone customer base compared to the prior year period. We gained 9,000 phone customers during the three months ended March 31, 2017, compared to an increase of 6,000 phone customers in the comparable prior year period. As of March 31, 2017, we served 273,000 phone customers, or 18.1% of estimated homes passed. Business services revenues grew 7.7% for the three months ended March 31, 2017, mainly due to a greater small- to medium-sized business customer base compared to the prior year period. Advertising revenues fell 29.9% for the three months ended March 31, 2017, principally due to lower levels of political advertising. Service costs increased 4.4% for the three months ended March 31, 2017, principally due to higher video programming costs. Programming costs were 6.3% higher, mainly due to higher fees associated with the renewal of programming contracts and contractual increases under agreements with certain local broadcast stations and cable networks, offset in part by a lower video customer base compared to the prior year period. Service costs as a percentage of revenues were 41.7% and 40.9% for the three months ended March 31, 2017 and 2016, respectively. Selling, general and administrative expenses grew 1.2% for the three months ended March 31, 2017, mainly as a result of greater marketing and bad debt expenses, offset in part by lower taxes and fees and advertising expenses. Marketing costs increased 11.4%, principally due to our Xtream bundle campaign and the marketing of our business services. Bad debt expenses rose 22.1%, largely due to the aging of certain business customer accounts. Taxes and fees declined 6.8%, principally due to lower franchise and patent fees. Advertising expenses fell 18.8%, predominantly due to a lower spending on promotional activities for our advertising sales group. Selling, general and administrative expenses as a percentage of revenues were 18.2% and 18.4% for the three months ended March 31, 2017 and 2016, respectively. Management fee expense grew 5.6% for the three months ended March 31, 2017, reflecting higher fees charged by MCC. Management fee expense as a percentage of revenues was 2.2% and 2.1% for the three months ended March 31, 2017 and 2016, respectively. Depreciation and amortization was 3.5% higher for the three months ended March 31, 2017, largely as a result of greater depreciation of investments in customer premise equipment, HSD bandwidth expansion and business support. Operating income decreased 0.6% for the three months ended March 31, 2017, due to higher service costs and, to a much lesser extent, depreciation and amortization, and selling, general and administrative expenses, offset by the increase in revenues. Interest expense, net, fell 13.9% for the three months ended March 31, 2017, due to lower average outstanding indebtedness and, to a much lesser extent, lower average borrowing costs. As a result of the changes in the mark-to-market valuations on our interest rate exchange agreements, we recorded a net gain on derivatives of $1.3 million and a net loss on derivatives of $7.3 million for the three months ended March 31, 2017 and 2016, respectively. See Notes 3 and 6 in our Notes to Consolidated Financial Statements. Other expense, net, was $0.3 million and $0.5 million for the three months ended March 31, 2017 and 2016, respectively, substantially representing revolving credit commitment fees. As a result of the factors described above, we recognized net income of $45.9 million and $34.7 million for the three months ended March 31, 2017 and 2016, respectively. OIBDA grew 0.9% for the three months ended March 31, 2017, as the increase in revenues was mostly offset by increases in service costs and, to a much lesser extent, selling, general and administrative expenses. Our net cash flows provided by operating activities are primarily used to fund investments to enhance the capacity and reliability of our network and further expand our products and services, and make scheduled and voluntary repayments of our indebtedness and periodic distributions to MCC. As of March 31, 2017, our near-term liquidity requirements included term loan principal repayments of $16.6 million over the next twelve months. As of the same date, our sources of liquidity included $9.5 million of cash and $279.1 million of unused and available commitments under our $368.5 million revolving credit facility, after giving effect to approximately $79.7 million of outstanding loans and $9.7 million of letters of credit issued to various parties as collateral. We believe that we will be able to continue to meet our current and long-term liquidity and capital requirements, including fixed charges, through existing cash, internally generated cash flows from operating activities, cash available to us under our revolving credit commitments and our ability to obtain future financing. If we are unable to obtain sufficient future financing on acceptable terms, or at all, we may need to take other actions to conserve or raise capital that we would not take otherwise. However, we have accessed the debt markets for significant amounts of capital in the past, and expect to continue to be able to access these markets in the future, as necessary. Net cash flows provided by operating activities were $81.1 million for the three months ended March 31, 2017, primarily due to OIBDA of $99.3 million, offset in part by interest expense of $17.8 million and, to a much lesser extent, the $1.2 million net change in our operating assets and liabilities. The net change in our operating assets and liabilities was primarily due to an increase in prepaid expenses and other assets of $5.4 million and a decrease in accounts payable, accrued expenses and other current liabilities of $2.5 million, offset in part by a decrease in accounts receivable, net, of $3.6 million and increases in accounts payable to affiliates of $2.2 million and in deferred revenue of $1.0 million. Net cash flows provided by operating activities were $94.4 million for the three months ended March 31, 2016, primarily due to OIBDA of $98.4 million and, to a much lesser extent, the $15.5 million net change in our operating assets and liabilities, offset in part by interest expense of $20.7 million. The net change in our operating assets and liabilities was primarily due to a decrease in accounts receivable, net, of $7.3 million, increases in accounts payable to affiliates of $5.5 million, in accounts payable, accrued expenses and other current liabilities of $5.1 million, and in deferred revenue of $1.1 million, offset in part by an increase in prepaid expenses and other assets of $3.4 million. Capital expenditures continue to be our primary use of capital resources and generally comprise substantially all of our net cash flows used in investing activities. Net cash flows used in investing activities were $42.6 million for the three months ended March 31, 2017, substantially comprising $46.0 million of capital expenditures, slightly offset by a net change in accrued property, plant and equipment of $3.4 million. Net cash flows used in investing activities were $41.2 million for the three months ended March 31, 2016, substantially comprising $42.3 million of capital expenditures, slightly offset by a net change in accrued property, plant, and equipment of $1.1 million. The table below sets forth our capital expenditures (dollars in thousands): 2017 2016 Change Customer premise equipment $ 20,036 $ 19,347 $ 689 2,096 1,959 137 Scalable infrastructure Line extensions 2,582 2,552 30 Upgrade / rebuild Support capital Total capital expenditures $ 46,037 $ 42,345 $ 3,692 The increase in capital expenditures largely reflects greater spending in scalable infrastructure, largely for Project Gigabit, in upgrade and rebuild, mainly the replacement of certain network assets, and in customer premise equipment, primarily for our next-generation advanced video set-tops. Net cash flows used in financing activities were $43.2 million for the three months ended March 31, 2017, substantially comprising $37.0 million of net repayments under our bank credit facility and $4.5 million of dividend payments on preferred members’ interest. As of March 31, 2017, our total indebtedness was $1.591 billion, of which approximately 69% was at fixed interest rates or had interest rate swaps that fixed the corresponding variable portion of debt. During the three months ended March 31, 2017, we paid cash interest of $12.1 million, net of capitalized interest. As of March 31, 2017, we maintained a $1.380 billion bank credit facility (the “credit facility”), comprising $1.011 billion of term loans with maturities ranging from January 2021 to June 2021 and $368.5 million of revolving credit commitments, which are scheduled to expire in October 2019. As of the same date, we had $279.1 million of unused lines under our revolving credit commitments, all of which were available to be borrowed and used for general corporate purposes, after taking into account $79.7 million of outstanding loans and $9.7 million of letters of credit issued to various parties as collateral The credit facility is collateralized by our ownership interests in our operating subsidiaries, and is guaranteed by us on a limited recourse basis to the extent of such ownership interests. The credit agreement governing the credit facility (the “credit agreement”) requires our operating subsidiaries to maintain a total leverage ratio (as defined in the credit agreement) of no more than 5.0 to 1.0 and an interest coverage ratio (as defined in the credit agreement) of no less than 2.0 to 1.0. For all periods through March 31, 2017, our operating subsidiaries were in compliance with all covenants under the credit agreement including, as of the same date, a total leverage ratio of 2.6 to 1.0 and an interest coverage ratio of 4.4 to 1.0. We do not believe that our operating subsidiaries will have any difficulty complying with any of the covenants under the credit agreement in the near future. We have entered into several interest rate exchange agreements (which we refer to as “interest rate swaps”) with various banks to fix the variable rate on a portion of our borrowings under the credit facility to reduce the potential volatility in our interest expense that may result from changes in market interest rates. As March 31, 2017, we had interest rate swaps that fixed the variable portion of $600 million of borrowings at a rate of 1.5%, all of which are scheduled to expire during December 2018. As of March 31, 2017, we had $500 million of outstanding senior notes, comprising $200 million of 5 1⁄2% senior notes due April 2021 and $300 million of 6 3⁄8% senior notes due April 2023. Our senior notes are unsecured obligations, and the indentures governing our senior notes (the “indentures”) limit the incurrence of additional indebtedness based upon a maximum debt to operating cash flow ratio (as defined in the indentures) of 8.5 to 1.0. For all periods through March 31, 2017, we were in compliance with all covenants under the indentures including, as of the same date, a debt to operating cash flow ratio of 4.0 to 1.0. We do not believe that we will have any difficulty complying with any of the covenants under the indentures in the near future. MCC’s corporate credit ratings are currently Ba3 by Moody’s, with a positive outlook, and BB by Standard and Poor’s (“S&P”), with a stable outlook, and our senior unsecured ratings are currently B2 by Moody’s, with a positive outlook, and B+ by S&P, with a stable outlook. There can be no assurance that Moody’s or S&P will maintain their ratings on MCC and us. A negative change to these credit ratings could result in higher interest rates on future debt issuance than we currently experience, or adversely impact our ability to raise additional funds. There are no covenants, events of default, borrowing conditions or other terms in the credit agreement or indentures that are based on changes in our credit rating assigned by any rating agency. Contractual Obligations and Commercial Commitments There have been no material changes to our contractual obligations and commercial commitments as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016. Critical Accounting Policies The preparation of our financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Periodically, we evaluate our estimates, including those related to doubtful accounts, long-lived assets, capitalized costs and accruals. We base our estimates on historical experience and on various other assumptions that we believe are reasonable. Actual results may differ from these estimates under different assumptions or conditions. We believe that the application of the critical accounting policies requires significant judgments and estimates on the part of management. For a summary of our critical accounting policies, refer to our Annual Report on Form 10-K for the year ended December 31, 2016. Goodwill and Other Intangible Assets In accordance with the Financial Accounting Standards Board’s Accounting Standards Codification (“ASC”) ASC 350 Intangibles — Goodwill and Other (“ASC 350”), the amortization of goodwill and indefinite-lived intangible assets is prohibited and requires such assets to be tested annually for impairment, or more frequently if impairment indicators arise. We have determined that our franchise rights and goodwill are indefinite-lived assets and therefore not amortizable. Because we believe there has not been a meaningful change in the long-term fundamentals of our business during the first three months of 2017, we determined that there has been no triggering event under ASC 350 and, as such, no interim impairment test was required as of March 31, 2017. Inflation and Changing Prices Our costs and expenses are subject to inflation and price fluctuations. Such changes in costs and expenses can generally be passed through to customers. Programming costs have historically increased at rates in excess of inflation and are expected to continue to do so. We believe that under the Federal Communications Commission’s existing cable rate regulations we may increase rates for video service to more than cover any increases in programming costs. However, competitive conditions and other factors in the marketplace may limit our ability to increase our rates. There have been no significant changes to the information required under this Item from what was disclosed in Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2016. Under the supervision and with the participation of the management of Mediacom Broadband LLC, including Mediacom Broadband LLC’s Chief Executive Officer and Chief Financial Officer, Mediacom Broadband LLC evaluated the effectiveness of Mediacom Broadband LLC’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, Mediacom Broadband LLC’s Chief Executive Officer and Chief Financial Officer concluded that Mediacom Broadband LLC’s disclosure controls and procedures were effective as of March 31, 2017. There has not been any change in Mediacom Broadband LLC’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2017 that has materially affected, or is reasonably likely to materially affect, Mediacom Broadband LLC’s internal control over financial reporting. Mediacom Broadband Corporation Under the supervision and with the participation of the management of Mediacom Broadband Corporation (“Mediacom Broadband”), including Mediacom Broadband’s Chief Executive Officer and Chief Financial Officer, Mediacom Broadband evaluated the effectiveness of Mediacom Broadband’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, Mediacom Broadband’s Chief Executive Officer and Chief Financial Officer concluded that Mediacom Broadband’s disclosure controls and procedures were effective as of March 31, 2017. There has not been any change in Mediacom Broadband’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the quarter ended March 31, 2017 that has materially affected, or is reasonably likely to materially affect, Mediacom Broadband’s internal control over financial reporting. See Note 10 in our Notes to Consolidated Financial Statements. There have been no material changes in our risk factors from those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2016. Exhibit Description 31.1 Rule 15d-14(a) Certifications of Mediacom Broadband LLC 31.2 Rule 15d-14(a) Certifications of Mediacom Broadband Corporation 32.1 Section 1350 Certifications of Mediacom Broadband LLC 32.2 Section 1350 Certifications of Mediacom Broadband Corporation 101 The following is financial information from Mediacom Broadband LLC’s and Mediacom Broadband Corporation’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2017, formatted in eXtensible Business Reporting Language (XBRL): (i) Consolidated Balance Sheets at March 31, 2017 and December 31, 2016, (ii) Consolidated Statements of Operations for the three months ended March 31, 2017 and 2016, (iii) Consolidated Statements of Cash Flows for the three months ended March 31, 2017 and 2016, (iv) Notes to Consolidated Financial Statements May 9, 2017 By: /s/ Mark E. Stephan Mark E. Stephan EXHIBIT INDEX EX-31.1 I, Rocco B. Commisso, certify that: (1) I have reviewed this report on Form 10-Q of Mediacom Broadband LLC; (2) Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; (3) Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; (4) The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and l5d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and (5) The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent function): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting. /s/ ROCCO B. COMMISSO Rocco B. Commisso I, Mark E. Stephan, certify that: c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of end of the period covered by this report based on such evaluation; and (1) I have reviewed this report on Form 10-Q of Mediacom Broadband Corporation; CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Mediacom Broadband LLC (the “Company”) on Form 10-Q for the period ended March 31, 2017 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Rocco B. Commisso, Chairman and Chief Executive Officer and Mark E. Stephan, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that: (1) the Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. In connection with the Quarterly Report of Mediacom Broadband Corporation (the “Company”) on Form 10-Q for the period ended March 31, 2017 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), Rocco B. Commisso, Chairman and Chief Executive Officer and Mark E. Stephan, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, that:

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professional_accounting

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended January 1, 2017 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Illumina, Inc. (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 5200 Illumina Way Registrant’s telephone number, including area code: (858) 202-4500 Name of each exchange on which registered Common Stock, $0.01 par value The NASDAQ Global Select Market Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer þ Accelerated filer o Non-accelerated filer o Smaller reporting company o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ As of February 3, 2017, there were 146.3 million shares (excluding 42.6 million shares held in treasury) of the registrant’s common stock outstanding. The aggregate market value of the common stock held by non-affiliates of the registrant as of July 3, 2016 (the last business day of the registrant’s most recently completed second fiscal quarter), based on the closing price for the common stock on The NASDAQ Global Select Market on July 1, 2016 (the last trading day before July 3, 2016), was $17.9 billion. This amount excludes an aggregate of approximately 19.4 million shares of common stock held by officers and directors and each person known by the registrant to own 10% or more of the outstanding common stock. Exclusion of shares held by any person should not be construed to indicate that such person possesses the power, directly or indirectly, to direct or cause the direction of the management or policies of the registrant, or that the registrant is controlled by or under common control with such person. Portions of the registrant’s definitive proxy statement for the 2017 annual meeting of stockholders are incorporated by reference into Items 10 through 14 of Part III of this Report. Item 1A Management’s Discussion and Analysis of Financial Condition and Results of Operations Exhibits and Financial Statement Schedule Special Note Regarding Forward-Looking Statements This annual report on Form 10-K contains, and our officers and representatives may from time to time make, “forward-looking statements” within the meaning of the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by words such as: “anticipate,” “intend,” “plan,” “goal,” “seek,” “believe,” “project,” “estimate,” “expect,” “strategy,” “future,” “likely,” “may,” “should,” “will,” or the negative of these terms, and similar references to future periods. Examples of forward-looking statements include, among others, statements we make regarding: our expectations as to our future financial performance, results of operations, or other operational results or metrics; the benefits that we expect will result from our business activities and certain transactions we have completed, such as product introductions, increased revenue, decreased expenses, and avoided expenses and expenditures; our expectations of the effect on our financial condition of claims, litigation, contingent liabilities, and governmental investigations, proceedings, and regulations; our strategies or expectations for product development, market position, financial results, and reserves; and other expectations, beliefs, plans, strategies, anticipated developments, and other matters that are not historical facts. Forward-looking statements are neither historical facts nor assurances of future performance. Instead, they are based only on our current beliefs, expectations, and assumptions regarding the future of our business, future plans and strategies, projections, anticipated events and trends, the economy, and other future conditions. Because forward-looking statements relate to the future, they are subject to inherent uncertainties, risks, and changes in circumstances that are difficult to predict and many of which are outside of our control. Our actual results and financial condition may differ materially from those indicated in the forward-looking statements. Therefore, you should not rely on any of these forward-looking statements. Important factors that could cause our actual results and financial condition to differ materially from those indicated in the forward-looking statements include, among others, the following: our ability to develop and commercialize our instruments and consumables, to deploy new products, services, and applications, and to expand the markets for our technology platforms; our ability to manufacture robust instrumentation and consumables; our ability to identify and integrate acquired technologies, products, or businesses successfully; our expectations and beliefs regarding prospects and growth for the business and its markets; the assumptions underlying our critical accounting policies and estimates; our assessments and estimates that determine our effective tax rate; our assessments and beliefs regarding the outcome of pending legal proceedings and any liability, that we may incur as a result of those proceedings; uncertainty, or adverse economic and business conditions, including as a result of slowing or uncertain economic growth in the United States or worldwide; and other factors detailed in our filings with the SEC, including the risks, uncertainties, and assumptions described in Item 1A “Risk Factors” below, or in information disclosed in public conference calls, the date and time of which are released beforehand. Any forward-looking statement made by us in this annual report on Form 10-K is based only on information currently available to us and speaks only as of the date on which it is made. We undertake no obligation, and do not intend, to publicly update any forward-looking statement, whether written or oral, that may be made from time to time, or to review or confirm analysts’ expectations, or to provide interim reports or updates on the progress of any current financial quarter, in each case whether as a result of new information, future developments, or otherwise. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge on our website, www.illumina.com. The information on our website is not incorporated by reference into this report. Such reports are made available as soon as reasonably practicable after filing with, or furnishing to, the SEC. The SEC also maintains an Internet site at www.sec.gov that contains reports, proxy and information statements, and other information regarding issuers that electronically file with the SEC. Copies of our annual report on Form 10-K will be made available, free of charge, upon written request. Illumina®, 24sure®, BaseSpace®, BeadArray, BlueFish®, BlueFuse®, BlueGnome®, cBot, CSPro®, DASL®, DesignStudio, Epicentre®, ForenSeq, Genetic Energy®, GenomeStudio®, GoldenGate®, HiScan®, HiSeq®, HiSeq X®, Infinium®, iScan®, iSelect®, MiniSeq, MiSeq®, MiSeqDx®, MiSeq FGx, NeoPrep, NextBio®, Nextera®, NextSeq®, NovaSeq, SeqMonitor, TruGenome®, TruSeq®, TruSight®, Understand Your Genome®, UYG®, VeraCode®, verifi®, VeriSeq, the pumpkin orange color, and the Genetic Energy streaming bases design are certain of our trademarks. This report also contains brand names, trademarks, or service marks of companies other than Illumina, and these brand names, trademarks, and service marks are the property of their respective holders. Unless the context requires otherwise, references in this annual report on Form 10-K to “Illumina,” the “Company,” “we,” “us,” and “our” refer to Illumina, Inc. and its subsidiaries. We are the global leader in sequencing- and array-based solutions for genetic analysis. Our products and services serve customers in a wide range of markets, enabling the adoption of genomic solutions in research and clinical settings. We were incorporated in California in April 1998 and reincorporated in Delaware in July 2000. Our principal executive offices are located at 5200 Illumina Way, San Diego, California 92122. Our telephone number is (858) 202-4500. Our customers include leading genomic research centers, academic institutions, government laboratories, and hospitals, as well as pharmaceutical, biotechnology, agrigenomics, commercial molecular diagnostic laboratories, and consumer genomics companies. Our portfolio of integrated systems, consumables, and analysis tools is designed to accelerate and simplify genetic analysis. This portfolio addresses the range of genomic complexity, price points, and throughput, enabling customers to select the best solution for their research or clinical challenge. Over the past five years, we have made key acquisitions to provide our customers with more comprehensive sample-to-answer solutions and to enable our goal of becoming a leader in the clinical market. These include: GenoLogics Life Sciences Software Inc., a developer of industry-leading laboratory information management systems, in August 2015; Myraqa, Inc., a regulatory and quality consulting firm specializing in IVDs and companion diagnostics, in July 2014; NextBio, a provider of clinical and genomic informatics, in November 2013; Advanced Liquid Logic Inc., a developer of digital microfluidics and liquid handling solutions, in July 2013; Verinata Health, Inc., a provider of non-invasive tests for the early identification of fetal chromosomal abnormalities, in February 2013; and BlueGnome Ltd., a provider of cytogenetics and in vitro fertilization screening solutions, in September 2012. We also invest in early-stage companies that are pursuing promising genomics-related technologies. For example, GRAIL, Inc. (GRAIL), formed in January 2016, was created to develop a blood test for early-stage cancer detection, and Helix Holdings I, LLC (Helix) was established in 2015 to enable individuals to explore their genetic information by providing sequencing and services for consumers through third-party partners. GRAIL and Helix are consolidated variable interest entities. Genetics Primer The instruction set for all living cells is encoded in deoxyribonucleic acid, or DNA. The complete set of DNA for any organism is referred to as its genome. DNA contains small regions called genes, which comprise a string of nucleotide bases labeled A, C, G, and T, representing adenine, cytosine, guanine, and thymine, respectively. These nucleotide bases occur in a precise order known as the DNA sequence. When a gene is “expressed,” a partial copy of its DNA sequence called messenger RNA (mRNA) is used as a template to direct the synthesis of a particular protein. Proteins, in turn, direct all cellular function. The illustration below is a simplified gene expression schematic. Variations among organisms are due, in large part, to differences in their DNA sequences. Changes can result from insertions, deletions, inversions, translocations, or duplications of nucleotide bases. These changes may result in certain genes becoming over-expressed (excessive protein production), under-expressed (reduced protein production), or silenced altogether, sometimes triggering changes in cellular function. These changes can be the result of heredity, but most often they occur at random. The most common form of variation in humans is called a single nucleotide polymorphism (SNP), which is a base change in a single position in a DNA sequence. Another type of variation, copy number variations (CNVs), occur when there are fewer or more copies of certain genes, segments of a gene, or stretches of DNA. In humans, genetic variation accounts for many of the physical differences we see (e.g., height, hair, eye color, etc.). Genetic variations also can have medical consequences affecting disease susceptibility, including predisposition to complex genetic diseases such as cancer, diabetes, cardiovascular disease, and Alzheimer’s disease. They can affect individual response to certain drug treatments, causing patients to experience adverse side effects, or to respond well or not at all. Scientists are studying these variations and their consequences in humans, as well as in a broad range of animals, plants, and microorganisms. Such research takes place in government, university, pharmaceutical, biotechnology, and agrigenomics laboratories around the world, where scientists expand our knowledge of the biological functions essential for life. Beginning at the genetic level, Illumina tools are used to elucidate the correlation between gene sequence and biological processes. Life-science research includes the study of the cells, tissues, organs, systems, and other components of living organisms. This research supports the development of new treatments to improve human health. Examples include more tailored clinical treatments, often referred to as precision medicine, as well as advances in agriculture and animal husbandry to meet growing needs for food and energy. Researchers who investigate human, viral, and bacterial genetic variation to understand the mechanisms of disease are enabling the development of more effective diagnostics and therapeutics. They also provide greater insight into genetic variation in plants (e.g., food and biofuel crops) and animals (e.g., livestock and domestic), enabling improvements in crop yields and animal breeding programs. By empowering genetic analysis and facilitating a deeper understanding of genetic variation and function, our tools advance disease research, drug development, and the creation of molecular diagnostic tests. We believe that this will trigger a fundamental shift in the practice of medicine and health care and that the increased emphasis on preventive and predictive molecular medicine will usher in the era of precision health care. Our Principal Markets Our organization is structured to target the markets and customers outlined below. Historically, our core business has been in the life sciences research market. This includes laboratories associated with universities, research centers, and government institutions, along with biotechnology and pharmaceutical companies. Researchers at these institutions use our products and services for basic and translational research across a spectrum of scientific applications, including targeted, exome, and whole-genome sequencing; genetic variation; gene expression; epigenetics; and metagenomics. Next-generation sequencing (NGS) technologies are being adopted due to their declining costs per sample as well as their ability to sequence large sample sizes and generate vast amounts of data. Both private and public funding drive this research, along with global initiatives to characterize genetic variation. We also serve applied markets including consumer genomics, agrigenomics, forensic genomics, and transplant biology. In consumer genomics, our customers use our technologies to provide personalized genetic data and analysis to individual consumers. In agrigenomics, government and corporate researchers use our products and services to explore the genetic and biological basis for productivity and nutritional constitution in crops and livestock. Researchers can identify natural and novel genomic variation and deploy genome-wide marker-based applications to accelerate breeding and production of healthier and higher-yielding crops and livestock. In forensic genomics, major law enforcement agencies use genomic information to investigate criminal cases, as do military and security intelligence agencies. In transplant diagnostics, we offer a sample-to-answer solution to perform high resolution HLA typing in a single assay, which enables users to determine how closely the tissues of one person match the tissues of another person. We provide sample-to-answer solutions to our customers in two key areas of translational and clinical genomics: reproductive and genetic health, and oncology. Illumina provides reproductive-health solutions, including noninvasive prenatal testing (NIPT), preimplantation genetic screening and diagnosis (PGS and PGD), and neonatal and genetic health testing. Our technology enables NIPT for early identification of fetal chromosomal abnormalities by analyzing cell-free DNA in maternal blood. Our PGS solution is used with in vitro fertilization (IVF) to determine, before implantation, whether an embryo has an abnormal number of chromosomes, which is a major cause of IVF failure and miscarriages. In the case of PGD, the technology determines which embryos are free from gene variants associated with genetic diseases. Cancer is a disease of the genome, and the goal of cancer genomics is to identify genomic changes that transform a normal cell into a cancerous one. Understanding these genomic changes improves diagnostic accuracy, increases understanding of the prognosis, and enables oncologists to target therapies to individuals. Customers in the translational and clinical oncology markets use our products to perform research that may help identify individuals who are genetically predisposed to cancer. Customers also utilize our technology to identify the molecular changes in a tumor so that physicians can tailor treatment based on the genetic variation. We believe that circulating tumor DNA (ctDNA) will become an important clinical tool for managing oncology patients during all stages of tumor progression. Our technology is being used to research the implications of ctDNA in treatment determination, treatment monitoring, minimal residual disease, and asymptomatic screening. For example, we have invested in GRAIL, which was formed to develop a blood-based test for early-stage cancer detection, and has been enabled by our sequencing technology. To advance genomic-based precision oncology care, we are working with key opinion leaders to set standards for NGS-based assays in routine clinical oncology practice and to define regulatory frameworks for this new testing paradigm. Our Principal Products and Technologies Our unique technology platforms support the scale of experimentation necessary for population-scale studies, genome-wide discovery, target selection, and validation studies (see Figure 1 below). Customers use our products to analyze the genome at all levels of complexity, from whole-genome sequencing to targeted panels. A large and dynamic Illumina user community has published tens of thousands of customer-authored scientific papers using our technologies. Through rapid innovation, we are changing the economics of genetic research, enabling projects that were previously considered impossible, and supporting clinical advances towards precision medicine. Most of our product sales consist of instruments and consumables (which include reagents, flow cells, and microarrays) based on our proprietary technologies. For the fiscal years ended January 1, 2017, January 3, 2016, and December 28, 2014, instrument sales comprised 20%, 27%, and 30%, respectively, of total revenues, and consumable sales represented 64%, 58%, and 56%, respectively, of total revenues. Figure 1: Illumina Platform Overview: DNA sequencing is the process of determining the order of nucleotide bases (A, C, G, or T) in a DNA sample. Our portfolio of sequencing platforms represents a family of systems that we believe set the standard for productivity, cost-effectiveness, and accuracy among NGS technologies. Customers use our platforms to perform whole-genome, de novo, exome and RNA sequencing, and targeted resequencing of specific gene regions and genes. Whole-genome sequencing determines the complete DNA sequence of an organism. In de novo sequencing, the goal is to sequence and analyze a sample without using information from prior sequencing of that species. In targeted resequencing, a portion of the sequence of an organism is compared to a standard or reference sequence from previously sequenced samples to identify genetic variation. Understanding the similarities and differences in DNA sequence between and within species helps us understand the function of the structures encoded in the DNA. Our DNA sequencing technology is based on our proprietary reversible terminator-based sequencing chemistry, referred to as sequencing by synthesis (SBS) biochemistry. SBS tracks the addition of labeled nucleotides as the DNA chain is copied in a massively parallel fashion. Our SBS sequencing technology provides researchers with a broad range of applications and the ability to sequence even large mammalian genomes in a few days rather than weeks or years. Our sequencing platforms can generate between 500 megabases (Mb) and 2.0 terabases (Tb) (equivalent to 16 human genomes) of genomic data in a single run, depending on the instrument and application. There are different price points per gigabase (Gb) for each instrument, and for different applications, which range from small-genome, amplicon, and targeted gene-panel sequencing to population-scale whole human genome sequencing. Since we launched our first sequencing system in 2007, our systems have reduced the cost of sequencing by more than a factor of 10,000. In addition, the sequencing time per Gb has dropped by a factor of approximately 3,500. Our BaseSpace Informatics Suite cloud platform plays a critical role in supporting our sequencing applications. BaseSpace Suite integrates directly with our sequencing instruments, allowing customers to manage their biological sample and sequencing runs, process and analyze the raw genomic data, and derive meaningful results. It facilitates data sharing, provides data-storage solutions and streamlines analysis through a growing number of applications from us and the bioinformatics community. Some components of the BaseSpace Informatics Suite can also be installed for customers on-site. For the fiscal years ended January 1, 2017, January 3, 2016, and December 28, 2014, sequencing revenue comprised 84%, 86%, and 81%, respectively, of total revenues. Arrays are used for a broad range of DNA and RNA analysis applications, including SNP genotyping, CNV analysis, gene expression analysis, and methylation analysis, and allow for the detection of millions of known genetic markers on a single array. Our BeadArray technology combines microscopic beads and a substrate in a proprietary manufacturing process to produce arrays that can perform many assays simultaneously. This facilitates large-scale analysis of genetic variation and biological function in a uniquely high-throughput, cost-effective, and flexible manner. Using our BeadArray technology, we achieve high-throughput analysis via a high density of test sites per array and the ability to format arrays in various configurations. Varying the size, shape, and format of the substrate into which the beads self-assemble and creating specific bead types for different applications lets us address multiple markets and market segments. Both our iScan array scanner system and our NextSeq 550 system can be used to image the arrays. For the fiscal years ended January 1, 2017, January 3, 2016, and December 28, 2014, array revenue comprised 16%, 14%, and 19%, respectively, of total revenues. We have developed various library preparation and sequencing kits to simplify workflows and accelerate analysis. Our sequencing applications include whole-genome sequencing kits, which sequence entire genomes of any size and complexity, and targeted resequencing kits, which can sequence exomes, specific genes, RNA or other genomic regions of interest. Our sequencing kits maximize the ability of our customers to characterize the target genome accurately and are sold in various configurations, which address a wide range of applications. Customers use Illumina array-based genotyping consumables for a wide range of analyses, including diverse species, disease-related mutations, and genetic characteristics associated with cancer. Customers can select from a range of human, animal, and agriculturally relevant genome panels or create their own custom arrays to investigate millions of genetic markers targeting any species. We provide whole-genome sequencing, genotyping, NIPT, and support services. Human whole-genome sequencing services are provided through our CLIA-certified, CAP-accredited laboratory. Using our services, customers can perform whole-genome sequencing projects and microarray projects (including large-scale genotyping studies and whole-genome association studies). We also provide NIPT services through our partner laboratories that direct samples to us on a test send-out basis in our CLIA-certified, CAP-accredited laboratory. In addition, we also offer support services to customers who have purchased our products. We have an extensive intellectual property portfolio. As of February 1, 2017, we own or have exclusive licenses to 671 issued U.S. patents and 572 pending U.S. patent applications, including 31 allowed applications that have not yet issued as patents. Our issued and pending patents cover various aspects of our arrays, assays, oligo synthesis, sequencing technology, instruments, digital microfluidics, software, bioinformatics, and chemical-detection technologies, and have terms that expire between 2017 and 2038. We continue to file new patent applications to protect the full range of our technologies. We have filed or have been granted counterparts for many of these patents and applications in foreign countries. We protect trade secrets, know-how, copyrights, and trademarks, as well as continuing technological innovation and licensing opportunities to develop and maintain our competitive position. Our success depends in part on obtaining patent protection for our products and processes, preserving trade secrets, patents, copyrights and trademarks, operating without infringing the proprietary rights of third parties, and acquiring licenses for technology or products. We are party to various exclusive and nonexclusive license agreements and other arrangements with third parties that grant us rights to use key aspects of our sequencing and array technologies, assay methods, chemical detection methods, reagent kits, and scanning equipment. Our exclusive licenses expire with the termination of the underlying patents, which will occur between 2017 and 2032. We have additional nonexclusive license agreements with various third parties for other components of our products. In most cases, the agreements remain in effect over the term of the underlying patents, may be terminated at our request without further obligation, and require that we pay customary royalties. Illumina has historically made substantial investments in research and development. Our research and development efforts prioritize continuous innovation coupled with product evolution. Research and development expenses for fiscal 2016, 2015, and 2014 were $504.4 million, $401.5 million, and $388.1 million, respectively. We expect research and development expense to increase during fiscal 2017 to support business growth and continuing expansion in research and product-development efforts. Marketing and Distribution We market and distribute our products directly to customers in North America, Europe, Latin America, and the Asia-Pacific region. In each of these areas, dedicated sales, service, and application-support personnel are expanding and supporting their respective customer bases. In addition, we sell through life-science distributors in certain markets within Europe, the Asia-Pacific region, Latin America, the Middle East, and South Africa. We expect to continue increasing our sales and distribution resources during 2017 and beyond as we launch new products and expand our potential customer base. We manufacture sequencing and array platforms and reagent kits. In 2016, we continued to increase our manufacturing capacity to meet customer demand. To address increasing product complexity and volume, we continue to automate manufacturing processes to accelerate throughput and improve quality and yield. We are committed to providing medical devices and related services that consistently meet customer and applicable regulatory requirements. We adhere to access and safety standards required by federal, state, and local health ordinances, such as standards for the use, handling, and disposal of hazardous substances. Our key manufacturing and distribution facilities operate under a quality management system certified to ISO 13485. Our manufacturing operations require a wide variety of raw materials, electronic and mechanical components, chemical and biochemical materials, and other supplies. Multiple commercial sources provide many of our components and supplies, but there are some raw materials and components that we obtain from single-source suppliers. To manage potential risks arising from single source suppliers, we believe that we could redesign our products using alternative components or for use with alternative reagents, if necessary. In addition, while we attempt to keep our inventory at minimal levels, we purchase incremental inventory as circumstances warrant to protect our supply chain. If the capabilities of our suppliers and component manufacturers are limited or stopped, due to disasters, quality, regulatory, or other reasons, it could negatively impact our ability to manufacture our products. Although we believe that our products and services provide significant advantages over products and services currently available from other sources, we expect continued intense competition. Our competitors offer products and services for sequencing, SNP genotyping, gene expression, and molecular diagnostics markets. They include companies such as Agilent Technologies, Inc., BGI, Oxford Nanopore Technologies Limited, Pacific Biosciences of California, Inc., QIAGEN N.V., Roche Holding AG., and Thermo Fisher Scientific, Inc., among others. Some of these companies have or will have substantially greater financial, technical, research, and other resources than we do, along with larger, more established marketing, sales, distribution, and service organizations. In addition, they may have greater name recognition than we do in the markets we address, and in some cases a larger installed base of systems. We expect new competitors to emerge and the intensity of competition to increase. To compete effectively, we must scale our organization and infrastructure appropriately and demonstrate that our products have superior throughput, cost, and accuracy. Segment and Geographic Information We are organized into three operating segments for purposes of evaluating our business operations and reviewing our financial results. One segment consists of Illumina’s core operations (Core Illumina). The other two segments relate to the activities of our consolidated variable interest entities (VIEs), GRAIL and Helix. The combined results of operations of our consolidated VIEs became material during the year ended January 1, 2017. As such, we commenced reporting two segments, Core Illumina and Consolidated VIEs, during 2016. We currently sell our products to a number of customers outside the United States, including customers in other areas of North America, Latin America, Europe, and the Asia-Pacific region. Shipments to customers outside the United States totaled $1,104.2 million, or 46% of total revenues, during fiscal 2016, compared to $1,012.4 million, or 46%, and $910.7 million, or 49%, in fiscal 2015 and 2014, respectively. The U.S. dollar has been determined to be the functional currency of the Company’s international operations due to the primary activities of our foreign subsidiaries. We expect that sales to international customers will continue to be an important and growing source of revenue. See note “12. Segment Information, Geographic Data, and Significant Customers” in Part II, Item 8 of this Form 10-K for further information concerning our foreign and domestic operations. Our backlog was approximately $650 million and $560 million as of January 1, 2017 and January 3, 2016, respectively. Generally, our backlog consists of orders believed to be firm as of the balance-sheet date. However, we may allow customers to make product substitutions as we launch new products. The timing of shipments depends on several factors, including agreed upon shipping schedules, which may span multiple quarters, and whether the product is catalog or custom. We expect approximately two-thirds of our backlog as of January 1, 2017, to be shipped within the fiscal year ending December 31, 2017. Although we generally recognize revenue upon the transfer of title to a customer, some customer agreements or applicable accounting treatments might require us to defer the recognition of revenue beyond title transfer. We are committed to the protection of our employees and the environment. Our operations require the use of hazardous materials that subject us to various federal, state, and local environmental and safety laws and regulations. We believe that we are in material compliance with current applicable laws and regulations. However, we could be held liable for damages and fines should contamination of the environment or individual exposures to hazardous substances occur. In addition, we cannot predict how changes in these laws and regulations, or the development of new laws and regulations, will affect our business operations or the cost of compliance. As we expand product lines to address the diagnosis of disease, regulation by governmental authorities in the United States and other countries will become an increasingly significant factor in development, testing, production, and marketing. Products that we develop in the molecular diagnostic markets, depending on their intended use, may be regulated as medical devices by the FDA and comparable agencies in other countries. In the United States, certain of our products may require FDA clearance following a pre-market notification process, also known as a 510(k) clearance, or premarket approval (PMA) from the FDA before marketing. The usually shorter 510(k) clearance process, which we used for the FDA-cleared assays that are run on our FDA-regulated MiSeqDx instrument, generally takes from three to six months after submission, but it can take significantly longer. The longer PMA process is much more costly and uncertain. It generally takes from 9 to 18 months after a complete filing, but it can take significantly longer and typically requires conducting clinical studies, which are not always needed for a 510(k) clearance. All of the products that are currently regulated by the FDA as medical devices are also subject to the FDA Quality System Regulation (QSR). Obtaining the requisite regulatory approvals, including the FDA quality system inspections that are required for PMA approval, can be expensive and may involve considerable delay. We cannot be certain which of our planned molecular diagnostic products will be subject to the shorter 510(k) clearance process and, in fact, some of our products may need to go through the PMA process. The regulatory approval process for such products may be significantly delayed, may be significantly more expensive than anticipated, and may conclude without such products being approved by the FDA. Without timely regulatory approval, we may not be able to launch or successfully commercialize such products. Changes to the current regulatory framework, including the imposition of additional or new regulations, could arise at any time during the development or marketing of our products. This may negatively affect our ability to obtain or maintain FDA or comparable regulatory clearance or approval of our products. In addition, the FDA may introduce new requirements that may change the regulatory requirements for either or both Illumina or our customers. If our products labeled as “For Research Use Only. Not for use in diagnostic procedures,” or RUO, are used, or could be used, for the diagnosis of disease, the regulatory requirements related to marketing, selling, and supporting such products could be uncertain. This is true even if such use by our customers occurs without our consent. If the FDA or other regulatory authorities assert that any of our RUO products are subject to regulatory clearance or approval, our business, financial condition, or results of operations could be adversely affected. Illumina products sold as medical devices in Europe will be regulated under the In Vitro Diagnostics Directive (98/79/EC). This regulation includes requirements for both presentation and review of performance data and quality-system requirements. Certain of our diagnostic products are currently available through laboratories that are certified under the Clinical Laboratory Improvements Amendments (CLIA) of 1988. These products are commonly called “laboratory developed tests,” or LDTs. For a number of years, the FDA has exercised its regulatory enforcement discretion to not regulate LDTs as medical devices if created and used within a single laboratory. However, the FDA is reexamining this regulatory approach and changes to the agency’s handling of LDTs could impact our business in ways that cannot be predicted at this time. In October 2014, the FDA published two draft guidance documents suggesting an approach for registration and listing of laboratories and assays along with a framework for regulation of LDTs by the FDA based on risk to patients rather than whether the LDTs were made by a conventional manufacturer or a single laboratory. The draft framework guidance includes pre-market review for higher-risk LDTs, including many used to guide treatment decisions, as well as companion diagnostics that have entered the market as LDTs. We cannot predict the nature or extent of the FDA's final guidance or regulation of LDTs, in general, or with respect to our or our customers’ LDTs, in particular. Certification of CLIA laboratories includes standards in the areas of personnel qualifications, administration, and participation in proficiency testing, patient test management, and quality control procedures. CLIA also mandates that, for high complexity labs such as ours, to operate as a lab, we must have an accreditation by an organization recognized by CLIA such as the College of Pathologists (CAP), which we have obtained and must maintain. If we were to lose our CLIA certification or CAP accreditation, our business, financial condition, or results of operations could be adversely affected. In addition, state laboratory licensing and inspection requirements may also apply to our products, which, in some cases, are more stringent than CLIA requirements. As of January 1, 2017, we had more than 5,500 employees. We consider our employee relations to be positive. Our success will depend in large part upon our ability to attract and retain employees. In addition, we employ a number of temporary and contract employees. We face competition in this regard from other companies, research and academic institutions, government entities, and other organizations. Risk Factors. Our business is subject to various risks, including those described below. In addition to the other information included in this Form 10-K, the following issues could adversely affect our operating results or our stock price. If we do not successfully manage the development, manufacturing, and launch of new products or services, including product transitions, our financial results could be adversely affected. We face risks associated with launching new products and pre-announcing products and services when the products or services have not been fully developed or tested. In addition, we may experience difficulty in managing or forecasting customer reactions, purchasing decisions, or transition requirements or programs with respect to newly launched products (or products in development), which could adversely affect sales of our existing products. For instance, in January 2017 we announced our NovaSeq 5000 and 6000 instrument systems, which were developed using our new sequencing architecture. If our products and services are not able to deliver the performance or results expected by our target markets or are not delivered on a timely basis, our reputation and credibility may suffer. If we encounter development challenges or discover errors in our products late in our development cycle, we may delay the product launch date. The expenses or losses associated with unsuccessful product development or launch activities or lack of market acceptance of our new products could adversely affect our business, financial condition, or results of operations. When we introduce or announce new or enhanced products, we face numerous risks relating to product transitions, including the inability to accurately forecast demand (including with respect to our existing products), manage excess and obsolete inventories, address new or higher product cost structures, and manage different sales and support requirements due to the type or complexity of the new or enhanced products. Announcements of currently planned or other new products may cause customers to defer or stop purchasing our products until new products become available. Our failure to effectively manage product transitions or introductions could adversely affect our business, financial condition, or results of operations. Our success depends upon the continued emergence and growth of markets for analysis of genetic variation and biological function. We design our products primarily for applications in the life sciences, diagnostic, agricultural, and pharmaceutical industries. The usefulness of our technologies depends in part upon the availability of genetic data and its usefulness in identifying or treating disease. We are focusing on markets for analysis of genetic variation or biological function, namely sequencing, genotyping, and gene expression profiling. These markets are relatively new and emerging, and they may not develop as quickly as we anticipate, or reach their full potential. Other methods of analysis of genetic variation and biological function may emerge and displace the methods we are developing. Also, researchers may not be able to successfully analyze raw genetic data or be able to convert raw genetic data into medically valuable information. In addition, factors affecting research and development spending generally, such as changes in the regulatory environment affecting life sciences and pharmaceutical companies, and changes in government programs that provide funding to companies and research institutions, could harm our business. If useful genetic data is not available or if our target markets do not develop in a timely manner, demand for our products may grow at a slower rate than we expect. Our continued growth is dependent on continuously developing and commercializing new products. Our target markets are characterized by rapid technological change, evolving industry standards, changes in customer needs, existing and emerging competition, strong price competition, and frequent new product introductions. Accordingly, our continued growth depends on developing and commercializing new products and services, including improving our existing products and services, in order to address evolving market requirements on a timely basis. If we fail to innovate or adequately invest in new technologies, our products and services will become dated, and we could lose our competitive position in the markets that we serve as customers purchase new products offered by our competitors. We believe that successfully introducing new products and technologies in our target markets on a timely basis provides a significant competitive advantage because customers make an investment of time in selecting and learning to use a new product and may be reluctant to switch once that selection is made. To the extent that we fail to introduce new and innovative products, or such products are not accepted in the market or suffer significant delays in development, we may lose market share to our competitors, which will be difficult or impossible to regain. An inability, for technological or other reasons, to successfully develop and introduce new products on a timely basis could reduce our growth rate or otherwise have an adverse effect on our business. In the past, we have experienced, and are likely to experience in the future, delays in the development and introduction of new products. There can be no assurance that we will keep pace with the rapid rate of change in our markets or that our new products will adequately meet the requirements of the marketplace, achieve market acceptance, or compete successfully with competing technologies. Some of the factors affecting market acceptance of new products and services include: availability, quality, and price relative to competing products and services; the functionality and performance of new and existing products and services; the timing of introduction of new products or services relative to competing products and services; scientists’ and customers’ opinions of the utility of new products or services; citation of new products or services in published research; regulatory trends and approvals; and general trends in life sciences research and applied markets. We may also have to write off excess or obsolete inventory if sales of our products are not consistent with our expectations or the market requirements for our products change due to technical innovations in the marketplace. We depend on third-party manufacturers and suppliers for some of our products, or sub-assemblies, components, and materials used in our products, and if shipments from these manufacturers or suppliers are delayed or interrupted, or if the quality of the products, components, or materials supplied do not meet our requirements, we may not be able to launch, manufacture, or ship our products in a timely manner, or at all. The complex nature of our products requires customized, precision-manufactured sub-assemblies, components, and materials that currently are available from a limited number of sources, and, in the case of some sub-assemblies, components, and materials, from only a single source. If deliveries from these vendors are delayed or interrupted for any reason, or if we are otherwise unable to secure a sufficient supply, we may not be able to obtain these sub-assemblies, components, or materials on a timely basis or in sufficient quantities or qualities, or at all, in order to meet demand for our products. We may need to enter into contractual relationships with manufacturers for commercial-scale production of some of our products, in whole or in part, or develop these capabilities internally, and there can be no assurance that we will be able to do this on a timely basis, in sufficient quantities, or on commercially reasonable terms. In addition, the lead time needed to establish a relationship with a new supplier can be lengthy, and we may experience delays in meeting demand in the event we must switch to a new supplier. The time and effort required to qualify a new supplier could result in additional costs, diversion of resources, or reduced manufacturing yields, any of which would negatively impact our operating results. Accordingly, we may not be able to establish or maintain reliable, high-volume manufacturing at commercially reasonable costs or at all. In addition, the manufacture or shipment of our products may be delayed or interrupted if the quality of the products, sub-assemblies, components, or materials supplied by our vendors does not meet our requirements. Current or future social and environmental regulations or critical issues, such as those relating to the sourcing of conflict minerals from the Democratic Republic of the Congo or the need to eliminate environmentally sensitive materials from our products, could restrict the supply of components and materials used in production or increase our costs. Any delay or interruption to our manufacturing process or in shipping our products could result in lost revenue, which would adversely affect our business, financial condition, or results of operations. If defects are discovered in our products, we may incur additional unforeseen costs, our products may be subject to recalls, customers may not purchase our products, our reputation may suffer, and ultimately our sales and operating earnings could be negatively impacted. Our products incorporate complex, precision-manufactured mechanical parts, electrical components, optical components, and fluidics, as well as computer software, any of which may contain errors or failures, especially when first introduced. In the course of conducting our business, we must adequately address quality issues associated with our products and services, including defects in our engineering, design, and manufacturing processes, as well as defects in third-party components included in our products. In addition, new products or enhancements may contain undetected errors or performance problems that, despite testing, are discovered only after commercial shipment. Defects or errors in our products may discourage customers from purchasing our products. The costs incurred in correcting any defects or errors may be substantial and could adversely affect our operating margins. Identifying the root cause of quality issues, particularly those affecting reagents and third-party components, may be difficult, which increases the time needed to address quality issues as they arise and increases the risk that similar problems could recur. Because our products are designed to be used to perform complex genomic analysis, we expect that our customers will have an increased sensitivity to such defects. If we do not meet applicable regulatory or quality standards, our products may be subject to recall, and, under certain circumstances, we may be required to notify applicable regulatory authorities about a recall. If our products are subject to recall or shipment holds, our reputation, business, financial condition, or results of operations could be adversely affected. We face intense competition, which could render our products obsolete, result in significant price reductions, or substantially limit the volume of products that we sell. We compete with life sciences companies that design, manufacture, and market products for analysis of genetic variation and biological function and other applications using a wide range of competing technologies. We anticipate that we will continue to face increased competition as existing companies develop new or improved products and as new companies enter the market with new technologies. One or more of our competitors may render one or more of our technologies obsolete or uneconomical. Some of our competitors have greater financial and personnel resources, broader product lines, a more established customer base, and more experience in research and development than we do. Furthermore, life sciences, clinical genomics, and pharmaceutical companies, which are our potential customers and strategic partners, could also develop competing products. We believe that customers in our markets display a significant amount of loyalty to their initial supplier of a particular product; therefore, it may be difficult to generate sales to potential customers who have purchased products from competitors. To the extent we are unable to be the first to develop or supply new products, our competitive position may suffer. The market for molecular diagnostics products is currently limited and highly competitive, with several large companies already having significant market share, intellectual property portfolios, and regulatory expertise. Established diagnostic companies also have an installed base of instruments in several markets, including clinical and reference laboratories, which could deter acceptance of our products. In addition, some of these companies have formed alliances with genomics companies that provide them access to genetic information that may be incorporated into their diagnostic tests. As we develop, market, or sell diagnostic tests, we may encounter delays in receipt, or limits in the amount, of reimbursement approvals and public health funding, which will impact our ability to grow revenues in the healthcare market. Physicians and patients may not order diagnostic tests that we develop, market, or sell, such as our verifi prenatal test, unless third-party payors, such as managed care organizations as well as government payors such as Medicare and Medicaid and governmental payors outside of the United States, pay a substantial portion of the test price. Third-party payors are often reluctant to reimburse healthcare providers for the use of medical tests that involve new technologies or provide novel diagnostic information. In addition, third-party payors are increasingly limiting reimbursement coverage for medical diagnostic products and, in many instances, are exerting pressure on diagnostic product suppliers to reduce their prices. Reimbursement by a payor may depend on a number of factors, including a payor's determination that tests using our technologies are: not experimental or investigational; medically necessary; appropriate for the specific patient; cost-effective; supported by peer-reviewed publications; and included in clinical practice guidelines. Since each third-party payor often makes reimbursement decisions on an individual patient basis, obtaining such approvals is a time-consuming and costly process that requires us to provide scientific and clinical data supporting the clinical benefits of each of our products. As a result, there can be no assurance that reimbursement approvals will be obtained. This process can delay the broad market introduction of new products, and could have a negative effect on our results of operations. As a result, third-party reimbursement may not be consistent or financially adequate to cover the cost of diagnostic products that we develop, market, or sell. This could limit our ability to sell our products or cause us to reduce prices, which would adversely affect our results of operations. Even if our tests are being reimbursed, third party payors may withdraw their coverage policies, cancel their contracts with our customers at any time, review and adjust the rate of reimbursement, require co-payments from patients, or stop paying for our tests, which would reduce our revenues. In addition, insurers, including managed care organizations as well as government payors such as Medicare and Medicaid, have increased their efforts to control the cost, utilization, and delivery of healthcare services. These measures have resulted in reduced payment rates and decreased utilization for the clinical laboratory industry. Reductions in the reimbursement rate of payors may occur in the future. Reductions in the prices at which our tests are reimbursed could have a negative impact on our results of operations. Litigation, other proceedings, or third party claims of intellectual property infringement could require us to spend significant time and money and could prevent us from selling our products or services. Our success depends in part on our non-infringement of the patents or proprietary rights of third parties. Third parties have asserted and may in the future assert that we are employing their proprietary technology without authorization. As we enter new markets or introduce new products, we expect that competitors will likely claim that our products infringe their intellectual property rights as part of a business strategy to impede our successful competition. In addition, third parties may have obtained and may in the future obtain patents allowing them to claim that the use of our technologies infringes these patents. We could incur substantial costs and divert the attention of our management and technical personnel in defending ourselves against any of these claims. Any adverse ruling or perception of an adverse ruling in defending ourselves against these claims could have an adverse impact on our stock price, which may be disproportionate to the actual impact of the ruling itself. Furthermore, parties making claims against us may be able to obtain injunctive or other relief, which effectively could block our ability to develop further, commercialize, or sell products or services, and could result in the award of substantial damages against us. In the event of a successful infringement claim against us, we may be required to pay damages and obtain one or more licenses from third parties, or be prohibited from selling certain products or services. In addition, we may be unable to obtain these licenses at a reasonable cost, if at all. We could therefore incur substantial costs related to royalty payments for licenses obtained from third parties, which could negatively affect our gross margins and earnings per share. In addition, we could encounter delays in product introductions while we attempt to develop alternative methods or products. Defense of any lawsuit or failure to obtain any of these licenses on favorable terms could prevent us from commercializing products, and the prohibition of sale of any of our products or services could adversely affect our ability to grow or maintain profitability. Reduction or delay in research and development budgets and government funding may adversely affect our revenue. The timing and amount of revenues from customers that rely on government and academic research funding may vary significantly due to factors that can be difficult to forecast, and there remains significant uncertainty concerning government and academic research funding worldwide as governments in the United States and Europe, in particular, focus on reducing fiscal deficits while at the same time confronting uncertain economic growth. Funding for life science research has increased more slowly during the past several years compared to previous years and has declined in some countries. Government funding of research and development is subject to the political process, which is inherently fluid and unpredictable. Other programs, such as defense, entitlement programs, or general efforts to reduce budget deficits could be viewed by governments as a higher priority. These budgetary pressures may result in reduced allocations to government agencies that fund research and development activities, such as the U.S. National Institute of Health, or NIH. Past proposals to reduce budget deficits have included reduced NIH and other research and development allocations. Any shift away from the funding of life sciences research and development or delays surrounding the approval of government budget proposals may cause our customers to delay or forego purchases of our products, which could adversely affect our business, financial condition, or results of operations. Our acquisitions expose us to risks that could adversely affect our business, and we may not achieve the anticipated benefits of acquisitions of businesses or technologies. As part of our strategy to develop and identify new products, services, and technologies, we have made, and may continue to make, acquisitions of technologies, products, or businesses. Acquisitions involve numerous risks and operational, financial, and managerial challenges, including the following, any of which could adversely affect our business, financial condition, or results of operations: difficulties in integrating new operations, technologies, products, and personnel; lack of synergies or the inability to realize expected synergies and cost-savings; difficulties in managing geographically dispersed operations; underperformance of any acquired technology, product, or business relative to our expectations and the price we paid; negative near-term impacts on financial results after an acquisition, including acquisition-related earnings charges; the potential loss of key employees, customers, and strategic partners of acquired companies; claims by terminated employees and shareholders of acquired companies or other third parties related to the transaction; the issuance of dilutive securities, assumption or incurrence of additional debt obligations or expenses, or use of substantial portions of our cash; diversion of management’s attention and company resources from existing operations of the business; inconsistencies in standards, controls, procedures, and policies; the impairment of intangible assets as a result of technological advancements, or worse-than-expected performance of acquired companies; and assumption of, or exposure to, known or unknown contingent liabilities or liabilities that are difficult to identify or accurately quantify. In addition, the successful integration of acquired businesses requires significant efforts and expense across all operational areas, including sales and marketing, research and development, manufacturing, finance, legal, and information technologies. There can be no assurance that any of the acquisitions we make will be successful or will be, or will remain, profitable. Our failure to successfully address the above risks may prevent us from achieving the anticipated benefits from any acquisition in a reasonable time frame, or at all. If we are unable to increase our manufacturing or service capacity and develop and maintain operation of our manufacturing or service capability, we may not be able to launch or support our products or services in a timely manner, or at all. We continue to rapidly increase our manufacturing and service capacity to meet the anticipated demand for our products. Although we have significantly increased our manufacturing and service capacity and we believe we have plans in place sufficient to ensure we have adequate capacity to meet our current business plans, there are uncertainties inherent in expanding our manufacturing and service capabilities, and we may not be able to sufficiently increase our capacity in a timely manner. For example, manufacturing and product quality issues may arise as we increase production rates at our manufacturing facilities and launch new products. Also, we may not manufacture the right product mix to meet customer demand, especially as we introduce new products. As a result, we may experience difficulties in meeting customer, collaborator, and internal demand, in which case we could lose customers or be required to delay new product introductions, and demand for our products could decline. Additionally, in the past, we have experienced variations in manufacturing conditions and quality control issues that have temporarily reduced or suspended production of certain products. Due to the intricate nature of manufacturing complex instruments, consumables, and products that contain DNA and enzymes, we may encounter similar or previously unknown manufacturing difficulties in the future that could significantly reduce production yields, impact our ability to launch or sell these products (or to produce them economically), prevent us from achieving expected performance levels, any of which could adversely affect our business, financial condition, or results of operations. An interruption in our ability to manufacture our products or an inability to obtain key components or raw materials due to a catastrophic disaster or infrastructure could adversely affect our business. We currently manufacture in a limited number of locations. Our manufacturing facilities are located in San Diego and the San Francisco Bay Area in California; Madison, Wisconsin; and Singapore. These areas are subject to natural disasters such as earthquakes, wildfires, or floods. If a natural disaster were to damage one of our facilities significantly or if other events were to cause our operations to fail, we may be unable to manufacture our products, provide our services, or develop new products. In addition, if the capabilities of our suppliers and component manufacturers are limited or stopped, due to disasters, quality, regulatory, or other reasons, it could negatively impact our ability to manufacture our products. Many of our manufacturing processes are automated and are controlled by our custom-designed laboratory information management system (LIMS). Additionally, the decoding process in our array manufacturing requires significant network and storage infrastructure. If either our LIMS system or our networks or storage infrastructure were to fail for an extended period of time, it may adversely impact our ability to manufacture our products on a timely basis and could prevent us from achieving our expected shipments in any given period. We also rely on our technology infrastructure, among other functions, to interact with suppliers; sell our products and services; fulfill orders; bill, collect, and make payments; ship products; provide services and support to customers; fulfill contractual obligations; and otherwise conduct business. Our systems may be vulnerable to damage or interruption from natural disasters, power loss, telecommunication failures, terrorist attacks, computer viruses, computer denial-of-service attacks, unauthorized access to customer or employee data or company trade secrets, and other attempts to harm our systems. Certain of our systems are not redundant, and our disaster recovery planning is not sufficient for every eventuality. Despite any precautions we may take, such problems could result in, among other consequences, interruptions in our services, which could harm our reputation and financial results. If we lose our key personnel or are unable to attract and retain additional personnel, we may be unable to achieve our goals. Our future success depends upon the continuing services of members of our senior management team and scientific and engineering personnel. The loss of their services could adversely impact our ability to achieve our business objectives. In addition, the continued growth of our business depends on our ability to hire additional qualified personnel with expertise in molecular biology, chemistry, biological information processing, software, engineering, sales, marketing, and technical support. We compete for qualified management and scientific personnel with other life science and technology companies, universities, and research institutions. Competition for these individuals, particularly in the San Diego and San Francisco areas, is intense, and the turnover rate can be high. Moreover, changes in immigration policies, laws and regulations in the United States or other jurisdictions may make it more difficult for us to hire and retain members of management and scientific and engineering personnel. Failure to attract and retain management and scientific and engineering personnel could prevent us from pursuing collaborations or developing our products or technologies. Additionally, integration of acquired companies and businesses can be disruptive, causing key employees of the acquired business to leave. Further, we use share-based compensation, including restricted stock units and performance stock units to attract key personnel, incentivize them to remain with us, and align their interests with those of the Company by building long-term stockholder value. If our stock price decreases, the value of these equity awards decreases and therefore reduces a key employee’s incentive to stay. Any inability to effectively protect our proprietary technologies could harm our competitive position. The proprietary positions of companies developing tools for the life sciences, genomics, forensics, agricultural, and pharmaceutical industries, including our proprietary position, generally are uncertain and involve complex legal and factual questions. Our success depends to a large extent on our ability to develop proprietary products and technologies and to obtain patents and maintain adequate protection of our intellectual property in the United States and other countries. The laws of some foreign countries do not protect proprietary rights to the same extent as the laws of the United States, and many companies have encountered significant challenges in establishing and enforcing their proprietary rights outside of the United States. These challenges can be caused by the absence of rules and methods for the establishment and enforcement of intellectual property rights outside of the United States. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary technologies are covered by valid and enforceable patents or are effectively maintained as trade secrets. Any finding that our patents or applications are unenforceable could harm our ability to prevent others from practicing the related technology, and a finding that others have inventorship or ownership rights to our patents and applications could require us to obtain certain rights to practice related technologies, which may not be available on favorable terms, if at all. Furthermore, as issued patents expire, we may lose some competitive advantage as others develop competing products, and, as a result, we may lose revenue. In addition, our existing patents and any future patents we obtain may not be sufficiently broad to prevent others from practicing our technologies or from developing competing products and may therefore fail to provide us with any competitive advantage. We may need to initiate lawsuits to protect or enforce our patents, or litigate against third party claims, which would be expensive, and, if we lose, may cause us to lose some of our intellectual property rights and reduce our ability to compete in the marketplace. Furthermore, these lawsuits may divert the attention of our management and technical personnel. There is also the risk that others may independently develop similar or alternative technologies or design around our patented technologies. In that regard, certain patent applications in the United States may be maintained in secrecy until the patents issue, and publication of discoveries in the scientific or patent literature tend to lag behind actual discoveries by several months. We also rely upon trade secrets and proprietary know-how protection for our confidential and proprietary information, and we have taken security measures to protect this information. These measures, however, may not provide adequate protection for our trade secrets, know-how, or other confidential information. Our strategic investments and joint ventures may result in losses. We periodically make strategic investments in various public and private companies with businesses or technologies that may complement our business. In addition, we periodically form companies, such as GRAIL and Helix, that remain consolidated within our financial statements but receive substantial funding from third-party investors who are granted certain control and governance rights. The market values of these strategic investments may fluctuate due to market conditions and other conditions over which we have no control. Other-than-temporary declines in the market price and valuations of the securities that we hold in other companies would require us to record losses related to our investment. This could result in future charges to our earnings. It is uncertain whether or not we will realize any long-term benefits associated with these strategic investments. In January 2017, we announced that GRAIL has received indications of interest to invest approximately $1 billion for GRAIL’s Series B financing, primarily from undisclosed private and strategic investors. GRAIL intends to raise additional capital in the Series B financing from other investors and has engaged a placement agent in connection with the contemplated additional financing. GRAIL intends to close the Series B prior to the end of March 2017. As of the closing of this transaction, we expect our voting interest to become less than 20 percent and that our remaining interest in GRAIL will be treated as a cost-method investment. In addition, we will no longer have representation on GRAIL’s board of directors. Any failure by GRAIL to close the contemplated financing transactions would have a significant, negative impact on its ability to grow. Such a failure could also result in the continued consolidation of GRAIL within our financial statements, which would result in incremental dilution compared to fiscal year 2016. Security breaches, including with respect to cyber-security, and other disruptions could compromise our information, products, and services and expose us to liability, which could cause our business and reputation to suffer. In the ordinary course of our business, we collect and store sensitive data, including intellectual property, our proprietary business information (and that of our customers), and personally identifiable information of our customers and employees, in our data centers and on our networks. The secure maintenance of this information is important to our operations and business strategy. Despite our security measures, our information technology and infrastructure may be vulnerable to cyber-attacks by hackers or breached due to employee error, malfeasance, or other disruptions. As a leader in the field of genetic analysis, we may face cyber-attacks that attempt to penetrate our network security, including our data centers; sabotage or otherwise disable our research, products, and services, including instruments at our customers’ sites; misappropriate our or our customers' and partners' proprietary information, which may include personally identifiable information; or cause interruptions of our internal systems and services. Any such breach could compromise our networks and the information stored there could be accessed, publicly disclosed, lost, or stolen. Any such access, disclosure, or other loss of information could result in legal claims or proceedings, liability under laws that protect the privacy of personal information, and damage to our reputation. Our products, if used for the diagnosis of disease, could be subject to government regulation, and the regulatory approval and maintenance process for such products may be expensive, time-consuming, and uncertain both in timing and in outcome. Our products are not subject to FDA clearance or approval if they are not intended to be used for the diagnosis, treatment or prevention of disease. However, as we expand our product line to encompass products that are intended to be used for the diagnosis of disease, such as our FDA-regulated MiSeqDx, certain of our products will become subject to regulation by the FDA, or comparable international agencies, including requirements for regulatory clearance or approval of such products before they can be marketed. Such regulatory approval processes or clearances may be expensive, time-consuming, and uncertain, and our failure to obtain or comply with such approvals and clearances could have an adverse effect on our business, financial condition, or operating results. In addition, changes to the current regulatory framework, including the imposition of additional or new regulations, could arise at any time during the development or marketing of our products, which may negatively affect our ability to obtain or maintain FDA or comparable regulatory approval of our products, if required. Molecular diagnostic products are regulated as medical devices by the FDA and comparable international agencies and may require either clearance from the FDA following the 510(k) pre-market notification process or premarket approval from the FDA, in each case prior to marketing. Obtaining the requisite regulatory approvals can be expensive and may involve considerable delay. If we fail to obtain, or experience significant delays in obtaining, regulatory approvals for molecular diagnostic products that we develop, we may not be able to launch or successfully commercialize such products in a timely manner, or at all. In addition, if our products labeled as “For Research Use Only. Not for use in diagnostic procedures,” or RUO, are used, or could be used, for the diagnosis of disease, the regulatory requirements related to marketing, selling, and supporting such products could change or be uncertain, even if such use by our customers is without our consent. If the FDA or other regulatory authorities assert that any of our RUO products are subject to regulatory clearance or approval, our business, financial condition, or results of operations could be adversely affected. If the FDA requires in the future that any of our LDT products be subject to regulatory clearance or approval, our business, financial condition, or results of operations could be adversely affected. Certain of our diagnostic products are currently available through laboratories that are certified under the Clinical Laboratory Improvements Amendments (CLIA) of 1988. These products are commonly called “laboratory developed tests,” or LDTs. For a number of years, the FDA has exercised its regulatory enforcement discretion to not regulate LDTs as medical devices if created and used within a single laboratory. However, the FDA has been reconsidering its enforcement discretion policy and has commented that regulation of LDTs may be warranted because of the growth in the volume and complexity of testing services utilizing LDTs. In October 2014, the FDA published two draft guidance documents suggesting an approach for registration and listing of laboratories and assays along with a framework for regulation of LDTs by the FDA based on risk to patients rather than whether the LDTs were made by a conventional manufacturer or a single laboratory. The draft framework guidance includes pre-market review for higher-risk LDTs, including many used to guide treatment decisions, as well as companion diagnostics that have entered the market as LDTs. We cannot predict the nature or extent of the FDA's final guidance or regulation of LDTs, in general, or with respect to our LDTs, in particular. If the FDA requires in the future that LDT products are subject to regulatory clearance or approval, our business, financial condition, or results of operations could be adversely affected. If product or service liability lawsuits are successfully brought against us, we may face reduced demand for our products and incur significant liabilities. Our products and services are used for sensitive applications, and we face an inherent risk of exposure to product or service liability claims if our products or services are alleged to have caused harm, resulted in false negatives or false positives, or do not perform in accordance with specifications. Product liability claims filed against us or against third parties to whom we may have an obligation could be costly and time-consuming to defend and result in substantial damages or reputational risk. We cannot be certain that we would be able to successfully defend any product or service liability lawsuit brought against us. Regardless of merit or eventual outcome, product or service liability claims may result in: decreased demand for our products; injury to our reputation; increased product liability insurance costs; costs of related litigation; and substantial monetary awards to plaintiffs. Although we carry product and service liability insurance, if we become the subject of a successful product or service liability lawsuit, our insurance may not cover all substantial liabilities, which could have an adverse effect on our business, financial condition, or results of operations. Doing business internationally creates operational and financial risks for our business. Conducting and launching operations on an international scale requires close coordination of activities across multiple jurisdictions and time zones and consumes significant management resources. If we fail to coordinate and manage these activities effectively, including the risks noted below, our business, financial condition, or results of operations could be adversely affected. We have sales offices located internationally throughout Europe, the Asia-Pacific region, and Brazil, as well as manufacturing facilities in Singapore. Shipments to customers outside the United States comprised 46%, 46%, and 49% of our total revenue for fiscal years 2016, 2015, and 2014, respectively. During 2016, a significant portion of our sales were denominated in foreign currencies while the majority of our purchases of raw materials were denominated in U.S. dollars. Changes in the value of the relevant currencies may affect the cost of certain items required in our operations. Changes in currency exchange rates may also affect the relative prices at which we are able sell products in the same market. Our revenues from international customers may be negatively impacted as increases in the U.S. dollar relative to our international customers local currency could make our products more expensive, impacting our ability to compete. Our costs of materials from international suppliers may increase if, in order to continue doing business with us, they raise their prices as the value of the U.S. dollar decreases relative to their local currency. Foreign policies and actions regarding currency valuation could result in actions by the United States and other countries to offset the effects of such fluctuations. Recent global financial conditions have led to a high level of volatility in foreign currency exchange rates and that level of volatility may continue, which could adversely affect our business, financial condition, or results of operations. In addition to the foregoing risks, international operations entail the following risks: longer payment cycles and difficulties in collecting accounts receivable outside of the United States; longer sales cycles due to the volume of transactions taking place through public tenders; challenges in staffing and managing foreign operations; tariffs and other trade barriers; unexpected changes in legislative or regulatory requirements of foreign countries into which we sell our products; difficulties in obtaining export licenses or in overcoming other trade barriers and restrictions resulting in delivery delays; and significant taxes or other burdens of complying with a variety of foreign laws. Additionally, we must comply with complex foreign and U.S. laws and regulations, such as the U.S. Foreign Corrupt Practices Act, the U.K. Bribery Act, and other local laws prohibiting corrupt payments to governmental officials, anti-competition regulations and sanctions imposed by the U.S. Office of Foreign Assets Control and other similar laws and regulations. Violations of these laws and regulations could result in fines and penalties, criminal sanctions, restrictions on our business conduct and on our ability to offer our products in one or more countries, and could also materially affect our brand, our ability to attract and retain employees, our international operations, our business and our operating results. Although we have implemented policies and procedures designed to ensure compliance with these laws and regulations, there can be no assurance that our employees, contractors, or agents will not violate our policies. We are subject to risks related to taxation in multiple jurisdictions. We are subject to income taxes in both the United States and numerous foreign jurisdictions. Significant judgments based on interpretations of existing tax laws or regulations are required in determining the provision for income taxes. Our effective income tax rate could be adversely affected by various factors, including, but not limited to, changes in the mix of earnings in tax jurisdictions with different statutory tax rates, changes in the valuation of deferred tax assets and liabilities, changes in existing tax policies, laws, regulations, or rates, changes in the level of non-deductible expenses (including share-based compensation), location of operations, changes in our future levels of research and development spending, mergers and acquisitions, or the result of examinations by various tax authorities. Although we believe our tax estimates are reasonable, if the U.S. Internal Revenue Service or other taxing authority disagrees with the positions taken by the Company on its tax returns, we could have additional tax liability, including interest and penalties. If material, payment of such additional amounts upon final adjudication of any disputes could have a material impact on our results of operations and financial position. Our operating results may vary significantly from period to period, and we may not be able to sustain operating profitability. Our revenue is subject to fluctuations due to the timing of sales of high-value products and services, the effects of new product launches and related promotions, the timing and availability of our customers’ funding, the impact of seasonal spending patterns, the timing and size of research projects our customers perform, changes in overall spending levels in the life sciences industry, and other unpredictable factors that may affect customer ordering patterns. Given the difficulty in predicting the timing and magnitude of sales for our products and services, we may experience quarter-to-quarter fluctuations in revenue resulting in the potential for a sequential decline in quarterly revenue. While we anticipate future growth, there is some uncertainty as to the timing of revenue recognition on a quarterly basis. This is because a substantial portion of our quarterly revenue is typically recognized in the last month of a quarter and because the pattern for revenue generation during that month is normally not linear, with a concentration of orders in the final weeks of the quarter. In light of that, our revenue cut-off and recognition procedures, together with our manufacturing and shipping operations, may experience increased pressure and demand during the time period shortly before the end of a fiscal quarter. A large portion of our expenses are relatively fixed, including expenses for facilities, equipment, and personnel. To meet the anticipated growth in our business, we may incur fixed expenses, such as costs related to facility expansions, before we generate revenue sufficient to fully support such expenses. In addition, we expect operating expenses to continue to increase significantly in absolute dollars, and we expect that our research and development and selling and marketing expenses will increase at a higher rate in the future as a result of the development and launch of new products. Accordingly, our ability to sustain profitability will depend in part on the rate of growth, if any, of our revenue and on the level of our expenses, and if revenue does not grow as anticipated, we may not be able to maintain annual or quarterly profitability. Any significant delays in the commercial launch of our products, unfavorable sales trends in our existing product lines, or impacts from the other factors mentioned above, could adversely affect our future revenue growth or cause a sequential decline in quarterly revenue. In addition, non-cash share-based compensation expense and expenses related to prior and future acquisitions are also likely to continue to adversely affect our future profitability. Due to the possibility of significant fluctuations in our revenue and expenses, particularly from quarter to quarter, we believe that quarterly comparisons of our operating results are not a good indication of our future performance. If our operating results fluctuate or do not meet the expectations of stock market analysts and investors, our stock price could decline. From time to time, we receive large orders that have a significant effect on our operating results in the period in which the order is recognized as revenue. The timing of such orders is difficult to predict, and the timing of revenue recognition from such orders may affect period to period changes in net sales. As a result, our operating results could vary materially from quarter to quarter based on the receipt of such orders and their ultimate recognition as revenue. We may not be able to convert our order backlog into revenue. Our backlog consists of orders believed to be firm as of the balance-sheet date. However, we may allow customers to make product substitutions as we launch new products. We may not receive revenue from some of these orders, and the order backlog we report may not be indicative of our future revenue. Many events can cause an order to be delayed or not completed at all, some of which may be out of our control. If we delay fulfilling customer orders, or if customers reconsider their orders, those customers may seek to cancel or modify their orders with us. Customers may otherwise seek to cancel or delay their orders even if we are prepared to fulfill them. If our orders in backlog do not result in sales, our operating results may suffer. Disruption of critical information technology systems or material breaches in the security of our systems could have an adverse effect on our operations, business, customer relations, and financial condition. Information technology systems (IT) help us operate efficiently, interface with customers, maintain financial accuracy and efficiency, and accurately produce our financial statements. IT systems are used extensively in virtually all aspects of our business, including product manufacturing and supply chain, sales forecast, order fulfillment and billing, customer service, logistics, and management of financial reports and data. Our success depends, in part, on the continued and uninterrupted performance of our IT systems. IT systems may be vulnerable to damage from a variety of sources, including telecommunications or network failures, power loss, natural disasters, human acts, computer viruses, computer denial-of-service attacks, unauthorized access to customer or employee data or company trade secrets, and other attempts to harm our systems. Certain of our systems are not redundant, and our disaster recovery planning is not sufficient for every eventuality. Despite any precautions we may take, such problems could result in, among other consequences, disruption of our operations, which could harm our reputation and financial results. If we do not allocate and effectively manage the resources necessary to build and sustain the proper IT infrastructure, we could be subject to transaction errors, processing inefficiencies, the loss of customers, business disruptions, or the loss of or damage to intellectual property through security breach. If our data management systems do not effectively collect, store, process, and report relevant data for the operation of our business, whether due to equipment malfunction or constraints, software deficiencies, or human error, our ability to effectively plan, forecast, and execute our business plan and comply with applicable laws and regulations will be impaired. Any such impairment could adversely affect our reputation, financial condition, results of operations, cash flows, and the timeliness with which we report our internal and external operating results. As we continuously adjust our work-flow and business practices and add additional functionality to our enterprise resource planning software and other software applications, problems could arise that we have not foreseen, including interruptions in service, loss of data, or reduced functionality. Such problems could adversely impact our ability to provide quotes, take customer orders, and otherwise run our business in a timely manner. In addition, if our new systems fail to provide accurate and increased visibility into pricing and cost structures, it may be difficult to improve or maximize our profit margins. As a result, our results of operations and cash flows could be adversely affected. Changes in accounting standards and subjective assumptions, estimates, and judgments by management related to complex accounting matters could significantly affect our financial results or financial condition. Generally accepted accounting principles and related accounting pronouncements, implementation guidelines, and interpretations with regard to a wide range of matters that are relevant to our business, such as revenue recognition, asset impairment and fair value determinations, inventories, business combinations and intangible asset valuations, and litigation, are highly complex and involve many subjective assumptions, estimates, and judgments. In particular, accounting rules related to companies that we form together with, or that receive substantial funding from, third-party investors such as GRAIL and Helix are highly complex and involve many subjective assumptions, estimates, and judgments. Changes in these rules or their interpretation or changes in underlying assumptions, estimates, or judgments could significantly change our reported or expected financial performance or financial condition. Ethical, legal, and social concerns related to the use of genetic information could reduce demand for our products or services. Our products may be used to provide genetic information about humans, agricultural crops, other food sources, and other living organisms. The information obtained from our products could be used in a variety of applications, which may have underlying ethical, legal, and social concerns regarding privacy and the appropriate uses of the resulting information, including preimplantation genetic screening of embryos, prenatal genetic testing, genetic engineering or modification of agricultural products, or testing genetic predisposition for certain medical conditions, particularly for those that have no known cure. Governmental authorities could, for social or other purposes, call for limits on or regulation of the use of genetic testing or prohibit testing for genetic predisposition to certain conditions, particularly for those that have no known cure. Similarly, such concerns may lead individuals to refuse to use genetics tests even if permissible. These and other ethical, legal, and social concerns about genetic testing may limit market acceptance of our technology for certain applications or reduce the potential markets for our technology, either of which could have an adverse effect on our business, financial condition, or results of operations. Conversion of our outstanding convertible notes may result in losses. As of January 1, 2017, we had $632.5 million aggregate principal amount of convertible notes due 2019, and $517.5 million aggregate principal amount of convertible notes due 2021 outstanding. The notes are convertible into cash, and if applicable, shares of our common stock under certain circumstances, including trading price conditions related to our common stock. Upon conversion, we are required to record a gain or loss for the difference between the fair value of the notes to be extinguished and their corresponding net carrying value. The fair value of the notes to be extinguished depends on our current incremental borrowing rate. The net carrying value of our notes has an implicit interest rate of 2.9% with respect to convertible notes due 2019, and 3.5% with respect to convertible notes due 2021. If our incremental borrowing rate at the time of conversion is lower than the implied interest rate of the notes, we will record a loss in our consolidated statement of income during the period in which the notes are converted. Our Certificate of Incorporation and Bylaws include anti-takeover provisions that may make it difficult for another company to acquire control of us or limit the price investors might be willing to pay for our stock. Certain provisions of our Certificate of Incorporation and Bylaws could delay the removal of incumbent directors and could make it more difficult to successfully complete a merger, tender offer, or proxy contest involving us. Our Certificate of Incorporation has provisions that give our Board the ability to issue preferred stock and determine the rights and designations of the preferred stock at any time without stockholder approval. The rights of the holders of our common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire, or of discouraging a third party from acquiring, a majority of our outstanding voting stock. In addition, the staggered terms of our board of directors could have the effect of delaying or deferring a change in control. In addition, certain provisions of the Delaware General Corporation Law (DGCL), including Section 203 of the DGCL, may have the effect of delaying or preventing changes in the control or management of Illumina. Section 203 of the DGCL provides, with certain exceptions, for waiting periods applicable to business combinations with stockholders owning at least 15% and less than 85% of the voting stock (exclusive of stock held by directors, officers, and employee plans) of a company. The above factors may have the effect of deterring hostile takeovers or otherwise delaying or preventing changes in the control or management of Illumina, including transactions in which our stockholders might otherwise receive a premium over the fair market value of our common stock. Unresolved Staff Comments. The following table summarizes the facilities we lease as of January 1, 2017, including the location and size of each principal facility, and their designated use. We believe our facilities are adequate for our current and near-term needs, and will be able to locate additional facilities as needed. San Diego, CA* R&D, Manufacturing, Warehouse, Distribution, and Administrative San Francisco Bay Area, CA* R&D, Manufacturing, Warehouse, and Administrative Cambridge, United Kingdom* R&D, Manufacturing, and Administrative Distribution and Administrative *Excludes approximately 885,000 square feet for which the leases do not commence until 2017 and beyond. Legal Proceedings. We are involved in various lawsuits and claims arising in the ordinary course of business, including actions with respect to intellectual property, employment, and contractual matters. In connection with these matters, we assesses, on a regular basis, the probability and range of possible loss based on the developments in these matters. A liability is recorded in the financial statements if it is believed to be probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Because litigation is inherently unpredictable and unfavorable results could occur, assessing contingencies is highly subjective and requires judgments about future events. We regularly review outstanding legal matters to determine the adequacy of the liabilities accrued and related disclosures. The amount of ultimate loss may differ from these estimates. Each matter presents its own unique circumstances, and prior litigation does not necessarily provide a reliable basis on which to predict the outcome, or range of outcomes, in any individual proceeding. Because of the uncertainties related to the occurrence, amount, and range of loss on any pending litigation or claim, we are currently unable to predict their ultimate outcome, and, with respect to any pending litigation or claim where no liability has been accrued, to make a meaningful estimate of the reasonably possible loss or range of loss that could result from an unfavorable outcome. In the event that opposing litigants in outstanding litigations or claims ultimately succeed at trial and any subsequent appeals on their claims, any potential loss or charges in excess of any established accruals, individually or in the aggregate, could have a material adverse effect on our business, financial condition, results of operations, and/or cash flows in the period in which the unfavorable outcome occurs or becomes probable, and potentially in future periods. Mine Safety Disclosures. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities. Our common stock has been quoted on The NASDAQ Global Select Market under the symbol “ILMN” since July 28, 2000. Prior to that time, there was no public market for our common stock. The following table sets forth, for the fiscal periods indicated, the quarterly high and low sales prices per share of our common stock as reported on The NASDAQ Global Select Market. Stock Performance Graph The graph below compares the cumulative total stockholder returns on our common stock for the last five fiscal years with the cumulative total stockholder returns on the NASDAQ Composite Index, the NASDAQ Biotechnology Index, and the S&P 500 Index for the same period. The graph assumes that $100 was invested on January 1, 2012 in our common stock and in each index and that all dividends were reinvested. No cash dividends have been declared on our common stock. Stockholder returns over the indicated period should not be considered indicative of future stockholder returns. Compare 5-Year Cumulative Total Return among Illumina, NASDAQ Composite Index, NASDAQ Biotechnology Index, and S&P 500 Index As of February 3, 2017, we had 184 record holders of our common stock. We have never paid cash dividends and have no present intention to pay cash dividends in the foreseeable future. The indentures for our 0% convertible senior notes due 2019 and 0.5% convertible senior notes due in 2021, which notes are convertible into cash and, in certain circumstances, shares of our common stock, require us to increase the conversion rate applicable to the notes if we pay any cash dividends. Purchases of Equity Securities by the Issuer On July 28, 2016, the Company’s Board of Directors authorized a new share repurchase program, which supersedes all prior and available repurchase authorizations, to repurchase $250.0 million of outstanding common stock. The following table summarizes shares repurchased pursuant to this program during the three months ended January 1, 2017. of Shares Paid per Share Total Number of Shares Purchased as Part of Publicly Announced Programs Approximate Dollar that May Yet Be Purchased Under October 3, 2016 - October 30, 2016 (1) All shares purchased during the three months ended January 1, 2017, were made in open-market transactions. Sales of Unregistered Securities None during the fiscal quarter ended January 1, 2017. Selected Financial Data. The following table sets forth selected historical consolidated financial data for each of our last five fiscal years during the period ended January 1, 2017. This information should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in in Part II, Item 8 of this Form 10-K. Statement of Income Data Years Ended January 1, 2017 (52 weeks) December 28, 2014 (52 weeks) Net income attributable to Illumina stockholders Net income attributable to Illumina stockholders for earnings per share Earnings per share attributable to Illumina stockholders: Shares used in calculating earnings per share: Balance Sheet Data January 1, Cash, cash equivalents and short-term investments Redeemable noncontrolling interest Management’s Discussion and Analysis of Financial Condition and Results of Operations. Our Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) will help readers understand our results of operations, financial condition, and cash flow. It is provided in addition to the accompanying consolidated financial statements and notes. This MD&A is organized as follows: Business Overview and Outlook. High level discussion of our operating results and significant known trends that affect our business. Results of Operations. Detailed discussion of our revenues and expenses. Liquidity and Capital Resources. Discussion of key aspects of our statements of cash flows, changes in our financial position, and our financial commitments. Off-Balance Sheet Arrangements. We have no off-balance sheet arrangements. Contractual Obligations. Tabular disclosure of known contractual obligations as of January 1, 2017. Critical Accounting Policies and Estimates. Discussion of significant changes we believe are important to understanding the assumptions and judgments underlying our financial statements. Recent Accounting Pronouncements. This MD&A discussion contains forward-looking statements that involve risks and uncertainties. See “Special Note Regarding Forward-Looking Statements” for additional factors relating to such statements. See “Risk Factors” in Item 1A of this report for a discussion of certain risk factors applicable to our business, financial condition, and results of operations. Operating results are not necessarily indicative of results that may occur in future periods. Business Overview and Outlook Our Company is organized into three operating segments for purposes of evaluating our business operations and reviewing our financial results. One segment consists of Illumina’s core operations (Core Illumina). The other two segments relate to the activities of our consolidated variable interest entities (VIEs), GRAIL and Helix. The combined results of operations of our consolidated VIEs became material during the year ended January 1, 2017. As such, we commenced reporting two segments, Core Illumina and Consolidated VIEs, during 2016. For information on GRAIL and Helix, refer to note “12. Segment Information, Geographic Data, and Significant Customers” in Part II, Item 8 of this Form 10-K. Our focus on innovation has established us as the global leader in sequencing- and array-based technologies, serving customers in a wide range of markets, enabling the adoption of genomic solutions in research and clinical settings. Consolidated financial highlights include the following: Net revenue increased 8.0% in 2016 over 2015 due to the growth in sales of our sequencing consumables and services, partially offset by lower shipments of our high-throughput platforms. We expect our revenue to continue to increase in 2017. Gross profit as a percentage of revenue (gross margin) decreased to 69.5% in 2016 from 69.8% in 2015. Gross margins in 2016 decreased primarily due to our increased manufacturing capacity, which was partially offset by a greater mix of sequencing consumables. Our gross margin in future periods will depend on several factors, including: market conditions that may impact our pricing power; sales mix changes among consumables, instruments, and services; product mix changes between established products and new products in new markets; excess and obsolete inventories; royalties; our cost structure for manufacturing operations; and product support obligations. Income from operations as a percentage of revenue decreased to 24.5% in 2016 compared to 27.6% in 2015 primarily due to the increase in research and development and selling, general, and administrative expenses as a percentage of revenue. We expect research and development and selling, general and administrative expenses to continue to grow. Our effective tax rate was 23.7% and 21.6% in 2016 and 2015, respectively. The variance from the U.S. federal statutory tax rate of 35% was primarily attributable to the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as in Singapore and the United Kingdom, partially offset by the tax impact associated with the investments in our consolidated variable interest entities. Our future effective tax rate may vary from the U.S. federal statutory tax rate due to the mix of earnings in tax jurisdictions with different statutory tax rates and the other factors discussed in the risk factor “We are subject to risks related to taxation in multiple jurisdictions” in Part I Item 1A “Risk Factors” of this Form 10-K. We may also be adversely impacted in the future if the tax court opinion regarding the exclusion of stock compensation from cost-sharing charges is overturned. We anticipate that our effective tax rate will trend lower than the U.S. federal statutory tax rate in the future due to the portion of our earnings that will be subject to lower statutory tax rates. We ended 2016 with cash, cash equivalents, and short-term investments totaling $1.6 billion, of which approximately $749.7 million was held by our foreign subsidiaries. Cash and cash equivalents held by our consolidated VIEs as of January 1, 2017 were $75.9 million. This overview and outlook provides a high-level discussion of our operating results and significant known trends that affect our business. We believe that an understanding of these trends is important to understanding our financial results for the periods reported herein as well as our future financial performance. This summary is not intended to be exhaustive, nor is it intended to be a substitute for the detailed discussion and analysis provided elsewhere in this Annual Report on Form 10-K. To enhance comparability, the following table sets forth audited consolidated statement of operations data for the years ended January 1, 2017, January 3, 2016, and December 28, 2014, stated as a percentage of total revenue. Product revenue Service and other revenue Cost of product revenue Cost of service and other revenue Amortization of acquired intangible assets Total cost of revenue Legal contingencies Acquisition related gain, net Headquarter relocation Cost-method investment gain, net Other expense, net Total other expense, net Add: Net loss attributable to noncontrolling interests Our fiscal year is the 52 or 53 weeks ending the Sunday closest to December 31, with quarters of 13 or 14 weeks ending the Sunday closest to March 31, June 30, September 30, and December 31. Fiscal year 2016 was 52 weeks, fiscal year 2015 was 53 weeks, and fiscal year 2014 was 52 weeks. (Dollars in thousands) Product revenue consists primarily of revenue from sales of consumables and instruments. Service and other revenue consists primarily of sequencing and genotyping service revenue as well as instrument service contract revenue. Our consolidated VIEs are in the development stage and have no revenues to date. 2016 Compared to 2015 Revenue increased $178.6 million, or 8%, to $2,398.4 million in 2016 compared to $2,219.8 million in 2015. Consumables revenue increased $263.6 million, or 21%, to $1,543.5 million in 2016 compared to $1,279.9 million in 2015, driven by growth in the sequencing instrument installed base. Instrument revenue decreased $125.2 million, or 21%, to $469.5 million in 2016 compared to $594.7 million in 2015, primarily due to lower shipments of our high-throughput platforms. Service and other revenue increased $37.2 million, or 11%, to $366.4 million in 2016 compared to $329.1 million in 2015, driven by revenue from genotyping services and instrument service contracts associated with a larger sequencing installed base, partially offset by our NIPT customers shifting to in-house testing on our sequencers. Revenue increased $358.4 million, or 19%, to $2,219.8 million in 2015 compared to $1,861.4 million in 2014. Consumables revenue increased $238.9 million, or 23%, to $1,279.9 million in 2015 compared to $1,041.0 million in the prior year, driven by growth in the sequencing instrument installed base. Instrument revenue increased $32.5 million, or 6%, to $594.7 million in 2015 compared to $562.2 million in the prior year, driven by shipments of HiSeq X and NextSeq systems. Service and other revenue increased $87.3 million, or 36%, to $329.1 million in 2015 compared to $241.8 million in the prior year, driven by the growth in NIPT service test volumes. Revenue from instrument service contracts also contributed to the increase as our sequencing instrument installed base continues to grow. Overall, these increases were negatively impacted by the foreign exchange fluctuations in the comparative periods. Absent these fluctuations, revenues would have grown 23% on a constant currency basis from 2014 to 2015. Total gross profit Total gross margin Gross margin decreased to 69.5% in 2016 compared to 69.8% in 2015. Gross margin decreased primarily due to our increased manufacturing capacity, which was partially offset by a greater mix of sequencing consumables. Gross margin increased to 69.8% compared to 69.7% in the prior year. Gross margin increased primarily due to a positive shift in product mix to sequencing consumables. Gross margin in 2014 was favorably impacted by the litigation settlement with Syntrix, which included a reversal of cost of sales of $10.4 million. See detailed discussions on this matter in note “9. Legal Proceedings” in Part II, Item 8 of this Form 10-K. Operating Expense Research and development (R&D) expense increased by $102.9 million, or 26%, in 2016 from 2015. Core Illumina R&D expense increased by $59.9 million, or 15%, primarily due to increased headcount and outside services as we continue to invest in the development of new products as well as enhancements to existing products. Our consolidated VIEs contributed $43.0 million to the increase, primarily due to $33.7 million incurred by GRAIL. Selling, general and administrative (SG&A) expense increased by $58.3 million, or 11% in 2016 from 2015. Core Illumina SG&A expense increased $35.5 million, or 7%, primarily due to headcount and facilities investment to support the continued growth and scale of our operations, as well as outside services. GRAIL and Helix contributed $13.7 million and $9.1 million to the increase, respectively. Legal contingencies in 2016 represent a reversal of prior year expense related to the settlement of patent litigation. Research and development expense increased by $13.5 million, or 3%, in 2015 from 2014, primarily due to increased headcount and related expenses as we continue to invest in the development of our products as well as enhancements to existing products. Research and development expense in 2014 included our litigation settlement and patent pooling agreement with Sequenom, as $48.8 million was recorded to research and development expense for an upfront payment. See detailed discussion on this matter in note “9. Legal Proceedings” to our financial statements in Part II, Item 8 of this Form 10-K. Selling, general and administrative expense increased by $58.4 million, or 13%, in 2015 from 2014, primarily driven by increased headcount and consulting services to support our continued growth, investments in scaling our operations, and start-up costs related to Helix. Legal contingencies in 2015 represent charges related to patent litigation. Legal contingencies in 2014 reflected predominantly the $82.1 million gain from our litigation settlement with Syntrix, offset by other legal contingency charges. Acquisition related gain, net, in 2015 and 2014 consisted of changes in fair value of contingent consideration. The changes in the fair value of the contingent consideration during the periods were primarily due to changes in the estimated payments and a shorter discounting period. Headquarter relocation costs for 2015 include a net gain related to a change in a lease exit liability, partially offset by accretion of interest on such liability. )% Interest income increased in 2016 compared to 2015 as a result of higher yields on our investments and higher savings and money market balances. Interest expense consisted primarily of accretion of discount on our convertible senior notes. The decrease in interest expense in 2016 compared to 2015 was due to a lower outstanding principal balance on the 2016 Notes, which matured in March 2016. Other expense, net, in 2016 is primarily attributable to $1.0 million related to equity method investment losses and $0.9 million in net foreign exchange loss. Other expense, net, in 2015 consisted primarily of $4.3 million in net foreign exchange loss and a $4.1 million loss on extinguishment of debt. Interest income primarily consisted of returns from our investment portfolio. Interest income increased slightly in 2015 compared to 2014 as a result of higher yields and higher investment balances throughout the period. Interest expense consisted primarily of accretion of discount on our convertible senior notes. The increase in interest expense in 2015 compared to 2014 was due to the issuance of our 2019 and 2021 Notes in June 2014, partially offset by the impact from the concurrent repurchase of $600.0 million in principal amount of our 2016 Notes. Cost-method investment gain, net in 2015 consisted primarily of gains on dispositions of cost-method investments, partially offset by impairment charges on other investments. Other expense, net, in 2015 consisted primarily of $4.3 million in foreign exchange loss and $4.1 million in loss on extinguishment of our 2016 notes. Other expense, net, in 2014, was negatively impacted by $31.4 million loss on extinguishment of debt recorded as a result of the repurchase of $600.0 million in principal amount of our 2016 Notes. Our effective tax rate was 23.7% and 21.6% in 2016 and 2015, respectively. In 2016, the variance from the U.S. federal statutory tax rate of 35% was primarily attributable to the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as in Singapore and the United Kingdom, partially offset by the tax impact associated with the investments in our consolidated variable interest entities. In 2015, the variance from the U.S. federal statutory tax rate of 35% was primarily attributable to a discrete tax benefit of $24.8 million, related to the exclusion of stock compensation from prior period cost-sharing charges as a result of a tax court opinion in which an unrelated third party was successful in challenging such charges. The decrease from the U.S. federal statutory tax rate also resulted from the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as in Singapore and the United Kingdom. Our effective tax rate was 21.6% and 21.3% in 2015 and 2014, respectively. In 2015, the variance from the U.S. federal statutory tax rate of 35% was attributable to a discrete tax benefit of $24.8 million, related to the exclusion of stock compensation from prior period cost-sharing charges as a result of a tax court opinion in which an unrelated third party was successful in challenging such charges. In 2015 and 2014, the variance from the U.S. federal statutory tax rate of 35% was also attributable to the mix of earnings in jurisdictions with lower statutory tax rates than the U.S. federal statutory tax rate, such as Singapore and the United Kingdom. At January 1, 2017, we had approximately $734.5 million in cash and cash equivalents, of which approximately $444.2 million was held by our foreign subsidiaries. Cash and cash equivalents held by our consolidated VIEs as of January 1, 2017 were $75.9 million. Cash and cash equivalents decreased by $34.3 million from last year, due to the factors described in the “Cash Flow Summary” below. Our primary source of liquidity, other than our holdings of cash, cash equivalents, and investments, has been cash flows from operations. Our ability to generate cash from operations provides us with the financial flexibility we need to meet operating, investing, and financing needs. It is our intention to indefinitely reinvest all current and future foreign earnings in foreign subsidiaries. Historically, we have liquidated our short-term investments and/or issued debt and equity securities to finance our business needs as a supplement to cash provided by operating activities. As of January 1, 2017, we had $824.2 million in short-term investments. Short-term investments held by our foreign subsidiaries as of January 1, 2017 were approximately $305.5 million. Our short-term investments include marketable securities consisting of U.S government-sponsored entities, corporate debt securities, and U.S. Treasury securities. During 2016, $75.5 million in principal of the 2016 Notes were converted. The 2016 Notes became convertible on April 1, 2014 through, and including, March 11, 2016. All 2016 Notes were converted by March 11, 2016. The convertible senior notes due 2019 and 2021 were not convertible as of January 1, 2017. We anticipate that our current cash, cash equivalents, and short-term investments, together with cash provided by operating activities are sufficient to fund our near term capital and operating needs for at least the next 12 months. Operating needs include the planned costs to operate our business, including amounts required to fund working capital and capital expenditures. Our primary short-term needs for capital, which are subject to change, include: support of commercialization efforts related to our current and future products, including expansion of our direct sales force and field support resources both in the United States and abroad; acquisitions of equipment and other fixed assets for use in our current and future manufacturing and research and development facilities; the continued advancement of research and development efforts; potential strategic acquisitions and investments; potential early repayment of debt obligations as a result of conversions; the expansion needs of our facilities, including costs of leasing and building out additional facilities; and repurchases of our outstanding common stock. During 2016, we used $249.3 million to repurchase our outstanding shares under the stock repurchase program authorized by our Board of Directors. As of January 1, 2017, $100.7 million remains under the authorized program. Certain noncontrolling Helix investors may require Illumina to redeem all noncontrolling interests in cash at the then approximate fair market value. Such redemption right is exercisable at the option of certain noncontrolling interest holders after January 1, 2021, provided that a bona fide pursuit of the sale of Helix has occurred and an initial public offering of Helix has not been completed. The fair value of the redeemable noncontrolling interests related to Helix as of January 1, 2017, was $42.6 million. On April 14, 2016, we announced our commitment to invest $100.0 million in a new venture capital investment fund (Venture Fund) established by Nicholas Naclerio, Ph.D., our former Senior Vice President, Corporate and Venture Development. The capital commitment is callable over ten years, and up to $40.0 million can be drawn down during the first year. During 2016, the Company transferred $3.2 million of its cost-method investments to the Venture Fund and contributed $7.4 million in cash. We expect that our revenue and the resulting operating income, as well as the status of each of our new product development programs, will significantly impact our cash management decisions. Our future capital requirements and the adequacy of our available funds will depend on many factors, including: our ability to successfully commercialize and further develop our technologies and create innovative products in our markets; scientific progress in our research and development programs and the magnitude of those programs; competing technological and market developments; and the need to enter into collaborations with other companies or acquire other companies or technologies to enhance or complement our product and service offerings. Cash Flow Summary Effect of exchange rate changes on cash and cash equivalents Net (decrease) increase in cash and cash equivalents Net cash provided by operating activities in 2016 consisted of net income of $428.1 million plus net adjustments of $304.2 million partially offset by net changes in net operating assets and liabilities of $45.0 million. The primary non-cash expenses added back to net income included depreciation and amortization expenses of $140.9 million, share-based compensation of $129.1 million, deferred income taxes of $93.6 million, accretion of debt discount of $29.7 million, and gain on litigation settlement of $(11.5) million. These non-cash add-backs were partially offset by $91.3 million in incremental tax benefit related to share-based compensation. Cash flow impact from changes in net operating assets and liabilities were primarily driven by an increase in inventory and a decrease in accrued liabilities. Net cash provided by operating activities in 2015 consisted of net income of $457.4 million plus net adjustments of $240.6 million partially offset by net changes in net operating assets and liabilities of $38.4 million. The primary non-cash expenses added back to net income included share-based compensation of $132.6 million, depreciation and amortization expenses of $126.4 million, deferred income taxes of $80.5 million, and accretion of debt discount of $38.5 million. These non-cash add-backs were partially offset by $126.7 million in incremental tax benefit related to share-based compensation, $15.6 million in cost-method investment gain, net and $6.1 million in change in fair value of contingent consideration. Cash flow impact from changes in net operating assets included increases in accounts receivable, inventory, and prepaid expenses and other current assets, partially offset by increases in accounts payable, accrued liabilities, and accrued legal contingencies. Net cash provided by operating activities in 2014 consisted of net income of $353.4 million plus net adjustments of $204.4 million, partially offset by net changes in net operating assets and liabilities of $56.5 million. The primary non-cash expenses added back to net income included share-based compensation of $152.6 million, depreciation and amortization expenses of $112.6 million, deferred income taxes of $99.8 million, accretion of debt discount of $38.1 million, and loss on extinguishment of debt of $31.4 million. These non-cash add backs were partially offset by $126.5 million in incremental tax benefit related to share-based compensation and $109.4 million in gain on litigation settlement. Cash flow impact from changes in net operating assets included increases in accounts receivable, inventory, other assets, and a decrease in accrued legal contingencies, partially offset by an increase in accrued liabilities. Net cash used in investing activities totaled $514.5 million in 2016. We purchased $894.4 million of available-for-sale securities and $682.9 million of our available-for-sale securities matured or were sold during the period. We also paid net cash of $17.8 million for acquisitions, $13.8 million for strategic investments, $11.5 million for intangibles, and invested $259.9 million in capital expenditures primarily associated with facilities and the purchase of manufacturing, research and development equipment. Net cash used in investing activities totaled $106.1 million in 2015. We purchased $797.0 million of available-for-sale securities and $876.8 million of our available-for-sale securities matured or were sold during the period. We also paid net cash of $36.6 million for acquisitions and invested $142.8 million in capital expenditures primarily associated with machinery and equipment, facilities, and information technology equipment and systems primarily related to our enterprise resource planning system implementation. Net cash used in investing activities totaled $406.6 million in 2014. We purchased $791.3 million of available-for-sale securities and $541.9 million of our available-for-sale securities matured or were sold during the period. We also invested $106.0 million in capital expenditures primarily associated with the purchase of manufacturing, research and development equipment, leasehold improvements, and information technology equipment and systems. Net cash used in financing activities totaled $204.7 million in 2016. We used $99.8 million to pay taxes related to net share settlement of equity awards, $29.2 million to pay acquisition related contingent consideration, and $249.3 million to repurchase our common stock. We used $65.9 million to repay financing obligations. We received $91.3 million in incremental tax benefit related to share-based compensation and $47.7 million in proceeds from the issuance of common stock through the exercise of stock options and under our employee stock purchase plan. Contributions from noncontrolling owners were $89.0 million. Net cash used in financing activities totaled $418.8 million in 2015. We used $127.2 million to pay taxes related to net share settlement of equity awards and $274.3 million to repurchase our common stock. We used $245.0 million to repay financing obligations. We received $126.7 million in incremental tax benefit related to share-based compensation and $71.8 million in proceeds from the issuance of common stock through the exercise of stock options and under our employee stock purchase plan. Contributions from noncontrolling owners were $32.1 million. Net cash used in financing activities totaled $166.7 million in 2014. We received $1,132.4 million in proceeds from the issuance of $1,150.0 million in principal amount of our convertible senior notes due 2019 and 2021, net of issuance costs paid in the period. We used $1,244.7 million to repurchase $600.0 million in principal amount of our 2016 Notes and used $237.2 million to repurchase our common stock. In addition, we paid $30.0 million primarily in conversions of our convertible senior notes due 2014. We received $126.5 million in incremental tax benefit related to share-based compensation and $96.3 million in proceeds from the issuance of common stock through the exercise of stock options and the sale of shares under our employee stock purchase plan. We do not participate in any transactions that generate relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. During the fiscal year ended January 1, 2017, we were not involved in any “off-balance sheet arrangements” within the meaning of the rules of the Securities and Exchange Commission. Contractual obligations represent future cash commitments and liabilities under agreements with third parties, and exclude orders for goods and services entered into in the normal course of business that are not enforceable or legally binding. The following table represents our contractual obligations as of January 1, 2017, aggregated by type (amounts in thousands): Payments Due by Period(1) Contractual Obligation Debt obligations(2) Build-to-suit leases Purchase obligations Amounts due under executive deferred compensation plan Contingent consideration payments related to acquisitions The table excludes $65.0 million of uncertain tax positions, $43.9 million of redeemable noncontrolling interest, and $89.5 million of capital commitments for the Venture Fund as the timing and amounts of the settlement remained uncertain as of January 1, 2017. See note “10. Income Taxes” and note “2. Balance Sheet Account Details” in Part II, Item 8 of this Form 10-K for further discussions of these items. Debt obligations include the principal amount of our convertible senior notes due 2019 and 2021, as well as interest payments to be made under the notes. Although these notes mature in 2019 and 2021, respectively, they may be converted into cash and shares of our common stock prior to maturity if certain conditions are met. Any conversion prior to maturity can result in repayments of the principal amounts sooner than the scheduled repayments as indicated in the table. See note “5. Convertible Senior Notes” in Part II, Item 8 of this Form 10-K for further discussion of the terms of the convertible senior notes. The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and accompanying notes. Management bases its estimates on historical experience, market and other conditions, and various other assumptions it believes to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact us in the future, the estimation process is, by its nature, uncertain given that estimates depend on events over which we may not have control. If market and other conditions change from those that we anticipate, our consolidated financial statements may be materially affected. In addition, if our assumptions change, we may need to revise our estimates, or take other corrective actions, either of which may also have a material effect on our consolidated financial statements. We believe that the following critical accounting policies and estimates have a higher degree of inherent uncertainty and require our most significant judgments. In addition, had we used estimates different from any of these, our consolidated financial statements could have been materially different from those presented. Members of our senior management have discussed the development and selection of our critical accounting policies and estimates, and our disclosure regarding them, with the audit committee of our board of directors. Our accounting policies are more fully described in note “1. Organization and Significant Accounting Policies” in Part II, Item 8 of this Form 10-K. Our revenue is generated primarily from the sale of products and services. Product revenue primarily consists of sales of instruments and consumables used in genetic analysis. Service and other revenue primarily consists of revenue generated from genotyping and sequencing services and instrument service contracts. The timing of revenue recognition and the amount of revenue recognized in each case depends upon a variety of factors, including the specific terms of each arrangement and the nature of our deliverables and obligations. Determination of the appropriate amount of revenue recognized involves significant judgment and estimates. We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. In instances where final acceptance of the product or system is required, revenue is deferred until all the acceptance criteria have been met. We occasionally offer discounts on newly introduced products to recent customers of existing products. These promotions sometimes involve the trade-in of existing products in exchange for a discount on new products. Where applicable, we defer a portion of revenue on the sales of existing products in recognition of the promotional discounts until the delivery of new products. All revenue is recorded net of discounts and sales taxes collected on behalf of governmental authorities. Revenue from product sales is recognized generally upon transfer of title to the customer, provided that no significant obligations remain and collection of the receivable is reasonably assured. Revenue from instrument service contracts is recognized as the services are rendered, typically evenly over the contract term. Revenue from genotyping and sequencing services is recognized when earned, which is generally at the time the genotyping or sequencing analysis data is made available to the customer or agreed upon milestones are reached. In order to assess whether the price is fixed or determinable, we evaluate whether an arrangement is cancellable or subject to future changes in price, deliverables, or other terms. If it is determined that the price is not fixed or determinable, we defer revenue recognition until the price becomes fixed or determinable. We assess collectibility based on a number of factors, including past transaction history with, and the creditworthiness of, the customer. If we determine that collection of a payment is not reasonably assured, revenue recognition is deferred until receipt of payment. We regularly enter into contracts where revenue is derived from multiple deliverables including products or services. These products or services are generally delivered within a short time frame, approximately three to six months, after the contract execution date. Revenue recognition for contracts with multiple deliverables is based on the individual units of accounting determined to exist in the contract. A delivered item is considered a separate unit of accounting when the delivered item has value to the customer on a stand-alone basis. Items are considered to have stand-alone value when they are sold separately by any vendor or when the customer could resell the item on a stand-alone basis. For transactions with multiple deliverables, consideration is allocated at the inception of the contract to all deliverables based on their relative selling price. The relative selling price for each deliverable is determined using vendor specific objective evidence (VSOE) of selling price or third-party evidence of selling price if VSOE does not exist. If neither VSOE nor third-party evidence exists, we use best estimate of the selling price for the deliverable. In order to establish VSOE of selling price, we must regularly sell the product or service on a standalone basis with a substantial majority priced within a relatively narrow range. VSOE of selling price is usually the midpoint of that range. If there are not a sufficient number of standalone sales and VSOE of selling price cannot be determined, then we consider whether third party evidence can be used to establish selling price. Due to the lack of similar products and services sold by other companies within the industry, we have rarely established selling price using third-party evidence. If neither VSOE nor third party evidence of selling price exists, we determine our best estimate of selling price using average selling prices over a rolling 12-month period coupled with an assessment of current market conditions. If the product or service has no history of sales or if the sales volume is not sufficient, we rely upon prices set by our pricing committee adjusted for applicable discounts. We recognize revenue for delivered elements only when we determine there are no uncertainties regarding customer acceptance. In certain markets, we sell products and provide services to customers through distributors that specialize in life science products. In most sales through distributors, the product is delivered directly to customers. In cases where the product is delivered to a distributor, revenue recognition is deferred until acceptance is received from the distributor, and/or the end-user, if required by the applicable sales contract. The terms of sales transactions through distributors are consistent with the terms of direct sales to customers. These transactions are accounted for in accordance with our revenue recognition policy described herein. We invest in various types of securities, including debt securities in government-sponsored entities, corporate debt securities, and U.S. Treasury securities. As of January 1, 2017, we had $824.2 million in short-term investments. In accordance with the accounting standard for fair value measurements, we classify our investments as Level 1, 2, or 3 within the fair value hierarchy. Fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets that we have the ability to access. Fair values determined by Level 2 inputs utilize data points that are observable such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs utilize unobservable data points for the asset. As discussed in note “4. Fair Value Measurements” in Part II, Item 8 of this Form 10-K, a majority of our security holdings have been classified as Level 2. These securities have been initially valued at the transaction price and subsequently valued utilizing a third party service provider who assesses the fair value using inputs other than quoted prices that are observable either directly or indirectly, such as yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures. We perform certain procedures to corroborate the fair value of these holdings, and in the process, we apply judgment and estimates that if changed, could significantly affect our statement of financial positions. Allowance for Doubtful Accounts We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We evaluate the collectibility of our accounts receivable based on a combination of factors. We regularly analyze customer accounts, review the length of time receivables are outstanding, review historical loss rates and assess current economic trends that may impact the level of credit losses in the future. Our allowance for doubtful accounts has generally been adequate to cover our actual credit losses. However, since we cannot reliably predict future changes in the financial stability of our customers, we may need to increase our reserves if the financial conditions of our customers deteriorate. Inventories are stated at lower of cost or market. We record adjustments to inventory for potentially excess, obsolete, or impaired goods in order to state inventory at net realizable value. We must make assumptions about future demand, market conditions, and the release of new products that will supersede old ones. We regularly review inventory for excess and obsolete products and components, taking into account product life cycles, quality issues, historical experience, and usage forecasts. Our gross inventory totaled $344.5 million and the cumulative adjustment for potentially excess and obsolete inventory was $44.3 million at January 1, 2017. Historically, our inventory adjustment has been adequate to cover our losses. However, if actual market conditions are less favorable than anticipated, additional inventory adjustments could be required. We are involved in various lawsuits and claims arising in the ordinary course of business, including actions with respect to intellectual property, employment, and contractual matters. In connection with these matters, we assess, on a regular basis, the probability and range of possible loss based on the developments in these matters. A liability is recorded in the financial statements if it is believed to be probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Because litigation is inherently unpredictable and unfavorable resolutions could occur, assessing contingencies is highly subjective and requires judgments about future events. We regularly review outstanding legal matters to determine the adequacy of the liabilities accrued and related disclosures in consideration of many factors, which include, but are not limited to, past history, scientific and other evidence, and the specifics and status of each matter. We may change our estimates if our assessment of the various factors changes and the amount of ultimate loss may differ from our estimates, resulting in a material effect on our business, financial condition, results of operations, and/or cash flows. Business Combinations Under the acquisition method of accounting, we allocate the fair value of the total consideration transferred to the tangible and identifiable intangible assets acquired and liabilities assumed based on their estimated fair values on the date of acquisition. The fair values assigned, defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between willing market participants, are based on estimates and assumptions determined by management. We record the excess consideration over the aggregate fair value of tangible and intangible assets, net of liabilities assumed, as goodwill. These valuations require us to make significant estimates and assumptions, especially with respect to intangible assets. In connection with certain of our acquisitions, additional contingent consideration is earned by the sellers upon completion of certain future performance milestones. In these cases, a liability is recorded on the acquisition date for an estimate of the acquisition date fair value of the contingent consideration by applying the income approach utilizing variable inputs such as anticipated future cash flows, risk-free adjusted discount rates, and nonperformance risk. Any change in the fair value of the contingent consideration subsequent to the acquisition date is recognized in acquisition related (gain) expense, net, a component of operating expenses, in our consolidated statements of income. This method requires significant management judgment, including the probability of achieving certain future milestones and discount rates. Future changes in our estimates could result in expenses or gains. Management typically uses the discounted cash flow method to value our acquired intangible assets. This method requires significant management judgment to forecast future operating results and establish residual growth rates and discount factors. The estimates we use to value and amortize intangible assets are consistent with the plans and estimates that we use to manage our business and are based on available historical information and industry estimates and averages. If the subsequent actual results and updated projections of the underlying business activity change compared with the assumptions and projections used to develop these values, we could experience impairment charges. In addition, we have estimated the economic lives of certain acquired assets and these lives are used to calculate depreciation and amortization expense. If our estimates of the economic lives change, depreciation or amortization expenses could be accelerated or slowed. Intangible Assets and Other Long-Lived Assets — Impairment Assessments We regularly perform reviews to determine if the carrying values of our long-lived assets are impaired. A review of identifiable intangible assets and other long-lived assets is performed when an event occurs indicating the potential for impairment. If indicators of impairment exist, we assess the recoverability of the affected long-lived assets and compare their fair values to the respective carrying amounts. In order to estimate the fair value of identifiable intangible assets and other long-lived assets, we estimate the present value of future cash flows from those assets. The key assumptions that we use in our discounted cash flow model are the amount and timing of estimated future cash flows to be generated by the asset over an extended period of time and a rate of return that considers the relative risk of achieving the cash flows, the time value of money, and other factors that a willing market participant would consider. Significant judgment is required to estimate the amount and timing of future cash flows and the relative risk of achieving those cash flows. Assumptions and estimates about future values and remaining useful lives are complex and often subjective. They can be affected by a variety of factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal forecasts. For example, if our future operating results do not meet current forecasts or if we experience a sustained decline in our market capitalization that is determined to be indicative of a reduction in fair value of our reporting unit, we may be required to record future impairment charges for purchased intangible assets. Impairment charges could materially decrease our future net income and result in lower asset values on our balance sheet. We are required to measure and recognize compensation expense for all share-based payments based on estimated fair value. We estimate the fair value of stock options granted and stock purchases under our employee stock purchase plan using the Black-Scholes-Merton (BSM) option-pricing model. The fair value of our restricted stock units is based on the market price of our common stock on the date of grant. The determination of fair value of share-based awards requires the use of certain estimates and highly judgmental assumptions that affect the amount of share-based compensation expense recognized in our consolidated statements of income. These include estimates of the expected volatility of our stock price, expected life of an award, expected dividends, the risk-free interest rate, and forecast of our future financial performance, in the case of performance stock units. We determine the volatility of our stock price by equally weighing the historical and implied volatility of our common stock. The historical volatility of our common stock over the most recent period is generally commensurate with the estimated expected life of our stock awards, adjusted for the impact of unusual fluctuations not reasonably expected to recur, and other relevant factors. Implied volatility is calculated from the implied market volatility of exchange-traded call options on our common stock. The expected life of an award is based on historical forfeiture experience, exercise activity, and on the terms and conditions of the stock awards. We determined expected dividend yield to be 0% given we have never declared or paid any cash dividends on our common stock and we currently do not anticipate paying such cash dividends. The risk-free interest rate is based upon U.S. Treasury securities with remaining terms similar to the expected term of the share-based awards. We update our forecast of future financial performance periodically, which impacts our estimate of the number of shares to be issued pursuant to the outstanding performance stock units. We amortize the fair value of share-based compensation on a straight-line basis over the requisite service periods of the awards. If any of the assumptions used change significantly, share-based compensation expense may differ materially from what we have recorded in the current period. We generally provide a one-year warranty on instruments. Additionally, we provide a warranty on consumables through the expiration date, which generally ranges from six to twelve months after the manufacture date. We establish an accrual for estimated warranty expenses based on historical experience as well as anticipated product performance. We periodically review the adequacy of our warranty reserve, and adjust, if necessary, the warranty percentage and accrual based on actual experience and estimated costs to be incurred. If our estimates of warranty obligation change or if actual product performance is below our expectations we may incur additional warranty expense. Cease-Use Loss upon Exit of Facility We may, from time to time, relocate or consolidate our office locations and cease to use a facility for which the lease continues beyond the cease-use date. We estimate cease-use loss as the present value of the remaining lease obligation offset by estimated sublease rental receipts during the remaining lease period, adjusted for deferred items and leasehold improvements. In this process, management is required to make significant judgments to estimate the present value of future cash flows from the assumed sublease, including the amount and timing of estimated sublease rental receipts, and the risk-adjusted discount rate. These assumptions are subjective in nature and the actual future cash flows could differ from our estimates, resulting in significant adjustments to the cease-use loss recorded. Our provision for income taxes, deferred tax assets and liabilities, and reserves for unrecognized tax benefits reflect our best assessment of estimated future taxes to be paid. Significant judgments and estimates based on interpretations of existing tax laws or regulations in the United States and the numerous foreign jurisdictions where we are subject to income tax are required in determining our provision for income taxes. Changes in tax laws, statutory tax rates, and estimates of our future taxable income could impact the deferred tax assets and liabilities provided for in the consolidated financial statements and would require an adjustment to the provision for income taxes. Deferred tax assets are regularly assessed to determine the likelihood they will be recovered from future taxable income. A valuation allowance is established when we believe it is more likely than not the future realization of all or some of a deferred tax asset will not be achieved. In evaluating our ability to recover deferred tax assets within the jurisdiction which they arise, we consider all available positive and negative evidence. Factors reviewed include the cumulative pre-tax book income for the past three years, scheduled reversals of deferred tax liabilities, our history of earnings and reliability of our forecasts, projections of pre-tax book income over the foreseeable future, and the impact of any feasible and prudent tax planning strategies. Based on the available evidence as of January 1, 2017, we were not able to conclude it is more likely than not certain deferred tax assets will be realized. Therefore, we recorded a valuation allowance of $18.1 million against certain U.S. and foreign deferred tax assets. We recognize the impact of a tax position in our financial statements only if that position is more likely than not of being sustained upon examination by taxing authorities, based on the technical merits of the position. Tax authorities regularly examine our returns in the jurisdictions in which we do business and we regularly assess the tax risk of our return filing positions. Due to the complexity of some of the uncertainties, the ultimate resolution may result in payments that are materially different from our current estimate of the tax liability. These differences, as well as any interest and penalties, will be reflected in the provision for income taxes in the period in which they are determined. Recent Accounting Pronouncements For summary of recent accounting pronouncements applicable to our consolidated financial statement see note “1. Organization and Summary of Significant Accounting Policies” in Part II, Item 8, Notes to Consolidated Financial Statements, which is incorporated herein by reference. Quantitative and Qualitative Disclosures About Market Risk. Interest Rate Sensitivity Our investment portfolio is exposed to market risk from changes in interest rates. The fair market value of fixed rate securities may be adversely impacted by fluctuations in interest rates while income earned on floating rate securities may decline as a result of decreases in interest rates. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. We attempt to ensure the safety and preservation of our invested principal funds by limiting default risk, market risk, and reinvestment risk. We mitigate default risk by investing in investment grade securities. We have historically maintained a relatively short average maturity for our investment portfolio, and we believe a hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest sensitive financial instruments. Changes in interest rates may impact gains or losses from the conversion of our outstanding convertible senior notes. In June 2014, we issued $632.5 million aggregate principal amount of 0% convertible senior notes due 2019 (2019 Notes) and $517.5 million aggregate principal amount of 0.5% convertible senior notes due 2021 (2021 Notes). At our election, the notes are convertible into cash, shares of our common stock, or a combination of cash and shares of our common stock under certain circumstances, including trading price conditions related to our common stock. If the trading price of our common stock reaches a price at 130% above the conversion price, the notes will become convertible. Upon conversion, we are required to record a gain or loss for the difference between the fair value of the debt to be extinguished and its corresponding net carrying value. The fair value of the debt to be extinguished depends on our then-current incremental borrowing rate. If our incremental borrowing rate at the time of conversion is higher or lower than the implied interest rate of the notes, we will record a gain or loss in our consolidated statement of income during the period in which the notes are converted. The implicit interest rates for the 2019 and 2021 Notes were 2.9% and 3.5%, respectively. An incremental borrowing rate that is a hypothetical 100 basis points lower than the implicit interest rate upon conversion of $100.0 million aggregate principal amount of each of the 2019 and 2021 Notes would result in losses of approximately $2.5 million and $4.1 million, respectively. Foreign Currency Exchange Risk We conduct a portion of our business in currencies other than the company’s U.S. dollar functional currency. These transactions give rise to monetary assets and liabilities that are denominated in currencies other than the U.S. dollar. The value of these monetary assets and liabilities are subject to changes in currency exchange rates from the time the transactions are originated until settlement in cash. Our foreign currency exposures are primarily concentrated in the Euro, Yen, and Australian dollar. Both realized and unrealized gains or losses on the value of these monetary assets and liabilities are included in the determination of net income. We use forward exchange contracts to manage foreign currency risks related to monetary assets and liabilities denominated in currencies other than the U.S. dollar. We only use derivative financial instruments to reduce foreign currency exchange rate risks; we do not hold any derivative financial instruments for trading or speculative purposes. We primarily use forward exchange contracts to hedge foreign currency exposures, and they generally have terms of one month or less. Realized and unrealized gains or losses on the value of financial contracts entered into to hedge the exchange rate exposure of these monetary assets and liabilities are also included in the determination of net income, as they have not been designated for hedge accounting. These contracts, which settle monthly, effectively fix the exchange rate at which these specific monetary assets and liabilities will be settled, so that gains or losses on the forward contracts offset the gains or losses from changes in the value of the underlying monetary assets and liabilities. As of January 1, 2017, the total notional amount of outstanding forward contracts in place for foreign currency purchases was $68.8 million. Financial Statements and Supplementary Data. INDEX TO CONSOLIDATED FINANCIAL STATEMENTS Consolidated Statements of Stockholders’ Equity The Board of Directors and Stockholders of We have audited the accompanying consolidated balance sheets of Illumina, Inc. as of January 1, 2017 and January 3, 2016, and the related consolidated statements of income, comprehensive income, stockholders’ equity, and cash flows for each of the three fiscal years in the period ended January 1, 2017. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Illumina, Inc. at January 1, 2017 and January 3, 2016, and the consolidated results of its operations and its cash flows for each of the three fiscal years in the period ended January 1, 2017, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Illumina, Inc.’s internal control over financial reporting as of January 1, 2017, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (2013 framework) and our report dated February 13, 2017 expressed an unqualified opinion thereon. /s/ ERNST & YOUNG LLP (in thousands, except par value) Build-to-suit lease liability Long-term debt, current portion Preferred stock, $0.01 par value, 10,000 shares authorized; no shares issued and outstanding at January 1, 2017 and January 3, 2016 Common stock, $0.01 par value, 320,000 shares authorized; 188,759 shares issued and 146,196 outstanding at January 1, 2017; 186,663 shares issued and 146,584 outstanding at January 3, 2016 Accumulated other comprehensive (loss) income Treasury stock, 42,563 shares and 40,079 shares at cost at January 1, 2017 and January 3, 2016, respectively (2,022,429 Total Illumina stockholders’ equity Total liabilities and stockholders’ equity Shares used in computing earnings per common share: Unrealized (loss) gain on available-for-sale securities, net of deferred tax Total consolidated comprehensive income Add: Comprehensive loss attributable to noncontrolling interests Comprehensive income attributable to Illumina stockholders Illumina Stockholders Accumulated Other Retained Stockholders’ Balance as of December 29, 2013 Unrealized loss on available-for-sale securities, net of deferred tax Issuance of common stock, net of repurchases Tax impact from the issuance, repurchase and conversion of convertible notes Reclassification of conversion option subject to cash settlement Net incremental tax benefit related to share-based compensation Equity based contingent compensation Warrant exercises Repurchase of convertible notes, net of issuances Unrealized gain on available-for-sale securities, net of deferred tax

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professional_accounting

AccountingIntermediate Accounting: Reporting And AnalysisRatio Analysis Byers Company presents the following condensed income Statement for 2019 and condensed December 31, 2019, balance sheet: Additional information: 1. The company’s common stock was outstanding the entire year. 2. Dividends of $1.50 per share on the common stock were declared in 2019. 3. On December 31, 2019, common stock is selling for $20 per share. 4. On January 1, 2019, the accounts receivable (net) balance was $24,000, total assets amounted to $380,000, and total shareholders’ equity was $241,000. 5. Of the company’s net sales, 78% are on credit. 6. The company operates on a 365-day business year. Required: Compute the following ratios for Byers (round all computations to two decimals): (1) earnings per share, (2) gross profit margin, (3) operating profit margin, (4) net profit margin, (5) total asset turnover, (6) return on assets, (7) return on common equity, (8) receivables turnover (in days), and (9) interest coverage. Ratio Analysis Byers Company presents the following condensed income Statement for 2019 and condensed December 31, 2019, balance sheet: Additional information: 1. The company’s common stock was outstanding the entire year. 2. Dividends of $1.50 per share on the common stock were declared in 2019. 3. On December 31, 2019, common stock is selling for $20 per share. 4. On January 1, 2019, the accounts receivable (net) balance was $24,000, total assets amounted to $380,000, and total shareholders’ equity was $241,000. 5. Of the company’s net sales, 78% are on credit. 6. The company operates on a 365-day business year. Required: Compute the following ratios for Byers (round all computations to two decimals): (1) earnings per share, (2) gross profit margin, (3) operating profit margin, (4) net profit margin, (5) total asset turnover, (6) return on assets, (7) return on common equity, (8) receivables turnover (in days), and (9) interest coverage. Intermediate Accounting: Reporting... James M. Wahlen + 2 others Publisher: Cengage Learning 1 The Demand For And Supply Of Financial Accounting Information2 Financial Reporting: Its Conceptual Framework3 Review Of A Company's Accounting System4 The Balance Sheet And The Statement Of Shareholders' Equity5 The Income Statement And The Statement Of Cash FlowsM Time Value Of Money Module6 Cash And Receivables7 Inventories: Cost Measurement And Flow Assumptions8 Inventories: Special Valuation Issues9 Current Liabilities And Contingent Obligations10 Property, Plant And Equipment: Acquisition And Subsequent Investments11 Depreciation, Depletion, Impairment, And Disposal12 Intangibles13 Investments And Long-term Receivables14 Financing Liabilities: Bonds And Long-term Notes Payable15 Contributed Capital16 Retained Earnings And Earnings Per Share17 Advanced Issues In Revenue Recognition18 Accounting For Income Taxes19 Accounting For Post Retirement Benefits20 Accounting For Leases21 The Statement Of Cash Flows22 Accounting For Changes And Errors. Chapter Questions Problem 1GI Problem 10GI Problem 1MC Problem 1RE Problem 10RE Problem 1E Problem 10E Problem 1P Problem 10P Problem 1C Problem 11C Chapter 5, Problem 16E Ratio Analysis Byers Company presents the following condensed income Statement for 2019 and condensed December 31, 2019, balance sheet: 1. The company’s common stock was outstanding the entire year. 2. Dividends of $1.50 per share on the common stock were declared in 2019. 3. On December 31, 2019, common stock is selling for $20 per share. 4. On January 1, 2019, the accounts receivable (net) balance was $24,000, total assets amounted to $380,000, and total shareholders’ equity was $241,000. 5. Of the company’s net sales, 78% are on credit. 6. The company operates on a 365-day business year. Compute the following ratios for Byers (round all computations to two decimals): (1) earnings per share, (2) gross profit margin, (3) operating profit margin, (4) net profit margin, (5) total asset turnover, (6) return on assets, (7) return on common equity, (8) receivables turnover (in days), and (9) interest coverage. Chapter 5, Chapter 5 Solutions Intermediate Accounting: Reporting And Analysis Ch. 5 - In general, how does the income statement help...Ch. 5 - What are the purposes of the income statement?Ch. 5 - Define income under the capital maintenance...Ch. 5 - Define comprehensive income. What was the intent...Ch. 5 - What is net income?Ch. 5 - What three things must a company determine to...Ch. 5 - Define revenues. What operating activities...Ch. 5 - What are the five steps to determine when revenues...Ch. 5 - Give an example and explanation for each of the...Ch. 5 - Define expenses. What do expenses measure? Ch. 5 - What are three principles for determining when...Ch. 5 - Define gains and losses. Give examples of three...Ch. 5 - What items are included in a company's operating...Ch. 5 - What items are included in a companys income from...Ch. 5 - How are unusual or infrequent gains or losses...Ch. 5 - What is interperiod tax allocation?Ch. 5 - What is intraperiod tax allocation, and why is it...Ch. 5 - What items are included in a company's results...Ch. 5 - Why are results from discontinued operations...Ch. 5 - What is earnings per shore? Where is earnings per...Ch. 5 - How is basic comings per share computed?Ch. 5 - What is included in comprehensive income?...Ch. 5 - What two alternatives does a company have for...Ch. 5 - Identify several differences between IFRS and U.S....Ch. 5 - What is a statement of cash flows? What is its...Ch. 5 - What are the three types of activities that a...Ch. 5 - When used with a company's other financial...Ch. 5 - Under the indirect method, how is the net cash...Ch. 5 - What are the three most common profit margins...Ch. 5 - What does financial statement user compute when...Ch. 5 - What is the rate of return on common equity? What...Ch. 5 - (Appendix 5.1) What criterio should a company use...Ch. 5 - (Appendix 5. 1) Why are financial statement users...Ch. 5 - Which of the following is expensed under the...Ch. 5 - The following information is available for Cooke...Ch. 5 - The following information is available for Wagner...Ch. 5 - Dobbin Corporation, a manufacturer of house-hold...Ch. 5 - A loss from the sale of a component of a business...Ch. 5 - In a statement of cash flows, receipts from sales...Ch. 5 - Brandt Corporation had sales revenue of 500,000...Ch. 5 - Refer to RE5-1. Prepare a single-step income...Ch. 5 - Shaquille Corporation began the current year with...Ch. 5 - Dorno Corporation incurred expenses during the...Ch. 5 - Niler Corporation reported the following after-tax...Ch. 5 - Jordan Corporation reported retained earnings of...Ch. 5 - Pallest Corporation reported the following pretax...Ch. 5 - Mangold Corporation reported income from...Ch. 5 - Amelias Bookstore reported net income of 62,000...Ch. 5 - During the current year, Ross Corporation...Ch. 5 - Simple Income Statement The following are selected...Ch. 5 - Cost of Goods Sold and Income Statement Schuch...Ch. 5 - Income Statement Calculation OConnor Companys...Ch. 5 - Results of Discontinued Operations On November 30,...Ch. 5 - Multiple-Step and Single-Step In coin Statements...Ch. 5 - Income Statement Deficiencies David Companys...Ch. 5 - Multiple-Step and Single-Step Income Statements,...Ch. 5 - Cost of Goods Sold, Income Statement. and...Ch. 5 - Net Cash Flow from Operating Activities The...Ch. 5 - Operating Cash Flows: Direct Method The following...Ch. 5 - Statement of Cash Flows The following items...Ch. 5 - Statement of Cash Flows The following are several...Ch. 5 - Classifications Where would each of the following...Ch. 5 - Rate of Change nalyses eiher Company presents the...Ch. 5 - Common-Size Analyses Meagley Company presents the...Ch. 5 - Ratio Analysis Byers Company presents the...Ch. 5 - Income Statement and Retained Earnings Huff...Ch. 5 - Segment Reporting (Appendix 5.1) Parks...Ch. 5 - Interim Reporting (Appendix 5.1) Miller Company...Ch. 5 - Results of Discontinued Operations On November 1,...Ch. 5 - Income Statement, Lower Portion At the beginning...Ch. 5 - Income Statement, Lower Portion Cunningham Company...Ch. 5 - Financial Statement Violations of U.S. GAAP The...Ch. 5 - Misclassiflcations Rox Corporations multiple-step...Ch. 5 - Misclassifications Olson Companys bookkeeper...Ch. 5 - Complex Income Statement The following items were...Ch. 5 - Comprehensive: Comparative Income Statements Tiger...Ch. 5 - Financial Statement Deficiencies The following is...Ch. 5 - Comprehensive: Balance Sheet from Statement of...Ch. 5 - Net Income and Comprehensive Income At the...Ch. 5 - Statement of Cash Flows A list of Fischer Companys...Ch. 5 - Statement of Cash Flows The following are Mueller...Ch. 5 - Statement of Cash Flows: Direct Method The...Ch. 5 - Rate of Change Analyses and Ratios Analyses The...Ch. 5 - Comprehensive: Income Statement and Retained...Ch. 5 - Comprehensive: Income Statement and Supporting...Ch. 5 - Interim Reporting Schultz Company prepares interim...Ch. 5 - Comparative Income Statements Century Company, a...Ch. 5 - Income Statement and Segment Reporting The...Ch. 5 - A friend of yours who is not an accounting major...Ch. 5 - Expense Recognition The FASB states that expenses...Ch. 5 - Cost, Expense, and Loss You were requested to...Ch. 5 - GAAP deal with, among other issues, defining a...Ch. 5 - Nonrecurring Items Lynn Company sells a component...Ch. 5 - Statement of Cash Flows The president of a company...Ch. 5 - Accrual Accounting GAAP requires the use of...Ch. 5 - Ethics and Sale of Operating Component It is the...Ch. 5 - Analyzing Starbuckss Income Statement and Cash...Ch. 5 - Researching GAAP Situation Kelly Company, a small... Additional Business Textbook Solutions Entries for notes receivable, including year-end entries The following selected transactions were completed by ... Determining missing items in return on investment computation One item is omitted from each of the following co... Financial & Managerial Accounting Entries for bad debt expense under the direct write-off and allowance methods Casebolt Company wrote off the fo... What are value-added activities? Value-added costs? Managerial Accounting: The Cornerstone of Business Decision-Making Equipment with a cost of 180,000 has an estimated residual value of 14,400, has an estimated useful life of 16 ... Entries for selected corporate transactions Selected transactions completed by Primo Discount Corporation durin... Corporate Financial Accounting SYSTEM FLOWCHART AP Using the format presented in Figure 2-4 in the text, develop a similar flowchart for the p... Why is the accounting for a manufacturing business more complicated than that for a merchandising business? College Accounting, Chapters 1-27 The Commerce Department reported receiving the following applications for the Malcolm Baldrige National Quality... CONSTANT GROWTH Your broker offers to sell you some shares of Bahnsen Co. common stock that paid a dividend of... Fundamentals of Financial Management (MindTap Course List) True to Myself Ethney Gentry was thrilled to have infiltrated the ultimate" good old boy" network, landing a jo... Management, Loose-Leaf Version What are the different forms of compensation? Foundations of Business (MindTap Course List) Define strategic business units (SBUs) MKTG 12:STUDENT ED.-TEXT Suppose I observe that communities with lots of doctors tend to have relatively high rates of illness. I conclu... The chapter mentions that companies frequently outsource the payroll function. Using the Internet, locate at le... CASH CONVERSION CYCLE Chastain Corporation is trying to determine the effect of its inventory turnover ratio an... Fundamentals of Financial Management, Concise Edition (MindTap Course List) (Total Cost and Marginal Cost) Complete the following table, assuming that each unit of labor costs $75 per day... ECON MICRO Why is a country better off not isolating itself from all other countries? Why do we have markets, and accordi... Essentials of Economics (MindTap Course List) (Market Equilibrium) Determine whether each of the following statements is true, false, or uncertain. Then brie... ECON: MICRO4 (New, Engaging Titles from 4LTR Press) Name two types of market failure. Explain why each may cause market outcomes to be inefficient. Principles of Economics (MindTap Course List) How might technology shape business report formats and their delivery in the future? Essentials of Business Communication (MindTap Course List) You deposit 2,000 in a savings account, and a year after you have 2,100. Meanwhile, the CPI rises from 200 to 2... Principles of Macroeconomics (MindTap Course List) Economists use labor-market data to evaluate how well an economy is using its most valuable resource its people... Brief Principles of Macroeconomics (MindTap Course List) All of the following topics fall within the study of microeconomics EXCEPT a. the impact of cigarette taxes on ... Principles of Microeconomics (MindTap Course List) Price discrimination is practiced by movie theaters, motels, golf courses, drugstores, and universities. Are th... Economics: Summarize how marketing creates value through the four types of utility. Contemporary Marketing Assume that a firm separately determined inventory under FIFO and LIFO and then compared the results. a. In eac... Why is it necessary to adjust the Merchandise Inventory account under a periodic inventory system? College Accounting (Book Only): A Career Approach A corporation reacquires 60,000 shares of its own 10 par common stock for 3,000,000, recording it at cost. a. W... Accounting (Text Only) Record general journal entries to correct the errors described below. Assume that the incorrect entries were po... Sell or process further Rise N Shine Coffee Company produces Columbian coffee in batches of 6,000 pounds. The s... FINANCIAL MARKETS AND INSTITUTIONS Assume that you recently graduated with a degree in finance and have just re... Fundamentals of Financial Management, Concise Edition (with Thomson ONE - Business School Edition, 1 term (6 months) Printed Access Card) (MindTap Course List) Fill in the missing data in the folloiwng table for a monopolist. Exploring Economics Can the following equation be used to find the value of a bond with N years to maturity that pays interest once... Pew Research Center is a nonpartisan polling organization that provides information about issues, attitudes, an... CLOSING INCOME SUMMARY AND DIVIDENDS TO RETAINED EARNINGS Kennington Company had a net income of 90,000 and pai... College Accounting, Chapters 1-27 (New in Accounting from Heintz and Parry) What is global inventory management, and how can it be used to increase the capability of a company to deliver ... Pkg Acc Infor Systems MS VISIO CD Your uncle repays a 100 loan from Tenth National Bank (TNB) by writing a 100 check from his TNB checking accoun... Partial-year depreciation Equipment acquired at a cost of 105,000 has an estimated residual value of 812,000 an... What uses are made of the information shown in the employees earnings record? PAYROLL ACCT.,2019 ED.(LL)-TEXT If total assets are $20,000 and total liabilities are $12,000, the amount of stockholders’ equity is: A. $32,00... Survey of Accounting (Accounting I) Concentration ratios have often been used to note the tightness of an oligopoly market. A high concentration ra... When there is a permanent increase in market demand in an increasing-cost industry, a firms Short-run Average T... Economics For Today What is the purpose of building a theory? Copy each of the following sentences, making essential changes in capitalization. The first question professor ... A firm maximizes its total revenue. Does it automatically maximize its profit too? Why or why not? Economics (MindTap Course List) Insourcing/Outsourcing: The FlexCon Piston Decision This case addresses many issues that affect insourcing/outs... Purchasing and Supply Chain Management What is value-chain analysis? What role does it play in strategic cost analysis? Cornerstones of Cost Management (Cornerstones Series) Insurance companies wouldnt exist unless customers were willing to pay the price of the insurance and the insur... Practical Management Science Decision on accepting additional business Homestead Jeans Co. has an annual plant capacity of 65,000 units, and... Heston Company acquired a patent on January 1, 2019, for $75,000. The patent has a remaining legal life of 15 y... Cornerstones of Financial Accounting Low-income families consume proportionately more of which of the following kinds of goods? a. Luxury goods b. S... Micro Economics For Today Explain the statement People respond to incentives and disincentives in relation to the demand curve and supply... MACROECONOMICS FOR TODAY The 2010-2011 Bain survey of management tools and trends found that the use of social media programs is growing... Understanding Management (MindTap Course List) How does the substitution of third-party payments by insurance companies and the government for the out-of-pock... Microeconomics: Private and Public Choice (MindTap Course List) How would you expect the actual unemployment rate to compare with the natural unemployment rate in the followin... Economics: Private and Public Choice (MindTap Course List) The American Wind Energy Association argues for additional government support because wind-generated electricit... Macroeconomics: Private and Public Choice (MindTap Course List)

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professional_accounting

Principles of Accounting, Volume 1: Financial Accounting Principles of Accounting, Volume 1: Financial AccountingMultiple Choice 1 Role of Accounting in Society 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting 1.2 Identify Users of Accounting Information and How They Apply Information 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities 1.4 Explain Why Accounting Is Important to Business Stakeholders 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education 2 Introduction to Financial Statements 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet Exercise Set A Exercise Set B Problem Set A Problem Set B 3 Analyzing and Recording Transactions 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions 3.3 Define and Describe the Initial Steps in the Accounting Cycle 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts 3.6 Prepare a Trial Balance 4 The Adjustment Process 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries 4.3 Record and Post the Common Types of Adjusting Entries 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance 4.5 Prepare Financial Statements Using the Adjusted Trial Balance 5 Completing the Accounting Cycle 5.1 Describe and Prepare Closing Entries for a Business 5.2 Prepare a Post-Closing Trial Balance 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business 6 Merchandising Transactions 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System 7 Accounting Information Systems 7.1 Define and Describe the Components of an Accounting Information System 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders 7.3 Analyze and Journalize Transactions Using Special Journals 7.4 Prepare a Subsidiary Ledger 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems 8 Fraud, Internal Controls, and Cash 8.1 Analyze Fraud in the Accounting Workplace 8.2 Define and Explain Internal Controls and Their Purpose within an Organization 8.3 Describe Internal Controls within an Organization 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements 9 Accounting for Receivables 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios 9.4 Discuss the Role of Accounting for Receivables in Earnings Management 9.5 Apply Revenue Recognition Principles to Long-Term Projects 9.6 Explain How Notes Receivable and Accounts Receivable Differ 9.7 Appendix: Comprehensive Example of Bad Debt Estimation 10 Inventory 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios 11 Long-Term Assets 11.1 Distinguish between Tangible and Intangible Assets 11.2 Analyze and Classify Capitalized Costs versus Expenses 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs 11.4 Describe Accounting for Intangible Assets and Record Related Transactions 11.5 Describe Some Special Issues in Accounting for Long-Term Assets 12 Current Liabilities 12.1 Identify and Describe Current Liabilities 12.2 Analyze, Journalize, and Report Current Liabilities 12.3 Define and Apply Accounting Treatment for Contingent Liabilities 12.4 Prepare Journal Entries to Record Short-Term Notes Payable 12.5 Record Transactions Incurred in Preparing Payroll 13 Long-Term Liabilities 13.1 Explain the Pricing of Long-Term Liabilities 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds 13.4 Appendix: Special Topics Related to Long-Term Liabilities 14 Corporation Accounting 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance 15 Partnership Accounting 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries 15.3 Compute and Allocate Partners’ Share of Income and Loss 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner 15.5 Discuss and Record Entries for the Dissolution of a Partnership 16 Statement of Cash Flows 16.1 Explain the Purpose of the Statement of Cash Flows 16.2 Differentiate between Operating, Investing, and Financing Activities 16.3 Prepare the Statement of Cash Flows Using the Indirect Method 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method A | Financial Statement Analysis B | Time Value of Money C | Suggested Resources LO 13.1An amortization table ________. breaks each payment into the amount that goes toward interest and the amount that goes toward the principal is a special table used in a break room to make people feel equitable separates time value of money tables into present value and future value separates time value of money tables into single amounts and streams of cash LO 13.1A debenture is ________. the interest paid on a bond a type of bond that can be sold back to the issuing company whenever the bondholder wishes a bond with only the company’s word that they will pay it back a bond with assets such as land to back their word that they will pay it back LO 13.1The principal of a bond is ________. the person who sold the bond for the company the person who bought the bond the interest rate printed on the front of the bond the face amount of the bond that will be paid back at maturity LO 13.1A convertible bond can be converted into ________. common stock and then converted into preferred stock common stock of a different company common stock of the company LO 13.1On January 1, a company issued a 5-year $100,000 bond at 6%. Interest payments on the bond of $6,000 are to be made annually. If the company received proceeds of $112,300, how would the bond’s issuance be quoted? LO 13.1On July 1, a company sells 8-year $250,000 bonds with a stated interest rate of 6%. If interest payments are paid annually, each interest payment will be ________. LO 13.1On January 1 a company issues a $75,000 bond that pays interest semi-annually. The first interest payment of $1,875 is paid on July 1. What is the stated annual interest rate on the bond? LO 13.1On October 1 a company sells a 3-year, $2,500,000 bond with an 8% stated interest rate. Interest is paid quarterly and the bond is sold at 89.35. On October 1 the company would collect ________. LO 13.1On April 1 a company sells a 5-year, $60,000 bond with a 7% stated interest rate. The market interest on that day was also 7%. If interest is paid quarterly, the company makes interest payments of ________. LO 13.2The effective-interest method of bond amortization finds the difference between the ________ times the ________ and the ________ times the ________. stated interest rate, principal, stated interest rate, carrying value stated interest rate, principal, market interest rate, carrying value stated interest rate, carrying value, market interest rate, principal market interest rate, carrying value, market interest rate, principal LO 13.2When a bond sells at a discount, the carrying value ________ after each amortization entry. stays the same cannot be determined LO 13.2The International Financial Reporting Standards require the use of ________. any method of amortization of bond premiums the straight-line method of amortization of bond discounts the effective-interest method of amortization of bond premiums and discounts any method approved by US GAAP LO 13.2The cash interest payment a corporation makes to its bondholders is based on ________. the market rate times the carrying value the stated rate times the principal the stated rate times the carrying value the market rate times the principal LO 13.2Whirlie Inc. issued $300,000 face value, 10% paid annually, 10-year bonds for $319,251 when the market of interest was 9%. The company uses the effective-interest method of amortization. At the end of the year, the company will record ________. a credit to cash for $28,733 a debit to interest expense for $31,267 a debit to Discount on Bonds Payable for $1,267 a debit to Premium on Bonds Payable for $1.267 LO 13.3Naval Inc. issued $200,000 face value bonds at a discount and received $190,000. At the end of 2018, the balance in the Discount on Bonds Payable account is $5,000. This year’s balance sheet will show a net liability of ________. LO 13.3Keys Inc. issued 100 bonds with a face value of $1,000 and a rate of 8% at $1,025 each. The journal entry to record this transaction includes ________. a credit to Bonds Payable for $102,500 a credit to cash for $102,500 a debit to cash for $100,000 a credit to Premium on Bonds Payable for $2,500 LO 13.3Huang Inc. issued 100 bonds with a face value of $1,000 and a 5-year term at $960 each. The journal entry to record this transaction includes ________. a debit to Bonds Payable for $100,000 a credit to Discount on Bonds Payable for $4,000 LO 13.3O’Shea Inc. issued bonds at a face value of $100,000, a rate of 6%, and a 5-year term for $98,000. From this information, we know that the market rate of interest was ________. more than 6% equal to 6% cannot be determined from the information given. LO 13.3Gingko Inc. issued bonds with a face value of $100,000, a rate of 7%, and a 10-yearterm for $103,000. From this information, we know that the market rate of interest was ________. equal to 1.3% LO 13.4The difference between equity financing and debt financing is that equity financing involves borrowing money. equity financing involves selling part of the company. debt financing involves selling part of the company. debt financing means the company has no debt. Access for free at https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters Authors: Mitchell Franklin, Patty Graybeal, Dixon Cooper Book title: Principles of Accounting, Volume 1: Financial Accounting Publication date: Apr 11, 2019 Book URL: https://openstax.org/books/principles-financial-accounting/pages/1-why-it-matters Section URL: https://openstax.org/books/principles-financial-accounting/pages/13-multiple-choice © Dec 12, 2022 OpenStax. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.

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Use these links to rapidly review the document ITEM 8. Financial Statements and Supplementary Data ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES For the transition period from to Commission file number 0-49916 (State or Other Jurisdiction of Incorporation or Organization) 84-1573084 6312 S Fiddler's Green Circle, Suite 200N (Zip Code) (Registrant's Telephone Number, Including Area Code) Common Stock, $0.001 par value Name of each exchange on which registered: NASDAQ (National Market) Securities Registered Pursuant to Section 12(g) of the Act: Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No ý Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act. Yes o No ý Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer ý Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No ý The aggregate market value of the voting and non-voting common stock held by non-affiliates (based on the closing price on the last business day of the registrant's most recently completed second fiscal quarter on The NASDAQ National Market) was $260.5 million. All executive officers and directors of the registrant have been deemed, solely for the purpose of the foregoing calculation, to be "affiliates" of the registrant. There were 15,618,936 shares of common stock outstanding as of February 22, 2011. DOCUMENTS INCORPORATED BY REFERENCE Certain information required for Items 10, 11, 12, 13 and 14 of Part III of this annual report on Form 10-K is incorporated by reference to the registrant's definitive proxy statement for the 2011 annual meeting of stockholders. Risk Factors 12 Unresolved Staff Comments 21 Properties 21 Legal Proceedings 22 Removed and Reserved 22 Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 23 Selected Financial Data 25 Management's Discussion and Analysis of Financial Condition and Results of Operations 26 Quantitative and Qualitative Disclosures About Market Risk 42 Financial Statements and Supplementary Data 43 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 76 Controls and Procedures 76 Other Information 78 Directors, Executive Officers and Corporate Governance 78 Executive Compensation 78 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 78 Certain Relationships and Related Transactions, and Director Independence 78 Principal Accounting Fees and Services 78 Exhibits, Financial Statement Schedules 79 Signatures 83 ITEM 1. Business Red Robin Gourmet Burgers, Inc., together with its subsidiaries, is a casual dining restaurant chain focused on serving an imaginative selection of high quality gourmet burgers in a family-friendly atmosphere. We opened the first Red Robin® restaurant in Seattle, Washington in September 1969. In 1979, the first franchised Red Robin® restaurant was opened in Yakima, Washington. In 2001, we formed Red Robin Gourmet Burgers, Inc., a Delaware corporation and consummated a reorganization of the company. Since that time, Red Robin Gourmet Burgers, Inc. has owned all of the outstanding capital stock or membership interests, either directly or indirectly, of Red Robin International, Inc., and our other operating subsidiaries through which we operate our company-owned restaurants. Unless otherwise provided in this annual report on Form 10-K, references to "Red Robin," "we", "us", "our", and "the Company" refer to Red Robin Gourmet Burgers, Inc. and our consolidated subsidiaries. For the fiscal year 2010, we generated total revenues of $864 million. As of the end of our fiscal year on December 26, 2010, the system included 450 restaurants, of which 314 were company-owned, and 136 were operated under franchise agreements with 21 franchisees. Our franchisees are independent organizations to whom we provide certain support. See "Restaurant Franchises and Licensing Arrangements" for additional information about our franchise program. As of December 26, 2010, there were Red Robin® restaurants in 40 states and 2 Canadian provinces. 2010 was a period of positive transition for Red Robin, during which we implemented a number of governance and management changes and we developed a plan to deliver strong, sustainable, best-in-class improvement in our operating and financial performance. We added four new independent board members, and appointed a new chief executive officer, Stephen E. Carley, who also serves as a fifth new director. Together they bring substantial strategic, financial, restaurant and food-service industry experience to the board and the Company. Mr. Carley joined the Company in September and devoted the fourth quarter of 2010 to leading our management team in reviewing the Company's brand, financial and operating performance, and developing a strategic action plan for long-term enhanced growth and profitability in 2011 and beyond. Our foundation is based on delivering great experiences for our guests, which will lead to sustainable, continually improving operating and financial results. This focus forms the basis for our vision, which is to inspire crazy loyalty through memorable "YUMMM"® experiences for our team members, guests and our communities including our shareholder community. Our mission is to be the everyday oasis for families and guests of all ages who want to enjoy craveable gourmet burgers in a fun, energetic environment with attentive and friendly service. We have identified and continue to examine opportunities that will drive strong financial performance through both revenue growth and improved expense management. We also see opportunities in both the short and long term to optimize the allocation of our capital. We have built key short and long-term strategies and initiatives around these opportunities, which we collectively have named "Project RED". The key objectives of Project RED include: Achieve Revenue growth. To drive revenue growth, we have developed several initiatives to increase guest traffic and sales in our restaurants through greater trial and frequency, increasing our average guest check through incremental sales and expansion of our dayparts, and more effectively balancing an adult focus with our family friendly service. See "Marketing and Advertising" below for additional information about our marketing strategy and initiatives. Manage Expenses across our enterprise. We continue to focus on managing our expenses in the operation of our restaurants and in our selling, general and administrative functions. Our restaurant operating costs include food and other commodities, labor cost and benefits, restaurant supplies, utilities, occupancy and other operating costs. Macroeconomic and other external factors, such as commodity and other price increases have historically put pressure on these costs. We are pursuing strategies to mitigate the impact of these external factors, including continuous review and revamping of our distribution and supply chain relationships, continued labor productivity improvement efforts, utility management programs and initiatives to streamline operations. We will continue these initiatives and examine any additional opportunities to reduce overhead costs and improve efficiencies throughout our organization as part of our ongoing cost management efforts. Optimize our Deployment of capital. We are focused on disciplined deployment of capital to both grow the brand and to maximize long-term shareholder returns by optimizing the return on our capital investments. Matters under consideration include new development opportunities, including the appropriate mix of franchised and company-owned units, new prototype restaurants, geographical locations and sizes of restaurants; opportunistic share repurchases; and optimizing our financial structure, including the refinancing of our existing debt in 2011. We will continue with opening a reduced number of NROs as we kick off our initiatives to increase restaurant traffic and sales and invest capital into our supporting infrastructure. The Red Robin brand has many desirable attributes, including a strong values-based and guest-focused culture, along with a talented team and a passionate desire to win. We intend to capitalize on these attributes as we execute our plans going forward. Red Robin was founded on four core values: Honor, Integrity, Continually Seeking Knowledge and Having Fun. These core values are the foundation for every Red Robin decision, from creating our gourmet burgers to hiring energetic team members. They also are the foundation for how we treat our team members, guests, and communities. These core values can be found embroidered on the sleeve of every team member's shirt, which serve as a constant reminder of what makes our company unique and special. Red Robin® restaurants are designed to create a fun and memorable "YUMMM"® dining experience in an exciting, high-energy, atmosphere, that is not only family-friendly, but also will include a renewed forward focus on adult occasions. We believe that we differentiate our restaurants from our competitors' by our brand architecture which defines the Red Robin Guest experience. Our menu features our signature product, the gourmet burger, which we make from premium quality ground beef; and other sandwiches made from chicken breasts, fish filets, turkey patties, as well as vegetarian and vegan burger sandwich options. We offer a wide selection of buns—including ciabatta, herbed focaccia and whole grain buns, jalapeno roll and marbled rye—and more than 30 toppings—including fresh guacamole, barbeque sauce, grilled pineapple, crispy onion straws, sautéed mushrooms, fried jalapenos, bruschetta salsa, pepperoni, chili, coleslaw and dill pickle slices—a choice of 11 different cheeses, and even a fried egg. In addition to gourmet burgers and chicken sandwiches, which accounted for approximately 51% of our total food sales in 2010, Red Robin serves an array of other items that appeal to a broad range of guests. These items include a variety of appetizers, salads, soups, pastas, seafood, other entrees, desserts, and the Company's signature Mad Mixology® alcoholic and non-alcoholic specialty beverages. All of our gourmet burgers and sandwiches are served with our all-you-can-eat Bottomless Steak Fries®. Our guests can order to meet their dietary needs and preferences by customizing their menu orders. We believe in giving our guests the "gift of time." All of Red Robin's menu items are designed to be delivered to guests in a time-efficient manner. Our service sequence is designed to consistently prepare every menu item in less than eight minutes, which allows guests to enjoy time-efficient lunches and dinners. We strive to provide guests with a 37-minute dining experience at lunch and a 42-minute dining experience at dinner. Red Robin also has an unparalleled and extraordinary approach to guest service using Unbridled Acts®. We have catalogued thousands of stories of Red Robin team members who live our values through random acts of kindness they bestow upon restaurant guests and other team members. Many of our Unbridled Acts® can be found on our website, www.redrobin.com. We encourage our team members to execute on the aspects of service that we have identified to be our biggest drivers of our guest loyalty. We also strive to provide our guests with exceptional dining value. In 2010, we had a per person average check of approximately $11.43, including beverages. We believe this price-to-value relationship and our LTOs featuring innovative gourmet burgers, salads, and sandwiches at a value price point differentiate us from our competitors, many of whom have significantly higher average guest checks, and it allows us to appeal to a broad base of consumers with a wide range of income levels. A low average guest check, combined with swift service and a family-friendly atmosphere further differentiates us from many other casual dining restaurants. Our typical restaurant management team consists of a general manager, an assistant general manager, a kitchen manager, and one or two assistant managers depending on restaurant sales volumes. The management team of each restaurant is responsible for the day-to-day operation of that restaurant, including hiring, training, and developing of team members, as well as operating results. Most of our restaurants employ approximately 85 hourly team members, many of whom work part-time. We try to identify seasoned leadership teams 12 months ahead of our new restaurant openings, with the expectation that seasoned leadership will provide a better team member and guest experience while enabling a new restaurant to quickly reach normalized operations. Learning and Development—New Restaurants Team members in a new restaurant complete a training process to ensure the smooth and efficient operation of the restaurant from the first day it opens to the public. We have created a set of core competencies that each of our trainers must possess before they participate in a new restaurant opening. This allows us to minimize training time and resources required to prepare teams at our new restaurants. We also continue to enhance our manager training curriculum to better prepare new managers for the challenging environment that a new restaurant creates so they can confidently execute our processes, systems, and values. Prior to opening a new restaurant, our training and opening team travels to the new restaurant location to prepare for an intensive training program for all team members hired for the new restaurant opening. Part of the training team stays on-site during the first week of operation. An additional team of training support also arrives during the first week of operation and remains for weeks two and three for on-site support. On-going Learning and Development We strive to maintain quality and consistency in each of our restaurants through the training and supervision of team members and the establishment of, and adherence to, high standards relating to personnel performance, food and beverage preparation and production as well as the maintenance of our restaurants. Each restaurant has a core group of certified trainers who provide on-the-job instruction for new team members who must be certified for their positions by passing a series of tests. These trainers participate in a train-the-trainer seminar that provides them with knowledge and tactics to enable them to coach our team members to meet our standards. Restaurant managers are required to complete a training program in one of our certified training restaurants that includes guest service, kitchen and management responsibilities. Newly trained managers are then assigned to their home restaurant where they obtain ongoing training with their general manager. We place a high priority on our continuing management development programs in order to ensure that qualified managers are available and prepared for future restaurant openings and to fill open management positions. We conduct semi-annual performance reviews with each manager to discuss prior performance and future performance goals. Annually, we hold a leadership conference during which our general managers receive additional training on leadership, food safety, management systems, hospitality, and other relevant topics on a rotating basis. Food Preparation, Quality Control and Purchasing Our food safety and quality assurance programs help manage our commitment to quality ingredients and food preparation. Our systems are designed to protect our food supply throughout the preparation process. We provide detailed specifications of our food ingredients, products, and supplies to our suppliers. We inspect specific qualified manufacturers and growers. Our restaurant managers are certified in a comprehensive safety and sanitation course by the National Restaurant Association's ServSafe program. Minimum cooking and cooling procedures and frequent temperature and quality assurance checks ensure the safety and quality of burgers and other ingredients we use in our restaurants. In order to provide the freshest ingredients and products and to maximize operating efficiencies between purchase and usage, each restaurant's management team determines the restaurant's daily usage requirements for food ingredients, products and supplies, and, accordingly, orders from approved local suppliers and distributors. The restaurant management team inspects all deliveries to ensure that the items received meet our quality specifications and negotiated prices. Beginning in 2010, we also engaged a third-party company to perform comprehensive food safety and sanitation inspections in all Red Robin® restaurants. To maximize our purchasing efficiencies and obtain the best possible prices for our high-quality ingredients, products and supplies, our centralized purchasing team generally negotiates fixed price agreements with terms between one month and two years on monthly commodity pricing formulas. Chicken represented approximately 13.8% and ground beef represented approximately 13.7% of our food costs in 2010. Our contracts for chicken in fiscal year 2011 are fixed price contracts through December 31, 2011. In 2011, our ground beef prices are expected to be based on current market prices with contract overages and are expected to run above 2010 prices. In addition, we have entered into supply agreements for 2011 for our Steak Fries, fry oil, ketchup and many other commodities at prices generally below 2010 levels. We monitor the primary commodities we purchase in order to minimize the impact of fluctuations in price and availability. However, certain commodities remain subject to price fluctuations. We have identified competitively priced, high quality alternative manufacturers, suppliers, growers, and distributors that are available should the need arise. Restaurant Development Since 2007, the average sales volumes for each successive class of new restaurant openings ("NROs") has increased, and the restaurant-level profit margins for the 2009 and 2010 NRO classes outperformed the rest of the restaurants in our system. In addition, our average net cash investment for new units continues to decline, currently down to approximately $1.9 million per new restaurant in 2010 from approximately $2.6 million per new restaurant in 2006. This continued progress on new restaurant (NRO) performance in recent years has given us the confidence to continue NRO development into 2011 and 2012. As we explore new development opportunities, we are limiting our new company-owned restaurant growth to 10 units in 2011 and 5 units in 2012. However, we will revisit our development decisions as we see the results on the strategies and initiatives discussed in this document. We will continue to fund new restaurant development from our operating cash flow. Restaurant Franchise and Licensing Arrangements As of December 26, 2010, we had 21 franchisees that were operating 136 restaurants in 21 states and two Canadian provinces, and we had eight exclusive franchise area development arrangements with certain of those franchisees. In 2010, our franchisees opened five new restaurants and closed two. We expect that our franchisees will open three to four new restaurants in 2011. Our two largest franchisees are Ansara Restaurant Group, Inc. with 21 restaurants located in Michigan and Ohio and Red Robin Restaurants of Canada, Ltd. with 18 restaurants located in Alberta and British Columbia, Canada. An affiliate of Mach Robin, LLC, a Red Robin franchisee, owns Red Robin Restaurants of Canada, Ltd. Although in recent years we have not actively sought or sold new franchises, we are carefully reviewing opportunities to reinstitute our franchise program, optimize our mix of company-owned and franchised restaurants and work with our existing franchisees to provide incentives to open new franchised restaurants where there are attractive development opportunities. Our typical franchise arrangement consists of an area development agreement and a separate franchise agreement for each restaurant. Our current form of area development agreement grants the franchisee the exclusive right to develop restaurants in a defined area over a defined term, which is usually five years. The franchise agreement for the restaurant authorizes the franchisee to operate the restaurant using our trademarks, service marks, trade dress, operating systems, recipes, manuals, processes, and related items. The franchise agreement typically grants the franchisee an initial term of 20 years and the option to extend the term for an additional 10 years provided the franchisee satisfies certain conditions. Under our current form of area development agreement, a franchisee must pay us a $10,000 area development fee at the time we execute the agreement for each restaurant the franchisee agrees to develop. When a franchisee opens a new restaurant, pursuant to the development agreement we collect an additional franchise fee of $25,000. Under area development agreements we made with certain of our franchisees in early years, the development fee and the franchise fee were lower. For existing franchisees who do not have a current development agreement, or whose agreements have expired or have otherwise terminated, we may negotiate a one-time fee for each restaurant they develop. We recognize area development fees and franchise fees as income when we have performed all of our material obligations and initial services related to each fee that assist the franchisee in developing and opening the restaurant. Until earned, we account for these fees as deferred revenue, an accrued liability. Our standard form of franchise agreement requires the franchisee to pay a royalty fee equal to 4.0% of adjusted gross restaurant sales. However, certain franchisees pay royalty fees ranging from 3.0% to 3.5% of adjusted gross restaurant sales under agreements we negotiated with those franchisees in prior years. Franchise Compliance Assurance We actively work with and monitor our franchisees' performance to help them develop and operate their restaurants in compliance with Red Robin's systems and procedures. During the restaurant development phase, we review the franchisee's site selection and provide the franchisee with our prototype building plans. We provide trainers to assist the franchisee in opening the restaurant for business. We advise the franchisee on all menu items, management training, and equipment and food purchases. On an ongoing basis, we conduct brand equity reviews of all franchise restaurants to determine their level of effectiveness in executing our concept. To continuously improve our marketing programs and operating systems, we maintain a marketing advisory council and a franchise business advisory council comprised of corporate and franchisee members. Through those councils, we solicit the input of our franchisees on marketing programs, including their suggestions as to which new menu items we should test and feature in future promotions. We also exchange best operating practices with our franchisees as we strive to improve our operating systems while attaining a high level of franchisee participation. Our restaurants are enabled with information technology and decision support systems that are designed to provide operational tools for sales, inventory, and labor management. This technology includes industry-specific, off-the-shelf systems, as well as proprietary software that helps us optimize food and beverage costs and labor scheduling. These solutions have been integrated with our point-of-sale systems to provide daily, weekly and period-to-date information that is important for managers to run an efficient and effective operation. In addition, we use an online guest feedback system, which provides real-time results on guest service, food quality, and atmosphere to each of our restaurants. We have a strong focus on the protection of our guests' credit card information. Our systems have been carefully designed and configured to protect against data loss and our practices and systems have been certified annually by an independent, outside auditor. In recent years, we utilize centralized financial, accounting, and HR systems for company-owned restaurants. In addition, an operations dashboard is used to integrate data from our centralized systems with the distributed information managed in our restaurants. We believe these tools combined are important in analyzing and improving profit margins. In 2011, we will continue to invest in our systems as we implement a major overhaul of our data infrastructure, including the replacement of several key operational and financial systems. We build brand equity and awareness primarily through national marketing, including national cable, digital, social media programs, and public relations initiatives. These programs are funded primarily through the marketing and national media advertising funds. In recent years, we have undertaken significant guest and market research initiatives to gain feedback and perceptions from our guests in order to help inform our business decisions. Among other things, we launched a guest satisfaction tool in all company restaurants that provides immediate feedback from guests, via the internet or by phone, on their experiences at our restaurants. Restaurant managers use this information to help them identify areas of focus to strengthen restaurant performance and track progress. We also continually monitor our national brand equity scores and business drivers among both current and potential guests. Our 2010 marketing strategy was an extension of successful testing in the fourth quarter of 2009 of LTO promotions supported by national television media advertising. We included television media support for three LTO promotions during 2010, in the spring, summer and fall, to promote product news, our value price point, and our product variety messages. The LTOs were also supported with online digital media, PR, and in-restaurant promotional materials. The television media support ran over four of the eight weeks of these product promotions. In all three of the promotional periods, guest counts and same store sales increased significantly during the weeks when the LTO was supported with TV media compared to the weeks prior to the TV media support. As a result national television advertising will be used to support similar promotions during 2011. In January 2011, after a test in company-owned Red Robin® restaurants, we rolled out Red Robin's Red Royalty™ program, our smart loyalty program, in all 300+ company-owned restaurants. Red Royalty will provide us with a robust database with insights into guest behavior and dining patterns, and enable us to deliver targeted and relevant messages and incentives to increase guest retention and frequency. In 2010, we continued the expansion of our Gift Card programs, primarily distribution of gift cards outside our restaurants via third party retailers, as well as increasing our focus on gift card occasions throughout the year inside our restaurants through our gift card merchandisers. As a result of these efforts, we have our gift cards in over 10,000 third party retailer locations at the end of 2010 and total gift card sales increased 22% in 2010 over 2009. We also plan to implement additional initiatives to support increase in alcohol sales by offering specials during off peak day parts, menu and point-of-purchase redesign to highlight our alcohol beverage business, a happy hour program that we began rolling out in all jurisdictions that allow happy hour programs in early 2011, suggestive sell programs focused on beverages, appetizers and desserts, and other programs to drive incremental traffic and frequency across the entire system. These initiatives are intended to increase visits by our adult guests while remaining family-friendly. As of December 26, 2010, we had 23,198 employees, to whom we refer as team members, consisting of 22,922 team members at company-owned restaurants and 276 team members at our corporate headquarters and our regional offices. None of our team members are covered by a collective bargaining agreement. We consider our team member relations to be good. We support our team members by offering competitive wages and benefits, including a 401(k) plan, an employee stock purchase plan, medical insurance, and stock based awards for corporate and operations directors. We motivate and prepare our team members by providing them with opportunities for increased responsibilities and advancement, as well as significant performance based incentives tied to sales, profitability, certain qualitative measures, and length of service. The following table sets forth information about our executive officers: Stephen E. Carley 58 Chief Executive Officer Eric C. Houseman 43 President and Chief Operating Officer Katherine L. Scherping 51 Senior Vice President and Chief Financial Officer Todd A. Brighton 53 Senior Vice President and Chief Development Officer Annita M. Menogan 56 Senior Vice President, Chief Legal Officer and Secretary Susan Lintonsmith 46 Senior Vice President and Chief Marketing Officer Chris Laping 38 Senior Vice President and Chief Information Officer Stephen E. Carley. Mr. Carley was appointed Chief Executive Officer in September 2010. He previously served from April 2001 until September 2010 as the Chief Executive Officer of El Pollo Loco, a privately held restaurant company headquartered in Costa Mesa, California. Prior to his service at El Pollo Loco, Mr. Carley served in various management positions with several companies, including PhotoPoint Corp., Universal City Hollywood, PepsiCo, and the Taco Bell Group. Eric C. Houseman. Mr. Houseman joined Red Robin in 1993. He was appointed President and Chief Operating Officer of Red Robin in August 2005. He previously served as Vice President of Operations from March 2000 until August 2005, Director of Operations—Oregon/Washington from January 2000 to March 2000, Senior Regional Operations Director from September 1998 to January 2000, and General Manager from January 1995 to September 1998. Katherine L. Scherping. Ms. Scherping joined Red Robin as Vice President and Chief Financial Officer in June 2005 and was promoted to Senior Vice President in 2007. From August 2004 until her employment with Red Robin, Ms. Scherping was the Controller for Policy Studies, Inc. in Denver, Colorado. From August 2002 until June 2003, she served as Chief Financial Officer and Treasurer of Tanning Technology Corporation in Denver, Colorado. From April 1999 until August 2002, Ms. Scherping served as Director of Finance and Treasurer of Tanning Technology Corporation. Ms. Scherping has over 29 years experience serving in various finance and accounting roles. Ms. Scherping is a Certified Public Accountant. Todd A. Brighton. Mr. Brighton joined Red Robin in April 2001 as Vice President of Development. He was appointed Senior Vice President and Chief Development Officer in August 2005. From August 1999 until his employment with Red Robin, Mr. Brighton worked for RTM Restaurant Group in Atlanta, Georgia as Director of Real Estate. Susan Lintonsmith. Ms. Lintonsmith joined Red Robin as Senior Vice President and Chief Marketing Officer in April 2007. Before joining Red Robin, Ms. Lintonsmith was Vice President and General Manager for WhiteWave Foods' Horizon Organic dairy brand from June 2005 to March 2007. Previous to WhiteWave, she served as Vice President of Global Marketing with Western Union from January 2002 to May 2005. Ms. Lintonsmith also spent over five years with the Coca-Cola Company in brand management, promotions and field marketing and over seven years with Pizza Hut Inc., last as Director of Marketing, New Products and Concepts. Annita M. Menogan. Ms. Menogan joined Red Robin in January 2006 as Vice President, Chief Legal Officer and Secretary and was promoted to Senior Vice President in 2007. From August 1999 to September 2005, Ms. Menogan was employed by Coors Brewing Company as Assistant General Counsel, and served as Vice President, Secretary and Deputy General Counsel of Adolph Coors Company and of Molson Coors Brewing Company, following the merger with Molson Inc. in February 2005. Ms. Menogan was engaged in the private practice of law from 1983 to 1999. Chris Laping. Mr. Laping joined Red Robin as Vice President and Chief Information Officer in June 2007 and was promoted to Senior Vice President in February 2011. Mr. Laping brings more than 20 years of information technology and business transformation experience to Red Robin. Prior to joining Red Robin, Mr. Laping worked at Statêra, Inc. from February 2006 to June 2007 as Principal and Chief Information Officer and served as a technology consultant to the Company. Before working as a consultant, Chris spent five years between 2001 and 2006 as a Vice President and Chief Information Officer for GMAC Commercial Holding Capital Corp. The restaurant industry is highly competitive. We compete against other segments of the restaurant industry, including quick-service and fast-casual restaurants. The number, size and strength of competitors vary by region, concept, market and even restaurant. We compete on the basis of taste, quality, price of food offered, guest service, ambiance, location, and overall dining experience. In particular, we face intense and substantial competition from fast or fast casual concepts focused on the sale of hamburgers. Many of these concepts are expanding faster than us and are penetrating both geographic and demographic markets that we target as well. Moreover, many of these concepts compete with smaller building units, which allow them to have greater flexibility in site selection and market penetration. We believe that our guest demographics, our gourmet burger concept, attractive price-value relationship, and the quality of our food and service enable us to differentiate ourselves from our competitors. We believe we compete favorably with respect to each of these factors. Many of our competitors are well-established national, regional, or local chains and may have substantially greater financial, marketing, and other resources than we do. We also compete with many other restaurant and retail establishments for site locations and team members. Our business is subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the summer months and winter holiday season. As a result, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality. Accordingly, results for any one quarter or year are not necessarily indicative of results to be expected for any other quarter or for any year, and comparable restaurant sales for any particular future period may decrease. We have a variety of registered trademarks and service marks that include the marks "Red Robin®", "America's Gourmet Burgers & Spirits®", "Mad Mixology®", "YUMMM®"* and our logo. We have registered these marks with the United States Patent and Trademark Office and the Canadian Intellectual Property Office (*YUMMM trademark application pending in Canada). In order to better protect our brand, we have also registered the Internet domain name www.redrobin.com. We believe that our trademarks, service marks, and other proprietary rights have significant value and are important to our brand-building efforts and the marketing of our restaurant concept. Our restaurants are subject to licensing and regulation by state and local health, safety, fire, and other authorities, including licensing requirements and regulations for the sale of alcoholic beverages and food. To date, we have been able to obtain or maintain any necessary licenses, permits, or approvals. The development and construction of new restaurants is subject also to compliance with applicable zoning, land use, and environmental regulations. We are also subject to federal regulation and state laws that regulate the offer and sale of franchises and substantive aspects of a franchisor-franchisee relationship. Various federal and state labor laws govern our relationship with our team members and affect operating costs. These laws govern minimum wage requirements, overtime pay, meal and rest breaks, unemployment tax rates, workers' compensation rates, citizenship or residency requirements, child labor regulations, and discriminatory conduct. Various states and municipalities are also establishing regulations with respect to disclosure of nutritional information. There has been an increasing focus on climate change recently, including increased attention from regulatory agencies and legislative bodies globally. This increased focus may lead to new initiatives directed at regulating an as yet unspecified array of environmental matters, such as the emission of greenhouse gases. We are unable to predict the potential effects that any such future environmental initiatives may have on our business as those effects are likely to be complex. We maintain a link to investor relations information on our website, www.redrobin.com, where we make available, free of charge, our Securities and Exchange Commission (SEC) filings, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Our website and the information contained on or connected to our website is not incorporated by reference herein, and our web address is included as an inactive textual reference only. From time-to-time the Company makes oral and written statements that reflect the Company's current expectations regarding future results of operations, economic performance, financial condition and achievements of the Company. We try, whenever possible, to identify these forward-looking statements by using words such as "anticipate," "assume," "believe," "estimate," "expect," "intend," "plan," "project," "may," "will," "would," and similar expressions. Certain forward-looking statements are included in this Form 10-K, principally in the sections captioned "Business," "Legal Proceedings," "Consolidated Financial Statements" and "Management's Discussion and Analysis of Financial Condition and Results of Operations." Forward-looking statements relate to, among other things: our business objectives and strategic plans, including the strength of our long-term growth and profit, expense management and capital deployment opportunities; our strategies and initiatives, including Project RED and its objectives; our ability to open and operate additional restaurants in both new and existing markets profitably, the anticipated number of new restaurants and the timing of such openings; our ability to invest in our systems and implement a major overhaul of our data infrastructure including the replacement of several key operational and financial systems; estimated costs of opening and operating new restaurants, including general and administrative, marketing and, franchise development costs; expected future revenues and earnings, comparable and non-comparable restaurant sales, results of operations, and future restaurant growth (both company-owned and franchised); anticipated restaurant operating costs, including commodity and food prices, labor and energy costs and selling, general and administrative expenses and ability to reduce overhead costs and improve efficiencies; anticipated advertising costs and plans to include television advertising to support 2011 LTO promotions and the success of our advertising and marketing activities and tactics, including our Red Royalty program and the effect on revenue and guest counts; our ability to attract new guests and retain loyal guests, and our new initiatives targeted at adult guests; any future price increases, including the increase anticipated in April 2011, and their impact on our revenue and profit; future capital deployment strategies, including potential share repurchases and debt refinancing, capital and anticipated expenditures including the amounts of such capital expenditures; our expectation that we will have adequate cash from operations and credit facility borrowings to reduce our debt and to meet all future debt service, capital expenditures, including new restaurant development, and working capital requirements in fiscal year 2011; planned debt re-financings; anticipated compliance with debt covenants; the sufficiency of the supply of commodities and labor pool to carry on our business; anticipated restaurant closings and related impairment charges; anticipated interest and tax expense; impact of the adoption of new accounting standards on our financial and accounting systems and analysis programs; expectations regarding competition and our competitive advantages; and expectations regarding consumer preferences and consumer discretionary spending. Although we believe that the expectations reflected in our forward-looking statements are based on reasonable assumptions, such expectations may prove to be materially incorrect due to known and unknown risks and uncertainties. In some cases, information regarding certain important factors that could cause actual results to differ materially from any forward-looking statement appears together with such statement. In addition, the factors described under Critical Accounting Policies and Estimates and Risk Factors, as well as other possible factors not listed, could cause actual results to differ materially from those expressed in forward-looking statements, including, without limitation, the following: concentration of restaurants in certain markets and lack of market awareness in new markets; changes in disposable income; consumer spending trends and habits; regional mall and lifestyle center traffic trends; increased competition in the casual dining restaurant market; effectiveness of our 2011 marketing campaign; costs and availability of food and beverage inventory; our ability to attract qualified managers and team members; changes in the availability of capital or credit facility borrowings; costs and other effects of legal claims by team members, franchisees, customers, vendors, stockholders and others, including settlement of those claims; effectiveness of management strategies and decisions; weather conditions and related events in regions where our restaurants are operated; and changes in accounting standards policies and practices or related interpretations by auditors or regulatory entities. All forward-looking statements speak only as of the date made. All subsequent written and oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by the cautionary statements. Except as required by law, we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which it is made or to reflect the occurrence of anticipated or unanticipated events or circumstances. ITEM 1A. Risk Factors An investment in our common stock involves a high degree of risk. You should carefully read and consider the risks described below before making an investment decision. The occurrence of any of the following risks could materially harm our business, financial condition, results of operations, or cash flows. The trading price or value of our common stock could decline, and you could lose all or part of your investment. When making an investment decision with respect to our common stock, you should also refer to the other information contained or incorporated by reference in this Annual Report on Form 10-K, including our consolidated financial statements and the related notes. Our "Project RED" initiatives may not be successful or achieve the desired results, if at all, in a timely fashion. In 2011, we began implementing a series of strategic initiatives known as "Project Red". These strategic initiatives are designed to both improve the Company's results in the short term and create sustainable growth in the long term. These initiatives focus on many segments of the Company's business, including, among other things, revenue generation, expense management and deployment of capital. There is no assurance that these initiatives and the projects undertaken to accomplish such initiatives will be successful, or that the Company has, or will have sufficient resources to successfully implement, sustain results from, or achieve any of the expected benefits of "Project RED". We are dependent on information technology, which may be inadequate to support our future growth strategies, and any material failure in the operations or upgrade of such technology could impair our ability to efficiently operate our business. We rely on information systems in all aspects of our operations, including (but not limited to) point-of-sale transaction processing in our restaurants; operation of our restaurant kitchens; management of our inventories; collection of cash; payment of payroll and other obligations; and various other processes and procedures. Our ability to efficiently manage our business depends significantly on the reliability and capacity of our in-house information systems and those technology services and systems for which we contract for from third parties. We have recently committed to a significant capital investment to upgrade and expand such systems and services. If the upgrade and expansion of such systems and services are unsuccessful or otherwise do not accomplish our intended goals, our operations could be significantly impacted, which could result in, among other things, dissatisfaction among our customers, and inadequate levels of inventory. We may experience some material interruptions in connection with the upgrade of our systems and services and the stabilization thereof. Despite the significant capital investment to upgrade the systems and service identified above, these new systems and services will continue over time to evolve and require upgrading over time, consequently requiring significant commitments of resources and capital to maintain and upgrade. While we have invested and continue to invest in technology security initiatives and disaster recovery programs, these measures cannot fully insulate us from technology disruption that could result in adverse effects on operations and profits. Significant capital investment might be required to remediate any problems, infringements, misappropriations or other third party claims. Our new marketing and branding strategies may not be successful, which could adversely impact our business. Over the past year we have been refocusing our marketing and branding strategy. As part of this initiative, we intend to continue using a national cable television advertising campaign to promote new products offered on a limited time basis. In addition, we have introduced a unique loyalty program, "Red Royalty", and throughout 2011 and beyond, we intend to focus on targeting adult guests and improving alcohol beverage sales. We do not have any assurance that our latest marketing strategies will be successful. If new advertising, modified branding and other marketing programs do not drive increased restaurant sales, the expense associated with these programs will adversely impact our financial results, and we may not generate the levels of comparable restaurant sales we expect. Moreover, many of our competitors have successfully used national marketing strategies, including network and cable television advertising in the past, and we may not be able to successfully compete against those established programs. Uncertainty regarding the economic recovery may negatively affect consumer spending and have adversely impacted our revenues and our results of operations and may continue to do so in the future. Current uncertainty regarding economic conditions and the existence and rate of any economic recovery may have an adverse effect on the businesses, results of operations and financial condition of the Company and its customers, distributors and suppliers. These conditions include continued unemployment, weakness and lack of consistent improvement in the housing markets; downtrend or delays in residential or commercial real estate development; volatility in financial markets; inflationary pressures and reduced consumer confidence. As a result, our customers may continue to remain apprehensive about the economy and maintain or further reduce their already lowered level of discretionary spending. This could impact the frequency with which our customers choose to dine out or the amount they spend on meals while dining out, thereby decreasing our revenues and potentially negatively affecting our operating results. We believe there is a risk that prolonged negative economic conditions might cause consumers to make long-lasting changes to their discretionary spending behavior, including dining out less frequently on a more permanent basis, which would have an adverse effect on our business. Moreover, our restaurants are primarily located near high activity areas such as regional malls, lifestyle centers, big box shopping centers, and entertainment centers. We depend on a high volume of visitors at these centers to attract guests to our restaurants. A decline in development or closures of businesses in these existing centers or a decline in visitors to the centers near our restaurants or in discretionary consumer spending could negatively affect our restaurant sales. Our revenues and operating results may fluctuate significantly due to various risks and unexpected circumstances, increases in costs, seasonality, weather, and other factors outside our control. We are subject to a number of significant risks that might cause our actual quarterly and annual results to fluctuate significantly or be impacted negatively. These risks include but are not limited to: extended periods of inclement weather which may affect guest visits as well as limit the availability and cost of key commodities such as beef, poultry, potatoes and other items that are important ingredients in our products or material disruptions in our supply chain; changes in borrowings and interest rates; changes to accounting methods or philosophies; impairment of long-lived assets, including goodwill, and losses on restaurant closures; unanticipated expenses from natural disasters and repairs to damaged or lost property. Moreover, our business is also subject to seasonal fluctuations. Historically, sales in most of our restaurants have been higher during the summer months and winter holiday season. As a result, our quarterly and annual operating results and comparable restaurant sales may fluctuate significantly as a result of seasonality and the factors discussed above. Accordingly, results for any one quarter or year are not necessarily indicative of results to be expected for any other quarter or for any year, and comparable restaurant sales for any particular future period may decrease. Decreased cash flow from operations, or an inability to access our revolving credit agreement could adversely impact our business initiatives or may result in our inability to execute our revenue, expense and capital deployment strategies. Our ability to fund our operating plans and to implement our capital deployment strategies depends on sufficient cash flow from operations or other financing, including using funding under our revolving credit agreement. Our strategies include but are not limited to repurchases of our stock, paying down debt, new restaurant development, investment in advertising, and franchise expansion. If we experience decreased cash flow from operations, our ability to fund our operations and planned initiatives, and to take advantage of growth opportunities, may be delayed or adversely affected. In addition, these disruptions or a negative impact on our revenues could adversely affect our ability to access or comply with our covenants under our credit facility. Moreover, any repurchase by us of our shares of common stock will further reduce cash available for operations and future growth. If we do not successfully manage the transitions associated with our new CEO, it could have an adverse impact on our revenues, operations, or results of operations. On September 13, 2010, we announced the appointment of our new CEO, Stephen E. Carley. Our success will be dependent upon his ability to gain proficiency in leading our Company, his ability to implement or adapt our corporate strategies and initiatives, and his ability to develop key professional relationships, including relationships with our team members, guests, franchisees and other key constituencies and business partners. Our new CEO could make organizational changes, including changes to our management team and may make future changes to our Company's structure. It is important for us to manage successfully these transitions as our failure to do so could adversely affect our ability to compete effectively. The Company faces various risks associated with shareholder activists. Several activist shareholders have publicly advocated for certain changes at the Company. Such activist shareholders or potential shareholders may attempt to gain additional representation on or control of our board of directors, the possibility of which may create uncertainty regarding the direction of our business. Perceived uncertainties as to our future direction may make it more difficult to attract and retain qualified personnel and business partners. A potential proxy contest would be disruptive to our operations and cause us to incur substantial costs. The SEC has recently proposed to give shareholders the ability to include their director nominees and their proposals relating to a shareholder nomination process in Company proxy materials, which would make it easier for activists to nominate directors to our board of directors. If the SEC implements its proxy access proposal, we may face an increase in the number of shareholder nominees for election to our board of directors. Future proxy contests and the presence of additional activist shareholder nominees on our board of directors could interfere with our ability to execute our strategic plan, be costly and time-consuming, disrupt our operations and divert the attention of management and our employees. Our ability to utilize or refinance our credit facility and our ability to raise capital in the future may be limited, which could adversely impact our business. Changes in our operating plans and strategic initiatives, lower than anticipated sales, increased expenses, or other events, including those described in this section, may cause us to seek additional debt financing on an accelerated basis. Our current credit agreement contains a number of restrictive covenants that limit our ability to, among other things, engage in mergers, acquisitions, joint ventures, and sale-leaseback transactions, and to sell assets, incur indebtedness, make investments, create liens, and pay dividends. Our credit agreement also requires us to comply with specified financial ratios and tests and to reduce the principal outstanding balance on our term loan on a quarterly basis with full repayment of the credit facility on June 15, 2012. These restrictions could affect our ability to operate our business and may limit our ability to take advantage of potential business opportunities as they arise. In addition, the ability of our lenders to honor their commitments under the credit facility may be diminished during the economic recovery. We may be unable to refinance our current credit agreement or to refinance it on favorable terms. Our current credit agreement matures on June 15, 2012. While we have been exploring a variety of alternatives to take advantage of the current low interest rate environment, we may be unable to obtain financing in a timely manner, if at all, or to obtain the amount we need or on terms equivalent to or better than our current terms. Such financing, if available, may involve significant cash payment obligations and covenants and/or financial ratios that restrict our ability to operate our business or implement future plans. If we are unable to refinance our credit facility, we may not have sufficient cash or resources to fund our operations or to take advantage of other business opportunities that may arise. Our success depends on our ability to compete effectively in the restaurant industry. Competition in the restaurant industry is increasingly intense. Our competitors include a large and diverse group of restaurant chains and individual restaurants that range from independent local operators that have opened restaurants in various markets from high growth targeted concepts in the quick serve and fast casual space to the well-capitalized national restaurant companies. Many of these concepts are expanding faster than us and are penetrating both geographic and demographic markets that we target as well. Moreover, many of these concepts compete with us for locations, often with smaller building units, which may allow for greater flexibility in site selection and market penetration. We also compete with other restaurants and with retail establishments for real estate. Many of our competitors are well established in the casual dining market segment and some of our competitors have substantially greater financial, marketing, and other resources than we have. Accordingly, they may be better equipped than us to increase marketing or to take other measures to maintain their competitive position, including the use of significant discount offers to attract guests. Changes in consumer preferences could negatively impact our results of operations. The restaurant industry is characterized by the continual introduction of new concepts and is subject to rapidly changing consumer preferences, tastes and eating and purchasing habits. Our restaurants compete on the basis of a varied menu and feature burgers, salads, soups, appetizers, other entrees, such as fajitas and pasta, desserts, and our signature alcoholic and non-alcoholic beverages in a family-friendly atmosphere. One of our strategies moving forward is to shift to a balance between family-friendly and adult-focused guest experiences, referencing our historical legacy. There is no assurance that this balanced focus will be successful or that it will not negatively impact our family guest experience. Moreover, our continued success depends, in part, upon the continued popularity of these foods and this style of casual dining. Shifts in consumer preferences away from this cuisine or dining style could have a material adverse effect on our future profitability. In addition, competitors' use of significant advertising and food discounting could influence our guests' dining choices Further, changing health or dietary preferences may cause consumers to avoid our products in favor of alternative foods. The food service industry as a whole rests on consumer preferences and demographic trends at the local, regional, national and international levels, and the impact on consumer eating habits of new information regarding diet, nutrition and health. Changes in nutritional guidelines issued by the federal government agencies, issuance of similar guidelines or statistical information by other federal, state or local municipalities, or academic studies, among other things, may impact consumer choice and cause consumers to select foods other than those that are offered by our restaurants. Price increases may negatively impact guest visits. We are expecting to take about a 1.5% price increase in April 2011 in order to offset increased operating expenses. While we have not experienced significant consumer resistance to our price increases in 2008 and prior periods, we cannot provide assurance that the planned 2011 price increase and any future price increases will not deter guests from visiting our restaurants, reduce the frequency of their visits, or affect their purchasing decisions. Approximately 48% of our Company-owned restaurants are located in the Western United States and, as a result, we are sensitive to economic and other trends and developments in this region. As of December 26, 2010, a total of 149 or 47.5% of all Company-owned restaurants, representing 55.1% of restaurant revenue, were located in the western United States (i.e., Arizona, California, Colorado, Nevada, Oregon, Idaho and Washington). As a result, we are particularly susceptible to adverse trends and economic conditions in this region, including its labor market. In recent years, California, Arizona and Nevada have been more negatively impacted by the housing downturn and the overall economic recession than other geographic areas. As a result, we have seen a more substantial decline in guest traffic at our restaurants in the western United States, which has had a negative effect on our operations as a whole. In addition, given our geographic concentration, negative publicity regarding any of our restaurants in the western United States could have a material adverse effect on our business and operations, as could other regional occurrences such as local strikes, energy shortages, or increases in energy prices, droughts, earthquakes, fires, or other natural disasters. A shift to a lower emphasis on expanding our restaurant base as a critical part of our long-term success may negatively affect our growth and results of operations. We have in the recent past considered the expansion of our restaurant base as a critical part of our long-term success. Although we continue to have confidence in development of new restaurants, due to a number of factors including better performance and reduced unit cost, we are limiting our new Company-owned restaurant growth for at least the next two years while we explore improvements to our unit design and other opportunities and review ways to maximize capital deployment. Consequently, we may miss opportunities to obtain optimum building sites or locations for our restaurants. Further, because we may devote restaurant development resources to other Company projects, we may be further delayed in ramping up development at an opportune time, which may negatively affect our ability to grow and support operations. Our ability and the ability of our franchisees to open and profitably operate new restaurants is subject to factors beyond our control. Our ability and the ability of our franchisees to timely and efficiently open new restaurants and to operate these restaurants on a profitable basis will depend upon numerous factors, many of which are beyond our control, including the following: continued unstable, negative macroeconomic factors nationally and regionally that impact restaurant-level performance and influence our decisions on the rate of expansion, timing, and the number of restaurants to be opened; identification and ability to secure an adequate supply of available and suitable restaurant sites; negotiation of favorable lease and construction terms; cost and availability of capital to fund restaurant expansion and operation; the availability of construction materials and labor; our ability to manage construction and development costs of new restaurants; timely adherence to development schedules; securing required governmental approvals and permits and in a timely manner; availability and retention of qualified operating personnel to staff our new restaurants, especially managers; competition in our markets and general economic conditions that may affect consumer spending or choice; our ability to attract and retain guests; and our ability to operate at acceptable profit margins. New or less mature restaurants, once opened, may vary in profitability and levels of operating revenue for six months or more. New and less mature restaurants typically experience higher operating costs in both dollars and percentage of revenue initially when compared to restaurants in the comparable restaurant base. Although the average unit volumes and restaurant level profit margins for each successive new restaurant classes since 2009 have continued to outperform comparable restaurants, there is no assurance that new restaurants will continue to experience such successes. Our restaurants are currently taking approximately six months or more to reach normalized operating levels due to inefficiencies typically associated with new restaurants. These include operating costs, which are often significantly greater during the first several months of operation. Further, some or all of our less mature restaurants may not attain operating results similar to those of our existing restaurants. Restaurant expansion through further penetrating existing markets could cause sales in some of our existing restaurants to decline. Our areas of highest concentration are California, Colorado, North Carolina, Ohio, Virginia, and Washington. We expect that approximately 70% of our new restaurants to be opened in 2011 will be in our existing markets. Because we typically draw guests from a relatively small radius around each of our restaurants, the sales performance and guest counts for existing restaurants near the area in which a new restaurant opens may decline due to the opening of the new restaurant. If our franchisees cannot develop or finance new restaurants, build them on suitable sites, or open them on schedule, our growth and success may be impeded. Some of our franchisees depend upon financing from banks and other financial institutions in order to construct and open new restaurants. If our franchisees experience difficulty in obtaining adequate financing, it could adversely affect the number and rate of new restaurant openings by our franchisees and adversely affect our future franchise revenues. Under our current form of area development agreement, franchisees must develop a predetermined number of restaurants in their area according to a schedule that lasts for the term of their development agreement. Given the current economic environment, franchisees may not have access to the financing and management resources they need to open the restaurants required by their development schedules or be able to find suitable sites on which to develop them. Franchisees may not be able to negotiate acceptable lease or purchase terms for the sites, obtain the necessary permits and government approvals or meet construction schedules. From time to time in the past, we have agreed to extend or modify development schedules for certain area developers, and we may do so in the future. Any such extensions or modifications may have a negative effect on revenues we realize from franchise operations. Our operations are susceptible to the changes in cost and availability of food which could adversely affect our operating results. Our profitability depends in part on our ability to anticipate and react to changes in food costs. Various factors beyond our control, including adverse weather conditions, governmental regulation, production, availability, recalls of food products, and seasonality, as well as the impact of the current macroeconomic environment on our suppliers, may affect our food costs or cause a disruption in our supply chain. Changes in the price or availability of commodities for which we do not have fixed price contracts could materially adversely affect our profitability. Expiring contracts with our food suppliers could also result in unfavorable renewal terms and therefore increase costs associated with these suppliers or may even necessitate negotiations with alternate suppliers. We cannot predict whether we will be able to anticipate and react to changing food costs by negotiating more favorable contract terms with suppliers or by adjusting our purchasing practices and menu prices, and a failure to do so could adversely affect our operating results. Moreover, because we provide a "value-priced" product, we may not be able to pass along food cost increases to our guests in the form of menu price increases. In addition, the ability of our suppliers to meet our supply requirements upon favorable terms, if at all, may be impacted by the economic recovery. Our franchisees could take actions that could harm our business. Franchisees are independent entities and are not our employees, partners, or affiliates. We share with our franchisees what we believe to be best practices in the restaurant industry; however, franchisees operate their restaurants as independent businesses. Consequently, the quality of franchised restaurant operations may be diminished by any number of factors beyond our control. Moreover, franchisees may not successfully operate restaurants in a manner consistent with our standards and requirements or may not hire and train qualified managers and other restaurant personnel. While we try to ensure that the quality of our brand and compliance with our operating standards, and the confidentiality thereof, are maintained by all of our franchisees, we cannot assure that our franchisees will avoid actions that adversely affect the reputation of Red Robin or the value of our proprietary information. Our image and reputation and the image and reputation of other franchisees may suffer materially, and system-wide sales could significantly decline if our franchisees do not operate these restaurants according to our standards. Our future success depends on our ability to protect our intellectual property. Our business prospects will depend in part on our ability to protect our proprietary information and intellectual property, including the Red Robin America's Gourmet Burgers & Spirits,® name and logo. Although we have registered trademarks for Red Robin®, America's Gourmet Burgers & Spirits® and Mad Mixology®, "YUMMM®", among others, with the United States Patent and Trademark Office and in Canada, our trademarks could be infringed in ways that leave us without redress, such as by imitation. In addition, we rely on trade secrets and proprietary know-how in operating our restaurants, and we employ various methods to protect those trade secrets and that proprietary know-how. However, such methods may not afford adequate protection and others could independently develop similar know-how or obtain access to our know-how, concepts and recipes. Consequently, our business could be adversely impacted and less profitable if we are unable to successfully defend and protect our intellectual property. Risks Related to the Restaurant Industry Health concerns relating to the consumption of beef, chicken, or other food products could affect consumer preferences and could negatively impact our results of operations. Consumer preferences could be affected by health concerns about food-related illness, the consumption of beef, the key ingredient in many of our menu items, or negative publicity or publication of government or industry findings concerning food quality, illness and injury. Further, consumers may react negatively to reports concerning our food products or health or other concerns or operating issues stemming from one or more of our restaurants. Such negative publicity, whether or not valid, may adversely affect demand for our food and could result in decreased guest traffic to our restaurants. A decrease in guest traffic to our restaurants as a result of these health concerns or negative publicity or as a result of a change in our menu or concept could materially harm our business and adversely affect our profitability. We are subject to extensive government regulation that may adversely hinder or impact our ability to govern various aspects of our business including our ability to expand and develop our restaurants. Our business is subject to various federal, state, and local government regulations, including those relating to the food safety and nutritional disclosure, alcoholic beverage control, public accommodations, and public health and safety. These regulations are subject to continual changes and updating. Difficulties or failures in obtaining or maintaining the required licenses and approvals or maintaining compliance with existing or newly enacted requirements could delay the opening or affect the continued operation and profitability of one or more restaurants in a particular area. We are also subject to "dram shop" statutes in some states. These statutes generally allow a person injured by an intoxicated person to recover damages from an establishment that wrongfully served alcoholic beverages to the intoxicated person. Failure to comply with alcoholic beverage control or dram shop regulations could subject the Company to liability and could adversely affect our business. Various federal and state employment laws govern our relationship with our team members and affect operating costs. These laws govern minimum wage requirements, overtime pay, meal and rest breaks, unemployment tax rates, workers' compensation rates, citizenship or residency requirements, labor relations, child labor regulations, and discriminatory conduct. Additional government-imposed increases in federal and state minimum wages, overtime pay, paid leaves of absence, and mandated health benefits, increased tax reporting and tax payment requirements for team members who receive tips, or a reduction in the number of states that allow tips to be credited toward minimum wage requirements could harm our operating results. We are also subject to federal and state laws that regulate the offer and sale of franchises and aspects of the licensor-licensee relationship. Many state franchise laws impose restrictions on the franchise agreement, including limitations on non-competition provisions and the termination or non-renewal of a franchise. Some states require that franchise materials be registered before franchises can be offered or sold in the state. Legislative or regulatory initiatives related to global warming/climate change concerns may negatively impact our business. There has been an increasing focus and continuous debate on global climate change recently, including increased attention from regulatory agencies and legislative bodies globally. This increased focus may lead to new initiatives directed at regulating an as yet unspecified array of environmental matters, such as the emission of greenhouse gases. Legislative, regulatory or other efforts in the United States to combat climate change could result in future increases in the cost of raw materials, taxes, transportation and utilities, which could decrease our operating profits and could necessitate future additional investments in facilities and equipment. We are unable to predict the potential effects that any such future environmental initiatives may have on the business as those effects are likely to be complex. A significant increase in litigation could have a material adverse effect on our results of operations, financial condition and business prospects. As a member of the restaurant industry, we are sometimes the subject of complaints or litigation from guests alleging illness, injury, or other food quality, health, or operational concerns. Adverse publicity resulting from these allegations could harm our restaurants, regardless of whether the allegations are valid or whether we are liable. In fact, we are subject to the same risks of adverse publicity resulting from these sorts of allegations even if the claim actually involves one of our franchisees. In addition, any failure by us to comply with the various federal and state labor laws governing our relationship with our team members including requirements pertaining to minimum wage, overtime pay, meal and rest breaks, unemployment tax rates, workers' compensation rates, citizenship or residency requirements, child labor regulations, and discriminatory conduct, may have a material adverse effect on our business or operations. We have been subject to such claims from time to time. The possibility of a material adverse effect on our business relating to employment litigation is even more pronounced given the high concentration of team members employed in the western United States, as this region, and California in particular, has a substantial amount of legislative and judicial activity pertaining to employment-related issues. Further, employee claims against us based on, among other things, discrimination, harassment, or wrongful termination may divert our financial and management resources that would otherwise be used to benefit the future performance of our operations. Changes in laws or regulations or the manner of their interpretation or enforcement could adversely impact our financial performance and restrict our ability to operate our business or execute our strategies. New laws or regulations, or changes in existing laws or regulations or the manner of their interpretation or enforcement, could increase our cost of doing business and restrict our ability to operate our business or execute our strategies. This includes, among other things, the possible taxation under U.S. law of certain income from foreign operations, and compliance costs and enforcement under the Dodd-Frank Act. The impact of the U.S. health care reform will be phased in between 2011 and 2014 and likely will have a significant adverse impact on our costs of providing employee health benefits beginning in 2011. As with any significant government action, the provisions of the health care reform legislation are still being assessed and may have additional financial accounting and reporting ramifications. The impact of any such changes, which we continue to evaluate on our business operations and financial statements, remains uncertain. ITEM 1B. Unresolved Staff Comments ITEM 2. Properties We currently lease the real estate for a majority of our company-owned restaurant facilities under operating leases with remaining terms ranging from less than one year to just over 15 years excluding options to extend. These leases generally contain options which permit us to extend the lease term at an agreed rent or at prevailing market rates. Certain leases provide for contingent rents, which are determined as a percentage of adjusted restaurant sales in excess of specified levels. We record a contingent rent liability and the corresponding rent expense when specified levels have been achieved or when management determines that achieving the specified levels during the fiscal year is probable. Certain lease agreements also require the Company to pay maintenance, insurance, and property tax costs. We own real estate for 32 company-owned restaurants located in Arizona (3); Arkansas (2); California (2); Colorado (3); Georgia (1); Illinois (1); Indiana (1); Maryland (1); Missouri (1); North Carolina (3); Ohio (5); Pennsylvania (3); Virginia (4); and Washington (2). In addition, we own one property in Florida and one property in California which are held for sale and a property in Texas which we lease to others. Our corporate headquarters are located in Greenwood Village, Colorado. We occupy this facility under a lease that expires on May 30, 2018. We believe that site selection is critical to our success and thus we devote substantial time and effort evaluating each prospective site. Our site selection criteria focuses on identifying markets, trade areas and other specific sites that are likely to yield the greatest density of desirable demographic characteristics, heavy retail traffic, and a highly visible site. Approved sites generally have a population of at least 70,000 people within a three-mile radius and at least 100,000 people within a five-mile radius. Sites generally require a strong daytime and evening population, adequate parking, and a visible and easy entrance and exit. In addition, Red Robin typically selects locations with a demographic profile that includes a household income average of $65,000 or greater and that has a high population of families. In order to maximize our market penetration potential, we have developed a flexible physical site format that allows us to operate in a range of real estate venues located near high activity areas, such as regional malls, lifestyle centers, big box shopping centers and entertainment centers, as well as existing structures that have been closed by other restaurant and retail concepts. Our current prototype restaurant is a free-standing building with approximately 5,800 square feet and approximately 200 seats. Based on this prototype, our average cash investment for a new restaurant opened in 2010 was approximately $1.9 million, excluding land and pre-opening costs. We typically operate our restaurants under operating leases for land on which we build our restaurants. However, we have also begun to develop restaurants using in-line mall locations in addition to our conversions of existing restaurant and other retail structures. In December 2009, the Company was served with a purported class action lawsuit, Marcos R. Moreno vs. Red Robin International, Inc. The case was filed in Superior Court in Ventura County, California and has been removed to Federal District Court for the Central District of California under the Class Action Fairness Act of 2005 ("CAFA"). Red Robin filed its Answer and Affirmative Defenses on February 10, 2010. The Court set a Scheduling Conference for March 29, 2010. The lawsuit alleges failure to pay wages and overtime, failure to provide rest and meal breaks or to pay compensation in lieu of such breaks, failure to pay timely wages on termination, failure to provide accurate wage statements, and unlawful business practices and unfair competition. Plaintiff is seeking compensatory and special damages, restitution for unfair competition, premium pay, penalties and wages under the Labor Code, and attorneys' fees, interest and costs. The Court granted Plaintiff's Motion to Stay, to which we agreed, pending a decision by the CA Supreme Court in Brinker Restaurant Corp. v. Superior Court. The Brinker case is based on similar arguments and likely would have persuasive or precedential effect on Moreno. Brinker has been fully briefed but oral argument has not been set by the Supreme Court. The oral arguments in the Brinker case will probably not be heard until Fall 2011. We believe this suit to be without merit. Although we plan to vigorously defend against this suit, we cannot predict the outcome of this lawsuit or whether we may be required to pay damages, settlement costs, legal costs or other amounts that may not be covered by insurance. In the normal course of business, there are various other claims in process, matters in litigation and other contingencies. These include claims resulting from "slip and fall" accidents, employment related claims and claims from guests or team members alleging illness, injury or other food quality, health or operational concerns. To date, no claims of these types of litigation, certain of which are covered by insurance policies, have had a material effect on us. While it is not possible to predict the outcome of these other suits, legal proceedings and claims with certainty, management does not believe that they would have a material adverse effect on our financial position and results of operations. ITEM 4. Removed and Reserved ITEM 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Our common stock is listed on The NASDAQ Global Select Market under the symbol RRGB. The table below sets forth the high and low per share sales prices for our common stock as reported by The NASDAQ Global Select Market for the indicated periods. 4th Quarter $ 22.90 $ 17.33 3rd Quarter 22.63 17.03 2nd Quarter 28.10 16.85 1st Quarter 29.10 16.87 1st Quarter 24.05 9.27 As of February 23, 2011, there were approximately 184 registered owners of our common stock. We did not declare or pay any cash dividends on our common stock during 2010. We currently anticipate that we will retain any future earnings for the operation and expansion of our business or to pay down debt. We have announced a share repurchase program of up to $50 million in common stock, including a target of $25 million in the first six months of 2011, subject to appropriate valuation of our shares, and other standard considerations. In addition, our credit agreement prohibits us from declaring or paying any dividends or making any other distributions on any of our shares, subject to specified exceptions. Accordingly, we do not anticipate declaring or paying any cash dividends on our common stock in the foreseeable future. Our credit agreement also limits our ability to engage in stock repurchases. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on then existing conditions including our financial condition, results of operations, contractual restrictions, capital requirements, business prospects, and other factors our board of directors may deem relevant. Issuer Purchases of Equity Securities No shares of equity securities were repurchased by the Company in fourth quarter 2010. Performance Graph The following graph compares the yearly percentage in cumulative total shareholders' return on Common Stock of the Company since December 25, 2005, with the cumulative total return over the same period for (i) the Russell 3000 Index, (ii) a 2010 peer group. The 2010 Peer Group is composed of the following restaurant companies: BJ's Restaurants Inc., Brinker International Inc., Buffalo Wild Wings Inc., California Pizza Kitchen Inc., CEC Entertainment, Inc., Cheesecake Factory Inc., Chipotle Mexican Grill, Inc., O'Charley's Inc., Panera Bread Company, PF Chang's China Bistro Inc., Ruby Tuesday Inc., and Texas Roadhouse Inc. The 2009 Peer Group was composed of the same companies, except that Landry's Restaurants Inc. was included. Pursuant to rules of the Securities and Exchange Commission ("SEC"), the comparison assumes $100 was invested on December 25, 2005, the last trading day in the Company's 2005 fiscal year, in the Company's Common Stock and in each of the indices. Also pursuant to SEC rules, the returns of each of the companies in the Peer Groups are weighted according to the respective company's stock market capitalization at the beginning of each period for which a return is indicated. Historic stock price is not indicative of future stock price performance. This performance graph shall not be deemed to be "soliciting material" or to be "filed" under either the Securities Act of 1933, as amended or the Securities Exchange Act of 1934, as amended. COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN* Among Red Robin Gourmet Burgers, Inc., The Russell 3000 Index and 2010 Peer Group $100 invested on 12/31/05 in stock or index, including reinvestment of dividends. Assumes fiscal year ending December 31 for purposes of comparability. Fiscal Years Red Robin Gourmet Burgers, Inc. $ 100.00 $ 70.35 $ 62.77 $ 33.03 $ 35.13 $ 42.13 Russell 3000 100.00 115.71 121.66 76.27 97.89 114.46 2010 Peer Group 100.00 96.91 76.25 49.57 76.23 118.69 ITEM 6. Selected Financial Data The table below contains selected consolidated financial and operating data. The statement of income, cash flow and balance sheet data for each year has been derived from our consolidated financial statements. You should read this information together with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and our consolidated financial statements and the related notes included elsewhere in this annual report on Form 10-K. Fiscal Year Ended(1) Statement of Income Data: Restaurant revenue $ 846,389 $ 828,031 $ 854,690 $ 747,530 $ 603,391 Total revenues 864,269 841,045 869,215 763,472 618,721 Total costs and expenses(6)(7) 854,536 813,104 824,025 710,901 570,873 Income from operations 9,733 27,941 45,190 52,571 47,848 Net income $ 7,299 $ 17,599 $ 27,126 $ 30,651 $ 29,362 Basic(8) $ 0.47 $ 1.14 $ 1.70 $ 1.84 $ 1.78 Diluted $ 0.46 $ 1.14 $ 1.69 $ 1.82 $ 1.75 Basic 15,536 15,392 15,927 16,647 16,538 Diluted 15,709 15,504 16,047 16,817 16,736 Cash and cash equivalents $ 17,889 $ 20,268 $ 11,158 $ 12,914 $ 2,762 Total assets 579,257 600,095 609,737 548,789 450,598 Long-term debt, including current portion 158,522 191,334 222,572 153,746 113,971 Total stockholders' equity 300,661 288,622 268,908 284,442 243,533 Cash Flow Data: Net cash provided by operating activities $ 70,613 $ 90,615 $ 91,164 $ 93,558 $ 78,525 Net cash used in investing activities (35,060 ) (49,548 ) (113,124 ) (125,195 ) (136,863 ) Net cash (used in) provided by financing activities (37,932 ) (31,957 ) 20,204 41,789 57,760 Selected Operating Data: Average annual comparable restaurant sales volumes(5) $ 2,779 $ 2,823 $ 3,231 $ 3,330 $ 3,314 Company-owned restaurants open at end of period 314 306 294 249 208 Franchised restaurants open at end of period 136 133 129 135 139 Comparable restaurant sales increase (decrease)(5) (0.6 )% (11.1 )% (1.4 )% 2.4 % 2.4 % 2006 was a 53-week fiscal year. All other periods presented include 52 weeks. Fiscal year 2008 reflects the acquisition of 15 franchised restaurants and one restaurant that had been under construction from three franchisees. See Note 3, Acquisition of Red Robin Franchised Restaurants, of Notes to Consolidated Financial Statements in Part II, Item 8 of this report. Fiscal year 2007 reflects the acquisition of 17 franchised restaurants in the state of California. Fiscal year 2006 reflects the acquisition of 13 franchised restaurants in the state of Washington. Comparable restaurants include those Company-owned restaurants that have achieved five full quarters of operations during the periods presented. Please see "Management's Discussion and Analysis of Financial Condition and Results of Operations—Total Revenues" for a further discussion of our comparable restaurant designation. Fiscal year 2010 reflects a significant and infrequent pre-tax charge of $2.6 million related to the retirement of the Company's chief executive officer and appointment of a new chief executive officer. Fiscal year 2010 also includes a pre-tax non-cash asset impairment charge of $6.1 million related to the impairment of four restaurants. Fiscal year 2009 reflects a net significant and infrequent pre-tax charge of $4.0 million related to the option tender offer completed during the first quarter 2009. This one-time charge represents the compensation expense related to the acceleration of vesting on the unvested options tendered in the offer, which would otherwise have been expensed over their vesting period in the future if they had not been tendered. Fiscal year 2006 earnings per basic and diluted share include approximately $0.11 per share related to an additional week. ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations As of December 26, 2010, we owned and operated or franchised 450 Red Robin® restaurants in 40 states and Canada, of which 314 were company-owned and 136 were operated under franchise. For the fiscal year 2011, we plan to open 10 new company-owned Red Robin® restaurants and we believe our franchisees will open about three to four new restaurants. Our primary source of revenue is from the sale of food and beverages at company-owned restaurants. We also earn revenue from royalties and fees from franchised restaurants. The following summarizes the operational and financial highlights of fiscal year 2010 and our 2011 outlook: Comparable Restaurant Revenue. For the fifty-two weeks ended December 26, 2010, the 303 restaurants in our current comparable base experienced a 0.6% decrease in sales from these same restaurants last year. This decrease was comprised of a 1.1% increase in guest counts that was more than fully offset by a decrease in price and mix of 1.7%. During fiscal 2010, we experienced four quarters of positive guest counts, reversing the negative trend that began in early 2008 and continued in 2009. We attribute this increased guest count to our 2010 marketing efforts and a stronger macroeconomic environment. The decline in pricing is also primarily the result of our 2010 Limited Time Offer ("LTO") promotions' lower price point and negative revenue impact of changes in product mix. In the third and fourth quarter 2010 both guest counts and overall comparable sales were positive. Marketing Efforts. In 2010, our marketing strategy was focused on product news with an emphasis on quality, value, and variety to drive guest traffic, retention, and loyalty, which are key components of our "YUMMM" ® advertising campaign. During 2010, we launched three LTO promotions featuring two products at a $6.99 price point ($5.99 price point in the first LTO promotion). For the fiscal year ended December 26, 2010, our television advertising support of our 2010 LTO promotions increased our total marketing spend to $15.4 million. We believe our 2010 LTO promotions, supported by national television and digital advertising, contributed to our increased guest counts and restaurant sales. Restaurant sales and guest counts during the promotional campaigns ran higher than pre- and post-promotional periods. In addition, our guest counts exceeded reported competitor guest traffic after our TV campaign began. We will continue our LTO promotional strategy supported with television advertising in 2011 which we expect to be equal to approximately 1.5% of restaurant revenues in 2011. Food Costs. During 2010, we saw an increase in the price of ground beef and produce compared to 2009 prices. We bought our ground beef on the spot market in 2010 at prices significantly in excess of 2009 prices. We experienced an increase in produce costs due to inclement weather during 2010. Pricing on our overall commodity basket on a blended basis is expected to increase 3% to 4% in 2011. We will continue to see pressure from ground beef, which is expected to be above 2010 average price by between 10% and 15%. In response to these rising commodity costs, we are expecting to take about a 1.5% price increase in April. We also expect to begin to see the benefit in 2011 from having consolidated our distribution system in 2010 and other cost reduction initiatives associated with Project RED. Labor. Labor costs as a percentage of revenue increased in fiscal year 2010 by 0.7% as a percentage of restaurant revenues primarily due to increase in manager bonuses as a percentage of average restaurant sales volumes. Labor costs are expected to be impacted in 2011 by minimum wage increases in certain states, in addition to increases in benefits and taxes. New Restaurant Openings. We opened 11 new company-owned restaurants during fiscal year 2010. In the near term, we are expecting 2011 development plans to be similar to 2010 as we seek to deploy our capital conservatively while maintaining restaurant growth. We plan on opening 10 new company-owned restaurants in 2011. We believe we will fund all 2011 costs for restaurant development to be funded from our operating cash flow. Asset Impairment. During the third quarter of fiscal 2010, we determined that four company-owned restaurants were impaired. The Company recognized a non-cash impairment pre-tax charge of $6.1 million related to the impairment of these four restaurants. We reviewed each restaurant's past and present operating performance combined with projected future results, primarily through projected undiscounted cash flows, which indicated possible impairment. The carrying amount of each restaurant was compared to its fair value as determined by management. The impairment charge represents the excess of each restaurant's carrying amount over its fair value. Executive Transition. Stephen E. Carley was appointed as Chief Executive Officer of the Company and as a member of the Board, effective as of September 13, 2010. In connection with the appointment of Mr. Carley as the Company's new Chief Executive Officer, the Company also announced the retirement of Dennis B. Mullen, the former Chief Executive Officer. $2.6 million in pre-tax charges related to executive transition were recorded to selling, general and administrative expense primarily in the fiscal third quarter. Unit Data and Comparable Restaurant Sales The following table details data pertaining to the number of restaurants for both company-owned and franchise locations for the years indicated. Beginning of period 306 294 249 Opened during period 11 15 31 Acquired from franchisees — 1 15 Closed during period (3 ) (4 ) (1 ) End of period 314 306 294 Opened during period(a) 7 5 10 Sold or closed during period(a) (4 ) (1 ) (16 ) Total number of Red Robin® restaurants 450 439 423 Includes two franchised restaurants that were closed in 2010 and re-opened during 2010. Operating results for each period presented below are expressed as a percentage of total revenues, except for the components of restaurant operating costs, which are expressed as a percentage of restaurant revenues: Restaurant 97.9 % 98.5 % 98.4 % Franchise royalties and fees 1.6 1.5 1.6 Other revenue 0.5 — — Total revenues 100.0 100.0 100.0 Restaurant operating costs (exclusive of depreciation and amortization shown separately below): Cost of sales 24.4 24.1 23.8 Labor (includes 0.1%, 0.2% and 0.1% of stock-based compensation expense, respectively) 35.5 34.8 33.9 Operating 14.8 14.8 14.5 Occupancy 7.4 7.5 6.7 Total restaurant operating costs 82.2 81.2 78.9 Depreciation and amortization 6.6 6.8 5.9 Selling, general and administrative (includes 0.4%, 0.7% and 0.6% of stock-based compensation expense, respectively) 10.3 9.1 9.6 Franchise development 0.5 0.5 0.5 Pre-opening costs 0.3 0.4 0.9 Asset impairment charge 0.7 — 0.2 Reacquired franchise and other acquisition costs — — 0.1 Income from operations 1.1 3.3 5.2 Other (income) expense: Interest expense, net 0.6 0.8 1.0 Other (0.0 ) — (0.1 ) Total other expenses 0.6 0.8 0.9 Income before income taxes 0.5 2.6 4.3 (Provision) benefit for income taxes 0.3 (0.5 ) (1.1 ) Net income 0.8 % 2.1 % 3.2 % Certain percentage amounts in the table above do not total due to rounding as well as the fact that restaurant operating costs are expressed as a percentage of restaurant revenues, as opposed to total revenues. Total Revenues (In thousands, except percentages and average weekly sales volumes) Restaurant revenue $ 846,389 $ 828,031 2.2 % $ 854,690 (3.1 )% Franchise royalties and fees 13,409 12,825 4.6 % 14,323 (10.5 )% Other revenue 4,471 189 NM (2) 202 (6.4 )% Total revenues $ 864,269 $ 841,045 2.8 % $ 869,215 (3.2 )% Average weekly sales volumes: Comparable restaurants $ 53,447 $ 54,280 (1.5 )% $ 62,128 (12.6 )% Non-comparable restaurants $ 58,842 $ 53,026 11.0 % $ 55,640 (4.7 )% 2008 Acquired Restaurants(1) $ — $ 51,392 (100.0 )% $ 53,057 (3.1 )% 2008 Acquired Restaurants refers to 15 franchised Red Robin® restaurants we acquired during 2008. Beginning the third quarter of 2009, these restaurants entered into the comparable restaurant population and their average weekly sales volume, from that time forward, are included in the comparable restaurant category. Percentage change of more than 100% is considered not meaningful. Restaurant revenue, which is comprised almost entirely of food and beverage sales, increased by $18.4 million, or 2.2%, from fiscal year 2009. The significant factors contributing to our increase in restaurant revenue was revenue growth from our new restaurant openings offset by the 0.6% decrease in sales from our comparable restaurants. Restaurant revenues for restaurants not in the comparable sales base increased $21.3 million, of which $17.9 million was attributable to restaurants opened during fiscal year 2010. Restaurants in the comparable sales base experienced a revenue decline of $3.0 million from prior year. In 2009, restaurant revenue declined $26.7 million, or 3.1%, from fiscal year 2008. Restaurants in the comparable sales base experienced a revenue decline of $82.3 million from the fiscal year 2008. Restaurant revenues for restaurants not in the comparable sales base increased $55.6 million, of which $33.4 million was attributable to restaurants opened during fiscal year 2009. Average weekly sales volumes represent the total sales for a population of restaurants in both a comparable and non-comparable category for each time period presented divided by the number of operating weeks in the period. Comparable restaurant average weekly sales volumes include those restaurants that are in the comparable base at the end of each period presented. At the end of fiscal year 2010, there were 303 comparable restaurants compared to 277 comparable restaurants at the end of 2009. Non-comparable restaurants presented include those restaurants that had not yet achieved the five full quarters of operations during the periods presented. At the end of fiscal year 2010, there were 13 non-comparable restaurants versus 49 at the end of fiscal year 2009. Fluctuations in average weekly sales volumes for comparable restaurants reflect the effect of same store sales changes as well as the performance of new restaurants entering the comparable base during the period. The 1.5% decrease in average comparable restaurant weekly sales in fiscal year 2010 was primarily the result of a decrease in average guest check during 2010 from our LTO Promotions. Franchise royalties and fees consist primarily of royalty income and initial franchise fees, increased $0.6 million or 4.6%, from 2009. The year over year increase in franchise royalties and fees is primarily attributable to the overall increase in reported franchise sales. Our franchisees reported that comparable sales increased 0.3% for U.S. restaurants and decreased 1.7% for Canadian restaurants in the year ended December 26, 2010. Franchise royalties and fees for 2009 decreased over 2008 due primarily to overall decrease in reported franchise sales. Other revenue consists primarily of gift card breakage. We recognize restaurant revenue when a gift card is redeemed by a guest. Gift card breakage revenue is recognized if the likelihood of gift card redemption is remote and we determine that there is not a legal obligation to remit the unredeemed gift card balance to the relevant jurisdiction. We base the gift card breakage rate upon specific historical redemption patterns. We recognize gift card breakage by applying our estimate of the rate of gift card breakage over the period of estimated performance. The Company completed its initial analysis of unredeemed gift card liabilities for gift cards that it sold in its restaurants during the first quarter 2010, and we recognized $3.5 million as a onetime pre-tax revenue adjustment during the fiscal first quarter 2010. We recognized $4.3 million (inclusive of the onetime revenue adjustment) of gift card breakage for fiscal year 2010. (In thousands, except percentages) Cost of sales $ 206,639 $ 199,195 3.7 % $ 203,463 (2.1 )% As a percent of restaurant revenue 24.4 % 24.1 % 0.3 % 23.8 % 0.3 % Cost of sales, comprised of food and beverage costs, is variable and generally fluctuates with sales volume. Cost of sales as a percentage of restaurant revenue increased 0.3% in 2010. The increase in food costs as a percentage of restaurant revenue in 2010 was driven by a 0.2% reduction in revenue from our 2010 LTO Promotions pricing, a 0.2% increase in ground beef costs and 0.2% increase in produce costs. These increases were partially offset by a combined 0.3% decrease in expenses for bread, fry oil and other meats. The increase in produce and ground beef is due to higher raw material costs and change in product mix. Cost of sales as a percentage of restaurant revenue increased 0.3% in 2009 compared to 2008 driven by a 0.4% increase in food costs as a percentage of restaurant revenue, partially offset by a 0.1% decrease in beverage costs as a percentage of revenue. The increase in food costs as a percentage of restaurant revenue in 2009 was due primarily to higher contracted raw material pricing for potatoes of 0.2% and ground beef of 0.1%. Labor $ 300,878 $ 287,981 4.5 % $ 289,702 (0.6 )% Labor costs include restaurant hourly wages, fixed management salaries, stock-based compensation expense, bonuses, taxes, and benefits for restaurant team members. Labor as a percentage of restaurant revenue increased in 2010 due to an increase in manager bonus expense, of 0.5%. Additionally, our 2010 LTO price promotions and changes in product mix resulted in an approximate 0.5% increase in labor expenses as a percentage of revenue. These increases were partially offset by a 0.2% decrease in hourly wages and a 0.2% decrease in payroll taxes due to the payroll tax holiday provided by the 2010 Hiring Incentives to Restore Employment (HIRE) Act. Offsetting these increases were decreases in stock compensation expense of 0.1%. Hourly wages as a percentage of restaurant revenue were relatively flat in 2010 compared to 2009 due to management's focus on productivity and maintaining staffing levels that are consistent with our sales volumes, which helped to offset minimum wage increases. Labor as a percentage of restaurant revenue for 2009 increased over the prior year due to an increase in fixed management salaries of 0.6%, insurance costs of 0.4%, and workers compensation costs of 0.2%. Additionally, a stock based compensation charge of $886,000, or 0.1% of restaurant revenue, related to the tender offer increased labor costs. Offsetting these increases were decreases in vacation expense of 0.2% and restaurant level bonuses of 0.2%. Operating $ 125,137 $ 122,183 2.4 % $ 123,823 (1.3 )% Operating costs include variable costs such as restaurant supplies, energy costs, and other costs such as service repairs and maintenance costs. During 2010, operating costs as a percentage of restaurant revenue remained flat. Contributing to this 0% change as a percentage of restaurant revenue was a combination of a 0.25% deleverage from lowered revenue due to price and product mix changes, an 0.1% increase in repairs and maintenance expense offset by a 0.15% decrease in restaurant supplies, and a 0.2% decrease in miscellaneous costs such as utilities, promotional and other expenses. Operating costs as a percentage of restaurant revenue increased 0.3% in 2009 primarily due to a 0.3% increase in repairs and maintenance expenses and a 0.2% increase in other miscellaneous costs, partially offset by a 0.2% decrease in restaurant supplies. Occupancy $ 63,055 $ 62,420 1.0 % $ 56,908 9.7 % As a percent of restaurant revenue 7.4 % 7.5 % (0.1 )% 6.7 % 0.8 % Occupancy costs include fixed rents, contingent rents, common area maintenance charges, real estate and personal property taxes, general liability insurance, and other property costs. Our occupancy costs generally increase with increases in sales volume from contingent rents or the addition of new restaurants, but decline as a percentage of restaurant revenue as we leverage our fixed costs. Occupancy costs as a percent of restaurant revenue decreased 0.1%, driven by a 0.2% decrease in general liability insurance as a percent of restaurant revenue, offset by an increase of fixed rent expense as a percentage of restaurant revenue of 0.1%. In 2009, fixed rent expense and real estate taxes as a percentage of restaurant revenue increased 0.7% and 0.2%, respectively. Offsetting this was a decrease in contingent rent expense of 0.2%, driven primarily by lower restaurant revenue. Additionally, many of the restaurants acquired from franchisees in previous years are "build to suit" locations that typically bear a higher occupancy cost as a percentage of restaurant revenue. Depreciation and amortization $ 56,738 $ 57,166 (0.7 )% $ 51,687 10.6 % As a percent of total revenues 6.6 % 6.8 % (0.2 )% 5.9 % 0.9 % Depreciation and amortization includes depreciation on capital expenditures for restaurants and corporate assets as well as amortization of acquired franchise rights and liquor licenses. Depreciation and amortization expense decreased $0.4 million, or 0.7%, due to three restaurant closures during the fiscal year and the reduction in depreciation and amortization from assets whose amortizable base was reduced through an impairment charge in the fiscal third quarter. Depreciation and amortization expense as a percentage of total revenues decreased in 2010 due to increased average restaurant sales volumes and a decrease in overall expense. In 2009, depreciation and amortization increased $5.5 million, or 11%, due primarily to the addition of depreciable assets from new restaurant openings and restaurants acquired in 2008. Depreciation and amortization as a percentage of total revenues increased in 2009 due to lower average restaurant sales volumes. Selling, general and administrative $ 88,836 $ 76,260 16.5 % $ 83,379 (8.5 )% As a percent of total revenues 10.3 % 9.1 % 1.2 % 9.6 % (0.5 )% Selling, general and administrative costs include all corporate and administrative functions that support existing operations and provide infrastructure to facilitate our future growth. Components of this category include management, supervisory and staff salaries, bonuses, stock-based compensation and related employee benefits, travel, information systems, training, office rent, professional and consulting fees, Board of Directors expenses, legal and marketing costs. Selling, general and administrative costs increased $12.6 million, or an increase as percent of total revenues of 1.2% in 2010 due primarily to an increase of $12.9 million in the marketing and advertising campaign related to television media support for the spring, summer and fall LTO campaigns. Additionally, we also experienced $2.6 million of additional expense for the 2010 CEO transition and $1.1 million of additional expense for the Board of Directors and governance-related matters. These increases were partially offset by $1.1 million decrease in bonuses at the corporate level and a $2.6 million decrease in stock compensation related primarily to the options tender offer during the first quarter of fiscal 2009. In 2009, selling, general and administrative costs decreased $7.1 million, or a decrease of 0.5% as a percent of revenue due to a decrease in marketing expenses of $7 million due to a reduced focus on national cable television advertising and a greater focus on digital and targeted direct advertising to promote product news and drive incremental guest traffic. Additionally, travel costs decreased $1.9 million primarily due to a decrease in travel costs related to our reduced number of new restaurant openings and the associated training activities. Offsetting these decreases was an increase in bonuses as 2008 performance-based bonuses were significantly reduced. Franchise development $ 4,122 $ 4,203 (1.9 )% $ 4,597 (8.6 )% As a percent of total revenues 0.5 % 0.5 % 0.0 % 0.5 % 0.0 % Franchise development costs include the costs of our franchise and operations support teams including salaries and benefits, travel and training expenses, and costs associated with our annual leadership conference. Franchise development costs as a percentage of total revenues were flat in 2010 compared to 2009 and were also flat in 2009 compared to 2008. Pre-opening Costs Pre-opening costs $ 3,015 $ 3,696 (18.4 )% $ 8,109 (54.4 )% As a percent of total revenues 0.3 % 0.4 % (0.1 )% 0.9 % (0.5 )% Average per restaurant pre-opening costs $ 258 $ 249 3.6 % $ 264 (5.7 )% Pre-opening costs, which are expensed as incurred, consist of the costs of labor, hiring, and training the initial work force for our new restaurants, travel expenses for our training teams, the cost of food and beverages used in training, marketing costs, lease costs incurred prior to opening, and other direct costs related to the opening of new restaurants. Pre-opening costs for 2010, 2009, and 2008 reflect the opening of 11, 15, and 31 new restaurants, respectively. Average per restaurant pre-opening costs represents total costs incurred for those restaurants that opened for business during the periods presented. The 2010 average per restaurant pre-opening costs increased moderately due to travel related costs. The 2009 average per restaurant pre-opening costs decreased over prior year due primarily to lower labor and travel costs of 15% and 9%, respectively, partially offset by an 11% increase in occupancy costs for our new restaurant openings as well as conversion of existing restaurant and other retail structures for four of the restaurants opened during the year. Asset Impairment Charge and Restaurant Closure Costs During the third quarter of fiscal 2010, we determined that four company-owned restaurants were impaired. The Company recognized a non-cash pre-tax impairment charge of $6.1 million related to these four restaurants. We reviewed each restaurant's past and present operating performance combined with projected future results, primarily through projected undiscounted cash flows, which indicated impairment. The carrying amount of each restaurant was compared to its fair value as determined by management. The impairment charge represents the excess of each restaurant's carrying amount over its fair value. We closed three and four restaurants in fiscal 2010 and 2009, respectively. The locations closed represented restaurants operating below acceptable profitability levels or were older restaurants whose leases were not extended or were in need of significant capital improvements that were not projected to provide acceptable returns in the foreseeable future. We recognized charges of $856,000 and $562,000 in fiscal 2010 and 2009, respectively, related to lease terminations and other closing related costs. These three closed restaurants in 2010 were not part of the impairment charge taken in the third quarter of fiscal 2010. In 2008 we recognized $1.0 million of asset impairment charges related to the write-down of the carrying value of a portion of long-lived assets associated with the four restaurants closed in 2009. In addition to the impairment charges related to the restaurant closures, we recognized $0.9 million of non-cash impairment charges in 2008 for two restaurants that were not meeting acceptable cash flow levels. There were no asset impairment charges recognized in 2009. Reacquired Franchise Costs As a result of the acquisition of the 15 restaurants during 2008, we incurred a total charge of $451,000, which is primarily related to avoided franchise fees. The guidance for accounting for business combinations requires that a business combination between two parties that have a preexisting relationship be evaluated to determine if a settlement of a preexisting relationship exists. The $451,000 charge reflects the lower royalty rates applicable to certain of the acquired restaurants compared to a standard royalty rate the Company would receive under the Company's current royalty agreements. See Note 3, Acquisition of Red Robin Franchised Restaurants, in the Notes to Condensed Consolidated Financial Statements for additional information regarding the acquisition and related charge. Interest expense in 2010, 2009 and 2008 was $5.1 million, $6.9 million, and $8.6 million, respectively. Interest expense in 2010 was lower than 2009 due to reduced outstanding borrowings under our credit facility offset by a slightly higher weighted average interest rate of 3.0% versus 2.8% in 2009. Interest expense in 2009 was lower than 2008 due to reduced outstanding borrowings under our credit facility and a lower weighted average interest rate of 2.8% versus 4.0% in 2008. We believe interest expense will increase in 2011 as we refinance our current credit facility at potentially higher interest rates. The provision for income taxes decreased $6.5 million, to a tax benefit of $2.6 million in 2010, from tax expense of $3.9 million in 2009. Our effective income tax rate was 54.3%, a tax benefit, for 2010, 18.3%, a tax expense, for 2009, and 26.6%, a tax expense, for 2008. The decreases in 2010 versus 2009 and 2009 versus 2008 were primarily due to the impact of more favorable general business and tax credits, primarily the FICA Tip Tax Credit, as a percent of current year income, which did not change at the same rate as the decrease in income. General. Cash and cash equivalents decreased $2.4 million to $17.9 million at December 26, 2010, from $20.3 million at the beginning of the fiscal year. This decrease in our cash position is the net result of $70.6 million of cash provided by operating activities, offset by $35.1 million used for the construction of new restaurants and expenditures for facility improvements, and $37.9 million net pay down of debt. We expect to continue to reinvest available cash flows from operations to develop new restaurants or enhance existing restaurants, make investments in our technology infrastructure, pay down debt, and repurchase some of our outstanding common stock subject to appropriate valuation of our stock and other standard considerations. Credit Facility. Our existing credit facility has permitted us to have a more flexible capital structure and facilitate our growth plans. The credit facility is comprised of (i) a $150 million revolving credit facility maturing on June 15, 2012, and (ii) a $150 million term loan maturing on June 15, 2012, both with rates based on the London Interbank Offered Rate (LIBOR) plus a margin that is currently 1.00%. The credit agreement also allows us, subject to lender participation which is at their sole discretion, to increase the revolving credit facility by up to an additional $100 million in the future and to request maturity extensions. As part of the credit agreement, we may also request the issuance of up to $15 million in letters of credit, the outstanding amount of which reduces the net borrowing capacity under the agreement. The credit facility requires the payment of an annual commitment fee based upon the unused portion of the credit facility. The credit facility's interest rates and the annual commitment rate are based on a financial leverage ratio, as defined in the credit agreement. Our obligations under the credit facility are secured by first priority liens and security interests in the capital stock of subsidiaries of the Company. Additionally, the credit agreement includes a negative pledge on all tangible and intangible assets of the Company and its subsidiaries (including all real and personal property) with customary exceptions. Our credit facility is with a consortium of banks that include Wells Fargo Bank N.A. (formerly Wachovia Bank N.A.), Bank of America N.A., Keybank N.A., and SunTrust Bank, National Association ("SunTrust") among others. We do not believe that any of our lenders will not be able to fulfill their lending commitments under our credit facility. In anticipation of 2012 expiration of the credit facility, we have begun discussions with our current lenders to refinance the credit facility in 2011, and are considering options in connection therewith. With regard to the current term loan facility, we are required to repay the principal amount of the term loan in consecutive quarterly installments which began September 30, 2007 and will end on the maturity date of the term loan. At December 26, 2010, we had $104.0 million of borrowings outstanding under our term loan, and $43.0 million of borrowings and $6.6 million of letters of credit outstanding under our $150 million revolving credit facility. Loan origination costs associated with the credit facility and the net outstanding balance of costs related to the original agreement and subsequent amendment to the credit facility are $500,000 and are included as deferred costs in other assets, net in the accompanying consolidated balance sheet as of December 26, 2010. We expect to incur loan origination and similar costs in connection with the refinancing. Covenants. We are subject to a number of customary covenants under our various credit agreements, including limitations on additional borrowings, acquisitions, and dividend payments. In addition, we are required to maintain two financial ratios: a leverage ratio calculated as our debt outstanding including issued standby letters of credit divided by the last twelve months' earnings before interest, taxes, depreciation, and amortization adjusted for certain non-cash charges; and a fixed charge ratio calculated as our consolidated cash flow divided by our consolidated debt service obligations. As of December 26, 2010, we were in compliance with all debt covenants and expect to remain in compliance with our current credit agreements through fiscal year 2011. Debt Outstanding. Total debt outstanding decreased $32.8 million to $158.5 million at December 26, 2010 from $191.3 million at December 27, 2009, primarily due to our scheduled debt repayments of $18.7 million and additional repayments of $13.1 million, as well as payments on our capital lease obligations of approximately $1.0 million. Our current credit agreement matures in 2012 and we expect to refinance our current credit facility to take advantage of the current low interest rate environment and maintain the financial flexibility we need to build our business in the future. The Company believes this refinancing will be completed in 2011. Contractual Obligations. The following table summarizes the amounts of payments due under specified contractual obligations as of December 26, 2010 (in thousands): Payments due by period Long-term debt obligations(1) $ 146,953 $ 18,739 $ 128,214 $ — $ — Capital lease obligations(2) 16,416 1,492 2,625 2,118 10,181 Operating lease obligations(3) 394,921 41,894 82,688 78,616 191,723 Purchase obligations(4) 3,115 3,115 — — — Other non current liabilities(5) 3,927 1,056 833 338 1,700 Total contractual obligations $ 565,332 $ 66,296 $ 214,360 $ 81,072 $ 203,604 Long-term debt obligations represent borrowings under our credit agreement including interest of $3.0 million based on a 2.07% average borrowing interest rate. Outstanding letters of credit of $6.6 million are included in the less than 1 year total. Capital lease obligations include interest of $4.9 million. Operating lease obligations represent future minimum lease commitments payable for land, buildings, and equipment used in our operations. This table excludes contingent rents, including amounts which are determined as a percentage of adjusted sales in excess of specified levels. Purchase obligations include commitments for the construction of new restaurants and other capital improvement projects and lease commitments for company-owned restaurants where leases have been executed but construction has not begun. Excluded are any agreements that are cancelable without significant penalty. While we have fixed price agreements and contracts with "spot" market prices relating to food costs, we do not have any material contracts (either individually or in the aggregate) in place committing us to a minimum or fixed level of purchases. Other noncurrent liabilities include executive deferred compensation, accrued restaurant bonuses for long-term incentive plans, uncertain tax positions, and vendor deposits. Capital Expenditures. Capital expenditures, including capital lease obligations, were $35.0 million, $49.1 million, and $85.4 million in 2010, 2009, and 2008, respectively. Fiscal year 2010, compared with fiscal year 2009, includes lower expenditures for new restaurants as well as reductions in facility improvements. The decrease in cash flows utilized in 2009 compared with 2008 includes lower expenditures for new restaurants as well as reductions in facility improvements. In fiscal year 2011, capital expenditures are expected to be approximately $39 to $41 million. In addition to the construction of 10 new restaurants, we will continue our investment in restaurant remodels and capital improvements. We will also make significant investments in our data infrastructure including the replacement of several key operational and financial systems. Stock Repurchase. During 2008, we purchased a total of 1,480,763 shares of our common stock for approximately $50.0 million with an average purchase price of $33.76 per share. Also during 2008, the Company's board of directors authorized an additional repurchase of up to $50.0 million of the Company's equity securities of which repurchases may be made from time to time in open market transactions and through privately negotiated transactions through December 31, 2011. No shares were repurchased under the plan through fiscal year 2010. The Company intends to spend up to $25 million to repurchase common stock funded by operating cash flow and available credit in the first six months of 2011, subject to appropriate valuation of the Company's shares and other standard considerations. 2009 Option Tender Offer. During the first quarter 2009, we completed a cash tender offer for out-of-the-money stock options held by 514 then current employees. As a result of the tender offer, we incurred a one-time pre-tax charge of $4.0 million for all unvested eligible options that were tendered. This one-time charge represents the compensation expense related to the acceleration of vesting on the unvested options tendered in the offer, which would otherwise have been expensed over their vesting period in the future if they had not been tendered. Approximately $0.9 million of the $4.0 million charge is recorded in labor expense and the remaining $3.1 million is recorded in selling, general and administrative expense in our condensed consolidated statements of income. We paid $3.5 million in cash for the approximate 1.6 million options tendered in the offer. Financial Condition and Future Liquidity. We require capital principally to grow the business through new restaurant construction, as well as to maintain, improve and refurbish existing restaurants, support for infrastructure needs, and for general operating purposes. In addition, we have and may continue to use capital repurchase our common stock. Our primary short-term and long-term sources of liquidity are expected to be cash flows from operations and our revolving credit facility. Based upon current levels of operations and anticipated growth, we expect that cash flows from operations will be sufficient to meet debt service, capital expenditures, and working capital requirements for at least the next twelve months. The Company and the restaurant industry in general maintain relatively low levels of accounts receivable and inventories, and vendors generally grant trade credit for purchases, such as food and supplies. We also continually invest in our business through the addition of new restaurants and refurbishment of existing restaurants, which are reflected as long-term assets and not as part of working capital. We typically maintain current liabilities in excess of our current assets which results in a working capital deficit. We are able to operate with a substantial working capital deficit because restaurant operations are primarily conducted on a cash basis. Rapid turnover results in limited investment in inventories, and cash from sales is usually received before related accounts payable for food, supplies and payroll become due. The primary inflationary factors affecting our operations are food, labor costs, energy costs, and materials used in the construction of new restaurants. A large number of our restaurant personnel are paid at rates based on the applicable minimum wage, and increases in the minimum wage have directly affected our labor costs in recent years. Many of our leases require us to pay taxes, maintenance, repairs, insurance, and utilities, all of which are generally subject to inflationary increases. We believe inflation had a negative impact on our financial condition and results of operations in fiscal year 2010, due primarily to higher costs for certain supplies, and commodity prices for certain foods we purchased at market rates. Our ground beef, which is purchased on the spot market, has consistently been higher than 2009 prices, our hamburger costs as a percentage of revenue were 0.2% higher than 2009. Uncertainties related to fluctuations in costs, including energy costs, commodity prices, annual indexed wage increases and construction materials make it difficult to predict what impact, if any, inflation may have on our business during 2011, but it is anticipated that inflation will continue to have a negative impact in fiscal year 2011. Critical Accounting Policies and Estimates We have identified the following as the Company's most critical accounting policies, which are those that are most important to the portrayal of the Company's financial condition and results and require management's most subjective and complex judgment. Information regarding the Company's other significant accounting policies is disclosed in Note 1, Description of Business and Summary of Significant Accounting Policies, of the Notes to the Consolidated Financial Statements in Part II, Item 8 of this report. Impairment of Long-Lived Assets. Long-lived assets, including restaurant sites, leasehold improvements, other fixed assets, and amortizable intangible assets are reviewed when indicators of impairment are present. Expected cash flows associated with an asset are the key factor in determining the recoverability of the asset. Identifiable cash flows are generally measured at the restaurant level. The estimate of cash flows is based upon, among other things, certain assumptions about expected future operating performance, including assumptions on future revenue trends. Management's estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, changes in economic conditions, changes to our business model, or changes in operating performance. If the sum of the undiscounted cash flows is less than the carrying value of the asset, we recognize an impairment loss, measured as the amount by which the carrying value exceeds the fair value of the asset. Judgments made by management related to the expected useful lives of long-lived assets and our ability to realize undiscounted cash flows in excess of the carrying amounts of such assets are affected by factors such as the ongoing maintenance and improvements of the assets, changes in economic conditions, and changes in operating performance. As the ongoing expected cash flows and carrying amounts of long-lived assets are assessed, these factors could cause us to realize a material impairment charge. During 2010, we determined that four company-owned restaurants were impaired. The Company recognized a non-cash impairment pre-tax charge of $6.1 million related to the impairment of these four restaurants. During 2008, we recorded $1.9 million pre-tax of impairments of certain long-lived restaurants for six restaurants. We may record future impairments for restaurants whose operating performance falls below current expectations. We have followed a consistent approach to evaluating whether there are impairments of long-lived assets. The Company makes adjustments to assumptions to reflect management's view of current market and economic conditions and with respect to conditions at specific locations. Goodwill. We evaluate goodwill annually or more frequently if indicators of impairment are present. We performed step one of the impairment test as of December 26, 2010. Step one of the impairment test is based upon a comparison of the carrying value of our net assets, including goodwill balances, to the fair value of our net assets. Fair value is measured using a combination of the market capitalization method, the income approach, and the market approach. The market capitalization method uses the Company's stock price and a control premium to derive fair value. The income approach consists of utilizing the discounted cash flow method that incorporates our estimates of future revenues and costs, discounted using a risk-adjusted discount rate. Our estimates used in the income approach are consistent with the plans and estimates used to manage operations. The market approach utilizes multiples of profit measures in order to estimate the fair value of the assets. We do evaluate all methods to ensure reasonably consistent results. Additionally, we evaluate the key input factors in the models used to determine whether a moderate change in any input factor or combination of factors would significantly change the results of the tests. Based on the completion of the step one test, we determined that goodwill was not impaired as of December 26, 2010, as the percentage by which the fair value exceeded the carrying value was approximately 14%. However, an impairment charge may be triggered in the future, if the value of our stock declines, sales in our restaurants decline beyond current forecast, or if there are significant adverse changes in the operating environment of the restaurant industry. We have followed a consistent approach to evaluating whether there are impairments of goodwill. The Company makes adjustments to assumptions to reflect management's view of current market and economic conditions. Lease Accounting. Under the provisions of certain of our leases, there are rent holidays and/or escalations in payments over the base lease term, as well as renewal periods. The effects of rent holidays and escalations are reflected in rent costs on a straight-line basis over the expected lease term, which includes cancelable option periods when it is deemed to be reasonably assured that we will exercise such option periods due to the fact that we would incur an economic penalty for not doing so. The lease term commences on the date when we become legally obligated for the rent payments which generally coincides with the time when the landlord delivers the property for us to develop and we waive contract contingencies. All rent costs recognized during construction periods are expensed immediately as pre-opening expenses. Judgments made by management for its lease obligations include the probable term for each lease that affects the classification and accounting for a lease as capital or operating; the rent holidays and/or escalations in payments that are taken into consideration when calculating straight-line rent; and the term over which leasehold improvements for each restaurant facility are amortized. These judgments may produce materially different amounts of depreciation, amortization and rent expense than would be reported if different assumed lease terms were used. We have not made any changes to the assumptions used to account for leases in the past three years. Insurance/Self-Insurance Liabilities. The Company is self-insured for a portion of losses related to group health insurance, general liability and workers' compensation. We maintain stop-loss coverage with third party insurers to limit our total exposure. The self-insurance liability represents an estimate of the cost of claims incurred and unpaid as of the balance sheet date. The estimated liability is not discounted and is established based upon analysis of historical data and actuarial based estimates, as well as incurred but not reported claims, and is closely monitored and adjusted when warranted by changing circumstances. In addition, our history of self-insured experience is short and our significant rate of growth could affect the accuracy of estimates based on historical experience. Should a greater amount of claims occur compared to what was estimated, or should medical costs increase beyond what was expected, our accrued liabilities might not be sufficient, and additional expenses may be recorded. Actual claims experience could also be more favorable than estimated, resulting in expense reductions. Unanticipated changes in our estimates may produce materially different amounts of expense than that reported historically under these programs. We have not made any changes to the assumptions used to account our self-insurance liabilities in the past three years. Estimating Fair Value. The Company has a deferred compensation plan, an associated life insurance policy and derivative financial instruments, which are all carried at fair value. Fair value is defined by accounting guidance as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company's approach to estimating fair value may require the Company to make significant judgments regarding inputs into the valuation In estimating fair values for derivative financial instruments, the Company believes that third-party market prices are the best evidence of exit price and where available, bases its estimates on such prices. All key assumptions and valuations are the responsibility of management. Income Taxes. The determination of the Company's provision for income taxes requires management's judgment in the use of estimates and the interpretation and application of complex tax laws. Judgment is also required in assessing the timing and amounts of deductible and taxable items. The Company establishes contingency reserves for material, known tax exposures relating to deductions, transactions and other matters involving some uncertainty as to the proper tax treatment of the item. The Company's reserves reflect its judgment as to the resolution of the issues involved if subject to judicial review. Several years may elapse before a particular matter, for which the Company has established a reserve, is audited and finally resolved or clarified. While the Company believes that its reserves are adequate to cover reasonably expected tax risks, issues raised by a tax authority may be finally resolved at an amount different than the related reserve. Such differences could materially increase or decrease the Company's income tax provision in the current and/or future periods. When facts and circumstances change (including a resolution of an issue or statute of limitations expiration), these reserves are adjusted through the provision for income taxes in the period of change. To the extent the Company determines that it will not realize the benefit of some or all of its deferred tax assets, then these assets will be adjusted through the Company's provision for income taxes in the period in which this determination is made. Unearned Revenues. Unearned revenues represent our liability for gift cards that have been sold but not yet redeemed. We recognize sales when the gift card is redeemed by the customer. Although there are no expiration dates or dormancy fees for our gift cards, based on our historical gift card redemption patterns, we can reasonably estimate the amount of gift cards for which redemption is remote, which is referred to as "breakage." We recognize breakage within other revenue for unused gift card amounts in proportion to actual gift card redemptions, which is also referred to as the "redemption recognition" method. The estimated value of gift cards expected to go unused is recognized over the expected period of redemption as the remaining gift card values are redeemed. Utilizing this method, we estimate both the amount of breakage and the time period of redemption. If actual redemption patterns vary from our estimates, actual gift card breakage income may differ from the amounts recorded. We update our estimate of our breakage rate periodically and apply that rate to gift card redemptions. Stock-Based Compensation Expense. We account for stock-based compensation in accordance with fair value recognition provisions, under which we recognize stock-based compensation using the Black-Scholes or Monte Carlo (for performance based units) option pricing model and recognize expense on a graded vesting basis over the requisite service periods of an option. Determining the appropriate fair value model and calculating the fair value of share-based payment awards require the input of highly subjective and judgmental assumptions including volatility, forfeiture rates, and expected option life. If any of the assumptions used in the model change significantly, share-based compensation expense may differ materially in the future from that recorded in the current period. We have not made any changes to the assumptions used to account for stock-based compensation in the past three years, other than an increase in the forfeiture rate we apply to officer grants, due to the recent officer transitions. During 2010, the Company granted performance based restricted stock units (PSUs) to executives and other key employees. These PSUs contain a market condition based on Total Shareholder Return and measure the overall stock price performance of the Company to the stock price performance of a selected industry peer group. The actual number of PSUs subject to the awards will be determined at the end of the performance period based on these performance metrics. The fair value of the PSUs is calculated using the Monte Carlo valuation method. This method utilizes multiple input variables to determine the probability of the Company achieving the market condition and the fair value of the awards. This method uses judgment and estimation which is the responsibility of management. Off Balance Sheet Arrangements Except for operating leases (primarily restaurant leases) entered into the normal course of business, we do not have any off balance sheet arrangements. In June 2009, the Financial Accounting Standards Board ("FASB") issued authoritative guidance on the consolidation of variable interest entities ("VIE"), which was effective beginning fiscal year 2010. The new guidance requires a qualitative approach to identifying a controlling financial interest in a VIE, and it requires ongoing assessment of whether an entity is a VIE and whether an interest in a VIE makes the holder the primary beneficiary of the VIE. This new guidance did not have a material effect on the Company. In January 2010, the FASB issued an update regarding guidance over the disclosure requirements of fair value measurements. This update adds new requirements for disclosure about transfers into and out of Levels One and Two and also adds additional disclosure requirements about purchases, sales, issuances, and settlements relating to Level Three measurements. The guidance is effective beginning fiscal year 2010 for the disclosure requirements around Levels One and Two measurements, and is effective beginning fiscal year 2011 for the disclosure requirements around Level Three. This new guidance currently has no impact on the fair value disclosures of the Company, as there have been no transfers out of Levels One or Two. ITEM 7A. Quantitative and Qualitative Disclosures About Market Risk Under our credit agreement, amended in June 2007, we are exposed to market risk from changes in interest rates on borrowings, which bear interest at one of the following rates we select: an Alternate Base Rate (ABR), based on the Prime Rate plus 0.00% to 0.25%, or a LIBOR, based on the relevant one, two, three or six-month LIBOR, at our discretion, plus 0.50% to 1.00%. The spread, or margin, for ABR and LIBOR loans under the credit agreement is subject to quarterly adjustment based on our then current leverage ratio, as defined by the credit agreement. As of December 26, 2010, we had $77.0 million of borrowings subject to variable interest rates, after considering the impact of variable-to-fixed interest rate swaps. A plus or minus 1.0% change in the effective interest rate applied to these loans would have resulted in pre-tax interest expense fluctuation of $770,000 on an annualized basis. Our objective in managing exposure to interest rate changes is to limit the impact of interest rate changes on earnings and cash flows and to lower overall borrowing costs. To achieve this objective, we use an interest rate swap and may use caps to manage our net exposure to interest rate changes related to our borrowings. As appropriate, on the date derivative contracts are entered into, we designate derivatives as either a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), or a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge). During March 2008, the Company entered into a variable-to-fixed interest rate swap agreement with SunTrust to mitigate our floating interest rate on an aggregate of up to $120 million of our debt that is currently or expected to be outstanding under our amended and restated credit facility. The interest rate swap has an effective date of March 19, 2008 and a termination date of March 19, 2010 for $50 million of the initial $120 million and March 19, 2011 for the remaining $70 million. The agreement was designated as a cash flow hedge under which we are required to make payments based on a fixed interest rate of 2.7925% calculated on an initial notional amount of $120 million, in exchange we will receive interest on a $120 million of notional amount at a variable rate. The variable rate interest we receive is based on the 3-month LIBOR rate. This hedge is highly effective and there were no gains or losses related to hedge ineffectiveness recognized in earnings during 2010. As of December 26, 2010, the $1 million unrealized gain, net of taxes, on the cash flow hedging instrument is reported in accumulated other comprehensive (loss). Refer to Note 9, Derivative and Other Comprehensive Income, of Notes to Consolidated Financial Statements in Part II, Item 8 of this report. Primarily all of our transactions are conducted, and our accounts are denominated, in United States dollars. Accordingly, we are not exposed to significant foreign currency risk. Many of the food products purchased by us are affected by changes in weather, production, availability, seasonality, and other factors outside our control. In an effort to control some of this risk, we have entered into some fixed price product purchase commitments which may exclude fuel surcharges and other fees. In addition, we believe that almost all of our food and supplies are available from several sources, which helps to control food commodity risks. Report of Independent Registered Public Accounting Firm 44 Consolidated Balance Sheets 45 Consolidated Statements of Income 46 Consolidated Statements of Stockholders' Equity 47 Consolidated Statements of Cash Flows 48 Notes to Consolidated Financial Statements 49 Greenwood Village, Colorado We have audited the accompanying consolidated balance sheets of Red Robin Gourmet Burgers, Inc. and subsidiaries (the "Company") as of December 26, 2010 and December 27, 2009, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 26, 2010. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Red Robin Gourmet Burgers, Inc. and subsidiaries as of December 26, 2010 and December 27, 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 26, 2010, in conformity with accounting principles generally accepted in the United States of America. We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company's internal control over financial reporting as of December 26, 2010, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2011 expressed an unqualified opinion on the Company's internal control over financial reporting. /s/ DELOITTE & TOUCHE LLP (In thousands, except share amounts) Restricted cash—marketing funds 91 189 Accounts receivable, net 6,983 5,179 Prepaid expenses and other current assets 7,509 6,203 Income tax receivable 3,822 4,713 Deferred tax asset 1,294 4,127 Other assets, net 6,759 4,159 Total assets $ 579,257 $ 600,095 Liabilities and Stockholders' Equity: Trade accounts payable $ 12,776 $ 10,891 Construction related payables 2,943 3,181 Unearned revenue, net 14,391 15,437 Accrued liabilities 18,592 19,483 Current portion of term loan notes payable 18,739 18,739 Current portion of long-term debt and capital lease obligations 838 779 Total current liabilities 97,416 95,422 Deferred rent 34,214 30,996 Long-term portion of term loan notes payable 85,214 103,954 Other long-term debt and capital lease obligations 53,731 67,862 Other non-current liabilities 8,021 13,239 Common stock; $0.001 par value: 30,000,000 shares authorized; 17,101,897 and 17,079,267 shares issued; 15,600,867 and 15,586,948 shares outstanding 17 17 Preferred stock, $0.001 par value: 3,000,000 shares authorized; no shares issued and outstanding — — Treasury stock 1,501,030 and 1,492,280 shares, at cost (50,321 ) (50,125 ) Accumulated other comprehensive loss, net of tax (197 ) (1,212 ) Total stockholders' equity 300,661 288,622 Total liabilities and stockholders' equity $ 579,257 $ 600,095 See Notes to Consolidated Financial Statements. Restaurant revenue $ 846,389 $ 828,031 $ 854,690 Franchise royalties and fees 13,409 12,825 14,323 Other revenue 4,471 189 202 Total revenues 864,269 841,045 869,215 Restaurant operating costs: Cost of sales (exclusive of depreciation and amortization shown separately below): 206,639 199,195 203,463 Labor (includes $839 , $1,371, and $1,229 of stock-based compensation, respectively) 300,878 287,981 289,702 Operating 125,137 122,183 123,823 Occupancy 63,055 62,420 56,908 Depreciation and amortization 56,738 57,166 51,687 Selling, general and administrative expenses (includes $3,273 $5,514 and $5,602 of stock-based compensation, respectively 88,836 76,260 83,379 Franchise development 4,122 4,203 4,597 Pre-opening costs 3,015 3,696 8,109 Asset impairment charge 6,116 — 1,906 Reacquired franchise and other acquisition costs — — 451 Total costs and expenses 854,536 813,104 824,025 Income from operations 9,733 27,941 45,190 Interest expense 5,112 6,903 8,557 Interest income (63 ) (111 ) (320 ) Other (46 ) (380 ) 14 Total other expenses 5,003 6,412 8,251 Income before income taxes 4,730 21,529 36,939 Provision (benefit) for income taxes (2,569 ) 3,930 9,813 Net income $ 7,299 $ 17,599 $ 27,126 Basic $ 0.47 $ 1.14 $ 1.70 Diluted $ 0.46 $ 1.14 $ 1.69 Basic 15,536 15,392 15,927 Diluted 15,709 15,504 16,047 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Accumulated (Loss) net of tax Paid-in Balance, December 30, 2007 16,805 $ 17 11 $ (83 ) $ 156,928 $ — $ 127,580 $ 284,442 Exercise of options, issuance of restricted stock, shares exchanged for exercise, and tax 130 — — — 946 — — 946 Tax benefit on exercise of stock options — — — — 326 — — 326 Acquisition of treasury stock — — 1,481 (50,042 ) — — — (50,042 ) Non-cash stock compensation — — — — 7,222 — — 7,222 Common stock issued through employee stock purchase plan 19 — — — 510 — — 510 Net income — — — — — — 27,126 27,126 Unrealized loss on cash flow hedge, net of tax — — — — — (1,622 ) — (1,622 ) Comprehensive income 25,504 Balance, December 28, 2008 16,954 17 1,492 (50,125 ) 165,932 (1,622 ) 154,706 268,908 Exercise of options, issuance of restricted stock, shares exchanged for exercise, and tax 94 (3,773 ) (3,773 ) Tender offer, net of tax of $1.3 million — — — — (2,167 ) — — (2,167 ) Unrealized gain on cash flow hedge, net of tax — — — — — 410 — 410 Comprehensive income — — — — — — — 18,009 Exercise of options, issuance of restricted stock, shares exchanged for exercise, and tax (9 ) — 9 (196 ) (263 ) — — (459 ) Tax benefit (expense) on exercise of stock options — — — — (502 ) — — (502 ) Net income — — — — — — 7,299 7,299 Unrealized gain on cash flow hedge, net of tax — — — — — 1,015 — 1,015 Comprehensive income — — — — — — — 8,314 Balance, December 26, 2010 17,102 $ 17 1,501 $ (50,321 ) $ 171,558 $ (197 ) $ 179,604 $ 300,661 Adjustments to reconcile net income to net cash provided by operating activities: Gift card breakage (4,286 ) — — Provision (benefit) for deferred income taxes (2,199 ) (1,290 ) 6,670 Amortization of debt issuance costs 342 342 310 Stock-based compensation 4,112 6,889 6,831 Restaurant closure costs 856 562 — Changes in operating assets and liabilities, net of effects of acquired business: Accounts receivable (1,108 ) 908 (848 ) Inventories (1,510 ) (1,403 ) (1,961 ) Prepaid expenses and other current assets (1,305 ) 3,583 759 Income tax receivable 891 1,495 (1,448 ) Other assets (3,183 ) (825 ) (1,051 ) Trade accounts payable and accrued liabilities 4,635 1,383 (3,879 ) Deferred rent 3,215 4,206 5,062 Net cash provided by operating activities 70,613 90,615 91,164 Purchases of property and equipment (34,962 ) (48,469 ) (83,227 ) Acquisition of franchise restaurants, net of cash acquired — (1,248 ) (29,969 ) Changes in marketing fund restricted cash (98 ) 169 72 Net cash used in investing activities (35,060 ) (49,548 ) (113,124 ) Borrowings of long-term debt 193,200 204,900 164,950 Payments of long-term debt and capital leases (231,943 ) (235,956 ) (96,486 ) Purchase of treasury stock — — (50,042 ) Proceeds from exercise of stock options and employee stock purchase plan 811 1,051 1,456 Payment of tender offer for stock options — (2,167 ) — Excess tax benefit related to exercise of stock options — 215 326 Net cash (used in) / provided by financing activities (37,932 ) (31,957 ) 20,204 Net increase (decrease) in cash and cash equivalents $ (2,379 ) $ 9,110 $ (1,756 ) Cash and cash equivalents, beginning of year 20,268 11,158 12,914 Cash and cash equivalents, end of year $ 17,889 $ 20,268 $ 11,158 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Description of Business and Summary of Significant Accounting Policies Red Robin Gourmet Burgers, Inc. (Red Robin or the Company), a Delaware corporation, develops and operates casual-dining restaurants. At December 26, 2010, the Company operated 314 company-owned restaurants located in 31 states. The Company also sells franchises, of which there were 136 restaurants, in 21 states and two Canadian provinces as of December 26, 2010. The Company operates its business as one operating and one reportable segment. Principles of Consolidation and Fiscal Year—The consolidated financial statements of the Company include the accounts of Red Robin and its wholly owned subsidiaries after elimination of all material intercompany accounts and transactions. The Company's fiscal year is 52 or 53 weeks ending the last Sunday of the calendar year. Fiscal years 2010, 2009, and 2008 include 52 weeks. The 2011 fiscal year will be 52 weeks ending December 25, 2011. Reclassifications—We have reclassified certain items in the accompanying Consolidated Financial Statements for prior periods to be comparable with the classification for the fiscal years ended December 26, 2010. These reclassifications had no effect on previously reported net income. Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The areas that require management's most significant estimares are impairment of long lived assets, goodwill, lease accounting, insurance/self-insurance, estimating fair value, income taxes, unearned revenue and stock based compensation expense. Actual results could differ from those estimates. Cash Equivalents—The Company considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. Amounts receivable from credit card issuers are typically converted to cash within two to four days of the original sales transaction. Accounts Receivable—Accounts receivable consists primarily of trade receivables due from franchisees for royalties. In 2010, there was approximately $1.8 million related to tenant improvement allowances in accounts receivable. The allowance for doubtful accounts as of December 26, 2010 and December 27, 2009 was $301,000 and $375,000, respectively. Inventories—Inventories consist of food, beverages, and supplies valued at the lower of cost (first-in, first-out method) or market. As of December 26, 2010 and December 27, 2009, food and beverage inventories were $5.4 million and $5.0 million, respectively, and supplies inventories were $10.6 million and $9.5 million, respectively. Restricted Cash-Marketing Funds—Restricted cash is restricted solely for use by the Company's cooperative marketing fund programs and have been segregated from the Company's assets. All U.S. franchisees and Company restaurants contributed 0.75% of adjusted sales for the first quarter 2010 and 2.0% of adjusted sales for the last three quarters of 2010 to one or more marketing funds to be used for future advertising in accordance with the terms of the programs. Property and Equipment—Property and equipment are recorded at cost. Expenditures for major additions and improvements are capitalized and minor replacements, maintenance, and repairs are expensed as incurred. Depreciation is computed on the straight-line method, based on the shorter of NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) 1. Description of Business and Summary of Significant Accounting Policies (Continued) the estimated useful lives or the terms of the underlying leases of the related assets. Interest incurred on funds used to construct company-owned restaurants is capitalized and amortized over the estimated useful life of the related assets. Capitalized interest totaled $68,000 in 2010, $110,000 in 2009, and $283,000 in 2008. The estimated useful lives for property and equipment are: Buildings 5 to 20 years Leasehold improvements Shorter of lease term or estimated useful life, not to exceed 20 years Furniture, fixtures and equipment 3 to 7 years Restaurant property leased to others 3 to 20 years The Company capitalizes certain overhead related to the development and construction of its new restaurants. Capitalized overhead for the years ended December 26, 2010, December 27, 2009, and December 28, 2008, was $2.4 million, $2.7 million, and $3.3 million, respectively. Costs incurred for the potential development of restaurants that are subsequently terminated are expensed. No such expense has been incurred in any of the fiscal years presented. Goodwill and Intangible Assets, net—Goodwill represents the excess of purchase price over the fair value of identifiable net assets acquired. Intangible assets, net are comprised primarily of leasehold interests, acquired franchise rights and the costs of purchased liquor licenses. Leasehold interests primarily represent the fair values of acquired lease contracts having contractual rents lower than fair market rents and are amortized on a straight-line basis over the remaining initial lease term. Acquired franchise rights, which represented the acquired value of franchise contracts, are amortized over the term of the franchise agreements. Liquor licenses are generally amortized over one to five years. Goodwill, which is not subject to amortization, is evaluated for impairment annually or more frequently at the level of the Company's single operating segment if indicators of impairment are present. The Company performed step one of the impairment test on the last day of the fiscal year, December 26, 2010. Step one of the impairment test is based upon a comparison of the carrying value of net assets, including goodwill balances, to the fair value of net assets. Based on the completion of the step one test, it was determined that no impairment charges of goodwill were required. Additionally, when we close individual restaurants, we consider whether the cost of closure should include an amount of goodwill based on the fair value method. There was no goodwill charged off in connection with 2010 restaurant closures. Impairment of Long-Lived Assets—The Company reviews its long-lived assets, including land, property and equipment, and amortizable intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to the future undiscounted net cash flows expected to be generated by the assets. Identifiable cash flows are measured at the lowest level for which they are largely independent of the cash flows of other groups of assets and liabilities, generally at the restaurant level. If the assets are determined to be impaired, the amount of impairment recognized is the amount by which the carrying amount of the assets exceeds their fair value. Fair value is generally determined using forecasted cash flows discounted using an estimated weighted average cost of capital. Restaurant sites and other assets to be disposed of are reported at the lower of their carrying amount or fair value, less estimated costs to sell. During 2010 and 2008, the Company recorded impairments of certain long-lived assets. See Note 4, Restaurant Impairment and Restaurant Closures. There were no impairments recorded in 2009. Fair Value Measurements—The Company measures certain financial assets and liabilities at fair value in accordance with the accounting guidance for measuring fair value. These assets and liabilities are measured at each reporting period, and certain of these are revalued as required. See Note 10, Fair Value Measurements. Other Assets, net—Other assets, net consist primarily of assets related to the employee deferred compensation plan, unamortized debt issuance costs and various deposits. Debt issuance costs are capitalized and amortized to interest expense on a straight-line basis which approximates the effective interest rate method over the term of the Company's long term debt. Debt issuance costs as of December 26, 2010, and December 27, 2009 were $500,000 and $842,000, respectively. Revenue Recognition—Revenues consist of sales from restaurant operations, gift card breakage, franchise royalties and fees, and rental income. Revenues from restaurant sales are recognized when payment is tendered at the point of sale. The Company sells gift cards which do not have an expiration date, and it does not deduct dormancy fees from outstanding gift card balances. The Company recognizes revenue from gift cards when: (i) the gift card is redeemed by the customer; or (ii) the likelihood of the gift card being redeemed by the customer is remote (gift card breakage), and the Company determines that there is not a legal obligation to remit the unredeemed gift card balance to the relevant jurisdiction. The determination of the gift card breakage rate is based upon the Company's specific historical redemption patterns. The Company recognizes gift card breakage by applying its estimate of the rate of gift card breakage over the period of estimated performance (currently 24 months). The Company completed its initial analysis of unredeemed gift card liabilities for gift cards that it sold in its restaurants during the first quarter 2010, and recognized $3.5 million into revenue as a one time adjustment. For the fiscal year ended 2010, the Company recognized $4.3 million (inclusive of the one time adjustment) into revenue related to unredeemed gift card breakage. The Company has not recognized breakage on third party gift card sales due to the relatively young age of the third party gift card program. Gift card breakage is included in other revenue in the consolidated statements of operations. Unearned gift card revenue at December 26, 2010 and December 27, 2009, was $14.0 million and $15.4 million, respectively. The Company typically grants franchise rights to independent contractors for a term of 20 years, with the right to extend the term for an additional ten years if they satisfy various conditions. The Company provides management expertise, training, pre-opening assistance and restaurant operating assistance in exchange for area development fees, franchise fees, license fees and royalties of 3% to 4% of the franchised adjusted gross restaurant sales. The Company recognizes area development fees and franchise fees as income when the Company has performed all material obligations and initial services, which generally occurs upon the opening of the new restaurant. Until earned, these fees are accounted for as deferred revenue. Deferred revenue for franchise fees (included in accrued liabilities on the balance sheet) totaled $230,000 and $375,000 as of December 26, 2010 and December 27, 2009, respectively. Area development fees are recognized proportionately with the opening of each new restaurant. Royalties are accrued as earned and are calculated each period based on the franchisee's reported adjusted sales. Advertising—Advertising and marketing costs are expensed as incurred. Advertising and marketing costs were $28.9 million, $17.2 million, and $24.4 million in 2010, 2009, and 2008, respectively, and are included in selling, general, and administrative expenses in the consolidated statements of income. Under the Company's franchise agreements, both the Company and the franchise partners must contribute a minimum percentage of revenues to two marketing and national media advertising funds (the Marketing Funds). These Marketing Funds are used to develop and distribute Red Robin® branded marketing materials, for media purchases and for administrative costs. The Company's portion of costs incurred by the Marketing Funds is recorded as selling, general and administrative expenses in the Company's financial statements. Restricted assets represent contributed funds held for future use. Rent—Our leases generally contain escalating rent payments over the lease term as well as optional renewal periods. We account for our leases by recognizing rent expense on a straight-line basis over the lease term, which includes reasonably assured renewal periods. The lease term begins when the Company has the right to control the use of the property, which is typically before rent payments are due under the lease agreement. The difference between the rent expense and rent paid is recorded as deferred rent in the consolidated balance sheet. Rent expense for the period prior to the restaurant opening is expensed in pre-opening costs. Tenant incentives used to fund leasehold improvements are recorded in deferred rent and amortized as reductions of lease rent expenses ratably over the lease term. Additionally, certain of the Company's operating lease agreements contain clauses that provide additional contingent rent based on a percentage of sales greater than certain specified target amounts. The Company recognizes contingent rent expense prior to the achievement of the specified target that triggers contingent rent, provided the achievement of that target is considered probable. See Note 13, Commitments and Contingencies. Self-Insurance Programs—The Company utilizes a self-insurance plan for health, general liability, and workers' compensation coverage. Predetermined loss limits have been arranged with insurance companies to limit the Company's per occurrence cash outlay. Accrued liabilities and accrued payroll and payroll-related liabilities include the estimated cost to settle reported claims and incurred but unreported claims. Pre-opening Costs—Pre-opening costs are expensed as incurred. Pre-opening costs include rental expenses through the date of opening for each restaurant, travel expenses, wages and benefits for the training and opening teams, and food, beverage and other restaurant opening costs incurred prior to a restaurant opening for business. Income Taxes—Deferred tax liabilities are recognized for the estimated effects of all taxable temporary differences, and deferred tax assets are recognized for the estimated effects of all deductible temporary differences and net operating losses, if any, and tax credit carryforwards. Measurement of the Company's current and deferred tax liabilities and assets is based on provisions of enacted tax laws. Earnings Per Share—Basic earnings per share amounts are calculated by dividing net income by the weighted-average number of common shares outstanding during the year. Diluted earnings per share amounts are calculated based upon the weighted average number of common and potentially dilutive common shares outstanding during the year. Potentially dilutive shares are excluded from the computation in periods in which they have an anti-dilutive effect. Diluted earnings per share reflect the potential dilution that could occur if holders of options exercised their holdings into common stock. During 2010, 2009, and 2008, a total of 511,000, 816,000, and 1.8 million weighted-average stock options outstanding were not included in the computation of diluted earnings per share because to do so would have been anti-dilutive for the periods presented. The Company uses the treasury stock method to calculate the impact of outstanding stock options. The computations for basic and diluted earnings per share are as follows (in thousands, except per share data): Basic weighted average shares outstanding 15,536 15,392 15,927 Dilutive effect of stock options and awards 173 112 120 Diluted weighted average shares outstanding 15,709 15,504 16,047 Comprehensive Income—Comprehensive income consists of the net income and other gains and losses affecting stockholders' equity that, under accounting principles generally accepted in the United States, are excluded from net income. Other comprehensive loss as presented in the consolidated statements of stockholders' equity for 2010 and 2009 consisted of the unrealized loss, net of tax, on the Company's cash flow hedge which will expire in March 2011. See Note 9. Derivative and Other Comprehensive Income. Stock Compensation Expense—The Company maintains several equity incentive plans under which it may grant stock options, stock appreciation rights, restricted stock, stock bonuses or other forms of awards granted or denominated in the Company's common stock or units of the Company's common stock, as well as cash bonus awards to employees, non-employees, directors and consultants. In 2010, the Company granted performance based restricted stock units ("PSUs") to executives and other key employees. These PSUs are subject to company performance metrics based on Total Shareholder Return and measure the overall stock price performance of the Company to the stock price performance of a selected industry peer group, thus resulting in a market condition. The Company also maintains an employee stock purchase plan. See Note 16, Stock Incentive Plans, for additional details. 2. Recent Accounting Pronouncements In June 2009, the Financial Accounting Standards Board ("FASB") issued authoritative guidance on the consolidation of variable interest entities ("VIE"), which was effective beginning fiscal year 2010. The new guidance requires a qualitative approach to identifying a controlling financial interest in a VIE, and it requires ongoing assessment of whether an entity is a VIE and whether an interest in a 2. Recent Accounting Pronouncements (Continued) VIE makes the holder the primary beneficiary of the VIE. This new guidance did not have a material effect on the Company. 3. Acquisition of Red Robin Franchised Restaurants The Company did not acquire any franchised restaurants during the fiscal year 2010. Managed Restaurant On December 31, 2008, the Company completed the acquisition of a restaurant location that the Company had previously operated under a management services agreement. The Company had assumed management of the restaurant effective June 18, 2007. Under the terms of the management services agreement, the Company had assumed all operating responsibilities of this restaurant in exchange for a management fee equal to all the revenues from this restaurant. In accordance with the authoritative guidance for VIE's in effect at the time, management had determined that the Company was the primary beneficiary of the operations of this restaurant and therefore has consolidated its results of operations with the Company's results since June 18, 2007, the date of the management services agreement. As a result of the completion of the purchase price allocation for this acquisition during fiscal year 2009, the Company recognized $787,000 of goodwill. Franchise Acquisitions in 2008 During the second quarter 2008, the Company completed its acquisitions of 15 existing Red Robin® franchised restaurants from three franchisees for a combined purchase price of $30.0 million. The purchase price was paid in cash, funded primarily through borrowings under the Company's credit facility. In addition, on April 15, 2008, the Company completed the purchase of an entity that owned a Red Robin® franchise restaurant that was under construction in Eau Claire, Wisconsin, which was then opened by the Company on May 5, 2008. The Company acquired the outstanding stock of the entity in exchange for $247,000 in cash and the assumption of indebtedness in the amount of approximately $850,000. In addition to the above-described acquisitions of existing restaurants, the Company gained access to development rights where these restaurants are located—territories that were formerly subject to exclusivity provisions in the former area development agreements with the selling franchisees. The financial results of all 16 restaurants have been included in the Company's financial results from their acquisition dates forward. The acquisition of the 16 restaurants was accounted for using the authoritative guidance for business combinations in effect at the time of acquisition. Based on a total purchase price of $30.0 million, net of a $451,000 charge related to the purchase of the restaurants, and the Company's estimates of the fair value of net assets acquired, $4.7 million of goodwill was generated by the 3. Acquisition of Red Robin Franchised Restaurants (Continued) acquisition, which is not amortizable for book purposes but is amortizable and deductible for tax purposes. Of the $12.9 million of intangible assets, $10.1 million was assigned to franchise rights with a weighted average life of approximately 20 years, and $2.8 million was assigned to leasehold interests with a weighted average life of approximately 20 years. As a result of the acquisition of the 16 restaurants, the Company incurred a total charge of $451,000, of which $402,000 is related to avoided franchise fees. Pro Forma Results (unaudited) Under the authoritative guidance for business combinations, the following unaudited pro forma information presents a summary of the results of operations of the Company assuming the 2008 acquisitions of the franchise restaurants occurred at the beginning of the period presented. Pro forma net income for 2008 excludes a nonrecurring $451,000 pre-tax charge, $331,000 net of tax, related to the reacquired franchise rights and other acquisition costs associated with the 2008 franchise acquisitions. The pro forma financial information is presented for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisition had taken place at the beginning of the period presented, nor is it indicative of future operating results. Revenue $ 884,224 Net income 27,994 Basic EPS 1.76 Diluted EPS 1.74 4. Restaurant Impairment and Restaurant Closures Restaurant Impairment During 2010, we determined that the long lived assets of four company-owned restaurants were impaired, and the Company recognized a non-cash impairment charge of $6.1 million resulting from the continuing and projected losses of these restaurants. We reviewed each restaurant's past and present operating performance combined with projected future results, primarily through projected undiscounted cash flows, which indicated possible impairment. The Company compared the carrying amount of each restaurant's assets to its fair value as estimated by management. The impairment charge represents the excess of each restaurant's carrying amount over its estimated fair value. The Company closed three restaurants in the fiscal year 2010. Two closed locations were at the end of their lease term and management did not believe the other location would provide acceptable returns in the foreseeable future. In fiscal fourth quarter 2008, we impaired one of these locations. There was no associated amount of goodwill to write off in connection with these closures. The Company incurred $856,000 in expenses related to these restaurant closures for fiscal year 2010. 4. Restaurant Impairment and Restaurant Closures (Continued) The Company closed four restaurants in the first quarter of 2009. This decision was the result of an initiative to identify restaurants that are in declining trade areas, performing below acceptable profitability levels and/or require significant capital expenditures. The locations closed in 2009 represented older restaurants whose leases were not extended or were in need of significant capital improvements that were not projected to provide acceptable returns in the foreseeable future. We evaluated the 2009 restaurant closures and determined there was no associated amount of goodwill to write-off in connection with these closures. During 2008, the Company recognized non-cash asset impairment charges of $1.0 million related to the write-down of the carrying value of a portion of long-lived assets associated with these restaurants. The Company recognized additional charges of $562,000 during 2009 related to lease terminations and other closing related costs. The Company recognized $0.9 million of non-cash impairment charges in the third quarter of 2008 for two restaurants one of which was closed in 2010 and one which has continuing operations. The Company reviewed each location's past and present operating performance combined with projected future results, primarily through projected undiscounted cash flows, which indicated possible impairment. The carrying amount of assets attributable to each location was compared to its fair value to determine the impairment charge required. 5. Property and Equipment Property and equipment consist of the following at December 26, 2010, and December 27, 2009, (in thousands): Land $ 35,190 $ 35,116 Buildings 75,461 69,853 Leasehold improvements 415,041 402,869 Furniture, fixtures and equipment 198,533 189,642 Restaurant property leased to others 4,561 4,561 Construction in progress 4,989 6,456 Accumulated depreciation and amortization (319,727 ) (276,961 ) Property and equipment, net $ 414,048 $ 431,536 Depreciation and amortization expense on property and equipment, including assets under capital lease, was $52.1 million in 2010, $52.3 million in 2009 and $47.5 million in 2008. In 2010, the Company recognized an impairment to depreciable property and equipment and intangible assets subject to amortization relating to the restaurant impairment discussed in Note 4, Restaurant Impairment and Restaurant Closures. The impairment charge reduced the total carrying amount of total property and equipment by $6.1 million, net. 6. Goodwill and Intangible Assets The following table presents goodwill as of December 26, 2010, and December 27, 2009, (in thousands). Balance at beginning of year $ 61,769 $ 60,982 Acquisitions (See Note 3) — 787 Balance at end of year $ 61,769 $ 61,769 The following table presents intangible assets subject to amortization as of December 26, 2010, and December 27, 2009, (in thousands): Intangible assets subject to amortization: Franchise rights $ 43,494 $ (11,925 ) $ 31,569 $ 44,346 $ (9,592 ) $ 34,754 Leasehold interests 12,955 (2,945 ) 10,010 12,955 (2,144 ) 10,811 Liquor licenses 7,661 (6,184 ) 1,477 6,833 (4,972 ) 1,861 $ 64,110 $ (21,054 ) $ 43,056 $ 64,134 $ (16,708 ) $ 47,426 There were no impairments of intangible assets subject to amortization in 2010 or 2009. The aggregate amortization expense related to intangible assets subject to amortization for 2010,2009, and 2008 was $4.6 million, $4.7 million and $4.1 million, respectively. The estimated aggregate future amortization expense as of December 26, 2010 is as follows, (in thousands): 2011 $ 4,512 7. Accrued Payroll and Payroll Related Liabilities and Accrued Liabilities Accrued payroll and payroll related liabilities consist of the following at December 26, 2010, and December 27, 2009, (in thousands): Payroll $ 8,118 $ 7,381 Corporate and restaurant bonuses 3,920 3,761 Workers compensation insurance 5,939 4,747 Accrued vacation 5,629 5,397 Federal and state payroll taxes 3,389 3,523 Other 2,142 2,103 $ 29,137 $ 26,912 Accrued liabilities consist of the following at December 26, 2010, and December 27, 2009, (in thousands): State and city sales taxes $ 4,741 $ 4,687 Interest rate swap, current(1) 411 1,833 Real estate, personal property, state income and other taxes payable 3,061 3,220 General liability insurance 2,378 3,082 Utilities 2,050 1,683 Credit card fees 1,211 1,266 See Note 9 Derivative and Other Comprehensive Income 8. Borrowings Borrowings at December 26, 2010, and December 27, 2009, are summarized below (in thousands): Borrowings Term loan facility $ 103,954 3.19 % $ 122,693 3.79 % Revolving credit facility, variable interest rate based on an applicable margin plus LIBOR 43,000 1.28 61,992 1.32 Capital lease obligations 11,568 6.04 6,649 8.07 Total Debt 158,522 191,334 Less: Current portion (19,577 ) (19,518 ) Long-term debt $ 138,945 $ 171,816 8. Borrowings (Continued) Maturities of long-term debt and capital lease obligations as of December 26, 2010 are as follows (in thousands): 2011 $ 19,577 Thereafter 7,926 The Company's credit facility is comprised of (i) a $150 million revolving credit facility maturing on June 15, 2012, and (ii) a $150 million term loan maturing on June 15, 2012, both with rates initially based on the LIBOR plus 0.50% to 1.00% depending on the Company's leverage ratios. The credit agreement also allows, subject to lender participation, the Company to increase the credit facility by up to an additional $100 million in the future or extend its maturity. At inception, the Company borrowed $150.0 million under the term loan facility and used the proceeds to repay all borrowings under the prior credit facility, to pay related transaction fees and expenses and to fund restaurant acquisitions. The term loan is scheduled to be repaid in consecutive quarterly installments of $4.7 million through March 2012 with an estimated final payment of $75.8 million in June 2012. Total repayments are estimated to be $18.7 million for calendar year 2011 and $80.5 million for calendar year 2012 assuming no repayment or refinancing of the credit facility. At December 26, 2010, the Company had $104 million in outstanding borrowings under the term loan facility and $43.0 million in outstanding borrowings under the revolving credit facility. As part of the credit agreement, the Company may also request the issuance of up to $15 million in letters of credit, the outstanding amount of which reduces the net borrowing capacity under the agreement. At December 26, 2010, the Company had letters of credit outstanding of $6.6 million. The credit facility requires the payment of an annual commitment fee based upon the unused portion of the credit facility. The credit facility's interest rates and the annual commitment rate are based on a financial leverage ratio, as defined in the credit agreement. The Company's obligations under the credit facility are secured by first priority liens and security interests in the capital stock of subsidiaries of the Company and certain owned real property. The Company and certain of its subsidiaries granted liens in substantially all personal property assets to secure the respective obligations under the credit facility. Additionally, certain of the Company's real and personal property secure other indebtedness of the Company. Loan origination costs associated with the various amendments to the credit facility and the net outstanding balance of costs related to the credit facility are $500,000 and are included as deferred costs in other assets, net in the accompanying consolidated balance sheet as of December 26, 2010. During March 2008, the Company entered into a variable-to-fixed interest rate swap agreement with SunTrust to hedge the Company's floating interest rate on an aggregate of up to $120 million of debt that is currently or expected to be outstanding under the Company's credit facility. Refer to Note 9, Derivative and Other Comprehensive Income. The Company is subject to a number of customary covenants under the various borrowing agreements, including limitations on additional borrowings, acquisitions, capital expenditures, lease commitments, dividend payments, and is required to maintain certain financial ratios. As of December 26, 2010, the Company was in compliance with all of its debt covenants. For all of 2010, we remained well below the maximum debt leverage ratio of 2.5-to-1 set forth in our credit agreement. 9. Derivative and Other Comprehensive Income The Company enters into derivative instruments for risk management purposes only, including derivatives designated as a cash flow hedge under guidance for derivative instruments and hedging activities. The Company uses interest rate-related derivative instruments to manage its exposure to fluctuations in interest rates. By using these instruments, the Company exposes itself, from time to time, to credit risk and market risk. Credit risk is the failure of either party to the contract to perform under the terms of the derivative contract. When the fair value of a derivative contract is positive, the counterparty owes the Company, which creates credit risk for the Company. The Company minimizes the credit risk by entering into transactions with high-quality counterparties whose credit rating is evaluated on a quarterly basis. The Company's counterparty in the interest rate swap is SunTrust Bank, National Association (SunTrust). Market risk, as it relates to the Company's interest-rate derivative, is the adverse effect on the value of a financial instrument that results from changes in interest rates. The Company minimizes market risk by establishing and monitoring parameters that limit the types and degree of market risk that the Company takes. In March 2008, the Company entered into the variable-to-fixed interest rate swap agreement with SunTrust to hedge the Company's floating interest rate on an aggregate of up to $120 million of debt that is currently outstanding under the Company's amended and restated credit facility. The interest rate swap has an effective date of March 19, 2008, and $50 million of the initial $120 million expired on March 19, 2010, in accordance with its original term, and the remaining $70 million will expire on March 19, 2011. The Company is required to make payments based on a fixed interest rate of 2.7925% calculated on the remaining notional amount of $70 million. In exchange, the Company will receive interest on $70 million of the notional amount at a variable rate that is based on the 3-month LIBOR rate. The Company entered into the above interest rate swap with the objective of offsetting the variability of its interest expense that arises because of changes in the variable interest rate for the designated interest payments and designated the swap as a cash flow hedge since its inception. Accordingly, changes in fair value of the interest rate swap contract were recorded, net of taxes, as a component of accumulated other comprehensive loss ("AOCL") in the accompanying condensed consolidated balance sheets. The Company reclassifies the effective gain or loss from AOCL, net of tax, on the Company's consolidated balance sheet to interest expense on the Company's consolidated statements of income as the interest expense is recognized on the related debt. 9. Derivative and Other Comprehensive Income (Continued) The following table summarizes the fair value and presentation in the condensed consolidated balance sheets of the interest rate swap as hedging instruments as of December 26, 2010 and December 27, 2009 (in thousands): Derivative Liability Balance Sheet Location Fair value at Accrued liabilities $ 411 $ 1,833 Other non-current liabilities — 222 Total derivatives $ 411 $ 2,055 The following table summarizes the effect of the interest rate swap on the condensed consolidated statements of income for the fiscal years ended December 26, 2010 and December 27, 2009 (in thousands): Unrealized loss on swap in AOCL (pretax) $ 357 $ 1,630 Realized loss (pretax effective portion) recognized in interest expense $ 2,022 $ 2,284 As a result of this activity, AOCL decreased by $1.7 million on a pretax basis or $1.0 million on an after tax basis for the fiscal year ended December 26, 2010, decreased by $812,000 on a pretax basis or $410,000 on an after tax basis for the fiscal year ended December 27, 2009, and increased by $2.8 million on a pretax basis or $1.7 million on an after tax basis for the fiscal year ended December 28, 2008. During 2010, the interest rate swap had no hedge ineffectiveness, as a result, no gains or losses were reclassified into net earnings as a result of hedge ineffectiveness. The Company expects no ineffectiveness in the remaining months of the swap. Additionally, the Company had no obligations at December 26, 2010 to post collateral under the terms of the Interest Rate Swap Agreement. Comprehensive income consists of net income and other gains and losses affecting stockholders' equity that are excluded from net income. Comprehensive income consisted of (in thousands): Unrealized gain / (loss) on cash flow hedge, net of tax 1,015 410 (1,622 ) Total comprehensive income $ 8,314 $ 18,009 $ 25,504 10. Fair Value Measurements Fair value measurements are made under a three-tier fair value hierarchy, which prioritizes the inputs used in the measuring of fair value: Level 1: Observable inputs that reflect unadjusted quoted prices in active markets that are accessible at the measurement date for identical, unrestricted assets or liabilities. 10. Fair Value Measurements (Continued) Level 2: Inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3: Inputs that are generally unobservable. These inputs may be used with internally developed methodologies that result in management's best estimate of fair value. Assets and Liabilities Measured at Fair Value The derivative liability associated with the interest rate swap is considered to be a Level Two instrument. The interest rate swap is a standard cash flow hedge whose fair value is estimated using industry-standard valuation models. Such models project future cash flows and discount the future amounts to a present value using market-based observable inputs, including interest rate curves. See Note 9, Derivative and Other Comprehensive Income, for the discussion of the derivative liability. The Company's deferred compensation plan is a nonqualified deferred compensation plan which allows highly compensated employees to defer a portion of their base salary, bonuses, and commissions each plan year. The carrying value of both the liability for the deferred compensation plan and associated life insurance policy are equal to their fair value. These agreements are required to be measured at fair value on a recurring basis and are valued using Level Two inputs. See Note 17 Employee Benefit Programs. At December 26, 2010, and December 27, 2009, a liability for participant contributions and investment income thereon of $2.6 million and $2.4 million, respectively, is included in other non-current liabilities. To offset its obligation, the Company's plan administrator purchases corporate-owned whole-life insurance contracts on certain team members. The cash surrender value of these policies at December 26, 2010, and December 27, 2009, was $2.5 million and $2.3 million, respectively, is included in other assets, net. As of December 26, 2010, the Company had no financial assets or liabilities that were measured using Level 1 or Level 3 inputs. The Company also had no non-financial assets or liabilities that were required to be measured on a recurring basis. The following table presents our assets and liabilities measured at fair value, of which the derivative, deferred compensation plan, and life insurance policy are valued on a recurring basis for the fiscal years ended December 26, 2010 and December 27, 2009 (in thousands): Life insurance policy $ 2,510 $ — $ 2,510 $ — Total assets measured at fair value $ 2,510 $ — $ 2,510 $ — Liabilities: Derivative 411 — 411 — Deferred compensation plan 2,545 — 2,545 — Total liabilities measured at fair value $ 2,956 $ — $ 2,956 $ — Derivative 2,055 — 2,055 — Disclosures of Fair Value of Other Assets and Liabilities The Company's liabilities under its credit facility and capital leases are carried at historical cost in the accompanying consolidated balance sheet. For disclosure purposes, we estimate the fair value of the credit facility and capital lease obligations using discounted cash flow analysis based on market rates obtained from independent third parties for similar types of debt. Both the credit facility and the Company's capital lease obligations are considered to be Level 2 instruments. The fair value of the Company's credit facility as of December 26, 2010, and December 27, 2009, was approximately $148.1 million and $179.5 million, respectively. There are $11.6 million of outstanding borrowings recorded for the Company's capital leases as of December 26, 2010, which have an estimated fair value of $11.5 million. At December 27, 2009, the carrying amount of the Company's capital lease obligations was $6.6 million, and the fair value was $7.7 million. Asset Impairment The Company took an impairment charge for four of its restaurants in the third quarter 2010 of $6.1 million. These are considered to be assets that are measured at fair value on a nonrecurring basis. The inputs used for the fair value measurement of the restaurants are considered Level Three. For further information refer to Note 4 Restaurant Impairment and Restaurant Closures . 11. Supplemental Disclosures to Consolidated Statements of Cash Flows Income taxes paid $ 865 $ 2,405 $ 4,597 Interest paid, net of amounts capitalized 4,709 6,567 8,262 Purchases of property and equipment on account 2,943 3,180 9,747 Capital lease obligations incurred for real estate and equipment purchases 5,328 471 399 12. Income Taxes The provision (benefit) for income taxes consists of the following (in thousands): Federal $ 596 $ 3,708 $ 1,079 State 369 1,512 2,064 Deferred: Federal (3,771 ) (2,037 ) 5,892 State 237 747 778 $ (2,569 ) $ 3,930 $ 9,813 The reconciliation of income tax provision that would result from applying the federal statutory rate to income tax provision as shown in the accompanying consolidated statements of income is as follows: Tax provision at U.S. federal statutory rate 35.0 % 35.0 % 35.0 % State income taxes 7.4 6.4 4.5 FICA tip tax credits (99.2 ) (23.9 ) (13.2 ) Other 2.5 0.8 0.3 Effective tax rate (54.3 )% 18.3 % 26.6 % The decreases in 2010 versus 2009 and 2009 versus 2008 were primarily due to more favorable general business and tax credits, primarily the FICA Tip Tax Credit, as a percent of current year income, which did not change at the same rate as the decrease in income. The Company's total deferred tax assets and liabilities at December 26, 2010, and December 27, 2009, are as follows (in thousands): Deferred tax assets $ 34,234 $ 34,627 Deferred tax liabilities (37,426 ) (38,835 ) Deferred tax (liabilities), net $ (3,192 ) $ (4,208 ) 12. Income Taxes (Continued) The Company's federal and state deferred taxes at December 26, 2010, and December 27, 2009, are as follows (in thousands): Current deferred tax assets and liabilities, net: Accrued compensation and related costs $ 6,515 $ 5,678 Advanced payments 826 1,955 General business and other tax credits 361 361 Interest rate swap 179 749 Other current deferred tax assets 627 482 Other current deferred tax liabilities (359 ) (297 ) Prepaid expenses (2,429 ) (891 ) Supplies inventory (4,426 ) (3,910 ) Current deferred tax asset, net $ 1,294 $ 4,127 Non-current deferred tax assets and liabilities, net: Deferred rent $ 9,788 $ 11,021 Stock-based compensation 4,859 5,795 General business and other tax credits 8,394 3,225 Alternative minimum tax credits 1,262 1,262 Accrued compensation and related costs 674 98 Advanced payments — 1,100 Other non current deferred tax assets 400 606 Other non current deferred tax liabilities (278 ) (256 ) Goodwill (3,720 ) (2,821 ) Property and equipment (26,214 ) (28,252 ) Franchise rights 349 (208 ) Interest rate swap — 95 Non-current deferred tax (liability), net (4,486 ) (8,335 ) $ (3,192 ) $ (4,208 ) Realization of net deferred tax assets are dependent upon profitable operations and future reversals of existing taxable temporary differences. Although realization is not assured, the Company believes it is more likely than not that the net recorded benefits will be realized through the reduction of future taxable income. The amount of the net deferred tax assets is considered realizable; however, it could be reduced in the near term if actual future taxable income is lower than estimated, or if there are differences in the timing or amount of future reversals of existing taxable temporary differences. The Company has federal alternative minimum tax credits of $1.3 million available with no expiration date. The Company also has general business and other tax credits totaling $8.7 million available to offset future taxes which expire through 2030. The Company adopted the requirements for accounting for uncertain tax positions on January 1, 2007. Under this interpretation, in order to recognize an uncertain tax benefit, the taxpayer must be able to more likely than not sustain the position, and the measurement of the benefit is calculated as the largest amount that is more than 50 percent likely to be realized upon resolution of the benefit. The Company has analyzed filing positions in all of the federal and state jurisdictions where it is required to file income tax returns, as well as all open tax years in these jurisdictions. The only periods subject to examination for the Company's federal and state returns are the 2006 through 2010 tax years. The following table summarizes the Company's unrecognized tax benefits (in thousands) for the year ended 2010: Beginning of year $ 1,226 $ 322 $ 374 Increase due to current year tax positions 144 1,105 86 Decrease due to current year tax positions (1,022 ) (177 ) — Settlements — — (31 ) Reductions related to lapses (75 ) (24 ) (107 ) End of year $ 273 $ 1,226 $ 322 The total amount of unrecognized tax benefits that, if recognized, would affect the effective tax rate is approximately $212,000. The Company does not anticipate significant changes in the aggregate amount of unrecognized tax benefits within the next twelve months, other than nominal tax settlements. The Company's policy for recording interest and penalties associated with audits is to record such items as a component of income before taxes. Penalties are recorded in Other (gains) losses, net, and interest paid or received is recorded in interest expense in the statement of income. In 2010, 2009, and 2008 no penalties were recorded. In 2010, 2009, and 2008 we recorded nominal interest expense on the identifiable tax liabilities. During 2010 we relieved approximately $250,000 of accrued interest associated with a change in tax position and lapses of statutes of limitations associated with uncertain tax positions. At December 26, 2010 and December 27, 2009 we had approximately $9,000 and $262,000, respectively, of accrued interest related to uncertain tax positions. 13. Commitments and Contingencies Leasing Activities—The Company leases land, buildings, and equipment used in its operations under operating leases. The Company's operating leases have remaining non-cancelable terms ranging from less than one year to more than 15 years. These leases generally contain renewal options which permit the Company to renew the leases at defined contractual rates or prevailing market rates. Certain equipment leases also include options to purchase equipment at the end of the lease term. Certain leases provide for contingent rents, which are determined as a percentage of adjusted restaurant sales in excess of specified levels. The Company records a contingent rent liability and the corresponding rent expense when specified levels have been achieved or when management determines that achieving the specified levels during the fiscal year is probable. Certain lease agreements also 13. Commitments and Contingencies (Continued) require the Company to pay maintenance, insurance, and property tax costs. Rental expense related to land, building, and equipment leases is as follows (in thousands): Minimum rent $ 41,845 $ 40,319 $ 35,429 Contingent rent 1,632 1,770 3,273 Equipment rent under operating leases 740 832 789 $ 44,217 $ 42,921 $ 39,491 The Company leases certain of its owned land, buildings, and equipment to outside parties under non-cancelable operating leases. Cost of the leased land, buildings, and equipment at December 26, 2010, and December 27, 2009, was $4.6 million in both periods, and related accumulated depreciation was $2.3 million and $2.2 million, respectively. Rental income was immaterial for fiscal years 2010, 2009 and 2008. Future minimum lease commitments and minimum rental income under all leases as of December 26, 2010 are as follows (in thousands): 2011 $ 1,492 $ 41,894 $ 150 2012 1,352 41,791 150 2015 923 38,449 150 Thereafter 10,183 191,723 38 Total 16,418 394,921 788 Less amount representing interest (4,850 ) Present value of future minimum lease payments 11,568 Less current portion (838 ) Long-term capital lease obligations $ 10,730 As of December 26, 2010 and December 27, 2009, property and equipment included $22.6 million and $13.9 million of assets under capital lease, respectively, and $7.5 million and $6.3 million of related accumulated depreciation, respectively. In the normal course of business, there are various other claims in process, matters in litigation, and other contingencies. These include claims resulting from "slip and fall" accidents, employment related claims and claims from guests or team members alleging illness, injury or other food quality, health or operational concerns. To date, no claims of these types of litigation, certain of which are covered by insurance policies, have had a material effect on us. While it is not possible to predict the outcome of these other suits, legal proceedings and claims with certainty, management is of the opinion that adequate provision for potential losses associated with these other matters has been made in the financial statements and that the ultimate resolution of these other matters will not have a material adverse effect on our financial position and results of operations. 14. Franchise Operations Results of franchise operations included in the consolidated statements of income consist of the following (in thousands): Franchise royalties and fees: Royalty income $ 13,175 $ 12,627 $ 13,964 Franchise fees 234 198 359 Total franchise royalties and fees 13,409 12,825 14,323 Franchise development costs: Payroll and employee benefit costs 861 650 937 General and administrative 3,261 3,553 3,660 Total franchise development costs 4,122 4,203 4,597 Operating income from franchise operations $ 9,287 $ 8,622 $ 9,726 The Company provides management expertise, training, pre-opening assistance, and restaurant operating assistance in exchange for area development fees, franchise fees, license fees, and royalties of 3% to 4% of the franchised adjusted gross restaurant sales. Franchise fee revenue is recognized when all material obligations and initial services to be provided by the Company have been performed, generally upon the opening of the new restaurant. Until earned, these fees are accounted for as deferred revenue. Deferred revenue totaled $230,000 and $375,000 as of December 26, 2010 and December 27, 2009, respectively. Area development fees are dependent upon the number of restaurants in the territory as well as the Company's obligations under the area franchise agreement. Consequently, as the Company's obligations are met, area development fees are recognized proportionately with the opening of each new restaurant. Royalties are accrued as earned and are calculated each period based on the franchisee's reported adjusted sales. 15. Stockholders' Equity During 2008, the Company purchased a total of 1,480,763 shares of the Company's common stock for approximately $50.0 million with an average purchase price of $33.76 per share. Also during 2008, the Company's board of directors authorized an additional repurchase of up to $50.0 million of the Company's equity securities of which repurchases may be made from time to time in open market transactions and through privately negotiated transactions through December 31, 2010. On August 12, 2010, the Company's board of directors extended this program through December 31, 2011. This repurchase plan does not obligate the Company to acquire any specific number of shares or acquire shares over any specified period of time. No shares were repurchased under the plan in fiscal years 2010 or 2009. 16. Stock Incentive Plans In 2007, stockholders approved the 2007 Performance Incentive Plan which was amended and restated in 2008 (the 2007 Stock Plan). The 2007 Stock Plan authorizes the issuance of stock options, stock appreciation rights (SARs), restricted stock, stock bonuses and other forms of awards granted or denominated in the Company's common stock or units of the Company's common stock, as well as cash bonus awards pursuant to the plan. Persons eligible to receive awards under the 2007 Stock Plan include officers and employees of the Company and any of the Company's subsidiaries, directors of the Company, and certain consultants and advisors to the Company or any of its subsidiaries. The maximum number of shares of the Company's common stock that may be issued or transferred pursuant to awards under the 2007 Stock Plan is 1,824,600 shares. Vesting of the awards under the 2007 Stock Plan is determined at the date of grant by the plan administrator. Each award granted under the 2007 Stock Plan fully vests, becomes exercisable and/or payable, as applicable, upon a change in control event. However, unless the individual award agreement provides otherwise, with respect to executive and certain other high level officers of the Company, upon occurrence of a change in control, no award will vest unless such officers' employment with the Company is terminated by the Company without cause during the two-year period following such change in control event. Each award expires on such date as shall be determined at the date of grant, however, the maximum term of options, SARs and other rights to acquire common stock under the plan is ten years after the initial date of the award, subject to provisions for further deferred payment in certain circumstances. The 2007 Stock Plan terminates on April 3, 2017, unless terminated earlier by the Company's board of directors. As of December 26, 2010, options to acquire a total of 684,375 shares of the Company's common stock remain outstanding under this plan of which 196,065 were vested. The Company has four other stock based compensation plans: the 1996 Stock Option Plan (the 1996 Stock Plan), the 2000 Management Performance Common Stock Option Plan (the 2000 Stock Plan), the 2002 Incentive Stock Option Plan (2002 Stock Plan) and the 2004 Performance Incentive Plan (the 2004 Stock Plan). No further grants can be made under these plans. In general, options granted under these plans were issued at the estimated fair market value at the date of grant. Vesting of awards under these plans were generally time based over a period of one to four years; however, in some cases, options under these plans vested based on the attainment of certain financial results. As of December 26, 2010, options to acquire a total of 245,471 of the Company's common stock remain outstanding under these plans of which 245,055 were fully vested. Options granted under these plans expire within ten years from the date of grant. As of December 26, 2010, there was $5.5 million of total unrecognized compensation cost, excluding estimated forfeitures, which is expected to be recognized over the weighted average vesting period of approximately 1.3 years for stock options, 1 year for the non-vested common shares and 1.6 years for the restricted stock units. During the first quarter 2009, the Company completed a cash tender offer for out-of-the-money stock options held by 514 then current employees. As a result of the tender offer, the Company incurred a one-time pre-tax charge of $4.0 million for all unvested eligible options that were tendered. This one-time charge represents the compensation expense related to the acceleration of vesting on the unvested options tendered in the offer, which would otherwise have been expensed over their vesting period in the future if they had not been tendered. Approximately $0.9 million of the $4.0 million charge is recorded in labor expense and the remaining $3.1 million is recorded in selling, general and administrative expense in our condensed consolidated statements of income. The Company paid $3.5 million in cash for the approximate 1.6 million options tendered in the offer. 16. Stock Incentive Plans (Continued) The table below summarizes the status of the Company's stock option plans (in thousands, except per share data and exercise price): Options outstanding, beginning of year 727 $ 23.07 2,084 $ 37.73 1,758 $ 38.55 Awards granted 344 21.19 413 15.70 568 34.48 Awards cancelled(1) (118 ) 21.44 (1,700 ) 39.83 (191 ) 40.75 Awards exercised (23 ) 14.68 (70 ) 8.98 (51 ) 18.66 Options outstanding, end of year 930 $ 22.78 727 $ 23.07 2,084 $ 37.73 Of the total awards cancelled during fiscal year 2009, approximately 1.6 million are related to the option tender offer. Years of Contractual Life Options outstanding as of December 26, 2010 930 $ 22.78 6.72 $ 2,514 Options vested and expected to vest as of December 26, 2010(1) 839 $ 23.13 6.56 $ 2,284 Options exercisable as of December 26, 2010 441 $ 26.37 5.05 $ 1,213 The expected to vest options are the result of applying the pre-vesting forfeiture rate assumption to total outstanding options. The following table summarizes information about stock options outstanding at December 26, 2010 (in thousands, except per share data, weighted average exercise price and contractual life): Exercisable Range of Exercise Prices $ 7.25 - $14.86 17 7.42 $ 13.06 9 $ 13.06 $14.93 - $14.93 231 7.74 14.93 103 14.93 $14.98 - $17.75 93 4.63 16.09 72 15.84 $17.96 - $19.77 98 7.59 19.35 6 18.62 $21.43 - $21.43 177 8.80 21.43 — — $21.61 - $26.81 108 4.88 25.60 83 26.29 The estimated fair value of each option granted is calculated using the Black-Scholes multiple option-pricing model. The average assumptions used in the model were as follows: Risk-free interest rate 1.5 % 1.5 % 1.9 % Expected years until exercise 3.6 3.6 2.7 Expected stock volatility 57.9 % 53.1 % 40.6 % Dividend yield 0.0 % 0.0 % 0.0 % Weighted-average Black-Scholes fair value per share at date of grant $ 9.12 $ 6.23 $ 9.52 Total intrinsic value of options exercised (in thousands) $ 176 $ 565 $ 711 The risk-free interest rate was based on the rate for zero coupon U.S. Government issues with a remaining term similar to the expected life. The expected life of the options represents the period of time the options are expected to be outstanding and is based on historical trends and team member exercise patterns. The expected stock price volatility represents an average of the Company's historical volatility measured over a period approximating the expected life. The dividend yield assumption is based on the Company's history and expectations of dividend payouts. Non-vested Common Stock During the fiscal years ended December 26, 2010 and December 27, 2009, the Company issued non-vested common stock as permitted under the 2007 Stock Plan. The Company can grant non-vested common stock to its directors, executive officers and other key employees. The non-vested common shares granted to directors are generally subject to a three year vesting requirement. The non-vested common shares granted to executive officers and other key employees are generally subject to a four year graded vesting requirement. The fair value of the non-vested common shares is based on the grant date market value of the common shares. The table below summarizes the status of the Company's non-vested shares under the 2007 Stock Plan (in thousands, except per share data and grant-date fair value): Grant-Date (per share) Nonvested shares outstanding, beginning of year 151 $ 31.35 154 $ 36.83 Awards granted — — 34 15.28 Awards cancelled (9 ) 22.42 (2 ) 22.99 Awards vested (115 ) 34.14 (35 ) 40.17 Nonvested shares outstanding, end of year 27 $ 22.40 151 $ 31.35 Restricted Stock Units During the fiscal years ended December 26, 2010 and December 27, 2009, the Company issued time-based restricted stock units (RSUs) to certain employees as permitted under the 2007 Stock Plan. The Company can grant RSUs to its directors, executive officers and other key employees. The RSUs vest in equal installments over four years on the anniversary date and upon vesting, one share of the Company's common stock is issued for each RSU. The fair value of each RSU granted is equal to the market price of the Company's stock at the date of grant. Compensation expense for the RSUs is recognized over the remaining weighted average vesting period, which is approximately 1.6 years. The table below summarizes the status of the Company's time based RSUs under the 2007 Stock Plan (in thousands):

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professional_accounting

You are here » Home » Companies » Company Overview » PTC India Financial Services Ltd PTC India Financial Services Ltd. NSE: PFS ISIN Code: INE560K01014 NSE 00:00 | 27 Jan 16.65 -0.60 Mkt Cap.(Rs cr) 1,066 VOLUME 1010978 Buy Price 16.65 Buy Qty 40000.00 Mkt Cap.(Rs cr) 1066.18 PTC India Financial Services Ltd. (PFS) - Auditors Report Company auditors report To the Members of PTC India Financial Services Limited Report on the Audit of the Standalone Financial Statements Qualified Opinion We have audited the standalone financial statements of PTC IndiaFinancial Services Limited ("the Company") which comprise the Balance Sheet asat March 31 2022 and the Statement of Profit and Loss Statement of Changes in Equityand Statement of Cash Flows for the year then ended and notes to the standalone financialstatements including a summary of significant accounting policies and other explanatoryinformation. In our opinion and to the best of our information and according to theexplanations given to us except for the possible effect of the matters described in theBasis for Qualified Opinion section of our report the aforesaid standalone financialstatements give the information required by the Companies Act 2013 ("the Act")in the manner so required and give a true and fair view in conformity with the IndianAccounting Standards prescribed under section 133 of the Act read with Companies (IndianAccounting Standards) Rules 2015 as amended and other accounting principles generallyaccepted in India of the state of affairs of the Company as at March 31 2022 and itstotal comprehensive income (comprising of profits and other comprehensive income) changesin equity and its cash flows for the year ended on that date. Basis for Qualified Opinion On January 19 2022 three independent directors of the Companyresigned mentioning lapses in governance and compliance. The Company basis directions ofthe audit committee in its meeting held on April 26 2022 appointed an independent firm(the "Forensic auditor") vide engagement letter dated July 18 2022 toundertake a forensic audit in relation to the allegations raised by exIndependentdirectors. On November 4 2022 the Forensic auditor submitted its final report tothe Company which included in addition to other observations instances of modificationof critical sanction terms post sanction approval from the Board non-compliance withpre-disbursement conditions disbursements made for clearing overdues (evergreening)disproportionate disbursement of funds and delayed presentation of critical information tothe Board. The Company's management has appointed a professional services firm (the"External Consultant") to assist the management in responding to suchobservations and subsequently also obtained a legal opinion contesting certain matterswith respect to the contents including matters highlighted as evergreening in theForensic audit report and approach adopted by the Forensic Auditor. Accordingly themanagement has rebutted the observations made by the Forensic auditor and has confirmedthat in their view there is no additional impact on the Company's standalonefinancial statements for financial year 2021-22 and that there are no indications of anyfraud or suspected fraud. The Company has uploaded Forensic audit report themanagement's responses report from External Consultant and legal opinion on thewebsite of stock exchanges. In the adjourned audit committee meeting held on Nov 13 2022 thecommittee considered the Forensic audit report and management's responses thereon andaccepted the findings in the report by majority but with dissent of two directors out offive directors. We have been informed about the discussions held in the meeting andreasons for dissent expressed by two directors as set out in the Company'scommunication to us dated November 15 2022 as attached in Annexure A accompanying ourreport. In the board meeting held on November 13 2022 the board of directorsof the Company (with the absence of Chairperson of the Audit Committee in the meeting whorecorded a dissent on the matters being discussed in his absence) considered the Forensicaudit report Management's responses Report of External Consultant and legalopinions. We have been informed about the observations and views expressed in the meetingas set out in the Company's communication to us dated November 16 2022 as attachedin Annexure B accompanying our report. Due to resignation of the former independent directors the Company hasnot complied with the various provisions of Companies Act 2013 and Securities andExchange Board of India (Listing Obligations and Disclosure Requirements) Regulations2015 related to constitution of committees and sub-committees of the Board timely conductof their meetings and filing of annual and quarterly results with respective authorities.The Company intends to file for condonation of delay for non-compliance of such provisionswith respective authorities. The Company has also not finalized the minutes of auditcommittee meetings held since November 9 2021 which results in non-compliance withapplicable provisions. (Refer Note 55(c) of the Standalone Financial Statements) In light of the constraints and limitations highlighted by the Forensicauditor while preparing the Forensic audit report and as also noted by the AuditCommittee several concerns raised therein as described in the second paragraph above(including observations around evergreening) and lack of specific procedures andconclusions thereon divergent views among directors regarding forensic audit report (asfurther detailed in Annexure A and B accompanying our report) we are unable to satisfyourselves in relation to the extent of forensic audit procedures and conclusion thereonincluding remediation of the additional concerns raised therein. Considering the above and indeterminate impact of potential fines and/or penalties due to noncompliance of various provisions as mentioned above we are unableto obtain sufficient and appropriate audit evidence to determine the extent ofadjustments if any that may be required to the standalone financial statements for theyear ended March 31 2022. We conducted our audit in accordance with the Standards on Auditing(SAs) specified under section 143(10) of the Act. Our responsibilities under thoseStandards are further described in the Auditor's Responsibilities for the Audit ofthe Standalone Financial Statements section of our report. We are independent of theCompany in accordance with the Code of Ethics issued by the Institute of CharteredAccountants of India together with the ethical requirements that are relevant to our auditof the standalone financial statements under the provisions of the Act and the Rulesthereunder and we have fulfilled our other ethical responsibilities in accordance withthese requirements and the Code of Ethics. We believe that the audit evidence obtained byus is sufficient and appropriate to provide a basis for our qualified opinion. Emphasis of Matter We draw attention to the following matters in the Notes to thestandalone financial statements: 1. SEBI vide its email dated March 2 2022 did not accede theCompany's request for conducting Board Meeting without an independent director.Subsequent to this with recommendation of the Holding Company the Company appointed fourindependent directors through circular resolution who have been also the independentdirectors on the Board of PTC India Limited (the "Holding Company"). TheCompany basis email from SEBI acknowledging Company's email which summarised themode of appointment of these directors through circular resolution and opinion receivedfrom external legal firm believes that there is no non-compliance with SEBI'sdirections vide its email dated March 2 2022. (Refer Note 55(b) of the StandaloneFinancial Statements) 2. The Company had received a communication from ROC on March 28 2018pursuant to complaints received from identified third parties alleging mismanagement inthe Company's operations. The Company had submitted a reply dated April 18 2018after discussion with the audit committee and denied all allegations and regarded them asfrivolous attempt made by such identified third parties. On September 24 2021 theCompany received another notice from ROC u/s 206(4) of the Companies Act 2013 pursuantto its previous communication in 2017-18 and reference to complaints received by them in2017-18 seeking further information on certain matters including details about erosion ofinvestments made in associate companies and actions taken by the management includingother details and details about NPA accounts. While the Company responded to this noticeon October 22 2021 and no further intimation from ROC has been received till date theCompany does not expect any action by ROC on this matter. (Refer Note 57 of the StandaloneFinancial Statements) 3. In assessing the recoverability of loans and advances the Companyhas considered internal and external sources of information (i.e. valuation report fromResolution Professional for loan assets under IBC proceedings or otherwise one timesettlement (OTS) proposal asset value as per latest available financials of the borrowerswith appropriate haircut as per ECL policy). The Company expects to recover the netcarrying value of these assets basis assessment of current facts and ECL methodologywhich factors in future economic conditions as well. However the eventual recovery fromthese loans may be different from those estimated as on the date of approval of thesestandalone financial statements. (Refer Note 56 of the Standalone Financial Statements) 4. As at March 31 2022 the Company has assessed its financialposition including expected realization of assets and payment of liabilities includingborrowings and believes that sufficient funds will be available to pay-off theliabilities through availability of High Quality Liquid Assets (HQLA) and undrawn lines ofcredit to meet its financial obligations in atleast 12 months from the reporting date.(Refer Note 58 of the Standalone Financial Statements) 5. We have been informed by the Company that RBI's officialsvisited the premises of the Company in May 2022 and reviewed few documents in context ofallegations made by former Independent directors of the Company. The management hasrepresented that while the Company has satisfactorily responded to queries of officialsno formal response has come from RBI so far in this regard. (Refer Note 55(a) of theStandalone Financial Statements) Our opinion is not modified in respect of these matters. Information Other than the Standalone Financial Statements andAuditor's Report Thereon The Company's Board of Directors is responsible for the otherinformation. The other information comprises the information included in theChairman's Statement Director's Report etc but does not include the standalonefinancial statements and our auditor's report thereon. Our opinion on the standalone financial statements does not cover theother information and we do not express any form of assurance conclusion thereon. In connection with our audit of the standalone financial statementsour responsibility is to read the other information and in doing so consider whether theother information is materially inconsistent with the standalone financial statements orour knowledge obtained in the audit or otherwise appears to be materially misstated. Ifbased on the work we have performed we conclude that there is a material misstatement ofthis other information we are required to report that fact. The other information has notbeen shared with us upto the date of this report and therefore at this stage we havenothing to report in this regard. Key Audit Matters Key audit matters are those matters that in our professional judgmentwere of most significance in our audit of the standalone financial statements for the yearended March 31 2022. These matters were addressed in the context of our audit of thestandalone financial statements as a whole and in forming our opinion thereon and we donot provide a separate opinion on these matters. Sr. Key Audit Matter No How the Key Audit Matter was addressed in our audit 1 Expected Credit Losses (ECL) model Audit Procedures As described in the notes to the standalone financial statements the impairment losses have been determined in accordance with Ind AS 109 Financial Instruments requiring considerable judgment and interpretation in its implementation which also involved significant judgement by management in measuring the expected credit losses. Key areas of judgment included: We assessed the appropriateness of the Company's policy on Expected Credit Loss recognition on financial instruments with reference to the applicable accounting standards and prudential norms laid down by RBI. Our audit approach consisted testing of the design and operating effectiveness of the internal controls and substantive testing: • Determining the criteria for a significant increase in credit risk ('SICR') • We evaluated and tested the design and tested the operating effectiveness of • Techniques used to determine the Probability of Default (TD') and Loss Given Default ('LGD') Company's controls over the data used to determine the impairment reserve internal credit quality assessments • Assumptions used in the expected credit loss model such as the financial condition of the counterparty expected future cash flows etc. external credit ratings and methodology followed for computation of ECL. Refer Notes 2 (g) 2 (q) 7 and 44A.2 to the standalone financial statements. • For Expected Credit Losses computed by the management we performed the following procedures: (a) Assessed the reasonableness of assumptions and judgement made by management on model adoption and parameters selection; (b) Examined the key data inputs (valuation of collateral the timing of cash flows and realisations) to the ECL model on a sample basis to assess their accuracy and completeness; (c) Evaluated and tested on sample basis the appropriateness of staging including determination of significant increase in credit risk. (d) Assessed the Company's methodology for ECL provisioning Classification and Measurement with the assistance of our internal experts; (e) Assessed accuracy and completeness of disclosures made as required by relevant accounting standards. 2 Impairment of loans to customers Audit Procedures Allowance for impairment losses on loans to customers involves significant judgement by management to determine the timing and amount of the asset to be impaired. We assessed the appropriateness of the Company's impairment review and provisioning policy by comparing with the RBI prudential norms and applicable accounting standards; Refer Notes 2 (g) 2 (q) 7 and 44A.2 to the standalone financial statements • We evaluated and tested the design and operating effectiveness of the relevant controls over the impairment assessments and impairment allowance computations for loans and advances to customers. • We tested the management assumptions estimates and judgements which could give rise to material misstatement: a. The completeness and timing of recognition of loss events; b. The measurement of provisions for individual instances of loans which is dependent on the valuation of security provided and the collaterals against each loan the timing of cash flows and realisations; c. We discussed with management and scrutinised the appropriateness of those key assumptions applied in management's impairment assessment and compared them with available external evidence where necessary. d. The measurement of modelled provisions which is dependent upon key assumptions relating to probability of default loss given default and expected future recoveries; e. Performed procedures to obtain comfort on the accuracy of the impairment calculation process through recalculation of the provision charge based on inputs; f. Assessed accuracy and completeness of disclosures made as required by relevant accounting standards. 3 Evaluation of uncertain tax positions for Income taxes Principal Audit Procedures The Company has material uncertain tax positions relating to matters under litigation for Income taxes. These matters involve significant management judgement to determine the possible outcome of disputes. We obtained details of completed income tax assessments during the year ended March 31 2022 from the management. We involved our internal experts to challenge the management's underlying assumptions in estimating the tax provisions and the possible outcome of the disputes. Our internal experts also considered legal precedence and other rulings in evaluating management's position on these uncertain tax positions relating to Income taxes. Refer Note 2 (j) 2 (q) and 34 to the standalone financial statements. Additionally we considered the effect of new information in respect of uncertain tax positions to evaluate whether any change was required to management's position on these uncertainties. Responsibilities of Management and Those Charged with Governance forthe Standalone Financial Statements The Company's Board of Directors is responsible for the mattersstated in section 134(5) of the Act with respect to the preparation of these standalonefinancial statements that give a true and fair view of the financial position financialperformance changes in equity and cash flows of the Company in accordance with theaccounting principles generally accepted in India including the Accounting Standardsspecified under section 133 of the Act. This responsibility also includes maintenance ofadequate accounting records in accordance with the provisions of the Act for safeguardingof the assets of the Company and for preventing and detecting frauds and otherirregularities; selection and application of appropriate accounting policies; makingjudgments and estimates that are reasonable and prudent; and design implementation andmaintenance of adequate internal financial controls that were operating effectively forensuring the accuracy and completeness of the accounting records relevant to thepreparation and presentation of the standalone financial statement that give a true andfair view and are free from material misstatement whether due to fraud or error. In preparing the standalone financial statements the Board ofDirectors is responsible for assessing the Company's ability to continue as a goingconcern disclosing as applicable matters related to going concern and using the goingconcern basis of accounting unless the Board of Directors either intends to liquidate theCompany or to cease operations or has no realistic alternative but to do so. The Board ofDirectors are also responsible for overseeing the Company's financial reportingprocess. Auditor's Responsibilities for the Audit of the StandaloneFinancial Statements Our objectives are to obtain reasonable assurance about whether thestandalone financial statements as a whole are free from material misstatement whetherdue to fraud or error and to issue an auditor's report that includes our opinion.Reasonable assurance is a high level of assurance but is not a guarantee that an auditconducted in accordance with SAs will always detect a material misstatement when itexists. Misstatements can arise from fraud or error and are considered material ifindividually or in the aggregate they could reasonably be expected to influence theeconomic decisions of users taken on the basis of these standalone financial statements. We give in "Annexure C" a detailed description ofAuditor's responsibilities for Audit of the Standalone Financial Statements. Report on Other Legal and Regulatory Requirements 1. As required by the Companies (Auditor's Report) Order 2020("the Order") issued by the Central Government of India in terms of sub-section(11) of section 143 of the Act we give in the "Annexure D" a statement on thematters specified in paragraphs 3 and 4 of the Order to the extent applicable. 2. As required by Section 143(3) of the Act we report that: (a) Except for the possible effect of the matters described in theBasis of Qualified Opinion section above we have sought and obtained all the informationand explanations which to the best of our knowledge and belief were necessary for thepurposes of our audit. (b) Except for the possible effect of the matters described in theBasis of Qualified Opinion section above in our opinion proper books of account asrequired by law have been kept by the Company so far as it appears from our examination ofthose books. (c) The Balance Sheet the Statement of Profit and Loss the Statementof Changes in Equity and the Statement of Cash Flow dealt with by this Report are inagreement with the books of account. (d) Except for the matter described in the Basis of Qualified Opinionsection above in our opinion the aforesaid standalone financial statements comply withthe Accounting Standards specified under Section 133 of the Act read with Rule 7 of theCompanies (Accounts) Rules 2014. (e) The matter described in Basis of Qualified Opinion paragraph abovein our opinion may have an adverse effect on the functioning of the Company. (f) On the basis of the written representations received from thedirectors as on March 31 2022 taken on record by the Board of Directors none of thedirectors are disqualified as on March 31 2022 from being appointed as a director interms of Section 164 (2) of the Act. (g) With respect to the adequacy of the internal financial controlswith reference to standalone financial statements of the Company and the operatingeffectiveness of such controls refer to our separate Report in "Annexure E". (h) With respect to the other matters to be included in theAuditor's Report in accordance with Rule 11 of the Companies (Audit and Auditors)Rules 2014 in our opinion and to the best of our information and according to theexplanations given to us: i. The Company has disclosed the impact of pending litigations on itsfinancial position in its standalone financial statements - Refer Note 52 to thestandalone financial statements; ii. The Company did not have any long-term contracts includingderivative contracts for which there were any material foreseeable losses. iii. There has been no delay in transferring amounts required to betransferred to the Investor Education and Protection Fund by the Company iv. a) The Management has represented that to the best of itsknowledge and belief no funds have been advanced or loaned or invested (either fromborrowed funds or share premium or any other sources or kind of funds) by the Company toor in any other person(s) or entity(ies) including foreign entities("Intermediaries") with the understanding whether recorded in writing orotherwise that the Intermediary shall directly or indirectly lend or invest in otherpersons or entities identified in any manner whatsoever by or on behalf of the Company("Ultimate Beneficiaries") or provide any guarantee security or the like onbehalf of the Ultimate Beneficiaries; b) The Management has represented that to the best of its knowledgeand belief no funds have been received by the Company from any person(s) or entity(ies)including foreign entities (Funding Parties) with the understanding whether recorded inwriting or otherwise that the Company shall whether directly or indirectly lend orinvest in other persons or entities identified in any manner whatsoever by or on behalf ofthe Funding Party ("Ultimate Beneficiaries") or provide any guarantee securityor the like on behalf of the Ultimate Beneficiaries; and c) Based on such audit procedures as considered reasonable andappropriate in the circumstances except for the possible effect of matters described inthe Basis of Qualified Opinion section above nothing has come to our notice that hascaused us to believe that the representations under sub-clause iv(a) and iv(b) contain anymaterial misstatement; and 3. As required by The Companies (Amendment) Act 2017 in our opinionaccording to information and explanations given to us the remuneration paid by theCompany to its directors is within the limits laid prescribed under Section 197 of the Actand the rules thereunder. Annexure A 1. Resolution as agreed by (adjourned) Audit Committee in meetingdated: 13th November 2022 and confirmed by all members. "It is noted that the Forensic Auditor has given his findings inthe Final Forensic Audit Report submitted by him on 4th November 2022. It is also notedthat the forensic auditor has concluded that the findings as given by him in the draftreport are not significantly altered by the explanations given by the management. TheAudit Committee discussed these findings in reasonable detail and noted that the auditcommittee can go into even further detail in giving its observations on the forensic auditreport. However as emphasized repeatedly by the management considering the urgency ofadoption of the annual accounts for the year ended March 22 it is felt that thesignificant and salient aspects of the forensic audit report have been brought out in thediscussion and also the statutory auditor who was present as an invitee during thisdiscussion has taken note of these observations and examined the report of the forensicauditor in complete detail. Therefore at this stage the audit committee decides not togo into a further detailed discussion of the contents of the forensic audit report itsfindings and conclusions in light of the priorities mentioned by the management.Accordingly the audit committee takes on record Final Forensic Audit Report submitted byCNK & Associates LLP and thanks them for their services. After this discussion it wasresolved that:- The audit committee accepts findings of the forensic auditor as givenin the Final Forensic Audit Report. The committee recommends them to the Board forappropriate follow up action. The Committee notes the constraints and scope limitationsoperating on the forensic auditor which find mention in the Forensic Audit Report andthat but for such limitations the forensic auditor would probably have been able to giveeven more specific findings. The Committee has also taken note of the responses given bythe management. The Committee also notes that an external agency was appointed by themanagement to act as advisors to the management in responding to the findings given by theforensic auditor. It is noted that the views expressed by the said advisors contain manyreservations disclaimers and limitations. Some of the salient disclaimers are mentionedin the email dt 8th Oct 22 sent by the Chairman of the Committee to the board members. Itis seen that the advisors state that they have relied on the justification provided by themanagement; and it is possible that there are factual inaccuracies where we have not beenprovided with the complete picture/information/documentation on a particular matter by theprocess owners. In turn the management states that it has relied upon theconsultant's findings to prepare their response to the forensic audit report. Theaudit committee therefore has given limited weightage to the recommendations of theconsultant. The committee also notes that the statutory auditor assures that allsignificant aspects of the forensic audit report have been taken into consideration bythem and further that these aspects have been taken into consideration in auditing thefinancial results for the year ended March 22 and that appropriate modifications based onthese findings have been suitably incorporated in their reports. The above resolution was proposed by the Chairman (D1) and approved ofby D4 & D5. D2 expressed his dissent stating that in addition to the other pointsas mentioned by him during the course of discussions he did not agree with the concept ofevergreening as interpreted / applied by the forensic auditor. He also felt that theforensic auditor had been selective in the presentation of certain facts and also he wasnot in agreement with the findings given by the forensic auditor in regard to Shri Ratneshand related matters. He was not in agreement with scope limitation or constraintsmentioned by Forensic Auditor. The Forensic Auditor has not done weekly discussions withthe management as stipulated in the engagement letter which is legally binding on him. Healso pointed out that the limitations mentioned in the Advisor's Report should beread in full not selectively and the limitations as expressed are as per generallyaccepted norms. D3 recorded his dissent on the basis of numerous issues mentioned byhim in the course of earlier discussion including all the points specifically stated byD2. Further Advisors has clarified that the facts mentioned in their note were based onindependent review of supporting documents in relation to reply submitted by PFS. Thus itwas their independent assessment. Basis the above the Resolution was adopted and passed with a majorityof 3 against 2 dissents." This is issued on specific requirement of Statutory Auditors and aboveresolution was passed during the meeting and minutes will be finalised shortly. Annexure B 2. Resolution as agreed by Board Meeting dated: 13th November 2022 andconfirmed by all members present in the meeting (except one Director -Audit committeechairman who was not present in the meeting) The Board considered the forensic audit report of CNK along withmanagement replies E&Y remarks legal opinion by Former CJI legal opinion of CAM andFormer Director (Finance) of PFC. The Board noted that the Audit Committee considered theforensic audit report of CNK on 11 12 and 13th Nov and accepted the report by majority(3:2). The Board deliberated the report and observed that; i. CNK report is that CNK has not identified any event having materialimpact on the financials of the Company. Hence not quantified. ii. CNK has not identified any instance of fraud and diversion of fundsby the company. iii. Procedural / operational issues identified by CNK needs to dealtwith expeditiously. iv. The Issue related to Mr. Ratnesh has already been examined by RMCcommittee of PTC (Holding Company) and approved by Board of PTC India. The report isalready submitted to the regulators. The Company has already complied by SEBI (LODR) by submitting the sameto Stock Exchanges along with management comments and E&Y remarks. The management isdirected to submit the report of Forensic Audit with management comments E&Y remarkslegal opinion by Former CJI legal opinion of CAM and former Director (Finance) of PFC andthis Board resolution to SEBI. The Board is of the view that recommendation of E&Y may be obtainedby management to strengthen the business processes & operational issues and submit tothe Board at the earliest. ANNEXURE C TO THE INDEPENDENT AUDITOR'S REPORT ON EVEN DATE ON THESTANDALONE FINANCIAL STATEMENTS OF PTC INDIA FINANCIAL SERVICES LIMITED As part of an audit in accordance with SAs we exercise professionaljudgment and maintain professional skepticism throughout the audit. We also: • Identify and assess the risks of material misstatement of thestandalone financial statements whether due to fraud or error design and perform auditprocedures responsive to those risks and obtain audit evidence that is sufficient andappropriate to provide a basis for our opinion. The risk of not detecting a materialmisstatement resulting from fraud is higher than for one resulting from error as fraudmay involve collusion forgery intentional omissions misrepresentations or the overrideof internal control. Obtain an understanding of internal control relevant to the audit inorder to design audit procedures that are appropriate in the circumstances. Under section143(3)(i) of the Act we are also responsible for expressing our opinion on whether thecompany has internal financial controls with reference to standalone financial statementsin place and the operating effectiveness of such controls. • Evaluate the appropriateness of accounting policies used and thereasonableness of accounting estimates and related disclosures made by management. • Conclude on the appropriateness of management's use of thegoing concern basis of accounting and based on the audit evidence obtained whether amaterial uncertainty exists related to events or conditions that may cast significantdoubt on the Company's ability to continue as a going concern. If we conclude that amaterial uncertainty exists we are required to draw attention in our auditor'sreport to the related disclosures in the standalone financial statements or if suchdisclosures are inadequate to modify our opinion. Our conclusions are based on the auditevidence obtained up to the date of our auditor's report. However future events orconditions may cause the Company to cease to continue as a going concern. • Evaluate the overall presentation structure and content of thestandalone financial statements including the disclosures and whether the standalonefinancial statements represent the underlying transactions and events in a manner thatachieves fair presentation. We communicate with those charged with governance regarding amongother matters the planned scope and timing of the audit and significant audit findingsincluding any significant deficiencies in internal control that we identify during ouraudit. We also provide those charged with governance with a statement that wehave complied with relevant ethical requirements regarding independence and tocommunicate with them all relationships and other matters that may reasonably be thoughtto bear on our independence and where applicable related safeguards. From the matters communicated with those charged with governance wedetermine those matters that were of most significance in the audit of the standalonefinancial statements for the year ended March 31 2022 (current period) and are thereforethe key audit matters. We describe these matters in our auditor's report unless lawor regulation precludes public disclosure about the matter or when in extremely rarecircumstances we determine that a matter should not be communicated in our report becausethe adverse consequences of doing so would reasonably be expected to outweigh the publicinterest benefits of such communication. ANNEXURE D TO INDEPENDENT AUDITORS' REPORT OF EVEN DATE ON THESTANDALONE FINANCIAL STATEMENTS OF PTC INDIA FINANCIAL SERVICES LIMITED FOR THE YEAR ENDEDMARCH 31 2022 [Referred to in paragraph 1 under ‘Report on Other Legal andRegulatory Requirements' in the Independent Auditors' Report] i. (a) A. The Company has maintained proper records showing fullparticulars including quantitative details and situation of Property Plant and Equipment. B. The Company has maintained proper records showing full particularsof intangible assets. (b) Property Plant and Equipment have been physically verified by themanagement at reasonable intervals during the year and no material discrepancies wereidentified on such verification. (c) According to the information and explanations given to us and onthe basis of our examination of the records of the Company the title deeds of immovableproperties (other than properties where the Company is the lessee and the lease agreementsare duly executed in favour of the lessee if any) as disclosed in the standalonefinancial statements are held in the name of the Company. (d) According to the information and explanations given to us theCompany has not revalued its property plant and Equipment (including Right of Use assetsif any) and its intangible assets. Accordingly the requirements under paragraph 3(i)(d)of the Order are not applicable to the Company. (e) According to the information and explanations given to us noproceeding has been initiated or pending against the Company for holding benami propertyunder the Benami Transactions (Prohibition) Act 1988 and rules made thereunder.Accordingly the provisions stated in paragraph 3(i) (e) of the Order are not applicableto the Company. ii. (a) The Company is involved in the business of rendering services.Accordingly the provisions stated in paragraph 3(ii)(a) of the Order are not applicableto the Company. (b) According to the information and explanations provided to us whilethe Company has been sanctioned working capital limits on the basis of security of loanassets no limits have been sanctioned on the basis of security of current assets. We havebeen informed by the Company that banks/ financial institutions have not considered loanassets (which are expected to be recovered in next twelve months) as current assets giventheir underlying nature of recovery over the longer tenure. Accordingly the requirementsunder paragraph 3(ii)(b) of the Order is not applicable to the Company. iii. (a) According to the information explanation provided to us theCompany's principal business is to give loans. Hence the requirements underparagraph 3(iii) (a) of the Order are not applicable to the Company. (b) Based on our examination and the information and explanations givento us except for the possible effect of the matters described in the Basis of QualifiedOpinion section of our main report in respect of the loans granted investments made andguarantees provided (letter of comfort) in our opinion the terms and conditions underwhich such loans and guarantees provided are not prejudicial to the interest of theCompany. (c) In respect of the aforesaid loans the schedule of repayment ofprincipal and payment of interest have been stipulated by the Company. Considering thatthe Company is a Non-Banking Financial Company engaged in the business of infrastructurefinance lending the borrower-wise details of the amount due date for payment and extent of delay (that has beensuggested in the Guidance Note on CARO 2020 issued by the Institute of CharteredAccountants of India for reporting under this clause) have not been detailed hereunderbecause it is not practicable to furnish such details owing to the voluminous nature ofdata generated in the normal course of the Company's business. Further except forthe possible effect of the matters described in the Basis of Qualified Opinion section ofour main report while there are delays the parties are generally regular in repaying theprincipal amounts as stipulated and interest as applicable and wherever the amounts areoverdue as at March 31 2022 the Company has evaluated and recognized provisions ifnecessary in accordance with the principles of Indian Accounting Standards (Ind AS) andthe guidelines issued by the Reserve Bank of India ("RBI") for IncomeRecognition and Asset Classification (which has been disclosed by the Company in Note 46to the standalone financial statements). (d) According to the information and explanations given to us and onthe basis of our examination of the records of the Company the details of amount overduefor more than ninety days are as follows: No. of Cases Principal amount overdue* (INR Lakhs) Interest amount overdue (INR Lakhs) Total overdue Remarks (specify whether reasonable steps have been taken by the Company for recovery of principal amount and interest) 10 95284.11 9910.29 105194.40 According to the information and explanation given to us except for the possible effect of the matters described in the Basis of Qualified Opinion section of our main report reasonable steps have been taken by the Company for recovery of principal amount and interest. *The amount indicates the total principal outstanding in case of theoverdue accounts as at March 31 2022. (e) The Company's principal business is to give loans. Hence theprovisions stated under paragraph 3(iii) (e) of the Order are not applicable to theCompany. (f) According to the information explanation provided to us theCompany has not granted any loans and / or advances in the nature of loans during the yearwhich are either repayable on demand or without stipulating the schedule for repayment ofprincipal and interest. Hence the requirements under paragraph 3(iii)(f) of the Order arenot applicable to the Company. iv. In our opinion and according to the information and explanationsgiven to us the Company is in the business of lending loans which are given at theinterest rates which are generally higher than the minimum rates stipulated in section185 and therefore section 185 is not applicable to the Company. The Company has not madeinvestments through more than two layers of investment companies in accordance with theprovisions of section 186 of the Act. Accordingly provisions stated in paragraph 3(iv) ofthe Order are not applicable to the Company. v. In our opinion and according to the information and explanationsgiven to us the Company has not accepted any deposits from the public within the meaningof Sections 73 74 75 and 76 of the Act and the rules framed there under. Accordinglythe provisions stated in clause 3(v) of the Order are not applicable to the Company. vi. The provisions of sub-section (1) of section 148 of the Act are notapplicable to the Company as the Central Government of India has not specified themaintenance of cost records for any of the products of the Company. Accordingly theprovisions stated in paragraph 3 (vi) of the Order are not applicable to the Company. (a) According to the information and explanations given to us and therecords of the Company examined by us in our opinion undisputed statutory dues includinggoods and services tax provident fund income-tax cess and other statutory dues asapplicable have generally been regularly deposited with the appropriate authorities. According to the information and explanations given to us noundisputed amounts payable in respect of goods and services tax provident fundincome-tax cess and other material statutory dues applicable to it were outstanding atthe year end for a period of more than six months from the date they became payable. (b) According to the information and explanation given to us and therecords of the Company examined by us there are no dues of goods and services tax cessand any other statutory dues as applicable which have not been deposited on account ofany dispute except as below: Name of the statute Nature of dues Amount Involved* (INR lakhs) Amount Unpaid (INR lakhs) Period to which the amount relates Forum where dispute is pending Income tax Act 1961 Income Tax 2936.70 937.09 2012-2017 Income Tax Appellate Authority Income tax Act 1961 Income Tax 754.58 94.99 2012-13 201415 2017-18 Upto Commissioner (Appeals) *Amount as per demand orders including interest and penalty whereverindicated in the order. viii. According to the information and explanations given to us thereare no transactions which are not accounted in the books of account which have beensurrendered or disclosed as income during the year in tax assessment of the Company. Alsothere are no previously unrecorded income which has been now recorded in the books ofaccount. Hence the provision stated in paragraph 3(viii) of the Order is not applicableto the Company. (a) In our opinion and according to the information and explanationsgiven to us the Company has not defaulted in repayment of loans or borrowings or inpayment of interest thereon to any lender. (b) According to the information and explanations given to us and onthe basis of our audit procedures we report that the Company has not been declared wilfuldefaulter by any bank or financial institution or government or any government authority. (c) In our opinion and according to the information and explanationsprovided to us money raised by way of term loans during the year have been applied forthe purpose for which they were raised. (d) According to the information and explanations given to us and theprocedures performed by us and on an overall examination of the standalone financialstatements of the Company we report that no funds raised on short-term basis have beenused for long-term purposes by the Company. (e) According to the information explanation given to us and on anoverall examination of the standalone financial statements of the Company we report thatthe Company has not taken any funds from an any entity or person on account of or to meetthe obligations of its associates. The Company does not have any subsidiary or jointventure. (f) According to the information and explanations given to us andprocedures performed by us we report that the Company has not raised loans during theyear on the pledge of securities held in its associate companies. The Company does nothave any subsidiary or joint venture. (a) The Company did not raise any money by way of initial public offeror further public offer (including debt instruments) during the year. Accordingly theprovisions stated in paragraph 3 (x)(a) of the Order are not applicable to the Company. (b) According to the information and explanations given to us and basedon our examination of the records of the Company the Company has not made anypreferential allotment or private placement of shares or fully partly or optionallyconvertible debentures during the year. Accordingly the provisions stated in paragraph 3(x)(b) of the Order are not applicable to the Company. (a) During the course of our audit examination of the books andrecords of the Company carried out in accordance with the generally accepted auditingpractices in India and according to the information and explanations given to us nofraud by the Company or on the Company has been noticed or reported during the yearexcept: I. the possible effect of the matters described in the Basis forQualified Opinion section of our main report; II. Following matters have been reported by the Company to the ReserveBank of India (RBI) during the year: - NSL Nagapatnam - The Company has loan recoverable from NSL Nagapatnamamounting to Rs. 12500 lakhs as at March 31 2022. The underlying project has beenreferred for resolution under IBC proceedings wherein the Company is also the party.Basis facts of the case during the year the Board has reviewed and directed themanagement to report this loan as "suspected fraud" to RBI basis report of theforensic auditor appointed by the Company to investigate the borrower's books andaccounts wherein such auditor couldn't verify the transactions within group entitiesand therefore the report remains inconclusive. We have been informed that vide itsletter dated August 12 2021 the Company sent a letter to RBI explaining all facts of thematter. In the previous year the Company had accrued 100% provision for ECL against theoutstanding balance and therefore net balance (net off provision for ECL) is NIL as atMarch 31 2022. - ILFS - The Company has loan recoverable from ILFS Tamil Naduamounting to Rs. 23069.47 lakhs (including accrued interest amounting to Rs. 4685.29lakhs) as at March 31 2022 with corresponding provision for ECL amounting to Rs.9400.16 lakhs as at March 31 2022. The Company has also recognized Rs. 13669.31 lakhsin Impairment Reserve as at March 31 2022 related to this matter. On Feb 4 2022 theCompany reported this account as "Fraud" in FMR 1 to RBI basis position taken byother lenders in the consortium. Basis forensic audit report from the Forensic auditorappointed by the consortium the nature of fraud primarily comprises of diversion andmisappropriation of borrowed funds routing of sales proceeds with accounts maintainedwith non-lender banks and availing services from vendors at higher prices compared toquotes available with the borrower. (b) We are in the process of filing a letter with the CentralGovernment in relation to inter alia matters included in the Basis of Qualified opinionpara of our main report. This is not a filing in Form ADT-4 as prescribed under rule 13 ofCompanies (Audit and Auditors) Rules 2014. (c) As represented to us by the management there are no whistle-blowercomplaints received by the Company during the year. Accordingly the provisions stated inparagraph (xi)(c) of the Order is not applicable to Company. However we draw yourattention to the resignation letters from former Independent directors as set out in thebasis of Qualified Opinion section of our main report. xii. In our opinion and according to the information and explanationsgiven to us the Company is not a Nidhi Company. Accordingly the provisions stated inparagraph 3(xii) (a) to (c) of the Order are not applicable to the Company. xiii. According to the information and explanations given to us andbased on our examination of the records of the Company except for the possible effect ofthe matters included in the Basis of Qualified Opinion section of our main reporttransactions with the related parties are in compliance with sections 177 and 188 of theAct where applicable and details of such transactions have been disclosed in thestandalone financial statements as required by the applicable accounting standards. (a) In our opinion and based on our examination the Company has aninternal audit system commensurate with the size and nature of its business. (b) We have considered internal audit reports issued by internalauditors during our audit in accordance with the guidance provided in SA 610 - ‘Usingthe work of Internal Auditors'. xv. According to the information and explanations given to us in ouropinion the Company has not entered into non-cash transactions with directors or personsconnected with its directors during the year and hence provisions of section 192 of theAct are not applicable to the Company. Accordingly the provisions stated in paragraph3(xv) of the Order are not applicable to the Company. (a) The Company is required to and has been registered under Section45-IA of the Reserve Bank of India Act 1934 as Non-banking Institution - Non-Deposittaking Systematically Important (NBFC- ND-SI) Company. (b) The Company has conducted the Non-Banking Financial activities witha valid Certificate of Registration (CoR) from the Reserve Bank of India (RBI) as per theReserve Bank of India Act 1934. The Company has not conducted any Housing Financeactivities. (c) The Company is not a Core investment Company (CIC) as defined inthe regulations made by Reserve Bank of India. Hence the reporting under paragraph clause3 (xvi)(c) of the Order are not applicable to the Company. (d) The Company does not have any CIC as part of its group. Hence theprovisions stated in paragraph clause 3 (xvi) (d) of the order are not applicable to theCompany. xvii. Based on the overall review of standalone financial statementsthe Company has not incurred cash losses in the current financial year and in theimmediately preceding financial year. Hence the provisions stated in paragraph clause 3(xvii) of the Order are not applicable to the Company. xviii. There has been no resignation of the statutory auditors duringthe year. Hence the provisions stated in paragraph clause 3 (xviii) of the Order are notapplicable to the Company. However vide our letter dated June 30 2022 read with ouremail dated May 14 2022 to the Company we have sent our intimation for proposed resignation as statutory auditors ofthe Company after completion of our responsibilities as statutory auditors for the yearended March 31 2022. xix. According to the information and explanations given to us andbased on our examination of financial ratios ageing and expected date of realization offinancial assets and payment of liabilities other information accompanying the standalonefinancial statements our knowledge of the Board of Directors and management plans exceptof the possible effect of the matters described in Basis of Qualified Opinion section ofour main report we are of the opinion that no material uncertainty exists as on the dateof audit report and the Company is capable of meeting its liabilities existing at the dateof balance sheet as and when they fall due within a period of one year from the balancesheet date. We however state that this is not an assurance as to the future viability ofthe Company. We further state that our reporting is based on the facts upto the date ofthis audit report and we neither give any guarantee nor any assurance that all liabilitiesfalling due within a period of one year from the balance sheet date will get dischargedby the Company as and when they fall due. (a) According to the information and explanations given to us theprovisions of Section 135 of the Act are applicable to the Company. In respect of otherthan ongoing projects the Company has transferred the amount remaining unspent to a Fundspecified in Schedule VII to the Companies Act 2013 within a period of six months fromthe end of the financial year as permitted under the second proviso to sub-section (5) ofsection 135 of the Act. (b) The Company does not have any ongoing projects as at March 312022. Accordingly reporting under clause xx(b) of the Order is not applicable. xxi. The reporting under clause 3(xxi) of the Order is not applicablein respect of audit of standalone financial statements. Accordingly no comment in respectof the said clause has been included in the report. ANNEXURE E TO THE INDEPENDENT AUDITOR'S REPORT OF EVEN DATE ON THESTANDALONE FINANCIAL STATEMENTS OF PTC INDIA FINANCIAL SERVICES LIMITED FOR THE YEAR ENDEDMARCH 31 2022 [Referred to in paragraph 2(g) under ‘Report on Other Legal andRegulatory Requirements' in the Independent Auditors' Report] Report on the Internal Financial Controls under Clause (i) ofSub-section 3 of Section 143 of the Companies Act 2013 ("the Act") We have audited the internal financial controls with reference tostandalone financial statements of PTC India Financial Services Limited ("theCompany") as of March 31 2022 in conjunction with our audit of the standalonefinancial statements of the Company for the year ended on that date. In our opinion except for the possible effect of the matters describedin the Basis for qualified opinion below on the achievement of the objectives of thecontrol criteria the Company has maintained in all material respects adequate internalfinancial controls with reference to standalone financial statements and such internalfinancial controls with reference to standalone financial statements were operatingeffectively as of March 31 2022 based on the internal control with reference tostandalone financial statements criteria established by the Company considering theessential components of internal control stated in the Guidance Note on Audit of InternalFinancial Controls Over Financial Reporting issued by the Institute of CharteredAccountants of India (ICAI) (the "Guidance Note"). We have considered the above in determining the nature timing andextent of audit tests applied in our audit of the standalone financial statements of theCompany for the year ended March 31 2022 and it affects our opinion on the standalonefinancial statements of the Company for the year ended on that date and we have issuedqualified opinion on the standalone financial statements. Refer Qualified Opinion para ofour main audit report. According to the information and explanations given to us and based onour audit we draw your attention to the following: 1. Matters described in the Basis of Qualified Opinion section of ourmain report including matters relating to divergent views among directors regardingforensic audit report constraints and limitations highlighted by the Forensic auditorwhile preparing the Forensic audit report as also noted by the Audit Committee severalconcerns raised therein (including the observations around evergreening) and lack ofspecific procedures and conclusions thereon; and 2. The Board at its meeting held on November 13 2022 gave certaindirections to expeditiously address the operational issues identified by the Forensicauditor including on obtaining recommendations from the External Consultant forstrengthening the business processes and operational issues (as fully detailed in AnnexureB). We understand that these steps are yet to be taken by the management. Pending conclusion of these matters we are unable to determine theirimpact on the design and operating effectiveness of internal financial controls overfinancial reporting including entity level controls as at March 31 2022. A ‘material weakness' is a deficiency or a combination ofdeficiencies in internal financial control with reference to standalone financialstatements such that there is a reasonable possibility that a material misstatement ofthe company's annual or interim financial statements will not be prevented or detected ona timely basis. Management's Responsibility for Internal Financial Controls The Company's Management is responsible for establishing andmaintaining internal financial controls based on the internal control with reference tostandalone financial statements criteria established by the Company considering theessential components of internal control stated in the Guidance Note. Theseresponsibilities include the design implementation and maintenance of adequate internalfinancial controls that were operating effectively for ensuring the orderly and efficientconduct of its business including adherence to Company's policies the safeguardingof its assets the prevention and detection of frauds and errors the accuracy andcompleteness of the accounting records and the timely preparation of reliable financialinformation as required under the Act. Auditors' Responsibility Our responsibility is to express an opinion on the Company's internalfinancial controls with reference to standalone financial statements based on our audit.We conducted our audit in accordance with the Guidance Note and the Standards on Auditingissued by ICAI and deemed to be prescribed under section 143(10) of the Act to the extentapplicable to an audit of internal financial controls. Those Standards and the GuidanceNote require that we comply with ethical requirements and plan and perform the audit toobtain reasonable assurance about whether adequate internal financial controls withreference to standalone financial statements was established and maintained and if suchcontrols operated effectively in all material respects. Our audit involves performing procedures to obtain audit evidence aboutthe adequacy of internal financial controls with reference to standalone financialstatements and their operating effectiveness. Our audit of internal financial controlswith reference to standalone financial statements included obtaining an understanding ofinternal financial controls with reference to standalone financial statements assessingthe risk that a material weakness exists and testing and evaluating the design andoperating effectiveness of internal control based on the assessed risk. The proceduresselected depend on the auditor's judgement including the assessment of the risks ofmaterial misstatement of the standalone financial statements whether due to fraud orerror. We believe that the audit evidence we have obtained is sufficient andappropriate to provide a basis for our qualified audit opinion on the Company'sinternal financial controls with reference to standalone financial statements. Meaning of Internal Financial Controls with reference to StandaloneFinancial Statements A Company's internal financial control with reference to standalonefinancial statements is a process designed to provide reasonable assurance regarding thereliability of financial reporting and the preparation of standalone financial statementsfor external purposes in accordance with generally accepted accounting principles. ACompany's internal financial control with reference to standalone financial statementsincludes those policies and procedures that (1) pertain to the maintenance of recordsthat in reasonable detail accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurance thattransactions are recorded as necessary to permit preparation of standalone financialstatements in accordance with generally accepted accounting principles and that receiptsand expenditures of the company are being made only in accordance with authorizations ofmanagement and directors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition use or disposition of thecompany's assets that could have a material effect on the standalone financial statements. Inherent Limitations of Internal Financial Controls with reference toStandalone Financial Statements Because of the inherent limitations of internal financial controls withreference to standalone financial statements including the possibility of collusion orimproper management override of controls material misstatements due to error or fraud mayoccur and not be detected. Also projections of any evaluation of the internal financialcontrols with reference to standalone financial statements to future periods are subjectto the risk that the internal financial control with reference to standalone financialstatements may become inadequate because of changes in conditions or that the degree ofcompliance with the policies or procedures may deteriorate. For M S K A & Associates ICAI Firm Registration No. 105047W Sd/- Rahul Aggarwal Membership No. 505676 UDIN: 22505676BDGXSP5731 Place: Gurugram Date: November 16 2022 Quick Links for PTC India Financial Services:

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professional_accounting

Arch Coal, Inc. Reports Third Quarter 2014 Results Third quarter adj. EBITDA increases versus the prior-year quarter Quarterly western cash margin expands sequentially on improving rail service Arch's liquidity reaches $1.3 billion, with $1.05 billion in cash and investments Earnings Highlights In $ millions, except per share data Revenues 1 $2,191.9 Loss from Operations 1 Diluted LPS Adjusted Diluted LPS 2 Adjusted EBITDA from continuing operations 2 1/- Excludes discontinued operations. 2/- Defined and reconciled under "Reconciliation of non-GAAP measures." ST. LOUIS , Oct. 28, 2014 -- Arch Coal, Inc. (NYSE: ACI ) today reported a net loss of $97 million , or $0.46 per diluted share, in the third quarter of 2014 compared with a net loss of $128 million , or $0.61 per diluted share, in the prior-year quarter. Revenues totaled $742 million for the three months ended Sept. 30, 2014 and adjusted earnings before interest, taxes, depreciation, depletion and amortization ("adjusted EBITDA") from continuing operations was $72 million , representing a slight increase compared with the same quarter of last year. In the third quarter of 2013, Arch recorded adjusted EBITDA from continuing operations of $69 million , excluding results from the company's Canyon Fuel assets, which were divested in August 2013. "Arch delivered a solid operating performance in the third quarter of 2014," said John W. Eaves , Arch's president and chief executive officer. "In particular, our western thermal operations improved cash margins per ton versus the second quarter due to increased shipment levels, higher price realizations and continued strong cost control." For the first nine months of 2014, Arch generated adjusted EBITDA from continuing operations of $164 million compared with $218 million in the prior-year period. Revenues declined slightly year-over-year to $2.2 billion for the nine months ended Sept. 30, 2014 on lower sales volume. "Looking ahead, we expect our western thermal operations, particularly in the Powder River Basin, to benefit from incrementally improving rail service in the fourth quarter of 2014 and in 2015," added Eaves. "In addition, we expect our metallurgical coal platform in Appalachia to benefit from a higher contribution by the low-cost Leer mine coupled with the favorable impact of idling the higher-cost Cumberland River complex." During the third quarter of 2014, Arch generated $80 million in cash from operations and spent $23 million on capital outlays, resulting in positive free cash flow of $57 million . As of Sept. 30, 2014 , Arch increased its cash and short-term investments balance to $1.05 billion compared with approximately $990 million at June 30, 2014 . In addition, the company's available liquidity, which includes its cash position and undrawn borrowings on its credit facilities, totaled more than $1.3 billion at the end of September. "Arch continues to successfully execute its plan to control costs and expenses, reduce capital outlays and preserve liquidity," said John T. Drexler , Arch's senior vice president and chief financial officer. "To that end, we are further reducing our expectations for corporate administrative expense and capital spending in 2014, and expect to end the year with approximately $1 billion in cash and short-term investments. This strong liquidity position, coupled with no debt maturities until mid-2018, provides Arch with the financial flexibility needed to navigate current coal market conditions." Arch continued to improve upon its industry-leading safety record in the third quarter of 2014. The company's total incident rate for the first nine months of 2014 was 15 percent better than achieved during the comparable time period in 2013. In September, the Coal-Mac complex in Appalachia completed three consecutive years without a lost-time incident, and the Coal Creek mine in the Powder River Basin reached one year without a reportable incident. Arch also built upon its environmental compliance record for the three months ended Sep. 30, 2014 . The Vindex mine was honored during the third quarter of 2014 with an environmental award for its excellence in reforestation from the Appalachian Regional Reforestation Initiative. "We made further strides in reaching Arch's safety and environmental goals during the third quarter of 2014," said Paul A. Lang , Arch's executive vice president and chief operating officer. "Five of our complexes attained A Perfect Zero – the dual accomplishment of operating without an environmental violation or reportable safety incident – during the quarter just ended. We commend our employees for their dedication and hard work, and view this unwavering focus on our core values as essential to long-term success." Operational Results "Arch's cash margin per ton increased quarter-over-quarter by 24 percent in the Powder River Basin and 7 percent in the Bituminous Thermal segment," said Lang. "That margin expansion helped offset lower cash margin per ton in Appalachia in the third quarter, which stemmed from the impact of two scheduled longwall moves and costs associated with the previously announced idling of Cumberland River. Good cost control remains a top priority at Arch, and we are currently projecting a strong end to 2014 in terms of cost containment." Arch Coal, Inc. Tons sold (in millions) Average sales price per ton Cash cost per ton Cash margin per ton Total operating cost per ton Operating margin per ton Consolidated results may not tie to regional breakout due to exclusion of other assets, rounding. Operating results exclude former Canyon Fuel subsidiary. Cash cost per ton is defined and reconciled under "Reconciliation of non-GAAP measures". Operating cost per ton is the sum of cash costs and depreciation, depletion and amortization expense divided by tons sold. Compared with the second quarter of 2014, Arch's consolidated cash margin per ton declined slightly in the third quarter, due to a higher percentage of Powder River Basin coal in the company's volume mix as well as higher cash costs per ton in Appalachia. Consolidated sales price per ton declined 2 percent over the same time period, but was partially offset by a decrease in consolidated cash costs per ton, primarily reflecting the benefit of higher shipment levels in the company's western operations and continued cost control efforts. In the Powder River Basin, third quarter 2014 cash margin per ton increased by 24 percent compared to the second quarter, partially attributable to higher realized prices per ton. Cash cost per ton declined 2 percent over the same time period, as the benefit of higher shipment levels largely offset higher repair and maintenance costs in the quarter just ended. In Appalachia, third quarter 2014 cash margin totaled $2.35 per ton compared with $7.00 per ton in the second quarter. Average sales price per ton declined modestly in the third quarter versus the second quarter, reflecting lower prices on thermal and metallurgical coal sales. As expected, third quarter 2014 cash cost per ton increased 6 percent versus the prior-quarter period, reflecting the impact of scheduled longwall moves at Mountain Laurel and Leer, as well as costs associated with winding down operations at Cumberland River. Bituminous Thermal In the Bituminous Thermal segment, Arch earned a cash margin of $12.33 per ton in the third quarter of 2014, representing a 7 percent increase versus the second quarter. Average sales price per ton increased marginally over the same time period, as the pricing on export sales improved sequentially, while cost per ton declined 2 percent, benefitting from higher shipment levels and strong cost control, particularly at West Elk. Arch believes that global coal markets are in the early stages of rebalancing. Even with extremely mild summer weather across the United States , Arch continues to expect power generation to increase modestly in 2014, after three straight years of decline. Arch also expects annual domestic coal consumption to rise by 10 million tons in 2014, and for coal to maintain close to 40 percent of the power generation market. Arch also forecasts coal stockpiles at power generators to decline below 135 million tons by Dec. 31, 2014 , reflecting a drop of nearly 15 million tons since the beginning of the year and a decline of 50 million tons since the end of 2012. On a regional basis, Arch believes coal inventories for Powder River Basin customers are currently below normal levels, likely resulting in coal conservation activities by customers until rail carrier service improves. Global thermal coal prices remain weak, but stronger power demand from a normal winter in Europe as compared to last year's mild weather could result in higher seaborne coal demand. Overall, Arch expects industry-wide coal exports from the United States to decline by roughly 20 million tons in 2014 and likely continue that trend in 2015, setting the stage for a more balanced Atlantic Basin market. Seaborne metallurgical coal markets remain over-supplied. While growth estimates for global steel consumption have been revised downward to 2 percent for 2014 and 2015, North American and European steel sector growth has remained above average. Arch continues to see reasonable demand for its metallurgical coals, but prices remain weak. As such, the company believes that metallurgical production curtailments announced to date – coupled with the lack of investment in future production, expected further production cuts and demand growth – will tighten global metallurgical markets over time. Company Outlook For 2014, Arch is maintaining its targeted sales volume range, which reflects the expectation for further improvement in rail service in the Powder River Basin during the fourth quarter. The company also recognizes the potential for some contracted tons in the Powder River Basin to carry over into 2015. Arch has again reduced its 2014 cost guidance range for the Bituminous Thermal segment due to a strong operating performance achieved year-to-date. The company also further reduced its corporate administrative budget, and now projects expenses of between $117 million and $121 million for 2014, representing a $7 million reduction since the start of the year. Additionally, Arch is reducing its capital expenditures for 2014, and now expects to spend between $160 million and $170 million for sustaining capital programs, inclusive of land and reserve additions. "While we continue to face challenges in coal markets, we remain focused on successfully managing those factors that we can control," said Eaves. "We believe our ongoing efforts to optimize our asset portfolio, control our costs, reduce capital spending and preserve financial flexibility are bearing fruit, and will position Arch for success, growth and value creation as coal markets recover." $ per ton Sales Volume (in millions tons) Committed, Priced Committed, Unpriced Total Committed Average Cash Cost Committed, Priced Thermal Committed, Unpriced Thermal Committed, Priced Metallurgical Committed, Unpriced Metallurgical Corporate (in $ millions) D,D&A S,G&A A conference call regarding Arch Coal's third quarter 2014 financial results will be webcast live today at 11 a.m. Eastern time . The conference call can be accessed via the "investor" section of the Arch Coal website ( http://investor.archcoal.com ). U.S.-based Arch Coal, Inc. is one of the world's top coal producers for the global steel and power generation industries, serving customers on five continents. Its network of mining complexes is the most diversified in the United States , spanning every major coal basin in the nation. The company controls more than 5 billion tons of high-quality metallurgical and thermal coal reserves, with access to all major railroads, inland waterways and a growing number of seaborne trade channels. For more information, visit www.archcoal.com . Forward-Looking Statements: This press release contains "forward-looking statements" – that is, statements related to future, not past, events. In this context, forward-looking statements often address our expected future business and financial performance, and often contain words such as "expects," "anticipates," "intends," "plans," "believes," "seeks," or "will." Forward-looking statements by their nature address matters that are, to different degrees, uncertain. For us, particular uncertainties arise from changes in the demand for our coal by the domestic electric generation industry; from legislation and regulations relating to the Clean Air Act and other environmental initiatives; from operational, geological, permit, labor and weather-related factors; from fluctuations in the amount of cash we generate from operations; from future integration of acquired businesses; and from numerous other matters of national, regional and global scale, including those of a political, economic, business, competitive or regulatory nature. These uncertainties may cause our actual future results to be materially different than those expressed in our forward-looking statements. We do not undertake to update our forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required by law. For a description of some of the risks and uncertainties that may affect our future results, you should see the risk factors described from time to time in the reports we file with the Securities and Exchange Commission. Arch Coal, Inc. and Subsidiaries Costs, expenses and other operating Cost of sales Amortization of acquired sales contracts, net Change in fair value of coal derivatives and coal trading activities, net Asset impairment and mine closure costs Selling, general and administrative expenses Other operating income, net Interest expense, net Interest and investment income Loss from continuing operations before income taxes Benefit from income taxes Loss from continuing operations Income from discontinued operations, net of tax $ (97,218) $(128,363) $ (318,217) Losses per common share Basic and diluted LPS - Loss from continuing operations $ (0.46) Basic and diluted LPS - Net loss Basic and diluted weighted average shares outstanding Dividends declared per common share Adjusted EBITDA from Continuing Operations (A) Adjusted diluted loss per common share (A) (A) Amounts are defined and reconciled under "Reconciliation of Non-GAAP Measures" later in this release. Short term investments Trade accounts receivable Other receivables Prepaid royalties Coal derivative assets Other noncurrent assets Total other assets Accrued expenses and other current liabilities Current maturities of debt Asset retirement obligations Accrued pension benefits Accrued postretirement benefits other than pension Accrued workers' compensation Other noncurrent liabilities Treasury stock, at cost Accumulated other comprehensive income Schedule of Consolidated Debt Term loan due 2018 ($1.91 billion and $1.93 billion face value, respectively) 7.00% senior notes due 2019 at par 9.875% senior notes due 2019 ($375.0 million face value) 8.00% senior secured notes due 2019 at par Less: current maturities of debt Calculation of net debt Less liquid assets Adjustments to reconcile to cash provided by operating activities: Amortization relating to financing activities Prepaid royalties expensed Employee stock-based compensation expense Asset impairment costs Amortization of premiums on debt securities held Gains on disposals and divestitures, net Changes in: Accounts payable, accrued expenses and other current liabilities Income taxes, net Cash provided by operating activities Minimum royalty payments Proceeds from sale-leaseback transactions Proceeds from disposals and divestitures Purchases of marketable securities Proceeds from sale or maturity of marketable securities and other investments Investments in and advances to affiliates Change in restricted cash Cash provided by (used in) investing activities Payments on term loan Net payments on other debt Dividends paid Debt financing costs Cash used in financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period Reconciliation of Non-GAAP Measures Included in the accompanying release, we have disclosed certain non-GAAP measures as defined by Regulation G. The following reconciles these items to net income and cash flows as reported under GAAP. Adjusted EBITDA Adjusted EBITDA is defined as net income attributable to the Company before the effect of net interest expense, income taxes, depreciation, depletion and amortization, and the amortization of acquired sales contracts. Adjusted EBITDA may also be adjusted for items that may not reflect the trend of future results. Adjusted EBITDA is not a measure of financial performance in accordance with generally accepted accounting principles, and items excluded from Adjusted EBITDA are significant in understanding and assessing our financial from operations, cash flows from operations or as a measure of our profitability, liquidity or performance under generally accepted accounting principles. We believe that Adjusted EBITDA presents a useful measure of our ability to incur and service debt based on ongoing operations. Furthermore, analogous measures are used by industry analysts to evaluate our operating performance. In addition, acquisition related expenses are excluded to make results more comparable between periods. Investors should be aware that our presentation of Adjusted EBITDA may not be comparable to similarly titled measures used by other companies. The table below shows how we calculate Adjusted EBITDA. Total Company Continuing Operations Discontinued Operations Income tax benefit Adjusted net loss and adjusted diluted loss per share Adjusted net loss and adjusted diluted loss per common share are adjusted for the after-tax impact of acquisition related costs and are not measures of financial performance in accordance with generally accepted accounting principles. We believe that adjusted loss and adjusted diluted loss per common share better reflect the trend of our future results by excluding items relating to significant transactions. The adjustments made to arrive at these measures are significant in understanding and assessing our financial condition. Therefore, adjusted net loss and adjusted diluted loss per share should not be considered in isolation, nor as an alternative to net loss or diluted loss per common share under generally accepted accounting principles. Tax impact of adjustments Adjusted net loss attributable to Arch Coal $ (1,752) Diluted weighted average shares outstanding Diluted loss per share attributable to Arch Coal Adjusted diluted loss per share Cash costs per ton Cash costs per ton exclude the costs of depreciation, depletion and amortization and pass-through transportation costs, and may be adjusted for other items that, due to accounting rules, are classified in "other income/expense" on the statement of operations, but relate directly to the costs incurred to produce coal. Cash costs per ton are not measures of financial performance in accordance with generally accepted accounting principles. We believe cash costs per ton better reflect our controllable costs and our operating results by including all cash costs incurred to produce coal. The adjustments made to arrive at these measures are significant in understanding and assessing our financial condition. Therefore, cash costs per ton should not be considered in isolation, nor as an alternative to cost of sales per ton under generally accepted accounting principles. The following reconciles cost of sales on our condensed consolidated statement of operations to cash cost per ton. Cost of sales on condensed consolidated statement of operations Transportation costs billed to customers Settlements of heating oil derivatives used to manage diesel fuel purchase price risk Other (other operating segments, operating overhead, land management, etc.) Total cash costs Total tons sold Total cash cost per ton

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professional_accounting

Customer & Supplier Resources / Contact Us Regional Sites Chile China Germany Netherlands Hungary (Hungarian) Hungary (English) Japan Albemarle Foundation Our Purpose & Values Albemarle Unlocked Bromine Specialties Fine Chemistry Services Working at Albemarle Albemarle Reports First Quarter Results CHARLOTTE, N.C., May 6, 2020 /PRNewswire/ -- Albemarle Corporation (NYSE: ALB) today announced its results for the first quarter ended March 31, 2020. First Quarter 2020 Highlights (Unless otherwise stated, all percent changes are based on year-over-year comparisons) Net sales of $739 million; Net income of $107 million, or $1.01 per diluted share; Adjusted diluted EPS of $1.00 Adjusted EBITDA of $196 million decreased by ~13% year-over-year, but above previously communicated guidance Taking action to bolster our balance sheet to enhance financial flexibility; drew $250 million on our revolver, repaid other short-term debt Accelerating our $100 million cost savings initiative; we now expect to realize between $50 and $70 million of these savings in 2020 Implementing short-term cash management actions to save between $25 and $40 million per quarter; reducing 2020 capital spending by about $150 million from plan As previously announced, J. Kent Masters was named Chairman, President and CEO of Albemarle effective April 20; separately, in March, Meredith Bandy joined Albemarle to oversee Investor Relations and Sustainability "Despite challenges related to COVID-19, our business performed safely and on plan during the first quarter of 2020. The economic impact of the global pandemic remains unclear, but we remain focused on what is within our control. That means ensuring that our employees are safe and healthy, and have the tools they need to perform; staying connected to our customers and suppliers; monitoring our cash management daily and taking action where appropriate; and accelerating our $100 million cost reduction program," said Kent Masters, Albemarle CEO. "I'd like to thank the entire Albemarle team for working diligently during these uncertain times to ensure we are able to meet our customers' needs and fulfill our obligations to our stakeholders. We remain confident in our strategy and will alter our execution of that strategy based on near-term conditions to position Albemarle for future success." We are withdrawing full-year 2020 outlook given the uncertainty around the duration and economic impact of the pandemic. We intend to reintroduce our full-year outlook as the situation allows. In an effort to help investors better understand our business, we are temporarily introducing a quarterly outlook. Albemarle anticipates that its Q2 2020 performance will be lower year-over-year based on reduced global economic activity due to the global pandemic. Q2 2020 Outlook $700 - $775 million Albemarle's cross-functional Global Response Team meets regularly to assess the situation and take necessary actions to address employee health and safety and operational challenges. We have implemented protocols including restricting travel, work-from-home for non-essential personnel, and shift adjustments, increased hygiene and social distancing for the essential workers at our plants. We have also increased communications with our employees, customers and suppliers to ensure we can meet our commitments safely and efficiently. Finally, we are supporting our communities through monetary and in-kind donations. First Quarter Results In millions, except per share amounts $ Change Net income attributable to Albemarle Corporation Adjusted EBITDA(a) Non-operating pension and OPEB items(a) Non-recurring and other unusual items(a) Adjusted diluted earnings per share(b) (a) See Non-GAAP Reconciliations for further details. (b) Totals may not add due to rounding. Net sales of $738.8 million decreased by $93.2 million compared to the prior year quarter, primarily driven by the Lithium and Catalysts business segments as discussed below. Adjusted EBITDA of $196.4 million decreased by $29.5 million from the prior year quarter as lower cost of goods sold partially offset lower net sales. Similarly, net income attributable to Albemarle of $107.2 million decreased by $26.4 million from the prior year. Corporate costs including SG&A, R&D, and interest and financing expenses were broadly in line with the prior year period. The effective income tax rate for the first quarter of 2020 was 16.0% compared to 24.4% in the same period in 2019, the difference being largely due to a change in the geographic mix of earnings. On an adjusted basis, the effective income tax rates were 16.7% and 22.5% for the first quarter of 2020 and 2019, respectively. Business Segment Results Lithium net sales of $236.8 million declined $55.1 million driven by lower pricing and volume. Lower contract pricing reflects 2020 price adjustments that were agreed to in late 2019. As expected, customers reduced Q1 2020 volumes as they worked off excess inventory purchased in Q4 2019. Adjusted EBITDA of $78.6 million declined by $37.0 million as product and customer mix and cost savings helped offset reduced net sales. Current Trends: Our lithium plants in Chengdu and Xinyu operated at reduced rates in early 2020 due to operating restrictions related to COVID-19. Those facilities are now operating at plan. To date, we have experienced minimal order reductions. However, customer closures and order cancellations are likely to affect specialty and technical grade products in Q2 2020. We continue to see solid battery grade orders in Q2 2020 as battery manufacturers catch up on backlog orders placed prior to COVID-19. Therefore, the impact of recent automotive OEM shutdowns is expected to be delayed into H2 2020. Bromine net sales of $231.6 million declined $17.5 million. Lower volumes due to logistics challenges were partially offset by higher average selling prices. Adjusted EBITDA of $83.3 million was up slightly as cost savings initiatives and reduced minority interest expense offset lower net sales. Current Trends: To date, Bromine demand has remained relatively strong; however, future demand is likely to be impacted by recent COVID-19 shut-downs. Due to our position in the supply chain most of the impact is expected to be delayed into H2 2020, and to rebound relatively quickly when economic activity returns to more normal levels. Catalysts net sales of $207.2 million declined $44.4 million due primarily to lower volumes. Fluid Catalytic Cracking (FCC) volume was down primarily from lower transportation fuel consumption as a result of stay-at-home orders and travel restrictions. Logistics challenges also impacted catalysts volumes. Adjusted EBITDA of $47.5 million declined $12.6 million as reduced raw materials costs and better product mix partially offset reduced net sales. Current Trends: Reduced transportation fuel consumption is expected to worsen into Q2 2020, putting further downward pressure on FCC volumes. To date, the Clean Fuel Technology (Hydroprocessing Catalysts or HPC) business has been relatively unaffected; however, based on previous economic downturns, we would expect HPC to be negatively impacted in H2 2020 as refiners defer spending into 2021. Other operations represents our Fine Chemistry Services (FCS) business. FCS net sales of $63.2 million increased $23.8 million and adjusted EBITDA of $22.8 million increased $15.6 million. The FCS business tends to be contract driven. Recent contracts include life sciences products which are typically anti-cyclical. Balance Sheet and Liquidity As of March 31, 2020, Albemarle had estimated liquidity of $1.7 billion including $553 million of cash and equivalents, $715 million remaining under our $1 billion revolver, $200 million available under our delayed draw term loan, and $190 million on other available credit lines. Total debt was $3.1 billion, representing net debt to adjusted EBITDA of approximately 2.7x. Current leverage is below the level required under debt covenants; however, we are in the process of negotiating a covenant waiver to ensure on-going financial flexibility. Cash Flow and Capital Deployment First quarter cash from operations of $155.1 million increased $100.1 million versus the prior year as working capital reductions more than offset lower earnings. Capital expenditures of $214.5 million were in-line with the prior year as progress continued on our Lithium expansion projects. We have evaluated our capital allocation priorities under a variety of economic scenarios. Our immediate capital allocation priorities are to maintain our investment grade rating and our quarterly dividend. In order to preserve cash and align with the current economic environment, we are accelerating our previously announced cost savings initiatives, implementing short-term cash management tactics and delaying capital expenditures. We now anticipate realizing $50 to $70 million of sustainable cost savings in 2020, up from $50 million previously. We also expect full-year capital spending to be approximately $850 to $950 million, down about $150 million from previous plan. Short term cash management actions include hiring limits, inventory reductions, and executive salary cuts. In February, the board declared a quarterly dividend of $0.385 per share, an increase of approximately 5% over the previous quarterly dividend. 2020 is expected to be our 26th consecutive year of dividend increase and the company remains committed to shareholder returns. Our share repurchase authorization remains in place; however, there are no near-term plans to execute share buybacks. Divestiture activity has been temporarily slowed as travel restrictions are delaying due diligence processes. 9:00 AM Eastern time Dial-in (U.S.): Dial-in (International): The Company's earnings presentation and supporting material are available on Albemarle's website at https://investors.albemarle.com. About Albemarle Albemarle Corporation (NYSE: ALB), headquartered in Charlotte, N.C., is a global specialty chemicals company with leading positions in lithium, bromine and refining catalysts. We power the potential of companies in many of the world's largest and most critical industries, from energy and communications to transportation and electronics. Working side-by-side with our customers, we develop value-added, customized solutions that make them more competitive. Our solutions combine the finest technology and ingredients with the knowledge and know-how of our highly experienced and talented team of operators, scientists and engineers. Discovering and implementing new and better performance-based sustainable solutions is what motivates all of us. We think beyond business-as-usual to drive innovations that create lasting value. Albemarle employs approximately 6,000 people and serves customers in approximately 75 countries. We regularly post information to www.albemarle.com, including notification of events, news, financial performance, investor presentations and webcasts, non-GAAP reconciliations, SEC filings and other information regarding our company, its businesses and the markets it serves. Some of the information presented in this press release, the conference call and discussions that follow, including, without limitation, information related to product development, production capacity, committed volumes, market trends, pricing, expected growth, earnings and demand for our products, input costs, surcharges, tax rates, stock repurchases, dividends, cash flow generation, costs and cost synergies, capital projects, economic trends, outlook and all other information relating to matters that are not historical facts may constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from the views expressed. Factors that could cause actual results to differ materially from the outlook expressed or implied in any forward-looking statement include, without limitation: changes in economic and business conditions; changes in financial and operating performance of our major customers and industries and markets served by us; the timing of orders received from customers; the gain or loss of significant customers; competition from other manufacturers; changes in the demand for our products or the end-user markets in which our products are sold; limitations or prohibitions on the manufacture and sale of our products; availability of raw materials; increases in the cost of raw materials and energy, and our ability to pass through such increases to our customers; changes in our markets in general; fluctuations in foreign currencies; changes in laws and government regulation impacting our operations or our products; the occurrence of regulatory actions, proceedings, claims or litigation; the occurrence of cyber-security breaches, terrorist attacks, industrial accidents, natural disasters or climate change; the inability to maintain current levels of product or premises liability insurance or the denial of such coverage; political unrest affecting the global economy, including adverse effects from terrorism or hostilities; political instability affecting our manufacturing operations or joint ventures; changes in accounting standards; the inability to achieve results from our global manufacturing cost reduction initiatives as well as our ongoing continuous improvement and rationalization programs; changes in the jurisdictional mix of our earnings and changes in tax laws and rates; changes in monetary policies, inflation or interest rates that may impact our ability to raise capital or increase our cost of funds, impact the performance of our pension fund investments and increase our pension expense and funding obligations; volatility and uncertainties in the debt and equity markets; technology or intellectual property infringement, including cyber-security breaches, and other innovation risks; decisions we may make in the future; the ability to successfully execute, operate and integrate acquisitions and divestitures; uncertainties as to the duration and impact of the coronavirus (COVID-19) pandemic; and the other factors detailed from time to time in the reports we file with the SEC, including those described under "Risk Factors" in our Annual Report on Form 10-K and our Quarterly Reports on Form 10-Q. These forward-looking statements speak only as of the date of this press release. We assume no obligation to provide any revisions to any forward-looking statements should circumstances change, except as otherwise required by securities and other applicable laws. Albemarle Corporation and Subsidiaries (In Thousands Except Per Share Amounts) (Unaudited) Selling, general and administrative expenses Interest and financing expenses Income before income taxes and equity in net income of unconsolidated investments Income tax expense Income before equity in net income of unconsolidated investments Equity in net income of unconsolidated investments (net of tax) Net income attributable to noncontrolling interests Weighted-average common shares outstanding – basic Weighted-average common shares outstanding – diluted (In Thousands) (Unaudited) Trade accounts receivable Other accounts receivable Less accumulated depreciation and amortization Net property, plant and equipment Other intangibles, net of amortization LIABILITIES AND EQUITY Accrued expenses Current portion of long-term debt Dividends payable Current operating lease liability Postretirement benefits Pension benefits Other noncurrent liabilities Equity: Albemarle Corporation shareholders' equity: Total Albemarle Corporation shareholders' equity Total liabilities and equity Selected Consolidated Cash Flow Data Cash and cash equivalents at beginning of year Cash flows from operating activities: Adjustments to reconcile net income to cash flows from operating activities: Gain on sale of property Stock-based compensation and other Dividends received from unconsolidated investments and nonmarketable securities Pension and postretirement (benefit) expense Pension and postretirement contributions Unrealized gain on investments in marketable securities Working capital changes Cash flows from investing activities: Acquisitions, net of cash acquired Capital expenditures Proceeds from sale of property and equipment Sales of marketable securities, net Investments in equity and other corporate investments Cash flows from financing activities: Proceeds from borrowings of credit agreements Other (repayments) borrowings, net Dividends paid to shareholders Dividends paid to noncontrolling interests Proceeds from exercise of stock options Withholding taxes paid on stock-based compensation award distributions Debt financing costs Net cash provided by financing activities Net effect of foreign exchange on cash and cash equivalents Decrease in cash and cash equivalents Cash and cash equivalents at end of period Consolidated Summary of Segment Results Net sales: Total net sales Adjusted EBITDA: Total adjusted EBITDA See accompanying non-GAAP reconciliations below. It should be noted that adjusted net income attributable to Albemarle Corporation, adjusted diluted earnings per share, non-operating pension and OPEB items per diluted share, non-recurring and other unusual items per diluted share, adjusted effective income tax rates, EBITDA, adjusted EBITDA, EBITDA margin and adjusted EBITDA margin are financial measures that are not required by, or presented in accordance with, accounting principles generally accepted in the United States, or GAAP. These non-GAAP measures should not be considered as alternatives to Net income attributable to Albemarle Corporation ("earnings"). These measures are presented here to provide additional useful measurements to review our operations, provide transparency to investors and enable period-to-period comparability of financial performance. The Company's chief operating decision maker uses these measures to assess the ongoing performance of the Company and its segments, as well as for business and enterprise planning purposes. A description of other non-GAAP financial measures that we use to evaluate our operations and financial performance, and reconciliation of these non-GAAP financial measures to the most directly comparable financial measures calculated and reported in accordance with GAAP can be found on the following pages of this press release, which is also is available on Albemarle's website at https://investors.albemarle.com. The Company does not provide a reconciliation of forward-looking non-GAAP financial measures to the most directly comparable financial measures calculated and reported in accordance with GAAP, as the Company is unable to estimate significant non-recurring or unusual items without unreasonable effort. The amounts and timing of these items are uncertain and could be material to the Company's results calculated in accordance with GAAP. Non-GAAP Reconciliations See below for a reconciliation of adjusted net income attributable to Albemarle Corporation, EBITDA and adjusted EBITDA, the non-GAAP financial measures, to Net income attributable to Albemarle Corporation ("earnings"), the most directly comparable financial measure calculated and reported in accordance with GAAP. Adjusted earnings is defined as earnings before the non-recurring, other unusual and non-operating pension and OPEB items as listed below. EBITDA is defined as earnings before interest and financing expenses, income taxes, and depreciation and amortization. Adjusted EBITDA is defined as EBITDA and the non-recurring, other unusual and non-operating pension and OPEB items as listed below. In thousands, except percentages and per share amounts Add back: Non-operating pension and OPEB items (net of tax) Non-recurring and other unusual items (net of tax) Adjusted net income attributable to Albemarle Corporation Adjusted diluted earnings per share Non-operating pension and OPEB items Non-recurring and other unusual items Adjusted EBITDA margin See below for a reconciliation of adjusted EBITDA on a segment basis, the non-GAAP financial measure, to Net income attributable to Albemarle Corporation, the most directly comparable financial measure calculated and reported in accordance with GAAP (in thousands, except percentages). Reportable Segments Total Consolidated Total % of Net Sales Three months ended March 31, 2020: Net income (loss) attributable to Albemarle Corporation Non-operating pension and OPEB items, consisting of mark-to-market actuarial gains/losses, settlements/curtailments, interest cost and expected return on assets, are not allocated to our operating segments and are included in the Corporate category. In addition, we believe that these components of pension cost are mainly driven by market performance, and we manage these separately from the operational performance of our businesses. In accordance with GAAP, these non-operating pension and OPEB items are included in Other income, net. Non-operating pension and OPEB items were as follows (in thousands): Interest cost Expected return on assets In addition to the non-operating pension and OPEB items disclosed above, we have identified certain other items and excluded them from our adjusted net income calculation for the periods presented. A listing of these items, as well as a detailed description of each follows below (per diluted share): Restructuring and other(1) Acquisition and integration related costs(2) Gain on sale of property(3) Discrete tax items(5) Total non-recurring and other unusual items (1) Included in Cost of goods sold, Selling, general and administrative expenses and Net income attributable to noncontrolling interest for the three months ended March 31, 2020 is $0.7 million, $1.5 million and a $0.3 million gain ($1.5 million after income taxes, or $0.01 per share), respectively, related to severance payments as part of a business reorganization plan. (2) Acquisition and integration related costs included in Selling, general and administrative expenses for the three months ended March 31, 2020 and 2019 of $3.0 million and $5.3 million ($2.3 million and $4.1 million after income taxes, or $0.02 and $0.04 per share), respectively, related to various significant projects including the Wodgina mine acquisition. (3) Included in Other income, net, for the three months ended March 31, 2019 is a gain of $11.1 million ($8.5 million after income taxes, or $0.08 per share) related to the sale of land in Pasadena, Texas not used as part of our operations. (4) Other adjustments for the three months ended March 31, 2020 included amounts recorded in: Other income, net - $2.6 million gain resulting from the settlement of a legal matter related to a business sold, partially offset by a $0.8 million loss resulting from the adjustment of indemnifications related to previously disposed businesses. After income taxes, this net gain totaled $1.2 million, or $0.01 per share. Other adjustments for the three months ended March 31, 2019 included amounts recorded in: Cost of goods sold - $0.4 million related to non-routine labor and compensation related costs in Chile that are outside normal compensation arrangements. Selling, general and administrative expenses - $0.5 million related to severance payments as part of a business reorganization plan. Other income, net - $1.6 million of a net gain resulting from the revision of indemnifications and other liabilities related to previously disposed businesses. (5) Included in Income tax expense for the three months ended March 31, 2020 are discrete net tax benefits of $1.1 million, or $0.01 per share. This net benefit is primarily related to excess tax benefits realized from stock-based compensation arrangements. Included in Income tax expense for the three months ended March 31, 2019 are discrete net tax expenses of $3.2 million, or $0.03 per share, primarily related to expenses for uncertain tax positions and foreign return to accrual adjustments, partially offset by a benefit for excess tax benefits realized from stock-based compensation arrangements. See below for a reconciliation of the adjusted effective income tax rate, the non-GAAP financial measure, to the effective income tax rate, the most directly comparable financial measure calculated and reported in accordance with GAAP (in thousands, except percentages). Income before income taxes and equity in net income of unconsolidated investments Effective income tax rate As reported Non-recurring, other unusual and non-operating pension and OPEB items As adjusted View original content to download multimedia:https://www.prnewswire.com/news-releases/albemarle-reports-first-quarter-results-301054253.html SOURCE Albemarle Corporation Meredith Bandy, 980.999.5168 About LocationsBusinesses Resource CenterNewsCareersContact UsInvestorsSustainability © 2021 Albemarle Corporation. All Rights Reserved. Albemarle uses cookies on this site with your consent to analyze our traffic and optimize your user experience. For more information, including about cookies we use without your consent and how to opt out, go to our Cookie Policy. By clicking “Accept”, you consent to the use of cookies and confirm that you are 16 or older. You can always opt-out (e.g. by deleting the cookies), however, you may not be able to use the full functionalities of the website.

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professional_accounting

Finance - NBFC / Bajaj Finance Ltd. BSE: 500034 | NSE: BAJFINANCE | Represents Equity.Intra - day transactions are permissible and normal trading is done in this category Series: EQ | ISIN: INE296A01024 | SECTOR: Finance - NBFCFinance - NBFC Bajaj Finance Bajaj Finance Ltd. | BSE 5756.00 -40.90 (-0.71%) | NSE 5760.70 -35.20 (-0.61%) | Trade | Add 5756.00 -40.90 (-0.71%) 5756.00 (43) 5756.00 (180) Download Annual Report in PDF format 2022 2021 2019 2018 2017 2016 2015 2014 2013 More 2012 2011 2010 2009 2008 2007 Annual Report 2022 2021 2019 2018 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 To the Members of Bajaj Finance Ltd. We have audited the accompanying standalone financial statements of Bajaj Finance Ltd. (the ''Company''), which comprise the Balance Sheet as at 31 March 2022, the Statement of Profit and Loss (including Other Comprehensive Income), the Statement of Changes in Equity and the Statement of Cash Flows for the year then ended, and a summary of significant accounting policies and other explanatory information (hereinafter referred to as the ''standalone financial statements''). In our opinion and to the best of our information and according to the explanations given to us, the aforesaid standalone financial statements give the information required by the Companies Act, 2013 (the ''Act'') in the manner so required and give a true and fair view in conformity with the Indian Accounting Standards prescribed under section 133 of the Act read with the Companies (Indian Accounting Standards) Rules, 2015, as amended, (''Ind AS'') and other accounting principles generally accepted in India, of the state of affairs of the Company as at 31 March 2022, and its profit, total comprehensive income, the changes in equity and its cash flows for the year ended on that date. We conducted our audit of the standalone financial statements in accordance with the Standards on Auditing specified under section 143(10) of the Act (''SAs''). Our responsibilities under those standards are further described in the Auditors'' responsibility for the audit of the standalone financial statements section of our report. We are independent of the Company in accordance with the Code of Ethics issued by the Institute of Chartered Accountants of India (''ICAI'') together with the ethical requirements that are relevant to our audit of the standalone financial statements under the provisions of the Act and the Rules made thereunder, and we have fulfilled our other ethical responsibilities in accordance with these requirements and the ICAI''s Code of Ethics. We believe that the audit evidence obtained by us is sufficient and appropriate to provide a basis for our audit opinion on the standalone financial statements. Emphasis of matter We draw attention to note no. 48(c) to the standalone financial statements in which the Company describes the continuing uncertainties arising from the COVID-19 pandemic. Our opinion is not modified in respect of this matter. Key audit matters Key audit matters are those matters that, in our professional judgement, were of most significance in our audit of the standalone financial statements of the current period. These matters were addressed in the context of our audit of the standalone financial statements as a whole, and in forming our opinion thereon, and we do not provide a separate opinion on these matters. We have determined the matters described below to be the key audit matters to be communicated in our report. S. N. Key audit matter Auditors'' response 1. Allowances for expected credit losses (''ECL''): We have examined the policies approved by the Board of As at 31 March 2022, the carrying value of Directors of the Company that articulate the objectives of loan assets measured at amortised cost, managing each portfolio and their business models. We have aggregated ? 144,276.25 crore (net of also verified the methodology adopted for computation of ECL allowance for expected credit loss ? 3,936.84 (''ECL Model'') that addresses policies approved by the Board of crore) constituting approximately 86% of the Directors, procedures and controls for assessing and measuring Company''s total assets. Significant judgement credit risk on all lending exposures measured at amortised is used in classifying these loan assets and cost. Additionally, we have confirmed that adjustments to the applying appropriate measurement principles. output of the ECL Model are consistent with the documented ECL on such loan assets measured at rationale and basis for such adjustments and that the amount of amortised cost is a critical estimate involving adjustments have been approved by the Audit Committee of the greater level of management judgement. As Board of Directors. part of our risk assessment, we determined Our audit procedures related to the allowance for ECL included that the ECL on such loan assets has a high the following, among others: degree of estimation uncertainty, with a potential range of reasonable outcomes for the standalone financial statements. The elements of estimating ECL which involved increased level of audit focus are the following: Testing the design and operating effectiveness of the following: • Completeness and accuracy of the EAD and the classification thereof into stages consistent with the definitions applied in accordance with the policy approved by the Board of Directors including the appropriateness of • Qualitative and quantitative factors used in staging the loan assets measured at amortised cost; • Basis used for estimating probabilities of default (''PD''), loss given default (''LGD'') and exposure at default (''EAD'') at product level with past trends; • Judgements used in projecting economic scenarios and probability weights applied to reflect future economic conditions; and • Adjustments to model driven ECL results to address emerging trends. the qualitative factors to be applied; • Completeness, accuracy and appropriateness of information used in the estimation of the PD and LGD for the different stages depending on the nature of the portfolio; • Accuracy of the computation of the ECL estimate including reasonableness of the methodology used to determine macro-economic overlays and adjustments to the output of the ECL Model; and • Validity of the changes made to the structured query language (''SQL'') queries used for the ECL calculations to ensure that the changes made to them are reviewed, documented and duly approved by the designated officials. (Refer note no. 3.4, 9 and 48(c) to the Test of details on a sample basis in respect of the following: standalone financial statements). • Accuracy and completeness of the input data such as period of default and other related information used in estimating the PD. • The mathematical accuracy of the ECL computation by using the same input data as used by the Company. • Use of the appropriate SQL queries for calibration of ECL rates and its application to the corresponding loan asset portfolio of the Company or part thereof. • Completeness and accuracy of the staging of the loans and the underlying data based on which the ECL estimates have been computed. • Evaluating the adequacy of the adjustment after stressing the inputs used in determining the output as per the ECL Model to ensure that the adjustment was in conformity with the overlay amount approved by the Audit Committee of the Company. 2. Information technology and general controls: The Company is dependent on its information technology (''IT'') systems due to the significant number of transactions that are processed daily across such multiple and discrete IT systems. Also, IT application controls are critical to ensure that changes to applications and underlying data are made in an appropriate manner and under controlled environment. Appropriate controls contribute to mitigating the risk of potential fraud or errors as a result of changes to applications and data. On account of the pervasive use of its IT systems, the testing of the general computer controls of the IT systems used in financial reporting was considered to be a key audit matter. With the assistance of our IT specialists, we obtained an understanding of the Company''s IT applications, databases and operating systems relevant to financial reporting and the control environment. For these elements of the IT infrastructure the areas of our focus included access security (including controls over privileged access), program change controls, database management and network operations. In particular: • We tested the design, implementation and operating effectiveness of the Company''s general IT controls over the IT systems relevant to financial reporting. This included evaluation of Company''s controls over segregation of duties and access rights being provisioned/modified based on duly approved requests, access for exit cases being revoked in a timely manner and access of all users being recertified during the period of audit. • We also tested key automated business cycle controls and logic for the reports generated through the IT infrastructure that were relevant for financial reporting or were used in the exercise of internal financial controls with reference to financial statements. Our tests included testing of the compensating controls or alternate procedures to assess whether there were any unaddressed IT risks that would materially impact the standalone financial statements. Information other than the financial statements and Auditors'' report thereon The Company''s Board of Directors is responsible for the other information. The other information comprises the Board''s Report (including annexures thereto), Business Responsibility Statement and Management Discussion and Analysis (''MD&A'') (collectively referred to as ''other information'') but does not include the consolidated financial statements, standalone financial statements, and our auditors'' report thereon. Our opinion on the standalone financial statements does not cover the other information and we do not express any form of assurance conclusion thereon. In connection with our audit of the standalone financial statements, our responsibility is to read the other information and, in doing so, consider whether the other information is materially inconsistent with the financial statements or our knowledge obtained in the audit or otherwise appears to be materially misstated. If, based on the work we have performed, we conclude that there is a material misstatement of this other information, we are required to report that fact. We have nothing to report in this regard. Management''s responsibility for the standalone financial statements The Company''s Board of Directors is responsible for the matters stated in section 134(5) of the Act with respect to the preparation of these standalone financial statements that give a true and fair view of the financial position, financial performance including other comprehensive income, changes in equity and cash flows of the Company in accordance with the Ind AS and other accounting principles generally accepted in India. This responsibility also includes maintenance of adequate accounting records in accordance with the provisions of the Act for safeguarding the assets of the Company and for preventing and detecting frauds and other irregularities; selection and application of appropriate accounting policies; making judgements and estimates that are reasonable and prudent; and design, implementation and maintenance of adequate internal financial controls, that were operating effectively for ensuring the accuracy and completeness of the accounting records, relevant to the preparation and presentation of the standalone financial statements that give a true and fair view and are free from material misstatement, whether due to fraud or error. In preparing the standalone financial statements, Management is responsible for assessing the Company''s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the going concern basis of accounting unless Management either intends to liquidate the Company or to cease operations, or has no realistic alternative but to do so. The Board of Directors of the Company is also responsible for overseeing the Company''s financial reporting process. Auditors'' responsibility for the audit of the standalone financial statements Our objectives are to obtain reasonable assurance about whether the standalone financial statements as a whole are free from material misstatement, whether due to fraud or error, and to issue an auditors'' report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with SAs will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence the economic decisions of users taken on the basis of these standalone financial statements. As part of an audit in accordance with SAs, we exercise professional judgement and maintain professional skepticism throughout the audit. We also: • Identify and assess the risks of material misstatement of the standalone financial statements, whether due to fraud or error, design and perform audit procedures responsive to those risks, and obtain audit evidence that is sufficient and appropriate to provide a basis for our opinion. The risk of not detecting a material misstatement resulting from fraud is higher than for one resulting from error, as fraud may involve collusion, forgery, intentional omissions, misrepresentations, or the override of internal control. • Obtain an understanding of internal financial control relevant to the audit in order to design audit procedures that are appropriate in the circumstances. Under section 143(3) (i) of the Act, we are also responsible for expressing our opinion on whether the Company has adequate internal financial controls system in place and the operating effectiveness of such controls. • Evaluate the appropriateness of accounting policies used and the reasonableness of accounting estimates and related disclosures made by the Management. • Conclude on the appropriateness of Management''s use of the going concern basis of accounting and, based on the audit evidence obtained, whether a material uncertainty exists related to events or conditions that may cast significant doubt on the Company''s ability to continue as a going concern. If we conclude that a material uncertainty exists, we are required to draw attention in our auditors'' report to the related disclosures in the standalone financial statements or, if such disclosures are inadequate, to modify our opinion. Our conclusions are based on the audit evidence obtained up to the date of our auditors'' report. However, future events or conditions may cause the Company to cease to continue as a going concern. • Evaluate the overall presentation, structure and content of the standalone financial statements, including the disclosures, and whether the standalone financial statements represent the underlying transactions and events in a manner that achieves fair presentation. Materiality is the magnitude of misstatements in the standalone financial statements that, individually or in aggregate, makes it probable that the economic decisions of a reasonably knowledgeable user of the standalone financial statements may be influenced. We consider quantitative materiality and qualitative factors in (i) planning the scope of our audit work and in evaluating the results of our work; and (ii) to evaluate the effect of any identified misstatements in the standalone financial statements. We communicate with those charged with governance regarding, among other matters, the planned scope and timing of the audit and significant audit findings, including any significant deficiencies in internal control that we identify during our audit. We also provide those charged with governance with a statement that we have complied with relevant ethical requirements regarding independence, and to communicate with them all relationships and other matters that may reasonably be thought to bear on our independence, and where applicable, related safeguards. From the matters communicated with those charged with governance, we determine those matters that were of most significance in the audit of the standalone financial statements of the current period and are therefore the key audit matters. We describe these matters in our auditors'' report unless law or regulation precludes public disclosure about the matter or when, in extremely rare circumstances, we determine that a matter should not be communicated in our report because the adverse consequences of doing so would reasonably be expected to outweigh the public interest benefits of such communication. Report on other legal and regulatory requirements 1. As required by section 143(3) of the Act, based on our audit on the separate financial statements, we report that: (a) We have sought and obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purposes of our audit. (b) In our opinion, proper books of account as required by law have been kept by the Company so far as it appears from our examination of those books. (c) The Balance Sheet, the Statement of Profit and Loss including Other Comprehensive Income, Statement of Changes in Equity and the Statement of Cash Flows dealt with by this Report are in agreement with the relevant books of account. (d) In our opinion, the aforesaid standalone financial statements comply with the Ind AS specified under section 133 of the Act. (e) On the basis of the written representations received from the Directors as on 31 March 2022 taken on record by the Board of Directors, none of the Directors are disqualified as on 31 March 2022 from being appointed as a Director in terms of section 164(2) of the Act. (f) With respect to the adequacy of the internal financial controls with reference to financial statements of the Company and the operating effectiveness of such controls, refer to our separate report in ''Annexure A''. Our report expresses an unmodified opinion on the adequacy and operating effectiveness of the Company''s internal financial controls with reference to financial statements. (g) With respect to the other matters to be included in the Auditors'' Report in accordance with the requirements of section 197(16) of the Act, as amended, in our opinion and to the best of our information and according to the explanations given to us, the remuneration paid by the Company to its Directors during the year is in accordance with the provisions of section 197 of the Act. (h) With respect to the other matters to be included in the Auditors'' Report in accordance with Rule 11 of the Companies (Audit and Auditors) Rules, 2014, as amended in our opinion and to the best of our information and according to the explanations given to us: i. The Company has disclosed the impact of pending litigations on its financial position in its standalone financial statements. ii. The Company has made provision, as required under the applicable law or accounting standards, for material foreseeable losses, if any, on long-term contracts including derivative contracts. iii. There has been no delay in transferring amounts, required to be transferred, to the Investor Education and Protection Fund by the Company. iv. (a) The Management has represented that, to the best of its knowledge and belief, no funds (which are material either individually or in the aggregate) have been advanced or loaned or invested (either from borrowed funds or share premium or any other sources or kind of funds) by the Company to or in any other person(s) or entity(ies), including foreign entities (''Intermediaries''), with the understanding, whether recorded in writing or otherwise, that the Intermediary shall, directly or indirectly lend or invest in other persons or entities identified in any manner whatsoever by or on behalf of the Company (''Ultimate Beneficiaries'') or provide any guarantee, security or the like on behalf of the ultimate beneficiaries; (b) The Management has represented, that, to the best of its knowledge and belief, no funds (which are material either individually or in the aggregate) have been received by the Company from any person(s) or entity(ies), including foreign entities (''Funding Parties''), with the understanding, whether recorded in writing or otherwise, that the Company shall, directly or indirectly, lend or invest in other persons or entities identified in any manner whatsoever by or on behalf of the funding party (''Ultimate Beneficiaries'') or provide any guarantee, security or the like on behalf of the ultimate beneficiaries; and (c) Based on the audit procedures that has been considered reasonable and appropriate in the circumstances, nothing has come to our notice that has caused us to believe that the representations under sub-clause (i) and (ii) of Rule 11(e), as provided under (a) and (b) above, contain any material misstatement. v. The final dividend proposed with respect to previous year, declared and paid by the Company during the year is in accordance with section 123 of the Act, as applicable. As stated in note no. 45(iii) to the standalone financial statements, the Board of Directors of the Company have proposed final dividend for the year which is subject to the approval of the members at the ensuing Annual General Meeting. The amount of dividend proposed is in accordance with section 123 of the Act, as applicable. 2. As required by the Companies (Auditors'' Report) Order, 2020 (the ''Order'') issued by the Central Government in terms of section 143(11) of the Act, we give in ''Annexure B'' a statement on the matters specified in paragraphs 3 and 4 of the Order. For Deloitte Haskins & Sells For G.M. Kapadia & Co. Chartered Accountants Chartered Accountants (Firm''s Registration No. 302009E) (Firm''s Registration No. 104767W) Sanjiv V. Pilgaonkar Rajen Ashar (Membership No. 039826) (Membership No. 048243) (UDIN: 22039826AHUJDO9772) (uDIN: 22048243AHUFXP9553) Date: 26 April 2022 Date: 26 April 2022 Place: Pune Place: Pune Bajaj Finance Stock Price | Bajaj Finance Stock Quote | Bajaj Finance Results | Bajaj Finance News | View All Related Searches

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professional_accounting

NuVasive Reports Fourth Quarter And Full Year 2018 Financial Results Company provides 2019 financial performance guidance SAN DIEGO, Feb. 20, 2019 /PRNewswire/ -- NuVasive, Inc. (NASDAQ: NUVA), the leader in spine technology innovation, focused on transforming spine surgery with minimally disruptive, procedurally integrated solutions, today announced financial results for the quarter and full year ended Dec. 31, 2018. Fourth Quarter 2018 Highlights: Revenue increased 6.3% to $288.3 million, or 6.9% on a constant currency basis; GAAP operating profit margin of 9.0%; Non-GAAP operating profit margin of 16.0%; and GAAP diluted earnings per share of $0.23; Non-GAAP diluted earnings per share of $0.69. Full Year 2018 Highlights: Revenue increased 7.3% to $1,101.7 million, or 7.1% on a constant currency basis; "NuVasive delivered strong year-over-year revenue growth of more than 7% in 2018, demonstrating the Company's ability to take share in a stable but relatively flat U.S. spine market. Additionally, we made significant progress at our West Carrollton manufacturing facility, exiting the year at 70% SKU rationalization. Collectively, these achievements serve to advance our mission to bring disruptive technology to surgeon partners to enable better, more predictable patient outcomes," said J. Christopher Barry, chief executive officer of NuVasive. "In 2019, NuVasive will focus on continuing to deliver above market revenue growth, while balancing operating leverage with reinvestment opportunities. We will demonstrate a disciplined approach toward funding key areas for long-term Company growth—furthering our product leadership in global implant systems, accelerating our Surgical Intelligence platform, and investing in surgeon training and education with an ongoing focus on globalization efforts." A full reconciliation of non-GAAP to GAAP measures can be found in the tables of this news release. Fourth Quarter 2018 Results NuVasive reported fourth quarter 2018 total revenue of $288.3 million, a 6.3% increase on a reported basis and 6.9% increase on a constant currency basis, compared to $271.2 million for the fourth quarter 2017. For the fourth quarter 2018, GAAP and non-GAAP gross profit was $202.2 million, and GAAP and non-GAAP gross margin was 70.1%. These results compared to GAAP and non-GAAP gross profit of $195.9 million and $196.3 million, respectively, and GAAP and non-GAAP gross margin of 72.2% and 72.4%, respectively for the fourth quarter 2017. Total GAAP and non-GAAP operating expenses for the fourth quarter 2018 were $176.3 million and $156.2 million, respectively. These results compared to GAAP and non-GAAP operating expenses of $166.5 million and $146.9 million, respectively, for the fourth quarter 2017. The Company reported GAAP net income of $12.2 million, or $0.23 per share, for the fourth quarter 2018 compared to GAAP net income of $23.5 million, or $0.45 per share, for the fourth quarter 2017. On a non-GAAP basis, the Company reported net income of $36.1 million, or $0.69 per share, for the fourth quarter 2018 compared to net income of $29.1 million, or $0.56 per share, for the fourth quarter 2017. Full Year 2018 Results NuVasive reported full year 2018 total revenue of $1,101.7 million, a 7.3% increase on a reported basis and 7.1% increase on a constant currency basis, compared to $1,026.7 million for the full year 2017. Total GAAP and non-GAAP gross profit for the full year 2018 was $790.6 million and $791.6 million, respectively, and GAAP and non-GAAP gross margin was 71.8% and 71.9%, respectively. These results compared to gross profit of $758.2 million and $758.8 million on a GAAP and non-GAAP basis, respectively, and a GAAP and non-GAAP gross margin of 73.9% for the full year 2017. Total GAAP and non-GAAP operating expenses for the full year 2018 were $736.4 million and $624.8 million, respectively. These results compared to GAAP and non-GAAP operating expenses of $646.8 million and $589.5 million, respectively, for the full year 2017. The Company reported GAAP net income of $12.5 million, or $0.24 per share, for the full year 2018 compared to GAAP net income of $81.6 million, or $1.48 per share, for the full year 2017. On a non-GAAP basis, the Company reported net income of $116.6 million, or $2.23 per share, for the full year 2018 compared to net income of $99.0 million, or $1.89 per share, for the full year 2017. Annual Financial Guidance for 2019 The Company estimates revenue for full year 2019 to be in the range of $1.14 billion to $1.16 billion, reflecting reported growth in the range of 3.5% to 5.5%. The Company expects currency to have a negative impact in 2019 of approximately $4 million. The Company estimates full year 2019 net income on a GAAP basis in the range of $1.00 to $1.10 per share and non-GAAP earnings per share in the range of $2.20 to $2.30. 2019 Guidance Range 1 Non-GAAP $1.14B - $1.16B % Growth - Reported 3.5% - 5.5% % Growth - Constant Currency2 Operating margin 9.5% - 10.0% 15.0% - 15.5% EBITDA margin Guidance reflects the range provided on February 20, 2019. Constant currency is a measure that adjusts US GAAP revenue for the impact of currency over the same period in the prior year. Supplementary Financial Information For additional financial detail, please visit the Investor Relations section of the Company's website at www.nuvasive.com to access Supplementary Financial Information. Reconciliation of Full Year EPS Guidance 2018 Actuals 1 2019 Guidance Range GAAP diluted net income per share Impact of change to diluted share count GAAP net income per share, adjusted to diluted Non-GAAP share count Business transition costs 4 Non-cash purchase accounting adjustments on acquisitions 5 Non-cash interest expense on convertible notes Litigation related expenses and settlements 6 Non-recurring consulting fees 7 Net loss on strategic investments Amortization of intangible assets Purchase of in-process research and development 8 European medical device regulation9 Tax effect of adjustments10 Non-GAAP earnings per share GAAP Weighted shares outstanding - basic GAAP Weighted shares outstanding - diluted Non-GAAP Weighted shares outstanding - diluted 11 Items may not foot due to rounding. Effective tax expense rate of ~24% applied to GAAP earnings and ~23% applied to Non-GAAP earnings. Costs related to acquisition, integration and business transition activities which include severance, relocation, consulting, leasehold exit costs, third party merger and acquisitions costs, contingent consideration fair value adjustments, and other costs directly associated with such activities. Represents costs associated with non-cash purchase accounting adjustments, such as acquired inventory fair market value adjustments, which are amortized over the period in which underlying products are sold. Represents the loss recorded in connection with the settlement of the Madsen Medical, Inc. litigation matter, as well as expenses associated with ongoing litigation with a former Board member and his current employer related to various matters, including infringement of the Company's intellectual property. Non-recurring consulting fees associated with the implementation of our state tax-planning strategy. Purchase of an in-process research and development asset which had no future alternative use. Charges represent the costs specific to updating our quality system, product labeling, asset write-offs and product remanufacturing to comply with European medical device regulation. The impact on results from taxes include tax affecting the adjustments above at the statutory rate as well as taking into account discrete items and including those discrete items in the annual effective tax rate calculation. The Company also includes those adjustments that would have benefited the tax rate in lieu of the above adjustments as part of the Company's tax filings. The impact of the changes to the tax rate results in an annual rate of ~43% benefit on a GAAP basis and ~18% on a non-GAAP basis in 2018. Adjusted non-GAAP diluted WASO excludes the impact of dilutive convertible notes and warrants for which the Company is economically hedged through its anti-dilutive bond hedge arrangements. Reconciliation of Non-GAAP Operating Margin % (in thousands, except %) Actuals 1 Guidance 1, 2 Non-GAAP Gross Margin % [A] GAAP Gross Margin [B] Non-GAAP Sales, Marketing & Administrative Expense [C] Non-recurring consulting fees4 Litigation related expenses5 GAAP Sales, Marketing & Administrative Expense [D] GAAP and Non-GAAP Research & Development Expense [E] Litigation related settlements [F]6 Amortization of intangible assets [G] Purchase of in-process research and development [H]7 European medical device regulation [I]8 Business transition costs [J] 9 Non-GAAP Operating Margin % [A - C - E] GAAP Operating Margin % [B - D - E - F - G - H - I - J] Expenses associated with ongoing litigation with a former Board member and his current employer related to various matters, including infringement of the Company's intellectual property. Represents the loss recorded in connection with the settlement of the Madsen Medical, Inc. litigation matter. Reconciliation of EBITDA Margin % 2018 Actuals 1, 2 2019 Guidance Range1, 3, 4 Interest income / expense, net Income tax benefit / (expense) Non-cash stock based compensation Business transition costs5 Non-cash purchase accounting adjustments on acquisitions6 In-process research and development9 European medical device regulation10 Effective tax expense rate of ~43% benefit applied to GAAP earnings and ~18% applied to Non-GAAP earnings. Reconciliation of Non-GAAP Information Management uses certain non-GAAP financial measures such as non-GAAP earnings per share, non-GAAP net income, non-GAAP operating expenses and non-GAAP operating profit margin, which exclude amortization of intangible assets, business transition costs, purchased in-process research and development, one-time restructuring and related items in connection with acquisitions, investments and divestitures, non-recurring consulting fees, certain litigation expenses and settlements, certain European medical device regulation costs, gains and losses from strategic investments, and non-cash interest expense (excluding debt issuance cost). Management also uses certain non-GAAP measures which are intended to exclude the impact of foreign exchange currency fluctuations. The measure constant currency utilizes an exchange rate that eliminates fluctuations when calculating financial performance numbers. The Company also uses measures such as free cash flow, which represents cash flow from operations less cash used in the acquisition and disposition of capital. Additionally, the Company uses an adjusted EBITDA measure which represents earnings before interest, taxes, depreciation and amortization and excludes the impact of stock-based compensation, business transition costs, purchased in-process research and development, one-time restructuring and related items in connection with acquisitions, investments and divestitures, non-recurring consulting fees, certain litigation expenses and settlements, certain European medical device regulation costs, gains and losses on strategic investments, and other significant one-time items. Management calculates the non-GAAP financial measures provided in this earnings release excluding these costs and uses these non-GAAP financial measures to enable it to further and more consistently analyze the period-to-period financial performance of its core business operations. Management believes that providing investors with these non-GAAP measures gives them additional information to enable them to assess, in the same way management assesses, the Company's current and future continuing operations. These non-GAAP measures are not in accordance with, or an alternative for, GAAP, and may be different from non-GAAP measures used by other companies. Set forth below are reconciliations of the non-GAAP financial measures to the comparable GAAP financial measure. During the quarter ended June 30, 2018, the Company began excluding from its non-GAAP financial results certain litigation related expenses associated with ongoing litigation with a former Board member and his current employer related to various matters, including infringement of the Company's intellectual property. For consistency and comparability, the Company has re-casted non-GAAP financial results for each of the quarters ended Dec. 31, 2017 and March 31, 2018 to exclude these litigation expenses in such periods, which were $0.4 million and $0.6 million, respectively. For the Three Months Ended December 31, 2018 Reconciliation of Non-GAAP Financial Measures to the Most Directly Comparable GAAP Financial Measures (Unaudited - in thousands, except per share data) WASO 5 Income to Reported GAAP % of revenue Litigation related expenses and settlements1 Net gain on strategic investments Tax effect of adjustments 4 Interest expense/(income), net Income tax expense Adjusted Non-GAAP Represents expenses associated with ongoing litigation with a former Board member and his current employer related to various matters, including infringement of the Company's intellectual property. The impact on results from taxes include tax affecting the adjustments above at the statutory rate as well as taking into account discrete items and including those discrete items in the annual effective tax rate calculation. The Company also includes those adjustments that would have benefited the tax rate in lieu of the above adjustments as part of the Company's tax filings. The impact of the changes to the tax rate results in an annual rate of ~43% benefit on a GAAP basis and ~18% on a non-GAAP basis. For the Year Ended December 31, 2018 Tax effect of adjustments7 Income tax benefit Reported GAAP1 Amortization of intangible assets 3 Litigation related expenses and settlements Depreciation and amortization3 Reported GAAP figures for 2017 have been recasted and presented based on the full retrospective method of adoption of ASC 606. When reconciling from reported GAAP net income, the adjustment for amortization of intangible assets excludes the amortization associated with non-controlling interest. In January 2018, the Company completed the acquisition of the non-controlling interest. WASO6 Investor Conference Call The Company will hold a conference call today at 4:30 p.m. ET / 1:30 p.m. PT to discuss the results of its fourth quarter and full year 2018 financial performance. The dial-in numbers are 1-877-407-9039 for domestic callers and 1-201-689-8470 for international callers. A live webcast of the conference call will be available online from the Investor Relations page of the Company's website at www.nuvasive.com. After the live webcast, the call will remain available on NuVasive's website through March 20, 2019. In addition, a telephone replay of the call will be available until Feb. 27, 2019. The replay dial-in numbers are 1-844-512-2921 for domestic callers and 1-412-317-6671 for international callers. Please use pin number: 13686677. NuVasive, Inc. (NASDAQ: NUVA) is the leader in spine technology innovation, focused on transforming spine surgery and beyond with minimally disruptive, procedurally integrated solutions designed to deliver reproducible and clinically-proven surgical outcomes. The Company's portfolio includes access instruments, implantable hardware, biologics, software systems for surgical planning, navigation and imaging solutions, magnetically adjustable implant systems for spine and orthopedics, and intraoperative monitoring service offerings. With more than $1 billion in revenues, NuVasive has approximately 2,600 employees and operates in more than 50 countries serving surgeons, hospitals and patients. For more information, please visit www.nuvasive.com. NuVasive cautions you that statements included in this news release or made on the investor conference call referenced herein that are not a description of historical facts are forward-looking statements that involve risks, uncertainties, assumptions and other factors which, if they do not materialize or prove correct, could cause NuVasive's results to differ materially from historical results or those expressed or implied by such forward looking statements. In addition, this news release contains selected financial results from the fourth quarter and full year 2018, as well as projections for 2019 financial guidance and longer-term financial performance goals. The Company's results for the fourth quarter and full year 2018 are prior to the completion of review and audit procedures by the Company's external auditors and are subject to adjustment. In addition, the Company's projections for 2019 financial guidance and longer-term financial performance goals represent initial estimates, and are subject to the risk of being inaccurate because of the preliminary nature of the forecasts, the risk of further adjustment, or unanticipated difficulty in selling products or generating expected profitability. The potential risks and uncertainties which contribute to the uncertain nature of these statements include, among others, risks associated with acceptance of the Company's surgical products and procedures by spine surgeons, development and acceptance of new products or product enhancements, clinical and statistical verification of the benefits achieved via the use of NuVasive's products (including the iGA™ platform), the Company's ability to effectually manage inventory as it continues to release new products, its ability to recruit and retain management and key personnel, and the other risks and uncertainties more fully described in the Company's news releases and periodic filings with the Securities and Exchange Commission. NuVasive's public filings with the Securities and Exchange Commission are available at www.sec.gov. NuVasive assumes no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which it was made. Consolidated Statements of Operations Year Ended December 31, Product revenue Cost of revenue (excluding below amortization of intangible assets) Cost of products sold Total cost of revenue Sales, marketing and administrative Purchase of in-process research and development Litigation liability loss Business transition costs Interest and other expense, net: Interest expense Other (expense) income, net Total interest and other expense, net Consolidated net income Add back net loss attributable to non-controlling interests $ (436) $ (1,743) Net income attributable to NuVasive, Inc. Net income per share attributable to NuVasive, Inc.: Weighted average shares outstanding: (in thousands, except par values and share amounts) Restricted cash and investments Accounts receivable, net of allowances of $16,171 and $13,026, respectively Inventory, net Prepaid income taxes Prepaid expenses and other current assets Accounts payable and accrued liabilities Contingent consideration liabilities Accrued payroll and related expenses Litigation liabilities Income tax liabilities Long-term senior convertible notes Deferred and income tax liabilities, non-current Other long-term liabilities Commitments and contingencies Preferred stock, $0.001 par value; 5,000,000 shares authorized, none outstanding Common stock, $0.001 par value; 120,000,000 shares authorized at December 31, 2018 and December 31, 2017, 56,648,077 and 56,164,060 issued and outstanding at December 31, 2018 and December 31, 2017, respectively Treasury stock at cost; 5,116,496 shares and 5,001,886 shares at December 31, 2018 and December 31, 2017, respectively Total NuVasive, Inc. stockholders' equity Non-controlling interests Total liabilities and equity Consolidated Statements of Cash Flows Amortization of non-cash interest Reserves on current assets Other non-cash adjustments Changes in operating assets and liabilities, net of effects from acquisitions: Litigation liability Other acquisitions and investments Proceeds from other investments Purchases of intangible assets Purchases of property and equipment Proceeds from the issuance of common stock Payment of contingent consideration Purchase of treasury stock Repurchases of convertible notes Proceeds from revolving line of credit Repayments on revolving line of credit Other financing activities Effect of exchange rate changes on cash Increase (decrease) in cash, cash equivalents and restricted cash Cash, cash equivalents and restricted cash at beginning of period Cash, cash equivalents and restricted cash at end of period View original content to download multimedia:http://www.prnewswire.com/news-releases/nuvasive-reports-fourth-quarter-and-full-year-2018-financial-results-300799072.html Investor Contact: Suzanne Hatcher, NuVasive, Inc., 858-458-2240, [email protected]; Media Contact: Jill Howard, NuVasive, Inc., 858-480-0571, [email protected]

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professional_accounting

Looking For a Retirement Plan For Your Business? Here’s One SIMPLE Option Has your small business procrastinated in setting up a retirement plan? You might want to take a look at a SIMPLE IRA. SIMPLE stands for “savings incentive match plan for employees.” If you decide you’re interested in a SIMPLE IRA, you must establish it by no later than October 1 of the year for which you want to make your initial deductible contribution. (If you’re a new employer and come into existence after October 1, you can establish the SIMPLE IRA as soon as administratively feasible.) Here are some of the basics of SIMPLEs: They’re available to businesses with 100 or fewer employees. They offer greater income deferral opportunities than individual retirement accounts (IRAs). However, other plans, such as SEPs and 401(k)s, may permit larger annual deductible contributions. Participant loans aren’t allowed (unlike 401(k) and other plans that can offer loans). As the name implies, it’s simple to set up and administer these plans. You aren’t required to file annual financial returns. If your business has other employees, you may have to make SIMPLE IRA employer “matching” contributions. Contribution amounts Any employee who has compensation of at least $5,000 in any prior two years, and is reasonably expected to earn $5,000 in the current year, can elect to have a percentage of compensation put into a SIMPLE. An employee may defer up to $12,500 in 2016. This amount is indexed for inflation each year. Employees age 50 or older can make a catch-up contribution of up to $3,000 in 2016. Consider your choices A SIMPLE IRA might be a good choice for your small business but it isn’t the only choice. You might also be interested in setting up a simplified employee pension plan, a 401(k) or other plan. Contact us to learn more about a SIMPLE IRA or to hear about other retirement alternatives for your business. How Auditors Assess Risk When Preparing Financial Statements Every year, your audit firm will conduct a fresh risk assessment before the start of fieldwork. Why? Because your auditor wants to mitigate the risk of expressing an incorrect opinion regarding the accuracy and integrity of the company’s financial statements. Inadvertently signing off on financial statements that contain material misstatements can open a Pandora’s box of risks — from shareholder lawsuits to increased regulatory oversight. 3-prong assessment Audit risk is a combination of three components: 1. Control risk. Sometimes a company’s internal controls are inadequate to prevent or detect material misstatements. Control risk increases when the company fails to deploy and enforce effective internal controls, or when employees or third parties override them without the company discovering their actions. 2. Inherent risk. This term refers to susceptibility to a material misstatement, regardless of whether the company has strong internal controls. Certain transactions and industries present greater inherent risk than others. For example, companies operating in developing countries face a greater threat of bribery and corruption by government officials, regardless of the internal controls they put in place. Inherent risk is also greater when accounting transactions are complex or involve a high degree of judgment. 3. Detection risk. Audit procedures are designed to uncover material misstatements. Detection risk is high when there’s a high probability that substantive audit procedures will fail to detect a material misstatement. When detection risk is elevated, the auditor might, for example, test a larger sample of transactions to mitigate audit risk. Control risk and inherent risk stem from a company’s industry and actions. Conversely, detection risk is typically managed by the audit team. Customized audit procedures The auditor’s role is to attest to your company’s financial statements. Specifically, your audit firm assures that your financial statements are “fairly presented in all material respects, compliant with Generally Accepted Accounting Principles (GAAP) and free from material misstatement.” Unqualified (or clean) audit opinions require detailed substantive procedures, such as confirming accounts receivable balances with customers and conducting test counts of inventory in the company’s warehouse. Generally, the more rigorous the auditor’s substantive procedures, the lower the likelihood of the audit team failing to detect a material misstatement. Collaborative effort Audit season is coming soon for calendar year-end entities. Before the start of fieldwork, let’s discuss changes in your business operations, accounting methods and industry conditions, along with other factors, that could create audit risk. We’ll adjust our audit programs accordingly to ensure that your financial statements are prepared with the highest level of quality and efficiency. Tax Reform Expands Availability of Cash Accounting Under the Tax Cuts and Jobs Act (TCJA), many more businesses are now eligible to use the cash method of accounting for federal tax purposes. The cash method offers greater tax-planning flexibility, allowing some businesses to defer taxable income. Newly eligible businesses should determine whether the cash method would be advantageous and, if so, consider switching methods. Previously, the cash method was unavailable to certain businesses, including: C corporations — as well as partnerships (or limited liability companies taxed as partnerships) with C corporation partners — whose average annual gross receipts for the previous three tax years exceeded $5 million, and Businesses required to account for inventories, whose average annual gross receipts for the previous three tax years exceeded $1 million ($10 million for certain industries). In addition, construction companies whose average annual gross receipts for the previous three tax years exceeded $10 million were required to use the percentage-of-completion method (PCM) to account for taxable income from long-term contracts (except for certain home construction contracts). Generally, the PCM method is less favorable, from a tax perspective, than the completed-contract method. The TCJA raised all of these thresholds to $25 million, beginning with the 2018 tax year. In other words, if your business’s average gross receipts for the previous three tax years is $25 million or less, you generally now will be eligible for the cash method, regardless of how your business is structured, your industry or whether you have inventories. And construction firms under the threshold need not use PCM for jobs expected to be completed within two years. You’re also eligible for streamlined inventory accounting rules. And you’re exempt from the complex uniform capitalization rules, which require certain expenses to be capitalized as inventory costs. Should you switch? If you’re eligible to switch to the cash method, you need to determine whether it’s the right method for you. Usually, if a business’s receivables exceed its payables, the cash method will allow more income to be deferred than will the accrual method. (Note, however, that the TCJA has a provision that limits the cash method’s advantages for businesses that prepare audited financial statements or file their financial statements with certain government entities.) It’s also important to consider the costs of switching, which may include maintaining two sets of books. The IRS has established procedures for obtaining automatic consent to such a change, beginning with the 2018 tax year, by filing Form 3115 with your tax return. Contact us to learn more. Should Cloud Computing Setup Costs Be Expensed or Capitalized? Companies will be able to capitalize, or spread out the costs of, setting up pricey business systems that operate on cloud technology under an update to U.S. Generally Accepted Accounting Principles (GAAP). Here are the details. FASB responds to business complaints Over the last three years, businesses have complained to the Financial Accounting Standards Board (FASB) about the different accounting treatment for cloud-based services vs. those operated on physical servers onsite. Businesses told the FASB that the economics of these arrangements are virtually the same. As more businesses moved to cloud-based business applications, those complaints grew louder. So, in August, the FASB published Accounting Standards Update (ASU) No. 2018-15, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. Existing GAAP “resulted in unnecessary complexity and needed to be updated to reflect emerging transactions in cloud computing arrangements that are service contracts,” FASB Chairman Russell Golden said in a statement. “To address this diversity in practice, this standard aligns the accounting for implementation costs of hosting arrangements — regardless of whether they convey a license to the hosted software.” Old rules, new rules Under existing GAAP, the accounting for services managed in the cloud differs depending on the type of contract a business has with a software provider. When a cloud computing (or hosting) arrangement doesn’t include a software license, the arrangement must be accounted for as a service contract. This means businesses must expense the costs as incurred. Under the updated guidance, businesses will be able to treat the expenses of reconfiguring their systems and setting up cloud-managed business services as long-term assets and amortize them over the life of the arrangement. The update also will align the accounting for implementation costs for cloud-managed systems with the accounting for costs associated with developing or obtaining internal-use software. Businesses will have to record the expense related to the capitalized implementation costs in the same line item in the income statement as the expense for the fees for the hosting arrangement. The update is effective for public businesses for fiscal years beginning after December 15, 2019, and interim periods within those fiscal years. (This means 2020 for calendar-year companies.) For all other entities, the update is effective for annual reporting periods beginning after December 15, 2020, and interim periods within annual periods beginning after December 15, 2021. Early adoption is also permitted. Research Credit Available To Some Businesses For the First Time The Tax Cuts and Jobs Act (TCJA) didn’t change the federal tax credit for “increasing research activities,” but several TCJA provisions have an indirect impact on the credit. As a result, the research credit may be available to some businesses for the first time. AMT reform Previously, corporations subject to alternative minimum tax (AMT) couldn’t offset the research credit against their AMT liability, which erased the benefits of the credit (although they could carry unused research credits forward for up to 20 years and use them in non-AMT years). By eliminating corporate AMT for tax years beginning after 2017, the TCJA removed this obstacle. Now that the corporate AMT is gone, unused research credits from prior tax years can be offset against a corporation’s regular tax liability and may even generate a refund (subject to certain restrictions). So it’s a good idea for corporations to review their research activities in recent years and amend prior returns if necessary to ensure they claim all the research credits to which they’re entitled. The TCJA didn’t eliminate individual AMT, but it did increase individuals’ exemption amounts and exemption phaseout thresholds. As a result, fewer owners of sole proprietorships and pass-through businesses are subject to AMT, allowing more of them to enjoy the benefits of the research credit, too. By reducing corporate and individual tax rates, the TCJA also will increase research credits for many businesses. Why? Because the tax code, to prevent double tax benefits, requires businesses to reduce their deductible research expenses by the amount of the credit. To avoid this result (which increases taxable income), businesses can elect to reduce the credit by an amount calculated at the highest corporate rate that eliminates the double benefit. Because the highest corporate rate has been reduced from 35% to 21%, this amount is lower and, therefore, the research credit is higher. Keep in mind that the TCJA didn’t affect certain research credit benefits for smaller businesses. Pass-through businesses can still claim research credits against AMT if their average gross receipts are $50 million or less. And qualifying start-ups without taxable income can still claim research credits against up to $250,000 in payroll taxes. If your company engages in qualified research activities, now’s a good time to revisit the credit to be sure you’re taking full advantage of its benefits. Sustainability Reports Looks Beyond the Numbers In recent years, environmental, social and governance (ESG) issues have become a hot topic. Many companies voluntarily include so-called “sustainability disclosures” about these issues in their financial statements. But should the Securities and Exchange Commission (SEC) make these disclosures mandatory and more consistent? Identifying ESG issues The term “sustainability” refers to anything that helps your company sustain itself — its people, its profits — into the future. A variety of nonfinancial issues fall under the ESG umbrella, including: Pollution and carbon emissions, Union relations, Political spending, Tax strategies, Employee training and education programs, Diversity practices, Health and safety matters, and Human rights policies. There’s often a link between ESG issues and financial performance. For example, regulatory violations can lead to fines, remedial costs and reputational damage. And the sale of toxic or unsafe products can result in product liability lawsuits, recalls and boycotts. On the flipside, identifying and successfully navigating ESG issues can add value by building trust with stakeholders, providing improved access to capital and lower borrowing costs, and enhancing loyalty with customers and employees. Tracking sustainability also helps companies identify ways to reduce their energy consumption, streamline their supply chains, eliminate waste and operate more efficiently. Studying the costs of mandatory disclosures Currently, most sustainability disclosures are made voluntarily. The Securities and Exchange Commission (SEC) does require companies to describe the effects of climate change under Release No. 33-9106, Commission Guidance Regarding Disclosure Related to Climate Change. Unfortunately, these disclosures have been criticized by investors for being too general and not useful. Recently, Sen. Mark Warner (D-VA) asked the Government Accountability Office (GAO) — an independent, nonpartisan U.S. government watchdog agency — to study the costs of requiring public companies to make ESG disclosures. His letter to the GAO references a 2015 survey, which found that 73% of institutional investors take ESG issues into consideration when they’re evaluating investment or voting decisions and managing investment risks. Specifically, Warner asked the GAO to: Analyze the effect of revising U.S. Generally Accepted Accounting Principles (GAAP) to account for ESG issues, Evaluate the extent to which 1) companies address ESG issues in their disclosures, and 2) investors seek ESG disclosures and why, Identify possible regulatory and nonregulatory actions that could improve and standardize ESG disclosures, and Compare U.S. and foreign ESG disclosure regimes. A major downside to today’s disclosures is inconsistency. Warner would like the GAO to explore ways to help investors “understand the likelihood of ESG risks and cut through boilerplate disclosure.” Not everyone wants the GAO to proceed with the study, however. Some business groups, including the U.S. Chamber of Commerce and Business Roundtable, believe the SEC should focus on providing material information to investors and not cater to what they call “special interest groups.” Sustainability audits It’s uncertain whether ESG disclosures will become mandatory, but many companies already share information about green business practices, diversity programs, fraud prevention policies and other ESG issues. These disclosures can help add long-term value and improve relationships with stakeholders. Contact us for help preparing or auditing an independent, integrated sustainability report for 2018. Tax-Free Fringe Benefits Help Small Businesses and Their Employees In today’s tightening job market, to attract and retain the best employees, small businesses need to offer not only competitive pay, but also appealing fringe benefits. Benefits that are tax-free are especially attractive to employees. Let’s take a quick look at some popular options. Businesses can provide their employees with various types of insurance on a tax-free basis. Here are some of the most common: Health insurance. If you maintain a health care plan for employees, coverage under the plan isn’t taxable to them. Employee contributions are excluded from income if pretax coverage is elected under a cafeteria plan. Otherwise, such amounts are included in their wages, but may be deductible on a limited basis as an itemized deduction. Disability insurance. Your premium payments aren’t included in employees’ income, nor are your contributions to a trust providing disability benefits. Employees’ premium payments (or other contributions to the plan) generally aren’t deductible by them or excludable from their income. However, they can make pretax contributions to a cafeteria plan for disability benefits, which are excludable from their income. Long-term care insurance. Your premium payments aren’t taxable to employees. However, long-term care insurance can’t be provided through a cafeteria plan. Life insurance. Your employees generally can exclude from gross income premiums you pay on up to $50,000 of qualified group term life insurance coverage. Premiums you pay for qualified coverage exceeding $50,000 are taxable to the extent they exceed the employee’s coverage contributions. Other types of tax-advantaged benefits Insurance isn’t the only type of tax-free benefit you can provide ¬― but the tax treatment of certain benefits has changed under the Tax Cuts and Jobs Act: Dependent care assistance. You can provide employees with tax-free dependent care assistance up to $5,000 for 2018 though a dependent care Flexible Spending Account (FSA), also known as a Dependent Care Assistance Program (DCAP). Adoption assistance. For employees who’re adopting children, you can offer an employee adoption assistance program. Employees can exclude from their taxable income up to $13,810 of adoption benefits in 2018. Educational assistance. You can help employees on a tax-free basis through educational assistance plans (up to $5,250 per year), job-related educational assistance and qualified scholarships. Moving expense reimbursement. Before the TCJA, if you reimbursed employees for qualifying job-related moving expenses, the reimbursement could be excluded from the employee’s income. The TCJA suspends this break for 2018 through 2025. However, such reimbursements may still be deductible by your business. Transportation benefits. Qualified employee transportation fringe benefits, such as parking allowances, mass transit passes and van pooling, are tax-free to recipient employees. However, the TCJA suspends through 2025 the business deduction for providing such benefits. It also suspends the tax-free benefit of up to $20 a month for bicycle commuting. Varying tax treatment As you can see, the tax treatment of fringe benefits varies. Contact us for more information. Identifying and Reporting Critical Audit Matters For over 40 years, the Securities and Exchange Commission (SEC) has required only a simple pass-fail statement in public companies’ audit reports. But the deadline for mandatory reporting of critical audit matters (CAMs) in audit reports is fast approaching. The revised model will provide insight to help investors and other stakeholders better understand a public company’s financial reporting practices — and help management reduce potential risks. Under existing SEC standards, auditor communication of CAMs is permissible on a voluntary basis. However, disclosure of CAMs in audit reports will be required for audits of fiscal years ending on or after June 30, 2019, for large accelerated filers; and for fiscal years ending on or after December 15, 2020, for all other companies to which the requirement applies. The new rule doesn’t apply to audits of emerging growth companies (EGCs), which are companies that have less than $1 billion in revenue and meet certain other requirements. This class of companies gets a host of regulatory breaks for five years after becoming public, under the Jumpstart Our Business Startups (JOBS) Act. In 2017, the Public Company Accounting Oversight Board (PCAOB) published Release No. 2017-001, The Auditor’s Report on an Audit of Financial Statements When the Auditor Expresses an Unqualified Opinion and Related Amendments to PCAOB Standards. The main provision of the rule requires auditors to describe CAMs in their audit reports. These are issues that: Have been communicated to the audit committee, Are related to accounts or disclosures that are material to the financial statements, and Involve especially challenging, subjective or complex judgments from the auditor. By highlighting a CAM, an auditor is essentially saying that the matter requires closer attention. Examples might include complex valuations of indefinite-lived intangible assets, uncertain tax positions, goodwill impairment, and manual accounting processes that rely on spreadsheets, rather than automated accounting software. New guidance In July 2018, the Center for Audit Quality issued a 12-page guide on implementing the revised model of the auditor’s report. The guide instructs auditors to select CAMs based on: The risks of material misstatement, The degree of auditor judgment for areas such as management estimates, Significant unusual transactions, The degree of subjectivity for a certain matter, and The evidence the auditor gathered during the review of the financial statements. The guide doesn’t say how many CAMs are required in an audit report or provide a checklist of potential issues. Instead, CAMs will be determined on a case-by-case basis. PCAOB Chairman James Doty has promised that CAMs will “breathe life into the audit report and give investors the information they’ve been asking for from auditors.” By identifying CAMs on the face of the audit report, auditors highlight challenging, subjective or complex matters that also may warrant closer attention from management. For more information about CAMs, contact us. Be Sure Your Employee Travel Expense Reimbursements Will Pass Muster With the IRS Does your business reimburse employees’ work-related travel expenses? If you do, you know that it can help you attract and retain employees. If you don’t, you might want to start, because changes under the Tax Cuts and Jobs Act (TCJA) make such reimbursements even more attractive to employees. Travel reimbursements also come with tax benefits, but only if you follow a method that passes muster with the IRS. The TCJA’s impact Before the TCJA, unreimbursed work-related travel expenses generally were deductible on an employee’s individual tax return (subject to a 50% limit for meals and entertainment) as a miscellaneous itemized deduction. However, many employees weren’t able to benefit from the deduction because either they didn’t itemize deductions or they didn’t have enough miscellaneous itemized expenses to exceed the 2% of adjusted gross income (AGI) floor that applied. For 2018 through 2025, the TCJA suspends miscellaneous itemized deductions subject to the 2% of AGI floor. That means even employees who itemize deductions and have enough expenses that they would exceed the floor won’t be able to enjoy a tax deduction for business travel. Therefore, business travel expense reimbursements are now more important to employees. The potential tax benefits Your business can deduct qualifying reimbursements, and they’re excluded from the employee’s taxable income. The deduction is subject to a 50% limit for meals. But, under the TCJA, entertainment expenses are no longer deductible. To be deductible and excludable, travel expenses must be legitimate business expenses and the reimbursements must comply with IRS rules. You can use either an accountable plan or the per diem method to ensure compliance. Reimbursing actual expenses An accountable plan is a formal arrangement to advance, reimburse or provide allowances for business expenses. To qualify as “accountable,” your plan must meet the following criteria: Payments must be for “ordinary and necessary” business expenses. Employees must substantiate these expenses — including amounts, times and places — ideally at least monthly. Employees must return any advances or allowances they can’t substantiate within a reasonable time, typically 120 days. The IRS will treat plans that fail to meet these conditions as nonaccountable, transforming all reimbursements into wages taxable to the employee, subject to income taxes (employee) and employment taxes (employer and employee). With the per diem method, instead of tracking actual expenses, you use IRS tables to determine reimbursements for lodging, meals and incidental expenses, or just for meals and incidental expenses, based on location. (If you don’t go with the per diem method for lodging, you’ll need receipts to substantiate those expenses.) Be sure you don’t pay employees more than the appropriate per diem amount. The IRS imposes heavy penalties on businesses that routinely overpay per diems. What’s right for your business? To learn more about business travel expense deductions and reimbursements post-TCJA, contact us. We can help you determine whether you should reimburse such expenses and which reimbursement option is better for you. Hidden Liabilities: What’s Excluded From the Balance Sheet? Financial statements help investors and lenders monitor a company’s performance. However, financial statements may not provide a full picture of financial health. What’s undisclosed could be just as significant as the disclosures. Here’s how a CPA can help stakeholders identify unrecorded items either through external auditing procedures or by conducting agreed upon procedures (AUPs) that target specific accounts. Start with assets Revealing undisclosed liabilities and risks begins with assets. For each asset, it’s important to evaluate what could cause the account to diminish. For example, accounts receivable may include bad debts, or inventory may include damaged goods. In addition, some fixed assets may be broken or in desperate need of repairs and maintenance. These items may signal financial distress and affect financial ratios just as much as unreported liabilities do. Some of these problems may be uncovered by touring the company’s facilities or reviewing asset schedules for slow-moving items. Benchmarking can also help. For example, if receivables are growing much faster than sales, it could be a sign of aging, uncollectible accounts. Evaluate liabilities Next, external accountants can assess liabilities to determine whether the amount reported for each item seems accurate and complete. For example, a company may forget to accrue liabilities for salary or vacation time. Alternatively, management might underreport payables by holding checks for weeks (or months) to make the company appear healthier than it really is. This ploy preserves the checking account while giving the impression that supplier invoices are being paid. It also mismatches revenues and expenses, understates liabilities and artificially enhances profits. Delayed payments can hurt the company’s reputation and cause suppliers to restrict their credit terms. Identify unrecorded items Finally, CPAs can investigate what isn’t showing on the balance sheet. Examples include warranties, pending lawsuits, IRS investigations and an underfunded pension. Such risks appear on the balance sheet only when they’re “reasonably estimable” and “more than likely” to be incurred. These are subjective standards. In-house accounting personnel may claim that liabilities are too unpredictable or remote to warrant disclosure. Footnotes, when available, may shed additional light on the nature and extent of these contingent liabilities. An external audit is your best line of defense against hidden risks and potential liabilities. Or, if funds are limited, an AUP engagement can target specific high-risk accounts or transactions. Contact our experienced CPAs to gain a clearer picture of your company’s financial well-being.

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Home | Previous Page Final Rule: Management's Report on Internal Control Over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports 17 CFR PARTS 210, 228, 229, 240, 249, 270 and 274 [RELEASE NOS. 33-8238; 34-47986; IC-26068; File Nos. S7-40-02; S7-06-03] RIN 3235-AI66 and 3235-AI79 AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: As directed by Section 404 of the Sarbanes-Oxley Act of 2002, we are adopting rules requiring companies subject to the reporting requirements of the Securities Exchange Act of 1934, other than registered investment companies, to include in their annual reports a report of management on the company's internal control over financial reporting. The internal control report must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting. Under the new rules, a company is required to file the registered public accounting firm's attestation report as part of the annual report. Furthermore, we are adding a requirement that management evaluate any change in the company's internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. Finally, we are adopting amendments to our rules and forms under the Securities Exchange Act of 1934 and the Investment Company Act of 1940 to revise the Section 302 certification requirements and to require issuers to provide the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 as exhibits to certain periodic reports. DATES: Effective Date: August 14, 2003. Compliance Dates: The following compliance dates apply to companies other than registered investment companies. A company that is an "accelerated filer," as defined in Exchange Act Rule 12b-2, as of the end of its first fiscal year ending on or after June 15, 2004, must begin to comply with the management report on internal control over financial reporting disclosure requirements in its annual report for that fiscal year. A company that is not an accelerated filer as of the end of its first fiscal year ending on or after June 15, 2004, including a foreign private issuer, must begin to comply with the annual internal control report for its first fiscal year ending on or after April 15, 2005. A company must begin to comply with the requirements regarding evaluation of any material change to its internal control over financial reporting in its first periodic report due after the first annual report required to include a management report on internal control over financial reporting. Companies may voluntarily comply with the new disclosure requirements before the compliance dates. A company must comply with the new exhibit requirements for the certifications required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 and changes to the Section 302 certification requirements in its quarterly, semi-annual or annual report due on or after August 14, 2003. To account for the differences between the compliance date of the rules relating to internal control over financial reporting and the effective date of changes to the language of the Section 302 certification, a company's certifying officers may temporarily modify the content of their Section 302 certifications to eliminate certain references to internal control over financial reporting until the compliance date, as further explained in Section III.E. below. Registered investment companies must comply with the rule and form amendments applicable to them on and after August 14, 2003, except as follows. Registered investment companies must comply with the amendments to Exchange Act Rules 13a-15(a) and 15d-15(a) and Investment Company Act Rule 30a-3(a) that require them to maintain internal control over financial reporting with respect to fiscal years ending on or after June 15, 2004. In addition, a registered investment company's certifying officers may temporarily modify the content of their Section 302 certifications to eliminate certain references to internal control over financial reporting, as further explained in Section II.I. below. Registered investment companies may voluntarily comply with the rule and form amendments before the compliance dates. FOR FURTHER INFORMATION CONTACT: N. Sean Harrison, Special Counsel, or Andrew D. Thorpe, Special Counsel, Division of Corporation Finance, at (202) 942-2910, or with respect to registered investment companies, Christian Broadbent, Senior Counsel, Division of Investment Management, at (202) 942-0721, or with respect to attestation and auditing issues, Edmund Bailey, Assistant Chief Accountant, Randolph P. Green, Professional Accounting Fellow, or Paul Munter, Academic Accounting Fellow, Office of the Chief Accountant, at (202) 942-4400, U.S. Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549. SUPPLEMENTARY INFORMATION: We are revising Items 307, 401 and 601 of Regulations S-B1 and S-K;2 adding new Item 308 to Regulations S-B and S-K; amending Form 10-K,3 Form 10-KSB,4 Form 10-Q,5 Form 10-QSB,6 Form 20-F,7 Form 40-F,8 Rule 12b-15,9 Rule 13a-14,10 Rule 13a-15,11 Rule 15d-1412 and Rule 15d-1513 under the Securities Exchange Act of 1934 (the "Exchange Act");14 amending Rules 1-02 and 2-0215 of Regulation S-X;16 amending Rules 8b-15,17 30a-218 and 30a-319 under the Investment Company Act of 1940 ("Investment Company Act");20 and amending Forms N-CSR21 and N-SAR22 under the Exchange Act and the Investment Company Act. Management's Report on Internal Control over Financial Reporting DISCUSSION OF AMENDMENTS IMPLEMENTING SECTION 404 Definition of Internal Control Comments on the Proposal Management's Annual Assessment of, and Report on, the Company's Internal Control over Financial Reporting Evaluation of Internal Control over Financial Reporting Auditor Independence Issues Material Weaknesses in Internal Control over Financial Reporting Method of Evaluating Location of Management's Report Quarterly Evaluations of Internal Control over Financial Reporting Differences between Internal Control over Financial Reporting and Disclosure Controls and Procedures Evaluation of Disclosure Controls and Procedures Periodic Disclosure about the Certifying Officers' Evaluation of the Company's Disclosure Controls and Procedures and Disclosure about Changes to its Internal Control over Financial Reporting Existing Disclosure Requirements Proposed Amendments to the Disclosure Requirements Final Disclosure Requirements Conclusions Regarding Effectiveness of Disclosure Controls and Procedures Attestation to Management's Internal Control Report by the Company's Registered Public Accounting Firm Types of Companies Affected Foreign Private Issuers Asset-Backed Issuers Small Business Issuers Bank and Thrift Holding Companies DISCUSSION OF AMENDMENTS RELATED TO CERTIFICATIONS Effect on Interim Guidance Regarding Filing Procedures Form of Section 302 Certifications PAPERWORK REDUCTION ACT EFFECT ON EFFICIENCY, COMPETITION AND CAPITAL FORMATION FINAL REGULATORY FLEXIBILITY ANALYSIS STATUTORY AUTHORITY AND TEXT OF RULE AMENDMENTS I. BACKGROUND A. Management's Report on Internal Control over Financial Reporting In this release, we implement Section 404 of the Sarbanes-Oxley Act of 2002 (the "Sarbanes-Oxley Act"),23 which requires us to prescribe rules requiring each annual report that a company, other than a registered investment company,24 files pursuant to Section 13(a) or 15(d) of the Exchange Act to contain an internal control report: (1) stating management's responsibility for establishing and maintaining an adequate internal control structure and procedures for financial reporting; and (2) containing an assessment, as of the end of the company's most recent fiscal year, of the effectiveness of the company's internal control structure and procedures for financial reporting. Section 404 also requires every registered public accounting firm that prepares or issues an audit report on a company's annual financial statements to attest to, and report on, the assessment made by management. The attestation must be made in accordance with standards for attestation engagements issued or adopted by the Public Company Accounting Oversight Board ("PCAOB").25 Section 404 further stipulates that the attestation cannot be the subject of a separate engagement of the registered public accounting firm. We received over 200 comment letters in response to our release proposing requirements to implement Sections 404, 406 and 407 of the Sarbanes-Oxley Act.26 Of these, 61 respondents commented on the Section 404 proposals.27 These comment letters came from corporations, professional associations, accountants, law firms, consultants, academics, investors and others. In general, the commenters supported the objectives of the proposed new requirements. Investors supported the manner in which we proposed to achieve these objectives and, in some cases, urged us to require additional disclosure from companies. Other commenters, however, thought that we were requiring more disclosure than necessary to fulfill the mandates of the Sarbanes-Oxley Act and suggested modifications to the proposals. We have reviewed and considered all of the comments that we received on the proposals. The adopted rules reflect many of these comments -- we discuss our conclusions with respect to each topic and related comments in more detail throughout the release. B. Certifications We also are adopting amendments to require companies to file the certifications mandated by Sections 302 and 906 of the Sarbanes-Oxley Act as exhibits to annual, semi-annual and quarterly reports. Section 302 required the Commission to adopt final rules that were to be effective by August 29, 2002, under which the principal executive and principal financial officers, or persons performing similar functions, of a company filing periodic reports under Section 13(a) or 15(d) of the Exchange Act28 must provide a certification in each quarterly and annual report filed with the Commission. Section 906 of the Sarbanes-Oxley Act added new Section 1350 to Title 18 of the United States Code,29 which contains a certification requirement subject to specific federal criminal provisions and that is separate and distinct from the certification requirement mandated by Section 302.30 On August 28, 2002, we adopted Exchange Act Rules 13a-14 and 15d-14 and Investment Company Act Rule 30a-2 and amended our periodic report forms to implement the statutory directive in Section 302.31 These rules and amendments became effective on August 29, 2002. On January 27, 2003, we adopted Form N-CSR to be used by registered management investment companies to file certified shareholder reports with the Commission.32 The provisions added to Title 18 by Section 906 were by their terms effective on enactment of the Sarbanes-Oxley Act. To enhance the ability of interested parties to effectively access the certifications through our Electronic Data Gathering, Analysis and Retrieval ("EDGAR") system and thereby enhance compliance with the certification requirements, we proposed to amend our rules and forms to require a company to file the certifications as an exhibit to the periodic reports to which they relate.33 The proposals addressed both Section 302 and 906 certifications. After discussions with the Department of Justice, we concluded that, in light of the inconsistent methods that companies have been employing to fulfill their obligations under Section 906,34 an exhibit requirement would consistently enable investors and the Commission staff, as well as the Department of Justice, to more effectively monitor compliance with this certification requirement. II. DISCUSSION OF AMENDMENTS IMPLEMENTING SECTION 404 A. Definition of Internal Control 1. Proposed Rule The proposed rules would have defined the term "internal controls and procedures for financial reporting"35 to mean controls that pertain to the preparation of financial statements for external purposes that are fairly presented in conformity with generally accepted accounting principles as addressed by the Codification of Statements on Auditing Standards §319 or any superseding definition or other literature that is issued or adopted by the Public Company Accounting Oversight Board. As noted in the Proposing Release, there has been some confusion over the exact meaning and scope of the term "internal control," because the definition of the term has evolved over time. Historically, the term "internal control" was applied almost exclusively within the accounting profession.36 As the auditing of financial statements evolved from a process of detailed testing of transactions and account balances towards a process of sampling and testing, greater consideration of a company's internal controls became necessary in planning an audit.37 If an internal control component had been adequately designed, then the auditor could limit further consideration of that control to procedures to determine whether the control had been placed in operation. Accordingly, the auditor could rely on the control to serve as a basis to reduce the amount, timing or extent of substantive testing in the execution of an audit. Conversely, if an auditor determined that an internal control component was inadequate in its design or operation, then the auditor could not rely upon that control. In this instance, the auditor would conduct tests of transactions and perform additional analyses in order to accumulate sufficient, competent audit evidence to support its opinion on the financial statements. From the outset, it was recognized that internal control is a broad concept that extends beyond the accounting functions of a company. Early attempts to define the term focused primarily on clarifying the portion of a company's internal control that an auditor should consider when planning and performing an audit of a company's financial statements.38 However, this did not improve the level of understanding of the term, nor satisfactorily provide the guidance sought by auditors. Successive definitions and formal studies of the concept of internal control followed. In 1977, based on recommendations of the Commission, Congress enacted the Foreign Corrupt Practices Act ("FCPA").39 The FCPA codified the accounting control provisions contained in Statement of Auditing Standards No. 1 (codified as AU §320 in the Codification of Statements on Auditing Standards). Under the FCPA, companies that have a class of securities registered under Section 12 of the Exchange Act, or that are required to file reports under Section 15(d) of the Exchange Act, are required to devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that: transactions are executed in accordance with management's general or specific authorization; transactions are recorded as necessary (1) to permit preparation of financial statements in conformity with generally accepted accounting principles or any other criteria applicable to such statements, and (2) to maintain accountability for assets; access to assets is permitted only in accordance with management's general or specific authorization; and the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences.40 In 1985, a private-sector initiative known as the National Commission on Fraudulent Financial Reporting, also known as the Treadway Commission, was formed to study the financial reporting system in the United States. In 1987, the Treadway Commission issued a report recommending that its sponsoring organizations work together to integrate the various internal control concepts and definitions and to develop a common reference point. In response, the Committee of Sponsoring Organizations of the Treadway Commission ("COSO")41 undertook an extensive study of internal control to establish a common definition that would serve the needs of companies, independent public accountants, legislators and regulatory agencies, and to provide a broad framework of criteria against which companies could evaluate the effectiveness of their internal control systems. In 1992, COSO published its Internal Control -- Integrated Framework.42 The COSO Framework defined internal control as "a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives" in three categories--effectiveness and efficiency of operations; reliability of financial reporting; and compliance with applicable laws and regulations. COSO further stated that internal control consists of: the control environment, risk assessment, control activities, information and communication, and monitoring. The scope of internal control therefore extends to policies, plans, procedures, processes, systems, activities, functions, projects, initiatives, and endeavors of all types at all levels of a company. In 1995, the AICPA incorporated the definition of internal control set forth in the COSO Report in Statement on Auditing Standards No. 78 (codified as AU §319 in the Codification of Statements on Auditing Standards).43 Although we recognized that the AU §319 definition was derived from the COSO definition, our proposal referred to AU §319 because we thought that the former constituted a more formal and widely-accessible version of the definition than the latter. 2. Comments on the Proposal We received comments from 25 commenters on the proposed definition of "internal control and procedures for financial reporting." Eleven commenters stated that the proposed definition of internal control was appropriate or generally agreed with the proposal.44 Two of these noted that the definition in AU §319 had been adopted by the bank regulatory agencies for use by banking institutions.45 Fourteen of the 25 commenters opposed the proposed definition. Two of these asserted that the proposed definition was too complex and would not resolve the confusion that existed over the meaning or scope of the term. Several of the commenters that were opposed to the proposed definition thought that we should refer to COSO for the definition of internal control, rather than AU §319.46 Some of these commenters noted that the objective of AU §319 is to provide guidance to auditors regarding their consideration of internal control in planning and performing an audit of financial statements. The common concern of these commenters was that AU §319 does not provide any measure or standard by which a company's management can determine that internal control is effective, nor does it define what constitutes effective internal control. One commenter believed that absent such evaluative criteria or definition of effectiveness, the proposed rules could not be implemented effectively.47 In addition, several of the commenters opposed to the proposed definition suggested that we use the term "internal control over financial reporting" rather than the term "internal controls and procedures for financial reporting,"48 on the ground that the former is more consistent with the terminology currently used within the auditing literature. A few of the commenters urged us to adopt a considerably broader definition of internal control that would focus not only on internal control over financial reporting, but also on internal control objectives associated with enterprise risk management and corporate governance. While we agree that these are important objectives, the definition that we are adopting retains a focus on financial reporting, consistent with our position articulated in the Proposing Release. We are not adopting a more expansive definition of internal control for a variety of reasons. Most important, we believe that Section 404 focuses on the element of internal control that relates to financial reporting. In addition, many commenters indicated that even the more limited definition related to financial reporting that we proposed will impose substantial reporting and cost burdens on companies. Finally, independent accountants traditionally have not been responsible for reviewing and testing, or attesting to an assessment by management of, internal controls that are outside the boundary of financial reporting. 3. Final Rules After consideration of the comments, we have decided to make several modifications to the proposed amendments. We agree that we should use the term "internal control over financial reporting" in our amendments to implement Section 404, as well as our revisions to the Section 302 certification requirements and forms of certification.49 Rapidly changing terminology has been one obstacle in the development of an accepted understanding of internal control. The term "internal control over financial reporting" is the predominant term used by companies and auditors and best encompasses the objectives of the Sarbanes-Oxley Act. In addition, by using this term, we avoid having to familiarize investors, companies and auditors with new terminology, which should lessen any confusion that may exist about the meaning and scope of internal control. The final rules define "internal control over financial reporting" as: A process designed by, or under the supervision of, the registrant's principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant's board of directors,50 management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the registrant; (2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the registrant are being made only in accordance with authorizations of management and directors of the registrant; and (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the registrant's assets that could have a material effect on the financial statements.51 We recognize that our definition of the term "internal control over financial reporting" reflected in the final rules encompasses the subset of internal controls addressed in the COSO Report that pertains to financial reporting objectives. Our definition does not encompass the elements of the COSO Report definition that relate to effectiveness and efficiency of a company's operations and a company's compliance with applicable laws and regulations, with the exception of compliance with the applicable laws and regulations directly related to the preparation of financial statements, such as the Commission's financial reporting requirements.52 Our definition is consistent with the description of internal accounting controls in Exchange Act Section 13(b)(2)(B).53 Following the general language defining internal control over financial reporting, clauses (1) and (2) include the internal control matters described in Section 103 of the Sarbanes-Oxley Act that the company's registered public accounting firm is required to evaluate in its audit or attestation report.54 This language is included to make clear that the assessment of management in its internal control report as to which the company's registered public accounting firm will be required to attest and report specifically covers the matters referenced in Section 103. A few commenters believed that it would cause confusion if the definition of internal control did not acknowledge the objectives set forth in Section 103 of the Sarbanes-Oxley Act. As discussed in Section II.G below, the PCAOB is responsible for establishing the Section 103 standards. Our definition also includes, in clause (3), explicit reference to assurances regarding use or disposition of the company's assets. This provision is specifically included to make clear that, for purposes of our definition, the safeguarding of assets is one of the elements of internal control over financial reporting and it addresses the supplementation of the COSO Framework after it was originally promulgated. In the absence of our change to the definition, the determination of whether control regarding the safeguarding of assets falls within a company's internal control over financial reporting currently could be subject to varying interpretation. Safeguarding of assets had been a primary objective of internal accounting control in SAS No. 1. In 1988, the ASB issued Statement of Auditing Standards No. 55 (codified as AU §319 in the Codification of Statements on Auditing Standards), which replaced AU §320. SAS No. 55 revised the definition of "internal control" and expanded auditors' responsibilities for considering internal control in a financial statement audit. The prior classification of internal control into the two categories of "internal accounting control" and "administrative control" was replaced with the single term "internal control structure," which consisted of three interrelated components--control environment, the accounting system and control procedures. Under this new definition, the safeguarding of assets was no longer a primary objective, but a subset of the control procedures component.55 The COSO Report followed this shift in the iteration of safeguarding of assets. The COSO Report states that operations objectives "pertain to effectiveness and efficiency of the entity's operations, including performance and profitability goals and safeguarding resources against loss."56 However, the report also clarifies that safeguarding of assets can fall within other categories of internal control.57 In 1994, COSO published an addendum to the Reporting to External Parties volume of the COSO Report. The addendum was issued in response to a concern expressed by some parties, including the U.S. General Accounting Office, that the management reports contemplated by the COSO Report did not adequately address controls relating to safeguarding of assets and therefore would not fully respond to the requirements of the FCPA.58 In the addendum, COSO concluded that while it believed its definition of internal control in its 1992 report remained appropriate, it recognized that the FCPA encompasses certain controls related to safeguarding of assets and that there is a reasonable expectation on the part of some readers of management's internal control reports that the reports will cover such controls. The addendum therefore sets forth the following definition of the term "internal control over safeguarding of assets against unauthorized acquisition, use or disposition": Internal control over safeguarding of assets against unauthorized acquisition, use or disposition is a process, effected by an entity's board of directors, management and other personnel, designed to provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the entity's assets that could have a material effect on the financial statements. As indicated above, to achieve the desired result and to provide consistency with COSO's 1994 addendum, we have incorporated this definition into our definition of "internal control over financial reporting." We are persuaded that this is appropriate given the fact that our definition will be used for purposes of public management reporting, and that the companies that will be subject to the Section 404 requirements also are subject to the FCPA requirements. So, under the final rules, safeguarding of assets as provided is specifically included in our definition of "internal control over financial reporting." B. Management's Annual Assessment of, and Report on, the Company's Internal Control over Financial Reporting We proposed to amend Item 307 of Regulations S-K and S-B, as well as Forms 20-F and 40-F, to require a company's annual report to include an internal control report of management containing: A statement of management's responsibility for establishing and maintaining adequate internal controls and procedures for financial reporting; The conclusions of management about the effectiveness of the company's internal controls and procedures for financial reporting based on management's evaluation of those controls and procedures; and A statement that the registered public accounting firm that prepared or issued the company's audit report relating to the financial statements included in the company's annual report has attested to, and reported on, management's evaluation of the company's internal controls and procedures for financial reporting. The proposed amendments did not list any additional disclosure requirements for the management report, but rather would have afforded management the flexibility to tailor the report to fit its company's particular circumstances. We received comments from 17 commenters on our proposed annual internal control report requirements. All of these commenters believed, in varying degrees, that we should set forth additional disclosure criteria or standards for the management report. Nine commenters stated that we should provide guidance as to the topics to be addressed in the management report, or specify standards or a common set of internal control objectives to be considered by management when assessing the effectiveness of its company's internal control over financial reporting to ensure that control objectives are addressed in a consistent fashion.59 These commenters believed that consistent standards for management's report on internal control would help investors to understand and compare the quality of various management internal control reports. Several commenters also thought that we should require management's internal control report to include certain recitations that would parallel recitations that the registered public accounting firm would have to make in its report attesting to management's assessment.60 Additional commenters believed that the management report on internal control should specifically reference the objectives contained in Section 103 of the Sarbanes-Oxley Act.61 Furthermore, although Section 404(b) of the Sarbanes-Oxley Act does not explicitly direct us to require companies to file the registered public accounting firms' attestation reports as part of the companies' annual report filings, we proposed a filing requirement that most of those commenting on this aspect of the proposal supported. After evaluating the comments received, we are adopting the proposals with several modifications. The final rules require a company's annual report to include an internal control report of management that contains: A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company; A statement identifying the framework used by management to conduct the required evaluation of the effectiveness of the company's internal control over financial reporting; Management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year, including a statement as to whether or not the company's internal control over financial reporting is effective.62 The assessment must include disclosure of any "material weaknesses"63 in the company's internal control over financial reporting identified by management. Management is not permitted to conclude that the company's internal control over financial reporting is effective if there are one or more material weaknesses in the company's internal control over financial reporting; and A statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management's assessment of the registrant's internal control over financial reporting.64 As proposed, our final rules also require a company to file, as part of the company's annual report, the attestation report of the registered public accounting firm that audited the company's financial statements. a. Evaluation of Internal Control over Financial Reporting In the Proposing Release, we requested comment on whether we should establish specific evaluative criteria for management's report on internal control. All of the commenters responding to this request supported the establishment of such evaluative criteria in order to improve comparability among the standards used by companies to conduct their annual internal control evaluations.65 Several commenters believed that we either should adopt the COSO Framework as the means by which management must evaluate its company's internal control over financial reporting or, alternatively, simply acknowledge the COSO Framework as being suitable for purposes of management's evaluation. Other commenters suggested that we require management to evaluate the effectiveness of a company's internal control over financial reporting using suitable control criteria established by a group that follows due process procedures. After consideration of the comments, we have modified the final requirements to specify that management must base its evaluation of the effectiveness of the company's internal control over financial reporting on a suitable, recognized control framework that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment.66 The COSO Framework satisfies our criteria and may be used as an evaluation framework for purposes of management's annual internal control evaluation and disclosure requirements. However, the final rules do not mandate use of a particular framework, such as the COSO Framework, in recognition of the fact that other evaluation standards exist outside of the United States,67 and that frameworks other than COSO may be developed within the United States in the future, that satisfy the intent of the statute without diminishing the benefits to investors. The use of standard measures that are publicly available will enhance the quality of the internal control report and will promote comparability of the internal control reports of different companies. The final rules require management's report to identify the evaluation framework used by management to assess the effectiveness of the company's internal control over financial reporting.68 Specifically, a suitable framework must: be free from bias; permit reasonably consistent qualitative and quantitative measurements of a company's internal control; be sufficiently complete so that those relevant factors that would alter a conclusion about the effectiveness of a company's internal controls are not omitted; and be relevant to an evaluation of internal control over financial reporting.69 b. Auditor Independence Issues Because the auditor is required to attest to management's assessment of internal control over financial reporting, management and the company's independent auditors will need to coordinate their processes of documenting and testing the internal controls over financial reporting. However, we remind companies and their auditors that the Commission's rules on auditor independence prohibit an auditor from providing certain nonaudit services to an audit client.70 As the Commission stated in its auditor independence release, auditors may assist management in documenting internal controls. When the auditor is engaged to assist management in documenting internal controls, management must be actively involved in the process. We understand the need for coordination between management and the auditor, however, we remind companies and auditors that management cannot delegate its responsibility to assess its internal controls over financial reporting to the auditor.71 The rules adopted today do not amend the Commission's rules on auditor independence. c. Material Weaknesses in Internal Control over Financial Reporting In the Proposing Release, we did not propose any specific standard on which management would base its conclusion that the company's internal control over financial reporting is effective. We requested comment on whether we should prescribe specific standards upon which an effectiveness determination would be based, and also what standards we should consider. Several commenters agreed that the final rules should specify standards, and all believed that the existence of a material weakness in internal control over financial reporting should preclude a conclusion by management that a registrant's internal control over financial reporting is effective. We have considered these comments, and agree that the rules should set forth this threshold for concluding that a company's internal control over financial reporting is effective. The final rules therefore preclude management from determining that a company's internal control over financial reporting is effective if it identifies one or more material weaknesses in the company's internal control over financial reporting.72 For purposes of the final rules, the term "material weakness" has the same meaning as in the definition under GAAS and attestation standards.73 The final rules also specify that management's report must include disclosure of any "material weakness" in the company's internal control over financial reporting identified by management in the course of its evaluation.74 d. Method of Evaluating Many commenters addressed the method of evaluating internal control over financial reporting, and some sought additional precision or guidance regarding the extent of evaluation, including the documentation required.75 The methods of conducting evaluations of internal control over financial reporting will, and should, vary from company to company. Therefore, the final rules do not specify the method or procedures to be performed in an evaluation. However, in conducting such an evaluation and developing its assessment of the effectiveness of internal control over financial reporting, a company must maintain evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the company's internal control over financial reporting. Developing and maintaining such evidential matter is an inherent element of effective internal controls.76 An instruction to new Item 308 of Regulations S-K and S-B and Forms 20-F and 40-F reminds registrants to maintain such evidential matter.77 The assessment of a company's internal control over financial reporting must be based on procedures sufficient both to evaluate its design and to test its operating effectiveness. Controls subject to such assessment include, but are not limited to: controls over initiating, recording, processing and reconciling account balances, classes of transactions and disclosure and related assertions included in the financial statements; controls related to the initiation and processing of non-routine and non-systematic transactions; controls related to the selection and application of appropriate accounting policies; and controls related to the prevention, identification, and detection of fraud. The nature of a company's testing activities will largely depend on the circumstances of the company and the significance of the control. However, inquiry alone generally will not provide an adequate basis for management's assessment.78 An assessment of the effectiveness of internal control over financial reporting must be supported by evidential matter, including documentation, regarding both the design of internal controls and the testing processes. This evidential matter should provide reasonable support: for the evaluation of whether the control is designed to prevent or detect material misstatements or omissions; for the conclusion that the tests were appropriately planned and performed; and that the results of the tests were appropriately considered. The public accounting firm that is required to attest to, and report on, management's assessment of the effectiveness of the company's internal control over financial reporting also will require that the company develop and maintain such evidential matter to support management's assessment.79 e. Location of Management's Report Although the final rules do not specify where management's internal control report must appear in the company's annual report, we think it is important for management's report to be in close proximity to the corresponding attestation report issued by the company's registered public accounting firm. We expect that many companies will choose to place the internal control report and attestation report near the companies' MD&A disclosure or in a portion of the document immediately preceding the companies' financial statements. C. Quarterly Evaluations of Internal Control over Financial Reporting We proposed to require a company's certifying officers to evaluate the effectiveness of the company's internal controls and procedures for financial reporting as of the end of the period covered by each annual and quarterly report that the company is required to file under the Exchange Act. The company's certifying officers already are required to evaluate the effectiveness of the company's disclosure controls and procedures on a quarterly basis.80 We noted that a quarterly evaluation requirement with respect to internal controls would create symmetry between our requirements for periodic evaluations of both the company's disclosure controls and procedures and its internal controls and procedures for financial reporting, and give effect to the language in the Section 302 certification requirements regarding quarterly internal control evaluations. We received responses from 25 commenters on the proposed amendments. Of the 25 commenters, four supported the proposal to require quarterly evaluations of internal controls and procedures for financial reporting.81 One commenter specifically concurred with our objective of creating symmetry between the requirements to conduct periodic evaluations of both the company's disclosure controls and procedures and its internal controls and procedures for financial reporting.82 Twenty-one commenters opposed quarterly evaluations of internal controls.83 Many of these believed that quarterly evaluations would impose substantial additional costs on companies without producing any incremental benefit to investors. One individual stated that the proper evaluation of a company's system of internal controls is a weighty and time-consuming process.84 Twelve of the commenters opposed to quarterly evaluations indicated that quarterly evaluations of all aspects of internal controls and procedures would be extremely burdensome, expensive and difficult to perform under the time constraints of quarterly reporting, particularly as the accelerated filing deadlines for quarterly reports take effect.85 Several other commenters argued that we should not go beyond the requirements of Section 404 of the Sarbanes-Oxley Act with respect to the frequency of internal control reporting without an adequate basis for doing so.86 These commenters remarked that such a decision would be better made after we have had sufficient experience with the Section 302 certification requirements adopted in August of 2002. Several commenters suggested alternatives to quarterly evaluations. Five commenters stated that it would be more appropriate and desirable if companies were required to make quarterly disclosure only of material changes to their internal control that occurred subsequent to management's most recent annual internal control evaluation.87 Two other commenters similarly recommended that the quarterly evaluation be less rigorous than the annual evaluation.88 One commenter stated that we should instead adopt an approach that requires less effort and assurance for purposes of quarterly reports, such as permitting companies to test compliance with controls relating to major applications on a rotating basis throughout the year.89 This commenter further stated that the objective of the quarterly evaluation should be to identify changes in controls during the quarter and evaluate whether they would change the certifying officers' conclusions about disclosure controls and internal controls as stated in the most recent annual report. The other commenter, although opposed to any quarterly evaluation requirement, believed that if we did require it, the quarterly evaluation should be viewed as an update of the annual evaluation, just as the quarterly report on Form 10-Q is an update of the annual report on Form 10-K.90 One commenter stated that if we require some form of quarterly certification, it should be limited to negative assurance that nothing has come to the certifying officers' attention since the prior year's evaluation to suggest that the controls are no longer effective.91 After consideration of the comments received, we have decided not to require quarterly evaluations of internal control over financial reporting that are as extensive as the annual evaluation. We recognize that some controls operate continuously while others operate only at certain times, such as the end of the fiscal year. We believe that each company should be afforded the flexibility to design its system of internal control over financial reporting to fit its particular circumstances. The management of each company should perform evaluations of the design and operation of the company's entire system of internal control over financial reporting over a period of time that is adequate for it to determine whether, as of the end of the company's fiscal year, the design and operation of the company's internal control over financial reporting are effective. Accordingly, we are adopting amendments that require a company's management, with the participation of the principal executive and financial officers, to evaluate any change in the company's internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. We also have adopted a modification to the Section 302 certification requirement and our disclosure requirements to adopt this approach, as discussed below. The management of a foreign private issuer that has Exchange Act reporting obligations must also, like its domestic counterparts, report any material changes to the issuer's internal control over financial reporting. However, because foreign private issuers are not required to file quarterly reports under Section 13(a) or 15(d) of the Exchange Act, the final rules clarify that a foreign private issuer's management need only disclose in the issuer's annual report the material changes to its internal control over financial reporting that have occurred in the period covered by the annual report.92 D. Differences between Internal Control over Financial Reporting and Disclosure Controls and Procedures Many of the commenters on the Proposing Release indicated that they were confused as to the differences between a company's disclosure controls and procedures and a company's internal control over financial reporting. Exchange Act Rule 13a-15(d) defines "disclosure controls and procedures" to mean controls and procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. The definition further states that disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that the information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. While there is substantial overlap between a company's disclosure controls and procedures and its internal control over financial reporting, there are both some elements of disclosure controls and procedures that are not subsumed by internal control over financial reporting and some elements of internal control that are not subsumed by the definition of disclosure controls and procedures. With respect to the latter point, clearly, the broad COSO description of internal control, which includes the efficiency and effectiveness of a company's operations and the company's compliance with laws and regulations (not restricted to the federal securities laws), would not be wholly subsumed within the definition of disclosure controls and procedures. A number of commenters suggested that the narrower concept of internal control, involving internal control over financial reporting, is a subset of a company's disclosure controls and procedures, given that the maintenance of reliable financial reporting is a prerequisite to a company's ability to submit or file complete disclosure in its Exchange Act reports on a timely basis. This suggestion focuses on the fact that the elements of internal control over financial reporting requiring a company to have a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles can be viewed as a subset of disclosure controls and procedures. We agree that some components of internal control over financial reporting will be included in disclosure controls and procedures for all companies. In particular, disclosure controls and procedures will include those components of internal control over financial reporting that provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles. However, in designing their disclosure controls and procedures, companies can be expected to make judgments regarding the processes on which they will rely to meet applicable requirements. In doing so, some companies might design their disclosure controls and procedures so that certain components of internal control over financial reporting pertaining to the accurate recording of transactions and disposition of assets or to the safeguarding of assets are not included. For example, a company might have developed internal control over financial reporting that includes as a component of safeguarding of assets dual signature requirements or limitations on signature authority on checks. That company could nonetheless determine that this component is not part of disclosure controls and procedures. We therefore believe that while there is substantial overlap between internal control over financial reporting and disclosure controls and procedures, many companies will design their disclosure controls and procedures so that they do not include all components of internal control over financial reporting. E. Evaluation of Disclosure Controls and Procedures The rules in place starting in August 2002 requiring quarterly evaluations of disclosure controls and procedures and disclosure of the conclusions regarding effectiveness of disclosure controls and procedures have not been substantively changed since their adoption, including in the rules that we adopt today. These evaluation and disclosure requirements will continue to apply to disclosure controls and procedures, including the elements of internal control over financial reporting that are subsumed within disclosure controls and procedures. With respect to evaluations of disclosure controls and procedures, companies must, under our rules and consistent with the Sarbanes-Oxley Act, evaluate the effectiveness of those controls and procedures on a quarterly basis. While the evaluation is of effectiveness overall, a company's management has the ability to make judgments (and it is responsible for its judgments) that evaluations, particularly quarterly evaluations, should focus on developments since the most recent evaluation, areas of weakness or continuing concern or other aspects of disclosure controls and procedures that merit attention. Finally, the nature of the quarterly evaluations of those components of internal control over financial reporting that are subsumed within disclosure controls and procedures should be informed by the purposes of disclosure controls and procedures.93 The rules adopted in August 2002 required the management of an Exchange Act reporting foreign private issuer to evaluate and disclose conclusions regarding the effectiveness of the issuer's disclosure controls and procedures only in its annual report and not on a quarterly basis. The primary reason for this treatment is because foreign private issuers are not subject to mandated quarterly reporting requirements under the Exchange Act. The rules adopted today continue this treatment.94 F. Periodic Disclosure about the Certifying Officers' Evaluation of the Company's Disclosure Controls and Procedures and Disclosure about Changes to its Internal Control over Financial Reporting 1. Existing Disclosure Requirements The rules that we adopted in August 2002 to implement the certification requirements of Section 302 of the Sarbanes-Oxley Act included new Item 307 of Regulations S-B and S-K. Paragraph (a) of Item 307 requires companies, in their quarterly and annual reports, to disclose the conclusions of the company's principal executive and financial officers (or persons performing similar functions) about the effectiveness of the company's disclosure controls and procedures as of a date within 90 days of the filing date of the quarterly or annual report. This disclosure enables the certifying officers to satisfy the representation made in their certifications that they have "presented in the quarterly or annual report their conclusions about the effectiveness of the disclosure controls and procedures based on their evaluation." Paragraph (b) of Item 307 requires the company to disclose in each quarterly and annual report whether or not there were significant changes in the company's internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. This disclosure enables the certifying officers to satisfy the representation made in their certifications that they have "indicated in the quarterly or annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses." 2. Proposed Amendments to the Disclosure Requirements In the Proposing Release, we proposed several revisions to the existing disclosure requirements regarding: (1) the certifying officers' evaluation of the company's disclosure controls and procedures; and (2) changes to the company's internal control over financial reporting. We also proposed to require quarterly disclosure regarding the conclusions of the certifying officers about the effectiveness of the company's internal control over financial reporting. Moreover, we proposed to require evaluations of both types of controls as of the end of the period covered by the quarterly or annual report, rather than "as of a date within 90 days of the filing date" of the quarterly or annual report, as currently required with respect to disclosure controls. With respect to the disclosure about changes to the company's internal control over financial reporting, we proposed to require a company to disclose "any significant changes made during the period covered by the quarterly or annual report" rather than "whether or not there were significant changes in the company's internal control over financial reporting that could significantly affect these controls subsequent to the date of their evaluation." The commenters were mixed in their reaction to these proposed changes. A couple of the commenters remarking on the point at which a company must undertake an evaluation of its controls "strongly agreed" with the proposed change to require evaluations as of the end of the period. Several other commenters preferred the existing "90 days within the filing date" evaluation point, noting that it provides more flexibility than the fixed point. Some of these commenters expressed concern that it would be hard to conduct evaluations on the last day of the period. One of the commenters suggested that the proposed requirement that a company disclose changes to its internal control over financial reporting that occurred at any time during a fiscal quarter was inconsistent with the proposed requirement that management evaluate such changes "as of the end of each fiscal quarter."95 An additional commenter asserted that it was critical that we offer companies some guidance as to the types of changes that constitute "significant changes."96 Finally, a few commenters noted that while we had proposed to delete the words "or other factors" from Exchange Act Rules 13a-14(b)(6) and 15d-14(b)(6) regarding disclosure of "significant changes in internal controls or in other factors that could significantly affect internal controls...," we had not likewise proposed to delete those words from the actual certification language. 3. Final Disclosure Requirements After consideration of the comments, we are adopting the proposals with several modifications. We are adopting as proposed the change of the evaluation date for disclosure controls to "as of the end of the period" covered by the quarterly or annual report. We are not specifying the point at which management must evaluate changes to the company's internal control over financial reporting. Given that the final rules do not require a company to state the conclusions of the certifying officers regarding the effectiveness of the company's internal control over financial reporting as of a particular date on a quarterly basis as proposed, as the company must with respect to disclosure controls and procedures, it is unnecessary to specify a date for the quarterly evaluation of changes in internal control over financial reporting. We believe that this change is consistent with the new accelerated reporting deadlines.97 We are amending the proposal that would have required companies to disclose any significant changes in its internal controls. Under the final rules, a company must disclose any change in its internal control over financial reporting that occurred during the fiscal quarter covered by the quarterly report, or the last fiscal quarter in the case of an annual report, that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting.98 Furthermore, we have deleted the phrase "or in other factors" from Exchange Act Rules 13a-14 and 15d-15 and the form of certification. Although the final rules do not explicitly require the company to disclose the reasons for any change that occurred during a fiscal quarter, or to otherwise elaborate about the change, a company will have to determine, on a facts and circumstances basis, whether the reasons for the change, or other information about the circumstances surrounding the change, constitute material information necessary to make the disclosure about the change not misleading.99 While an evaluation of the effectiveness of disclosure controls and procedures must be undertaken on a quarterly basis, we expect that for purposes of disclosure by domestic companies, the traditional relationship between disclosure in annual reports on Form 10-K and intervening quarterly reports on Form 10-Q will continue. Disclosure in an annual report that continues to be accurate need not be repeated. Rather, disclosure in quarterly reports may make appropriate reference to disclosures in the most recent annual report (and, where appropriate, intervening quarterly reports) and disclose subsequent developments required to be disclosed in the quarterly report. We note that, as required by the Sarbanes-Oxley Act, the quarterly certification regarding disclosure that the certifying officers must make to the company's auditors and audit committee provides:100 The company's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the company's auditors and the audit committee of the company's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the company's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the company's internal control over financial reporting. We expect that if a certifying officer becomes aware of a significant deficiency, material weakness or fraud requiring disclosure outside of the formal evaluation process or after the management's most recent evaluation of internal control over financial reporting, he or she will disclose it to the company's auditors and audit committee. 4. Conclusions Regarding Effectiveness of Disclosure Controls and Procedures In disclosures required under current Item 307 of Regulations S-K and S-B, Item 15 of Form 20-F and General Instruction B(6) to Form 40-F, some companies have indicated that disclosure controls and procedures are designed only to provide "reasonable assurance" that the controls and procedures will meet their objectives. In reviewing those disclosures, the Commission staff generally has not objected to that type of disclosure. The staff has, however, requested companies including that type of disclosure to set forth, if true, the conclusions of the principal executive and principal financial officer that the disclosure controls and procedures are, in fact, effective at the "reasonable assurance" level. Other companies have included disclosure that there is "no assurance" that the disclosure controls and procedures will operate effectively under all circumstances. In these instances, the staff has requested companies to clarify that the disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives and to set forth, if true, the conclusions of the principal executive and principal financial officers that the controls and procedures are, in fact, effective at the "reasonable assurance" level. The concept of reasonable assurance is built into the definition of internal control over financial reporting that we are adopting. This conforms to the standard contained in the internal accounting control provisions of Section 13(b)(2) of the Exchange Act101 and current auditing literature.102 If management decides to include a discussion of reasonable assurance in the internal control report, the discussion must be presented in a manner that neither makes the disclosure in the report confusing nor renders management's assessment concerning the effectiveness of the company's internal control over financial reporting unclear. G. Attestation to Management's Internal Control Report by the Company's Registered Public Accounting Firm In the Proposing Release, we proposed to amend Rules 210.1-02 and 210.2-02 of Regulation S-X to make conforming revisions to Regulation S-X to reflect the registered public accounting firm attestation requirements mandated by Section 404(b) of the Sarbanes-Oxley Act. Under the proposals, we set forth a definition for the new term "attestation report on management's evaluation of internal control over financial reporting" and certain requirements for the accountant's attestation report. We are adopting the proposals substantially as proposed. However, the final rules define the expanded term "attestation report on management's evaluation of internal control over financial reporting." Several commenters suggested that we use this more specific term, noting that auditors currently perform attestation engagements on a broad variety of subjects. Amended Rule 2-02 requires every registered public accounting firm that issues an audit report on the company's financial statements that are included in its annual report required by Section 13(a) or 15(d) of the Exchange Act containing an assessment by management of the effectiveness of the registrant's internal control over financial reporting must attest to, and report on, such assessment. At the time of the enactment of the Sarbanes-Oxley Act, the applicable standard for attestation by auditors of internal control over financial reporting was set forth in Statements on Standards for Attestation Engagements No. 10 ("SSAE No. 10"). That standard was used by auditors providing attestations on a voluntary basis to companies, as well as by auditors whose financial institution clients are required to obtain attestations under Federal Deposit Insurance Corporation Improvement Act of 1991,103 as discussed below. Under the Sarbanes-Oxley Act, the PCAOB has become the body that sets auditing and attestation standards generally for registered public accounting firms to use in the preparation and issuance of audit reports on the financial statements of issuers, and under Section 404(b) of the Sarbanes-Oxley Act, the PCAOB is required to set standards for the registered public accounting firms' attestations to, and reports on, management's assessment regarding its internal control over financial reporting. On April 16, 2003, the PCAOB designated Statements on Standards for Attestation Engagements as existed on April 16 as the standard for attestations of management's assessment of the effectiveness of internal control over financial reporting pending further PCAOB standard-setting in the area (and subject to our approval of the PCAOB's actions), and on April 25, we approved the PCAOB's action. SSAE No. 10 is thus the standard applicable on a transition basis for attestations required under Section 404 of the Act and the rules we are adopting today, again pending further PCAOB standard-setting (and our approval). We expect that the PCAOB will assess the appropriateness of those standards and modify them as needed, and any future standards adopted by the PCAOB will apply to registered public accounting firms in connection with the preparation and issuance of attestation reports on management's assessment of the effectiveness of internal control over financial reporting. H. Types of Companies Affected Section 404 of the Sarbanes-Oxley Act states that the Commission must prescribe rules that require each annual report required by Section 13(a) or 15(d) of the Exchange Act to contain an internal control report. The Act exempts registered investment companies from this requirement.104 1. Foreign Private Issuers Section 404 of the Sarbanes-Oxley Act makes no distinction between domestic and foreign issuers and, by its terms, clearly applies to foreign private issuers. These amendments, therefore, apply the management report on internal control over financial reporting requirement to foreign private issuers that file reports under Section 13(a) or 15(d) of the Exchange Act. We have, however, adopted a later compliance date for foreign private issuers than for accelerated filers. 2. Asset-Backed Issuers In the Proposing Release, we proposed to exclude issuers of asset-backed securities from the proposed rules implementing Section 404 of the Act. We noted that because of the unique nature of asset-backed issuers, such issuers are subject to substantially different reporting requirements. Most significantly, asset-backed issuers are generally not required to file the types of financial statements that other companies must file. Also, such entities typically are passive pools of assets, without a board of directors or persons acting in a similar capacity. We did not receive any comments on the proposed exclusion of asset-backed issuers from the internal control reporting requirements, and we are excluding asset-backed issuers from the new disclosure requirements as proposed. 3. Small Business Issuers Our proposed rules implementing Section 404 of the Act did not distinguish between large and small issuers. Similarly, Section 404 of the Act directs that the management report on internal control over financial reporting apply to any company filing periodic reports under Section 13(a) or 15(d) of the Exchange Act. Accordingly, these amendments apply to all issuers that file Exchange Act periodic reports, except registered investment companies, regardless of their size. However, we are sensitive that many small business issuers may experience difficulty in evaluating their internal control over financial reporting because these issuers may not have as formal or well-structured a system of internal control over financial reporting as larger companies. Accordingly, we are providing an extended compliance period for small business issuers and other companies that are not accelerated filers.105 In addition, our approach of not mandating specific criteria to be used by management to evaluate a company's internal control over financial reporting should provide small issuers some flexibility in meeting these disclosure requirements. 4. Bank and Thrift Holding Companies In the Proposing Release, we stated that we were coordinating with the Federal Deposit Insurance Corporation (the "FDIC") and the other federal banking regulators to eliminate, to the extent possible, any unnecessary duplication between our proposed internal control report and the FDIC's internal control report requirements. Under regulations adopted by the FDIC implementing Section 36 of the Federal Deposit Insurance Act,106 a federally insured depository institution with total assets of $500 million or more ("institution"), is required, among other things, to prepare an annual management report that contains: A statement of management's responsibility for preparing the institution's annual financial statements, for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and for complying with designated laws and regulations relating to safety and soundness;107 and Management's assessment of the effectiveness of the institution's internal control structure and procedures for financial reporting as of the end of the fiscal year and the institution's compliance with the designated safety and soundness laws and regulations during the fiscal year.108 The FDIC's regulations additionally require the institution's independent accountant to examine, and attest to, management's assertions concerning the effectiveness of the institution's internal control structure and procedures for financial reporting.109 The institution's management report and the accountant's attestation report must be filed with the FDIC, the institution's primary federal regulator (if other than the FDIC), and any appropriate state depository institution supervisor and must be available for public inspection.110 Although bank and thrift holding companies are not required under the FDIC's regulations to prepare these internal control reports, many of these holding companies do so under a provision of Part 363 of the FDIC's regulations111 that permits an insured depository institution that is the subsidiary of a holding company to satisfy its internal control report requirements with an internal control report of the consolidated holding company's management if: Services and functions comparable to those required of the subsidiary by Part 363 are provided at the holding company level;112 and The subsidiary has, as of the beginning of its fiscal year, (i) total assets of less than $5 billion or (ii) total assets of $5 billion or more and a composite rating of 1 or 2 under the Uniform Financial Institutions Rating System.113 Section 404 of the Sarbanes-Oxley Act does not contain an exemption for insured depository institutions that are both subject to the FDIC's internal control report requirements and required to file Exchange Act reports. In fact, it makes no distinction whatsoever between institutions subject to the FDIC's requirements and other types of Exchange Act filers. Accordingly, regardless of whether an insured depository institution is subject to the FDIC's requirements, insured depository institutions or holding companies that are required to file periodic reports under Section 13(a) or 15(d) of the Exchange Act are subject to the internal control reporting requirements that we are adopting today. Although our final rules are similar to the FDIC's internal control report requirements, the rules differ in a few significant respects. Most notably, our final rules do not require a statement of compliance with designated laws and regulations relating to safety and soundness. Conversely, the following provisions in our rules are not included in the FDIC's regulations: The requirement that the report include a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting;114 The requirement that management disclose any material weakness that it has identified in the company's internal control over financial reporting (and related stipulation that management is not permitted to conclude that the company's internal control over financial reporting is effective if there are one or more material weaknesses); The requirement that the company state that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting; and The requirement that the company must provide the registered public accounting firm's attestation report on management's assessment of internal control over financial reporting in the company's annual report filed under the Exchange Act.115 Several commenters generally supported our goal to eliminate or reduce duplicative reporting requirements. Some of these commenters asserted that we should recognize the substantial protections to depositors and investors provided by the federal laws that govern depository institutions and their holding companies. They suggested that our final rules should state that compliance with the FDIC's internal control report requirements satisfies the internal control report requirements that we are adopting under Section 404. A number of these commenters also thought that if we did not exempt insured depository institutions already filing internal control reports under the FDIC's requirements, we should provide an exemption in our rules mirroring the FDIC's exemption that excludes insured depository institutions or their holding companies with less than $500 million in assets from the internal control report requirements. After consultation with the staffs of the FDIC, the Federal Reserve Board, the Office of Thrift Supervision and the Office of the Comptroller of Currency, we have determined that insured depository institutions that are subject to Part 363 of the FDIC's regulations (as well as holding companies permitted to file an internal control report on behalf of their insured depository institution subsidiaries in satisfaction of these regulations) and also subject to our new rules implementing Section 404 of the Sarbanes-Oxley Act116 should be afforded considerable flexibility in determining how best to satisfy both sets of requirements. Therefore, they can choose either of the following two options: They can prepare two separate management reports to satisfy the FDIC's and our new requirements; or They can prepare a single management report that satisfies both the FDIC's requirements and our new requirements. If an insured depository institution or its holding company chooses to prepare a single report to satisfy both sets of requirements, the report of management on the institution's or holding company's internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f) or 15d-15(f)) will have to contain the following:117 A statement of management's responsibility for preparing the registrant's annual financial statements, for establishing and maintaining adequate internal control over financial reporting for the registrant, and for the institution's compliance with laws and regulations relating to safety and soundness designated by the FDIC and the appropriate federal banking agencies; A statement identifying the framework used by management to evaluate the effectiveness of the registrant's internal control over financial reporting as required by Exchange Act Rule 13a-15 or 15d-15; Management's assessment of the effectiveness of the registrant's internal control over financial reporting as of the end of the registrant's most recent fiscal year, including a statement as to whether or not management has concluded that the registrant's internal control over financial reporting is effective, and of the institution's compliance with the designated safety and soundness laws and regulations during the fiscal year. This discussion must include disclosure of any material weakness in the registrant's internal control over financial reporting identified by management;118 and A statement that the registered public accounting firm that audited the financial statements included in the registrant's annual report has issued an attestation report on management's assessment of the registrant's internal control over financial reporting. Additionally, the institution or holding company will have to provide the registered public accounting firm's attestation report on management's assessment in its annual report filed under the Exchange Act.119 For purposes of the report of management and the attestation report, financial reporting must encompass both financial statements prepared in accordance with GAAP and those prepared for regulatory reporting purposes. I. Registered Investment Companies Section 404 of the Sarbanes-Oxley Act does not apply to registered investment companies, and we are not extending any of the requirements that would implement section 404 to registered investment companies.120 Several commenters objected to the proposed requirement that the Section 302 certification include a statement of the officers' responsibility for internal controls.121 These commenters argued that this requirement would contradict Section 405 of the Sarbanes-Oxley Act and represent a "back-door" application of Section 404, from which registered investment companies are exempt.122 We disagree. The certification requirements implement Section 302 of the Sarbanes-Oxley Act, from which registered investment companies are not exempt.123 We are not subjecting registered investment companies to the requirements implementing Section 404 of the Sarbanes-Oxley Act, including the annual and quarterly evaluation requirements with respect to internal control over financial reporting and the requirements for an annual report by management on internal control over financial reporting and an attestation report on management's assessment. We are adopting the following technical changes to our rules and forms implementing Section 302 of the Sarbanes-Oxley Act for registered investment companies in order to conform to the changes that we are adopting for operating companies.124 Paragraph (d) of Investment Company Act Rule 30a-3. The amendments use the same term "internal control over financial reporting" that we are using in the rules for operating companies and include the same definition of "internal control over financial reporting" that we are adopting in Exchange Act Rules 13a-15(f) and 15d-15(f). Paragraph (a) of Investment Company Act Rule 30a-3. The amendments require every registered management investment company, other than a small business investment company, to maintain internal control over financial reporting. These amendments parallel those that we are adopting for operating companies in Exchange Act Rules 13a-15(a) and 15d-15(a). Introductory text and sub-paragraph (b) of paragraph 4 of the certification in Item 10(a)(2) of Form N-CSR. The amendments require the signing officers to state that they are responsible for establishing and maintaining internal control over financial reporting, and that they have designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under their supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Paragraph (4)(d) of the certification of Item 10(a)(2), and Item 9(b) of Form N-CSR. The amendments require disclosure of any change in the investment company's internal control over financial reporting that occurred during the most recent fiscal half-year that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. Paragraph (5) of the certification of Item 10(a)(2) of Form N-CSR. The amendments require the signing officers to state that they have disclosed to the investment company's auditors and the audit committee all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the investment company's ability to record, process, summarize, and report financial information. We are not, however, adopting proposed amendments that would have required the evaluation by an investment company's management of the effectiveness of its disclosure controls and procedures to be as of the end of the period covered by each report on Form N-CSR, rather than within 90 days prior to the filing date of the report, as our certification rules currently require.125 Commenters noted that this would require investment company complexes that have funds with staggered fiscal year ends to perform evaluations of their disclosure controls and procedures as many as twelve times per year. They argued that requiring such frequent evaluations would be extremely costly, inefficient, and operationally disruptive, and would not provide any benefits to shareholders.126 We agree that the costs of requiring investment company complexes to perform evaluations of their disclosure controls and procedures twelve times per year would outweigh the benefits to investors. The certification rules we are adopting will require an investment company complex to perform at most four such evaluations per year.127 Transition Period for Registered Investment Companies Registered investment companies must comply with the rule and form amendments applicable to them on and after August 14, 2003, except as follows. Registered investment companies must comply with the amendments to Exchange Act Rules 13a-15(a) and 15d-15(a) and Investment Company Act Rule 30a-3(a) that require them to maintain internal control over financial reporting with respect to fiscal years ending on or after June 15, 2004. In addition, registered investment companies must comply with the portion of the introductory language in paragraph 4 of the certification in Item 10(a)(2) of Form N-CSR that refers to the certifying officers' responsibility for establishing and maintaining internal control over financial reporting, as well as paragraph 4(b) of the certification, beginning with the first annual report filed on Form N-CSR for a fiscal year ending on or after June 15, 2004. J. Transition Period We received a number of comments urging us to adopt an extended transition period for compliance with the new disclosure requirements.128 We have decided to delay the compliance date of the requirement to provide a management report assessing the effectiveness of internal control over financial reporting and an auditor's attestation to, and report on, that assessment beyond that in the Proposing Release so that companies and their auditors will have time to prepare and satisfy the new requirements. These compliance dates do not apply to registered investment companies, which are not required to provide the management report assessing the effectiveness of internal control over financial reporting and the related auditor's attestation.129 A company that is an "accelerated filer," as defined in Exchange Act Rule 12b-2, as of the end of its first fiscal year ending on or after June 15, 2004, must begin to comply with the management report on internal control over financial reporting disclosure requirements promulgated under Section 404 of the Sarbanes-Oxley Act in its annual report for that fiscal year. We recognize that non-accelerated filers, including smaller companies and foreign private issuers, may have greater difficulty in preparing the management report on internal control over financial reporting. Therefore, these types of companies must begin to comply with the disclosure requirements in annual reports for their first fiscal year ending on or after April 15, 2005. A company must begin to comply with the quarterly evaluation of changes to internal control over financial reporting requirements for its first periodic report due after the first annual report that must include management's report on internal control over financial reporting. We believe that the transition period is appropriate in light of both the substantial time and resources needed to properly implement the rules130 and the corresponding benefit to investors that will result. In addition, the transition period will provide additional time for the PCAOB to consider relevant factors in determining and implementing any new attestation standard as it finds appropriate, subject to our approval. Consistent with this extended compliance period for management's internal control report and the related attestation, and for the subsequent evaluation of changes in internal control over financial reporting, the following provisions of the rules adopted today are subject to the extended compliance period: The provisions of Items 308(a) and (b) of Regulations S-K and S-B and the comparable provisions of Forms 20-F and 40-F requiring management's internal control report and the related attestation; The amendments to Rules 13a-15(a) and 15d-15(a) under the Exchange Act relating to maintenance of internal control over financial reporting; and The provisions of Rules 13a-15(c) and (d) and 15d-15(c) and (d) under the Exchange Act requiring evaluations of internal control over financial reporting and changes thereto. The extended compliance period does not in any way affect the provisions of our other rules and regulations regarding internal controls that are in effect, including, without limitation, Rule 13b-2 under the Exchange Act. Other rules relating to evaluation and disclosure adopted today are effective on August 14, 2003. These other rules include amendments to Items 308(c) of Regulations S-K and S-B and the comparable provisions of Forms 20-F and 40-F requiring disclosure regarding certain changes in internal control over financial reporting. These amendments modify existing requirements regarding disclosure of changes in internal control over financial reporting, are related to statements made in the Section 302 certifications of principal executive and financial officers, and provide clarifications that are beneficial and whose implementation need not be delayed. These other rules that are effective on August 14, 2003, also include amendments relating to disclosure controls and procedures. III. DISCUSSION OF AMENDMENTS RELATED TO CERTIFICATIONS A. Proposed Rules We proposed to amend our rules and forms to require companies to file the certifications required by Section 302 of the Sarbanes-Oxley Act as an exhibit to the periodic reports to which they relate. Specifically, we proposed to amend the exhibit requirements of Forms 20-F and 40-F and Item 601 of Regulations S-B and S-K to add the Section 302 certifications to the list of required exhibits. In addition, we proposed to amend Exchange Act Rules 13a-14 and 15d-14 to require that Section 906 certifications accompany the periodic reports to which they relate, and to amend Forms 20-F and 40-F and Item 601 of Regulations S-B and S-K to add Section 906 certifications to the list of required exhibits. We also proposed to amend Investment Company Act Rule 30a-2 to require that Section 906 certifications accompany the periodic reports on Form N-CSR to which they relate and Item 10 of Form N-CSR to add the Section 906 certifications as a required exhibit. We received eight comment letters in response to the proposals.131 The primary topic addressed by the commenters was whether Section 906 of the Sarbanes-Oxley Act applied to annual reports filed on Form 11-K. Most of the commenters believed that issuers required to file annual reports on Form 11-K should be exempt from the requirement to furnish a Section 906 certification as an exhibit.132 Two commenters noted that the language of Section 906 that requires certification of the chief executive officer and chief financial officer (or equivalent thereof) is inconsistent with the actual administration of employee benefit plans because such plans do not have individuals acting as chief executive officer and chief executive officer.133 Those commenters noted that employee benefit plans are typically administered through one or more committees that are appointed as the plan's named fiduciaries to administer the plan and oversee investments.134 In addition, some commenters believed that we should provide an exemption for Form 11-K because employee benefit plans are already subject to extensive regulation under the Employee Retirement Income Security Act of 1974 ("ERISA"),135 which includes a requirement for the plan administrator to certify, under penalties of perjury and other criminal and administrative penalties, the accuracy of the plan's disclosures under ERISA.136 Commenters also addressed other topics related to Section 906. One commenter requested that the Commission allow Section 906 certifications to remain confidential.137 That commenter expressed concern that a plaintiff could use a Section 906 certification to create a basis for liability that did not otherwise exist.138 One commenter objected to the proposal to deem Section 906 certifications as "furnished," rather than as "filed."139 After considering all of the comments, we are adopting the proposals substantially as proposed. On April 11, 2003, U.S. Senator Joseph Biden introduced a statement into the Congressional Record that discusses Section 906.140 The statement asserts that Section 906 "is intended to apply to any financial statement filed by a publicly-traded company, upon which the investing public will rely to gauge the financial health of the company," which includes financial statements included in current reports on Forms 6-K and 8-K and annual reports on Form 11-K.141 The language added to Title 18 by Section 906 refers to "periodic reports containing financial statements," and our proposals to require companies to furnish Section 906 certifications as exhibits applied to periodic (annual, semi-annual and quarterly) reports but did not address current reports on Forms 6-K and 8-K.142 One commenter addressed the statement in the Congressional Record, indicating that the suggested requirements would create substantial practical burdens for companies to provide Section 906 certifications in current reports filed on Forms 6-K or 8-K.143 We are also concerned that extending Section 906 certifications to Forms 6-K or 8-K could potentially chill the disclosure of information by companies. As noted above, four commenters argued that Section 906 should not apply to Form 11-K.144 In light of these developments, we are considering, in consultation with the Department of Justice, the application of Section 906 to current reports on Forms 6-K and 8-K and annual reports on Form 11-K and the possibility of taking additional action. B. Final Rules We are amending the exhibit requirements of Forms 20-F and 40-F and Item 601 of Regulations S-B and S-K to add the Section 302 certifications to the list of required exhibits.145 In the final rules, the specific form and content of the required certifications is set forth in the applicable exhibit filing requirement.146 To coordinate the rules requiring an evaluation of "disclosure controls and procedures" and "internal control over financial reporting," we are moving the definition of the term "disclosure controls and procedures" from Exchange Act Rules 13a-14(c) and 15d-14(c) and Investment Company Act Rule 30a-2(c) to new Exchange Act Rules 13a-15(c) and 15d-15(c) and Investment Company Act Rule 30a-3(c), respectively. We are amending Exchange Act Rules 13a-14 and 15d-14 and Investment Company Act Rule 30a-2 to require the Section 906 certifications to accompany periodic reports containing financial statements as exhibits. We also are amending the exhibit requirements in Forms 20-F, 40-F and Item 601 of Regulations S-B and S-K to add the Section 906 certifications to the list of required exhibits to be included in reports filed with the Commission. In addition, we are amending Item 10 of Form N-CSR to add the Section 906 certifications as a required exhibit. Because the Section 906 certification requirement applies to periodic reports containing financial statements that are filed by an issuer pursuant to Section 13(a) or 15(d) of the Exchange Act, the exhibit requirement will only apply to reports on Form N-CSR filed under these sections and not to reports on Form N-CSR that are filed under the Investment Company Act only.147 A failure to furnish the Section 906 certifications would cause the periodic report to which they relate to be incomplete, thereby violating Section 13(a) of the Exchange Act.148 In addition, referencing the Section 906 certifications in Exchange Act Rules 13a-14 and 15d-14 and Investment Company Act Rule 30a-2 subjects these certifications to the signature requirements of Rule 302 of Regulation S-T.149 Section 906 requires that the certifications "accompany" the periodic report to which they relate. This is in contrast to Section 302, which requires the certifications to be included "in" the periodic report. In recognition of this difference, we are permitting companies to "furnish," rather than "file," the Section 906 certifications with the Commission.150 Thus, the certifications would not be subject to liability under Section 18 of the Exchange Act.151 Moreover, the certifications would not be subject to automatic incorporation by reference into a company's Securities Act registration statements, which are subject to liability under Section 11 of the Securities Act,152 unless the issuer takes steps to include the certifications in a registration statement. Although Section 906 does not explicitly require the certifications to be made public, we believe that it is appropriate to require certifications that "accompany" a publicly filed periodic report to be provided publicly in this manner. We believe that Congress intended for Section 906 certifications to be publicly provided. Civil liability already exists under our signature requirements and the Section 302 certifications. In addition, any Section 906 certification submitted to the Commission as correspondence is subject to the Freedom of Information Act.153 Finally, the requirement to furnish Section 906 certifications as exhibits serves a number of important functions. First, the exhibit requirement enhances compliance by allowing the Commission, the Department of Justice and the public to monitor the certifications effectively. Second, by subjecting the Section 906 certifications to the signature requirements of Regulation S-T, companies are required to retain a manually signed signature page or other authenticating document for a five-year period. This requirement helps to preserve evidential matter in the event of prosecution. There are important distinctions to be made between Sections 302 and 906 of the Sarbanes-Oxley Act. Unlike the Section 302 certifications, the Section 906 certifications are required only in periodic reports that contain financial statements. Therefore, amendments to periodic reports that do not contain financial statements would not require a new Section 906 certification, but would require a new Section 302 certification to be filed with the amendment.154 In addition, unlike the Section 302 certifications, the Section 906 certifications may take the form of a single statement signed by a company's chief executive and financial officers.155 C. Effect on Interim Guidance Regarding Filing Procedures We provided interim guidance regarding voluntary filing procedures for Section 906 certifications.156 That guidance encouraged issuers to submit their Section 906 certifications as exhibits to the periodic reports to which they relate.157 For issuers that are not investment companies, that interim voluntary guidance shall remain in effect until the rules become effective. In the event that the EDGAR system is not updated by the effective date, companies should submit the required certifications as Exhibit 99.158 For registered investment companies, the interim guidance shall remain in effect until the rules become effective.159 D. Form of Section 302 Certifications We proposed several amendments to the form of certifications to be provided pursuant to Section 302 of the Sarbanes-Oxley Act. In particular, we proposed the following: The addition of a statement that principal executive and financial officers are responsible for designing internal controls and procedures for financial reporting or having such controls and procedures designed under their supervision; The clarification that disclosure controls and procedures may be designed under the supervision of principal executive and financial officers; and The revision of the statement as to the effectiveness of disclosure controls and procedures and internal controls and procedures for financial reporting would be as of the end of the period. We have adopted the proposals referred to above substantially as proposed. In addition, we have made the following changes: We have incorporated the term "internal control over financial reporting" into the certification; We have amended the provision of the certification relating to changes in internal control over financial reporting, consistent with the final rules discussed above regarding evaluation and disclosure, so that it refers to changes that have materially affected or are reasonably likely to materially affect internal control over financial reporting; We have clarified that the statement as effectiveness of disclosure controls and procedures be as of the end of the period, but that the date of the evaluation is not specified; and We have made minor changes in the organization of the certification. E. Transition Period The final rules regarding filing of certifications under Sections 302 and 906, for companies other than registered investment companies, will be effective on August 14, 2003. The compliance dates applicable to registered investment companies are described in Section II. I., above. We believe that changes in the form of Section 302 certification described above are beneficial to both registrants and investors because they clarify the provisions of the certification. With one exception, discussed below, the changes are also not related to our new requirements regarding management's internal control report. With that one exception, appropriateness of the modified certification is thus not affected by the extended compliance period we are providing in connection with management's internal control report and the related attestation. Our rules adopted today also therefore provide that the form of Section 302 certification will be modified, with that one exception, in accordance with these rules effective on August 14, 2003. We are applying the extended compliance period to the portion of the introductory language in paragraph 4 of the Section 302 certification that refers to the certifying officers' responsibility for establishing and maintaining internal control over financial reporting for the company, as well as paragraph 4(b), which must be provided in the first annual report required to contain management's internal control report and thereafter. As noted above, this extended compliance period does not in any way affect the provisions of our other rules and regulations regarding internal controls that are in effect. IV. PAPERWORK REDUCTION ACT A. Background Certain provisions of our final amendments contain "collection of information" requirements within the meaning of the Paperwork Reduction Act of 1995 ("PRA").160 We published a notice requesting comment on the collection of information requirements in the proposing release for the rule amendments, and we submitted these requirements to the Office of Management and Budget ("OMB") for review in accordance with the PRA.161 The titles for the collection of information are: (1) "Form 10-Q" (OMB Control No. 3235-0070); (2) "Form 10-QSB" (OMB Control No. 3235-0416); (3) "Form 10-K" (OMB Control No. 3235-0063); (4) "Form 10-KSB" (OMB Control No. 3235-0420); (5) "Form 20-F" (OMB Control No. 3235-0288); (7) "Regulation S-X" (OMB Control No. 3235-0009); (8) "Regulation S-K" (OMB Control No. 3235-0071); (9) "Regulation S-B" (OMB Control No. 3235-0417); and (10) "Form N-CSR" (OMB Control No. 3235-0570). The forms are periodic reports adopted under the Exchange Act and the Investment Company Act. The regulations set forth the disclosure requirements for periodic reports, registration statements and proxy and information statements filed by companies to ensure that investors are informed. The hours and costs associated with preparing, filing and sending these forms constitute reporting and cost burdens imposed by each collection of information. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid OMB control number. Compliance with the requirements is mandatory. Under our rules for the retention of manual signatures,162 companies must retain, for a period of five years, an original signature page or other document authenticating, acknowledging or otherwise adopting the certifying officers' signatures that appear in their electronically filed periodic reports. Responses to the information collections are not kept confidential. B. Summary of the Final Rules The final rules require the annual report of every company that files periodic reports under Section 13(a) or 15(d) of the Exchange Act, other than reports by registered investment companies, to contain a report of management that includes: A statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting; Management's assessment of the effectiveness of the company's internal control over financial reporting, as of the end of the most recent fiscal year; and A statement that the registered public accounting firm that audited the financial statements included in the annual report has issued an attestation report on management's evaluation of the company's internal control over financial reporting. We are adding these requirements pursuant to the legislative mandate in Section 404 of the Sarbanes-Oxley Act. Under our final rules, a company also will be required to evaluate and disclose any change in its internal control over financial reporting that occurred during the fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. We are also adopting amendments to require companies to file the certifications mandated by Sections 302 and 906 of the Sarbanes-Oxley Act as exhibits to their annual, semi-annual and quarterly reports. These amendments will enhance the ability of investors, the Commission staff, the Department of Justice and other interested parties to easily and efficiently access the certifications through our Electronic Data Gathering, Analysis and Retrieval ("EDGAR") system and facilitate better monitoring of a company's compliance with the certification requirements. C. Summary of Comment Letters and Revisions to Proposals We requested comment on the PRA analysis contained in the proposing releases addressing Section 404 and Sections 302 and 906 of the Sarbanes-Oxley Act.163 We received no comments on our PRA estimates for the certification requirements. With respect to our PRA estimates for the rules implementing Section 404 of the Sarbanes-Oxley Act, eight commenters thought that our PRA estimates significantly understated the actual time and costs that companies would have to expend evaluating and reporting on their internal control over financial reporting.164 However, few of these commenters provided actual alternative cost estimates, and none provided estimates that could be applied generally to all types and sizes of companies. One commenter believed that, based on its experience, we understated the burden estimate by at least a factor of 100.165 In response to these commenters, and based on follow-up conversations with several of the commenters who expressed a view on our burden and cost estimates, we have revised our estimates as discussed more fully in Section IV.D below. We have made a substantive modification to the proposed rules in response to the cost concerns expressed by commenters. Specifically, the final rules require companies to undertake a quarterly evaluation only of any change occurring during the fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. This change should substantially mitigate some of the costs and burdens associated with the proposed requirements. We have made additional substantive changes to the proposed rule as well. First, the final rules require management to evaluate the company's internal control over financial reporting using a suitable framework, such as the COSO Framework. Second, the final rules expand the list of information that must be included in the management report and specify that management cannot conclude that a company's internal control over financial reporting is effective if there are one or more material weaknesses in such control. Under the final rules, management must identify the framework used to evaluate the company's internal control over financial reporting and disclose any material weaknesses in the company's internal control over financial reporting discovered through the evaluation. We do not believe that these changes significantly alter the burdens imposed on companies resulting from the required assessment of internal control over financial reporting. D. Revisions to PRA Reporting and Cost Burden Estimates As discussed above, in consideration of commenters' remarks, we are revising our PRA burden and cost estimates for the rules pertaining to Section 404 that we originally submitted to the OMB in connection with the proposed rules. We derived our new burden hour estimates for the annual report forms by estimating the total amount of time that it will take a company's management to conduct the annual evaluation of its internal control over financial reporting and to prepare the required management report.166 Our annual burden estimate is based on several assumptions. First, we assumed that the annual number of responses for each form would be consistent with the number of filings that we received in fiscal year 2002.167 Second, we assumed that there is a direct correlation between the extent of the burden and the size of the reporting company, with the burden increasing commensurate with the size of the company. We believe that there will be a marked disparity of burdens and costs resulting from the new internal control requirements between the largest and smallest reporting companies. Our estimates reflect an average burden for all sizes of companies. Third, we assumed that the first-year burden would be greater than that for subsequent years, as a portion of the costs will reflect one-time expenditures associated with complying with the rule, such as compiling documentation, implementing new processes, and training staff. We also adjusted the second and third year estimates to account for the fact that management should become more efficient at conducting its internal control assessment and preparing the disclosure after the first year as the process becomes more routine.168 Under these assumptions, we estimate that the average incremental burden for an annual filing will be 383 hours per company and the portion of that burden that is reflected as the cost associated with outside professionals is approximately $34,300 per company. For large corporations, we expect that this burden will be substantially higher. Indeed, we received estimates in the thousands of hours for some large and complex companies. Conversely, we expect small companies to find their burden to be less than this average. We also believe that many companies will experience costs well in excess of this average in the first year of compliance with the final rules. We believe that costs will decrease in subsequent years. This burden will also vary among companies based on the complexity of their organization and the nature of their current internal control procedures. We therefore calculated our estimates by averaging the estimated burdens over a three-year period. We derived our burden estimates for the quarterly report forms by estimating the total amount of time that it will take a company's management to conduct the quarterly evaluation of material changes to the company's internal control over financial reporting and for the company to prepare the required disclosure about such changes. We believe that these quarterly evaluations will impose little additional burden, as much of the structure to conduct these evaluations will be established in connection with the annual evaluations. We estimate that the quarterly reporting will impose an additional burden of five hours per company in connection with each quarterly report. Accordingly, we did not revise our original burden hour estimates for the quarterly report forms. We estimate the total annual incremental burden (for annual and quarterly reports) associated with the new internal control evaluation and disclosure requirements for all companies to be approximately 3,792,888 hours of company personnel time and a cost of $481,013,550 for the services of outside professionals.169 Table 1 below presents these burdens and costs for each form affected by the final rules implementing Section 404 of Sarbanes-Oxley. We calculated the burden by multiplying the estimated number of affected responses by the estimated average number of hours that management will spend conducting its assessment of the company's internal control over financial reporting and preparing the related disclosure. For Exchange Act annual reports, we estimate that 75% of the burden of preparation is carried by the company internally and that 25% of the burden of preparation is carried by outside professionals retained by the company at an average cost of $300 per hour.170 The portion of the burden carried by outside professionals is reflected as a cost, while the portion of the burden carried by the company internally is reflected in hours. There is no change to the estimated burden of the collections of information entitled "Regulation S-K," "Regulation S-B" and "Regulation S-X" because the burdens that these regulations impose are reflected in our revised estimates for the forms. Table 1: Incremental Paperwork Burden for the rules implementing Section 404 We do not believe that the amendments with respect to the Section 302 certifications result in a need to alter the burden estimates that we previously submitted to OMB because they merely relocate the certifications from the text of quarterly and annual reports filed or submitted under Section 13(a) or 15(d) of the Exchange Act to the "Exhibits" section of the reports. We are, however, revising the burden estimates for quarterly and annual reports and for Form N-CSR based on the amendment with respect to the Section 906 certification.171 The PRA estimates for these amendments do not reflect a cost because we believe that the entire burden will be borne by company personnel. With respect to semi-annual reports on Form N-CSR, because the financial statements of registered management investment companies are not as complex as those of operating companies, we estimate that the amendments relating to the Section 906 certifications would result in an increase of one burden hour per portfolio.172 We estimate that there are approximately 3,700 registered management investment companies that are required to file reports on Form N-CSR, containing 9,850 portfolios. The following table illustrates the incremental PRA estimates for the new Section 906 certification requirements: Table 2: Incremental Paperwork Burden for Certification Requirements Form Annual Responses Hours/Form Total Hours Added 20-F 1,194 2 2,388 40-F 134 2 268 10-K 8,484 2 16,968 10-KSB 3,820 2 7,640 10-Q 23,743 2 47,486 10-QSB 11,299 2 22,598 N-CSR 7,400 2.66173 19,700 V. COST-BENEFIT ANALYSIS The amendments implementing Section 404 of the Sarbanes-Oxley Act are congressionally mandated. We recognize that implementation of the Sarbanes-Oxley Act will likely result in costs and benefits to the economy. We are sensitive to the costs and benefits imposed by our rules, and we have considered costs and benefits of our amendments. A. Benefits One of the main goals of the Sarbanes-Oxley Act is to enhance the quality of reporting and increase investor confidence in the financial markets. Recent market events have evidenced a need to provide investors with a clearer understanding of the processes that surround the preparation and presentation of financial information. These amendments are intended to accomplish the Act's goals by improving public company disclosure to investors about the extent of management's responsibility for the company's financial statements and internal control over financial reporting and the means by which management discharges its responsibility. The establishment and maintenance of internal control over financial reporting has always been an important responsibility of management. An effective system of internal control over financial reporting is necessary to produce reliable financial statements and other financial information used by investors. By requiring a report of management stating management's responsibility for the company's financial statements and internal control over financial reporting and management's assessment regarding the effectiveness of such control, investors will be able to better evaluate management's performance of its stewardship responsibilities and the reliability of a company's financial statements and other unaudited financial information. The required annual evaluation of internal control over financial reporting will encourage companies to devote adequate resources and attention to the maintenance of such control. Additionally, the required evaluation should help to identify potential weaknesses and deficiencies in advance of a system breakdown, thereby facilitating the continuous, orderly and timely flow of information within the company and, ultimately, to investors and the marketplace. Improved disclosure may help companies detect fraudulent financial reporting earlier and perhaps thereby deter financial fraud or minimize its adverse effects. All of these benefits will increase market efficiency by improving investor confidence in the reliability of a company's financial disclosure and system of internal control over financial reporting. These benefits are not readily quantifiable. Commenters overwhelmingly supported the benefits of the amendments. The amendments related to Section 302 of the Sarbanes-Oxley Act relocate the certifications required by Exchange Act Rules 13a-14 and 15d-14 from the text of quarterly and annual reports filed or submitted under Section 13(a) or 15(d) of the Exchange Act to the "Exhibits" section of these reports. The amendments related to Section 906 of the Sarbanes-Oxley Act require that the certifications required by Section 1350 of Title 18 of the United States Code, added by Section 906 of the Act, accompany the periodic reports to which they relate as exhibits. These changes will enhance the ability of investors and the Commission staff to verify that the certifications have, in fact, been submitted with the Exchange Act reports to which they relate and to review the contents of the certifications to ensure compliance with the applicable requirements. In addition, the changes will enable the Department of Justice, which has responsibility for enforcing Section 906, to review effectively the form and content of the certifications required by that section. B. Costs The final rules related to Section 404 of the Sarbanes-Oxley Act require companies, other than registered investment companies, to include in their annual reports a report of management on the company's internal control over financial reporting. The management report on internal control over financial reporting must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting; a statement identifying the framework used to evaluate the effectiveness of the company's internal control over financial reporting; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's evaluation of the company's internal control over financial reporting. The final rules will increase costs for all reporting companies. These costs are mitigated somewhat because companies have an existing obligation to maintain an adequate system of internal accounting control under the FCPA. Moreover, one commenter noted that some companies already voluntarily include management reports on their internal controls in their annual reports. The preparation of the management report on internal control over financial reporting will likely involve multiple parties, including senior management, internal auditors, in-house counsel, outside counsel and audit committee members. Many commenters believed that our proposal to require quarterly evaluations of a company's internal control over financial reporting would significantly increase the costs of preparing periodic reports. Several commenters also were concerned that the proposals would result in increased audit fees. We have limited data on which to base cost estimates of the final rules. Using our PRA burden estimates, we estimate the aggregate annual costs of implementing Section 404(a) of the Sarbanes-Oxley Act to be around $1.24 billion (or $91,000 per company).174 We recognize the magnitude of the cost burdens and we are making several accommodations to address commenters' concerns and to ease compliance, including: Requiring quarterly disclosure only of any change that has materially affected, or is reasonably likely to materially affect, a company's internal control over financial reporting; and An extended transition period for the new internal control reporting requirements. We originally proposed to require a company to include an internal control report in its annual report for fiscal years ending on or after September 15, 2003. Under the final rules, a company that is an "accelerated filer" under the definition in Exchange Act Rule 12b-2 must begin to comply with the internal control report requirement in its annual report for its first fiscal year ending on or after June 15, 2004. All other companies must begin to comply with the requirement in their annual reports for their first fiscal year ending on or after April 15, 2005. A longer transition period will help to alleviate the immediate impact of any costs and burdens imposed on companies. A longer transition period may even help to reduce costs as companies will have additional time to develop best practices, long-term processes and efficiencies in preparing management reports. Also, a longer transition period will expand the period of availability of outside professionals that some companies may wish to retain as they prepare to comply with the new requirements. The PRA burden estimate, however, excludes several costs attributable to Section 404. The estimate does not include the costs associated with the auditor's attestation report, which many commenters have suggested might be substantial. It also excludes estimates of likely "indirect" costs of the final rules. For instance, the final rules increase the cost of being a public company; therefore the final rules may discourage some companies from seeking capital from the public markets. Moreover, the final rules may also discourage non-U.S. firms from seeking capital in the United States. The incremental costs of the amendments related to Section 302 of the Sarbanes-Oxley Act are minimal. Since companies must already include the certifications required by Exchange Act Rules 13a-14 and 15d-14 in their quarterly and annual reports, there should be no incremental cost to relocating the certifications from the text of the reports to the "Exhibits" section of these reports. Requiring the Section 906 certifications to be included as an exhibit to the periodic reports to which they relate will lead to some additional costs for companies that currently are submitting the certifications to the Commission in some other manner. While these costs are difficult to quantify, we estimate that the annual paperwork burden of the amendments will be approximately $23.4 million.175 One commenter has expressed concern that companies may assume greater legal risk by making their Section 906 certifications publicly available.176 To the extent that companies may assume greater legal risk by including the Section 906 certifications as part of their periodic reports filed pursuant to the Exchange Act where these reports are incorporated by reference into Securities Act registration statements, we address this risk by requiring companies to "furnish," rather than "file," the certifications with the Commission for purposes of Section 18 of the Exchange Act or incorporation by reference into other filings. Thus, the amendments should mitigate this potential indirect cost of compliance. We believe that it is appropriate to require the certifications that accompany a periodic report to be publicly available. We believe that Congress intended for Section 906 certifications to be publicly available. Civil liability already exists by virtue of the pre-existing signature requirements and Section 302 certifications. In addition, any Section 906 certification submitted to the Commission as correspondence is subject to the Freedom of Information Act.177 VI. EFFECT ON EFFICIENCY, COMPETITION AND CAPITAL FORMATION Section 23(a)(2) of the Exchange Act178 requires us to consider the anti-competitive effects of any rules that we adopt under the Exchange Act. In addition, Section 23(a)(2) prohibits us from adopting any rule that would impose a burden on competition not necessary or appropriate in furtherance of the purposes of the Exchange Act. The amendments related to Section 404 of the Sarbanes-Oxley Act represent the implementation of a congressional mandate. The final rules require management reports that improve investors' understanding of management's responsibility for the preparation of reliable financial information and maintaining adequate internal control over financial reporting. We anticipate that these requirements will enhance the proper functioning of the capital markets by increasing the quality and accountability of financial reporting and restoring investor confidence. Section 2(b) of the Securities Act,179 Section 3(f) of the Exchange Act180 and Section 2(c) of the Investment Company Act181 require us, when engaging in rulemaking to consider or determine whether an action is necessary or appropriate in the public interest, and consider whether the action will promote efficiency, competition, and capital formation. The amendments related to Section 404 are designed to enhance the quality and accountability of the financial reporting process and may help increase investor confidence, which implies increased efficiency and competitiveness of the U.S. capital markets. Increased market efficiency and investor confidence also may encourage more efficient capital formation. We requested comments on the effect of these amendments on efficiency, competition and capital formation analyses in the proposing release addressing Section 404. We received no comments in response to these requests. The amendments related to Section 302 of the Sarbanes-Oxley Act would relocate the certifications required by Exchange Act Rules 13a-14 and 15d-14 from the text of quarterly and annual reports filed or submitted under Section 13(a) or 15(d) of the Exchange Act to the "Exhibits" section of these reports. This relocation will enhance the ability of investors and the Commission staff to verify that the certifications have, in fact, been submitted with the Exchange Act reports to which they relate and to review the contents of the certifications to ensure compliance with the applicable requirements. The amendments related to Section 906 of the Sarbanes-Oxley Act also will streamline compliance with Section 1350 of Title 18 of the United States Code, added by Section 906 of the Act, and will enable investors, the Commission staff and the Department of Justice, which has responsibility for enforcing Section 1350, to verify submission and efficiently review the form and content of the certifications required by that provision. We do not believe that the amendments related to certifications will impose any burden on competition, nor are we aware of any impact on capital formation that would result from the amendments. Depending on how an issuer's principal executive and principal financial officers presently satisfy the Section 906 certification requirements, issuers may incur some additional costs in submitting these certifications as an exhibit to their periodic reports. While these costs are difficult to quantify, we believe that they would be nominal. We requested comment on whether the amendments would affect competition, efficiency and capital formation. We received no comments in response to this request. VII. FINAL REGULATORY FLEXIBILITY ANALYSIS This Final Regulatory Flexibility Analysis ("FRFA") has been prepared in accordance with the Regulatory Flexibility Act.182 This FRFA relates to new rules and amendments that require Exchange Act companies, other than registered investment companies, to include in their annual reports a report of management on the company's internal control over financial reporting. The management report on internal control over financial reporting must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting; a statement identifying the framework used to evaluate the effectiveness of the company's internal control over financial reporting; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's evaluation of the company's internal control over financial reporting. This FRFA also addresses new rules and amendments that require companies to file the certifications mandated by Sections 302 and 906 of the Sarbanes-Oxley Act as exhibits to their periodic reports. An Initial Regulatory Flexibility Analysis ("IRFA") was prepared in accordance with the Regulatory Flexibility Act in conjunction with each of the releases proposing these rules.183 The proposing releases solicited comments on these analyses. A. Need for the Amendments We are adopting these disclosure requirements to comply with the mandate of, and to fulfill the purposes underlying the provisions of, the Sarbanes-Oxley Act of 2002. The new evaluation and disclosure requirements regarding a company's internal control over financial reporting are intended to enhance the quality of reporting and increase investor confidence in the fairness and integrity of the securities markets by making it clear that a company's management is responsible for maintaining and annually assessing such controls. The amendments related to Sections 302 and 906 of the Sarbanes-Oxley Act will enhance the ability of investors and the Commission staff to verify that the certifications have, in fact, been submitted with the Exchange Act reports to which they relate and to review the contents of the certifications to ensure compliance with the applicable requirements. The amendments also will streamline compliance with Section 1350 of Title 18 of the United States Code and will enable investors, the Commission staff and the Department of Justice, which has responsibility for enforcing Section 1350, to verify a company's submission of the Section 906 certification and efficiently review the form and content of the certifications. B. Significant Issues Raised by Public Comment In the Proposing Releases, we requested comment on any aspect of the IRFA, including the number of small entities that would be affected by the proposals, and both quantitative and qualitative nature of the impact. Several commenters expressed concern that small business issuers, including small entities, would be particularly disadvantaged by our proposal to require quarterly evaluations of internal control over financial reporting. We received no commentary on the impact on small entities of the new certification requirements. C. Small Entities Subject to the Amendments The new disclosure items affect issuers that are small entities. Exchange Act Rule 0-10(a)184 defines an issuer, other than an investment company, to be a "small business" or "small organization" if it had total assets of $5 million or less on the last day of its most recent fiscal year. We estimate that there are approximately 2,500 issuers, other than investment companies, that may be considered small entities. For purposes of the Regulatory Flexibility Act, an investment company is a "small entity" if it, together with other investment companies in the same group of related investment companies, has net assets of $50 million or less as of the end of its most recent fiscal year.185 We estimate that there are approximately 190 registered management investment companies that, together with other investment companies in the same group of related investment companies, have net assets of $50 million or less as of the end of the most recent fiscal year.186 The new disclosure items with respect to management's report on internal control over financial reporting and the registered public accounting firm's attestation report apply to any small entity, other than a registered investment company, that is subject to Exchange Act reporting requirements. The new certification requirements apply to any small entity that is subject to Exchange Act reporting requirements. D. Reporting, Recordkeeping and other Compliance Requirements The amendments require a company's management to disclose information regarding the company's internal control over financial reporting, including management's assessment of the effectiveness of the company's internal control over financial reporting. All small entities that are subject to the reporting requirements of Section 13(a) or 15(d) of the Exchange Act, other than registered investment companies, are subject to these evaluation and disclosure requirements. Because reporting companies already file the forms being amended, no additional professional skills beyond those currently possessed by these filers necessarily are required to prepare the new disclosure, although some companies may choose to engage outside professionals to assist them in complying with the new requirements. We expect that these new disclosure items will increase compliance costs incurred by small entities. We have calculated for purposes of the Paperwork Reduction Act that each company would be subject to an added annual reporting burden of approximately 398 hours and the portion of that burden that is reflected as the cost associated with outside professionals is approximately $35,286.187 We believe, however, that the annual average burden and costs for small issuers are much lower.188 For the new certification requirements, we estimate that a company, including a small entity, will be subject to an additional reporting burden of eight hours per year.189 These burden estimates reflect only the burden and cost of the required collection of information. E. Agency Action to Minimize Effect on Small Entities The Regulatory Flexibility Act directs us to consider alternatives that would accomplish our stated objectives, while minimizing any significant adverse impact on small entities. In connection with the amendments, we considered the following alternatives: Establishing different compliance or reporting requirements or timetables that take into account the resources available to small entities; Clarifying, consolidating or simplifying compliance and reporting requirements under the rules for small entities; Using performance rather than design standards; and Exempting small entities from all or part of the requirements. Several of these alternatives were considered but rejected, while other alternatives were taken into account in the final rules. We believe the final rules fulfill the intent of the Sarbanes-Oxley Act of enhancing the quality of reporting and increasing investor confidence in the fairness and integrity of the securities markets. Sections 302, 404 and 906 of the Sarbanes-Oxley Act make no distinction based on a company's size. We think that improvements in the financial reporting process for all companies are important for promoting investor confidence in our markets. For example, a 1999 report commissioned by the organizations that sponsored the Treadway Commission found that the incidence of financial fraud was greater in small companies.190 However, we are sensitive to the costs and burdens that small entities will face. The final rules require only a quarterly evaluation of material changes to a company's internal control over financial reporting, unlike the proposed rules that would have required management to evaluate the effectiveness of a company's internal control over financial reporting on a quarterly basis. In response to comments, including comments submitted by the Small Business Administration, we have decided not to adopt this proposal. We believe that a blanket exemption for small entities from coverage of the requirements is not appropriate and would be inconsistent with the policies underlying the Sarbanes-Oxley Act. However, we have provided an extended transition period for companies that do not meet the definition in Exchange Act Rule 12b-2191 of an "accelerated filer" for the rules implementing Section 404 of the Sarbanes-Oxley Act. Under the adopted rules, non-accelerated filers, including small business issuers, need not prepare the management report on internal control over financial reporting until they file their annual reports for fiscal years ending on or after April 15, 2005. This deferral provides non-accelerated filers more time to develop structured and formal systems of internal control over financial reporting. We believe that the new disclosure and certification requirements are clear and straightforward. The amendments require only brief disclosure. An effective system of internal control over financial reporting has always been necessary to produce reliable financial statements and other financial information. Our amendments do not specify any particular controls that a company's internal control over financial reporting should include. Each company is afforded the flexibility to design its internal control over financial reporting according to its own set of circumstances. This flexibility should enable companies to keep costs of compliance as low as possible. Therefore, it does not seem necessary to develop separate requirements for small entities. The final rules impose both design and performance standards regarding disclosure of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the company and management's assessment of the effectiveness of such controls. The rules do, however, afford a company the flexibility to design its internal control over financial reporting to fit its particular circumstances. We believe that it would be inconsistent with the purposes of the Sarbanes-Oxley Act to specify different requirements for small entities. VIII. STATUTORY AUTHORITY AND TEXT OF RULE AMENDMENTS The amendments described in this release are being adopted under the authority set forth in Sections 5, 6, 7, 10, 17 and 19 of the Securities Act, as amended, Sections 12, 13, 15, 23 and 36 of the Exchange Act, Sections 8, 30, 31 and 38 of the Investment Company Act, as amended and Sections 3(a), 302, 404, 405 and 906 of the Sarbanes-Oxley Act. 17 CFR Part 210 Accountants, Accounting, Reporting and recordkeeping requirements, Securities. Reporting and recordkeeping requirements, Securities, Small businesses. 17 CFR Parts 229, 240 and 249 Reporting and recordkeeping requirements, Securities. 17 CFR Parts 270 and 274 Investment companies, Reporting and recordkeeping requirements, Securities. TEXT OF AMENDMENTS For the reasons set out in the preamble, the Commission amends title 17, chapter II, of the Code of Federal Regulations as follows: PART 210 - FORM AND CONTENT OF AND REQUIREMENTS FOR FINANCIAL STATEMENTS, SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934, PUBLIC UTILITY HOLDING COMPANY ACT OF 1935, INVESTMENT COMPANY ACT OF 1940, INVESTMENT ADVISERS ACT OF 1940, AND ENERGY POLICY AND CONSERVATION ACT OF 1975 1. The authority citation for Part 210 is revised to read as follows: Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 78c, 78j-1, 78l, 78m, 78n, 78o(d), 78q, 78u-5, 78w(a), 78ll, 78mm, 79e(b), 79j(a), 79n, 79t(a), 80a-8, 80a-20, 80a-29, 80a-30, 80a-31, 80a-37(a), 80b-3, 80b-11, 7202 and 7262, unless otherwise noted. 2. Section 210.1-02 is amended by: a. Removing the authority citation following §210.1-02; b. Redesignating paragraph (a) as paragraph (a)(1); and c. Adding paragraph (a)(2). The revisions read as follows: §210.1-02 Definition of terms used in Regulation S-X (17 CFR part 210). (a)(1) * * * (2) Attestation report on management's assessment of internal control over financial reporting. The term attestation report on management's assessment of internal control over financial reporting means a report in which a registered public accounting firm expresses an opinion, or states that an opinion cannot be expressed, concerning management's assessment of the effectiveness of the registrant's internal control over financial reporting (as defined in §240.13a-15(f) or 240.15d-15(f) of this chapter) in accordance with standards on attestation engagements. When an overall opinion cannot be expressed, the registered public accounting firm must state why it is unable to express such an opinion. 3. Amend §210.2-02 by: a. Revising the section heading; b. Revising the headings of paragraphs (a), (b), (c) and (d); and c. Adding paragraph (f). The addition and revisions read as follows. §210.2-02 Accountants' reports and attestation reports on management's assessment of internal control over financial reporting. (a) Technical requirements for accountants' reports. * * * (b) Representations as to the audit included in accountants' reports. * * * (c) Opinions to be expressed in accountants' reports. * * * (d) Exceptions identified in accountants' reports. * * * (f) Attestation report on management's assessment of internal control over financial reporting. Every registered public accounting firm that issues or prepares an accountant's report for a registrant, other than an investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), that is included in an annual report required by section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) containing an assessment by management of the effectiveness of the registrant's internal control over financial reporting must attest to, and report on, such assessment. The attestation report on management's assessment of internal control over financial reporting shall be dated, signed manually, identify the period covered by the report and clearly state the opinion of the accountant as to whether management's assessment of the effectiveness of the registrant's internal control over financial reporting is fairly stated in all material respects, or must include an opinion to the effect that an overall opinion cannot be expressed. If an overall opinion cannot be expressed, explain why. The attestation report on management's assessment of internal control over financial reporting may be separate from the accountant's report. PART 228 - INTEGRATED DISCLOSURE SYSTEM FOR SMALL BUSINESS ISSUERS 4. The general authority citation for Part 228 is revised to read as follows: Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77jjj, 77nnn, 77sss, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll, 78mm, 80a-8, 80a-29, 80a-30, 80a-37, 80b-11, 7202, 7241, and 7262; and 18 U.S.C. 1350, unless otherwise noted. 5. Revise §228.307 to read as follows: §228.307 (Item 307) Disclosure controls and procedures. Disclose the conclusions of the small business issuer's principal executive and principal financial officers, or persons performing similar functions, regarding the effectiveness of the small business issuer's disclosure controls and procedures (as defined in §240.13a-15(e) or 240.15d-15(e) of this chapter) as of the end of the period covered by the report, based on the evaluation of these controls and procedures required by paragraph (b) of §240.13a-15 or 240.15d-15 of this chapter. 6. Add §228.308 to read as follows: §228.308 (Item 308) Internal control over financial reporting. (a) Management's annual report on internal control over financial reporting. Provide a report of management on the small business issuer's internal control over financial reporting (as defined in §240.13a-15(f) or 240.15d-15(f) of this chapter) that contains: (1) A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the small business issuer; (2) A statement identifying the framework used by management to evaluate the effectiveness of the small business issuer's internal control over financial reporting as required by paragraph (c) of §240.13a-15 or 240.15d-15 of this chapter; (3) Management's assessment of the effectiveness of the small business issuer's internal control over financial reporting as of the end of the small business issuer's most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. This discussion must include disclosure of any material weakness in the small business issuer's internal control over financial reporting identified by management. Management is not permitted to conclude that the small business issuer's internal control over financial reporting is effective if there are one or more material weaknesses in the small business issuer's internal control over financial reporting; and (4) A statement that the registered public accounting firm that audited the financial statements included in the annual report containing the disclosure required by this Item has issued an attestation report on management's assessment of the small business issuer's internal control over financial reporting. (b) Attestation report of the registered public accounting firm. Provide the registered public accounting firm's attestation report on management's assessment of the small business issuer's internal control over financial reporting in the small business issuer's annual report containing the disclosure required by this Item. (c) Changes in internal control over financial reporting. Disclose any change in the small business issuer's internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of §240.13a-15 or 240.15d-15 of this chapter that occurred during the small business issuer's last fiscal quarter (the small business issuer's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuer's internal control over financial reporting. Instructions to Item 308 1. The small business issuer must maintain evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the small business issuer's internal control over financial reporting. 2. A small business issuer that is an Asset-Backed Issuer (as defined in §240.13a-14(g) and §240.15d-14(g) of this chapter) is not required to disclose the information required by this Item. 7. Amend §228.401 by removing the phrase "internal controls and procedures for financial reporting" in paragraph (e)(2)(iv) of Item 401 and adding, in its place, the phrase "internal control over financial reporting". 8. Amend §228.601 by: a. Removing the last sentence of paragraph (a)(1); b. Revising the Exhibit Table; c. Revising paragraph (b)(7) to read "No exhibit required."; d. Revising the heading in paragraph (b)(11) to read "Statement re: computation of per share earnings"; and e. Revising paragraphs (b)(27) through (b)(98). The revisions read as follows. §228.601 (Item 601) Exhibits. EXHIBIT TABLE (b) Description of exhibits. * * * (27) through (30) [Reserved] (31) Rule 13a-14(a)/15d-14(a) Certifications. The certifications required by Rule 13a-14(a) (17 CFR 240.13a-14(a)) or Rule 15d-14(a) (17 CFR 240.15d-14(a)) exactly as set forth below: CERTIFICATIONS* I, [identify the certifying individual], certify that: I have reviewed this [specify report] of [identify small business issuer]; Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the small business issuer as of, and for, the periods presented in this report; The small business issuer's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the small business issuer and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the small business issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; (c) Evaluated the effectiveness of the small business issuer's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the small business issuer's internal control over financial reporting that occurred during the small business issuer's most recent fiscal quarter (the small business issuer's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the small business issuer's internal control over financial reporting; and The small business issuer's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the small business issuer's auditors and the audit committee of the small business issuer's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the small business issuer's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the small business issuer's internal control over financial reporting. Date: ............... * Provide a separate certification for each principal executive officer and principal financial officer of the small business issuer. See Rules 13a-14(a) and 15d-14(a) (32) Section 1350. (i) The certifications required by Rule 13a-14(b) (17 CFR 240.13a-14(b)) or Rule 15d-14(b) (17 CFR 240.15d-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). (ii) A certification furnished pursuant to this Item will not be deemed "filed" for purposes of section 18 of the Exchange Act (15 U.S.C. 78r), or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the small business issuer specifically incorporates it by reference. PART 229 - STANDARD INSTRUCTIONS FOR FILING FORMS UNDER SECURITIES ACT OF 1933, SECURITIES EXCHANGE ACT OF 1934 AND ENERGY POLICY AND CONSERVATION ACT OF 1975 - REGULATION S-K Authority: 15 U.S.C. 77e, 77f, 77g, 77h, 77j, 77k, 77s, 77z-2, 77z-3, 77aa(25), 77aa(26), 77ddd, 77eee, 77ggg, 77hhh, 77iii, 77jjj, 77nnn, 77sss, 78c, 78i, 78j, 78l, 78m, 78n, 78o, 78u-5, 78w, 78ll, 78mm, 79e, 79j, 79n, 79t, 80a-8, 80a-9, 80a-20, 80a-29, 80a-30, 80a-31(c), 80a-37, 80a-38(a), 80a-39, 80b-11, 7202, 7241, and 7262; and 18 U.S.C. 1350, unless otherwise noted. 10. By revising §229.307 to read as follows: Disclose the conclusions of the registrant's principal executive and principal financial officers, or persons performing similar functions, regarding the effectiveness of the registrant's disclosure controls and procedures (as defined in §240.13a-15(e) or 240.15d-15(e) of this chapter) as of the end of the period covered by the report, based on the evaluation of these controls and procedures required by paragraph (b) of §240.13a-15 or 240.15d-15 of this chapter. 11. By adding §229.308 to read as follows: (a) Management's annual report on internal control over financial reporting. Provide a report of management on the registrant's internal control over financial reporting (as defined in §240.13a-15(f) or 240.15d-15(f) of this chapter) that contains: (1) A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the registrant; (2) A statement identifying the framework used by management to evaluate the effectiveness of the registrant's internal control over financial reporting as required by paragraph (c) of §240.13a-15 or 240.15d-15 of this chapter; (3) Management's assessment of the effectiveness of the registrant's internal control over financial reporting as of the end of the registrant's most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. This discussion must include disclosure of any material weakness in the registrant's internal control over financial reporting identified by management. Management is not permitted to conclude that the registrant's internal control over financial reporting is effective if there are one or more material weaknesses in the registrant's internal control over financial reporting; and (4) A statement that the registered public accounting firm that audited the financial statements included in the annual report containing the disclosure required by this Item has issued an attestation report on management's assessment of the registrant's internal control over financial reporting. (b) Attestation report of the registered public accounting firm. Provide the registered public accounting firm's attestation report on management's assessment of the registrant's internal control over financial reporting in the registrant's annual report containing the disclosure required by this Item. (c) Changes in internal control over financial reporting. Disclose any change in the registrant's internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of §240.13a-15 or 240.15d-15 of this chapter that occurred during the registrant's last fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. 1. The registrant must maintain evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the registrant's internal control over financial reporting. 2. A registrant that is an Asset-Backed Issuer (as defined in §240.13a-14(g) and §240.15d-14(g) of this chapter) is not required to disclose the information required by this Item. 12. By amending §229.401 by removing the phrase "internal controls and procedures for financial reporting" in paragraph (h)(2)(iv) of Item 401 and adding, in its place, the phrase "internal control over financial reporting". 13. By amending §229.601 by: a. Removing the second and third sentences of paragraph (a)(1); b. Revising the Exhibit Table which follows the Instructions to the Exhibit Table; and c. Revising paragraphs (b)(27) through (b)(98). (a) Exhibits and index required. * * * Instructions to the Exhibit Table I have reviewed this [specify report] of [identify registrant]; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. * Provide a separate certification for each principal executive officer and principal financial officer of the registrant. See Rules 13a-14(a) and 15d-14(a). (32) Section 1350 Certifications. (ii) A certification furnished pursuant to this item will not be deemed "filed" for purposes of Section 18 of the Exchange Act (15 U.S.C. 78r), or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference. PART 240 - GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 14. The general authority citation for Part 240 is revised to read as follows: Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7202, 7241, 7262, and 7263; and 18 U.S.C. 1350, unless otherwise noted. 15. By revising §240.12b-15 to read as follows: §240.12b-15 Amendments. All amendments must be filed under cover of the form amended, marked with the letter "A" to designate the document as an amendment, e.g., "10-K/A," and in compliance with pertinent requirements applicable to statements and reports. Amendments filed pursuant to this section must set forth the complete text of each item as amended. Amendments must be numbered sequentially and be filed separately for each statement or report amended. Amendments to a statement may be filed either before or after registration becomes effective. Amendments must be signed on behalf of the registrant by a duly authorized representative of the registrant. An amendment to any report required to include the certifications as specified in §240.13a-14(a) or §240.15d-14(a) must include new certifications by each principal executive and principal financial officer of the registrant, and an amendment to any report required to be accompanied by the certifications as specified in §240.13a-14(b) or §240.15d-14(b) must be accompanied by new certifications by each principal executive and principal financial officer of the registrant. The requirements of the form being amended will govern the number of copies to be filed in connection with a paper format amendment. Electronic filers satisfy the provisions dictating the number of copies by filing one copy of the amendment in electronic format. See §232.309 of this chapter (Rule 309 of Regulation S-T). 16. By amending §240.13a-14 by: a. Revising paragraphs (a) and (b); b. Removing paragraph (c); c. Redesignating paragraphs (d), (e) and (f) as paragraphs (c), (d) and (e); d. Revising newly redesignated paragraph (c), the introductory text of newly redesignated paragraph (d) and newly redesignated paragraph (e); and e. Adding and reserving new paragraph (f). §240.13a-14 Certification of disclosure in annual and quarterly reports. (a) Each report, including transition reports, filed on Form 10-Q, Form 10-QSB, Form 10-K, Form 10-KSB, Form 20-F or Form 40-F (§§249.308a, 249.308b, 249.310, 249.310b, 249.220f or 249.240f of this chapter) under section 13(a) of the Act (15 U.S.C. 78m(a)), other than a report filed by an Asset-Backed Issuer (as defined in paragraph (g) of this section), must include certifications in the form specified in the applicable exhibit filing requirements of such report and such certifications must be filed as an exhibit to such report. Each principal executive and principal financial officer of the issuer, or persons performing similar functions, at the time of filing of the report must sign a certification. (b) Each periodic report containing financial statements filed by an issuer pursuant to section 13(a) of the Act (15 U.S.C. 78m(a)) must be accompanied by the certifications required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) and such certifications must be furnished as an exhibit to such report as specified in the applicable exhibit requirements for such report. Each principal executive and principal financial officer of the issuer (or equivalent thereof) must sign a certification. This requirement may be satisfied by a single certification signed by an issuer's principal executive and principal financial officers. (c) A person required to provide a certification specified in paragraph (a) or (b) of this section may not have the certification signed on his or her behalf pursuant to a power of attorney or other form of confirming authority. (d) Each annual report filed by an Asset-Backed Issuer (as defined in paragraph (g) of this section) under section 13(a) of the Act (15 U.S.C. 78m(a)) must include a certification addressing the following items: * * * (e) With respect to Asset-Backed Issuers, the certification required by paragraph (d) of this section must be signed by the trustee of the trust (if the trustee signs the annual report) or the senior officer in charge of securitization of the depositor (if the depositor signs the annual report). Alternatively, the senior officer in charge of the servicing function of the master servicer (or entity performing the equivalent functions) may sign the certification. (f) [Reserved] 17. Section 240.13a-15 is revised to read as follows: §240.13a-15 Controls and procedures. (a) Every issuer that has a class of securities registered pursuant to section 12http://www.law.uc.edu/CCL/34Act/sec12.html of the Act (15 U.S.C. 78l), other than an Asset-Backed Issuer (as defined in §240.13a-14(g)), a small business investment company registered on Form N-5 (§§ 239.24 and 274.5 of this chapter), or a unit investment trust as defined by section 4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), must maintain disclosure controls and procedures (as defined in paragraph (e) of this section) and internal control over financial reporting (as defined in paragraph (f) of this section). (b) Each such issuer's management must evaluate, with the participation of the issuer's principal executive and principal financial officers, or persons performing similar functions, the effectiveness of the issuer's disclosure controls and procedures, as of the end of each fiscal quarter, except that management must perform this evaluation: (1) In the case of a foreign private issuer (as defined in §240.3b-4) as of the end of each fiscal year; and (2) In the case of an investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), within the 90-day period prior to the filing date of each report requiring certification under §270.30a-2 of this chapter. (c) The management of each such issuer, other than an investment company registered under section 8 of the Investment Company Act of 1940, must evaluate, with the participation of the issuer's principal executive and principal financial officers, or persons performing similar functions, the effectiveness, as of the end of each fiscal year, of the issuer's internal control over financial reporting. The framework on which management's evaluation of the issuer's internal control over financial reporting is based must be a suitable, recognized control framework that is established by a body or group that has followed due-process procedures, including the broad distribution of the framework for public comment. (d) The management of each such issuer, other than an investment company registered under section 8 of the Investment Company Act of 1940, must evaluate, with the participation of the issuer's principal executive and principal financial officers, or persons performing similar functions, any change in the issuer's internal control over financial reporting, that occurred during each of the issuer's fiscal quarters, or fiscal year in the case of a foreign private issuer, that has materially affected, or is reasonably likely to materially affect, the issuer's internal control over financial reporting. (e) For purposes of this section, the term disclosure controls and procedures means controls and other procedures of an issuer that are designed to ensure that information required to be disclosed by the issuer in the reports that it files or submits under the Act (15 U.S.C. 78a et seq.) is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an issuer in the reports that it files or submits under the Act is accumulated and communicated to the issuer's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. (f) The term internal control over financial reporting is defined as a process designed by, or under the supervision of, the issuer's principal executive and principal financial officers, or persons performing similar functions, and effected by the issuer's board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the issuer; (2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the issuer are being made only in accordance with authorizations of management and directors of the issuer; and (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the issuer's assets that could have a material effect on the financial statements. 18. By amending §240.15d-14 by: §240.15d-14 Certification of disclosure in annual and quarterly reports. (a) Each report, including transition reports, filed on Form 10-Q, Form 10-QSB, Form 10-K, Form 10-KSB, Form 20-F or Form 40-F (§§249.308a, 249.308b, 249.310, 249.310b, 249.220f or 249.240f of this chapter) under section 15(d) of the Act (15 U.S.C. 78o(d)), other than a report filed by an Asset-Backed Issuer (as defined in paragraph (g) of this section), must include certifications in the form specified in the applicable exhibit filing requirements of such report and such certifications must be filed as an exhibit to such report. Each principal executive and principal financial officer of the issuer, or persons performing similar functions, at the time of filing of the report must sign a certification. (b) Each periodic report containing financial statements filed by an issuer pursuant to section 15(d) of the Act (15 U.S.C. 78o(d)) must be accompanied by the certifications required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) and such certifications must be furnished as an exhibit to such report as specified in the applicable exhibit requirements for such report. Each principal executive and principal financial officer of the issuer (or equivalent thereof) must sign a certification. This requirement may be satisfied by a single certification signed by an issuer's principal executive and principal financial officers. (d) Each annual report filed by an Asset-Backed Issuer (as defined in paragraph (g) of this section) under section 15(d) of the Act (15 U.S.C. 78o(d)), must include a certification addressing the following items: * * * 19. Section 240.15d-15 is revised to read as follows: §240.15d-15 Controls and procedures. (a) Every issuer that files reports under section 15(d) of the Act (15 U.S.C. 78o(d)), other than an Asset-Backed Issuer (as defined in §240.15d-14(g) of this chapter), a small business investment company registered on Form N-5 (§§239.24 and 274.5 of this chapter), or a unit investment trust as defined in section 4(2) of the Investment Company Act of 1940 (15 U.S.C. 80a-4(2)), must maintain disclosure controls and procedures (as defined in paragraph (e) of this section) and internal control over financial reporting (as defined in paragraph (f) of this section). PART 249 - FORMS, SECURITIES EXCHANGE ACT OF 1934 20. The general authority citation for Part 249 and the subauthority citation for "Section 249.331" are revised to read as follows: Authority: 15 U.S.C. 78a et seq., 7202, 7233, 7241, 7262, 7264, and 7265; and 18 U.S.C. 1350, unless otherwise noted. Section 249.331 is also issued under 15 U.S.C. 78j-1, 7202, 7233, 7241, 7264, 7265; and 18 U.S.C. 1350. 21. By amending Form 10-Q (referenced in §249.308a) by: a. Removing the last sentence of General Instruction G; b. Revising Item 4 to "Part I - Financial Information;" and c. Removing the "Certifications" section after the "Signatures" section. The revision reads as follows. Note: The text of Form 10-Q does not, and this amendment will not, appear in the Code of Federal Regulations. Part I - Financial Information Item 4. Controls and Procedures. Furnish the information required by Items 307 of Regulation S-K (17 CFR 229.307) and 308(c) of Regulation S-K (17 CFR 229.308(c)). 22. By amending Form 10-QSB (referenced in §249.308b) by: a. Removing the last sentence of paragraph 2 of General Instruction F; Note: The text of Form 10-QSB does not, and this amendment will not, appear in the Code of Federal Regulations. FORM 10-QSB Furnish the information required by Items 307 of Regulation S-B (17 CFR 228.307) and 308(c) of Regulation S-B (17 CFR 228.308(c)). 23. By amending Form 10-K (referenced in § 249.310) by: a. Removing the phrase "(who also must provide the certification required by Rule 13a-14 (17 CFR 240.13a-14) or Rule 15d-14 (17 CFR 240.15d-14) exactly as specified in this form)" each time it appears in the first sentence of paragraph (2)(a) of General Instruction D.; b. Removing the phrase "(Items 1 through 9 or any portion thereof)" and adding, in its place, the phrase "(Items 1 through 9A or any portion thereof)" in the first sentence of paragraph (2) of General Instruction G.; c. Removing the phrase "(Items 10, 11, 12 and 13)" and adding, in its place, the phrase "(Items 10, 11, 12, 13 and 14)" in the first sentence of paragraph (3) of General Instruction G.; d. Removing the phrase "(Items 1 through 9)" in the third sentence of paragraph (4) of General Instruction G and adding, in its place, the phrase "(Items 1 through 9A)"; e. Removing the phrase "(Items 10 through 13)" in the third sentence of paragraph (4) of General Instruction G and adding, in its place, the phrase "(Items 10 through 14)"; f. Redesignating Item 14 of Part III as Item 9A of Part II and revising newly redesignated Item 9A; g. Redesignating Item 15 in Part III as Item 14; h. "Instruction to Item 15" is corrected to read "Instruction to Item 14"; i. Redesignating Item 16 in Part IV as Item 15; j. Removing the "Certifications" section after the "Signatures" section and before the reference to "Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Act by Issuers Which Have Not Registered Securities Pursuant to Section 12 of the Act." Note: The text of Form 10-K does not, and this amendment will not, appear in the Code of Federal Regulations. Furnish the information required by Items 307 and 308 of Regulation S-K (17 CFR 229.307 and 229.308). 24. By amending Form 10-KSB (referenced in § 249.310b) by: a. Removing the phrase "(who also must provide the certification required by Rule 13a-14 (17 CFR 240.13a-14) or Rule 15d-14 (17 CFR 240.15d-14) exactly as specified in this form)" each time it appears in the first sentence of paragraph 2 of General Instruction C.; b. Redesignating Item 14 of Part III as Item 8A of Part II and revising newly redesignated Item 8A; c. Redesignating Item 15 of Part III as Item 14; d. "Instruction to Item 15" is corrected to read "Instruction to Item 14"; e. Revising Item 2 of Part III of "INFORMATION REQUIRED IN ANNUAL REPORT OF TRANSITIONAL SMALL BUSINESS ISSER"; and f. Removing the "Certifications" section after the "Signatures" section and before the reference to "Supplemental Information to be Furnished With Reports Filed Pursuant to Section 15(d) of the Exchange Act By Non-reporting Issuers." Note: The text of Form 10-KSB does not, and this amendment will not, appear in the Code of Federal Regulations. Form 10-KSB Item 8A. Controls and Procedures Furnish the information required by Items 307 of Regulation S-B (17 CFR 228.307) and 308 of Regulation S-B (17 CFR 228.308). INFORMATION REQUIRED IN ANNUAL REPORT OF TRANSITIONAL SMALL BUSINESS ISSER Item 2. Description of Exhibits. As appropriate, the issuer should file those documents required to be filed as Exhibit Number 2, 3, 5, 6, and 7 in Part III of Form 1-A. The registrant also shall file: (12) Additional exhibits - Any additional exhibits which the issuer may wish to file, which shall be so marked as to indicate clearly the subject matters to which they refer. (13) Form F-X - Canadian issuers shall file a written irrevocable consent and power of attorney on Form F-X. (31) The exhibit described in paragraph (b)(31) of Item 601 of Regulation S-B. 25. By amending Form 20-F (referenced in §249.220f) by: a. Revising paragraph (e) to General Instruction B; b. Revising Item 15 of Part II; c. Removing the phrase "internal controls and procedures for financial reporting" in paragraph (b)(4) of Item 16A of Part II and adding, in its place, the phrase "internal control over financial reporting"; d. Removing the "Certifications" section after the "Signatures" section and before the section referencing "Instructions as to Exhibits"; and e. In the "Instruction as to Exhibits" section, redesignate paragraph 12 as paragraph 14 and add new paragraph 12 and paragraph 13. The revisions and addition read as follows. Note: The text of Form 20-F does not, and this amendment will not, appear in the Code of Federal Regulations. FORM 20-F B. General Rules and Regulations That Apply to this Form. (e) Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, provide the certifications required by Rule 13a-14 (17 CFR 240.13a-14) or Rule 15d-14 (17 CFR 240.15d-14). Item 15. Controls and Procedures. (a) Disclosure Controls and Procedures. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, disclose the conclusions of the issuer's principal executive and principal financial officers, or persons performing similar functions, regarding the effectiveness of the issuer's disclosure controls and procedures (as defined in 17 CFR 240.13a-15(e) or 240.15d-15(e)) as of the end of the period covered by the report, based on the evaluation of these controls and procedures required by paragraph (b) of 17 CFR 240.13a-15 or 240.15d-15. (b) Management's annual report on internal control over financial reporting. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, provide a report of management on the issuer's internal control over financial reporting (as defined in 17 CFR 240.13a-15(f) or 240.15d-15(f)) that contains: (1) A statement of management's responsibility for establishing and maintaining adequate internal control over financial reporting for the issuer; (2) A statement identifying the framework used by management to evaluate the effectiveness of the issuer's internal control over financial reporting as required by paragraph (c) of 17 CFR 240.13a-15 or 240.15d-15; (3) Management's assessment of the effectiveness of the issuer's internal control over financial reporting as of the end of the issuer's most recent fiscal year, including a statement as to whether or not internal control over financial reporting is effective. This discussion must include disclosure of any material weakness in the issuer's internal control over financial reporting identified by management. Management is not permitted to conclude that the issuer's internal control over financial reporting is effective if there are one or more material weaknesses in the issuer's internal control over financial reporting; and (4) A statement that the registered public accounting firm that audited the financial statements included in the annual report containing the disclosure required by this Item has issued an attestation report on management's assessment of the issuer's internal control over financial reporting. (c) Attestation report of the registered public accounting firm. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, provide the registered public accounting firm's attestation report on management's assessment of the issuer's internal control over financial reporting in the issuer's annual report containing the disclosure required by this Item. (d) Changes in internal control over financial reporting. Disclose any change in the issuer's internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of 17 CFR 240.13a-15 or 240.15d-15 that occurred during the period covered by the annual report that has materially affected, or is reasonably likely to materially affect, the issuer's internal control over financial reporting. Instructions to Item 15. 1. The issuer must maintain evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the issuer's internal control over financial reporting. 2. An issuer that is an Asset-Backed Issuer (as defined in 17 CFR 240.13a-14(g) and 17 CFR 240.15d-14(g)) is not required to disclose the information required by this Item. Instructions as to Exhibits 12. The certifications required by Rule 13a-14(a) (17 CFR 240.13a-14(a)) or Rule 15d-14(a) (17 CFR 240.15d-14(a)) exactly as set forth below: I have reviewed this annual report on Form 20-F of [identify company]; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the company as of, and for, the periods presented in this report; The company's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the company and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the company, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (c) Evaluated the effectiveness of the company's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the company's internal control over financial reporting that occurred during the period covered by the annual report that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting; and * Provide a separate certification for each principal executive officer and principal financial officer of the company. See Rules 13a-14(a) and 15d-14(a). 13. (a) The certifications required by Rule 13a-14(b) (17 CFR 240.13a-14(b)) or Rule 15d-14(b) (17 CFR 240.15d-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350). (b) A certification furnished pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) or Rule 15d-14(b) (17 CFR 240.15d-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) will not be deemed "filed" for purposes of Section 18 of the Exchange Act [15 U.S.C. 78r], or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the company specifically incorporates it by reference. a. Revising paragraph (6) to General Instruction B; and b. Removing the phrase "internal controls and procedures for financial reporting" and adding, in its place, the phrase "internal control over financial reporting" in paragraph (8)(b)(4) of General Instruction B; and B. Information To Be Filed on this Form (6) Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act: (a) (1) Provide the certifications required by Rule 13a-14(a) (17 CFR 240.13a-14(a)) or Rule 15d-14(a) (17 CFR 240.15d-14(a)) as an exhibit to this report exactly as set forth below. I have reviewed this annual report on Form 40-F of [identify issuer]; Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the issuer as of, and for, the periods presented in this report; The issuer's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the issuer and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the issuer, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (c) Evaluated the effectiveness of the issuer's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the issuer's internal control over financial reporting that occurred during the period covered by the annual report that has materially affected, or is reasonably likely to materially affect, the issuer's internal control over financial reporting; and The issuer's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the issuer's auditors and the audit committee of the issuer's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the issuer's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer's internal control over financial reporting. * Provide a separate certification for each principal executive officer and principal financial officer of the issuer. See Rules 13a-14(a) and 15d-14(a). (2) (i) Provide the certifications required by Rule 13a-14(b) (17 CFR 240.13a-14(b)) or Rule 15d-14(b) (17 CFR 240.15d-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) as an exhibit to this report. (ii) A certification furnished pursuant to Rule 13a-14(b) (17 CFR 240.13a-14(b)) or Rule 15d-14(b) (17 CFR 240.15d-14(b)) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) will not be deemed "filed" for purposes of Section 18 of the Exchange Act [15 U.S.C. 78r], or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the issuer specifically incorporates it by reference. (b) Disclosure Controls and Procedures. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, disclose the conclusions of the issuer's principal executive and principal financial officers, or persons performing similar functions, regarding the effectiveness of the issuer's disclosure controls and procedures (as defined in 17 CFR 240.13a-15(e) or 240.15d-15(e)) as of the end of the period covered by the report, based on the evaluation of these controls and procedures required by paragraph (b) of 17 CFR 240.13a-15 or 240.15d-15. (c) Management's annual report on internal control over financial reporting. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, provide a report of management on the issuer's internal control over financial reporting (as defined in 17 CFR 240.13a-15(f) or 240.15d-15(f)) that contains: (d) Attestation report of the registered public accounting firm. Where the Form is being used as an annual report filed under Section 13(a) or 15(d) of the Exchange Act, provide the registered public accounting firm's attestation report on management's assessment of internal control over financial reporting in the annual report containing the disclosure required by this Item. (e) Changes in internal control over financial reporting. Disclose any change in the issuer's internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of 17 CFR 240.13a-15 or 240.15d-15 that occurred during the period covered by the annual report that has materially affected, or is reasonably likely to materially affect, the issuer's internal control over financial reporting. Instructions to paragraphs (b), (c), (d) and (e) of General Instruction B. 6. 2. An issuer that is an Asset-Backed Issuer (as defined in 17 CFR 240.13a-14(g) and 240.15d-14(g)) is not required to disclose the information required by this Item. PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940 27. The authority citation for Part 270 is amended by revising the subauthority citation for "Section 270.30a-2" to read as follows: Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-39, unless otherwise noted. Section 270.30a-2 is also issued under 15 U.S.C. 78m, 78o(d), 80a-8, 80a-29, 7202, and 7241; and 18 U.S.C. 1350, unless otherwise noted. 28. By revising the last sentence of §270.8b-15 to read as follows: §270.8b-15 Amendments. * * * An amendment to any report required to include the certifications as specified in §270.30a-2(a) must include new certifications by each principal executive and principal financial officer of the registrant, and an amendment to any report required to be accompanied by the certifications as specified in §240.13a-14(b) or §240.15d-14(b) and §270.30a-2(b) must be accompanied by new certifications by each principal executive and principal financial officer of the registrant. 29. Section 270.30a-2 is revised to read as follows: §270.30a-2 Certification of Form N-CSR. (a) Each report filed on Form N-CSR (§§249.331 and 274.128 of this chapter) by a registered management investment company must include certifications in the form specified in Item 10(a)(2) of Form N-CSR and such certifications must be filed as an exhibit to such report. Each principal executive and principal financial officer of the investment company, or persons performing similar functions, at the time of filing of the report must sign a certification. (b) Each report on Form N-CSR filed by a registered management investment company under Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m(a) or 78o(d)) and that contains financial statements must be accompanied by the certifications required by Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) and such certifications must be furnished as an exhibit to such report as specified in Item 10(b) of Form N-CSR. Each principal executive and principal financial officer of the investment company (or equivalent thereof) must sign a certification. This requirement may be satisfied by a single certification signed by an investment company's principal executive and principal financial officers. 30. By revising §270.30a-3 to read as follows: § 270.30a-3 Controls and procedures. (a) Every registered management investment company, other than a small business investment company registered on Form N-5 (§§239.24 and 274.5 of this chapter), must maintain disclosure controls and procedures (as defined in paragraph (c) of this section) and internal control over financial reporting (as defined in paragraph (d) of this section). (b) Each such registered management investment company's management must evaluate, with the participation of the company's principal executive and principal financial officers, or persons performing similar functions, the effectiveness of the company's disclosure controls and procedures, within the 90-day period prior to the filing date of each report on Form N-CSR (§§ 249.331 and 274.128 of this chapter). (c) For purposes of this section, the term disclosure controls and procedures means controls and other procedures of a registered management investment company that are designed to ensure that information required to be disclosed by the investment company on Form N-CSR (§§249.331 and 274.128 of this chapter) is recorded, processed, summarized, and reported within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by an investment company in the reports that it files or submits on Form N-CSR is accumulated and communicated to the investment company's management, including its principal executive and principal financial officers, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. (d) The term internal control over financial reporting is defined as a process designed by, or under the supervision of, the registered management investment company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that: (1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the investment company; (2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the investment company are being made only in accordance with authorizations of management and directors of the investment company; and (3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the investment company's assets that could have a material effect on the financial statements. PART 274 - FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 31. The authority citation for Part 274 is amended by revising the authority citation for "Section 274.128" to read as follows: Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m, 78n, 78o(d), 80a-8, 80a-24, 80a-26, and 80a-29, unless otherwise noted. Section 274.128 is also issued under 15 U.S.C. 78j-1, 7202, 7233, 7241, 7264, and 7265; and 18 U.S.C. 1350. 32. Form N-SAR (referenced in §§ 249.330 and 274.101) is amended by revising the reference "internal controls and procedures for financial reporting" in paragraph (b)(6)(iv) of the Instruction to Sub-Item 102P3 to read "internal control over financial reporting". 33. Form N-CSR (referenced in §§ 249.331 and 274.128) is amended by: a. In General Instruction D, revising the reference "Items 4, 5, and 10(a)" to read "Items 4, 5, and 10(a)(1)"; b. Revising paragraph 2.(a) of General Instruction F; c. In paragraph (c) of Item 2, revising the reference "Item 10(a)" to read "Item 10(a)(1)"; d. In paragraph (f)(1) of Item 2, revising the reference "Item 10(a)" to read "Item 10(a)(1)"; e. In paragraph (b)(4) of Item 3, revising the reference "internal controls and procedures for financial reporting" to read "internal control over financial reporting"; f. Revising Item 9; and g. In Item 10: (i) The introductory text and paragraphs (a) and (b) are redesignated as paragraphs (a), (a)(1) and (a)(2), respectively; (ii) Revising newly redesignated paragraph (a) and newly redesignated paragraph (a)(2); and (iii) Adding new paragraph (b) and an Instruction to Item 10. The revisions and additions read as follows. Note: The text of Form N-CSR does not, and these amendments will not, appear in the Code of Federal Regulations. FORM N-CSR F. Signature and Filing of Report. 2. (a) The report must be signed by the registrant, and on behalf of the registrant by its principal executive and principal financial officers. (a) Disclose the conclusions of the registrant's principal executive and principal financial officers, or persons performing similar functions, regarding the effectiveness of the registrant's disclosure controls and procedures (as defined in Rule 30a-3(c) under the Act (17 CFR 270.30a-3(c))) as of a date within 90 days of the filing date of the report that includes the disclosure required by this paragraph, based on the evaluation of these controls and procedures required by Rule 30a-3(b) under the Act (17 CFR 270.30a-3(b)) and Rules 13a-15(b) or 15d-15(b) under the Exchange Act (17 CFR 240.13a-15(b) or 240.15d-15(b)). (b) Disclose any change in the registrant's internal control over financial reporting (as defined in Rule 30a-3(d) under the Act (17 CFR 270.30a-3(d)) that occurred during the registrant's last fiscal half-year (the registrant's second fiscal half-year in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. Item 10. Exhibits. (a) File the exhibits listed below as part of this Form. (a)(2) A separate certification for each principal executive and principal financial officer of the registrant as required by Rule 30a-2(a) under the Act (17 CFR 270.30a-2(a)), exactly as set forth below: 1. I have reviewed this report on Form N-CSR of [identify registrant]; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have: (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal half-year (the registrant's second fiscal half-year in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and (b) If the report is filed under Section 13(a) or 15(d) of the Exchange Act, provide the certifications required by Rule 30a-2(b) under the Act (17 CFR 270.30a-2(b)), Rule 13a-14(b) or Rule 15d-14(b) under the Exchange Act (17 CFR 240.13a-14(b) or 240.15d-14(b)), and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. 1350) as an exhibit. A certification furnished pursuant to this paragraph will not be deemed "filed" for purposes of Section 18 of the Exchange Act (15 U.S.C. 78r), or otherwise subject to the liability of that section. Such certification will not be deemed to be incorporated by reference into any filing under the Securities Act of 1933 or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference. Instruction to Item 10. Letter or number the exhibits in the sequence that they appear in this item. By the Commission. J. Lynn Taylor Assistant Secretary 1 17 CFR 228.10 et seq. 3 17 CFR 249.310. 4 17 CFR 249.310b. 5 17 CFR 249.308a. 7 17 CFR 249.220f. 9 17 CFR 240.12b-15. 10 17 CFR 240.13a-14. 12 17 CFR 140.15d-14. 14 15 U.S.C. 78a et seq. 15 17 CFR 210.1-02 and 2-02. 16 17 CFR 210.1-01 et seq. 17 17 CFR 270.8b-15. 18 17 CFR 270.30a-2. 20 15 U.S.C. 80a-1 et seq. 21 17 CFR 249.331; 17 CFR 274.128. 23 Pub. L. 107-204, 116 Stat. 745 (2002). 24 Section 404 of the Sarbanes-Oxley Act does not apply to any registered investment company due to an exemption in Section 405 of the Sarbanes-Oxley Act. See sec. 405 of Pub. L. 107-204, 116 Stat. 745 (2002). 25 On April 25, 2003, the Commission approved the PCAOB's adoption of the auditing and attestation standards in existence as of April 16, 2003 as interim auditing and attestation standards. See Release No. 33-8222 (Apr. 25, 2003) [68 FR 23335]. 26 Release No. 33-8138 (Oct. 22, 2002) [67 FR 66208] ("Proposing Release"). The public comments we received can be viewed in our Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549, in File No. S7-40-02. Public comments submitted by electronic mail are available on our website, www.sec.gov. 27 The commenters on File No. S7-40-02 are as follows: Academics Paul Walker, Ph.D., CPA; Accounting Firms BDO Seidman, LLP; Deloitte & Touche LLP; Ernst & Young LLP; KPMG LLP; PricewaterhouseCoopers LLP; Associations America's Community Bankers; American Bankers Association; American Bar Association; American Corporate Counsel Association; American Institute of Certified Public Accountants; Association for Financial Professionals; the Association of the Bar of the City of New York; Association for Investment Management and Research; the Business Roundtable; Community Bankers Association of New York State; Edison Electric Institute; Financial Executives International; Independent Community Bankers of America; the Institute of Internal Auditors; Maine Bankers Association; Manufacturers Alliance/MAPI Inc.; Massachusetts Bankers Association; National Association of Real Estate Investment Trusts; New York Bankers Association; New York County Lawyers' Association; New York State Bar Association; Software & Information Industry Association; Software Finance and Tax Executives Council; Wisconsin Bankers Association; Corporations Cardinal Health, Inc.; Compass Bancshares, Inc.; Computer Sciences Corporation; Eastman Kodak Company; Eli Lilly and Company; Emerson Electric Co.; Executive Responsibility Advisors, LLC; Greif Bros.; Intel Corporation; International Paper Company; Protiviti; Government Entities Federal Reserve Bank of Atlanta; Small Business Administration; Law Firms Dykema Gossett PLLC; Karr Tuttle Campbell; Fried, Frank, Harris, Shriver and Jacobson; Sutherland, Asbill & Brennan LLP; Individuals Thomas Damman; D. Scott Huggins; Tim J. Leech; Simon Lorne; Ralph Saul; Lee Squire; Robert J. Stuckey; Foreign Companies Siemens Aktiengesellcraft; International Entities British Bankers Association; British Embassy; Canadian Bankers Association; Confederation of British Industry; European Commission; Institute of Chartered Accountants of England and Wales. 28 15 U.S.C. 78m(a) or 78o(d). Section 13(a) of the Exchange Act requires every issuer of a security registered pursuant to Section 12 of the Exchange Act [15 U.S.C. 78l] to file with the Commission such annual reports and such quarterly reports as the Commission may prescribe. Section 15(d) of the Exchange Act requires each issuer that has filed a registration statement that has become effective pursuant to the Securities Act of 1933 [15 U.S.C. 77a et seq.] (the "Securities Act") to file such supplementary and periodic information, documents and reports as may be required pursuant to Section 13 in respect of a security registered pursuant to Section 12, unless the duty to file under Section 15(d) has been suspended for any fiscal year. See Exchange Act Rule 12h-3 [17 CFR 240.12h-3]. 29 18 U.S.C. 1350. 30 See Release No. 34-46300 (Aug. 2, 2002) [67 FR 51508] at n. 11, containing supplemental information on the Commission's original certification proposal in light of the enactment of the Sarbanes-Oxley Act of 2002. 31 See Release No. 33-8124 (Aug. 28, 2002) [67 FR 57276] . 32 See Release No. IC-25914 (Jan. 27, 2003) [68 FR 5348]. 33 See Release No. 33-8212 (Mar. 21, 2003) [68 FR 15600]. 34 These methods have included: (1) submitting the statement as non-public paper correspondence; (2) submitting the statement as non-public electronic correspondence with the EDGAR filing of the periodic report; (3) submitting the statement under (1) or (2) above supplemented by an Item 9 Form 8-K report so that the statement is publicly available; (4) submitting the statement as an exhibit to the periodic report; and (5) submitting the statement in the text of the periodic report (typically, below the signature block for the report). 35 We proposed to use this term throughout the rules implementing the annual internal control report requirements of Section 404 of the Sarbanes-Oxley Act, as well as the revised Sarbanes-Oxley Section 302 certification requirements, to complement the defined term "disclosure controls and procedures" referred to in the Section 302 requirements. Congress used the term "internal controls" in Section 302 and "internal control structure and procedures for financial reporting" in Section 404. 36 For a history of the development of internal control standards, see Steven J. Root, Beyond COSO-Internal Control to Enhance Corporate Governance (1998). 37 In 1941, the Commission adopted amendments to Rules 2-02 and 3-07 of Regulation S-X that formally codified this practice. See Accounting Series Release No. 21 (Feb. 5, 1941) [11 FR 10921]. 38 An early definition for the term appeared in Internal Control--Elements Of a Coordinated System and Its Importance to Management and the Independent Public Accountant, a report published in 1949 by the American Institute of Accountants, the predecessor to the American Institute of Certified Public Accountants ("AICPA"). The report defined internal control to mean "the plan of organization and all of the coordinate methods and measures adopted within a business to safeguard its assets, check the accuracy and reliability of its accounting data, promote operational efficiency, and encourage adherence to prescribed managerial policies." Subsequent definitions of the term attempted to clarify the distinction by labeling the controls relevant to an audit as "internal accounting controls" and the non-accounting controls as "administrative controls." The AICPA officially dropped these distinctions in 1988. See Root, at p. 76. 39 Title I of Pub. Law No. 95-213 (1977). Beginning in 1973, as a result of the work of the Office of the Watergate Special Prosecutor, the Commission became aware of a pattern of conduct involving the use of corporate funds for illegal domestic political contributions. A subsequent Commission investigation revealed that instances of undisclosed questionable or illegal corporate payments--both domestic and foreign--were widespread. On May 12, 1976, the Commission submitted to the Senate Banking, Housing and Urban Affairs Committee a report entitled Report on Questionable and Illegal Corporate Payments and Practices. The report described and analyzed the Commission's investigation concerning improper corporate payments and outlined legislative and other responses that the Commission recommended to remedy these problems. One of the Commission's recommendations was that Congress enact legislation aimed expressly at enhancing the accuracy of the corporate books and records and the reliability of the audit process. 40 See Exchange Act Section 13(b)(2) [15 U.S.C. 78m(b)(2)]. 41 The Treadway Commission was sponsored by the AICPA, the American Accounting Association, the Financial Executives International (formerly Financial Executives Institute), the Institute of Internal Auditors and the Institute of Management Accountants (formerly the National Association of Accountants). The Treadway Commission's report, the Report of the National Commission on Fraudulent Financial Reporting (Oct. 1987), is available at www.coso.org. 42 See COSO, Internal Control-Integrated Framework (1992) ("COSO Report"). In 1994, COSO published an addendum to the Reporting to External Parties volume of the COSO Report. The addendum discusses the issue of, and provides a vehicle for, expanding the scope of a public management report on internal control to address additional controls pertaining to safeguarding of assets. In 1996, COSO issued a supplement to its original framework to address the application of internal control over financial derivative activities. 43 Auditing Standards Board, AICPA, Statement on Auditing Standards No. 78, Consideration of Internal Control in a Financial Statement Audit: An Amendment to Statement on Auditing Standards No. 55 (1995). 44 See letters regarding File No. S7-40-02 of: America's Community Bankers ("ACB"); American Corporate Counsel Association ("ACCA"); American Institute of Certified Public Accountants ("AICPA"); Compass Bancshares, Inc. ("Compass"); Computer Sciences Corporation ("CSC"); the Edison Electric Institute ("EEI"); the Independent Community Bankers of America ("ICBA"); the Institute of Internal Auditors ("IIA"); the Association of the Bar of the City of New York, Committee on Corporate Law ("NYCB-CCL"); Protiviti; and Siemens AG. 45 See letters regarding File No. S7-40-02 of ACB and ICBA. 46 See letters regarding File No. S7-40-02 of: the American Bar Association, Committee on the Federal Regulation of Securities and the Committee on Law and Accounting ("ABA"); the Federal Reserve Bank of Atlanta ("FED"); IIA; Simon Lorne ("Lorne"); and Pricewaterhouse Coopers LLP ("PwC"). 47 See ABA letter regarding File No. S7-40-02. 48 See letters regarding File No. S7-40-02 of: AICPA; Compass; Deloitte & Touche LLP ("D&T"); IIA; KPMG LLP ("KPMG"); and PwC. 49 See new Item 308 of Regulations S-K and S-B, amended Items 1-02 and 2-02 of Regulation S-X; amended Items 307and 401 of Regulations S-K and S-B; amended Exchange Act Rules 13a-14, 13a-15, 15d-14 and 15d-15; and amended Forms 20-F and 40-F. 50 The COSO Report states that the composition of a company's board and audit committee, and how the directors fulfill their responsibilities related to the financial reporting process, are key aspects of the company's control environment. An important element of the company's internal control over financial reporting "...is the involvement of the board or audit committee in overseeing the financial reporting process, including assessing the reasonableness of management's accounting judgments and estimates and reviewing key filings with regulatory agencies." See COSO Report at 130. The Commission similarly has stated in the past that both a company's management and board have important roles to play in establishing a supportive control environment. In its 1981 Statement of Policy regarding the FCPA, the Commission stated, "In the last analysis, the key to an adequate `control environment' is an approach on the part of the board and top management which makes clear what is expected and that conformity to these expectations will be rewarded while breaches will be punished." See Release No. 34-17500 (Jan. 29, 1981) [46 FR 11544]. 51 See amended Exchange Act Rules 13a-14(d) and 15d-14(d). The scope of the term "preparation of financial statements in accordance with generally accepted accounting principles" in the definition encompasses financial statements prepared for regulatory reporting purposes. 52 Codification of Statements on Auditing Standards Section 317 requires auditors to consider a company's compliance with laws and regulations that have a direct and material effect on the financial statements. 53 15 U.S.C. 78m(b)(2)(B). 54 Section 103 of the Sarbanes-Oxley Act requires the PCAOB to establish by rule standards to be used by registered public accounting firms in the preparation and issuance of audit reports. In carrying out this responsibility, the PCAOB must include in the auditing standards that it adopts, among other things: a requirement that each registered public accounting firm describe in each audit report the scope of its testing of the company's internal control structure and procedures performed in fulfilling its internal control evaluation and reporting required by Section 404(b) of the Sarbanes-Oxley Act; present in the audit report (or attestation report) its findings from such testing; and an evaluation of whether the company's internal control structure and procedures: (1) include maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the company's assets; and (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with the authorization of management and directors of the company. In the audit report (or attestation report), the registered public accounting firm also must describe, at a minimum, material weaknesses in such internal controls and any material noncompliance found on the basis of such testing. See Sections 103(a)(2)(A)(iii)(I), (II) and (III) of the Sarbanes-Oxley Act. See also, Interim Professional Attestation Standards Rule 3300T, adopted in PCAOB Release No. 2003-006 (Apr. 18, 2003), and approved by the Commission on April 25, 2003. 55 Control procedures were described as policies and procedures in addition to the control environment and accounting system that management established to provide reasonable assurance that specific entity objectives will be achieved. SAS 55 also states that control procedures may generally be categorized as procedures that include, among other things, "adequate safeguards over access to and use of assets and records, such as secured facilities and authorization for access to computer programs and data files." See Statement on Auditing Standards No. 55, paragraph no. 11. 56 See COSO "Addendum to Reporting to External Parties," Internal Control-Integrated Framework, (1994) ("1994 Addendum") at p. 154. 57 The COSO Report states: "Although these [objectives relating to safeguarding of resources] are primarily operations objectives, certain aspects of safeguarding can fall under other categories. . . [T]he goal of ensuring that any such asset losses are properly reflected in the entity's financial statements represents a financial reporting objective." The category in which an objective falls can sometimes depend on the circumstances. Continuing the discussion of safeguarding of assets, controls to prevent theft of assets - such as maintaining a fence around inventory and a gatekeeper verifying proper authorization of requests for movement of goods - fall under the operations category. These controls normally would not be relevant to the reliability of financial statement preparation, because any inventory losses would be detected pursuant to periodic physical inspection and recorded in the financial statements. However, if for financial reporting purposes management relies solely on perpetual inventory records, as may be the case for interim reporting, the physical security controls would then also fall within the financial reporting category. This is because these physical security controls, along with other controls over the perpetual inventory records, would be needed to ensure reliable financial reporting. Id. at 37. 58 As stated in n. 1 to the 1994 Addendum, the FCPA requires companies, among other things, to "devise and maintain a system of internal accounting controls sufficient to provide reasonable assurances that (i) transactions are executed in accordance with management's general or specific authorization; (ii) transactions are recorded as necessary ... to maintain accountability for assets; (iii) access to assets is permitted only in accordance with management's general or specific authorization; and (iv) the recorded accountability for assets is compared with the existing assets at reasonable intervals and appropriate action is taken with respect to any differences." 59 See letters regarding File No. S7-40-02 of: ABA; CSC; EEI; FED; Eastman Kodak Co. ("Kodak"); KPMG; Protiviti; and PwC. 60 See letters regarding File No. S7-40-02 of: ACCA and Financial Executives Institute ("FEI"). 61 See letters regarding File No. S7-40-02 of: AICPA; BDO Seidman, LLP ("BDO"); D&T; Ernst & Young LLP ("E&Y"); KPMG; and PwC. 62 Management must state whether or not the company's internal control over financial reporting is effective. A negative assurance statement indicating that nothing has come to management's attention to suggest that the company's internal control over financial reporting is not effective will not be acceptable. 63 A "material weakness" is defined in Statement on Auditing Standards No. 60 (codified in Codification of Statements on Auditing Standards AU §325) as a reportable condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements caused by errors or fraud in amounts that would be material in relation to the financial statements being audited may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions. See discussion in Section II.B.3.b. below. 64 See new Item 308 of Regulations S-B and S-K, Item 15 of Form 20-F and General Instruction B(6) of Form 40-F. 65 Many commenters cited the absence of evaluative criteria in AU §319 in their arguments against the reference to AU §319 in our proposed definition of "internal controls and procedures for financial reporting." 66 See amended Exchange Act Rule 13a-15(c) or 15d-15(c), amended Item 15 of Form 20-F and amended General Instruction (B) to Form 40-F. 67 The Guidance on Assessing Control published by the Canadian Institute of Chartered Accountants and the Turnbull Report published by the Institute of Chartered Accountants in England & Wales are examples of other suitable frameworks. 68 We are aware that some of the evaluation frameworks used to assess a foreign company's internal controls in its home country do not require a statement regarding whether the company's system of internal control has been effective. Under our final rules, management of a foreign reporting company who relies on such an evaluation framework used in its home country is nevertheless under an obligation to state affirmatively whether its company's internal controls are, or are not, effective. 69 See AT §101, paragraph 24. 70 See Release No. 33-8183 (Jan. 28, 2003) [68 FR 6006]. 71 Management's acceptance of responsibility for the documentation and testing performed by the auditor does not satisfy the auditor independence rules. 72 This is consistent with interim attestation standards. See AT §501. 73 The term "significant deficiency" has the same meaning as the term "reportable condition" as used in AU §325 and AT §501. The terms "material weakness" and "significant deficiency" both represent deficiencies in the design or operation of internal control that could adversely affect a company's ability to record, process, summarize and report financial data consistent with the assertions of management in the company's financial statements, with a "material weakness" constituting a greater deficiency than a "significant deficiency." Because of this relationship, it is our judgment that an aggregation of significant deficiencies could constitute a material weakness in a company's internal control over financial reporting. 74 See new Item 308(d) of Regulations S-B and S-K. 75 See, for example, letters re: File No. S7-40-02 of: ABA; AICPA; BDO; Intel; and Eli Lilly and Company. 76 Section 13(b)(2)(A) of the Exchange Act [15 U.S.C. 78m(b)(2)(A)] requires companies to "make and keep books, records, and accounts, which in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the issuer." See also Section 13(b)(2)(B) of the Exchange Act [15 U.S.C. 78m(b)(2)(B)] and In re Microsoft Corp., Administrative Proceeding File No. 3-10789 (June 3, 2002). In the Microsoft order, the Commission stated that such books and records include not only general ledgers and accounting entries, but also memoranda and internal corporate reports. We have previously stated, as a matter of policy, that under Section 13(b)(2) "every public company needs to establish and maintain records of sufficient accuracy to meet adequately four interrelated objectives: appropriate reflection of corporate transactions and the disposition of assets; effective administration of other facets of the issuer's internal control system; preparation of its financial statements in accordance with generally accepted accounting principles; and proper auditing." Statement of Policy Regarding the Foreign Corrupt Practices Act of 1977, Release No. 34-17500 (Jan. 29, 1981) [46 FR 11544]. 77 See Instruction 1 to new Item 308 of Regulations S-K and S-B, Instruction 1 to Item 15 of Form 20-F and Instruction 1 to paragraphs (b), (c), (d) and (e) of General Instruction B.6 to Form 40-F. 78 This statement should not be interpreted to mean that management personally must conduct the necessary activities to evaluate the design and test the operating effectiveness of the company's internal control over financial reporting. Activities, including those necessary to provide management with the information on which it bases its assessment, may be conducted by non-management personnel acting under the supervision of management. 79 See Statements on Standards for Attestation Engagements No. 10. 80 See Exchange Act Rules 13a-15(b) and 15d-15(b) [17 CFR 240.13a-15(b) and 240.15d-15(b)]. 81 See letters regarding File No. S7-40-02 of: AICPA; Executive Responsibility; FED; and Protiviti. 82 See Protiviti letter regarding File No. S7-40-02. 83 See letters regarding File No. S7-40-02 of: ABA; ACB; ACCA; Association for Financial Professionals ("AFP"); Am. Bankers Assoc.; BDO; Business Roundtable ("BRT"); Computer Sciences Corporation ("CSC"); Compass; Thomas Damman ("Damman"); EEI; Emerson Electric Co. ("Emerson"); FEI; Fried, Frank, Harris, Shriver and Jacobson ("Fried Frank"); International Paper Company ("IPC"); ICBA; NYCB-CCL; New York State Bar Association ("NYSBA"); Siemens AG ("Siemens"); Software & Information Industry Association ("SIIA"); and Software Finance and Tax Executives Council ("SOFTEC"). 84 See Damman letter regarding File No. S7-40-02. 85 See letters regarding File No. S7-40-02 of: ABA; ACB; ACCA; BRT; CSC; Emerson; Fried Frank; ICBA; IPC; NYCB-CCL; SIIA; and SOFTEC. 86 See letters regarding File No. S7-40-02 of: Am. Bankers Assoc.; CSC; Fried Frank. 87 See letters regarding File No. S7-40-02 of: Damman; Compass; EEI; Executive Responsibility Advisors, LLC ("Executive Responsibility"); and Siemens. 88 See letters regarding File No. S7-40-02 of: ABA and BDO. 89 See BDO letter regarding File No. S7-40-02. 91 See Emerson letter regarding File No. S7-40-02. 92 See Exchange Act Rules 13a-15(d) and 15d-15(d) [17 CFR 240.13a-15(d) and 240.15d-15(d)]. 93 For example, where a component of internal control over financial reporting is subsumed within disclosure controls and procedures, even where systems testing of that component would clearly be required as part of the annual evaluation of internal control over financial reporting, management could make a different determination of the appropriate nature of the evaluation of that component for purposes of a quarterly evaluation of disclosure controls and procedures. 94 See Exchange Act Rules 13a-15(b) and 15d-15(b). 96 See Intel letter regarding File No. S7-40-02. 97 See Release No. 33-8128 (Sept. 16, 2002) [67 FR 58480]. The final rule amendments do not require that the evaluation take place on the last day of the period, but that the statement of effectiveness of the issuer's disclosure controls and internal control over financial reporting be as of the end of the period. 98 We have also made conforming changes to Forms 20-F and 40-F to clarify that the management of a foreign private issuer must disclose in the issuer's annual report filed on Form 20-F or 40-F any change in the issuer's internal control over financial reporting that occurred during the period covered by the annual report and that materially affected, or is reasonably likely to affect, this internal control. See Item 15(d) of Form 20-F and General Instruction B(6)(e) of Form 40-F. 99 See Exchange Act Rules 10b-5 and 12b-20 [17 CFR 240.10b-5 and 17 CFR 240.12b-20]. 100 This is the disclosure required by paragraph 5 of the certification form. 101 15 U.S.C. 78m(b)(2). 102 See Codification of Statement on Auditing Standards AU §319.18. 103 Pub. L. 102-242, 105 Stat. 2242 (1991). 104 See Section 405 of the Sarbanes-Oxley Act. 105 See Section II. J. below. 106 12 U.S.C. 1831m. 107 The designated laws and regulations are federal laws and regulations concerning loans to insiders and federal and state laws and regulations concerning dividend restrictions. See 12 CFR Part 363, Appendix A, Guideline 12. 108 See 12 CFR 363.2, adopted in 58 FR 31332. These requirements only apply to an insured depository institution with total assets of $500 million or more. We recognize that the FDIC's regulations use the term "internal control structure and procedures for financial reporting" rather than the term "internal control over financial reporting" used in our rules. We think the differences in the meaning of the two terms are insignificant because both Section 36(b)(2) of the Federal Deposit Insurance Act and Section 404(a) of the Sarbanes-Oxley Act refer to "internal control structure and procedures for financial reporting." Nevertheless, the FDIC has defined the term "financial reporting" to include financial statements prepared in accordance with generally accepted accounting principles ("GAAP") and those prepared for regulatory reporting purposes (see FDIC Financial Institution Letter FIL-86-94, dated December 23, 1994). 109 12 CFR 363.3. 110 12 CFR 363.4(a) and (b). 111 12 CFR Part 363. 112 Services and functions are considered "comparable" if the holding company prepares and submits the management assessment of the effectiveness of the internal control structure and procedures for financial reporting and compliance with the designated safety and soundness laws and regulations based on information concerning the relevant activities and operations of those subsidiary institutions subject to Part 363. See 12 CFR Part 363, Appendix A, Guideline 4. 113 This rating is more commonly known as the CAMELS rating, which addresses Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk. See 12 CFR 363.1(b)(2). The appropriate federal banking agency may determine that an insured depository institution with total assets in excess of $9 billion that is a subsidiary of a holding company may not satisfy its FDIC internal control report requirement with an internal control report of the consolidated holding company's management if the agency determines that there could be a significant risk to the affected deposit insurance fund if the institution were allowed to satisfy its requirements in this manner. See 12 CFR 363.1(b)(3). 114 The FDIC's regulations do not specifically require that management identify the control framework used to evaluate the effectiveness of the institution's internal control over financial reporting. However, given the requirements of Sections 101 and 501 of the American Institute of Certified Public Accountants' attestation standards, the FDIC believes that the framework used must be disclosed or otherwise publicly available to all users of reports that institutions file with the FDIC pursuant to Part 363 of the FDIC's regulations. 115 The FDIC's regulations do require an independent public accountant to examine, attest to, and report separately on, the assertion of management concerning the institution's internal control structure and procedures for financial reporting, but these regulations do not require the accountant to be a registered public accounting firm. See 12 CFR 363.3(b). 116 Our rules do not provide an exemption that parallels the FDIC's exemption for insured depository institutions with less than $500 million in assets. It would be incongruous to provide an exemption in our rules for small depository institutions and not other small, non-depository Exchange Act reporting companies. 117 An insured depository institution subject to both the FDIC's requirements and our new requirements choosing to file a single report to satisfy both sets of requirements will file the report with its primary federal regulator under the Exchange Act and the FDIC, its primary federal regulator (if other than the FDIC), and any appropriate state depository institution supervisor under Part 363 of the FDIC's regulations. A holding company choosing to prepare a single report to satisfy both sets of requirements will file the report with the Commission under the Exchange Act and the FDIC, the primary federal regulator of the insured depository institution subsidiary subject to the FDIC's requirements, and any appropriate state depository institution supervisor under Part 363. 118 Management will not be permitted to conclude that the registrant's internal control over financial reporting is effective if there are one or more material weaknesses in the registrant's internal control over financial reporting. 119 An insured depository institution subject to both the FDIC's requirements and our new requirements choosing to file a single management report to satisfy both sets of requirements will file the attestation report with its primary federal regulator under the Exchange Act and the FDIC, its primary federal regulator (if other than the FDIC), and any appropriate state depository institution supervisor under Part 363 of the FDIC's regulations. A holding company choosing to prepare a single management report to satisfy both sets of requirements will file the attestation report with the Commission under the Exchange Act and the FDIC, the primary federal regulator of the insured depository institution subsidiary subject to the FDIC's requirements, and any appropriate state depository institution supervisor under Part 363. 120 See Section 405 of the Sarbanes-Oxley Act ("Nothing in section 401, 402, or 404, the amendments made by those sections, or the rules of the Commission under those sections shall apply to any investment company registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8)."). The provisions that would not extend to registered investment companies include amendments to Exchange Act rules 13a-15(c) and 15d-15(c) (requiring annual evaluation of the effectiveness of internal control over financial reporting); Exchange Act rules 13a-15(d) and 15d-15(d) (requiring quarterly evaluation of any change in internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, internal control over financial reporting); and Items 308(a) and (b) of Regulations S-K and S-B (requiring annual report by management on internal control over financial reporting and attestation report on management's evaluation of internal control over financial reporting). 121 Proposed paragraph 4 of the certification section of proposed Form N-CSR. Proposing Release, note 26 above, 67 FR at 66250. We received 7 comment letters on the proposed changes to the certification rules with respect to investment companies in the Proposing Release. See letters regarding File No. S7-40-02 of: the Investment Company Institute ("ICI"); Protiviti; OppenheimerFunds, Inc. ("Oppenheimer"); The Association of the Bar of the City of New York; Leslie Ogg of Board Services Corporation ("Ogg"); Federated Funds; and D&T. 122 See letters regarding File No. S7-40-02 of: Association of the Bar of the City of New York; ICI; and Oppenheimer. 123 See Section 302(a)(4)(A) and (B) of the Sarbanes-Oxley Act (requiring signing officers to certify that they are responsible for establishing and maintaining internal controls and have designed the internal controls to ensure that material information relating to the issuer is made known to the signing officers). 124 For a discussion of changes to the form of the Section 302 certification for operating companies, see Section III. D. below. 125 Proposed Exchange Act Rules 13a-15(c) and 15d-15(c), proposed Investment Company Act Rule 30a-2(b)(4)(iii), and proposed Investment Company Act Rule 30a-3(b). 126 See letters regarding File No. S7-40-02 of: D&T; ICI; Ogg; and Oppenheimer. 127 See Release No. IC-25914 (Jan. 27, 2003) [68 FR 5348, 5352 n. 43] (noting that in the case of a series fund or family of investment companies in which the disclosure controls and procedures for each fund in the series or family are the same, a single evaluation of the effectiveness of the disclosure controls and procedures for the series or family could be used in multiple certifications for the funds in the series or family, as long as the evaluation has been performed within 90 days of the report on Form N-CSR). 128 See, for example, the letters regarding File No. S7-40-02 of: AICPA; D&T; CSC; E&Y; and Association of the Bar of the City of New York, Committee on Securities Regulation ("NYCB-CSR"). 129 See Section II. I., above, for compliance dates applicable to registered investment companies. 130 See Section V. below. 131 See letters regarding File No. S7-06-03 of: ABA; Cleary, Gottlieb, Steen & Hamilton ("Cleary"); Prof. Paul A. Griffin ("Griffin"); Intel Corporation ("Intel"); ICI; PwC; John Stalnaker and Patrick Derksen ("Stalnaker"); and Rooks Pitts ("Rooks"). 132 See letters regarding File No. S7-06-03 of: ABA; Cleary; Intel; and PwC. 133 See letters File No. S7-06-03 of ABA and Cleary. 134 Id. 135 Pub. L. No. 83-406, 88 Stat. 129 (1974). 136 See letters regarding File No. S7-06-03 of: ABA; Cleary; and PwC. 137 See ABA letter regarding File No. S7-06-03. 139 See Stalnaker letter regarding File No. S7-06-03. 140 See 149 Cong. Rec. S5325 (daily ed. Apr. 11, 2003). 141 Id. at S5331. 142 See Release No. 33-8212 (Mar. 21, 2003) [68 FR 15600] at fn. 37. 145 We recently adopted Form N-CSR, to be used by registered management investment companies to file certified shareholder reports with the Commission. See Release No. IC-25914 (Jan. 27, 2003) [68 FR 5348]. As adopted, Form N-CSR requires the Section 302 certifications to be filed as an exhibit to a report on Form N-CSR. Item 10(b) of Form N-CSR. 146 Accordingly, we are revising Exchange Act Rules 13a-14 and 15d-14 to delete from those rules the detailed description of the contents of the required certifications and to revise the instructions to Forms 10-Q, 10-QSB, 10-K, and 10-KSB to delete the references to the Section 302 certification requirements. We are also adopting similar changes to Investment Company Act Rule 30a-2 and Form N-CSR. 147 See General Instruction A of Form N-CSR (Form N-CSR is a combined reporting form to be used for reports of registered management investment companies under Section 30(b)(2) of the Investment Company Act and Sections 13(a) or 15(d) of the Exchange Act); n. 28 above (discussing issuers covered by Sections 13(a) and 15(d) of the Exchange Act). Registered management investment companies that are required to file reports on Form N-CSR pursuant to Section 13(a) or 15(d) of the Exchange Act will be required to provide the Section 906 certifications under Exchange Act Rules 13a-14(b) and 15d-14(b) as well as Investment Company Act Rule 30a-2(b). By contrast, registered management investment companies that are required to file reports on Form N-CSR are required to provide the Section 302 certifications solely under Investment Company Act Rule 30a-2(a), which was adopted under Sections 13(a) and 15(d) of the Exchange Act as well as the Investment Company Act. Release No. 33-8124 (Aug. 28, 2002) [67 FR 57276, 57295]; Release No. IC-25914 (Jan. 27, 2003) [68 FR 5348, 5365]. 148 See also Section 3(b)(1) of the Sarbanes-Oxley Act, which provides that "[a] violation by any person of this Act . . . shall be treated for all purposes in the same manner as a violation of the Securities Exchange Act of 1934 . . . and any such person shall be subject to the same penalties, and to the same extent, as for a violation of that Act. . . ." 149 See Rule 302(b) of Regulation S-T [17 CFR 232.302(b)]. Among other things, this rule requires that an issuer maintain manually signed certifications or other authenticating documents. 150 See, for example, Item 601(b)(32)(ii) of Regulation S-K. 151 15 U.S.C. 78r. 152 15 U.S.C. 77k. 153 5 U.S.C. 552 et seq. 154 See Exchange Act Rule 12b-15 [17 CFR 240.12b-15] and Investment Company Act Rule 8b-15 [17 CFR 270.8b-15]. Depending on the contents of the amendment, the form of certification required to be included may be subject to modification. 155 See Exchange Act Rules 13a-14(b) and 15d-14(b) [17 CFR 240.13a-14(b) and 240.15d-14(b)] and Investment Company Act Rule 30a-2(b) [17 CFR 270.30a-2(b)]. 156 See Release No. 33-8212 (Mar. 21, 2003) [68 FR 15600] at Section III. 157 We are modifying that interim guidance, however, to more closely parallel the provisions of Section 302 of Regulation S-T that require retention of manual signatures for electronically filed signed statements. Issuers furnishing Section 906 certifications to the Commission as an exhibit to the periodic reports to which they relate during the period covered by the interim guidance should insert the following legend after the text of each certification: "A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to [name of issuer] and will be retained by [name of issuer] and furnished to the Securities and Exchange Commission or its staff upon request." 158 Use of Exhibit 99 for this purpose will remain in effect until we announce that our EDGAR system permits registrants to file or furnish exhibits 31 and 32 for Section 302 and 906 certifications. We will issue a statement and post it on the Commission's website to announce this date as soon as it becomes known. 159 For a registered management investment company filing reports on Form N-CSR, the EDGAR document type should be EX-99.906CERT for the Section 906 certifications. 160 44 U.S.C. 3501 et seq. 161 44 U.S.C. 3507(d) and 5 CFR 1320.11. 162 See Rule 302 of Regulation S-T [17 CFR 232.302]. 163 See Release No. 33-8138 (Oct. 22, 2002) [67 FR 66208] and Release No. 33-8212 (Mar. 21, 2003) [68 FR 15600]. 164 See letters regarding File No. S7-40-02 of: AICPA; BDO; D&T; Emerson; E&Y; IPC; Intel; and NYCB-CCL. 165 See Intel letter regarding File No. S7-40-02. 166 Our estimates are based on information from with several large and small firms, accounting firms and trade and professional associations. 167 The estimates used in the releases proposing these rules were based on the number of filings that we received in fiscal year 2001. 168 We assumed the estimated burdens in the second and third years would decline by 75% from the first year estimate. 169 Our PRA estimates do not include any additional burdens or costs that a company will incur as a result of having to obtain an auditor's attestation report on management's internal control report because the PCAOB, rather than the Commission, is responsible for establishing the attestation standards and the Sarbanes-Oxley Act itself requires companies to obtain such an attestation. We have, however, included an estimated 0.5 hour burden in our revised annual burden estimates to account for the filing by the company of the attestation report. 170 The burden allocation for Forms 20-F and 40-F, however, use a 25% internal to 75% outside professional allocation to reflect the fact that foreign private issuers rely more heavily on outside professionals for the preparation of these forms. 171 While Section 906 of the Sarbanes-Oxley Act requires that certifications must accompany a periodic report, we are increasing our PRA burdens in view of the fact that the amendments explicitly require companies to furnish Section 906 certifications as exhibits to these reports. To date, companies have used various methods to fulfill their obligations under Section 906, and have not consistently submitted the certifications as part of the report. 172 Many registered management investment companies have multiple portfolios. However, they prepare separate financial statements for each portfolio. Thus, the burden of the Section 906 certifications is estimated on a portfolio basis rather than a registered management investment company basis. 173 This number represents the burden associated with the average number of portfolios per form. This number will vary for each registered management investment company depending on the number of portfolios. We estimate that the paperwork burden for each portfolio is one hour. 174 This estimate is based on the estimated total burden hours of 5,396,266, an assumed 75%/25% split of the burden hours between internal staff and external professionals, and an hourly rate of $200 for internal staff time and $300 for external professionals. The hourly cost estimate is based on consultations with several registrants and law firms and other persons who regularly assist registrants in preparing and filing periodic reports with the Commission. Our PRA estimate does not reflect any additional cost burdens that a company will incur as a result of having to obtain an auditor's attestation on management's internal control report. 175 This calculation is based on an estimate of burden hours multiplied by a cost of $200.00 per hour. (117,048 hours multiplied by $200.00 per hour). The hourly cost estimate is based on consultations with several registrants and law firms and other persons who regularly assist registrants in preparing and filing periodic reports with the Commission. 178 15 U.S.C. 78w(a)(2). 179 15 U.S.C §77b(b). 180 15 U.S.C. 78c(f). 181 15 U.S.C. 80a-2(c). 182 5 U.S.C. 601. 184 17 CFR 240.0-10(a). 185 17 CFR 270.0-10. 186 This estimate is based on figures compiled by the Commission staff regarding investment companies registered on Forms N-1A, N-2 and N-3, which are required to file reports on Form N-CSR. 187 This estimate includes the burden for one annual report and three quarterly reports. 188 Under the method we used to estimate the PRA burdens associated with the Section 404 rules, we estimated that companies with less than $100 million in revenues would be subject to an added annual reporting burden of approximately 100 hours. 189 The estimated burden for one annual report and three quarterly reports. 190 See Beasley, Carcello and Hermanson, Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies (Mar. 1999) (study commissioned by the Committee of Sponsoring Organizations of the Treadway Commission). 191 17 CFR 240.12b-2. http://www.sec.gov/rules/final/33-8238.htm Modified: 08/28/2008

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CANCER GENETICS, INC. 201 Route 17 North 2nd Floor Rutherford, NJ 07070 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ý No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act. ¨ (Do not check if a smaller reporting company) If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. x Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No ý As of May 8, 2017, there were 19,761,729 shares of common stock, par value $0.0001 of Cancer Genetics, Inc. outstanding. CANCER GENETICS, INC. AND SUBSIDIARIES Financial Statements (Unaudited) Notes to Unaudited Consolidated Financial Statements Unregistered Sales of Equity Securities and Use of Proceeds from Sales of Registered Securities Item 1. Financial Statements (Unaudited) Consolidated Balance Sheets (Unaudited) Accounts receivable, net of allowance for doubtful accounts FIXED ASSETS, net of accumulated depreciation Patents and other intangible assets, net of accumulated amortization Investment in joint venture Total other assets Obligations under capital leases, current portion Term note, current portion Term note Obligations under capital leases Deferred rent payable and other Warrant liability Deferred revenue, long-term Preferred stock, authorized 9,764 shares, $0.0001 par value, none issued Common stock, authorized 100,000 shares, $0.0001 par value, 19,756 and 18,936 shares issued and outstanding at March 31, 2017 and December 31, 2016, respectively Accumulated (deficit) See Notes to Unaudited Consolidated Financial Statements. Consolidated Statements of Operations (Unaudited) (in thousands, except per share amounts) Change in fair value of acquisition note payable Change in fair value of warrant liability Total other (expense) Loss before income taxes Income tax (benefit) Net (loss) Basic and diluted net (loss) per share Basic and diluted weighted-average shares outstanding Consolidated Statements of Cash Flows (Unaudited) CASH FLOWS FROM OPERATING ACTIVITIES Adjustments to reconcile net (loss) to net cash (used in) operating activities: Provision for bad debts (recoveries) Amortization of debt issuance costs Amortization of discount on debt Loss in equity method investment Loss on extinguishment of debt Changes in: Accounts payable, accrued expenses and deferred revenue Net cash (used in) operating activities CASH FLOWS FROM INVESTING ACTIVITIES Purchase of fixed assets Patent costs Net cash (used in) investing activities CASH FLOWS FROM FINANCING ACTIVITIES Principal payments on capital lease obligations Proceeds from warrant exercises Proceeds from Partners for Growth IV, L.P. term note Principal payments on Silicon Valley Bank term note Payment of debt issuance costs and loan fees Net cash provided by (used in) financing activities SUPPLEMENTAL CASH FLOW DISCLOSURE Cash paid for interest SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES Fixed assets acquired through capital lease arrangements Derivative warrants issued with debt Note 1. Organization, Description of Business, Basis of Presentation and Recent Accounting Pronouncements We are an emerging leader in the field of precision medicine, enabling individualized therapies in the field of oncology through our diagnostic products and services and molecular markers. We develop, commercialize and provide molecular- and biomarker-based tests and services that enable physicians to personalize the clinical management of each individual patient by providing genomic information to better diagnose, monitor and inform cancer treatment and that enable biotech and pharmaceutical companies engaged in oncology trials to better select candidate populations and reduce adverse drug reactions by providing information regarding genomic factors influencing subject responses to therapeutics. We have a comprehensive, disease-focused oncology testing portfolio. Our tests and techniques target a wide range of cancers, covering nine of the top ten cancers in prevalence in the United States, with additional unique capabilities offered by our FDA-cleared Tissue of Origin® test for identifying difficult to diagnose tumor types or poorly differentiated metastatic disease. We were incorporated in the State of Delaware on April 8, 1999 and have offices and state-of-the-art laboratories located in California, New Jersey, North Carolina, Shanghai (China), and Hyderabad (India). Our laboratories comply with the highest regulatory standards as appropriate for the services they deliver including CLIA, CAP, NY State, California State and NABL (India). Our services are built on a foundation of world-class scientific knowledge and intellectual property in solid and blood-borne cancers, as well as strong academic relationships with major cancer centers such as Memorial Sloan-Kettering, Mayo Clinic, and the National Cancer Institute. The accompanying unaudited condensed financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and with the instructions for interim reporting as prescribed by the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary to make the financial statements not misleading have been included. As such, the information included in this quarterly report on Form 10-Q should be read in conjunction with the audited consolidated financial statements as of and for the year ended December 31, 2016, filed with the Securities and Exchange Commission on March 23, 2017. The consolidated balance sheet as of December 31, 2016, included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP. Interim financial results are not necessarily indicative of the results that may be expected for any future interim period or for the year ending December 31, 2017. Liquidity and Going Concern At March 31, 2017, our cash position and history of losses required management to asses our ability to continue operating as a going concern, according to FASB Accounting Standards Update No. 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”). Management evaluated the history and operational losses to have a material effect on our ability to continue as a going concern, unless we take actions to alleviate those conditions. Our primary sources of liquidity have been funds generated from our debt financings and equity financings. We have reduced, and plan to continue reducing, our operating expenses, and expect to grow our revenue in 2017 and beyond, and have also increased our cash collections from our customers and third-party payors and plan to continue to improve our cash collection results. Management believes that its existing cash and cash equivalents, taken together with the borrowings available from the Silicon Valley Bank line of credit, will be sufficient to fund the Company's operations for at least the next twelve months after filing this Quarterly Report on Form 10-Q. In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606), requiring an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. As issued and amended, ASU 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective and permits the use of either a full retrospective or retrospective with cumulative effect transition method. The updated standard becomes effective for the Company in the first quarter of fiscal year 2018. Early adoption is permitted in the first quarter of fiscal year 2017. The Company believes its Biopharma Service revenue could be affected by the new standard. The Company is presently evaluating its Biopharma Service contacts for multiple elements and variable consideration provisions that may affect the timing of revenue recognition subsequent to ASU 2014-09’s adoption. The Company expects to adopt the new standard on January 1, 2018, using the modified retrospective approach, which involves applying the new standard to all contracts initiated on or after the effective date and recording an adjustment to opening equity for pre-existing contracts that have remaining obligations as of the effective date. In March 2016, the FASB issued ASU 2016-09, Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting. Under this ASU, entities are permitted to make an accounting policy election to either estimate forfeitures on share-based payment awards, as required by current guidance, or to recognize forfeitures as they occur. The guidance became effective for interim and annual periods beginning after December 15, 2016. Effective January 1, 2017, we adopted this standard. We elected to recognize forfeitures on share-based payment awards as they occur. The adoption, along with the remaining provisions of ASU 2016-09, did not have a material impact on our consolidated financial statements. Note 2. Revenue and Accounts Receivable Revenue by service type for the three months ended March 31, 2017 and 2016 is comprised of the following (in thousands): Accounts receivable by service type at March 31, 2017 and December 31, 2016 consists of the following (in thousands): Allowance for doubtful accounts Allowance for Doubtful Accounts (in thousands) Bad debt recoveries Revenue for Biopharma Services are customized solutions for patient stratification and treatment selection through an extensive suite of DNA-based testing services. Clinical Services are tests performed to provide information on diagnosis, prognosis and theranosis of cancers to guide patient management. These tests can be billed to Medicare, another third party insurer or the referring community hospital or other healthcare facility. Discovery Services are services that provide the tools and testing methods for companies and researchers seeking to identify new DNA-based biomarkers for disease. The breakdown of our Clinical Services revenue (as a percent of total revenue) is as follows: Other insurers Other healthcare facilities We have historically derived a significant portion of our revenue from a limited number of test ordering sites, although the test ordering sites that generate a significant portion of our revenue have changed from period to period. Test ordering sites account for all of our Clinical Services along with a portion of the Biopharma Services revenue. Our test ordering sites are largely hospitals, cancer centers, reference laboratories, physician offices and biopharmaceutical companies. Oncologists and pathologists at these sites order the tests on behalf of the needs of their oncology patients or as part of a clinical trial sponsored by a biopharmaceutical company in which the patient is being enrolled. We generally do not have formal, long-term written agreements with such test ordering sites, and, as a result, we may lose a significant test ordering site at any time. The top five test ordering sites during each of the three months ended March 31, 2017 and 2016 accounted for approximately 35% of our testing volumes. During the three months ended March 31, 2017, there was one biopharmaceutical company which accounted for approximately 11% of our total revenue. During the three months ended March 31, 2016, there were two biopharmaceutical companies which accounted for approximately 11% and 10% of our total revenue, respectively. Note 3. Earnings Per Share For purposes of this calculation, stock warrants, outstanding stock options and unvested restricted shares are considered common stock equivalents using the treasury stock method, and are the only such equivalents outstanding. Basic net loss and diluted net loss per share data were computed as follows (in thousands except per share data): Numerator: Net (loss) for basic earnings per share Net (loss) for diluted earnings per share Denominator: Weighted-average basic common shares outstanding Assumed conversion of dilutive securities: Common stock purchase warrants Potentially dilutive common shares Denominator for diluted earnings per share – adjusted weighted-average shares Basic net (loss) per share Diluted net (loss) per share The following table summarizes equivalent units outstanding that were excluded from the earnings per share calculation because their effects were anti-dilutive (in thousands): Restricted shares of common stock Note 4. Sale of Net Operating Losses On February 22, 2017, we sold $18,177,059 of gross State of New Jersey NOL’s relating to the 2014 and 2015 tax years for approximately $876,000 as well as $167,572 of state research and development tax credits. The sale resulted in the net receipt by the Company of approximately $970,000. This figure includes all costs and expenses associated with the sale of these state tax attributes as deducted from the gross sales price of $1,043,517. Note 5. Term Notes and Line of Credit On March 22, 2017, we refinanced our debt with Silicon Valley Bank (“SVB”), by repaying the outstanding term loan (“SVB Term Note”), which was scheduled to mature in April 2019, and entered into a new two year asset-based revolving line of credit agreement. The new SVB credit facility provides for an asset-based line of credit (“ABL”) for an amount not to exceed the lesser of (a) $6.0 million or (b) 80% of eligible accounts receivable plus the lesser of 50% of the net collectable value of third party accounts receivable or three (3) times the average monthly collection amount of third party accounts receivable over the previous quarter. The ABL requires monthly interest payments at the Wall Street Journal prime rate plus 1.5% (5.5% at March 31, 2017) and matures on March 22, 2019. We paid to SVB a $30,000 commitment fee at closing and will pay a fee of 0.25% per year on the average unused portion of the ABL. We concurrently entered into a new three year $6.0 million term loan agreement (“PFG Term Note”) with Partners for Growth IV, L.P. (“PFG”). The PFG Term Note is an interest only loan with the full principal and any outstanding interest due at maturity on March 22, 2020. Interest is payable monthly at a rate of 11.5% per annum, with the possibility of reducing to 11.0% in 2018 based on achieving certain financial milestones set forth by PFG. We may prepay the PFG Term Note in whole or part at any time without penalty. We paid PFG a commitment fee of $120,000 at closing. Both loan agreements require us to comply with certain financial covenants, including minimum adjusted EBITDA, revenue and liquidity covenants, and restrict us from, among other things, paying cash dividends, incurring debt and entering into certain transactions without the prior consent of the lenders. Repayment of amounts borrowed under the new loan agreements may be accelerated if an event of default occurs, which includes, among other things, a violation of such financial covenants and negative covenants. Our obligations to SVB under the ABL facility are secured by a first priority security interest on substantially all of our assets, and our obligations under the PFG Term Note are secured by a second priority security interest subordinated to the SVB lien. In connection with the PFG Term Note, we issued seven year warrants to the lenders to purchase an aggregate of 443,262 shares of our common stock at an exercise price of $2.82 per share. The number of warrants may be reduced by 20% subject to us achieving certain financial milestones set forth by PFG. The following is a summary of long-term debt (in thousands): SVB Term Note, repaid in 2017 PFG Term Note, net of discount of $992 Less unamortized debt issuance costs Term notes, net Less current maturities Long-term portion At March 31, 2017, the principal amount of the PFG Term Note of $6,000,000 is due in 2020. Note 6. Stock-Based Compensation We have two equity incentive plans: the 2008 Stock Option Plan (the “2008 Plan”) and the 2011 Equity Incentive Plan (the “2011 Plan”, and together with the 2008 Plan, the “Stock Option Plans”). The Stock Option Plans are meant to provide additional incentive to officers, employees and consultants to remain in our employment. Options granted are generally exercisable for up to 10 years. At March 31, 2017, 758,101 shares remain available for future awards under the 2011 Plan and 133,154 shares remain available for future awards under the 2008 Plan. A summary of employee and non-employee stock option activity for the three months ended March 31, 2017 is as follows: Options Outstanding Weighted- Term (in years) Outstanding January 1, 2017 Cancelled or expired Outstanding March 31, 2017 Exercisable March 31, 2017 Aggregate intrinsic value represents the difference between the fair value of our common stock and the exercise price of outstanding, in-the-money options. As of March 31, 2017, total unrecognized compensation cost related to non-vested stock options granted to employees was $2,862,783 which we expect to recognize over the next 2.52 years. As of March 31, 2017, total unrecognized compensation cost related to non-vested stock options granted to non-employees was $76,875 which we expect to recognize over the next 0.76 years. The estimate of unrecognized non-employee compensation is based on the fair value of the non-vested options as of March 31, 2017. The fair value of options granted to employees is estimated on the grant date using the Black-Scholes option valuation model. This valuation model requires us to make assumptions and judgments about the variables used in the calculation, including the expected term (the period of time that the options granted are expected to be outstanding), the volatility of our common stock, a risk-free interest rate, and expected dividends. To the extent actual forfeitures differ from the estimates, the difference will be recorded as a cumulative adjustment in the period estimates are revised. No compensation cost is recorded for options that do not vest. We use the simplified calculation of expected life described in the SEC’s Staff Accounting Bulletin No. 107, Share-Based Payment, and volatility is based on the historical volatility of our common stock. The risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option. We use an expected dividend yield of zero, as we do not anticipate paying any dividends in the foreseeable future. Forfeitures will be recorded when they occur. The following table presents the weighted-average assumptions used to estimate the fair value of options granted to employees during the periods presented: Weighted-average fair value of options granted during the period In May 2014, we issued 200,000 options to our Director, Raju Chaganti, with an exercise price of $15.89. See Note 11 for additional information. The following table presents the weighted-average assumptions used to estimate the fair value of options reaching their measurement date for non-employees during the periods presented: Restricted stock awards have been granted to employees, directors and consultants as compensation for services. At March 31, 2017, there was $315,049 of unrecognized compensation cost related to non-vested restricted stock granted to employees and directors; we expect to recognize the cost over 1.63 years. The following table summarizes the activities for our non-vested restricted stock awards for the three months ended March 31, 2017: Non-vested Restricted Stock Awards Weighted-Average Grant Date Fair Value Non-vested at January 1, 2017 Non-vested at March 31, 2017 The following table presents the effects of stock-based compensation related to stock option and restricted stock awards to employees and non-employees on our Consolidated Statements of Operations during the periods presented (in thousands): Total stock-based compensation Note 7. Warrants On March 22, 2017, we issued seven year warrants to PFG and certain of its affiliates to purchase an aggregate of 443,262 shares of our common stock at an exercise price of $2.82 per share, in conjunction with our debt refinancing described in Note 5. The number of warrants may be reduced by 20% subject to us achieving certain financial milestones set forth by PFG. The warrants can be net settled in common stock using the average 90-trading day price of our common stock. These warrants are defined in the table below as 2017 Debt derivative warrants. During the three months ended March 31, 2017, the Company received approximately $1,750,000 from shareholders who exercised warrants to purchase 777,900 shares of common stock at $2.25. In addition, on March 28, 2017, warrant holders exercised warrants to purchase 90,063 shares of common stock at an exercise price of $2.25 per share using the net issuance exercise method whereby 45,162 shares were surrendered as payment in full of the exercise price resulting in a net issuance of 44,901 shares. The following table summarizes the warrant activity for the three months ended March 31, 2017 (in thousands, except exercise price): Issued With / For January 1, 2017 Warrants Issued 2017 Warrants Exercised Warrants Outstanding March 31, 2017 Non-Derivative Warrants: Debt guarantee 2015 Offering Total non-derivative warrants Derivative Warrants: 2016 Offerings 2017 Debt Total derivative warrants These warrants are subject to fair value accounting and contain a contingent net cash settlement feature. These warrants are subject to fair value accounting and contain a net settlement provision that uses the 90-trading day price of our common stock. These warrants are subject to a 20% reduction if certain financial milestones are met. Weighted-average exercise prices are as of March 31, 2017. Note 8. Fair Value of Warrants The following table summarizes the derivative warrant activity subject to fair value accounting for the three months ended March 31, 2017 (in thousands): Issued with/for Fair value of outstanding as of of warrants of warrants exercised The following tables summarize the assumptions used in computing the fair value of derivative warrants subject to fair value accounting at the date of issue or exercise during the three months ended March 31, 2017 and 2016, and at March 31, 2017 and December 31, 2016. Exercised During the Three Months Ended March 31, 2017 Expected life (years) Issued During the Three Months Ended March 31, 2017 Note 9. Fair Value Measurements Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The Fair Value Measurements and Disclosures Topic of the FASB Accounting Standards Codification requires the use of valuation techniques that are consistent with the market approach, the income approach and/or the cost approach. Inputs to valuation techniques refer to the assumptions that market participants would use in pricing the asset or liability. Inputs may be observable, meaning those that reflect the assumptions market participants would use in pricing the asset or liability developed based on market data obtained from independent sources, or unobservable, meaning those that reflect our own assumptions about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances. In that regard, the Topic establishes a fair value hierarchy for valuation inputs that give the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The fair value hierarchy is as follows: Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that we have the ability to access as of the measurement date. Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, or other inputs that are observable or can be corroborated by observable market data. Level 3: Significant unobservable inputs that reflect our own assumptions about the assumptions that market participants would use in pricing an asset or liability. The following table summarizes the financial liabilities measured at fair value on a recurring basis segregated by the level of valuation inputs within the fair value hierarchy utilized to measure fair value (in thousands): Quoted Prices in Active Markets for Identical Assets Note payable The ultimate payment to VenturEast will be the value of 84,278 shares of common stock at the time of payment. The value of the note payable to VenturEast was determined using the fair value of our common stock. During the three months ended March 31, 2017, we recognized a loss of approximately $232,000 due to the change in value of the note. At March 31, 2017, the warrant liability consists of stock warrants issued as part of the 2016 Offerings that contain contingent redemption features and warrants issued as part of the debt refinancing outlined in Note 5. In accordance with derivative accounting for warrants, we calculated the fair value of these warrants, and the assumptions used are described in Note 8, “Fair Value of Warrants.” During the three months ended March 31, 2017, we recognized a loss of approximately $7,294,000 on the derivative warrants due to the increase in our stock price. Realized and unrealized gains and losses related to the change in fair value of the VenturEast note and warrant liability are included in other income (expense) on the Consolidated Statements of Operations. The following table summarizes the activity of the note payable to VenturEast, which was measured at fair value using Level 3 inputs (in thousands): to VenturEast Fair value at December 31, 2016 Fair value at March 31, 2017 Note 10. Joint Venture Agreement In November 2011, we entered into an affiliation agreement with the Mayo Foundation for Medical Education and Research (“Mayo”), subsequently amended. Under the agreement, we formed a joint venture with Mayo in May 2013 to focus on developing oncology diagnostic services and tests utilizing next generation sequencing. The joint venture is a limited liability company, with each party initially holding fifty percent of the issued and outstanding membership interests of the new entity (the “JV”). The agreement requires aggregate capital contributions by us of up to $6.0 million, of which $2.0 million has been paid to date. The timing of the remaining installments is subject to the JV's achievement of certain operational milestones agreed upon by the board of governors of the JV. In exchange for its membership interest, Mayo’s capital contribution takes the form of cash, staff, services, hardware and software resources, laboratory space and instrumentation, the fair market value of which will be approximately equal to $6.0 million. Mayo’s continued contribution will also be conditioned upon the JV’s achievement of certain milestones. Our share of the JV’s net loss was approximately $12,000 for each of the three months ended March 31, 2017 and 2016, and is included in research and development expense on the Consolidated Statements of Operations. We have a net receivable due from the JV of approximately $10,000 at March 31, 2017, which is included in other current assets in the Consolidated Balance Sheets. The joint venture is considered a variable interest entity under ASC 810-10, but we are not the primary beneficiary as we do not have the power to direct the activities of the JV that most significantly impact its performance. Our evaluation of ability to impact performance is based on our equal board membership and voting rights and day-to-day management functions which are performed by the Mayo personnel. Note 11. Related Party Transactions We have a consulting agreement with Equity Dynamics, Inc. (“EDI”), an entity controlled by John Pappajohn, effective April 1, 2014 pursuant to which EDI receives a monthly fee of $10,000. Total expenses for the three months ended March 31, 2017 and 2016 were $30,000. As of March 31, 2017, we owed EDI $40,000. In 2010, we entered into a three-year consulting agreement with Dr. Chaganti, which was subsequently renewed through December 31, 2016 pursuant to which Dr. Chaganti receives $5,000 per month for providing consulting and technical support services. Pursuant to the terms of the renewed consulting agreement, Dr. Chaganti received an option to purchase 200,000 shares of our common stock at a purchase price of $15.89 per share vesting over a period of four years. Total non-cash stock-based compensation recognized under the consulting agreement for the three months ended March 31, 2017 and 2016 was $25,625 and $16,125, respectively. Also pursuant to the consulting agreement, Dr. Chaganti assigned to us all rights to any inventions which he may invent during the course of rendering consulting services to us. In exchange for this assignment, if the USPTO issues a patent for an invention on which Dr. Chaganti is listed as an inventor, we are required to pay Dr. Chaganti (i) a one-time payment of $50,000 and (ii) 1% of any net revenues we receive from any licensed sales of the invention. In the first quarter of 2016, we paid Dr. Chaganti $50,000 which was recognized as an expense in fiscal 2015 when one patent was issued. Note 12. Contingencies In the normal course of business, the Company may become involved in various claims and legal proceedings. In the opinion of management, the ultimate liability or disposition thereof is not expected to have a material adverse effect on our financial condition, results of operations, or liquidity. As used herein, the “Company,” “we,” “us,” “our” or similar terms, refer to Cancer Genetics, Inc. and its wholly owned subsidiaries: Cancer Genetics Italia, S.r.l., Gentris, LLC and BioServe Biotechnologies (India) Private Limited, except as expressly indicated or unless the context otherwise requires. The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to help facilitate an understanding of our financial condition and our historical results of operations for the periods presented. This MD&A should be read in conjunction with the audited consolidated financial statements and notes thereto included in our annual report on Form 10-K filed with the SEC on March 23, 2017. This MD&A may contain forward-looking statements that involve risks and uncertainties. See “Cautionary Note Regarding Forward-Looking Statements” below. Our vision is to become the oncology diagnostics partner for biopharmaceutical companies and clinicians by participating in the entire care continuum from bench to bedside. We believe the diagnostics industry is undergoing a rapid evolution in its approach to oncology testing, embracing precision medicine and individualized testing as a means to drive higher standards of patient treatment and disease management. Similarly, biopharmaceutical companies are increasingly engaging companies such as ours to provide information on clinical trial participants' molecular profiles in order to identify biomarker and genomic variations that may be responsible for differing responses to pharmaceuticals, and particularly to oncology drugs, thereby increasing the efficiency of trials while lowering related costs. We believe tailored therapeutics can revolutionize oncology medicine through molecular- and biomarker-based testing services, enabling physicians and researchers to target the factors that make each patient and disease unique. Our services are performed at our state-of-the-art laboratories located in New Jersey, North Carolina, California, Shanghai (China), and Hyderabad, India. Our laboratories comply with the highest regulatory standards as appropriate for the services they deliver including CLIA, CAP, NY State, California State and NABL (India). Our services are built on a foundation of world-class scientific knowledge and intellectual property in solid and blood-borne cancers, as well as strong academic relationships with major cancer centers such as Memorial Sloan-Kettering, Mayo Clinic, and the National Cancer Institute. Our clinical offerings include our portfolio of proprietary tests targeting hematological, urogenital and HPV-associated cancers, in conjunction with ancillary non-proprietary tests. Our proprietary tests target cancers that are difficult to prognose and predict treatment outcomes through currently available mainstream techniques. We provide our proprietary tests and services, along with a comprehensive range of non-proprietary oncology-focused tests and laboratory services, to oncologists and pathologists at hospitals, cancer centers, and physician offices, as well as biotech and pharmaceutical companies to support their clinical trials. Our proprietary tests are based principally on our expertise in specific cancer types, test development methodologies and proprietary algorithms correlating genetic events with disease specific information. Our portfolio primarily includes comparative genomic hybridization (CGH) microarrays and next generation sequencing (NGS) panels, and DNA fluorescent in situ hybridization (FISH) probes. The non-proprietary testing services we offer are focused in part on specific oncology categories where we are developing our proprietary tests. We believe that there is significant synergy in developing and marketing a complete set of tests and services that are disease focused and delivering those tests and services in a comprehensive manner to help with treatment decisions. The insight that we develop in delivering the non-proprietary services are often leveraged in the development of our proprietary programs and now increasingly in the validation of our proprietary programs, such as MatBA and Focus::NGS. We expect to continue to incur significant losses for the near future. We incurred losses of $15.8 million and $20.2 million for fiscal years ended December 31, 2016 and 2015, respectively, and $9.6 million for the three months ended March 31, 2017. As of March 31, 2017, we had an accumulated deficit of $123.5 million. Key Factors Affecting our Results of Operations and Financial Condition Our overall long-term growth plan is predicated on our ability to develop and commercialize our proprietary tests, penetrate the Biopharma community to achieve more revenue supporting clinical trials and develop and penetrate the Indian market. Our proprietary tests include CGH microarrays, NGS panels, and DNA FISH probes. We continue to develop additional proprietary tests. To facilitate market adoption of our proprietary tests, we anticipate having to successfully complete additional studies with clinical samples and publish our results in peer-reviewed scientific journals. Our ability to complete such studies is dependent upon our ability to leverage our collaborative relationships with leading institutions to facilitate our research and obtain data for our quality assurance and test validation efforts. We believe that the factors discussed in the following paragraphs have had and are expected to continue to have a material impact on our results of operations and financial condition. Our revenue is primarily generated through our Clinical Services and Biopharma Services. Clinical Services can be billed to Medicare, another third party insurer or the referring community hospital or other healthcare facility or patients in accordance with state and federal law. Biopharma Services are billed to the customer directly. While we have agreements with our Biopharma clients, volumes from these clients are subject to the progression and continuation of the clinical trials which can impact testing volume. We also derive limited revenue from Discovery Services, which are services provided in the development of new testing assays and methods. Discovery Services are billed directly to the customer. We have historically derived a significant portion of our revenue from a limited number of test ordering sites, although the test ordering sites that generate a significant portion of our revenue have changed from period to period. Test ordering sites account for all of our Clinical Services revenue along with a portion of the Biopharma Services revenue. Our test ordering sites are hospitals, cancer centers, reference laboratories, physician offices and biopharmaceutical companies. Oncologists and pathologists at these sites order the tests on behalf of the needs of their oncology patients or as part of a clinical trial sponsored by a biopharmaceutical company in which the patient is being enrolled. The top five test ordering clients during the three months ended March 31, 2017 and 2016 accounted for 35% of our testing volumes. During the three months ended March 31, 2017, one Biopharma client accounted for approximately 11% of our revenue. During the three months ended March 31, 2016, two Biopharma clients accounted for approximately 11% and 10% of our revenue, respectively. We receive revenue for our Clinical Services from Medicare, other insurance carriers and other healthcare facilities. Some of our customers choose, generally at the beginning of our relationship, to pay for laboratory services directly as opposed to having patients (or their insurers) pay for those services and providing us with the patients’ insurance information. A hospital may elect to be a direct bill customer and pay our bills directly, or may provide us with patient information so that their patients pay our bills, in which case we generally expect payment from their private insurance carrier or Medicare. In a few instances, we have arrangements where a hospital may have two accounts with us, so that certain tests are billed directly to the hospital, and certain tests are billed to and paid by a patient’s insurer. The billing arrangements generally are dictated by our customers and in accordance with state and federal law. For the three months ended March 31, 2017, Medicare accounted for approximately 14% of our total revenue, other insurance accounted for approximately 23% of our total revenue and other healthcare facilities accounted for 6% of our total revenue. On average, we generate less revenue per test from other healthcare facilities billed directly, than from other insurance payers. Our cost of revenues consists principally of internal personnel costs, including stock-based compensation, laboratory consumables, shipping costs, overhead and other direct expenses, such as specimen procurement and third party validation studies. We are pursuing various strategies to reduce and control our cost of revenues, including automating our processes through more efficient technology and attempting to negotiate improved terms with our suppliers. With our three acquisitions since 2014, we have made significant progress with integrating our resources and services in an effort to reduce costs. We will continue to assess other possible advantages to help us improve our cost structure. We classify our operating expenses into three categories: research and development, sales and marketing, and general and administrative. Our operating expenses principally consist of personnel costs, including stock-based compensation, facility costs, outside services, laboratory consumables and overhead, development costs, marketing program costs and legal and accounting fees. Research and Development Expenses. We incur research and development expenses principally in connection with our efforts to develop our proprietary tests. Our primary research and development expenses consist of direct personnel costs, laboratory equipment and consumables and overhead expenses. In 2013, we entered into a joint venture with the Mayo Foundation for Medical Education and Research, with a focus on developing oncology diagnostic services and tests utilizing next generation sequencing. These efforts have continued. All research and development expenses are charged to operations in the periods they are incurred. General and Administrative Expenses. General and administrative expenses consist principally of personnel-related expenses, professional fees, such as legal, accounting and business consultants, occupancy costs, bad debt and other general expenses. We have experienced decreases in our general and administrative expenses but anticipate increases as we expand our business operations. Sales and Marketing Expenses. Our sales and marketing expenses consist principally of personnel and related overhead costs for our sales team and their support personnel, travel and entertainment expenses, and other selling costs including sales collaterals and trade shows. We expect our sales and marketing expenses to increase as we expand into new geographies and add new clinical tests and services. Our business experiences decreased demand during spring vacation season, summer months and the December holiday season when patients are less likely to visit their health care providers. We expect this trend in seasonality to continue for the foreseeable future. Three Months Ended March 31, 2017 and 2016 The following table sets forth certain information concerning our results of operations for the periods shown: Research and development expenses )% General and administrative expenses Sales and marketing expenses Interest income (expense) Non-GAAP Financial Information In addition to disclosing financial results in accordance with United States generally accepted accounting principles (“GAAP”), the table below contains non-GAAP financial measures that we believe are helpful in understanding and comparing our past financial performance and our future results. The non-GAAP financial measures disclosed by the Company exclude the non- operating changes in the fair value of derivative instruments. These non-GAAP financial measures should not be considered a substitute for, or superior to, financial measures calculated in accordance with GAAP, and the financial results calculated in accordance with GAAP and reconciliations from these results should be carefully evaluated. Management believes that these non-GAAP measures provide useful information about the Company’s core operating results and thus are appropriate to enhance the overall understanding of the Company’s past financial performance and its prospects for the future. The non-GAAP financial measures in the table below include adjusted net (loss) and the related adjusted basic and diluted net (loss) per share amounts. Reconciliation from GAAP to Non-GAAP Results (in thousands, except per share amounts): Reconciliation of net (loss): Adjusted net (loss) Reconciliation of net (loss) per share, basic and diluted: Adjustments to net (loss) Adjusted basic and diluted net (loss) per share Adjusted net (loss) decreased 61% to $2.1 million during the three months ended March 31, 2017, down from an adjusted net (loss) of $5.3 million during the three months ended March 31, 2016. Adjusted basic and diluted net (loss) per share decreased 72% to $0.11 during the three months ended March 31, 2017, down from $0.39 during the three months ended March 31, 2016. The breakdown of our revenue is as follows: Revenue increased 15%, or $0.9 million, to $7.0 million for the three months ended March 31, 2017, from $6.1 million for the three months ended March 31, 2016, principally due to increased test volume in our clinical services and a higher number of active biopharma projects as we execute on a growing number of signed contracts with pharmaceutical and biotechnology companies. Our average revenue (excluding probe revenue) per test decreased to $398 per test for the three months ended March 31, 2017 from $424 per test for the three months ended March 31, 2016, principally due to the additional Clinical Services volume from our Los Angeles facility, which yields lower average revenue per test. Test volume increased by 19% from 10,327 tests for the three months ended March 31, 2016 to 12,310 tests for the three months ended March 31, 2017. Revenue from Biopharma Services increased 11%, or $0.4 million, to $3.7 million for the three months ended March 31, 2017, from $3.4 million for the three months ended March 31, 2016, due to a higher number of active biopharma projects as we execute on a growing number of signed contracts with pharmaceutical and biotechnology companies. Revenue from Clinical Services customers increased by $0.5 million, or 20%, compared to the three months ended March 31, 2016, due to higher clinical volumes of the tests we perform. Cost of revenues increased 3%, or $0.1 million, for the three months ended March 31, 2017, principally due an increase in lab supplies of $0.3 million as a result of increased volume and revenues, partially offset by a $0.1 million reduction in compensation and a $0.1 million reduction in shipping, as a result of the Company’s focus on reducing cost and improving gross margin. Gross margin improved to 40% during the three months ended March 31, 2017 from 32% during the three months ended March 31, 2016, due to cost reduction initiatives and synergies across locations. Research and development expenses decreased 28%, or $0.4 million, to $1.1 million for the three months ended March 31, 2017, from $1.5 million for the three months ended March 31, 2016, principally due to a $0.5 million decrease in the costs of software and maintenance and reduced payroll and benefit costs of $0.2 million, offset by an increase in lab supplies of $0.4 million. General and administrative expenses decreased 19%, or $0.8 million, to $3.5 million for the three months ended March 31, 2017, from $4.3 million for the three months ended March 31, 2016, principally due to a $0.2 million decrease in payroll and benefit costs, a $0.3 million decrease in professional services and a $0.2 million decrease in facility costs resulting from the elimination of building management fees at our North Carolina location. Sales and marketing expenses decreased 25%, or $0.3 million, to $1.0 million for the three months ended March 31, 2017, from $1.3 million for the three months ended March 31, 2016, principally due to decreased compensation costs of $0.2 million and decreased travel costs of $0.1 million. Net interest expense increased 45% during the three months ended March 31, 2017 due to recognizing a loss on extinguishment of debt of $0.1 million. The change in fair value of note payable resulted in approximately $0.2 million in non-cash expense for the three months ended March 31, 2017 and approximately $34,000 in non-cash income for the three months ended March 31, 2016. The fair value of the note representing part of the purchase price for BioServe increased during the three months ended March 31, 2017 as a consequence of an increase in our stock price. Changes in fair value of some of our common stock warrants may impact our quarterly results. Accounting rules require us to record certain of our warrants as a liability, measure the fair value of these warrants each quarter and record changes in that value in earnings. As a result of an increase in our stock price, we recognized non-cash expense of $7.3 million for the three months ended March 31, 2017. In the future, if our stock price increases, with all other factors being equal, we would record a non-cash charge as a result of changes in the fair value of our common stock warrants. Alternatively, if the stock price decreases, with all other factors being equal, we may record non-cash income. We recognized non-cash income of $17,000 during the three months ended March 31, 2016 due to the expiration of other unexercised warrants. During the three months ended March 31, 2017, we expensed approximately $46,000 of issuance costs associated with the derivative warrants issued as part of the 2017 debt refinancing. During the three months ended March 31, 2017, we received approximately $1.0 million of net proceeds from the sale of state NOL’s and state research and development credits. No such sales occurred in the first quarter of 2016. Sources of Liquidity Our primary sources of liquidity have been funds generated from our debt financings and equity financings. In addition, we have generated funds from the following sources: (i) cash collections from customers and (ii) cash received from sale of state NOL’s. In general, our primary uses of cash are providing for operating expenses, working capital purposes and servicing debt. As of March 31, 2017, we have not borrowed on our line of credit, which allows for borrowings of up to $6.0 million. Our net cash flow from operating, investing and financing activities for the periods below were as follows: Cash provided by (used in): We had cash and cash equivalents of $9.7 million at March 31, 2017, and $9.5 million at December 31, 2016. The $0.2 million increase in cash and cash equivalents for the three months ended March 31, 2017, principally resulted from the proceeds from the exercise of warrants of $1.8 million and proceeds from refinancing our debt of $6.0 million, partially offset by $2.4 million of net cash used in operations, fixed asset additions of $0.2 million and principal payments made on the Silicon Valley Bank term note of $4.7 million. We also paid $0.3 million of debt issuance costs and loan fees pursuant to our refinanced debt. The $6.2 million decrease in cash and cash equivalents for the three months ended March 31, 2016, principally resulted from $5.8 million of net cash used in operations and a $0.3 million used to purchase fixed assets. At March 31, 2017, we had total indebtedness of $6.0 million, excluding capital lease obligations. Cash Used in Operating Activities Net cash used in operating activities was $2.4 million for the three months ended March 31, 2017. We used $0.9 million in net cash to fund our core operations, which included $0.3 million in cash paid for interest. We incurred additional uses of cash when adjusting for working capital items as follows: a net increase in accounts receivable of $0.9 million and a net decrease in accounts payable, accrued expenses and deferred revenue of $0.7 million, offset by a decrease in other current assets of $0.2 million. For the three months ended March 31, 2016, we used $5.8 million in operating activities. We used $4.2 million in net cash to fund our core operations, which included $0.1 million in cash paid for interest. We incurred additional uses of cash when adjusting for working capital items as follows: a net increase in accounts receivable of $1.8 million; an decrease in other current assets of $0.3 million; and a net decrease in accounts payable, accrued expenses and deferred revenue of $0.1 million. Cash Used in Investing Activities Net cash used in investing activities was $0.2 million for the three months ended March 31, 2017 and principally resulted from the purchase of fixed assets. Cash Provided by/Used in Financing Activities Net cash provided by financing activities was $2.8 million for the three months ended March 31, 2017 and principally resulted from proceeds received from warrants exercised of $1.8 million and proceeds from refinancing our debt of $6.0 million, offset by principal payments made on our Silicon Valley Bank term note of $4.7 million and debt issuance costs and loan fees of $0.3 million related to our refinanced debt. Net cash used in financing activities was $41,000 for the three months ended March 31, 2016 and principally resulted from payments made on capital leases. Capital Resources and Expenditure Requirements We expect to continue to incur material operating losses in the near future. It may take several years, if ever, to achieve positive operational cash flow. We may need to raise additional capital to fund our current operations, to repay certain outstanding indebtedness and to fund expansion of our business to meet our long-term business objectives through public or private equity offerings, debt financings, borrowings or strategic partnerships coupled with an investment in our company or a combination thereof. If we raise additional funds through the issuance of convertible debt securities, or other debt securities, these securities could be secured and could have rights senior to those of our common stock. In addition, any new debt incurred by the Company could impose covenants that restrict our operations and increase our interest expense. The issuance of any new equity securities will also dilute the interest of our current stockholders. Given the risks associated with our business, including our unprofitable operating history and our ability to develop additional proprietary tests, additional capital may not be available when needed on acceptable terms, or at all. If adequate funds are not available, we will need to curb our expansion plans or limit our research and development activities, which would have a material adverse impact on our business prospects and results of operations. We believe that our current cash, taken together with the borrowings available from the Silicon Valley Bank line of credit, will support operations for at least the next 12 months from the date of this report. We continue to explore opportunities for additional equity or debt financing, and we are taking steps to improve our operating cash flow. We can provide no assurances that our current actions will be successful or that any additional sources of financing will be available to us on favorable terms, if at all, when needed. Our forecast of the period of time through which our current financial resources will be adequate to support our operations and the costs to support our general and administrative, sales and marketing and research and development activities are forward-looking statements and involve risks and uncertainties. We expect our sales and marketing, research and development and other general and administrative expenses to increase as we continue to expand our business. Our forecast of the period of time through which our current financial resources will be adequate to support our operations and our expected operating expenses are forward-looking statements and involve risks and uncertainties. Actual results could vary materially and negatively as a result of a number of factors, including: our ability to achieve revenue growth and profitability; the costs for funding the operations we recently acquired; our ability to improve efficiency of billing and collection processes; our ability to obtain approvals for our new diagnostic tests; our ability to execute on our marketing and sales strategy for our tests and gain acceptance of our tests in the market; our ability to obtain adequate reimbursement from governmental and other third-party payors for our tests and services; the costs, scope, progress, results, timing and outcomes of the clinical trials of our tests; the costs of operating and enhancing our laboratory facilities; our ability to succeed with our cost control initiative; the timing of and the costs involved in regulatory compliance, particularly if the regulations change; the costs of maintaining, expanding and protecting our intellectual property portfolio, including potential litigation costs and liabilities; our ability to manage the costs of manufacturing our tests; our rate of progress in, and cost of research and development activities associated with, products in research and early development; the effect of competing technological and market developments; costs related to expansion; our ability to secure financing and the amount thereof; and other risks and uncertainties discussed in our annual report on Form 10-K for the year ended December 31, 2016 and other reports, as applicable, we file with the Securities and Exchange Commission. We expect that our operating expenses and capital expenditures will increase in the future as we expand our business. We plan to increase our sales and marketing headcount to promote our new clinical tests and services and to expand into new geographies and to continue our research and development expenditures associated with performing work with research collaborators, to expand our pipeline and to perform work associated with our research collaborations. For example, in 2011 we entered into an affiliation agreement to form a joint venture with the Mayo Foundation for Medical Education and Research pursuant to which we made an initial $1.0 million capital contribution in October 2013 and $1.0 million in the third quarter of 2014. We may make additional capital contributions of up to $4.0 million, subject to the joint venture entity’s achievement of certain operational milestones. Until we can generate a sufficient amount of revenues to finance our cash requirements, which we may never do, we may need to raise additional capital to fund our operations. Subject to the availability of financing, we may use significant cash to fund acquisitions. In March 2017, we entered into a new line of credit with Silicon Valley Bank and refinanced our term note with a new lender, Partners for Growth. See Note 5 of Notes to Unaudited Consolidated Financial Statements included in Item 1 of this Quarterly Report on Form 10-Q. Over the past several years, we have generated operating losses in all jurisdictions in which we may be subject to income taxes. As a result, we have accumulated significant net operating losses and other deferred tax assets. Because of our history of losses and the uncertainty as to the realization of those deferred tax assets, a full valuation allowance has been recognized. We do not expect to report a benefit related to the deferred tax assets until we have a history of earnings, if ever, that would support the realization of our deferred tax assets. Utilization of these net operating loss carryforwards is subject to limitation due to ownership changes that may delay the utilization of a portion of the carryforwards. Since inception, we have not engaged in any off-balance sheet activities as defined in Item 303(a)(4) of Regulation S-K. Critical Accounting Policies and Significant Judgment and Estimates Our management’s discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of our consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates based on historical experience and make various assumptions, which management believes to be reasonable under the circumstances, which form the basis for judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Section 107 of the JOBS Act provides that an “emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act for complying with new or revised accounting standards. In other words, an “emerging growth company” can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we have chosen to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable. The notes to our audited consolidated financial statements in our annual report on Form 10-K for the year ended December 31, 2016 contain a summary of our significant accounting policies. We consider the following accounting policies critical to the understanding of the results of our operations: Revenue recognition; Accounts receivable and bad debts; Stock-based compensation; and Warrant liability. This report on Form 10-Q contains forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995 under Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “projects,” “predicts,” “potential,” or the negative of those terms, and similar expressions and comparable terminology intended to identify forward-looking statements. These statements reflect our current views with respect to future events. There are a number of important factors that could cause the actual results to differ materially from those expressed in any forward-looking statement made by us. These factors include, but are not limited to: our ability to achieve profitability by increasing sales of our laboratory tests and services and to continually develop and commercialize novel and innovative diagnostic tests and services for cancer patients; our ability to obtain reimbursement from governmental and other third-party payors for our tests and services; our ability clinically validate our pipeline of tests currently in development; our ability to keep pace with rapidly advancing market and scientific developments; our ability to satisfy U.S. (including FDA) and international regulatory requirements with respect to our tests and services, many of which are new and still evolving; ability to raise additional capital to meet our liquidity needs; competition from clinical laboratory services companies, tests currently available or new tests that may emerge; our ability to maintain our clinical collaborations and enter into new collaboration agreements with highly regarded organizations in the cancer field so that, among other things, we have access to thought leaders in the field and to a robust number of samples to validate our tests; our ability to maintain our present customer base and obtain new customers; potential product liability or intellectual property infringement claims; our dependency on third-party manufacturers to supply or manufacture our products; our ability to attract and retain a sufficient number of scientists, clinicians, sales personnel and other key personnel with extensive experience in oncology, who are in short supply; our ability to obtain or maintain patents or other appropriate protection for the intellectual property in our proprietary tests and services; our dependency on the intellectual property licensed to us or possessed by third parties; our ability to expand internationally and launch our tests in emerging markets, such as India and Brazil; our ability to adequately support future growth; and the risk factors discussed in our annual report on Form 10-K for the year ended December 31, 2016, as updated in other reports, as applicable, that we file with the Securities and Exchange Commission. Given these uncertainties, you should not place undue reliance on these forward-looking statements. These forward-looking statements represent our estimates and assumptions only as of the date of this quarterly report on Form 10-Q and, except as required by law, we undertake no obligation to update or review publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this quarterly report on Form 10-Q. You should read this quarterly report on Form 10-Q and the documents referenced herein and filed as exhibits completely and with the understanding that our actual future results may be materially different from what we expect. We evaluated, under the supervision and with the participation of the principal executive officer and principal financial officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (“Exchange Act”), as amended, as of March 31, 2017, the end of the period covered by this report on Form 10-Q. Based on this evaluation, our President and Chief Executive Officer (principal executive officer) and our Chief Operating Officer (principal financial officer) have concluded that our disclosure controls and procedures were effective at the reasonable assurance level at March 31, 2017. Disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act (i) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (ii) is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives. Due to the inherent limitations of control systems, not all misstatements may be detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Controls and procedures can only provide reasonable, not absolute, assurance that the above objectives have been met. There were no changes in our internal control over financial reporting during the three months ended March 31, 2017 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. There have been no material changes to the risk factors disclosed in Part 1, Item 1A, of our annual report on Form 10-K for the year ended December 31, 2016. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds from Sales of Registered Securities On March 22, 2017, in connection with our debt refinancing, we issued seven year warrants to the lenders to purchase an aggregate of 443,262 shares of our common stock at an exercise price of $2.82 per share. The number of warrants may be reduced by 20% subject to us achieving certain financial milestones set forth by PFG. The issuance of the warrants and the underlying warrant shares was exempt from registration under Section 4(a)(2) of the Securities Act or 1933. The above description of the terms of the warrant is qualified in its entirety by the full text of the warrant, which was filed as Exhibit 10.83 to the Annual Report on Form 10-K for the year ended December 31, 2016 and incorporated herein. Item 4. Mine Safety Disclosures On May 11, 2017, we entered into an employment agreement with Rita Shaknovich, M.D., Ph.D., which provides for her appointment as Chief Medical Officer and Chair of our Clinical Advisory Board of the Company, effective May 28, 2017 (“Employment Agreement”). The Employment Agreement provides for, among other things, (i) an annual base salary of $316,000, and (ii) eligibility for an annual cash bonus of up to 20% of her base salary. Pursuant to the terms of the Employment Agreement the Company will grant to Dr. Shaknovich an option to purchase 50,000 shares of the Company’s common stock under the Company’s current equity incentive plan. The Employment Agreement has an initial two year term and automatically renews for additional one-year terms. The Employment Agreement also provides for post-termination benefits, subject to the execution of a release, including: (a) monthly payments equal to her base salary immediately prior to such termination for a period of six to twelve months (depending on length of service) in the event her employment is terminated without “cause” or she resigns for “good reason” not in connection with a “change of control”, (b) a lump sum payment equal to twelve months of her then base salary plus an amount equal to the prior year bonus in the event her employment terminated without “cause” or she resigns for “good reason” within twelve months following a change of control and (c) a lump sum payment equal to six months of her then base salary plus an amount equal to the prior year bonus in the event her employment terminated with “cause” or she resigns without “good reason” within twelve months following a change of control. The Employment Agreement is attached hereto as Exhibit 10.1 and is incorporated herein by reference. See the Index to Exhibits following the signature page hereto, which Index to Exhibits is incorporated herein by reference. (Registrant) /s/ Panna L. Sharma Panna L. Sharma (Principal Executive Officer) /s/ John A. Roberts John A. Roberts (Principal Financial Officer) /s/ Igor Gitelman Igor Gitelman Chief Accounting Officer (Principal Accounting Officer) Employment Agreement, dated as of May 11, 2017 by and between the Company and Rita Shaknovich * + Certification of Principal Executive Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under The Securities Exchange Act of 1934, as amended * Certification of Principal Financial Officer pursuant to Rules 13a-14(a) and 15d-14(a) promulgated under The Securities Exchange Act of 1934, as amended * Certifications of Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 ** Certifications of Principal Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of The Sarbanes-Oxley Act of 2002 ** The following materials from the Registrant’s quarterly report on Form 10-Q for the quarter ended March 31, 2017, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheet at March 31, 2017 (unaudited) and December 31, 2016, (ii) Consolidated Statements of Operations for the three month periods ended March 31, 2017 and 2016 (unaudited), (iii) Consolidated Statements of Cash Flows for the three month periods ended March 31, 2017 and 2016 (unaudited) and (iv) Notes to Consolidated Financial Statements (unaudited) Filed herewith. Furnished herewith. Indicates a management contract or compensatory plan in which directors and/or executive officers are eligible to participate.

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professional_accounting

On the Board’s Agenda: Mitigating the Threat of Fraud and Corruption Each year, the typical organization loses 5% of its revenues as a result of fraud¹ through activities such as the misappropriation of company assets, corruption and bribery, financial reporting fraud, theft of physical assets or intellectual property, and more. Anthony Campanelli Further, the risks facing organizations continue to grow in number and complexity. With its 2013 update to the Internal Control—Integrated Framework, the Committee of Sponsoring Organizations (COSO) acknowledged that “business and operating environments have changed dramatically, becoming increasingly complex, technologically driven, and global.”² The globalized business environment exposes organizations to increased fraud and corruption risks, which are further heightened when supply chains extend to countries with a high Corruption Perception Index rating.³ To address such risks, boards of directors should consider developing an up-to-date understanding of their organizations’ fraud and corruption risks and understand the issues well enough to ask the “right” questions of management and know whether they are receiving the “right” answers. Assessing and Mitigating the Risks Although regulators in many jurisdictions require management and/or directors to oversee that the organization designs and implements effective anti-fraud controls, many organizations continue to be victims of fraud or corruption. While organizations often developed anti-fraud and anti-corruption policies and procedures, these procedures may not be effectively integrated into the organization’s day-to-day operations. Therefore, management and boards may need to confirm that their policies and principles are being followed throughout the organization. Additionally, the whistleblower “hotline” or “speak-up” program, which is typically overseen by the audit committee also is an important element of an effective anti-fraud control program.⁴ (The ACFE’s 2016 Global Fraud Study found that frauds are most commonly detected through tips, especially in organizations that have reporting hotlines.) Because hotlines and other anti-fraud controls can potentially generate reports on a wide range of activities, audit committees may need to determine the level of information to be reported to them. Dan Konigsburg While some audit committees may want to be informed of every reported incident, others may find that level of reporting to be overwhelming. As a result, the audit committee may wish to set a few guiding principles around the type of matters that should be reported to them. For example, audit committees will likely want to be informed of allegations or instances of corruption, bribery and insider trading; significant deficiencies in internal control; senior management malfeasance; accounting irregularities; theft and financial losses; and broad deviations from the organization’s anti-fraud policies. Boards also may want to consider how to address internal control issues, including those regulated by the Sarbanes-Oxley Act of 2002 (Sarbox) and recommended by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Sarbox was enacted in response to a prevalence of financial reporting frauds among other capital markets challenges. The Act requires organizations to evaluate the design and effectiveness of their internal control programs and provide external certifications. Recently, attention has returned to internal control certification with the release of the 2013 COSO framework and stricter oversight of auditors by regulatory bodies, such as the Public Companies Accounting Oversight Board (PCAOB). Both COSO and the PCAOB have emphasized the importance of establishing robust risk assessment procedures, increasing the consideration of fraud risks and examining activities performed on the companies’ behalf by suppliers and service providers. As part of the scoping of the internal control certification program, management should consider assessing the likely sources of material financial reporting risks and advocate the use of a “top down, risk-based” approach, while also considering exposure to fraud. While internal control certification programs are intended to strengthen the control environment, it is important to understand that these programs do not provide absolute assurance that fraudulent acts will not occur. Michael Rossen Investigating Incidents of Fraud and Corruption When fraud or corrupt practices do occur, the financial damage to the organization is often far surpassed by the damage the wrongdoing can cause to the organization’s brand and reputation. It is not surprising, then, that organizations often prefer to see events investigated as quickly as possible to contain the financial and reputational damage and enable the organization to move on. For this reason, organizations are often tempted to investigate actual or alleged incidents of fraud or corruption using in-house resources, although the effectiveness of these investigations may be limited. For example, not all organizations have a sufficient investigation methodology or the experienced resources to execute an in-depth and rigorous investigation. Further, the level of investigative scrutiny may be less stringent when an in-house team investigates and questions its own colleagues. Pressure from management to close the investigation as quickly as possible to limit damage may also lead to incomplete results and a bias towards concluding that incidents are isolated events rather than part of a broader issue. When fraud or corruption is suspected, audit committees should consider ensuring that the appropriate investigative team is consulted and engaged early in the process. Many organizations wait to call in outside advisers, such as forensic investigators, legal counsel and external auditors, until after the organization has completed its own in-house investigation, with the expectation that the external advisers will review the procedures performed and conclude that the incident had been resolved appropriately. More often, however, the organization’s internal investigation may compromise evidence and complicate the post‑investigative review, particularly when it uncovers gaps in the in-house investigation, resulting in additional time and cost to the organization to remediate such issues. Key Program Components When evaluating the various elements that comprise effective anti-fraud and anti-corruption programs, board members may want to consider the following components. —The overall compliance structure, including the roles, resources and responsibilities of the compliance, legal and internal audit functions. —The thoroughness of the anti-fraud and anti-corruption risk assessment, including the criteria used to determine high-risk accounts, activities and operations. —Policies and procedures covering risky accounts and activities, such as revenue recognition, reserves and activities of third-parties acting on the company’s behalf, particularly with government officials. —Training protocols, including how training is monitored and assessed as well as its method of delivery, frequency and content. This could include training for new hires, managers and employees with responsibility for business functions such as third-party due diligence or the approval of charitable contributions, as well as train-the trainer activities. —Protocols for third-party due diligence, including the assessment of the sufficiency and quality of due diligence reports and how red flags are addressed. —The substance and frequency of senior management and regional compliance officer anti-fraud and anti-corruption communications. —The nature of the whistleblower reporting systems for employees and third parties, including communications and training, anonymity, ease of use, frequency of use, whistleblower protections and language capability. —Ongoing monitoring and review processes, including internal audit programs and protocols for investigation and reporting. —Policies regarding disciplinary and incentive procedures for violations of anti-fraud and anti-corruption policies and procedures. —Anti-fraud and anti-corruption merger and acquisition due diligence procedures including both pre- and post-closing acquisition due diligence. —Produced by Anthony Campanelli, Advisory partner, Regulatory, Forensics and Compliance, Deloitte Financial Advisory Services LLP, and Dan Konigsburg and Michael Rossen, both managing directors with the Global Center for Corporate Governance, Deloitte Touche Tohmatsu Limited. 1. Association of Certified Fraud Examiners, Report to the Nations on Occupational Fraud and Abuse, 2016 Global Fraud Study 2. COSO: Internal Control – Integrated Framework; Executive Summary. 3. See On the Board’s Agenda “Understanding third-party risk,” April 2016 for further information on third-party risk. 4. A further discussion on whistleblower programs is provided in the full On the Board’s Agenda “Mitigating the threat of fraud and corruption.” Targeting Fraud and Abuse with Analytics Chief Audit Executives Cite Major Skills Gaps, Lack of Impact: Global Study Rebuilding Trust After a Crisis: Eric Pillmore, Former Tyco Governance Executive COSO’s New Proposal Seeks to Link Risk to Business Strategy< Risk and Compliance Considerations in the Wake of the ‘Panama Papers’ The Uses of Social Media Data in Investigations: Five Questions Anti-Fraud September 14, 2016, 12:01 am This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication. As used in this document, "Deloitte"and "Deloitte Risk and Financial Advisory" means Deloitte & Touche LLP, which provides audit and risk advisory services; Deloitte Financial Advisory Services LLP, which provides forensic, dispute, and other consulting services; and its affiliate, Deloitte Transactions and Business Analytics LLP, which provides a wide range of advisory and analytics services. These entities are separate subsidiaries of Deloitte LLP. Please see www.deloitte.com/us/about for a detailed description of our legal structure. Certain services may not be available to attest clients under the rules and regulations of public accounting. Deloitte Risk and Financial Advisory helps organizations effectively navigate business risks and opportunities—from strategic, reputation, and financial risks to operational, cyber, and regulatory risks—to gain competitive advantage. We apply our experience in ongoing business operations and corporate lifecycle events to help clients become stronger and more resilient. Our market-leading teams help clients embrace complexity to accelerate performance, disrupt through innovation, and lead in their industries. Copyright © 2019 Deloitte Development LLC. All rights reserved. Previous Challenges Ahead from New Revenue Standard Next The Hidden Costs of a Cyberattack The technology breakthroughs of the past two decades are transforming how people live, work, and interact. They are also creating fresh opportunities for financial crime on a grand scale. To help detect, prevent, and address new and existing threats, organizations can implement a fraud risk management infrastructure powered by analytics. Behavioral Compliance: How Are You Using Data? There are several reasons why some organizations are turning to behavioral analytics and compliance, including lost revenue, increased regulatory scrutiny, and reputational damage. Predictive behavioral analytics can be critical to developing a mature compliance function equipped to detect inappropriate behavior before it becomes the norm. If executed effectively, the tool can turn the compliance function into a strategic advantage. Fraud Film Festival Spotlights Role of Advanced Technologies Fraud detection and prevention efforts have evolved considerably over the last several years. A private screening of “Abacus: Small Enough to Jail,” Oscar-nominated for “Best Documentary” in 2018, provided risk and compliance professionals an opportunity to hear from the filmmaker and the documentary subjects. Attendees also could learn how advanced technologies are changing the ways large organizations detect and prevent potential fraud.

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professional_accounting

income flow statement These days, there is accounting software available to help you prepare this statement. In the "Cash from Operations" section, the two adjustments are the: (+) D&A: $10m. Get the detailed quarterly/annual income statement for Dow Inc. (DOW). Operating Cash Flow Formula. Cannot be prepared using data from the fund flow statement. The Statement of Cash Flows (also referred to as the cash flow statement) is one of the three key financial statements that report the cash generated and spent during a specific period of time (e.g., a month, quarter, or year). Step 3: Determine the revenue for the period. The last two financial statements - the P&L and the cash flow statement - are used in two . Line Item. Here's an overview of what you can find on each one. At the top row, write down your [Company Name] Cash Flow Statement. Learn what goes in a cash flow statement, and ensure you'll put together a cash flow statement that provides insights to help your business make better decisions. Learn to read through a fund flow statement easily with our article. The income statement, also called a profit and loss statement, is one of the major financial statements issued by businesses, along with the balance sheet and cash flow statement. Discount Rate ZAL stock discount rate: cost of equity and WACC. Cash Flow Statement. Income Statement, Balance Sheet, Cash Flow Statement. The statement of cash flows includes the cash impact of changes to accounts payable and accounts receivable, as well as every other material impact on cash from both the income statement and balance sheet. The cash flow statement (CFS), along with the income statement (I/S) and balance sheet (B/S), represent the three core financial statements. Figure 20: Cash Flow Statement Showing Continuing and Discontinued Depreciation Derivation. If you look closely at the 2015 Cash Flow from operations, there is a charge for Venezuela's accounting change that has contributed $1,084 million in 2015. 1. Interest income. of financial statement to know about the company's performance, stability and solvency position. Short Term Investments on Balance Sheet. the income generated from normal business operations and includes discounts and deductions for returned merchandise. creditors, investors, suppliers, competitors, employees, etc.) An income statement just shows the profit of the company in a year while the cash flow statement shows the amount of cash a business has at hand. That means, the net profit is $ (200 - 110) = $90. Here is a basic example of how cash flow is calculated: If Barry . Not only is it an important report for internal stakeholders, but it can also help external ones, like lenders and investors, determine whether a company is successful and worthy of investment. . An all-purpose financial statement is . A profit and loss statement (P&L), or income statement or statement of operations, is a financial report that provides a summary of a . You'll sometimes see income statements called a profit and loss statement (P&L), statement of operations, or statement of earnings.. Income statements can be created to analyze and compare business performance over a month, a quarter or a year, and are an effective tool to review cash flow and predict . Types of Income Statements. Streamline your budgeting with this sample cash flow statement template. Balancing Figure: The balancing figure tells the current liquid assets of a company at a certain point . It also shows whether a company is making profit or loss for a given period. A company made revenue of $200 in 2016, and the expenses they have incurred were $110. An income statement sets out your company income versus expenses, to help calculate profit. The most common type of income statement is the classified income statement. From the net income line on the income statement. Plus: Depreciation and Amortization (D&A) We know from the exhibits above that Kellogg's 2019 Cash Flow From Operations was $1.176 billion. The cash flow statement takes the net profit from the income statement and accounts for changes in the amount of equity in the business shown on the balance sheet. Balance Sheet Equation. The cash flow statement depicts the changes in a company's cash position from one period to the next. This first step is to use the two balance sheets to calculate the change in each account by subtracting the beginning balance from the ending balance. The corresponding cash flow statement shows depreciation expense including both continuing and discontinued operations with a value of 256,706 for the 6 months ended April 1, 2011. Types of Income Statements. Rambo Abel | October 24, 2020 at 5:45 am Reply. Rental income. Disadvantages of the cash flow statement. The income statement reveals the income and expenditure of the organization. On the other hand, a balance sheet shows the assets, liabilities, and shareholders' equity. Cash flows from operating activities. Conclusion. The most common type of income statement is the classified income statement. Progressive Tax. Business owners, investors, creditors, and auditors use these documents to analyze and draw out conclusions about the financial health of a business. Net Operating Income. It acts as a link between the balance sheet and the income statement. . The statement displays the company's revenue, costs, gross profit, selling and administrative expenses, other expenses and income, taxes paid, and net profit in a coherent and logical manner. Discount Rate ZAL stock discount rate: cost of equity and WACC. Let's take an example to understand this. Income before income taxes. The balance sheet and income statement are two of the most important financial statements every business tracks. An income statement is a measure of a company's profitability. You use information from your income statement and your balance sheet to create your cash flow statement. To determine its Revenue, we must consult the company's income statement: Revenue on Kellogg's 2019 income statement. It's one of the most common financial statements in business and shows a company's total revenue and expenses to determine profit. To prepare an income statement, small businesses need to analyze and report their revenues, expenses and the resulting profits or losses, for a specific reporting period. The Cash Flow from Operations in the Cash Flow Statement represent Cash transactions that have to do with a company's core operations and is therefore an extremely important measure of the health of a Business. A personal financial statement is a document, or set of documents, that outlines an individual's financial position at a given point in time. It is simply an allocation of the cost of an asset over its useful life. The cash flow statement is a formal financial report that outlines where income is coming from, and where it is being spent. Some examples of income are: Revenue or fees earned from selling a product or service. The income statement includes depreciation expense, which doesn't actually have an associated cash outflow. In order to prepare a cash flow statement, you will need to reference two balance sheets, a complete income statement, and know some additional information. In this excel tutorial we learn how to build all three financial statements including income statement, balance statement, and cash flow statement. A cash flow statement can play a crucial role in analyzing a business's finances. Earnings per share (EPS): Division of net income by the total number of outstanding shares. The Cash Flow Statement - Direct Method. Unlike the balance sheet and income statement, the cash flow statement does not include sales made on receivables so the net income amount appearing on this statement can be very different from the value that appears on other financial reports. The third important financial statement is the cash flow statement. EBITDA: Earnings before interest, depreciation, taxes, and amortization. Higher net income is great, but the ability to actually use that net income is dependent on receiving cash on the cash flow statements. There are two ways in which we calculate the Cash Flow From Operations. The importance of the CFS is tied to the reporting standards under accrual accounting. Net Asset Formula. It is calculated by taking total revenues and subtracting from them the COGS and total expenses, which includes SG&A, Depreciation and Amortization, interest, etc. They aren't reported on the Income Statement and therefore do not affect Net Income in any way whatsoever. Total costs were $254.4 billion. In a nutshell, an income statement measures revenue, expenses, and profitability. An income statement is a report that shows how much revenue a company generated, how much it paid out in expenses and how much was left to claim as profit over a given period of time. Before you can build a cash flow statement, you'll need an income statement. Cash Flow vs Income Statement. - Income from different sources - Payment of Miscellaneous expenses - Extension of credit period to the debtors or creditors It shows the current liquid assets of a company at a certain point in time. Format. Walmart Inc. operating income increased from 2020 to 2021 and from 2021 to 2022. Analyze Piper Sandler Companies Operating Income. In the true sense, explanatory notes in the annual reports should also be called financial statements. An income statement is used to determine the performance of a company, specifically how much revenue it generated, the expenses it incurred, and the resulting profit or loss from the revenue and. Below is a portion of ExxonMobil Corporation's income statement for fiscal-year 2021, reported as of Dec. 31, 2021. Search for: . Analyze or showcase the cash flow of your business for the past twelve months with this accessible cash flow statement template. We have more work to do. All three financial statements are different, but they are intricately linked. To do that, determine net income and remove non-cash expenses (e.g. What is a Cash Flow Statement? The objective is to present the summary of expenses and incomes for the accounting period concerned. This lets you easily identify the file upon opening. Unlike the balance sheet and income statement, the cash flow statement does not include sales made on receivables so the net income amount appearing on this statement can be very different from the value that appears on other financial reports. Net income or earnings shows the profitability of a company over a period of time. Types of Financial Statement. A company has. As an alternative, you can download cash . It is also known as sales on the income statement. Step 2: Generate the Trial Balance Report for the period, which is used to prepare the income statement. Using the information on ABC Company, Inc.'s balance sheet, we determine the changes on each account as follows: After computing for the changes of each account, we . The cash flow from investing activities can be used to determine capital expenditures from a company's cash flow statement. Dependencies. Companies use the balance sheet, income statement, and cash flow statement to provide transparency to their stakeholders. An income statement is a financial document that details the revenue and expenses of a company. Figure 19: Income Statement with Depreciation Expense Continuing . Cash Flow Statement: Income Statement: Objective: The objective is to show the actual cash received and spent within a stated period of time. That period is driven by how frequently local law or custom requires publicly-traded companies to report their earnings to regulators and investors. It is the top line or gross income figure from which costs are subtracted to determine net income. The preparation of the income statement and the cash flow statement is mandatory for all business organisations. Profit and Loss Statement Format. A cash flow statement shows the actual cash received and spent during a specific period of time. operating expenses and operating incomes, which are required for ascertaining profit or loss. The income statement is an essential part of the financial statements that an organization releases. The other parts of the financial statements are the balance sheet and statement of cash flows. The cash flow statement, sometimes called the statement of cash flows, is one of the three main financial statements, along with the balance sheet and income statement, that every company must draft periodically.. This amount is the bottom line of an income statement. If your income statement shows you made a $30,000 net profit last month, you would have . Also known as "profit and loss statement (P&L)" or "statement of operations" or "statement of revenues and expenses," the income statement shows a summary of the financial position of a company. By nature, the income statement is a period statement as it relates to a specific period. However, these figures do not mean anything. Unlike the income statement, which reports income on an accrual basis, the cash flow statement shows the immediate sources and uses of cash during an . Income statement. Net income. It differs, though, because the timing of non-cash transactions is less easily . . Third, Income Statement structure and contents, including income metrics for measuring financial performance. An income statement is a financial statement that shows you the company's income and expenditures. Similar Stocks . The cash flow statement is a summary of all the money flowing into and out of your company over the specified period of time. The Direct Method and. And finally, a cash flow statement records the increases and decreases in cash. Working capital changes (e.g. An income statement provides users with a business's revenues and gains, as well as expenses and losses, over a specific period of time. Your income statement, also called a profit and loss statement (P&L), reports your business's profits and losses over a specific period of time. Next, the only line item in the " Cash from Investing " section is capital expenditures, which in Year 1 is assumed to be: (-) Capex: $40m. Fund flow statement is an important document for analysing health of any company. This lets you know what cash you have available for paying bills, payroll, and debt payments. Since it includes object codes from both a balance sheet and an income statement, object codes range from 0001 - 9999. Some investors and analysts use income statements to make investing decisions. Fund flow statements have no specific format. The company can determine the major revenues it has earned. Part of the world considers the statement of stockholders equity as another financial statement. 4. Removal of income to be presented elsewhere in the cash flow statement (e.g. Dependent on an income statement. Every company strives to make money, and there are a variety of ways to do so. As you might expect, an income statement shows a business's revenues. Trace the changes of each accounts (except cash) in the balance sheet and determine its effect to cash. This is why some analysts will say that cash flow is the better metric of a company's financial health. The ending amount of net PP&E is calculated during the current balance sheet year by comparing the beginning amount of net PP&E and its changes during . Net income or. These reports provide information about the changes in the various elements of a balance sheet over an accounting period: The cash flow statement tracks the movement of money reported in the balance sheet. Income Statement. All-Purpose Financial Statement: A record of financial activity that is suitable for a variety of users to properly assess the financial health of a company. The cash flow statement is a formal financial report that outlines where income is coming from, and where it is being spent. A cash flow statement sets out a business's cash flows from its operating activities, its financing activities, and its investment activities. The three periodic financial statements include the cash flow statement, the income statement, and the statement of changes in equity. By now, you have a solid base to finish your cash flows successfully. Piper Sandler reported last year Operating Income of 441.51 Million. Step 4: Make Adjustments for Non-cash Items from Statement of Total Comprehensive Income. There are three main financial statements: Income statement; Balance sheet; Cash flow statement The balance sheet reports on your business's assets, liabilities, and equity. The income statement is an essential part of the financial statements that an organization releases. It is prepared based on the operations of a firm. critical and non-cash items in the income statement are the primary reason why accounting income differs from cash flow. Total revenue was $276.7 billion. ABC Company. The difference between a cash flow statement and an income statement is that an income statement also takes into account some non-cash . profit or loss of a firm. All three statements are interconnected and create different views of a. The income statement, along with balance sheet and cash flow statement, helps you understand the financial health of your business. 2. It is one of the main financial statements. The sources of information appearing in the table can be used to prepare a cash flow statement. Given Revenue of $13.578 billion, the operating cash flow ratio is 8.7%. Your cash flow statement shows you how cash has . Gross Sales Formula. (-) Increase in NWC: $20m. Find out the revenue, expenses and profit or loss over the last fiscal year. Secondly, it is significant because it is based on the matching principal and shows the expense incurred by a company to earn the revenues. The Pro Forma Income (P&L) and Cash Flow Statements. Revenue is the sales made to the customers by . Second, the income statement relationship to other statements that appear at the end of the accounting cycle, including the Balance Sheet, Retained Earnings Statement, and Cash Flow Statement (SCFP). You can use an income statement to summarize business operations for a certain time frame (e.g., monthly, quarterly, etc.). Piper Sandler Operating Income is relatively stable at the moment as compared to the past year. 1. . Usually, the net income on the income statement is prepared on an accrual basis. It is usually composed of two sections - a balance sheet section and an income flow section. Cash Flow Statement (CFS) The net income of $18m is the starting line item of the CFS. Similar Stocks . Income statements are prepared according to a specified format. Whether it's active or passive income, all sources of revenue must be shown on the income statement. The income statement isn't the sole report you should use to get financial insight into your business. Balance Sheet Purpose. Leave one row empty for formatting, then write Period Beginning and Period Ending in the next two rows. Statement of Cash Flows (indirect method) for the year ended 12/31/20X1. They can have either a horizontal or vertical format. The cash flow statement (CFS), sometimes known as the statement of cash flows, is a financial statement that outlines the amount of cash and cash equivalents entering and leaving a business.. Like the income statement, it also measures the performance of a company over a period. Nominal accounts' balances are taken for it preparation. depreciation and amortization) from that number. Depreciation: The extent to which assets (for example, aging equipment) have lost value over time. 2. The income statement is one of three statements used in both corporate finance (including financial modeling) and accounting. There are broadly three types of financial statements viz. A BASE calculation can be used for net PP&E and rearranged for CAPEX. Income statement As the name implies, this is where you can find details about a company's income. The Balance Sheet that was discussed earlier in this lesson provides a snapshot in time of the financial health of a firm or the valuation (again, at a snapshot in time) of a specific investment project. It also includes costs of goods sold (COGS) and expenses over a period of time. 3. The income statement. To construct an indirect cash flow statement, you first need to focus on operating activities. Source: Macrotrends. This document is also called a profit and loss (P&L) statement. A financial statement then further groups the accounts on the trial balance into a balance sheet and income statement. The two statements are used by the readers (stakeholders, i.e. These numbers are then used to calculate a business's income . Companies produce income statements monthly, quarterly or annually to check financial health and performance. Take the profit or loss statement and statement of other comprehensive income. To start making your Cash Flow Statement, open up Excel and create a new file. Create Your Excel File. Other benefits: The income statement shows the profitability of the company over a period of time. The step-wise creation of the income statement is determined as under: Step 1: Select the period for which the income statement is to be reflected. Income Statement, Balance Sheet, Cash Flow Statement. Net income: Income before taxes less taxes. Balance Sheet. Royalty payments. Income Statement records only revenue items, i.e. The cash flow statement is comprised of the cash activity in a given period from both the balance sheet and the income statement. source: Colgate SEC Filings Even though Colgate's Net Income in 2015 was $1,548 million, its cash flow from Operations seems to be in line with the past. Cash Flow Statement is a financial statement that reports the cash generated and spent during a period. Sparklines, conditional formatting, and crisp design make this both useful and gorgeous. The other parts of the financial statements are the balance sheet and statement of cash flows. The cash flow statement is completely different from the income statement. Starting with the company's net sales. You can find the net income number on your profit and loss statement (also called the income statement). Income Statement presents only the financial results of a firm, i.e. But from the point of view of the cash flow statement, we need to consider the cash . an increase in trade receivables must be deducted to arrive at sales revenue that actually resulted in . Amount of income (loss) from continuing operations, including income (loss) from equity method investments, before deduction of income tax expense (benefit), and income (loss) attributable to noncontrolling interest. dividend income and interest income should be classified under investing activities unless in case of for example an investment bank). Hence, one needs to make adjustments to find the EBIT (earnings before interest and taxes). Income Statement, Balance Sheet, Cash Flow Statement. The income statement lets you know how money entered and left your business, while the balance sheet shows how those transactions affect different accountslike accounts receivable, inventory, and accounts payable. The Pro Forma Income (P&L) and Cash Flow Statements The Balance Sheet that was discussed earlier in this lesson provides a snapshot in time of the financial health of a firm or the valuation (again, at a snapshot in time) of a specific investment project. 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professional_accounting

The fiscal cliff has been avoided temporarily as the Congress has passed H.R. 8, the "American Taxpayer Relief Act of 2012" (the "Act"). The Senate passed the Act in the early morning hours of January 1, 2013, by a vote of 89-8. After spending most of the day debating whether to attempt to add additional spending cuts to the Act, the Republican leadership in the House of Representatives finally decided to bring the Senate-passed Act to the floor for a vote. On January 1, just before midnight, the House passed the Act by a vote of 257-167, with 85 Republicans joining 172 Democrats voting in favor of the Act. President Obama signed the Act on January 2, 2013. The provisions of the Act are effective for tax years beginning after December 31, 2012, so there is no gap that resulted from Congress not acting until January 1st. The Act continues many of the income, estate, gift, and generation-skipping transfer ("GST") tax provisions that have been in effect over the last two years, with certain important changes, which are summarized in this Special Alert. Income Tax Rates. The maximum income tax bracket increased to 39.6% but not for taxable income in excess of $250,000, as the President long wanted. Under the compromise worked out in the Senate, the 39.6% bracket will not apply for a married couple filing a joint return until their taxable income reaches $450,000 ($400,000 for an unmarried individual, $225,000 for a married individual filing separately, and $425,000 for heads of household). These thresholds are indexed for inflation for tax years beginning after 2013. The 3.8% tax on net investment income remains in the law and will result in a maximum income tax rate of 43.4% for taxpayers subject to that tax. Capital Gain and Dividend Income. The current maximum income tax rate of 15% on long term capital gain and qualified dividend income will increase to 20% beginning in 2013 for taxpayers subject to the 39.6% rate described above. These thresholds are also indexed for inflation and the 3.8% tax on net investment income will raise the tax rate to 23.8% for many taxpayers. Estate, Gift and GST Tax Rates and Exemptions. One of the most important features of the Act for high net worth taxpayers is its treatment of the estate, gift and GST tax rates and lifetime exemption amount. The rate was scheduled to increase to 55% on January 1 and the exemption was to decrease to $1,000,000. Instead, the exemption will continue at $5,000,000 for the estate, gift and GST taxes and the maximum rate will increase to 40% from the 35% that was applicable the last two years. The $5,000,000 amount is indexed for inflation after 2011 and should be approximately $5,250,000 for 2013. This exemption also remains portable between spouses so a surviving spouse can use that part of the exemption that was not used by the previously deceased spouse, subject to the same limitations that have been applicable for the last two years. The rates and lifetime exemption amount are now "permanent" in the sense that there is not a fixed date at which they automatically change. It is certainly the case, however, that the next Congress, or any future Congress, is free to make further changes. The extension of the $5,000,000 lifetime exemption for gift taxes, as well as estate and GST taxes, is good news, however, for those who started the donative process too late to complete their transfers by year-end. Many were concerned that the permanent lifetime gift tax exemption would be set at a lower amount; however, the Act keeps it unified with the estate and GST tax exemptions. Phase-out of Itemized Deductions and Personal Exemptions. The gradual phase-out of itemized deductions for high income taxpayers returns to the law in 2013 as previously scheduled. The level at which the phase-out begins, however, has been increased from previous levels. A married couple filing a joint return will lose an amount of itemized deductions equal to 3% of the excess of their adjusted gross income over $300,000 ($250,000 for unmarried individuals, $150,000 for married individuals filing separately and $275,000 for heads of household). These amounts are indexed for inflation. A maximum of 80% of a taxpayer's itemized deductions is subject to the phase-out and the phase-out does not apply to estates and trusts. The phase-out will add a little more than one percentage point to the effective income tax rate for many taxpayers. The itemized deduction phase-out did not apply for tax years 2010, 2011 and 2012. For tax years 2009 and before, the phase-out began at $100,000 of adjusted gross income, adjusted for inflation. The phase-out applies to all itemized deductions except for medical expenses, investment interest, the deduction for casualty or theft losses and the deduction permitted for wagering losses. The deduction for personal exemptions will also be phased out beginning at the same threshold amounts. Alternative Minimum Tax. The debate that has gone on each year about patching the alternative minimum tax so that it does not apply to middle income taxpayers will finally come to an end as the Act establishes inflation indexing for the threshold at which the tax applies. The threshold for 2012 will be $78,750 for married couples filing a joint return ($50,600 for unmarried individuals and $39,375 for married individuals filing separately). There is no change to the alternative minimum tax imposed on corporations, estates and trusts. S Corporation Built-in Gain Tax. The Act continues through 2012 and 2013 a reduced period of five years over which an S corporation that was previously treated as a C corporation is subject to income tax on gains in its assets that were "built-in" as of the time the corporation's election to be treated as an S corporation became effective. After 2013, the recognition period will revert to 10 years absent further legislation. S Corporation Charitable Contribution of Appreciated Property. The Act continues for 2012 and 2013 a special provision that allows an S corporation to pass through to its shareholders a charitable contribution deduction for the fair market value of contributed capital assets, even if the shareholder's tax basis in his stock is less than the amount of the contribution. Exclusion of Gain on Qualified Small Business Stock. The Act extends the exclusion for 100% of the gain recognized upon the sale of qualified small business stock to such stock acquired before January 1, 2014. Qualified small business stock is stock of a C corporation that has not more than $50,000,000 in gross assets and engages in an active business. The stock must be acquired at its original issuance and be held for at least five years. The maximum amount of gain that can be excluded is the greater of ten times the taxpayer's basis in the stock or $10,000,000. Bonus Depreciation. The Act extends the special first-year depreciation of 50% for new tangible personal property placed in service during 2013. Expensing of Film and Television Production Costs. The provision allowing the first $15,000,000 of the cost of producing a qualified film or television program to be deducted rather than capitalized has been extended through tax years 2012 and 2013. Extension of Increased Expensing of Certain Capital Assets. The Act extends the expensing provisions for certain capital assets that were in effect for 2010 and 2011 through 2012 and 2013. A taxpayer may elect to expense, rather than capitalize and depreciate, the cost of certain tangible personal property with a cost up to $500,000. This ability to expense the cost of newly acquired assets will phase out if the taxpayer acquires more than $2,000,000 of such property. Other Provisions. The Act also extends a variety of business and other tax credits. We have published a separate newsletter of the various energy related tax credits provided for by the Act. We will be happy to provide you with information on other specific credits upon request. What the Act Did Not Do. A number of provisions that have been discussed as revenue raising alternatives and were of concern to many high income taxpayers are not contained in the Act. The Act does not restrict the deduction for the fair market value of capital assets donated to charity, apart from the overall itemized deduction phase-out. While the phase-out of itemized deductions did return to the law, no absolute ceiling amount on deductions was imposed. The Act also did not impose a 10-year minimum term on Grantor Retained Annuity Trusts ("GRATs"), nor did it impose any statutory limit on valuation discounts for intra-family transfers. A proposal to include trusts that are grantor trusts for income tax purposes in the gross estate of the grantor at death was also not included in the Act. Congress has also long debated a provision to tax as ordinary income, rather than capital gain, amounts received with respect to a profits interest in a partnership or limited liability company (often referred to as a "carried interest"). This provision is not part of the Act. The omission of these items from the Act does not mean these items will not be considered again. The Act was just the first step in a long process to control our national deficit. The automatic spending cuts scheduled to take effect on January 1st were postponed for only two months and the debt ceiling must be addressed. The President and many in Congress believe that we still need more revenue, along with spending cuts, to manage the deficit effectively. While the watershed issue of tax rates has probably been resolved for the foreseeable future, any number of other provisions that would increase tax revenue are still very much on the table. Please contact us if you have any questions about the Act.

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Payment For Depression and Anxiety Includible In Income. The petitioner, a waiter at a seafood restaurant, was diagnosed with attention deficit disorder along with a depressive disorder. Upon being fired from his job, the petitioner sued and received a $35,000 settlement. $5,000 of the $35,000 was designated as lost wages which are taxable as compensation, and the remaining $30,000 was designated as payment for "pain and suffering and emotional distress." The IRS took the position that the $30,000 should also be included in income because it was paid to compensate the petitioner for the personal effects on him of being terminated and not because of any personal injury or physical sickness (as required for exclusion under I.R.C. Sec. 104). The court agreed with the IRS position because the origin of the claim indicated that the payment was made to compensate for the anxiety and depression he sustained as a result of being terminated. The payments were not made on account of any personal injury or physical sickness. Smith v. Comr., T.C. Sum. Op. 2014-93. Lawyer Advice Results in Multi-Million Dollar Gift Tax Liability. This case involved the merger of two corporations, one owned by the parents and one owned by a son. The parents' S corporation developed and manufactured a machine that the son had invented. The son did not patent the invention, and the parents' corporation claimed the research and development credits associated with the machine. The sons' corporation sold the machine (liquid dispenser) to various users, but the intellectual property rights associated with the machine were never formally received. The two corporations were merged for estate planning purposes, with the parents' receiving less stock value than their asset ownership value. The lawyers involved in structuring the transaction "postulated" a technology transfer for significant value from the son to the parents that had occurred in 1987. The transfer was postulated because there were no documents concerning the alleged transaction executed in 1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that no technology transfer had occurred and that the merger resulted in a gift from the parents to the son of $29.6 million for which no gift tax return had been filed and no taxes paid. The Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million. No penalties were imposed on the taxpayers. Cavallaro v. Comr., T.C. Memo. 2014-189. Court Allows 45 Percent Discount For Fractional Interest. The decedent owned fractional interests in artwork at the time of death that had been placed in a grantor-retained interest trust (GRIT), but had signed an agreement waiving his right to file a partition action. The decedent survived the 10-year term of the GRIT with the decedent's undivided interest passing equally to the decedent's three children with each child receiving a 16.67 percent interest in the artwork. The decedent's spouse died before the end of the GRIT with her undivided 50 percent interest in the artwork passing to the decedent. However, the decedent disclaimed a sufficient amount of interest in the artwork to optimize the use of the unified credit so as to pass the disclaimed portion to his children without estate tax. The decedent then entered into an agreement with the children giving up his right to partition. The waiver of his right was disregarded for valuation purposes under I.R.C. Sec. 2703(a)(2) - the provision that states that property value is to be determined without regard to any restriction on the right to sell or use property. In addition, the Tax Court held that the exception from I.R.C. Sec. 2703(a)(2) contained in I.R.C. Sec. 2703(b) did not apply. The Tax Court applied a 10 percent discount to the pro-rata value of the artwork due to uncertainties concerning their value associated with childrens' intentions concerning the artwork. On appeal, the court held that a 45 percent discount should apply because the IRS provided no evidence as to any discount, simply arguing that no discount should apply. Conversely, the court noted that the estate provided substantial evidence on the discount issue. Thus, when the Tax Court rejected the IRS position of no discount, the Tax Court should have accepted the estate's evidence that IRS failed to contradict. Estate of Elkins v. Comr., No. 13-60472, 2014 U.S. App. LEXIS 17882 (5th Cir. Sept. 15, 2014), rev'g., 140 T.C. 86 (2013). Partial Income Inclusion For Damage Award Stemming From Bad Tax Advice. The petitioners, a married couple, had a disabled child that they attempted to provide for via income-producing real estate. The petitioners engaged in multiple I.R.C. Sec. 1031 exchanges that ultimately, and upon their tax advisor's advice, turned into an abusive tax shelter. They received $375,000 in settlement of their claims of a lawsuit against their accountants and claimed the sum was not taxable as a return of capital. In essence, the petitioners claimed that the award represented compensatory damages for losses they suffered due to accountant negligence with respect to the disposition of their real property. The IRS claimed the amount was fully includible in income as damages for lost profits. The Court noted that generally such awards represent a return of capital that is not includible in the taxpayer's income. Under the facts of the case, the petitioners claimed amounts exceeding what they could prove was lost. Thus, some portion of the $375,000 award will be includible in income and some will be a non-taxable return of capital. Cosentino v. Comr., T.C. Memo. 2014-186. No Long-Term Homeowner Credit For Acquisition of Interest of Former Spouse. The petitioner and his wife were divorced in 2010 and, as part of the settlement, the petitioner's former wife quitclaimed her 50 percent interest in the former marital home to the petitioner. The petitioner claimed a long-term homeowner credit on his 2010 return and the IRS denied the credit because he had not "purchased" the home as defined by I.R.C. Sec. 36(c)(3). The court agreed. The transfer of the interest in the home was incident to a divorce and the petitioner received a carry-over basis in the home as to that interest which is a prohibited manner in which a home can be acquired and qualify for the credit. Sullivan v. Comr., T.C. Sum. Op. 2014-89. Settlement Payment Included In Income. The petitioner was diagnosed with a degenerative disease that ultimately prevented him from working. He had a disability policy through his employer and received short-term disability benefits for the last few months of his employment. He later applied for long-term disability benefits, but was denied because the insurance company determined that he wasn't totally disabled. The petitioner sued and obtained a settlement amount of $65,000 that would be reported as long-term disability benefits. The petitioner claimed that the amount was excluded from income under I.R.C. Sec. 104(a)(2) as payment for physical illness, and would also be excludible under I.R.C. Sec. 104(a)(1) as a worker's compensation payment. The IRS disagreed and the court upheld the IRS determination. The amount was not paid for any claim of physical injury or sickness, but for a failure to pay disability benefits that the company had contracted to pay. The court also noted that under California law a settlement had to be approved by the CA Workers' Compensation Appeals Board, and that the petitioner had not submitted the payment for approval. The court also noted that the amount was paid for sickness on a disability policy that the employer paid for where the premiums were not included in the petitioner's income. As such, the amount as included in the petitioner's income. Ktsanes v. Comr., T.C. Sum. Op. 2014-85. No Deduction For Bonus Paid To Sole Shareholder. In this case, a personal service C corporation paid an $815,000 bonus to its sole shareholder and attempted to deduct the amount. The corporation paid the amount in an attempt remove corporate profit and the corporation reported zero taxable income for the year in issue by virtue of the deduction for the bonus paid. The IRS disallowed the deduction on the basis that the corporate bank account only contained $288,000 at the time the bonus was paid and that the deduction is only allowed when sufficient funds are available to pay the amount. The Tax Court upheld the IRS position on the basis that the amount of the payment cannot be treated as a distribution when the account has insufficient funds to honor the check. Thus, the deduction was disallowed. The court also noted that the sole shareholder's wife kept the corporate books and records and wrote the check at issue thereby subjecting the transaction to "special scrutiny." Vanney Associates, Inc. v. Comr., T.C. Memo. 2014-184. No Deduction For Farmhouse-Related Expenses. The taxpayer was an architect that used a bonus that he received from his architectural firm in 1975 to buy 420 acres of farmland and an old run-down farmhouse. The taxpayer continued to live in town until 2010. From time-to-time, he farmed the tillable ground and rented the pasture ground to neighboring farmers for cash rent. For the tax years at issue, the taxpayer reported substantial losses as a result of deducting expenses related to the farmhouse in addition to expenses related to the farm ground. The IRS denied the deductions related to the farmhouse. The farmhouse had never been rented out for cash and family members occasionally lived in the house over the years in exchange for improvements made to the house. The Tax Court, ruling for the IRS held that the farmhouse-related deductions were not allowed either under I.R.C. Sec. 212 or Sec. 162 because the taxpayer failed to present evidence that he incurred claimed expenses and because the taxpayer failed to establish the existence of a real estate rental business. In addition, the Tax Court determined that the taxpayer had failed to establish that the farmhouse was held for the production of income. On appeal, the court affirmed. The appellate court noted that the taxpayer had not established a profit motive for any alleged farmhouse rental business and did not establish that he ever treated the farmhouse as part of the farm ground (which did involve a business activity). The appellate court also held that the farmhouse was not property held for the production of income. Meinhardt v. Comr., No. 13-2924, 2014 U.S. App. LEXIS 17455 (8th Cir. Sept. 10, 2014), aff'g., T.C. Memo. 2013-85 Partners have No Basis in Unsecured Notes Contributed To LLC Taxed As Partnership. The petitioner and his company were members of an LLC taxed as a partnership. The partnership experienced financial issues and the petitioner's company inquired of their attorney whether they could contribute promissory notes to the LLC. The attorney advised the petitioner that the notes would provide basis to the petitioner equal to the face value of the notes. Based on that advice, the petitioner contributed unsecured promissory notes without any assumption of the LLC's debt. The notes contained incorrect dates and incorrect values as to amounts payable. The court held that the petitioner's basis in the notes was zero. There was no evidence that the petitioner was personally obligated to contribute any fixed amount for a specific, preexisting LLC liability. No accuracy-related penalty was imposed. VisionMonitor Software, LLC v. Comr., T.C. Memo. 2014-182. Class of Delivery Drivers Determined To Be Employees For Tax Purposes. This case involves a class of about 2,300 persons that drive full-time for FedEx delivering packages. The claimed that they should be classified as "employees" and not as independent contractors for tax purposes and for purposes of the federal Family and Medical Lease Act (FMLA). The trial court determined that the drivers were independent contractors for tax purposes, and the parties settled on the FMLA issue. On appeal, the court determined that the drivers were employees based on their relationship with FedEx - FedEx controlled the drivers' appearance, the vehicles that they drove, the time of work and how and when packages were received and moved. Alexander v. FedEx Ground Package System, Inc., No. 12-17458, 2014 U.S. App. LEXIS 16585 (9th Cir. Aug. 27, 2014). IRA Contribution Limits Are Constitutional And Airline Award Points Are Taxable In this case, the petitioner claimed that the statutory limits on deductibility of IRA contributions were unconstitutional. The court disagreed, and held that no deduction was allowed for IRA contributions because the petitioner's wife was an active participant in her employer's sponsored retirement plan and the couples combined MAGI was greater than the phaseout ceiling. While the petitioner claimed that he never received airline "thank you" reward points, the court determined that the value had to be included in income. Shankar v. Comr., 143 T.C. No. 5 (2014). No Loving, Touching, Squeezing Means No Tax Exemption. Under I.R.C. Sec. 501(c)(7), a club organized substantially for pleasure, recreation or another nonprofitable purpose is tax-exempt if no part of the club's earnings inures to the benefit of a private shareholder. It's under this provision that social clubs (including sororities and fraternities) are tax-exempt. However, IRS has ruled that an "online sorority" does not qualify to be tax-exempt under the provision. The IRS said face-to-face interaction was required to achieve tax exemption under the statute. The sorority did not have any fixed facility where members could meet, and the lack of spending funds for social or recreational purposes was crucial. IRS said that the face-to-face annual meeting wasn't enough because is was an organizational meeting rather than a social meeting. Under Rev. Rul. 58-589, commingling of members must be a material part of the organization for the organization to be tax exempt. In addition, the social organization must simply provide personal growth or other benefits to members - it must focus on social and recreational activities. Priv. Ltr. Rul. 201434022 (May 29, 2014). S Corporation Losses Only Deductible To Extent of Basis. The petitioners were a married couple where the lawyer-wife had died and the husband was an eye doctor. The husband was the sole shareholder of his S corporation, and both of them had been convicted of willful failure to filed federal income tax returns and were sentenced to prison followed by a supervised release and a fine. They hired a firm to perform forensic accounting to determine the correct tax liabilities for the years they failed to file returns and deducted the payment to the firm as legal and professional services on Schedule C. They also deposited funds into the S corporation bank account, claiming that the deposits were loans that increased basis. The court, agreeing with the IRS, denied any basis increase in the S corporate stock because the petitioners did not establish that the deposits were loans. But, the court upheld the invoices for forensic accounting services. Hall v. Comr., T.C. Memo. 2014-171. Taxation of Frequent Flyer Miles. In Announcement 2002-18, the IRS took the position that frequent flyer miles that an are awarded to a taxpayer in exchange for purchases are only taxable if they are converted to cash, or are changed to compensation paid in the form of travel or other promotional benefits (or in situations where such benefits are used for tax avoidance purposes). In this case, the Tax Court held that the receipt of points that a bank issued to the petitioner which were then redeemed to buy a plane ticket were includible in income. The court pointed out that the points were a non-cash award for the petitioner opening a bank account with the bank and were really in the nature of interest or money and that Notice 2002-18 didn't apply. Shankar, et al. v Comr., 143 T.C. No. 5 (2014). Tax Credit Available to Offset Taxes Paid To Foreign Country. The Internal Revenue Code (Code) taxes the income of a U.S. taxpayer that is earned in a foreign country. That foreign country also taxes the same income. However, the Code allows many taxpayers to either deduct the foreign taxes from gross income for U.S. tax purposes or claim a credit capped at the lesser of the proportion of U.S. tax of the taxpayer's taxable income from foreign sources or the taxpayer's entire taxable income as it bears to the taxpayer's taxable income. In 2013, the U.S. Supreme court held that foreign paid taxes are creditable under I.R.C. Sec. 901. The court, affirming the Tax Court, has followed the Supreme Court's guidance. PPL Corporation and Subsidiaries v. Comr., No. 11-1069, 2014 U.S. App. LEXIS 16479 (3d Cir. Aug. 26, 2014). First-Time Homebuyer Tax Credit Allowed Because Trailer Was Not a Principal Residence. The petitioner had a house built in Wichita, Kansas and moved in to it in November of 2009. She had previously owned a different home in Wichita, but sold it in 2004 due to job issues and moved in with her daughter. In 2005, the petitioner resumed employment with her prior employer with her post of duty considered to by in California. In 2007, the petitioner bought a membership in an R.V. park in California and purchased a fifth-wheel (trailer) that was placed on a lot in the R.V. park. She lived in the trailer while working in California. On her 2009 return, the petitioner claimed a first-time homebuyer tax credit and IRS denied the credit due to the petitioner's ownership interest in and use of the trailer. The IRS also imposed an accuracy-related penalty. However, the court determined that the trailer did not meet the definition of "principal residence" under I.R.C. Sec. 36(c)(2) because the trailer was not "affixed" to the land under state (CA) law and, thus, did not meet the requirement of being a fixture under local law contained in Treas. Reg. Sec. 1.121-1(b)(1) (which governs for purposes of I.R.C. Sec. 36). Accordingly, the court allowed the first-time homebuyer tax credit. Oxford v. Comr., T.C. Sum. Op. 2014-80. Real Estate Professional Requirements Not Met. In this case, the petitioner had various real estate activities in addition to his day job. He produced spreadsheets of his time spent in the real estate activities involving single-family homes, but did not produce any contemporaneous log or calendar. The spreadsheets were created after-the-fact. The court also determined that the spreadsheet data was excessive, duplicative and counterfactual. The court determined that the petitioner was not a real estate professional and that losses associated with the real estate activities were not deductible. The court also imposed a 20 percent accuracy-related penalty. Graham v. Comr., T.C. Sum. Op. 2014-79. Lack of Profit Motive Bars Loss Deduction. The petitioner invested in three partnerships that were created to provide investors with charitable deductions from investments in cemetery plots that were held for over one year and then contributed to charity. The partnerships failed to hold the plots for longer than a year, but reported that the investors could claim charitable contribution deductions for more than the appraised values, as opposed to basis. The partnerships also had no income or expense for the tax years at issue other than the charitable deductions. The petitioner claimed a loss on his investments based on the partnership interests being worthless at year-end. IRS denied the losses on the basis that the petitioner's investment lacked profit intent. The court agreed with the IRS and that profit intent was clearly lacking. The partnerships, the court noted, were not created to realize any income or make a profit. Just because the Congress allows a deduction for a charitable contribution does not mean that a loss incurred in generating a charitable deduction should be allowed. The charitable contributions were allowed. McElroy v. Comr., T.C. Memo. 2014-163. Pass-Through Loss Allowed Under Facts and Circumstances Test. The petitioner founded a company of which he turned over day-to-day management to his son and moved to Florida (from company headquarters in Louisiana). When the business started to fail, he visited the business more often and increased his efforts on research and development, even inventing a new products and securing a new line of credit. The business carried in excess of a $3 million loss from 2008 to a prior year and received a refund of approximately $1 million. IRS denied the loss on audit on the basis that the petitioner was passive. The petitioner claimed that he spent more than 100 hours in the business during the tax year at issue and that his involvement for those hours was regular, continuous and substantial. The court agreed with the petitioner, based on all of the facts and circumstances, that he was materially participating for purposes of the passive loss rules. The court noted that. The court did not require the petitioner to produce a log book or calendar recording his participation. Wade v. Comr., T.C. Memo. 2014-169. Rental Loss Disallowed On Home. Here, the petitioner was a merchant marine that spent much time away from home and rented his home to a friend. The rental amount was below fair market rental value, and the friend only paid for one month. The petitioner did not attempt to collect the unpaid rent amounts. The petitioner claimed a deduction for rental losses which IRS denied on the basis that the petitioner could not prove that he rented the home at market value and made no attempt to collect unpaid rent. The court upheld the IRS position, noting additionally that the petitioner could not establish his time spent away from home and not at sea. Hunter v. Comr., T.C. Memo. 2014-164 Bank Is Immediately Liable For Funds in Bank Account When Getting Notice of IRS Levy. This case points out that the interest of the IRS in a delinquent taxpayer's bank accounts vests immediately on issuance of a levy and the property subject to levy must be immediately surrendered. If not, the bank is personally liable for the depositor's tax bill. Here, the taxpayer had an AGI of $21,594 in 2008 but received a tax refund of $78,169 in 2009 attributable to the 2008 tax year. Instead of notifying the IRS of the obvious error, the taxpayer deposited the funds with the defendant, the taxpayer's bank. The defendant also did not inform the bank that he was not actually entitled to the funds and that the source of the funds was an obvious IRS error. An IRS revenue officer assigned to the matter went to the taxpayer's home with a jeopardy levy in hand at 9:30 a.m. on Sept. 9, 2009, and notified the taxpayer that he owed roughly $93,000. The revenue officer demanded payment, but the taxpayer did not pay the deficiency at that time. The IRS revenue officer served the taxpayer with the IRS notice to levy his bank accounts. Ten minutes later, the IRS revenue officer served the jeopardy levy on the defendant. Less than two hours later, the taxpayer withdrew all of the funds in one of his bank accounts with the defendant, and left less than $8,000 in a different account, which was turned over to the IRS. Two days later, the defendant froze the bank accounts. The IRS sought the balance of the taxpayer's tax liability from the defendant. The court noted that, for a jeopardy levy, IRS need only provide the taxpayer with notice and demand for immediate payment under I.R.C. Sec. 6331 before imposing the levy. IRS properly followed that procedure and could then levy immediately. The defendant claimed that it acted reasonably within two hours of receiving the IRS levy and should not be held personally liable for the withdrawn funds. The court disagreed, noting that I.R.C. Sec. 6332 (the liability provision) does not contain any reasonability requirement. In addition, the court noted that the government's interest vested immediately upon notifying the bank of the levy and the bank was immediately responsible for preserving the taxpayer's bank accounts for the IRS. The court also noted that I.R.C. Sec. 6332 contained a reasonability requirement only with respect to an additional 50 percent penalty which could make the defendant liable for 150 percent of the levied property. United States v. JPMorgan Chase Bank NA, CV 13-3291 GAF (RZx), 2014 U.S. Dist. LEXIS 113896 (C.D. Cal. Aug. 15, 2014). ATV Not Tax Exempt For Lack of Being Used Predominantly In Ag Production Activities. The petitioner, an elderly Iowa farmer, purchased an ATV to use on his farm. He paid $439.12 in sales tax and sought a refund on the basis that the ATV was exempt from sales tax as farm machinery and equipment. Iowa Code Sec. 423.1(18) defined "farm machinery and equipment" as equipment used in ag production and exempts it from sales tax if it is directly and primarily used in the production of agricultural products. The petitioner testified that he used the ATV 25 percent of the time to carry salt and minerals to livestock, 15 percent to carry corn to feed livestock, 25 percent to check cows and calves, 25% to check fence and 10% to check his crops and hay field. The Iowa Department of Revenue (IDOR) denied the exemption on the basis that only 40 percent of the petitioner's use of the ATV was in direct ag production activities (25 percent to carry salt and minerals to livestock and 15 percent to carry corn to feed livestock) and that the predominant use of the ATV was therefore not in direct ag production activities. In re Phillips, No. 14DORFC005 (Iowa Dept. of Inspection and Appeals Proposed Decision (Aug. 13, 2014). Claimed Charitable Deduction of Donated Remainder Interest At Issue. In this case, the petitioner claimed a $33 million charitable deduction of a remainder interest in the membership interests of an LLC. The LLC was the landlord of property that was subject to a triple net lease. At issue was the value of the remainder interest and the application of the IRS tables contained in I.R.C. Sec. 7520. The court determined that the contribution of the remainder interest (to the University of Mich.) resulted in a deduction that far exceeded the partnership's investment. After the contribution, the University sold the remainder interest to another entity then resold it and the last purchaser then contributed it to another charity which again triggered a charitable deduction that exceeded the entity's or the donor's investment. The court denied summary judgment, noting that the entire scheme suggested a tax shelter. On whether the appraisal of the remainder interest was a qualified appraisal, the court determined that the appraisal barely satisfied the requirements of I.R.C. Sec. 170. RERI Holdings I, LLC v. Comr., 143 T.C. No. 3 (2014); Zarlengo v. Comr., T.C. Memo. 2014-161. Another Property Settlement That Failed To Qualify As Deductible Alimony. In yet another case, the court held that a property settlement arising in the divorce context was not deductible alimony. Here, the amount of the settlement, $63,500, was established by the divorce court as a property settlement. Peery v. Comr., T.C. Memo. 2014-151. Permanent Conservation Easement Largely Upheld. The petitioners, a married couple, bought a 40-acre tract within the Pike's Peak viewshed. They also owned another adjacent 60 acres and sought to plat both tracts as a subdivision with a 2.5 acre size limitation per lot. Before platting the property, the petitioners granted a conservation easement on the 40-acre parcel with a development size restriction of one lot of 40 acres. The pre-easement value as established by the petitioners' appraiser was $1.6 million and the post-easement value was $400,000. The IRS originally disallowed the entire deduction due to a failure to satisfy I.R.C. Sec. 170, but later conceded that the Code requirements were satisfied and then challenged the appraised values. The Tax Court determined that the petitioners' appraised values were closer to what the court determined were most accurate. The result was that the petitioners were entitled to a charitable deduction of over $1.1 million and no penalties or interest. Schmidt v. Comr., T.C. Memo. 2014-159. Taxpayer Did Not Materially Participate in Airplane Activity. The petitioner operated a business in which he trained telephone representatives and also he also practiced law. He also conducted an airplane rental activity which the court found was unrelated to the telephone activity. The court, agreeing with the IRS, disallowed the flying deductions against the income from the telephone business activity. The petitioner also failed to establish that he had devoted sufficient hours to the airplane activity to satisfy the material participation tests under the passive loss rules - either the 500-hour test or the 100-hour test. The court noted that the petitioner had failed to keep records of the time spent on the airplane activity. The court also upheld the IRS-imposed negligence penalty and underreporting penalty. Williams v. Comr., T.C. Memo. 2014-158. Office In The Home Generates Some Deductions. The petitioner lived in NYC and worked for a business that was headquartered in L.A. The petitioner worked from her apartment at the employer's request, and divided her studio apartment into thirds with one-third used for business. During 2009, the tax year at issue, the petitioner paid for a cleaning service, cable, telephone and internet access, clothing for the employer, and a cell phone for business use. The IRS disallowed all of the associated deductions that were claimed as unreimbursed employee business expenses. However, the Tax Court allowed a deduction for one-third of the petitioner's apartment rent and cleaning service charges. The Tax Court also deductions for telephone and 70 percent of the internet cost. As for electricity charges, the petitioner's records were insufficient to allow a deduction for any amount. Cell phone charges were not deductible due to lack of substantiation required (cell phones were listed property in 2009 and subject to strict substantiation rules which were removed by the SMJA of 2010). The Tax Court did not allow any deduction for clothing expenses because the petitioner admitted that the purchased clothing were also suitable for personal wear. Miller v. Comr., T.C. Sum. Op. 2014-74. Divorce-Related Payments By Virtue of Property Settlement Not Deductible. This case points out, again, that payments in a divorce by means of a property settlement are not deductible. Here, the petitioner signed a separation agreement that was incorporated into a divorce decree. The agreement awarded the petitioner's ex-wife $65,000 to be paid within 30 days of the execution of the agreement. The petitioner deducted the $65,000 as alimony. Under I.R.C. Sec. 71(b)(1)(B), such payments are generally not deductible. The court disallowed the deduction the imposed a 20 percent substantial understatement penalty. Also, numerous scrivenor errors in separation agreement. Peery v. Comr., T.C. Memo. 2014-151. Taxpayer Not Engaged In Cattle Business With Profit Intent. The petitioner was a full time insurance professional and also engaged in various real estate ventures from his home base in North Carolina. He got involved in cattle breeding with an individual located (at least part of the time) in Indiana. The cattle breeding venture resulted in numerous breached contracts, unpaid bills and promissory notes and unregistered genetic lines of cattle. The cattle breeding business was not operated in a business-like manner. In addition, the cattle breeding venture showed four consecutive years of losses while he was showing a substantial increase in income from this insurance and real estate businesses. The court determined that IRS prevailed under the I.R.C. Sec. 183 tests and petitioner's cattle breeding venture was deemed to be conducted without a profit intent. Gardner v. Comr., T.C. Memo. 148. Businesses Were Separate and Distinct and Could Use Different Accounting Methods. A corporation's former subsidiary business converted to an LLC with the corporation as it's sole member and the IRS determined that the businesses were separate and distinct trades or businesses under I.R.C. Sec. 446(d) because they were engaged in different activities, had separate books, separate records, were not located near each other and did not share employees except for top-end executives. Thus, the businesses could use different accounting methods for each of the different businesses. There was not creation or sharing of profits and losses between the businesses, and income of the businesses was clearly reflected. This was the case even though the LLC did not elect to be taxed as a corporation and, as a result, was a treated for tax purposes as a division of the corporation. C.C.A. 201430013 (Mar. 24, 2014). State Law Does Not Control For Purposes of Adoption Credit. The taxpayers adopted a child of mixed ancestry and claimed the I.R.C. Sec. 23(b) credit for associated expenses because the child was not likely to be adopted due to mixed parentage. To get the credit, the state must make a determination that the child is a special needs child. The taxpayers claimed that state law specifies that a special needs child is one not likely to be adopted because the child is black or of mixed parentage, and that the statute constituted a determination. The court held that the statute did not constitute a determination because no individualized decision with respect to the child had been made. Lahmeyer v. United States, No. 13-23288-CIV-ALTONAGA/O'Sullivan, 2014 U.S. Dist. LEXIS 114896 (S.D. Fla. Jul. 25, 2014). Gambling Activity Did Not Rise To Trade or Business Level. The plaintiff was a Mexican citizen and nonresident of the U.S. that brought a tax refund action exceeding $16 million. He claimed that he was engaged in the trade or business of slot machine gambling in Las Vegas and, as a result, his taxes should be based on his net income in accordance with I.R.C. Sec. 871(b) (nonresident alien is taxed on taxable income connected with trade or business conducted in the U.S.). The plaintiff had retired from a Mexican potato farming business in 2001 and began his "betting business" at that time, making numerous trips to Las Vegas annually. For the years at issue, the plaintiff reported a net loss in some years and profit in other years. On audit, IRS disallowed wagering costs due to lack of trade or business and issued deficiency notice and assessed tax at 30 percent rate pursuant to I.R.C. Sec. 871(a)(1). Court determined that test set forth in Comr. v. Groetzinger, 480 U.S. 23 (1987) was to be utilized in determining the existence of a trade or business, and that the test was not satisfied because the plaintiff did not engage in gambling activities on a basis that were continuous and regular. The court turned to the factors set forth in Treas. Reg. Sec. 1.183-2 to determine whether the plaintiff had the requisite profit intent to be deemed to be in the conduct of a trade or business and determined that: (1) he did not pursue his gambling activity for the purpose of making a profit; (2) he couldn't rely on advisors or gain expertise because playing slots is controlled by a random number generator with the outcome based on pure luck; (3) his time spent on the activity was sporadic and did not consume much of his personal time; (4) he had no expectation that the assets used in the activity would increase in value (because there were none); (5) he didn't participate in any other activities that would enhance his success in playing slot machines; (6) the history of income or loss from the activity was a neutral factor; (7) the amount of occasional profits slightly favored the plaintiff; (8) the taxpayer was very wealthy and didn't need income from slots to support himself, and; (9) there were substantial elements of personal pleasure. Thus, the plaintiff did not engage in playing slots with the required profit intent. The court upheld the IRS position. Free-Pacheco v. United States, No. 12-121T, 2014 U.S. Claims LEXIS 666 (Fed. Cl. Jun. 25, 2014). Another Horse Breeding and Training Activity Not Engaged in With Profit Intent. A married couple operated numerous Steak 'n Shake franchises, but later also began breeding and training Tennessee Walking Horses. After the husband died in a 2003 house fire, the surviving spouse became President of the corporation that ran the franchises and was very involved in the franchise businesses. The couple had purchased several hundred acres in TN for slightly under $1 million to operate their horse breeding and training activity. They ran up substantial losses from the horse activity which they attempted to deduct. The IRS denied the deductions and the surviving spouse paid the tax and sued for a refund. The court upheld the IRS determination. The court noted that under the multi-factor analysis the taxpayers (and later the widow) didn't substantially alter their methods or adopt new procedures to minimize losses, didn't get the advice of experts and continued to operated the activity while incurring the losses. The court noted that the losses existed long after the expected start-up phase would have expired. Profits were minimal in comparison and the taxpayers had substantial income from the franchises. Also, the court noted that the widow had success in other ventures, those ventures were unrelated to horse activities. Estate of Stuller v. United States, No. 11-3080, 2014 U.S. Dist. LEXIS 100617 (C.D. Ill. Jul. 24, 2014). Date of "Purchase" Is Key Date For FTHBTC Purposes On Existing Homes. The petitioner bought an existing home in January of 2009 that needed substantial repairs to make it habitable. The petitioner began using the house in May of 2009 after making over $10,000 of repairs. The petitioner claimed the First Time Homebuyer Tax Credit (FTHBTC) based on the purchase price plus the repair cost. IRS disallowed the part of the credit attributable to the repairs (note - the house was a low-cost home substantially less than the maximum credit allowed). While I.R.C. Sec. 36(c)(4) bases the credit on the "purchase price" of the home and defines that phrase as the "adjusted basis of the principal residence on the date the residence is purchased", the court determined that "purchase date" is normally the date when the taxpayer takes legal or equitable title with respect to existing housing. But, the phrase is the date occupancy is established for a constructed residence based on Woods v. Comr., 137 T.C. 159 (2011). Here, the court determined that the petitioner did not "construct" the house and that, therefore, the credit was to be computed with respect to the purchase price when he took title to the property and the IRS determination was upheld. Leslie v. Comr., T.C. Sum. Op. 2014-65. For A Residence Acquired From A 2010 Decedent Gain On Sale Can Be Excluded. For death's in 2010 an election could be made to opt-out of the federal estate tax. Such an election resulted in a modified carry over basis rule being applied to assets in the decedent's estate. Under I.R.C. Sec. 121(d)(11), property acquired from a decedent (or decedent's estate or trust) can take into account the decedent's ownership and use to determine eligibility for the gain exclusion rule. In this administrative ruling, the IRS determined that the I.R.C. Sec. 121(d)(11) provision is not repealed for 2010 deaths, but is repealed by P.L. 111-312 (the 2010 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010) for deaths before or after 2010. C.C.M. 201429022 (May 27, 2014). Self-Rental Rule Applicable With Result That Net Rental Income Not Passive. The petitioner had substantial income from non-real estate trades or businesses, but tried to qualify as a real estate professional so as to fully deduct substantial rental real estate losses. The petitioner, however, could not substantiate his activity. Two commercial rentals were profitable. The rentals were to two S corporations in which the petitioner was also the president and majority shareholder and an active participant. While the petitioner claimed that he did not provide any services to the S corporations, the petitioner had also claimed in another lawsuit brought by his children against him (who claimed that the petitioner didn't work enough in the S corporations to justify his large salary) that he was actively involved and was "creating" and "inventing" and was participating in the strategy and growth of the business. Because the petitioner had taken the position in the other litigation that he was active, the court determined that he was materially participating with the result that the net income from the self-rentals was recharacterized as non-passive. Schumann v. Comr., T.C. Memo. 2014-138. No Deduction For Kid Wages Because No Proof That They Provided Services. The petitioner did consulting and tax prep work out of her home. She filed a Schedule C on which she claimed deduction for home office expenses. She said that the percentage of the home used for businesses was 33 percent on Form 8829. She also paid small amounts of "wages" to three children for work in her business activities that were actually paid to them in the form of credit card purchases for meals and tutoring. On the percentage issue, the court noted that the petitioner simply took the basement as one of the three levels of her home and took 33 percent as the business use percentage. The court agreed with IRS and disallowed expenses associated with the home office due to lack of evidence on which the court could base an estimate of the space actually used for business use. On the deduction for wages, the court noted that two of the children were required to file (their income exceeded the standard deduction) had they not been minors, but that they were compensated for services that were actually household chores. Thus, no deduction for wages as business expenses was allowed. Ross v. Comr., T.C. Sum. Op. 2014-68. Excess Passive Losses Can Still Be Used Even If Gain Previously Excluded. Under the passive loss rules, in a fully taxable transaction, if all of the gain or loss on the disposition of an activity is realized, then the excess of any loss from that activity over any net income or gain from all other passive activities is treated as a non-passive loss. Here, IRS reached the conclusion that the use of I.R.C. Sec. 121 does not mean that a transaction is not a "fully taxable transaction." For instance, if a taxpayer sells a rental property that used to be the taxpayer's principal residence, the possibility exists that when the property is sold that the gain on sale could at least be partially offset by the gain exclusion of I.R.C. Sec. 121 (if the use and occupancy requirements are satisfied). If the rental activity has unused passive losses, the I.R.C. Sec. 121 exclusion does not bar the ability to release the excess losses under I.R.C. Sec. 469(g)(1). C.C.A. 201428008 (Apr. 21, 2014). Bad Debt Deduction Not Allowed. The petitioner operated a consulting business and upon rehiring a former employee gave the employee $33,000 to help him through some tough times. The petitioner stated to the employee that it was a loan, but no note or contract was executed. The employee did not pay back the amount and the petitioner claimed a business bad debt deduction on his return. The petitioner also sued the employee and the case was resolved two years after the tax year in issue when the deduction was claimed. The evidence was devoid of any indication of either a business or non-business bad debt. Court noted that even if the evidence had established that the loan was a bona fide debt, the petitioner would not have been able to establish that the bad debt was a business bad debt. In addition, even if the debt was found to be a business debt, the petitioner would have failed to establish that the debt became worthless in the year in issue. Dickenson v. Comr., T.C. Memo. 2014-136. No Mortgage Interest Deduction For Rental Property Because No Proof Rental Business Commenced. Under I.R.C. Sec. 163(h), acquisition debt and home equity debt is deductible with the total of the two together not to exceed $1.1 million. Here, the petitioner purchased a California residence in 2004 and resided in it with his wife and children. He moved out in 2006 while his wife and children continued to reside in the home through 2012. The couple was divorced in 2008. In 2005, however, the petitioner and wife purchased another home with the intent of renting it out for weekly vacations and similar events. However, the petitioner and spouse weren't able to rent the property out due to substantial repairs that needed to be done in advance of renting the property. The petitioner lived in the second home while not traveling for work. On their joint return, the petitioner deducted amounts for mortgage interest with respect to the second home. IRS disallowed the deduction and the court agreed. The property was not a rental property and the petitioner continued to reside in the property. While mortgage interest was deducted on the aggregate loan exceeded $1.1 million, the court disallowed the excess amount attributable to the second home and noted that had the parties (who were divorced during the years in issue) each paid interest expense, each of them would have been able to deduct up to $1.1 million in qualifying debt. Hume v. Comr., T.C. Memo. 2014-135. When IRS Requires Electronic Depositing of Taxes, Depositing Non-Electronically Results in Penalties. The plaintiff is a fiduciary of pension plans, IRAs and employee benefit plans for which it is responsible for withholding federal income taxes. The plaintiff timely and fully deposited all withheld income taxes, but didn't do so electronically as required by IRS regulations when the deposit exceeds $200,000. IRS assessed failure-to-deposit penalties of over $250,000 by virtue of I.R.C. Sec. 6656(a). The court upheld the IRS position based on the plain language of the statute and the fact that the Congress had allowed a grace period from the electronic deposit rule at issue from July 1, 1997 to July 1, 1998, and that no grace period any longer applied. Commonwealth Bank and Trust Company v. United States, No. 3:13-CV-01204-CRS, 2014 U.S. Dist. LEXIS 91489 (W.D. Ky. Jul. 7, 2014). IRS Says That Status As Real Estate Professional Not Dependent on Aggregation Election. The taxpayer had multiple real estate rental activities and owned a real property business. While the taxpayer engaged in the rental activities for more than 750 hours during the tax year, the taxpayer did not participate in each rental activity for at least 750 hours and did not make an election via Treas. Reg. Sec. 1.469-9 to aggregate the activities into a single activity. The IRS had previously taken the position that a taxpayer, to qualify as a real estate professional, had to put in more than 750 hours in each activity. But, here, the IRS determined that whether a taxpayer is a real estate professional for purposes of the passive loss rules is not affected by an aggregation election. Hence, once a taxpayer qualifies as a real estate professional, the requirements for material participation are applied as to each separate activity absent an aggregation election. C.C.M. 201427016 (Apr. 28, 2014). To Deduct Vehicle Expenses, Only Logging Odometer Readings Is Not Enough. In this case, the the petitioner used his personal pickup truck to travel to his employer's customers. He recorded his odometer reading at the beginning and end of each month in his calendar book, but didn't record any personal travel that he made with his truck and didn't provide any other documentation related to his truck expenses. However, he claimed that he drove over 40,000 in business miles and claimed over $20,000 in vehicle expenses based on the standard mileage rate. The court upheld the disallowance of the deduction due to lack of substantiation. Garza v. Comr., T.C. Memo. 2014-121. You Have Mail From the IRS and You Cannot Deny It. This case points out that a taxpayer simply cannot refuse to check their mail and successfully claim that notice of a tax deficiency was not received from the IRS. Here, the IRS sent a notice of deficiency to the taxpayer on multiple occasions via certified mail, return receipt requested. Finally, the U.S.P.S. ceased attempting delivery and returned it to the IRS. The taxpayer claimed that he never got notice of the deficiency. However, the Tax Court found that the taxpayer was able to get his mail and had multiple opportunities to check and retrieve it, and held that he could not simply refuse to get his mail and claim that he didn't have notice of the deficiency. The court also determined that the taxpayer could not dispute the underlying tax deficiency related to the notice. Onyango v. Comr., 142 T.C. No. 24 (2014). Wife Was Independent Contractor, and Carryforward Losses Not Allowed. The petitioner, a lawyer, hired his wife to work with an eccentric client that she related well with. On their MFJ returns for the years in issue, the payments to the wife were reported as contract labor expense and also as gross receipts on Schedule C (subject to s.e. tax). IRS claimed that the wife was an employee and that payroll taxes should have been paid and disallowed the deduction for the s.e. taxes paid, and reclassified as wage income the amount reported as gross receipts on Schedule C. Based on all of the common-law factors, the court determined that she was an independent contractor and not an employee. The IRS also disallowed carryforward losses due to the petitioner's failure to establish the activity that generated the losses and the income in the carryforward years. Jones v. Comr., T.C. Memo. 2014-125. No Deductible Losses Attributable To House Not Held For Income Production Purposes In this case, the petitioners, a married couple, owned some rental properties. With respect to the property at issue, the couple had previously rented it. However, during the years at issue (2007 and 2008) they didn't receive any rent and engaged in only minor attempts to sell the property. The incurred a loss with respect to the property which they deducted. The IRS denied the deduction on the basis that the petitioners did not engage hold the house for the years at issue for the purpose of producing income and there was no for-profit activity with respect to the house for the years in issue. The court agreed with the IRS. Robinson v. Comr., T.C. Memo. 2014-120. Wife Not Estopped from Challenging Husband’s Alleged Divorce-Related Expenses Because She Signed Tax Return Claiming Same Expenses. In a divorce proceeding, the husband submitted expenses for reimbursement that he incurred in caring for cattle that he owned with his wife before their sale. The trial court awarded him only some of his requested expenses, and the husband appealed. On review, the court affirmed, finding that it was for the trial court to make determinations as to the credibility of the husband’s assertions. The court also declined to adopt a rule of quasi-estoppel and find that since the wife signed a tax return on which the same expenses were claimed by the husband, she should have been estopped from complaining as to the validity of the same expenses in the divorce action. Else v. Else, No. A-13-156, 2014 Neb. App. LEXIS 106 (Neb. Ct. App. Jun. 10, 2014). No Deduction For Exacted Conservation Easement Because No Proof Of Consideration. In this case from Colorado, the petitioner sought to develop an historic site into condominiums. The petitioner sought to build the condos in the parking lot for the historic building and preserve the historic building in order to get the city to modify existing zoning restrictions, but the city sought conservation easements in return. Petitioner valued easement at $7 million, but did not indicate on return that it had received anything in return for the easement. IRS claimed that filing and appraisal requirements were not satisfied with result that easement-related deduction was approximately $400,000. The court determined that the petitioner was not entitled to any deduction due to the lack of consideration for the easements at issue. Seventeen Seventy Sherman Street, LLC v. Comr., T.C. Memo 2014-124. Taxpayer’s Three-Acre Tract Properly Qualified for Both Homestead Exemption and Open-Space Land Valuation. A taxpayer owned three contiguous parcels of land: a three-acre tract, a one-acre tract, and a nine-acre tract. He lived in a home located on the one-acre tract. Before 2010, the taxpayer was granted by the appraisal district a valuation of the three-acre tract as open-space land for purposes of ad valorem taxes. In 2010 and 2011, the appraisal district denied the taxpayer’s application for a residence homestead exemption for the same three-acre tract. The trial court ruled in favor of the taxpayer in his challenge to the appraisal district’s decision, and the appraisal district appealed. On appeal, the court affirmed the trial court’s ruling, finding that a taxpayer is entitled to a homestead exemption for an entire parcel of property if the contiguous lots total less than 20 acres and they are used as a residence homestead. The court rejected the appraisal district’s argument that the homestead exemption was incompatible with the “agricultural use” requirement necessary for the open-space land valuation. Tex. Tax Code Ann. § 11.13(k) (which provided that the amount of any residence homestead exemption for a qualified residential structure did not apply to the value of that portion of the structure used for other purposes) did not apply to the case at hand because the statute applied only to residential structures, not land. No legal authority provided that land could not be used as a residence homestead and also for agricultural purposes. In fact, Tex. Tax Code Ann. § 23.55(i) did provide that a parcel of land qualifying for open-space valuation did not undergo a change of use when it was claimed as part of a residence homestead. Parker County Appraisal Dist. v. Francis, No. 02-13-00182-CV, 2014 Tex. App. LEXIS 6690 (Tex. Ct. App. Jun. 19, 2014). No Tax Deduction For Façade Easement. In this litigation that has generated multiple court opinions, the petitioner donated a façade conservation easement with respect to the petitioner's row house in an historic district in NYC. Under the terms of the easement, the petitioner could not alter the façade without the permission of the donee and the petitioner was required to maintain the façade and the balance of the row house. Under the existing rules of the historic district, the row house was already subject to substantial restrictions on construction and demolition. In the initial Tax Court decision (T.C. Memo. 2010-151), the Tax Court determined that the petitioner was not entitled to any deduction. On appeal, the U.S. Court of Appeals for the Second Circuit (682 F.3d 189 (2d Cir. 2012) upheld the charitable deduction of $59,959 because the petitioner's appraiser sufficiently explained how he arrived at valuation numbers before and after easement restriction. The court determined that it was irrelevant that the IRS believed that the method employed was "sloppy" or haphazardly applied because the pertinent regulation required only that the appraiser identify the valuation method that was used and did not require that the method be reliabale. The court held that the appraiser sufficiently supplied a basis for the valuation and the approach used was nearly identical to that approved in Simmons v. Comr., T.C. Memo. 2009-208. In addition, the appraisal provided the IRS with sufficient information to evaluate the claimed deduction. The petitioner submitted two Form 8283s when combined provided all of the required information and substantially complied with the requirement of the information required to be submitted. The court upheld the charitable deduction for the cash donation to the organization arranging for the donation of the easement (which was required as a condition of facade easement donation). However, no deduction was allowed for the easement itself because there was no benefit to the taxpayer other than the facilitation of the facade easement. However, the court remanded the case to the Tax Court to resolve other claims made by IRS. On remand, the Tax Court (T.C. Memo. 2013-18) held that the petitioner was not entitled to any deduction for the façade easement because the subject property was already subject to substantial restrictions and didn't have any value for purposes of the charitable contribution deduction. On further review, the appellate court affirmed. Scheidelman v. Comr., No. 13-2650, 2014 U.S. App. LEXIS 11941 (2d Cir. Jun. 18, 2014).

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FORM 10-K /A Amendment No. 1 [X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2011 [ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT For the transition period from _________ to ________ Galaxy Gaming, Inc. Nevada 20-8143439 (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 6980 O’Bannon Drive, (Address of principal executive offices) (Zip Code) Registrant’s telephone number: 702-939-3254 Securities registered under Section 12(b) of the Exchange Act: Title of each class Securities registered under Section 12(g) of the Exchange Act: Common Stock, par value $0.001 Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes [ ] No [X] Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes [ ] No [X] Indicate by checkmark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 232.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Yes [ ] No [X] Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. [ ] Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting company [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, or the average bid and asked price of such common equity, as of the last business day of the registrant’s second fiscal quarter was $3,605,028. Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 38,310,591 as of March 29, 2012. EXPLANATORY NOTE This Amendment No. 1 to the Annual Report on Form 10-K/A (the “Amendment”) amends the Annual Report on Form 10-K of Galaxy Gaming, Inc. (the “Company”) for the year ended December 31, 2011 (the “Original Filing”), that was originally filed with the U.S. Securities and Exchange Commission on April 16, 2012. The Amendment is being filed to submit Exhibit 101. The Amendment revises the exhibit index included as Exhibit 101 (XBRL interactive data) is included as an exhibit to the Amendment. The Amendment is also being filed to make certain minor amendments to the Annual Report. Except as described above, the Amendment does not modify or update the disclosures presented in, or exhibits to, the Original Filing in any way. Those sections of the Original Filing that are unaffected by the Amendment are not included herein. The Amendment continues to speak as of the date of the Original Filing. Furthermore, the Amendment does not reflect events occurring after the filing of the Original Filing. Accordingly, the Amendment should be read in conjunction with the Original Filing, as well as the Company’s other filings made with the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act subsequent to the filing of the Original Filing. ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2011 Item 1. Business 4 Item 1A. Risk Factors 11 Item 1B. Unresolved Staff Comments 11 Item 2. Properties 11 Item 3. Legal Proceedings 11 Item 4. Mine Safety Disclosures 11 Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities 11 Item 6. Selected Financial Data 13 Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 13 Item 7A. Quantitative and Qualitative Disclosures About Market Risk 15 Item 8. Financial Statements and Supplementary Data 15 Item 9. Changes In and Disagreements With Accountants on Accounting and Financial Disclosure 16 Item 9A(T). Controls and Procedures 16 Item 9B. Other Information 16 Item 10. Directors, Executive Officers and Corporate Governance 17 Item 11. Executive Compensation 19 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 21 Item 13. Certain Relationships and Related Transactions, and Director Independence 22 Item 14. Principal Accountant Fees and Services 22 Item 15. Exhibits, Financial Statement Schedules 22 SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain statements, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives, and expected operating results, and the assumptions upon which those statements are based, are “forward-looking statements”. These forward-looking statements generally are identified by the words “believes,” “project,” “expects,” “anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “will continue,” “will likely result,” and similar expressions. Forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. Our ability to predict results or the actual effect of future plans or strategies is inherently uncertain. Factors which could have a material adverse affect on our operations and future prospects on a consolidated basis include, but are not limited to: changes in economic conditions, legislative/regulatory changes, availability of capital, interest rates, competition, and generally accepted accounting principles. These risks and uncertainties should also be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. ITEM 1. BUSINESS Unless the context indicates otherwise, references to “Galaxy Gaming,” “we,” “us,” “our” or the “Company,” refers to Galaxy Gaming, Inc., a Nevada corporation, the company filing this report. “GGPVT” refers to a prior Galaxy Gaming, Inc., a privately held company that previously operated under the Galaxy Gaming moniker and was acquired by us. Further, unless indicated otherwise, the terms and titles, “chief executive officer,” “CEO,” “interim chief financial officer,” “interim CFO,” “chairman,” “chairman of the board” and “president” refers to Mr. Robert B. Saucier; “CFO” and “chief financial officer” refers to Mr. Andrew Zimmerman; “COO” refers to our “chief operating officer,” Mr. William O’Hara and “Board” refers to the Company’s board of directors. History and development of Galaxy Gaming. In 1997, our founder, Robert B. Saucier, was an investor in a small casino in Washington State that featured casino table games. During his tenure at this casino, Mr. Saucier invented a side bet for blackjack known as Horseshoe Blackjack. The side bet became very popular and the casino’s winnings from the games increased significantly. On October 7, 1997, Galaxy Gaming Corporation, a privately held Nevada corporation (“GGCORP”) was formed and Mr. Saucier exchanged all of his rights, title and interest in his invention for stock in GGCORP. Other casinos, recognizing the popularity and profitability of this side bet, requested intellectual property licenses to offer the Horseshoe Blackjack side bet at their casinos. GGCORP modified the invention, changed the name of the side bet to Lucky Ladies and filed for a method patent, which was later granted by the U.S. Patent and Trademark Office. In 2002, the business and assets of GGCORP were acquired by Galaxy Gaming, LLC, a Nevada limited liability company (“GGLLC”). GGLLC expanded its product line including the introduction of two popular casino table games known as “Texas Shootout” and “Emperor’s Challenge.” These new products, combined with an enlarged sales force and an expanded distribution network, attributed to GGLLC’s growth in subsequent years. In 2007, GGPVT acquired the assets and business operations of GGLLC. In February 2009, GGPVT executed a reverse merger with Secured Diversified Investment, Ltd., a publicly traded Nevada corporation (“SDI”) for the purpose of transferring GGPVT’s business into the publicly traded SDI shell corporation. With that transaction, GGPVT became a wholly-owned subsidiary of SDI and in September 2009, the two companies merged and the resulting entity was named “Galaxy Gaming, Inc.” See “Note 1 History of business entities” in “Item 8. Financial Statements and Supplementary Data” included in this Form 10-K. Description of the business. We are engaged in the business of designing, developing, manufacturing and/or acquiring proprietary casino table games and associated technology, platforms and systems for the global gaming industry. Beginning in 2011, we expanded our product line with the addition of fully automated table games, known as e-Tables and separately, we entered into agreements to license our content for use by internet gaming operators. Casinos use our proprietary products to enhance their gaming floor operations and improve their profitability, productivity and security, as well as offer popular cutting-edge gaming entertainment content and technology to their players. We market our products to land-based, riverboat and cruise ship gaming establishments and beginning in 2011, to internet gaming companies. The game concepts and the intellectual property associated with these games are typically protected by patents, trademarks and/or copyrights. We market our products primarily via our internal sales force to casinos throughout North America, the Caribbean, the British Isles, Europe, Australia and to cruise ships and internet gaming sites worldwide. We currently have an installed base of our products on over 2,500 gaming tables located in over 500 casinos, which positions us as the second largest provider of proprietary table games in the world. Revenues consist of primarily recurring royalties received from our clients for the licensing of our game content and other products. Typically over 90% of our total revenues are recurring. In 2011, recurring revenues represented 99.2% of our total revenues. These recurring revenues generally have few direct costs thereby generating high gross profit margins in excess of 90%. In lieu of reporting as “gross profit,” this amount would be comparable to “revenues less cost of ancillary products and assembled components” on our financial statements. Additionally, we receive non-recurring revenue as reimbursement from the sale of associated products. We group our products into three product categories we classify as “Proprietary Table Games,” “Enhanced Table Systems” and “e-Tables.” Our product categories are summarized below. Additional information regarding our products may be found on our web site, www.galaxygaming.com. Information found on the web site should not be considered part of this report. Proprietary Table Games. We design, develop and deliver our Proprietary Table Games to enhance our casino clients’ table game operations. Casinos use our Proprietary Table Games in lieu of those games in the public domain (e.g. Blackjack, Craps, Roulette, etc.) because of their popularity with players and to increase profitability. Our table games are grouped into two product types we call “Side Bets” and “Premium Games.” Side Bets are proprietary features and wagering schemes typically added to public domain games such as poker, baccarat, pai gow poker, craps and blackjack table games. Premium Games are unique stand-alone Proprietary Table Games with their own unique set of rules and strategies. Generally, Premium Games generate higher revenue per table placement than the Side Bet games. Internally, we track revenue by each of our Proprietary Table Games. We do not internally track the cost associated with the revenue of each of our proprietary casino games since it would require subjective allocations of common costs. Samplings of our Proprietary Table Games are listed below. Side Bets Premium Games 21 Magic Buffalo Blackjack Bonus 21+3 Classic Blackjack Deuces Wild 21+3 Top 3 Blackjack Emperor’s Challenge 21+3 Xtreme Blackjack Four the Money All 6 for Three Card Poker Kokomo Stud Benz for a Buck Blackjack Player’s Edge 21 Bonus Blackjack Random Wild Bonus Craps Rainbow Poker Bust Bonus Super 3 Poker Colors for Pai Gow Poker Texas Shootout D-T Dice for Pai Gow Poker Three Card Poker Double Match Three Card Split Emperor’s Treasure Triple Attack Blackjack JoKolor for Pai Gow Poker Two Way Hold ‘em Casino Poker Lucky 8 Baccarat YES Dice Lucky Ladies Pai Gow Insurance Poker 3 Bonus Prime for Three Card Poker Share the Wealth Suited Royals Super Pairs Triple Match Enhanced Table Systems. Enhanced Table Systems are electronic enhancements used on casino table games to add to player appeal and to enhance game security. We include in this product category our Bonus Jackpot System, our Inter-Casino Jackpot System and MEGA-Share. Enhanced Table Systems: Bonus Jackpot System. In 2008, we began deployment of a research and development project to create an electronically enhanced table game platform we trademarked the “Bonus Jackpot System.” We developed our Bonus Jackpot System to compete with our competitors’ progressive jackpot systems. Early in the design process, we decided to not simply emulate the standard progressive jackpot system offered by competitors, but instead we chose to design, engineer and manufacture a system to further enhance the table game player’s experience beyond their current experiences and likewise further improve the casino’s profit from table games. We have committed a significant portion of our resources to the research and development of this system. We believe we have benefited from this commitment as our Bonus Jackpot System has evolved into a leading casino table game platform in the industry. The Bonus Jackpot System consists of two independent sub-systems known as the Bet Tabulator System and TableVision. The Bet Tabulator System is an advanced system installed on gaming tables that is used to detect players’ wagers. Casinos use this system to evaluate game play, determine dealer efficiency and to assist in calculating jackpots and bonusing offerings. TableVision is an electronic display system used on gaming tables to display game information to the players in lieu of traditional static paper or plastic displays. Casinos use TableVision as an enhanced display to generate additional player interest and to promote various aspects of the game offered such as jackpots and bonusing programs. When the Bet Tabulator System and TableVision are used together, the Bonus Jackpot System allows the casino to seamlessly collect and process data and in turn, offer jackpots and other bonusing schemes to their players as determined by them using the data collected and processed. The inaugural series of the Bonus Jackpot System, known as the “Milky Way Series,” was first installed into a casino in March 2009. We consider our Milky Way Series to have been a success for us, as it was our entry into developing electronic bonusing platforms for casino table games. The Milky Way Series is still currently in use and it continues to generate recurring revenue for us. We anticipate we will continue to receive revenues from the Milky Way Series in 2012. Shortly after the Milky Way Series was deployed, we began development of the next series of our Bonus Jackpot System, which we branded the “Andromeda Series,” continuing the theme of branding each major release of our Bonus Jackpot System with the name of a known galaxy. Early in 2010, we completed development of the first phase of Andromeda Series. The major advancement of the Andromeda Series over the Milky Way Series was the ability for two-way communication between gaming tables located anywhere in the world and one or more data processing centers. We believe this achievement for casino table games was the first of its kind in the world. The availability of the data processing centers is the result of an agreement we entered into with Amazon Web Services, a unit of Amazon.com. In August 2010, we released Andromeda Series – Stage 2 (“Andromeda–2”). Among other improvements, Andromeda–2 increased the maximum number of player positions at a table from 7 to 16 and increased the number of betting positions per player from 1 to 6, both firsts within the casino table game industry. Andromeda–2 also introduced an advanced sensor design placed in front of each player, which increased reliability and provided the player with a positive indication when their wager is recorded. In March 2011, we released Andromeda–3, which added advanced player display options to the TableVision platform including the ability of the Bonus Jackpot System to keep track of and display more than one jackpot. This advancement, combined with the multiple sensor advancements achieved with Andromeda–2, permits us to offer a unique bonusing system called “MEGA-Share” to our casino clients. We began generating revenue from Andromeda–3 in the fourth quarter of 2011. We continue to develop enhancements and improvements to our Andromeda Series and are currently designing and developing our Andromeda–4 system, which we expect to be completed in 2012. Concurrently, we have commenced preliminary design and development of our next major series which we have designated the “Triangulum Series.” It is anticipated that the Triangulum Series may be released in late 2012 or 2013 and will further our reputation for designing leading edge technology and products for the casino table game industry. Enhanced Table Systems: Inter-Casino Jackpot System. In 2009, we saw an opportunity to leverage the abilities of our Bonus Jackpot System to connect and/or aggregate bonus or progressive jackpots from multiple casinos into a common network. This methodology has long been practiced in the slot machine industry beginning with the introduction of IGT’s Megabucks in the 1990’s. These systems are referred to as “wide area progressives” and nearly every major slot machine manufacturer has a wide area progressive system. We developed our version of a wide area progressive jackpot system for table games that we call the Inter-Casino Jackpot System. In April 2011, using our proprietary Andromeda–2 Bonus Jackpot System, we implemented our Inter-Casino Jackpot System in Nevada by connecting nine casinos located in Las Vegas which are operated by Station Casinos, a Las Vegas based, locals oriented, casino chain. This system linked our proprietary Deuces Wild game operating in each of the nine casinos and allowed Station Casinos to offer a combined jackpot. Our preferred method of compensation is to collect a fee from our casino clients based upon their player’s participation in the Inter-Casino Jackpot System. Enhanced Table Systems: MEGA-Share. MEGA-Share is a game play methodology invented by us that allows a player of one of our table games to share in the winnings of a jackpot together with other players. An example of this concept would be when multiple table game players are playing in a casino and one of them obtains a winning hand entitling them to a jackpot, the event also triggers a second MEGA-Share jackpot that is divided among all players who qualified for MEGA-Share. MEGA-Share rewards the other players playing on other tables, other games, or even other casinos with a share of the MEGA-Share jackpot, provided that they placed a qualifying MEGA-Share wager. We believe MEGA-Share may offer casinos an opportunity to significantly increase player interest, thereby increasing their revenues, which in turn could result in generating increased recurring revenue for us. For table games, MEGA-Share uses our Andromeda-3 Bonus Jackpot System. We installed and commenced beta-testing our first MEGA-Share system in an off-strip casino in Las Vegas in December 2011. e-Tables. In February 2011, we acquired the worldwide rights, excluding Oklahoma, Kentucky and the Caribbean, to the TableMAX e-Table system and simultaneously obtained the e-Table rights to the casino table games Caribbean Stud, Caribbean Draw, Progressive Blackjack, Texas Hold’em Bonus and Blackjack Bullets. See Note 18 in “Item 8. Financial Statements and Supplementary data” included in this Form 10-K. The TableMAX e-Table system is a fully automated, dealer-less, multi-player electronic table game platform. These platforms will allow us to offer our table game content in markets where live table games are not permitted, such as racinos, video lottery and arcade markets. Our e-Table product enables the automation of certain components of traditional table games such as data collection, placement of bets, collection of losing bets and payment of winning bets. This automation provides benefits to both casino operators and players, including greater security and faster speed of play, reduced labor and other game related costs and increased profitability. Strategy. Our long-term business strategy is designed to capitalize on the opportunities we perceive within the gaming industry. We are an experienced developer of proprietary table games but a relative newcomer to developing and providing advanced electronic table game platforms and e-Tables. Throughout our history, we have been focused on creating and expanding our base of recurring revenues that we earn on a monthly basis. Our plan is to continue to increase the recurring revenues we receive by employing the following strategies: 1. Expand our inventory of products and technologies to attain a fully comprehensive portfolio; 2. Increase our per unit price point by leveraging our Enhanced Table Systems; and 3. Grow our e-Table business. Expand our inventory of products and technologies to attain a fully comprehensive portfolio. Historically, only one company in the table game industry, Shuffle Master Gaming, Inc., has had the ability to offer casinos nearly all of the table game products they require. Their unique ability to offer numerous products both in terms of game content and what they term as “utility” products (e.g. card shufflers, smart dealing shoes, baccarat displays, etc.), has stifled competition from other companies, including us, who are disadvantaged without a complete product line offering. Our strategy is to be an alternative for casino operators by offering a complete and comprehensive portfolio of games, products, systems, technologies and methodologies for casino table games. If we achieve this objective, we intend to offer complete turn-key systems rather than compete solely as a purveyor of individual products only. We intend to continuously develop and/or seek to acquire new proprietary table games to complement our existing offerings and to extend our penetration of proprietary table games on the casino floor. We expect to accomplish this strategic shift this through internal development of products as well as continued acquisitions from others. Our first preference is to develop internally our products and intellectual property. Our CEO works closely with our engineering team to develop new cutting-edge table game content and ancillary products. Together they have been responsible for the continued development of our Proprietary Table Games and Enhanced Table Systems. We intend to further expand our product line including so-called “utility” products now offered by our competitors through our continued research, design, development and engineering efforts. In addition, we are constantly seeking to acquire marketable products developed by others. In 2010, we acquired the Deuces Wild Hold’em Fold’em and Random Wild games and associated intellectual property from T&P Gaming, Inc. In October 2011 we acquired over 20 different table games, including 21+3, Two-way Hold'em and Three Card Poker from Prime Table Games. Those games are currently played on approximately 500 tables in 200 casinos in the United States, the United Kingdom and in the Caribbean. Prime Table Games’ intellectual property portfolio included 47 patents and patents pending, 96 worldwide trademark and design registrations and 47 domain name registrations. In November 2011, we acquired the table games Bonus Craps, Four The Money, Rainbow Poker and Roulette Craps together with nine patents, various trademarks and an assignment of existing licensing agreements with various casinos throughout the United States from Lakes Entertainment, Inc. We anticipate the continued acquisition and/or development of additional new proprietary table games and associated intellectual property, which when combined with our existing portfolio, will give us the complete inventory of proprietary games to offer casinos a complete solution, thereby increasing our competitiveness in the marketplace. Increase our per unit price point by leveraging our Enhanced Table Systems. Our Enhanced Table Systems permit us the opportunity to significantly increase the amount of recurring revenue we receive from each table game placement. Accordingly, our goal is to concentrate on installing new game placement using one or more of our Enhanced Table Systems and to convert our existing Proprietary Table Game placements that currently do not incorporate our Enhanced Table Systems. We have modified most of our Premium Table Games and many of our Side Bets to benefit from the economics this new system affords us. In the future, we intend to be able to offer this platform for all games. Additionally, we expect that most or all of our new Proprietary Table Games will include the Bonus Jackpot System component. The technology developed with the Bonus Jackpot System has allowed us to offer not only bonus jackpots and progressive jackpots, but also provides us the infrastructure to offer our Inter-Casino Jackpot System and MEGA-Share, which we believe will be a popular option for casinos seeking to increase their game play activity. We have identified jurisdictions where we may have the ability to offer this program and have commenced seeking the requisite approvals. In jurisdictions where our Inter-Casino Jackpot System is approved, we intend to increase our sales efforts towards connecting casinos together into a common jackpot system. We invented the concept called MEGA-Share, which we first installed in December 2011. MEGA-Share and our Inter-Casino Jackpot System are unrelated but can be combined if so desired by our clients. A casino could operate either one but not the other, or operate both simultaneously. We believe MEGA-Share has the ability to become a “must-have” product for casinos and as a result could be a significant contributor to our future revenue growth. Accordingly, we also intend to intensify our sales efforts on obtaining MEGA-Share placements. Grow our e-Table business. Our TableMAX product line is developed for us by TableMAX Corporation. Having installed the majority of TableMAX e-Tables we received last year, we are awaiting the next major release of the TableMAX e-Table, referred to as the “Model E.” We have been informed by TableMAX Corporation that the majority of the Model E’s development is complete and it has been submitted for regulatory approval with Gaming Labs International, an independent testing organization. We anticipate the requisite approval for the Model E in 2012 and expect to offer this product to gaming operators in late 2012 or early 2013. Competition. We compete with other gaming products and supply companies for space on the casino floor, as well as for our client’s capital spending. Our competition for casino placement and players comes from a variety of sources, including companies that design and market proprietary table games, electronic table game platforms, e-Tables and other gaming products. With respect to our Proprietary Table Games, we compete with several companies who primarily develop and license proprietary table games. Our competitors include, but are not limited to, Shuffle Master Gaming, DEQ Systems, TCS/John Huxley, and Masque Publishing. Competition in this product group is particularly based on price, brand recognition, player appeal and the strength of underlying intellectual property. Smaller developers and vendors are more able to participate in developing and marketing table games, compared to other gaming products, because of the lower cost and complexity associated with the development of these products and a generally less stringent regulatory environment. Larger competitors have superior capital resources, distribution and product inventory than we do. We compete on these bases, as well as on the strength of our extensive sales, service and distribution channels. We have been able to increase our placements of table games not only because of the general growth of table games, but also by displacing other table game products. With respect to our Enhanced Table Systems, we compete primarily with Shuffle Master Gaming and DEQ Systems. Shuffle Master Gaming has a progressive jackpot system it uses with its proprietary table games. DEQ Systems, which has limited game content, often uses its platform with other companies’ games including ours and Shuffle Master. With respect to our Inter-Casino Jackpot System, we compete primarily with Shuffle Master Gaming. We believe the methodology used by our Inter-Casino Jackpot System will likely become popular and as a result, we anticipate new competitors in the future. With respect to our e-Table system, there are numerous other companies that manufacture and/or sell e-Tables that are similar. These companies include, but are not limited to, TCS/John Huxley, Aristocrat, Interblock, Aruze Corporation, Novomatic Industries, PokerTek, Inc. and Shuffle Master Gaming. Our e-Tables, as well as those of other companies, also compete for casino floor space with live table games and slots. One of our competitive strengths in this segment is the ability to offer our proprietary table game titles on e-Table platforms. In 2010, we entered into a royalty agreement with PokerTek, Inc. to license our game content whereby we would receive royalties for the use of our products if placed on their electronic platform. In 2011, we did not earn any royalties from this agreement we anticipate we will receive minimal revenues from this agreement in 2012. Many of our competitors have longer operating histories, significantly greater resources, greater brand recognition and more firmly established supply relationships. Moreover, we expect additional competitors to emerge in the future. We believe that the principal competitive factors in our market include products that appeal to casinos and players, jurisdictional approvals and a well-developed sales and distribution network. Although we plan to compete effectively in this market, we recognize that this market is relatively new and is evolving rapidly, and accordingly, there can be no assurance that we will be able to compete effectively. We believe that our success will depend upon our ability to remain competitive in our field. We compete with others in efforts to obtain or create innovative products, obtain financing, acquire other gaming companies, and license and distribute products. The failure to compete successfully in the market for proprietary table games, electronic table game platforms and multi-casino jackpots could have a material adverse effect on our business. Product supply. We obtain most of the parts for our products from outside suppliers, including both off-the-shelf items as well as components manufactured to our specifications. We also manufacture a small number of parts in-house that are used both for product assembly and for servicing existing products. We generally perform warehousing, quality control, final assembly and shipping ourselves from our facilities in Las Vegas, Nevada, although small inventories are maintained and repairs are performed by our field service employees. We believe that our sources of supply for components and raw materials are adequate and that alternative sources of materials are available. Research and development. We employ a staff of electrical, mechanical and software engineers, graphic artists and game developers to support, improve and upgrade our products and to develop and explore other potential table game products. We perform our research and development ourselves at our corporate offices. We may also use third party developers to conduct research and development for certain product offerings. We believe that one of our strengths is identifying new product opportunities and developing new products. Therefore we expect to continue to spend a significant portion of our annual revenues on research and development, including the acquisition of intellectual property from third parties. We have incurred approximately $286,142 and $285,310 in research and development expenditures during 2011 and 2010, respectively. Intellectual property. Our products and the intellectual property associated with them are typically protected by patents, trademarks and copyrights. There can be no assurance that the steps we have taken to protect our intellectual property will be sufficient. In addition, the laws of some foreign countries do not protect intellectual property to the same extent as the laws of the United States, which could increase the likelihood of infringement. Furthermore, other companies could develop similar or superior products without violating our intellectual property rights. If we resort to legal proceedings to enforce our intellectual property rights, the proceedings could be burdensome, disruptive and expensive, and distract the attention of management, and there can be no assurance that we would prevail. We have been and are subject to litigation claiming that we have infringed the rights of others and/or that certain of our patents and other intellectual property are invalid or unenforceable. We have also brought actions against others to protect our rights. For a discussion of these cases see “Item 3. Legal Proceedings” and Note 10 in “Item 8. Financial Statements and Supplementary Data” included in this Form 10-K. Government regulation. We are subject to regulation by governmental authorities in most jurisdictions in which we offer our products. Gaming regulatory requirements vary from jurisdiction to jurisdiction, and obtaining licenses, registrations, findings of suitability for our officers, directors, and principal stockholders and other required approvals with respect to us, our personnel and our products are time consuming and expensive. Generally, gaming regulatory authorities have broad discretionary powers and may deny applications for or revoke approvals on any basis they deem reasonable. We have approvals that enable us to conduct our business in numerous jurisdictions, subject in each case to the conditions of the particular approvals. These conditions may include limitations as to the type of game or product we may sell or lease, as well as limitations on the type of facility, such as riverboats, and the territory within which we may operate, such as tribal nations. In addition to jurisdictions in which we, and specific personnel, were required to have authorizations with respect to some or all of our products and activities, we have authorizations with respect to certain Native American tribes throughout the United States that have compacts with the states in which their tribal dominions are located or operate or propose to operate casinos. These tribes generally require suppliers of gaming and gaming-related equipment to obtain authorizations. Gaming devices and equipment. We sell or lease products that are considered to be “gaming devices’’ or “gaming equipment’’ in jurisdictions in which gaming has been legalized. Although regulations vary among jurisdictions, each jurisdiction requires various licenses, findings of suitability, registrations, approvals, or permits for companies and their key personnel in connection with the manufacture and distribution of gaming devices and equipment. Regulation of officers, directors and stockholders. In many jurisdictions, any officer or director is required to file an application for a license, finding of suitability or other approval and, in the process, subject himself or herself to an investigation by those authorities. As for stockholders, any beneficial owner of our voting securities or other securities may, at the discretion of the gaming regulatory authorities, be required to file an application for a license, finding of suitability, or other approval and, in the process, subject himself or herself to an investigation by those authorities. The gaming laws and regulations of most jurisdictions require beneficial owners of more than 5% of our outstanding voting securities to file certain reports and may require our key employees or other affiliated persons to undergo investigation for licensing or findings of suitability. In the event a gaming jurisdiction determines that one of our officers, directors, key employees, stockholders, or other personnel is unsuitable to act in such a capacity, we may be required to terminate our relationship with such person or lose our rights and privileges in that jurisdiction. This may have a materially adverse effect on us. We may be unable to obtain all the necessary licenses and approvals or ensure that our officers, directors, key employees, affiliates and certain other stockholders will satisfy the suitability requirements in each jurisdiction in which our products are sold or used. The failure to obtain such licenses and approvals in one jurisdiction may affect our licensure and approvals in other jurisdictions. In addition, a significant delay in obtaining such licenses and approvals could have a material adverse effect on our business prospects. Our articles of incorporation permit us to require any shareholder who fails to obtain a required finding of suitability to surrender their shares to us in exchange for compensation based upon a predetermined methodology. Gaming jurisdictions. Gaming jurisdictions that have legalized gaming typically require various licenses, registrations, findings of suitability, permits, and approvals of manufacturers and distributors of gaming devices and equipment as well as licensure provisions related to changes in control. In general, such requirements involve restrictions and approvals. Additionally we license and/or lease our products through licensed distributors. We now offer our products in the following gaming jurisdictions: United States Canada Other Arizona Mississippi Alberta Aruba California Missouri British Columbia Australia Colorado Nevada Manitoba Puerto Rico Connecticut New Jersey Nova Scotia St. Maarten Florida New Mexico Ontario Switzerland Idaho North Dakota Quebec United Kingdom Illinois Ohio U.S. Virgin Islands Indiana Oklahoma Maine Washington Michigan West Virginia Native American gaming regulation. Gaming on Native American lands within the United States is governed by the Federal Indian Gaming Regulatory Act of 1988 ("IGRA") and specific tribal ordinances and regulations. Class III gaming, as defined under IGRA, also requires a Tribal-State Compact, which is a written agreement between a specific tribe and the respective state. This compact authorizes the type of Class III gaming activity and the standards, procedures and controls under which the Class III gaming activity must be conducted. The National Indian Gaming Commission ("NIGC") has oversight authority over gaming on Native American lands and generally monitors tribal gaming including the establishment and enforcement of required minimum internal control standards. Each tribe is sovereign and must have a tribal gaming commission or office established to regulate tribal gaming activity to ensure compliance with IGRA, NIGC, and its Tribal-State Compact. We have complied with each of the numerous vendors licensing and specific product approval and shipping notification requirements imposed by Tribal-State Compacts and enforced by tribal and/or state gaming agencies under IGRA in the Native American lands in which we do business. Application of future or additional regulatory requirements. In the future, we intend to seek the necessary registrations, licenses, approvals, and findings of suitability for us, our products, and our personnel in other jurisdictions throughout the world where significant sales of our products are expected to be made. However, we may be unable to obtain these registrations, licenses, approvals or findings of suitability, which if obtained, may be revoked, suspended, or conditioned. In addition, we may be unable to obtain on a timely basis, or to obtain at all, the necessary approvals of our future products as they are developed, even in those jurisdictions in which we already have existing products licensed or approved. If a registration, license, approval or finding of suitability is required by a regulatory authority and we fail to seek or do not receive the necessary registration, license, approval or finding of suitability, we may be prohibited from selling our products in that jurisdiction or may be required to sell our products through other licensed entities at a reduced profit. Employees. We have nineteen employees, including executive officers, management personnel, accounting personnel, office staff, sales staff, service technicians and research and development personnel. Our employees are co-employed by Advanstaff, Inc. a professional employer organization used by us to provide payroll and human resource services. As needed from time to time, we also pay for the services of independent contractors. Subsidiary. In the year ending December 31, 2011, we have one wholly owned subsidiary, Galaxy Gaming of Washington, LLC. This company was dormant for several years and was dissolved prior to the date of this report. ITEM 1A. RISK FACTORS. A smaller reporting company is not required to provide the information required by this Item. ITEM 1B. UNRESOLVED STAFF COMMENTS ITEM 2. PROPERTIES We do not own any real property used in the operation of our current business. We maintain our corporate office at 6980 O’Bannon Drive, Las Vegas, Nevada. We currently pay rent to a related party pursuant to a lease was entered into effective September 1, 2010 for a period of two years with a monthly rental payment of $10,359. We currently occupy 6,200 square feet and are currently anticipating that we will need to seek additional space to accommodate our expanded operations. For information on l egal proceedings, see Note 10 in “Item 8 Financial Statements and Supplementary Data” included in this Form 10-K. ITEM 4. MINE SAFETY DISCLOSURES ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES Market information. Prior to its reverse merger with SDI in 2009, GGPVT was a privately-held company and accordingly there was no public market for its securities. Also prior to the reverse merger, the common stock of SDI was quoted on the OTC Bulletin Board (“OTCBB”), which is sponsored by the Financial Industry Regulatory Authority (“FINRA”), under the symbol SDFD.OB. The OTCBB is a network of security dealers who buy and sell stock. The dealers are connected by a computer network that provides information on current "bids" and "asks," as well as volume information. A few months after the reverse merger, FINRA reissued SDI’s stock ticker symbol as SECD.OB. After SDI and its wholly owned subsidiary GGPVT were merged, we requested a new symbol from FINRA and were issued the symbol GLXZ.OB. The following table sets forth the range of high and low bid quotations for our common stock for each of the periods indicated as reported by the OTCBB. These quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. Quarter Ended High ($) Low ($) High ($) Low ($) December 31, 0.30 0.16 0.60 0.31 September 30, 0.35 0.15 0.45 0.14 June 30, 0.50 0.23 0.55 0.15 March 31, 0.40 0.19 0.65 0.31 Penny stock. The SEC has adopted rules that regulate broker-dealer practices in connection with transactions in penny stocks. Penny stocks are generally equity securities with a market price of less than $5.00, other than securities registered on certain national securities exchanges or quoted on the NASDAQ system, provided that current price and volume information with respect to transactions in such securities is provided by the exchange or system. The penny stock rules require a broker-dealer, prior to a transaction in a penny stock, to deliver a standardized risk disclosure document prepared by the SEC, that: (a) contains a description of the nature and level of risk in the market for penny stocks in both public offerings and secondary trading; (b) contains a description of the broker's or dealer's duties to the customer and of the rights and remedies available to the customer with respect to a violation of such duties or other requirements of the securities laws; (c) contains a brief, clear, narrative description of a dealer market, including bid and ask prices for penny stocks and the significance of the spread between the bid and ask price; (d) contains a toll-free telephone number for inquiries on disciplinary actions; (e) defines significant terms in the disclosure document or in the conduct of trading in penny stocks; and (f) contains such other information and is in such form, including language, type size and format, as the SEC shall require by rule or regulation. The broker-dealer also must provide, prior to effecting any transaction in a penny stock, the customer with (a) bid and offer quotations for the penny stock; (b) the compensation of the broker-dealer and its salesperson in the transaction; (c) the number of shares to which such bid and ask prices apply, or other comparable information relating to the depth and liquidity of the market for such stock; and (d) a monthly account statement showing the market value of each penny stock held in the customer's account. In addition, the penny stock rules require that prior to a transaction in a penny stock not otherwise exempt from those rules, the broker-dealer must make a special written determination that the penny stock is a suitable investment for the purchaser and receive the purchaser's written acknowledgment of the receipt of a risk disclosure statement, a written agreement as to transactions involving penny stocks, and a signed and dated copy of a written suitability statement. These disclosure requirements may have the effect of reducing the trading activity for our common stock. Therefore, stockholders may have difficulty selling our securities. Holders of our common stock. As of March 29, 2012, we had 38,310,591 shares of our common stock issued and outstanding, held by 51 shareholders of record. There are a significantly greater number of shareholders whose shares are held in street name. Based on information available to us as of April 4, 2012, we estimate that we have approximately 250 beneficial holders in total. All of the prior issued and outstanding equity interests, preferred and common stock, issued by SDI prior to the reverse merger were extinguished and rendered null and void. Dividend policy. There are no restrictions in our articles of incorporation or bylaws that prevent us from declaring dividends. The Nevada Revised Statutes, however, do prohibit us from declaring dividends where after giving effect to the distribution of the dividend: 1. we would not be able to pay our debts as they become due in the usual course of business, or; 2. our total assets would be less than the sum of our total liabilities plus the amount that would be needed to satisfy the rights of shareholders who have preferential rights superior to those receiving the distribution. We have not declared any dividends and we do not plan to declare any dividends in the foreseeable future. Transfer agent. Our stock transfer agent and registrar is Empire Stock Transfer, Inc. located at 1859 Whitney Mesa Drive, Henderson, Nevada 89014. Their telephone number is (702) 818-5898. Securities authorized for issuance under equity compensation plans. We have not yet adopted any formal equity compensation plans. In anticipation of establishing an equity compensation plan we: (1) granted options to our CFO to purchase 22,500 shares of our common stock at a price of $0.55 per share, exercisable for three years. Additional grants of options to our CFO to purchase 22,500 shares of our common stock at a price of $0.55 per share, exercisable for three years, will be made at the beginning of each additional year of service through November 2012. (2) agreed that our outside Board members, Dan Scott and Richard Baldwin, will receive immediately-vested options to purchase 46,250 shares of our common stock per quarter. (3) agreed on March 29, 2012, to an initial employee stock grant program which granted 802,500 shares to 12 different employees in various grant sizes. A revised version of this same plan was approved on April 16, 2012. See Note 18 in “Item 8. Financial Statements and Supplementary Data” included in this Form 10-K. Recent sales of unregistered securities. In June 2009, we closed a private offering of common stock. A total of 138,750 shares were sold to thirteen purchasers for a total purchase price of $55,500. Of this total, 37,500 shares were purchased for cash proceeds in the amount of $15,000. Additionally 86,000 shares were sold to our employees in exchange for promissory notes in the aggregate amount of $34,400. The notes are secured by the shares purchased, bear interest at a rate of six percent (6%) per year, and are payable over the course of two years. We are in the process of finalizing these share issuances and where appropriate, cancelling any pro-rata shares of employees who did not fully pay these notes. Finally 15,250 shares were issued in exchange for services rendered by our COO valued at $6,100. We issued 100,000 shares of common stock in settlement of accounts payable. Convertible notes payable in the amount of $200,000, plus accrued interest, were converted to equity resulting in the issuance of 1,042,989 common shares. In July 2009 we commenced a private offering of common stock to raise approximately $400,000. Investor demand for the offering prompted our Board to extend the amount offered. As a result of the over-subscription, a total of 1,722,858 shares and 861,429 warrants were purchased for cash proceeds of $603,000. The offering was closed in December 2009. During the year ended December 31, 2009, we issued 1,101,583 shares of common stock for services to be performed in non-cash transactions pursuant to various service agreements. On April 1, 2010 we sold a total of 1,428,572 shares of common stock and 714,286 warrants to two principals of a competitor for total cash proceeds of $500,000. On February 24, 2011 we sold a total of 533,333 shares of common stock and 266,667 warrants for total cash proceeds of $200,000. On October 1, 2011, as a part of the asset acquisition structure for Prime Table Games, 2,000,000 shares valued at $0.40 each were issued separately to the two owners of Prime Table Games. The offering and sale of our shares were exempt from registration under rule 506 of Regulation D. The shares were offered exclusively to accredited and/or sophisticated investors and there was no solicitation or advertising. ITEM 6. SELECTED FINANCIAL DATA ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion and analysis of our financial condition, results of operations and liquidity and capital resources as of December 31, 2011 and 2010 and for the years ended December 31, 2011 and 2010. This discussion should be read together with our audited consolidated financial statements and related notes included in “Item 8. Financial Statements and Supplementary Data” included in this Annual Report on Form 10-K (“Form 10-K”). Some of the information contained in this discussion includes forward-looking statements that involve risks and uncertainties; therefore our "Special Note Regarding Forward-Looking Statements" should be reviewed for a discussion of important factors that could cause actual results to differ materially from the results described in, or implied by, such forward-looking statements. We develop, acquire, manufacture and market technology and entertainment-based products for the gaming industry for placement on the casino floor. Our products primarily relate to licensed casino operators’ table games activities and focus on either increasing their profitability, productivity and security or expanding their gaming entertainment offerings in the form of proprietary table games, electronically enhanced table game platforms or fully-automated electronic tables. Our products are offered in highly regulated markets throughout the world. Our products are manufactured at our headquarters and manufacturing facility in Las Vegas, Nevada, as well as outsourced for certain sub-assemblies in the United States. Plan of operation. See “Item 1. Business” included in this Form 10-K for a more detailed discussion of our business, strategy and a description of each of our product categories. Results of operations for the years ended December 31, 2011 and 2010. For the year ended December 31, 2011 our continuing operations generated gross revenues of $3,684,865 compared to $3,054,856 in the prior year, an increase of $630,009 or 21%. The increase was attributable to the growth in our recurring revenue from table game content and fees associated with the performance of our electronic game platform. This was also materially enhanced at year-end by initial revenues stemming from the 21+3 and Three Card Poker products acquired from the Prime Table Games acquisition, which closed in October. The Prime Table Games acquisition materially enhanced revenues for the fourth quarter of 2011, and is expected to be the primary revenue driver for us in future years. Additionally, we are not expected to add any material expenses related to the two primary products, 21+3 and Three Card Poker, but costs will be expended to further research and potentially enhance the protection of the remaining products in the acquired Prime Table Games portfolio. The Prime Table Games acquisition was valued by a national business valuation firm headquartered in Dallas, Texas, at a dollar value of approximately $22.2 million. For financing information on this acquisition, see the “Liquidity and capital resources” section later in this overview. Additionally in 2011, we entered into a definitive agreement (“TMAX Agreement”) with TableMAX Corporation (“TMAX”) a provider of electronic table games and platforms headquartered in Las Vegas, Nevada and with a principal investor in TMAX. Under the terms of the TMAX Agreement, we have exclusive worldwide rights (excluding one international territory and two U.S. states) to the TMAX electronic gaming platform and certain games titles. We created an operating division (the “TableMAX Division”) which conducts sales, distribution, marketing, engineering, sub-licensing and manufacturing related to the TMAX products and related intellectual property. The term of the TMAX Agreement is five years. At any time during the term of the TMAX Agreement, either TMAX or we may make a written offer to purchase the sole ownership of the TableMAX Division. TMAX agreed to assign, for the term of the TMAX Agreement, all of its existing gaming installations and usable inventory to the TableMAX Division. We agreed to furnish our intellectual property relating to our table game content for use by the TableMAX Division, royalty-free for the term of the TMAX Agreement. Although we are responsible for the losses of the TableMAX Division, TMAX has agreed to reimburse us during the first 12 months from the date of the TMAX Agreement for operating expenses of the TableMAX Division up to a maximum of $600,000. A subsequent verbal agreement by both company’s to reimburse Galaxy for loses beyond this initial 12 month period is currently in place until decisions as to potential contract changes are made. Net profits from the TableMAX Division will be split between TMAX and us on a sliding scale basis dependent upon the number of TableMAX Division table installations and profit results as defined in the TMAX Agreement. Because of this arrangement, TMAX had a neutral impact on our performance in 2011. Our recurring revenues and fees were $3,655,148 and $2,950,157 in 2011 and 2010, respectively, representing an increase of $704,991 or 24%. Recurring revenues as a percentage of all revenues was 99.2% and 96.6% for the years 2011 and 2010, respectively. We experienced a decline in the sale or reimbursement of our products and manufactured equipment, to $48,868 in 2011 from $100,594 in 2010, a decrease of $51,726 or 51%. This decline was the result of a decrease in our sales of our Enhanced Table Systems. Accordingly, this decrease resulted in the decrease of costs of ancillary products and assembled components to $99,219 in 2011 compared to $135,738 in 2010, a decrease of $36,519 or 26.9%. Selling, general and administrative expenses were $3,198,029 in 2011 compared to $2,642,319 in 2010, an increase of $555,710 or 21.0%. The increase was primarily due to increased sales related expenses including payroll, travel and trade shows; increases in regulatory costs associated with product approvals and gaming licenses in new jurisdictions; and legal expenses associated with the ongoing legal proceedings. Research and development expenses were $286,142 in 2011 compared to $285,310 on 2010, an increase of $832. Other expenses decreased to $148,593 in 2011 from $164,165 in 2010, a decrease of $15,573 or 9.5%. Related the above mentioned and significant Prime Table Games amortization, our net loss significantly increased to ($473,336) in 2011 as compared to ($135,861) in 2010, representing an increased loss of $337,47 5 or 248.4%. Liquidity and capital resources. As of December 31, 2011 we had total current assets of $1,448,272 and total assets of $23,115,41 0 . Our total current liabilities as of December 31, 2011 were $2,805,193. Our operating activities used $244,305 in cash for the year ended December 31, 2011 and contributed cash to the organization of $35,593 in cash for the year ended December 31, 2010. The primary components of our negative operating cash flow for the year ended December 31, 2011 were our net loss of $473,336 , an increase of $ 575,185 in accounts receivable, along with an increase in inventory of $107,327, offset by an increase of $250,757 in accured expenses. Total current liabilities are as follows: Account 2011 2010 Accounts payable $ 274,576 $ 195,899 Accrued expenses 358,860 108,103 Accrued interest – related party 0 25,973 Deferred revenue 336,048 220,867 Notes payable – related party 469 107,850 Notes payable – current portion 1,835,240 81,058 Total current liabilities $ 2,805,193 $ 739,750 The growth in the deferred revenue account represents our continued shift to a bill -in-advance process that reduces collection issues, and helps to stabilize revenues , both from a timing as well as a projection perspective structure. Where possible, we will continue to move clients in this direction. Cash flows provided by financing activities during the year ended December 31, 2011 were $22,073, primarily consisting of the proceeds from the issuance of common shares less payments made on note payable. Non-cash financing activities consisted primarily of the acquisition of Prime Table Games was $23.0 million, which consisted of the issuance of 1,000,000 shares of our stock valued at $0.40 per share to each of the two owners (total value of $800,000), along with two promissory notes (with a dollars to pound conversion rate of .64) as follows: Maturities US Portion (Note 1) UK Portion (Note 2) 2012 $ 874,088 £ 598,796 $ 935,619 $ 1,809,707 2013 1,162,446 720,060 1,125,094 2,287,540 2015 1,846,854 1,021,211 1,595,641 3,442,495 Total $ 12,200,000 £ 6,400,000 $ 10,000,000 $ 22,200,000 Additionally, investing activities contributed cash of $7,562 for the year as increases property and equipment of $20,948 were offset with payments on a note receivable of $28,510. We intend to fund our continuing operations through increased sales. Additionally, the issuance of debt or equity financing arrangements may be required to fund expenditures or other cash requirements. On February 24, 2011 we sold 533,333 shares of common stock and 266,667 warrants for total cash proceeds of $200,000. On October 4, 2011 we granted 2,000,000 shares of common stock, valued at $0.40 per share, as a part of the value for the acquisition of Prime Table Games’ assets. Despite this prior funding, there can be no assurance that we will be successful in raising additional funding, if required. If we are not able to secure additional funding, the implementation of our business plan may be impaired. There can be no assurance that such additional financing will be available to us on acceptable terms or at all. We will from time to time acquire products and businesses complementary to our business. As a public entity, we may issue shares of our common stock and preferred stock in private or public offerings to obtain financing, capital or to acquire other businesses that can improve our performance and growth. To the extent that we seek to acquire other businesses in exchange for our common stock, fluctuations in our stock price could have a material adverse effect on our ability to complete acquisitions. Off balance sheet arrangements. As of December 31, 2011 there were no off balance sheet arrangements. Significant equipment. We do not anticipate the purchase of any significant equipment for the next twelve months. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES BOUT MARKET RISK ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Index to Financial Statements Required by Article 8 of Regulation S-X: Audited Financial Statements for Galaxy Gaming, Inc.: F-1 Report of Independent Registered Public Accounting Firm F-2 Balance Sheets as of December 31, 2011 and 2010 F-3 Statements of Operations for the years ended December 31, 2011 and 2010 F-4 Statement of Stockholders’ Equity (Deficit) as of December 31, 2011 F-5 Statements of Cash Flows for the years ended December 31, 2011 and 2010 F-6-18 Notes to Financial Statements Silberstein Ungar, PLLC CPAs and Business Advisors Bingham Farms, MI 48025-4586 www.sucpas.com REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors We have audited the accompanying balance sheets of Galaxy Gaming, Inc. as of December 31, 2011 and 2010, and the related statements of operations, stockholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company has determined that it is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Galaxy Gaming, Inc. as of December 31, 2011 and 2010 and the results of its operations and cash flows for the years then ended, in conformity with accounting principles generally accepted in the United States of America. /s/ Silberstein Ungar, PLLC Silberstein Ungar, PLLC Bingham Farms, Michigan ASSETS 2011 2010 Cash and cash equivalents $ 200,128 $ 444,434 Accounts receivables – trade, net 843,328 311,961 Miscellaneous receivables 112,513 15,790 Prepaid expenses 57,650 24,940 Inventory 217,162 175,372 Note receivable – related party, current portion 17,491 16,475 Total Current Assets 1,448,272 988,972 Property and Equipment, net 42,637 44,101 Intellectual property, net 15,999,052 119,831 Intangible assets, net 4,112,711 346,790 Goodwill 1,091,000 0 Note receivable – related party, net of current portion 374,449 403,975 Other 47,290 18,113 Total Other Assets 21,624,502 888,709 Total Assets $ 23,115,411 $ 1,921,782 Notes payable, current portion 1,835,240 81,058 Total Current Liabilities 2,805,193 739,750 Notes payable, net of debt discount, net of current portion 20,035,366 1,148,448 Total Liabilities 22,840,559 1,888,198 Stockholders’ Equity Preferred stock, 10,000,000 shares, $.001 par value preferred stock authorized; 0 shares issued and outstanding 0 0 Common stock, 65,000,000 shares authorized; 37,508,091 shares issued and outstanding (2010 – 34,974,758) 37,507 34,974 Additional paid-in capital 1,915,311 1,252,393 Stock warrants 513,181 470,632 Stock subscription receivable (3,916 ) (10,520 ) Accumulated deficit (2,187,231 ) (1,713,895 ) Total Stockholders’ Equity 274,852 33,584 Total Liabilities and Stockholders ’ Equity $ 23,115,411 $ 1,921,782 The accompanying notes are an integral part of the financial statements. STATEMENTS OF OPERATIONS Year ended December 31, Product leases and royalties $ 3,655,148 $ 2,950,157 Product sales and service 29,717 104,699 Total Revenue 3,684,865 3,054,856 Costs of ancillary products and assembled components 99,219 135,738 Selling, general and administrative 3,198,029 2,642,319 Research and development 286,142 285,310 Depreciation 22,412 12,833 Amortization 435,218 26,258 Total Costs and Expenses 4,041,020 3,102,458 Loss from Operations (356,155 ) (47,602 ) Interest income 24,821 26,150 Interest expense (89,844 ) (114,409 ) Amortization of debt discount (52,158 ) 0 Total Other Income (Expense) (117,181 ) (88,259 ) Income (Loss) before Provision for Income Taxes (473,336 ) (135,861 ) Provision for Income Taxes 0 0 Net Loss $ (473,336 ) $ (135,861 ) Net Loss per Share: Basic and Diluted $ (0.01 ) $ (0.00 ) Weighted Average Number of Shares Outstanding: Basic and Diluted 37,508,091 33,931,722 STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT) AS OF DECEMBER 31, 2011 Common Stock Additional Paid in Stock Stock Subscription Accumulated Shares Amount Capital Warrants Receivable Deficit Total Beginning balance, January 1, 2010 33,056,186 $ 33,056 $ 944,774 $ 147,504 $ (25,967 ) $ (1,578,034 ) $ (478,667 ) Payments received for stock subscription receivable — — — — 15,447 — 15,447 Shares issued for payment of accounts payable 40,000 40 15,960 — — — 16,000 Common stock and warrants issued under private placement financing 1,428,572 1,428 175,444 323,128 — — 500,000 Share based compensation expense — — 26,665 — — — 26,665 Common stock issued for asset acquisition 450,000 450 89,550 — — — 90,000 Net loss from continuing operations — — — — — (135,861 ) (135,861 ) Balance, December 31, 2010 34,974,758 34,974 1,252,393 470,632 (10,520 ) (1,713,895 ) 33,584 Common stock and warrants issued for cash 533,333 533 156,918 42,549 — — 200,000 Payments received for stock subscription receivable — — — — 6,604 — 6,604 Common stock issued in connection with asset acquisition 2,000,000 2,000 478,000 — — — 480,000 Net loss for the year ended December 31, 2011 — — — — — (473,336 ) (473,336 ) Balance, December 31, 2011 37,508,091 $ 37,507 $ 1,915,311 $ 513,181 $ (3,916 ) $ (2,187,231 ) $ 274,852 FOR THE YEARS ENDED DECEMBER 31, 2011 AND 2010 Cash Flows from Operating Activities: 2011 2010 Net loss from for the year $ (473,336 ) $ (135,861 ) Adjustments to Reconcile Net Loss to Net Cash Used in Operating Activities: Depreciation expense 22,412 12,832 Amortization expense 435,218 26,258 Amortization of debt discount 52,158 0 Provision for bad debts 44,000 55,617 Write-off of inventory 15,000 0 Share-based compensation 28,000 26,665 Changes in Assets and Liabilities (Increase) decrease in accounts receivable (575,185 ) 4,982 (Increase) in miscellaneous receivable (100,813 ) (8,184 ) (Increase) in inventory (107,327 ) (51,701 ) (Increase) decrease in prepaid expenses (32,710 ) 18,374 Increase (decrease) in accounts payable 78,677 (97,449 ) Increase (decrease) in accrued expenses 250,757 (9,895 ) Increase (decrease) in accrued interest – related party (25,973 ) 9,553 Increase in deferred revenue 115,181 12,138 Net Cash Used in Operating Activities (273,941 ) (136,671 ) Acquisition of property and equipment (20,948 ) (24,617 ) Payments received on note receivable 28,510 40,026 Increase in other assets 0 (18,113 ) Net Cash Used in Investing Activities 7,562 (2,704 ) Payments on notes payable – related party (103,474 ) (249,349 ) Collection of stock subscription receivable 6,604 15,447 Payments on note payable (81,057 ) (91,128 ) Proceeds from issuance of common stock 200,000 500,000 Net Cash Provided by Financing Activities 22,073 174,970 Net Increase (Decrease) in Cash and Cash Equivalents (244,306 ) 35,595 Cash and Cash Equivalents – Beginning of Year 444,434 408,839 Cash and Cash Equivalents – End of Year $ 200,128 $ 444,434 Supplemental Cash Flow Information: Cash paid for interest $ 115,537 $ 55,454 Cash paid for income taxes $ 0 $ 0 Non – Cash Investing and Financing Activities: Common Stock issued for payment of accounts payable $ 0 $ 16,000 Intangible assets acquired through the issuance of notes payable recorded at fair values $ 21,150,000 $ 126,000 Intangible assets acquired through the issuance of common stock recorded at fair values $ 480,000 $ 90,000 Debt discount related to fair value of notes payable $ 1,530,000 $ 0 Inventory reclassified to products held for lease $ 50,537 $ 0 NOTE 1. NATURE OF OPERATIONS History of business entities. On January 1, 2007, Galaxy Gaming, LLC (“GGLLC”), a Nevada limited liability company, entered into several agreements with the original Galaxy Gaming, Inc., a Nevada privately held corporation (“GGPVT”). GGPVT was incorporated in the State of Nevada on December 29, 2006, and acquired the business operations of one or more companies using the “Galaxy Gaming” moniker. Pursuant to these agreements, GGLLC sold selected assets, such as inventory and fixed assets, to GGPVT. On December 31, 2007, GGPVT acquired, through an asset purchase agreement, GGLLC’s remaining intellectual property including patents, patent applications, trademarks, trademark applications, copyrights, know-how and trade secrets related to the casino gaming services including but not limited to games, side bets, inventions and ideas. GGPVT also acquired the existing client base from GGLLC. Secured Diversified Investment, Ltd. Secured Diversified Investment, Ltd., a publically held Nevada corporation (“SDI”), was served with an involuntary petition for relief under Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Nevada, Case No. 08-16332. The Bankruptcy Court’s Order for Relief was entered on July 30, 2008. By order entered January 27, 2009, the Bankruptcy Court confirmed SDI’s Plan of Reorganization (“Plan”). On February 10, 2009, SDI entered into a share exchange agreement with GGPVT (the “Reverse Merger”). In connection with the Reverse Merger, SDI obtained 100% of the issued and outstanding shares of GGPVT and GGPVT became a wholly-owned subsidiary of SDI. Pursuant to the terms and conditions of the Reverse Merger and the terms of the Plan, SDI issued 25,000,000 shares of common stock pro-rata to the former shareholders of GGPVT in exchange for obtaining ownership of 100% of the issued and outstanding shares of GGPVT”). SDI also issued 4,000,006 shares of new common stock on a pro rata basis to its creditors in exchange for the discharge of its outstanding debts under Chapter 11 of the U.S. Bankruptcy Code. All of SDI’s issued and outstanding equity interests existing prior to the Reverse Merger were extinguished and rendered null and void. Immediately following these events there were 29,000,006 shares of common stock issued and outstanding. Following the closing of the share exchange agreement, SDI discontinued all prior operations and focused exclusively on the business and operations of its wholly-owned subsidiary, GGPVT. On September 1, 2009, our Board approved a merger of SDI with its subsidiary, GGPVT, pursuant to Nevada Revised Statute. §92A.180 (“Short Form Merger”) and the merged company was named “Galaxy Gaming, Inc.” Description of business. We design, manufacture and market casino table games and electronic jackpot bonus system platforms played in land-based and cruise ship gaming establishments. The game concepts and the intellectual property associated with these games are typically protected by patents, trademarks and/or copyrights. We market our products and license our intellectual property via our own sales force to casinos and to cruise ships worldwide. Revenues come primarily from recurring royalties received from our clients for the licensing of game content and other fees paid based upon the performance of our electronic platforms. Additionally, we receive revenue as reimbursement from the sale of our associated products. On February 21, 2011, we entered into a definitive agreement with TableMAX Corporation (TMAX) a provider of electronic table games and platforms headquartered in Las Vegas, Nevada. Under the terms of the agreement, we have exclusive worldwide rights (excluding one international and two U.S. territories) to the TMAX electronic gaming platform and certain game titles. See Note 17 in “Item 8. Financial Statements and Supplementary data” included in this Form 10-K. On October 1, 2011, we executed an asset purchase agreement (“Prime Agreement”) with Prime Table Games LLC and Prime Table Games UK (collectively “Prime Table Games”). Under the terms of the Prime Agreement we acquired over 20 different table games, including 21+3, Two-way Hold'em and Three Card Poker, which are currently played on approximately 500 tables in 200 casinos in the United States, the United Kingdom and in the Caribbean. (Three Card Poker rights are limited to the British Isles.) The intellectual property portfolio includes 46 patents and patents pending, 96 worldwide trademark and design registrations and 47 domain name registrations. See Note 17 in “Item 8. Financial Statements and Supplementary data” included in this Form 10-K. On November 1, 2011, we entered into an asset purchase agreement (the “Lakes Agreement”) with Lakes Entertainment, Inc., a Minnesota corporation (“Lakes”). Included in the acquisition are nine patents, various trademarks and four casino table games known as Bonus Craps, Bonus Roulette, Rainbow Poker and Four the Money. In addition, we received assignment of licensing agreements for approximately 40 placements in 12 casinos. See Note 17 in “Item 8. Financial Statements and Supplementary data” included in this Form 10-K. NOTE 2. SIGNIFICANT ACCOUNTING POLICIES This summary of our significant accounting policies is presented to assist in understanding our financial statements. The financial statements and notes are representations of our management team, who are responsible for their integrity and objectivity. These accounting policies conform to generally accepted accounting principles and have been consistently applied to the preparation of the financial statements. Basis of accounting. The financial statements have been prepared on the accrual basis of accounting in conformity with accounting principles generally accepted in the United States of America. Revenues are recognized as income when earned and expenses are recognized when they are incurred. We do not have significant categories of cost as our income is recurring with high margins. Expenses such as wages, consulting expenses, legal, regulatory and professional fees, and rent are recorded when the expense is incurred. Cash and cash equivalents. We consider cash on hand, cash in banks, certificates of deposit, and other short-term securities with maturities of three months or less when purchased, as cash and cash equivalents. Our bank accounts are deposited in insured institutions. The funds are insured up to $250,000. At December 31, 2011, our bank deposits did not exceed the insured amounts. Reclassifications. Certain accounts and financial statement captions in the prior periods have been reclassified to conform to the current period financial statements. Inventory. Inventory consists of products designed to enhance table games, such as signs, layouts, bases for the different signs and electronic devices to support our enhanced bonus platforms. The inventory value is determined by the average cost method and management maintains inventory levels based on historical and industry trends. Signs and layouts do not change unless the table game changes. We do not allocate overhead to inventory as such costs are not significant. Fair value of financial instruments. The fair value of cash and cash equivalents, accounts receivable, miscellaneous receivable, prepaid expenses, inventory, accounts payable, accrued expenses and deferred revenue approximates the carrying amount of these financial instruments due to their short-term nature. The fair value of long-term debt, which approximates its carrying value, is based on current rates at which we could borrow funds with similar remaining maturities. Property and equipment. Property and equipment are being depreciated over their estimated useful lives, 3 to 7 years, using the straight-line method of depreciation for book purposes. Impairment of long-lived assets . We continually monitor events and changes in circumstances that could indicate carrying amounts of long-lived assets may not be recoverable. When such events or changes in circumstances are present, we assess the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future cash flows is less than the carrying amount of those assets, we recognize an impairment loss based on the excess of the carrying amount over the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less costs to sell. Intellectual property and intangible assets . These intellectual property and intangible assets have finite lives and are being amortized using the straight-line method over their economic useful lives, five to thirty years. The intangible assets are analyzed for potential impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. Goodwill. We have classified as goodwill the excess of the purchase price over the fair value of assets acquired. On an annual basis, goodwill is tested for impairment and adjusted to reflect any impairment loss. No such loss was recorded for the year ended December 31, 2011. Revenue recognition. Revenue is primarily derived from the licensing of products and intellectual property. Consistent with our strategy, revenue is generated from negotiated and performance-based recurring licensing fees for table game content and related products. We also receive a one-time sale or reimbursement of manufactured equipment. When a table game is licensed without electronic enhancements, we generally sell the associated products and negotiate a month-to-month license fee for the game content. When a table game is licensed with electronic enhancements, such as the Bonus Jackpot System, we generally sell the associated products, negotiate a month-to-month license fee for the game content and collect an additional recurring fee associated with the performance of the system such as a fee per each wager placed. NOTE 2. SIGNIFICANT ACCOUNTING POLICIES (continued) Revenue recognition (continued). Substantially all revenue is recognized when it is earned. Clients may be invoiced monthly in advance for content fees and the advance billings are carried as deferred revenue on the balance sheet. Additionally, clients may be invoiced at the time of shipment or delivery of product sales and invoiced in arrears for performance-based items. Also, clients may be invoiced monthly or quarterly in arrears for content fees. The monthly recurring invoices are based on executed agreements with each client. Total revenue from recurring royalties for the licensing of game content, fees paid based upon the performance of our electronic platforms and Inter-Casino Jackpot system was $3,655,148 and $2,950,157 for the years ended December 31, 2011 and 2010, respectively. Revenue from reimbursement from the sale of product was $29,717 and $104,699 for the years ended December 31, 2011 and 2010, respectively. Revenue as reimbursement from the sale of our associated products is recognized when the following criteria are met: (1) Persuasive evidence of an arrangement exists; (2) Shipment or delivery has occurred and any acceptable terms have been fulfilled; (3) The price is fixed and or determinable; and (4) Collectability is reasonably assured or probable The combination of hardware and software included in our Enhanced Table Systems and e-Tables are essential to the operation of the system. As such we do not segregate the portion of revenue between manufactured equipment and any software or electronic devices needed to use the equipment when the system is sold. We do not market the software separately from the equipment. Costs of ancillary products and assembled components. Costs of ancillary products and assembled components include pay tables, layouts and signage as it relates to a specific proprietary game that our client may elect to purchase in connection with the use of our game and the cost of the assembled components of the Bonus Jackpot System. Research and development. Research and development costs are charged to expense when incurred and are included in the statements of operations. These costs include salaries, benefits, and other internal costs allocated to software and hardware development efforts, as well as purchased components. Deferred income taxes. Deferred income taxes are recognized by applying enacted statutory rates, applicable to future years, to temporary differences between the tax bases and financial statement carrying values of our asset and liabilities. Valuation allowances are recorded to reduce deferred tax assets to amounts that are more likely than not to be realized. Basic income (loss) per share. Basic earnings per share excludes dilution and is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Stock-based compensation. Stock-based compensation is accounted for at fair value in accordance with ASC Topic 718. During the year ended December 31, 2010, the Board approved the adoption of a stock option plan. As of December 31, 2011, we had not granted any stock options under this plan. Subsequently, on March 29, 2012, our Board approved an issuance of fully paid common stock to certain longstanding employees. See Note 18. Management estimates. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates and assumptions have been made in determining the depreciable lives of such assets and the allowance for doubtful accounts receivable. Actual results could differ from those estimates. Recently issued accounting guidance. We do not expect the adoption of recently issued accounting pronouncements to have a significant impact on our results of operations, financial position or cash flow. NOTE 3. NOTE RECEIVABLE – RELATED PARTY The note receivable at December 31, 2011 and 2010 was as follows: Note receivable $ 391,940 $ 420,450 Less: current portion (17,491 ) (16,475 ) Long-term note receivable $ 374,449 $ 403,975 We acquired, with an asset purchase agreement from GGLLC, the note receivable stated above, as part of the purchase of the remaining intellectual property including patents, patent applications, trademarks, trademark applications, copyrights, know-how and trade secrets related to the casino gaming services including but not limited to games, side bets, inventions and ideas. The purchase was financed by a ten year unsecured note with a 6% fixed interest rate, monthly principal and interest payments of $6,598 with the unpaid principal and interest due in February 2017. Interest income associated with this note receivable was $24,821 and $26,150 for the years ended December 31, 2011 and 2010, respectively. The terms of the note were amended in September 2010 whereby the monthly principal and interest payment was reduced to $3,332 and the unpaid principal and interest is due August 2015. Management evaluates collectability on a regular basis and will set up reserves for uncollectible amounts when it has determined that some or all of this receivable may be uncollectible. At December 31, 2011, management believed that 100% of the notes receivable principal and interest amounts are collectable. NOTE 4. PREPAID EXPENSES Prepaid expenses consist of the following as of December 31, 2011 and 2010: Marketing agreement $ 0 $ 4,000 IT system 6,129 7,292 Insurance 18,371 463 Legal 7,500 0 Trade show expense 13,557 8,583 Property taxes 588 3,718 Rent 10,360 0 Other 1,145 884 Total Prepaid Expenses $ 57,650 $ 24,940 NOTE 5. PROPERTY AND EQUIPMENT We owned property and equipment, recorded at cost, which consisted of the following at December 31, 2011 and 2010: Computer equipment $ 43,845 $ 37,403 Furniture and fixtures 62,976 51,187 Office equipment 10,320 10,320 Leasehold improvements 6,367 3,650 Subtotal 123,508 102,560 Less: Accumulated depreciation (80,871 ) (58,459 ) Property and equipment, net $ 42,637 $ 44,101 Depreciation expense was $22,412 and $12,833 for the years ended December 31, 2011 and 2010, respectively. NOTE 6. INTELLECTUAL PROPERTY AND INTANGIBLE ASSETS Intellectual property and intangible assets consisted of the following at December 31, 2011 and 2010: Intellectual property $ 140,967 $ 140,967 Territory 150,000 150,000 Deuces Wild assets 216,000 216,000 Trademarks 2,740,000 0 Patents 13,259,000 0 Non-compete 660,000 0 Customer relationships 3,400,000 0 Total Intellectual property and intangible assets 20,565,967 506,967 Less: Accumulated amortization (454,204 ) (40,346 ) Intellectual property and intangible assets, net $ 20,111,763 $ 466,621 Amortization expense was $413,858 and $26,258 related to the above assets for the years ended December 31, 2011 and 2010, respectively. We acquired intellectual property including patents, patent applications, trademarks, trademark applications, copyrights, know-how and trade secrets related to the casino gaming services, including but not limited to, games, side bets, inventions and ideas, valued at $140,967 from a related party. We purchased back a regional territory from an outside sales representative. The total value of this agreement was $150,000 and the resulting intangible asset has an infinite life. We executed an asset purchase agreement on April 15, 2010, with T&P Gaming, Inc., and its majority owners whereby we acquired the client installation base, intellectual property, territorial license and related inventory associated with the “Deuces Wild Hold’em Fold’em game (“Deuces Wild”) and related “Random Wild” game for $216,000. On October 1, 2011, we entered into an asset purchase agreement with Prime Table Games, LLC. A subsequent valuation report performed by a national business valuation firm out of Dallas, TX, concluded the following valuation of the deal: Asset Fair Value Trademarks $ 2,740,000 Patents 13,259,000 Goodwill 1,091,000 Non-Compete Agreement 660,000 Customer Relationships 3,400,000 Total $ 21,150,000 The intellectual property and intangible assets are analyzed for potential impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. The territorial license has an infinite life. NOTE 7. ACCRUED EXPENSES AND TAXES We recorded accrued expenses and taxes, which consisted of the following at December 31, 2011 and 2010: Wages and related costs $ 124,821 $ 85,515 Accrued settlement 127,500 0 Accrued interest 1,380 2,615 Accrued expenses 105,159 19,973 Total accrued expenses $ 358,860 $ 108,103 NOTE 8. LONG-TERM DEBT Long - term debt consists of the following at December 31, 2011 and 2010: Note payable - commercial bank $ 1,148,448 $ 1,172,393 Notes payable, net of debt discount - asset acquisition 20,722,158 57,113 Less: Current portion (1,835,240 ) (81,058 ) Total long – term debt $ 20,035,366 $ 1,148,448 The note payable is paid to a commercial bank in monthly installments of $9,159 including fixed interest of 7.3%, for ten years, through February 2017, at which time there is a balloon payment of $1,003,230. This liability was assumed with the asset purchase agreement from the GGLLC. The note payable financed the purchase of the intellectual property including patents, patent applications, trademarks, trademark applications, copyrights, know-how and trade secrets related to the casino gaming services including but not limited to games, side bets, inventions and ideas. The note agreement with the commercial bank remains in the name of GGLLC and we have no direct obligation to the commercial bank. In connection with the asset purchase agreement associated with the T&P Gaming acquisition executed on April 15, 2010, we obtained seller financing in the amount of $126,000 payable over eighteen months at an interest rate of 6% per annum. Monthly principal and interest payments of $7,301 were required with the first payment paid upon closing. The promissory note was fully paid-off in the year ended December 31, 2011. In October, 2011 we closed an asset acquisition of Prime Table Games (US and UK components). Included within the structure of the $23 million acquisition was a $22.2 million component consisting of two promissory notes: 1) a US note for $12.2 million, and 2) a £6.4 million ($10.0 million USD) note. The notes were recorded at fair value, net of a debt discount of $1,530,000. Maturities of our long-term debt as of December 31, 2011 are as follows: Maturities as of: Total 2012 $ 1,835,240 2013 2,315,274 Thereafter 8,674,339 Total Long Term Debt $ 23,348,448 Less: Debt discount (1,477,842 ) Long-term Debt, net of debt discount 21,870,606 NOTE 9. NOTE PAYABLE – RELATED PARTY We received working capital loans from GGLLC, a related party, in 2008 and 2007. The loans bore 9% interest and were due 90 days after demand. The loans were fully paid in 2011. The note balances were $0 and $103,943 at December 31, 2011 and 2010, respectively. Accrued interest owed on this loan was $0 and $25,973 for the years ended December 31, 2011 and 2010, respectively. NOTE 10. COMMITMENTS AND CONTINGENCIES Operating lease obligation. We lease our offices from a related party that is connected with our CEO. We entered into a lease effective September 1, 2010 for a period of two years with a monthly rental payment of $10,359. Rent expense was $124,319 and $143,551 for the years ended December 31, 2011 and 2010, respectively. Rent to be paid under the lease agreement is summarized as follows: Twelve months ended December 31, 2011 $ 124,319 Total Lease Obligation $ 207,191 NOTE 10. COMMITMENTS AND CONTINGENCIES (continued) Legal proceedings. Our current material litigation is briefly described below. We assume no obligation to update the status of pending litigation, except as required by applicable law, statute or regulation. Sherron settlement – In 2008, Sherron Associates, Inc. (“Sherron”) filed a suit against us claiming they were the assignee of a judgment against our CEO and further claiming we were the alter-ego of our CEO and therefore responsible for payment of the judgment. We denied all liability in the Sherron matter. In order to reduce the costs and uncertainties associated with litigation, the parties executed a settlement agreement on October 25, 2011. In connection with the settlement agreement we agreed to pay Sherron the sum of $150,000. Monthly installments in the amount of $7,500 per month commenced November 1, 2011, with scheduled increases in phases over the course of one year to a maximum of $17,500 per month. The obligation was memorialized by a promissory note, at zero percent interest. The note has default interest of 12% per annum, secured by a confession of judgment in the amount of $150,000, which can be filed by Sherron immediately upon a default in any payment. Our obligation is personally guaranteed by our CEO. We recorded a provision for litigation settlement of $150,000 during the quarter ended September 30, 2011. Our CEO agreed to pay Sherron the sum of $350,000 by June 1, 2012. If he fails to make the payment by that date, he is obligated to pay Sherron the sum of $375,000 by November 1, 2012. If our CEO fails to make that payment on the specified due date, we have agreed to make the payment by November 15, 2012. In the event payment is not made by November 15, 2012, Sherron may file a confession of judgment for $375,000 against our CEO and us with interest accruing at the rate of 12% per annum from November 15, 2012. If our CEO fails to make the $350,000 payment to Sherron by June 1, 2012, then our CEO and we will meet by August 1, 2012, to discuss whether or not he has the means to pay Sherron $375,000 by November 1, 2012. If, after the August 1, 2012, meeting, our CEO and we agree that he does not have the means to pay the $375,000 by November 1, 2012, then he will assign 1.5 million or more of shares of our stock held by Triangulum Partners, LLC (depending on the trading price of our shares as of August 1, 2012) to us and such assignment shall provide us the power and authority to sell such shares on the open market in order to satisfy the $375,000 owed to Sherron. If we are unable to raise the full amount of $375,000 through the sales of shares by November 15, 2012, or we are unable to sell any shares by that date, then our CEO guarantees and owes either $375,000 or any remaining balance thereof to us. California administrative licensing action – In March 2003, Galaxy Gaming of California, LLC (“GGCA”), then a subsidiary of GGLLC, submitted an application to the California Gambling Control Commission (the “Commission”) for a determination of suitability for licensure to do business with tribal gaming operations in California. At the time, our CEO was a member of GGCA and was required to be included in the application process. The Division of Gambling Control of the California Department of Justice (“Division”) processed the application and in 2005 made an initial recommendation to the Commission alleging GGCA was unsuitable. Claiming the information compiled by the Division was inaccurate and the process seriously flawed and biased, GGCA and our CEO, requested the Commission assign an administrative law judge (“ALJ”) to further adjudicate the process in December 2006. The Commission granted their request and required the Division to first submit a statement of issues (“SOI”) against GGCA, which was filed in October 2009. In February 2009, we independently applied to the Commission for a finding of suitability. We also sought the abandonment of the GGCA application. Since the Division (subsequently renamed the “Bureau of Gambling Control”), named our CEO in the SOI, the Commission decided to not process our application until resolution of the administrative action relating to GGCA. It also did not act upon our request to abandon the GGCA application. During these proceedings, we are entitled to conduct business in California, provided that, we obtain the requisite authorization with each tribe in California either through obtainment of an appropriate license or an exempt status determination. Total revenues derived from California for the year ended December 31, 2011, was $177,402. Our ability to continue to conduct business in California could be contingent upon a successful resolution of the action against GGCA. Accordingly, we decided to vigorously defend the administrative action, to seek the abandonment of the GGCA application and to seek an independent finding of suitability with the Commission. The GGCA administrative action remains pending. Hearings before the ALJ concluded in January 2012, and closing briefs are expected to be filed by the third quarter of 2012. The ALJ will present her findings to the Commission, which will ultimately decide the matter, subject to judicial review. An adverse decision could prevent us from conducting business in California and also potentially pay reasonable costs of the investigation and prosecution of the case. Although the action is against our CEO and GGCA, it is unknown whether the Bureau will attempt to seek reimbursement against us or whether such reimbursement would be granted. An adverse finding of suitability could also influence other gaming regulatory agencies and negatively affect our ability to conduct business in those jurisdictions. We believe the allegations against GGCA and our CEO are baseless and entirely without merit and intend to continue to vigorously respond to this action. Reel Games, Inc. – On November 10, 2011, we were served with a summons and complaint by Reel Games, Inc. in the United States District Court Southern District of Florida, alleging amongst other things, misappropriations of trade secrets, breach of confidence, fraud and intentional interference with contract. Reel Games, Inc. has claimed that the value of the information misappropriated alone is in excess of $1 million. The allegations stem from a mutual non-disclosure and non-circumvention agreement executed by the parties in May 2010, in connection with us evaluating the acquisition of certain assets of Reel Games, Inc. In December 2011, we filed a Motion for Dismissal, which remains pending. We believe that the claims are entirely without merit and intend to defend this matter vigorously. Unax Gaming – On March 14, 2012, we filed a complaint for patent infringement against Unax Service, LLC, a Washington limited liability company and Xuming Shangguan a.k.a. Sean Shangguan d.b.a. Unax Gaming in the United States District Court, Western District of Washington. We claim that the defendants’ games known as “Double Action Blackjack” and “Squeezit Blackjack” infringe on several patents held by us. We seek a permanent injunction against the infringing games, actual and exemplary damages, court costs and attorney fees. We intend to vigorously pursue all remedies available to us in the matter. Washington administrative notice – On March 19, 2012, we received a notice of administrative charges from the Washington State Gambling Commission ("Commission") as a result of a routine audit conducted by them in 2010. The notice involves alleged untimely notifications, predominantly by predecessor companies. Since receiving the notice, we have had preliminary discussions with Commission officials to resolve the matters raised in the notice. Our executive management currently believes the matter will be resolved expeditiously and without material effect to our business operations in Washington. If unresolved, we could be subject to fines, reimbursement of the Commission's investigative costs or harsher sanctions. Total revenues derived from Washington for the year ended 2011 were $1,154,925. In the ordinary course of conducting our business, we are, from time to time, involved in other litigation, administrative proceedings and regulatory government investigations including but not limited to those in which we are a plaintiff. NOTE 11. ALLOWANCE FOR DOUBTFUL ACCOUNTS We record an allowance for doubtful accounts based on periodic reviews of accounts receivable. As of December 31, 2011 and 2010, we had an allowance for doubtful accounts of $41,306 and $19,912, respectively. NOTE 12. STOCKHOLDERS’ EQUITY (DEFICIT) We had 65,000,000 shares of $.001 par value common stock and 10,000,000 shares of $.001 par value preferred stock authorized as of December 31, 2011. On April 1, 2010, we sold a total of 1,428,572 shares of common stock and 714,286 warrants for total cash proceeds of $500,000. In 2011, we issued 533,333 shares and stock warrants of 266,667 generating cash proceeds of $200,000 that was used to fund ongoing operations. Additionally, as a part of the asset acquisition of Prime Table Games on October 1, 2011, a total of 2,000,000 shares of common stock valued at $480,000 were issued to the two owners of that organization. There were 37,508,091 common shares and -0- preferred shares issued and outstanding at December 31, 2011. NOTE 13. RELATED PARTY TRANSACTIONS We lease our offices from a related party that is related to our CEO. We paid legal fees directly to the law firm retained by our CEO. The law firm was employed in 2009, 2010 and 2011 for the express purpose of defending the Sherron litigation. We believed this strategy to vacate the underlying judgment was a faster, surer and less expensive method to defend the Sherron litigation, than other alternatives available to us. Total fees from this law firm charged to expense were $61,887 and $42,632 for 2011 and 2010, respectively. We anticipate no further legal fees pertaining to the Sherron litigation as a result of the settlement. See Note 10 . We have a note receivable from a related party totaling $391,940 and $420,450 at December 31, 2011 and 2010, respectively. See Note 3. We received working capital loans from GGLLC, a related party, in 2008 and 2007. In 2011, the loans were fully paid. See Note 9. In 2011, we paid fees in the amount of $13,950 for administrative services to a company controlled by the wife of our CEO. NOTE 14. INCOME TAXES For the year ended December 31, 2011, we had a net loss, and therefore, do not have a tax liability for the year. We have a previous net operating loss carry-forward of $1,160,000. Any income will be netted against this loss carry-forward, with the remainder to be used through the year 2028 to offset future taxable income. The cumulative net operating loss carry-forward for income tax purposes may differ from the cumulative financial statement loss due to permanent differences and timing differences between book and tax reporting. Additionally, we have a foreign tax credit carry-forward of approximately $181,000 that can be used in the future to offset federal income tax owed. We periodically review the need for a valuation allowance against deferred tax assets based upon earnings history and trends. We believe the valuation allowances provided are appropriate. The cumulative tax effect at the expected rate of 34% of significant items comprising our net deferred tax amount is as follows: Deferred tax asset attributable to: 2011 2010 Net operating loss carryover $ 555,334 $ 394,400 Valuation allowance (555,334 ) (394,400 ) Net deferred tax asset $ 0 $ 0 NOTE 15. NON-CASH INVESTING AND FINANCING CASH FLOW DISCLOSURES We sold 101,250 shares of common stock to employees in exchange for various notes receivable totaling $40,500. As of December 31, 2011 and 2010, $3,916 and $10,520, respectively, was still outstanding and has been recorded as a stock subscription receivable. During the year ended December 31, 2010, we issued 40,000 shares of common stock in settlement of accounts payable. We issued 450,000 shares of common stock in connection with an asset acquisition from T&P Gaming. During the year ended December 31, 2011, we issued 2,000,000 shares of common stock as partial payment in connection with an asset acquisition from Prime Table Games. NOTE 16. STOCK OPTIONS AND WARRANTS We issued 714,286 warrants in connection with the sale of common stock on April 1, 2010. Additionally, we issued 266,667 warrants in connection with the sale of common stock during the quarter ended June 30, 2011. We have accounted for these warrants as equity instruments in accordance with EITF 00-19 (ASC 815-40), Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock, and as such, will be classified in stockholders’ equity as they meet the definition of “…indexed to the issuer’s stock” in EITF 01-06 (ASC 815-40) The Meaning of Indexed to a Company’s Own Stock. We have estimated the fair value of the warrants issued in connection with the sale of common stock at $323,128 and the employment agreement at $10,665 using the Black-Scholes option pricing model. During the years ended December 31, 2011 and 2010, we issued 22,500 stock options each year as part of the employment agreement with our CFO, who subsequently terminated his employment. See Note 18. Black-Scholes testing was performed on these options, but because the options were nullified as a result of his resignation, the results were reversed as of December 31, 2011. During the year ended December 31, 2011, we issued 373,750 stock options to two Board members. The options were valued at the fair market value of the services performed, which resulted in an expense of $28,000 for the year ended December 31, 2011. NOTE 16. STOCK OPTIONS AND WARRANTS (continued) Key assumptions used by us are summarized as follows: Private Placement Warrants Issued Exercise price $ 0.40 $ 0.40 Volatility 165 % 146 % Expected dividend yield 0.00 % 0.00 % Risk-free rate over the estimated expected life of the warrants 1.63 % .0066 % Expected term (in years) 3.0 3.0 The warrants issued have been accounted for as an equity transaction. The cost of the options issued in connection with the employment agreement and to the Board members were classified as operating expenses for the year ended December 31, 2011. A summary of changes in share purchase warrants during the year ended December 31, 2011 is as follows: Warrants Weighted Average Exercise Price Outstanding, January 1, 2011 1,750,715 $ 0.40 Issued 266,667 0.40 Exercised 0 0 Expired 0 0 Outstanding, December 31, 2011 2,017,382 $ 0.40 A summary of changes in employee stock options during the year ended December 31, 2011 is as follows: Stock Options Weighted Average Exercise Price Outstanding, January 1, 2011 291,250 $ 0.4325 Issued 323,750 0.3360 Outstanding, December 31, 2011 615,000 $ 0.3898 NOTE 17. ASSET ACQUISITIONS AND SIGNIFICANT TRANSACTIONS Acquisition of T&P Gaming’s assets. On April 15, 2010, we executed an asset purchase agreement with T&P Gaming, Inc. and its majority owners whereby we acquired the client installation base, intellectual property, territorial license and related inventory associated with the Deuces Wild Hold’em Fold’em and Random Wild games. The purchase price was $216,000. Terms of the purchase included a down payment of $90,000, payable in the form of 450,000 shares of our common stock with the balance paid by a promissory note payable over eighteen months at an interest rate of 6% per annum. Monthly principal and interest payments of $7,301 were required. The promissory note was fully paid in the year ended December 31, 2011. Acquisition of Prime Table Games’ assets. On October 4, 2011 we executed an asset purchase agreement (“Prime Agreement”) with Prime Table Games LLC and Prime Table Games UK (collectively “Prime Table Games”). Under the terms of the Prime Agreement we acquired over 20 different table games, including 21+3, Two-way Hold'em and Three Card Poker which are currently played on approximately 500 tables in 200 casinos in the United States, the United Kingdom and in the Caribbean. (Three Card Poker rights are limited to the British Isles.) The intellectual property portfolio includes 36 patents, 11 patents pending, 96 worldwide trademark and design registrations and 47 domain name registrations. The two principals of Prime Table Games also executed with us a non-compete agreement. NOTE 17. ASSET ACQUISITIONS AND SIGNIFICANT TRANSACTIONS (continued) The acquisition was accounted for using the acquisition method of accounting. The allocation of fair value of the purchase price, based on an independent valuation, is as follows: Terms of the purchase included a down payment of $480,000, payable in the form of 2,000,000 shares of our common stock with the balance due in the form of two promissory notes. One of the notes is payable to Prime Table Games LLC in the amount of $12,200,000 (USD) and the other is payable to Prime Table Games UK in the amount of £6,400,000 (GBP). At the closing of the acquisition, the parties agreed to a conversion rate of one United States Dollar is equal to 64/100 British Pound Sterling, ($1.00USD = £0.64GBP). Interest on the promissory notes was 0% in 2011. The fair value of the notes, net of the debt discount was $20,670,000. The rate increases to 3% in 2012 and increases at 1% per year thereafter to maximum of 9%. Payments on each of the notes are as follows: Prime Table Games LLC. Monthly payments are due under this note, commencing with $100,000 due on or before January 28, 2012. Subsequent payments are due on the 28th day of each month and the payment amount shall increase to $130,000 per month beginning 16 months after the closing, $160,000 per month beginning in 28 months, $190,000 per month beginning in 40 months and $220,000 beginning in 52 months until fully paid. Prime Table Games UK. Monthly payments are due under this note, commencing with £64,000 due on or before January 28, 2012. Subsequent payments are due on the 28th day of each month and the payment amount shall increase to £76,800 per month beginning 16 months after the closing, £89,600 per month beginning in 28 months, £102,400 per month beginning in 40 months, £115,200 per month in 52 months until fully paid. In the event future monthly revenue received by us from the “Assets,” as defined in the Prime Agreement is less than 90% of the notes monthly payment due to Prime Table Games, then the note payments may, at our option, be adjusted to the higher of $100,000 per month (for the Prime Table Games LLC note) and £64,000 per month (for the Prime Table Games UK note) or 90% of the monthly revenue amount. If we engage in this payment adjustment election, the note shall not be deemed in default and the interest rate of the note will increase 2% per annum for the duration of the note or until the standard payment schedule resumes. The notes are collateralized by the all of the assets acquired from Prime Table Games LLC and Prime Table Games UK. Acquisition of Lakes Entertainment’s assets. On November 1, 2011, we entered into an asset purchase agreement (the “Lakes Agreement”) with Lakes Entertainment, Inc., a Minnesota corporation (“Lakes”). Under the Lakes Agreement, we acquired certain business assets of Lakes. The acquisition includes a portfolio of patented casino table games, including Bonus Craps, Four The Money, Rainbow Poker, and Roulette Craps, together with an assignment of the Lakes’ rights under existing licensing agreements with various casinos throughout the United States. The assignment of some of the contractual rights included in the acquisition will require the consent of the licensee and may be subject to customary regulatory approvals. The purchase price was $1 plus additional revenue sharing payments (“Contingent Consideration”), which we are obligated to pay. The Contingent Consideration is based upon differing percentages of the gross revenues generated by the acquired assets following the acquisition. Under the Lakes Agreement, Lakes has retained a perpetual, royalty-free license to install and offer for play any of the assigned casino games in any casino owned or managed by Lakes. The Lakes Agreement allows us the option at any time to buy-out Lakes’ right to the Contingent Consideration. In the event an agreed amount of Contingent Consideration has been not received within 18 months after the closing of the Lakes Agreement, Lakes will have the option to re-acquire all assets assigned under the Lakes Agreement and to collect all revenue generated by such assets going forward. In connection with the Lakes Agreement, Lakes has executed a non-competition agreement restricting Lakes participation in any business whose products are substantially similar to the casino games acquired by us under the Lakes Agreement for a period of two years. TableMAX agreement. On February 21, 2011, we entered into a definitive agreement (“TMAX Agreement”) with TableMAX Corporation (“TMAX”) a provider of electronic table games and platforms headquartered in Las Vegas, Nevada and a principal investor in TMAX. Under the terms of the TMAX Agreement, we have exclusive worldwide rights (excluding one international territory and two U.S. states) to the TMAX electronic gaming platform and certain games titles. We created an operating division (the “TableMAX Division”) which conducts sales, distribution, marketing, engineering, sub-licensing and manufacturing related to the TMAX products and related intellectual property. The TableMAX Division is wholly owned by us and is not considered owned by, related to, a joint venture partner of or an agent of TMAX in any manner. The term of the TMAX Agreement is five years. At any time during the term of the TMAX Agreement, either TMAX or we may make a written offer to purchase the sole ownership of the TableMAX Division. Such offer shall be subject to the parties’ mutual agreement and neither party shall be under any obligation to accept such an offer. If such an agreement has not been consummated within six months of the expiration of the TMAX Agreement, then each party must indicate to the other party no later than six months from the scheduled expiration of the TMAX Agreement, their intent to renew the TMAX Agreement for a term of at least one year, or terminate. TMAX agreed to assign, for the term of the TMAX Agreement, all of its existing gaming installations and usable inventory to the TableMAX Division. We agreed to furnish our intellectual property relating to our table game content for use by the TableMAX Division, royalty-free for the term of the TMAX Agreement. The TMAX Agreement specifies annual performance targets whereby we are required, on a cumulative basis, to have minimum table placements. If we fail to meet the performance criteria as defined in the TMAX Agreement, we will be required to pay TMAX the difference between TMAX’s share of the actual profit obtained by the TableMAX Division and the estimated profit that would have been obtained if the minimum performance criteria had been obtained. We are responsible for the losses of the TableMAX Division however; TMAX has agreed to reimburse us during the first 12 months from the date of the TMAX Agreement for operating expenses of the TableMAX Division up to a maximum of $600,000. Net profits from the TableMAX Division will be split between TMAX and us on a sliding scale basis dependent upon the number of TableMAX Division table installations and profit results as defined in the TMAX Agreement. NOTE 18. SUBSEQUENT EVENTS Zimmerman resignation. Mr. Andrew Zimmerman, Chief Financial Officer, Secretary and Treasurer, resign his positions to pursue other business interests. His resignation was effective February 1, 2012. Our Board appointed Mr. Robert Saucier to assume all three roles on an interim basis. We are actively engaged in a search to permanently fill these positions. There were no known disagreements with Mr. Zimmerman regarding our operations, policies or practices. Unax Gaming litigation. On March 14, 2012, we filed a lawsuit against Unax Service, et al. See Note 10 . Employee stock grant program. On March 29, 2012, our Board approved an employee stock grant program for selected long term employees. Under this plan, twelve employees were granted shares of common stock. For purposes of this transaction, we expensed the shares at $0.10 each, which was an approximately 29% reduction of the closing bid on the date of the grant. The stock grant plan was for a total of 802,500 shares, which are fully vested at the time of issuance and will be expensed in the amount of $80,250 plus payroll related and other transaction expenses. The shares are restricted and may not be transferred for a minimum of six months. All tax liabilities related to the stock grants are the responsibility of each individual employee. Washington administrative notice. On March 19, 2012, we received a notice of administrative charges from the Washington State Gambling Commission. See Note 10 . Scott resignation. Mr. Daniel Scott, director, resigned from our Board on April 13, 2012. CEO compensation. Our Board authorized the annual cash compensation to Mr. Robert Saucier, our CEO, be increased to $120,000 commencing on January 1, 2012. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE No events occurred requiring disclosure under Item 307 and 308 of Regulation S-K during the fiscal year ending December 31, 2011. ITEM 9A(T). CONTROLS AND PROCEDURES Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in company reports filed or submitted under the Securities Exchange Act of 1934 (the “Exchange Act”) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include without limitation, controls and procedures designed to ensure that information required to be disclosed in company reports filed or submitted under the Exchange Act is accumulated and communicated to management, including our CEO and Treasurer, as appropriate to allow timely decisions regarding required disclosure. As required by Rules 13a-15 and 15d-15 under the Exchange Act, our CEO and CFO carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2011. Based on their evaluation, they concluded that our disclosure controls and procedures were effective. Our internal control over financial reporting is a process designed by, or under the supervision of, our CEO and CFO and effected by our Board, management and other personnel, to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of our financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets; provide reasonable assurance that transactions are recorded as necessary to permit preparation of our financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with the authorization of our Board and management; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on our financial statements. Under the supervision and with the participation of our management, including our CEO, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation under the criteria established in Internal Control – Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2011. This annual report does not include an attestation report of our registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by our registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit us to provide only management’s report in this annual report. During the most recently completed fiscal quarter, there has been no change in our internal control over financial reporting that has materially affected or is reasonably likely to materially affect, our internal control over financial reporting. ITEM 9B. OTHER INFORMATION ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE Directors and executive officers. The following information sets forth the names of our current directors and executive officers and their ages. Name Age Office(s) held Robert Saucier 57 President, CEO, Chairman of the Board, interim CFO, Secretary and Treasurer William O’Hara 71 COO and Director Richard Baldwin 40 Director Set forth below is a brief description of the background and business experience of each of our current executive officers and directors. Robert B. Saucier is our President, CEO, and Chairman of the Board. In addition, with the departure of Mr. Zimmerman on February 1, 2012, Mr. Saucier has since served as our Interim CFO, Interim Secretary and Interim Treasurer. Mr. Saucier is our founder and has served as our President and CEO since inception and for our accounting and operational predecessors since 1997. Besides leading the executive team, Mr. Saucier’s primary responsibilities include product development, strategic planning, developing acquisition strategies and investor relations. During his career, Mr. Saucier has founded and grown five start-up companies. He was founder and CEO of the Mars Hotel Corporation, (1992 - 1998) a company that developed and managed the first non-tribal casino in Washington. Previously, Mr. Saucier founded International Pacific, an Inc. 500 company which recorded a 2,447% rate (five year period) and served as its President and Chairman (1986 -1992). He also founded and led Titan International, Inc. (1981 - 1986), a company that was engaged in electronic safety, security and surveillance systems. Throughout his career, Mr. Saucier has consulted with and invested in numerous business ventures and real estate development projects. William O’Hara is our Chief Operating Officer and a director and is in charge of the day-to-day operations of our business. After a successful 21-year career in the cosmetic, cosmetology and aesthetic industry, Mr. O’Hara began his gaming industry career as the first employee of Shuffle Master Gaming in 1991. Mr. O’Hara relocated to Las Vegas in 1992 to head up that company’s sales, service and marketing. In 1998, he joined Casinovations, Inc. as Senior Vice President of operations and president of its Mississippi subsidiary. In 2000, Mr. O’Hara joined PDS Gaming as the Senior Vice President of their newly formed electronic table games division. Mr. O’Hara joined Galaxy Gaming in February 2008. Mr O’Hara previously served on the Board of Directors of the Missouri Riverboat Gaming Association and Casino Management Association. Richard Baldwin is a director. Mr. Baldwin has over 17 years of corporate finance, capital markets and general management experience. He currently serves as President and Chief Financial Officer at TableMAX Gaming, Inc., a start-up company that develops proprietary technology for the global casino gaming industry and currently our strategic partner. Previously, he held several executive level positions, including Chief Financial Officer positions at Tropicana Entertainment, Shuffle Master Gaming (NASDAQ Global Select Market: “SHFL”), and as Director of Corporate Finance & Investor Relations at International Game Technology (NYSE: “IGT”). Mr. Baldwin started his career in public accounting with Deloitte & Touche LLP, is a graduate of the University of Nevada, Las Vegas, and is a Nevada registered CPA. Our bylaws authorize no less than one and no more than fifteen directors. We currently have three directors. Term of office. Our directors are appointed for a one-year term to hold office until the next annual meeting of our shareholders or until removed from office in accordance with our bylaws. Our officers are appointed by our Board and hold office until removed by the Board. Family relationships. There are no family relationships between or among the directors, executive officers or persons nominated or chosen by us to become directors or executive officers. Director or officer involvement in certain legal proceedings. To the best of our knowledge, except as described below, during the past five years, none of the following occurred with respect to a present or former director or executive officer of the Company: (1) any bankruptcy petition filed by or against any business of which such person was a general partner or executive officer either at the time of the bankruptcy or within two years prior to that time; (2) any conviction in a criminal proceeding or being subject to a pending criminal proceeding (excluding traffic violations and other minor offenses); (3) being subject to any order, judgment or decree, not subsequently reversed, suspended or vacated, of any court of any competent jurisdiction, permanently or temporarily enjoining, barring, suspending or otherwise limiting his involvement in any type of business, securities or banking activities; and (4) being found by a court of competent jurisdiction (in a civil action), the Securities and Exchange Commission or the Commodities Futures Trading Commission to have violated a federal or state securities or commodities law, and the judgment has not been reversed, suspended or vacated. Committees of the Board. Mr. Scott formerly served on our compensation committee and has not been replaced. We do not currently have an executive committee or stock plan committee. Audit committee. We do not have a separately-designated standing audit committee. The entire Board performs the functions of an audit committee, but no written charter governs the actions of the Board when performing the functions of what would generally be performed by an audit committee. The Board approves the selection of our independent accountants and meets and interacts with the independent accountants to discuss issues related to financial reporting. In addition, the Board reviews the scope and results of the audit with the independent accountants, reviews with management and the independent accountants our annual operating results, considers the adequacy of our internal accounting procedures and considers other auditing and accounting matters including fees to be paid to the independent auditor and the performance of the independent auditor. Nominating committee. Our Board does not maintain a nominating committee. As a result, no written charter governs the director nomination process. The size of our Board, at this time, does not require a separate nominating committee. When evaluating director nominees, our directors consider the following factors: (1) The appropriate size of our Board; (2) Our needs with respect to the particular talents and experience of our directors; (3) The knowledge, skills and experience of nominees, including experience in finance, administration or public service, in light of prevailing business conditions and the knowledge, skills and experience already possessed by other members of the Board; (4) Experience in political affairs; (5) Experience with accounting rules and practices; and (6) The desire to balance the benefit of continuity with the periodic injection of the fresh perspective provided by new Board members. Our goal is to assemble a Board that brings together a variety of perspectives and skills derived from high quality business and professional experience. In doing so, the Board will also consider candidates with appropriate non-business backgrounds. Other than the foregoing, there are no stated minimum criteria for director nominees, although the Board may also consider such other factors as it may deem are in our best interests as well as our stockholders. In addition, the Board identifies nominees by first evaluating the current members of the Board willing to continue in service. Current members of the Board with skills and experience that are relevant to our business and who are willing to continue in service are considered for re-nomination. If any member of the Board does not wish to continue in service or if the Board decides not to re-nominate a member for re-election, the Board then identifies the desired skills and experience of a new nominee in light of the criteria above. Current members of the Board are polled for suggestions as to individuals meeting the criteria described above. The Board may also engage in research to identify qualified individuals. To date, we have not engaged third parties to identify or evaluate or assist in identifying potential nominees, although we reserve the right in the future to retain a third party search firm, if necessary. The Board does not typically consider shareholder nominees because it believes that our current nomination process is sufficient to identify directors who serve our best interests. Section 16(a) beneficial ownership reporting compliance. Section 16(a) of the Exchange Act requires our directors and executive officers and persons who beneficially own more than ten percent of a registered class of our equity securities to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other equity securities. Officers, directors and greater than ten percent beneficial shareholders are required by SEC regulations to furnish us with copies of all Section 16(a) forms they file. To the best of our knowledge based solely on a review of Forms 3, 4, and 5 (and any amendments thereof) received by us during or with respect to the year ended December 31, 2011, the following persons have failed to file, on a timely basis, the identified reports required by Section 16(a) of the Exchange Act during fiscal year ended December 2011: Name and principal position Number of late reports Transactions not timely reported Known failures to Robert Saucier, CEO 1 1 0 Andrew Zimmerman, CFO n/a n/a n/a William O’Hara, COO n/a n/a n/a Dan Scott, director n/a n/a n/a Rich Baldwin, director n/a n/a n/a Code of Ethics. As of December 31, 2011, we had not adopted a Code of Ethics for Financial Executives, which would include our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. ITEM 11. EXECUTIVE COMPENSATION Compensation discussion and analysis. Our current executive compensation system consists of cash compensation to the executive officers, who are primarily responsible for the day-to-day management and continuing development of our business. We presently do not have an employment agreement or any fixed policy regarding compensation of Robert Saucier, our CEO. Currently, Mr. Saucier receives cash compensation of approximately $120,000 per year, which was raised to that level as of January 1, 2012. See Note 18 in “Item 8. Financial Statements and Supplementary Data” included in this Form 10-K. As our founder, Mr. Saucier holds a strong entrepreneurial interest in developing and expanding our business to the best of his ability. Our CFO, Andrew Zimmerman was party to a three-year employment agreement with us that terminated on February 1, 2012. Mr. Zimmerman’s compensation arrangement consisted of a base annual salary. Our COO, William O’Hara, is party to a three-year employment agreement with us. The initial three-year term expired in February 2011, however Mr. O’Hara continues to be represented by the agreement. Mr. O’Hara’s compensation arrangement consists of a base annual salary together with a potential monthly bonus to be awarded for those months in which we achieve higher sales figures than in any previous month. The objective of this arrangement is to provide Mr. O’Hara with regular compensation that is reasonable in light of the cash constraints faced by our developing business while also providing an incentive for the COO to lead the operations towards a continually expanding revenue base. Additionally, Mr. O’Hara was the recipient of a stock grant of 225,000 shares at a strike price of $0.10 per share on March 29, 2012. See “Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters” for more complete information included in this Form 10-K. Summary compensation table. The table below summarizes all compensation awarded to, earned by, or paid to our current executive officers for each of the last two completed fiscal years. Name and principal position Year Salary ($) Stock awards($) Option awards ($) (A) Non-equity incentive plan ($) All other compensation ($) Total ($) Robert Saucier, CEO 2011 30,782 0 0 0 0 30,782 2010 28,125 0 0 0 0 28,125 Andy Zimmerman, CFO 2011 148,438 0 3,235 0 0 151,673 2010 121,537 0 10,665 0 0 132,202 William O’Hara, COO 2011 148,438 0 0 0 0 157,469 2010 141,250 0 0 0 0 144,201 Narrative disclosure to the summary compensation table. We do not have a written employment contract with our CEO, Robert Saucier. His compensation increased to $120,000 annually as of January 1, 2012. Our COO, William O’Hara is party to a three-year employment agreement with us. Mr. O’Hara receives a base annual salary of $150,000. In addition, for each month in which our total sales are higher than any previous month, Mr. O’Hara earns a bonus equal to 10% of the increased sales above the prior monthly record. Mr. O’Hara’s contract expired in February 2011, however, Mr. O’Hara will receive six months of severance pay including benefits if his termination is other than for cause. Our CFO, Secretary, and Treasurer, Andrew Zimmerman was also party to a three-year employment agreement with us through November 2012. Mr. Zimmerman’s base compensation consists of a monthly salary paid in bi-monthly installments. Under his employment agreement with us, Mr. Zimmerman’s base salary began at $6,600 and increased in phases over the course of his first year of employment to a maximum of $12,500 per month. Mr. Zimmerman’s employment with us ended effective February 1, 2012. Messrs. Saucier, Zimmerman and O’Hara each agreed to temporarily reduce their salaries by 10% effective April 1, 2010. We restored one half of the reduction effective September 15, 2010, and the remaining amount effective with the pay period ending March 15, 2011. (A) The dollar amounts of Option awards are the aggregate grant date fair value of the option awards. Please refer to Note 16 in “Item 8. Financial Statements and Supplementary Data” included in this Form 10-K for further information about our calculation of those amounts, which we based on the reported closing market price of our common stock on the OTCBB on the date we granted the options. Outstanding equity awards at fiscal year-end table. The table below summarizes all unexercised options, stock that has not vested, and equity incentive plan awards for each named executive officer outstanding as of the end of our last completed fiscal year. OPTION AWARDS STOCK AWARDS or shares shares or Robert Saucier, CEO - - - - - - - - - William O’Hara, COO - - - - - - - - - Andrew Zimmerman, CFO(1) Mr. Zimmerman was initially granted options to purchase 37,500 shares of our common stock at a price of $0.55 per share, exercisable for three years. Additional grants of options to purchase 22,500 shares of our common stock at a price of $0.55 per share, exercisable for three years, will be made at the beginning of each additional year of service to Mr. Zimmerman. Our Stock Option Plan requires an employee to exercise any stock option purchases within three months of their departure. Accordingly, the expiration of Mr. Zimmerman’s is now scheduled for May 1, 2012. Compensation of directors table. The table below summarizes all compensation paid to our directors for our last completed fiscal year. Fees earned Non-equity Non-qualified or paid Stock Option incentive plan deferred compensation All other Name in cash awards awards compensation earnings compensation Total Robert Saucier 30,782 0 0 0 0 0 30,782 William O’Hara 148,438 0 0 0 0 0 148,438 Dan Scott 16,000 0 16,000 0 0 0 32,000 Richard Baldwin 12,000 0 12,000 0 0 0 24,000 Narrative disclosure to the director compensation table. Robert Saucier and William O’Hara do not currently receive any cash compensation from us or for their service as members of the Board. The compensation summarized above reflects the compensation each of our directors and former directors received in their capacities as our executive officers. Dan Scott and Richard Baldwin each receive a cash stipend in the amount of $4,000 per quarter. We have also agreed that Mr. Scott and Mr. Baldwin will receive immediately-vested options to purchase 46,250 shares of our common stock per quarter. Stock option grants. In anticipation of establishing an equity compensation plan we granted options to our CFO to purchase 37,500 shares of our common stock at a price of $0.55 per share, exercisable for three years. Additional grants of options to purchase 22,500 shares of our common stock at a price of $0.55 per share, exercisable for three years, will be made at the beginning of each additional year of service. We also agreed that our outside Board members, Dan Scott and Richard Baldwin, would receive immediately-vested options to purchase 46,250 shares of our common stock per quarter. The exercise price and term of such stock options has not been determined at this time. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The following table sets forth, as of March 29, 201 2 , the beneficial ownership of our common stock by each executive officer and director, by each person known by us to beneficially own more than 5% of the our common stock and by the executive officers and directors as a group. Except as otherwise indicated, all shares are owned directly and the percentage shown is based on 38,310,591 shares of common stock issued and outstanding on March 29, 201 2 : Name of beneficial owner (1) Amount of beneficial ownership Percent of class Triangulum Partners, LLC (2) 24,250,000 63.60 % William O’Hara, COO and director (2) 240,250 0.63 % Mr. Richard Baldwin, director (4) 0 0.00 % Total of All Directors and Executive Officers: 24,990,250 65.23 % More Than 5% beneficial owners: None. (1) As used in this table, "beneficial ownership" means the sole or shared power to vote, or to direct the voting of, a security, or the sole or shared investment power with respect to a security (i.e., the power to dispose of, or to direct the disposition of, a security). In addition, for purposes of this table, a person is deemed, as of any date, to have "beneficial ownership" of any security that such person has the right to acquire within 60 days after such date. (2) Mr. Robert Saucier is the Manager of Triangulum Partners, LLC. In that capacity, he is able to direct voting and investment decisions regarding the entity’s shares of common stock. (3) Of Mr. O’Hara’s 240,250 shares of our stock, 225,000 was granted as part of an Employee Stock Grant program on March 29, 2012. See “Item 11. Executive Compensation” and See Note 1 8 in “Item 8. Financial Statements and Supplementary data” included in this Form 10-K. (4) Mr. Baldwin has options that are currently vested in the amount of 138,750. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE Except as set forth below, none of our directors or executive officers, nor any proposed nominee for election as a director, nor any person who beneficially owns, directly or indirectly, shares carrying more than 5% of the voting rights attached to all of our outstanding shares, nor any members of the immediate family (including spouse, parents, children, siblings, and in-laws) of any of the foregoing persons has any material interest, direct or indirect, in any transaction over the last two years or in any presently proposed transaction which, in either case, has or will materially affect us: (1) We currently lease our corporate offices at 6980 O’Bannon Drive, Las Vegas, Nevada from a party related to our Chairman. (2) We paid legal fees directly to a law firm retained personally by our Chairman. See Note 10 in Item 8 Financial Statements and Supplementary Data included in this Form 10-K. We are not a “listed issuer” within the meaning of Item 407 of Regulation S-K and there are no applicable listing standards for determining the independence of our directors. Applying the definition of independence set forth in Rule 4200(a)(15) of The Nasdaq Stock Market, Inc., we believe that Mr. Richard Baldwin is our sole independent director. ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES Below is the table of Audit Fees billed by our auditor in connection with the audit of our annual financial statements for the years ended: Fee type 2011 2010 Audit fees $ 13,000 $ 13,000 Audit-related fees 11,908 7,250 Tax fees 3,500 3,500 All other fees 0 2,000 Total fees $ 28,408 $ 25,750 Item 15. Exhibits, Financial Statements Schedules (a) Financial Statements and Schedules The following financial statements and schedules listed below are included in this Form 10-K. Financial Statements (See Item 8) (b) Exhibits Exhibit Number Description 3.1 Amended and Restated Articles of Incorporation(3) 3.2 Amended and Restated Bylaws(3) 10.1 Exclusive Operating and License Agreement with TableMAX Gaming, Inc.(1) 10.2 Asset Purchase Agreement with Prime Table Games, LLC(2) 10.3 Prime Table Games Promissory Note and Security Agreement - US(2) 10.4 Prime Table Games Promissory Note and Security Agreement - UK(2) 23.1 Consent of Silberstein Ungar, PLLC, Certified Public Accountants 31.1 Certification of Chief Executive Officer pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Chief Financial Officer pursuant to Securities Exchange Act Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 32.1 Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 101** The following materials from the Company’s Annual Report on Form 10-K for the quarter ended December 31, 2011 formatted in Extensible Business Reporting Language (XBRL). **Provided herewith (1)Incorporated by reference to the Form 8K, filed by the Company with the Securities and Exchange Commission on February 24, 2011. (2)Incorporated by reference to the Form 8K, filed by the Company with the Securities and Exchange Commission on October 11, 2011. (3) Incorporated by reference to the Form 8K, filed by the Company with the Securities and Exchange Commission on February 13, 2009. Pursuant to the requirements of Section 13 or 15(d) of the Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. By: /s/ Robert Saucier Robert Saucier President, Chief Executive Officer and Director Interim Chief Financial Officer, Treasurer and Secretary April 19 , 2012 By: /s/ William O'Hara William O'Hara Chief Operation Officer and Director

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Business / FIN General Steel Reports Second Quarter 2014 Financial Results Quarterly Gross Margin Improves to a 36-Month High of 4.8% Quarterly EBITDA Improves by $54.4 million Year-over-Year to $33.6 million Quarterly Operating Cash Flows Improve by $121.4 million Year-over-Year to $56.1 million Company Reiterates EPS Guidance of $0.08 to $0.12 for Second Half of 2014 BEIJING, August 14, 2014 /PRNewswire/ — General Steel Holdings, Inc. (“General Steel” or the “Company”) (NYSE: GSI), a leading non-state-controlled steel producer in China, today announced its financial results for the second quarter ended June 30, 2014. Henry Yu, Chairman and Chief Executive Officer of General Steel commented, “We are very proud that our turn-around efforts are now driving measurable improvements to our financials, as gross margin expanded to a 36-month high and EBITDA substantially improved to a positive $33.6 million. These highlights reflect the success we have had over the past year in lowering our unit production cost and enhancing our operating efficiencies.” “During the second quarter, industry fundamentals significantly improved, and we were able to hold firm on our pricing. We are seeing a better demand-and-supply balance, and it is increasingly more evident that the market dynamics and competitive landscape will substantially improve in the coming months.” Mr. Yu concluded. John Chen, Chief Financial Officer of General Steel, commented, “This quarter we saw contributions to profitability from our two major initiatives. Our sourcing strategy lowered our raw material costs and, our upgraded production lines and technical improvements lowered our unit costs. We also turned around our operating cash flows to an inflow of $56.1 million, providing us with greater operating flexibility for the quarters ahead. Given our solid execution and the improved market fundamentals, we anticipate additional margin expansion and are confident that we will deliver on our target EPS range of 8 to 12 cents for the second half of 2014.” Second Quarter 2014 Financial Information Sales volume decreased by 5.7% year-over-year to approximately 1.31 million metric tons, compared with 1.38 million metric tons in the second quarter of 2013. Sales totaled $588.0 million, compared with $653.7 million in the second quarter of 2013. Gross profit was $28.1 million on gross margin of 4.8%, compared with a gross loss of $(35.5) million in the second quarter of 2013. Operating income totaled $6.3 million, compared with an operating loss of $(46.9) million in the second quarter of 2013. Net loss attributable to the Company reduced to approximately $(11.0) million, or $(0.20) per diluted share, compared with a net loss of $(39.8) million, or $(0.72) per diluted share in the second quarter of 2013. As of June 30, 2014, the Company had cash and restricted cash of $492.9 million. First Six Months 2014 Financial Information Sales volume decreased by 2.4% year-over-year to approximately 2.62 million metric tons, compared with 2.69 million metric tons in the first six months of 2013. Sales were $1.2 billion, compared with $1.3 billion in the first six months of 2013. Gross profit was $5.5 million on gross margin of 0.5%, compared with a gross loss of $(31.5) million in the first six months of 2013. Operating loss was $(37.3) million, compared with an operating loss of $(15.0) million in the first six months of 2013. Net loss attributable to the Company was $(54.6) million, or $(0.98) per diluted share, compared with a net loss of $(36.7) million, or $(0.67) per diluted share in the first six months of 2013. Second Quarter 2014 Financial and Operating Results Total sales for the second quarter of 2014 decreased by 10.0% year-over-year to $588.0 million, compared with $653.7 million in the second quarter of 2013. The year-over-year sales decreases were due to decreases in both average selling price of rebar and sales volume. Total sales volume in the second quarter of 2014 was 1.31 million metric tons, a decrease of 5.7% compared with 1.38 million metric tons in the second quarter of 2013. The average selling price of rebar at Longmen Joint Venture in the second quarter of 2014 decreased to approximately $450.0 per metric ton, down by 6.8% from $482.7 per metric ton in the second quarter of 2013. Gross Profit/Loss Gross profit for the second quarter of 2014 was $28.1 million, or 4.8% of total sales, as compared with a gross loss of $(35.5) million, or (5.4%) of total sales in the second quarter of 2013. The 1,020 basis points improvement in gross margin during the quarter was mainly attributable to decreased unit costs of rebar manufactured. Operating Expenses and Operating Income/Loss Selling, general and administrative expenses for the second quarter of 2014 were $18.8 million, a decrease of 9.6% from $20.8 million in the second quarter of 2013. Driven by effective headcount expense control, general and administrative expenses decreased to $9.1 million in the second quarter of 2014, compared with $11.6 million in the second quarter of 2013. Selling expenses was $9.7 million in the second quarter of 2014, slighted increased from $9.3 million in the same period of 2013. The increase in selling expenses was mainly due to the increase in freight expenses as a result of the PRC government’s policy to increase freight train fees in early 2014. Other operating loss from change in the fair value of profit sharing liability during the second quarter of 2014 was $(2.9) million, compared with a gain of $9.5 million recognized in the same period of last year. The loss recognized from change in the fair value of profit sharing liability was primarily due to the amortization of the present value discount. Correspondingly, income from operations for the second quarter of 2014 was $6.3 million, an improvement of $53.2 million compared with loss from operations of $(46.9) million for the second quarter of 2013. Finance Expense Finance and interest expense in the second quarter of 2014 was $26.6 million, of which, $5.7 million was the non-cash interest expense on capital lease as compared with $5.1 million in the same period of 2013, and $20.9 million was the interest expense on bank loans and discounted note receivables as compared with $16.1 million in the same period of 2013. The increase in finance and interest expenses was mainly a result of higher finance costs charged by banks and more of the early redemption on note receivables. Net Loss and Net Loss per Share Net loss attributable to General Steel for the second quarter of 2014 narrowed $(11.0) million, or $(0.20) per diluted share, based on 55.8 million weighted average shares outstanding. This compares to a net loss of $(39.8) million, or $(0.72) per diluted share, based on 55.0 million weighted average shares outstanding in the second quarter of 2013. First Six Months 2014 Financial and Operating Results Total sales for the first six months of 2014 decreased by 9.4% year-over-year to $1.2 billion, compared with $1.3 billion in the first six months of 2013. The year-over-year sales decreases were due to decreases in both average selling price of rebar and sales volume. Total sales volume in the first six months of 2014 was 2.62 million metric tons, a decrease of 2.4% compared with 2.69 million metric tons in the first six months of 2013. The average selling price of rebar at Longmen Joint Venture in the first six months of 2014 decreased to approximately $450.4 per metric ton, down by 9.6% from $498.4 per metric ton in the first six months of 2013. Gross profit for the first six months of 2014 was $5.5 million, or 0.5% of total sales, as compared with a gross loss of $(31.5) million, or (2.4%) of total sales in the first six months of 2013. Operating Expenses and Operating Loss Selling, general and administrative expenses for the first six months of 2014 were $39.9 million, slightly increased from $39.8 million in the first six months of 2013. General and administrative expenses were $21.9 million, compared with $22.5 million in the same period of 2013. Selling expenses increased by 4.1% to $18.0 million, compared to $17.3 million in the same period of 2013. Other operating loss from change in the fair value of profit sharing liability during the first six months of 2014 was $(3.0) million, compared with a gain of $56.3 million in the same period of last year. Correspondingly, loss from operations for the first six months of 2014 was $(37.3) million, compared with loss from operations of $(15.0) million for the first six months of 2013. Finance and interest expense in the first six months of 2014 was $55.3 million, of which, $10.7 million was the non-cash interest expense on capital lease as compared with $10.2 million in the same period of 2013, and $44.6 million was the interest expense on bank loans and discounted note receivables as compared with $35.9 million in the first six months of 2013. Net loss attributable to General Steel for the first six months of 2014 was $(54.6) million, or $(0.98) per diluted share, based on 55.8 million weighted average shares outstanding. This compares to a net loss of $(36.7) million, or $(0.67) per diluted share, based on 54.9 million weighted average shares outstanding in the first six months of 2013. As of June 30, 2014, the Company had cash and restricted cash of approximately $492.9 million, compared to $431.3 million as of December 31, 2013. The Company had an inventory balance of $209.0 million as of June 30, 2014, compared to $212.9 million as of December 31, 2013. Business Outlook For the six months ending December 31, 2014, the Company reiterates that it currently projects: Sales to range from $1.3 billion to $1.4 billion, on sales volume of approximately 3 million metric tons; Net income attributable to the Company to range from $4.5 million to $6.5 million; and EPS attributable to the Company to range from $0.08 to $0.12. Conference Call and Webcast: General Steel will hold a corresponding conference call and live webcast at 8:00 a.m. EDT on Thursday, August 14, 2014 (which corresponds to 8:00 p.m. Beijing/Hong Kong Time on Thursday, August 14, 2014) to discuss the results and answer questions from investors. Listeners may access the call by dialing: US Toll Free: International Toll: China Toll China Toll Free Conference ID: The call will also be available as a live, listen-only Webcast under the “Events and Presentations” page on the “Investor Relations” section of the Company’s Website at http://www.corpasia.net/us/GSI/irwebsite/index.php?mod=event. Following the live Webcast, an online archive of the Webcast will be available for 90 days. About General Steel Holdings, Inc. General Steel Holdings, Inc., headquartered in Beijing, China, produces a variety of steel products including rebar, high-speed wire and spiral-weld pipe. The Company has operations in China’s Shaanxi and Guangdong provinces, Inner Mongolia Autonomous Region and Tianjin municipality, with seven million metric tons of crude steel production capacity under management. For more information, please visit www.gshi-steel.com. To be added to the General Steel email list to receive Company news, or to request a hard copy of the Company’s Annual Report on Form 10-K, please send your request to [email protected]. This press release may contain certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations or beliefs about future events and financial, political and social trends and assumptions it has made based on information currently available to it. The Company cannot assure that any expectations, forecasts or assumptions made by management in preparing these forward-looking statements will prove accurate, or that any projections will be realized. Actual results could differ materially from those projected in the forward-looking statements as a result of inaccurate assumptions or a number of risks and uncertainties. These risks and uncertainties are set forth in the Company’s filings under the Securities Act of 1933 and the Securities Exchange Act of 1934 under “Risk Factors” and elsewhere, and include: (a) those risks and uncertainties related to general economic conditions in China, including regulatory factors that may affect such economic conditions; (b) whether the Company is able to manage its planned growth efficiently and operate profitable operations, including whether its management will be able to identify, hire, train, retain, motivate and manage required personnel or that management will be able to successfully manage and exploit existing and potential market opportunities; (c) whether the Company is able to generate sufficient revenues or obtain financing to sustain and grow its operations; (d) whether the Company is able to successfully fulfill our primary requirements for cash; and (e) other risks, including those disclosed in the Company’s Annual Report on Form 10-K, filed with the United States Securities and Exchange Commission. Forward-looking statements contained herein speak only as of the date of this release. The Company does not undertake any obligation to update or revise publicly any forward-looking statements, whether to reflect new information, future events or otherwise. General Steel Holdings, Inc. Joyce Sung Email: [email protected] Asia Bridge Capital Limited Carene Toh Email: [email protected] GENERAL STEEL HOLDINGS, INC. AND SUBSIDIARIES Restricted cash Restricted notes receivable Loans receivable – related parties Accounts receivable, net Accounts receivable – related parties Other receivables, net Other receivables – related parties Advances on inventory purchase Advances on inventory purchase – related parties Prepaid expense and other Prepaid taxes Short-term investment PLANT AND EQUIPMENT, net Advances on equipment purchase Investment in unconsolidated entities Long-term deferred expense Intangible assets, net of accumulated amortization TOTAL OTHER ASSETS LIABILITIES AND DEFICIENCY Short term notes payable Accounts payable – related parties Short term loans – bank Short term loans – others Short term loans – related parties Current maturities of long-term loans – related party Other payables and accrued liabilities Other payable – related parties Customer deposits Customer deposits – related parties Deposit due to sales representatives Deposit due to sales representatives – related parties Taxes payable Deferred lease income, current Capital lease obligations, current NON-CURRENT LIABILITIES: Long-term loans – related party Deferred lease income, noncurrent Capital lease obligations, noncurrent Profit sharing liability at fair value TOTAL NON-CURRENT LIABILITIES DEFICIENCY: Preferred stock, $0.001 par value, 50,000,000 shares authorized, 3,092,899 shares issued and outstanding as of June 30, 2014 and December 31, 2013 Common stock, $0.001 par value, 200,000,000 shares authorized, 58,314,688 and 58,234,688 shares issued, 55,842,382 and 55,762,382 shares outstanding as of June 30, 2014 and December 31, 2013, respectively Treasury stock, at cost, 2,472,306 shares as of June 30, 2014 and December 31, 2013 Paid-in-capital Statutory reserves Accumulated deficits Accumulated other comprehensive income TOTAL GENERAL STEEL HOLDINGS, INC. DEFICIENCY TOTAL DEFICIENCY TOTAL LIABILITIES AND DEFICIENCY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS (In thousands, except per share data) SALES – RELATED PARTIES COST OF GOODS SOLD – RELATED PARTIES TOTAL COST OF GOODS SOLD GROSS PROFIT (LOSS) CHANGE IN FAIR VALUE OF PROFIT SHARING LIABILITY INCOME (LOSS) FROM OPERATIONS Finance/interest expense Gain (loss) on disposal of equipment and intangible assets Income from equity investments Foreign currency transaction gain (loss) Lease income Other non-operating income (expense), net LOSS BEFORE PROVISION FOR INCOME TAXES AND NONCONTROLLING INTEREST Less: Net loss attributable to noncontrolling interest NET LOSS ATTRIBUTABLE TO GENERAL STEEL HOLDINGS, INC. OTHER COMPREHENSIVE LOSS Foreign currency translation adjustments COMPREHENSIVE LOSS Less: Comprehensive loss attributable to noncontrolling interest COMPREHENSIVE LOSS ATTRIBUTABLE TO GENERAL STEEL HOLDINGS, INC. WEIGHTED AVERAGE NUMBER OF SHARES Basic and Diluted LOSS PER SHARE Net (loss) income Adjustments to reconcile net loss to cash provided by (used in) operating activities: Depreciation, amortization and depletion Change in fair value of derivative liabilities-warrants (Gain) loss on disposal of equipment and intangible assets Provision for doubtful accounts Reservation of mine maintenance fee Stock issued for services and compensation Amortization of deferred financing cost on capital lease Foreign currency transaction (gain) loss Deferred lease income Changes in operating assets and liabilities Other receivables Advances on inventory purchases Advances on inventory purchases – related parties Other payables – related parties Net cash provided by (used in) operating activities Cash proceeds from short term investment Cash proceeds from sales of equipment and intangible assets Equipment purchase and intangible assets Net cash used in investing activities CASH FLOWS FINANCING ACTIVITIES: Borrowings on short term notes payable Payments on short term notes payable Borrowings on short term loans – bank Payments on short term loans – bank Borrowings on short term loan – others Payments on short term loans – others Borrowings on short term loan – related parties Payments on short term loans – related parties Deposits due to sales representatives Payments on long-term loans – related party Net cash provided by financing activities EFFECTS OF EXCHANGE RATE CHANGE IN CASH INCREASE IN CASH CASH, beginning of period CASH, end of period Tags: MNG Next story QKL Stores Inc. 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Details: F2021C01265 ASA 300 - Planning an Audit of a Financial Report - October 2009 - F2021C01265 ASA 300 Standards/Accounting & Auditing as amended, taking into account amendments up to Auditing Standard ASA 2020-1 Amendments to Australian Auditing Standards These Auditing Standards establish requirements and provide application and other explanatory material to auditors regarding their responsibilities to plan an audit of a financial report. Auditing Standard ASA 2020-1 Amendments to Australian Auditing Standards - F2020L00252 s 65, 66 Registered 14 Dec 2021 Compiled Auditing Standard Auditing Standard ASA 300 Planning an Audit of a Financial Report This compilation was prepared on 10 November 2021 taking into account amendments made by ASA 2011‑1, ASA 2013‑2, ASA 2015‑1 and ASA 2020-1. Compilation Number: 4 Compilation Date: 14 December 2021 Prepared by the Auditing and Assurance Standards Board Obtaining a Copy of this Auditing Standard The most recently compiled versions of Auditing Standards, original Standards and amending Standards (see Compilation Details) are available on the AUASB website: www.auasb.gov.au Auditing and Assurance Standards Board Podium Level Level 14, 530 Collins Street E‑mail: [email protected] Collins Street West © 2021 Commonwealth of Australia. The text, graphics and layout of this Auditing Standard are protected by Australian copyright law and the comparable law of other countries. Reproduction within Australia in unaltered form (retaining this notice) is permitted for personal and non‑commercial use subject to the inclusion of an acknowledgment of the source as being the Australian Auditing and Assurance Standards Board (AUASB). Requests and enquiries concerning reproduction and rights for commercial purposes within Australia should be addressed to the Executive Director, Auditing and Assurance Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria 8007 or sent to [email protected]. Otherwise, no part of this Auditing Standard may be reproduced, stored or transmitted in any form or by any means without the prior written permission of the AUASB except as permitted by law. This Auditing Standard reproduces substantial parts of the corresponding International Standard on Auditing issued by the International Auditing and Assurance Standards Board (IAASB) and published by the International Federation of Accountants (IFAC), in the manner described in the statement on Conformity with International Standards on Auditing. The AUASB acknowledges that IFAC is the owner of copyright in the International Standard on Auditing incorporated in this Auditing Standard throughout the world. All existing rights in this material are reserved outside Australia. Reproduction outside Australia in unaltered form (retaining this notice) is permitted for personal and non‑commercial use only. Further information and requests for authorisation to reproduce this Auditing Standard for commercial purposes outside Australia should be addressed to the Executive Director, Auditing and Assurance Standards Board, PO Box 204, Collins Street West, Melbourne, Victoria 8007 or sent to [email protected]. Any decision to approve a request may also require the agreement of IFAC. ISSN 1833‑4393 COMPILATION DETAILS AUTHORITY STATEMENT CONFORMITY WITH INTERNATIONAL STANDARDS ON AUDITING Application.......................................................................................................... Aus 0.1‑Aus 0.2 Operative Date................................................................................................................. Aus 0.3 Scope of this Auditing Standard Effective Date.............................................................................................................................. 3 Objective..................................................................................................................................... 4 Involvement of Key Engagement Team Members....................................................................... 5 Preliminary Engagement Activities............................................................................................... 6 Planning Activities.................................................................................................................. 7‑11 Documentation.......................................................................................................................... 12 Additional Considerations in Initial Audit Engagements............................................................ 13 Application and Other Explanatory Material The Role and Timing of Planning........................................................................................ A1‑A3 Involvement of Key Engagement Team Members..................................................................... A4 Preliminary Engagement Activities...................................................................................... A5‑A7 Planning Activities............................................................................................................ A8‑A17 Documentation................................................................................................................ A18‑A21 Additional Considerations in Initial Audit Engagements.......................................................... A22 Appendix 1: Considerations in Establishing the Overall Audit Strategy Auditing Standard ASA 300 Planning an Audit of a Financial Report (as Amended) This compilation takes into account amendments made up to and including 3 March 2020 and was prepared on 10 November 2021 by the Auditing and Assurance Standards Board (AUASB). This compilation is not a separate Auditing Standard made by the AUASB. Instead, it is a representation of ASA 300 (October 2009) as amended by other Auditing Standards which are listed in the Table below. Table of Standards Operative Date ASA 300 [A] Financial reporting periods commencing on or after 1 January 2010 ASA 2011‑1 [B] Financial reporting periods commencing on or after 1 July 2011 ASA 2013‑2 [C] ASA 2015‑1 [D] Financial reporting periods ending on or after 15 December 2016 ASA 2020‑1 [E] Financial reporting periods commencing on or after 15 December 2021* [A] Federal Register of Legislation – registration number F2009L04077, 11 November 2009 [B] Federal Register of Legislation – registration number F2011L01379, 30 June 2011 [C] Federal Register of Legislation – registration number F2013L01939, 14 November 2013 [D] Federal Register of Legislation – registration number F2015L02032, 16 December 2015 [E] Federal Register of Legislation – registration number F2020L00252, 13 March 2020 Table of Amendments Paragraph affected By … [paragraph] Appendix 1 Last sub‑heading ASA 2011‑1 [27] ASA 2013‑2 [55] [56] [57] A13 directly after existing A12 ASA 2015‑1 [52-53] A14 directly after inserted A13 ASA 2015‑1 [54 and 56] ASA 2015-1 [55] Footnote 11 Auditing Standard ASA 300 Planning an Audit of a Financial Report (as amended to 3 March 2020) is set out in paragraphs Aus 0.1 to A22 and Appendix 1. This Auditing Standard is to be read in conjunction with ASA 101 Preamble to AUASB Standards, which sets out how AUASB Standards are to be understood, interpreted and applied. This Auditing Standard is to be read also in conjunction with ASA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in Accordance with Australian Auditing Standards. This Auditing Standard conforms with International Standard on Auditing ISA 300 Planning an Audit of Financial Statements issued by the International Auditing and Assurance Standards Board (IAASB), an independent standard‑setting board of the International Federation of Accountants (IFAC). Paragraphs that have been added to this Auditing Standard (and do not appear in the text of the equivalent ISA) are identified with the prefix “Aus”. Compliance with this Auditing Standard enables compliance with ISA 300. The Auditing and Assurance Standards Board (AUASB) made Auditing Standard ASA 300 Planning an Audit of a Financial Report pursuant to section 227B of the Australian Securities and Investments Commission Act 2001 and section 336 of the Corporations Act 2001, on 27 October 2009. This compiled version of ASA 300 incorporates subsequent amendments contained in other Auditing Standards made by the AUASB up to and including 3 March 2020 (see Compilation Details). Aus 0.1 This Auditing Standard applies to: (a) an audit of a financial report for a financial year, or an audit of a financial report for a half‑year, in accordance with the Corporations Act 2001; and (b) an audit of a financial report, or a complete set of financial statements, for any other purpose. Aus 0.2 This Auditing Standard also applies, as appropriate, to an audit of other historical financial information. Aus 0.3 This Auditing Standard is operative for financial reporting periods ending on or after 1 January 2010. [Note: For operative dates of paragraphs changed or added by an Amending Standard, see Compilation Details.] 1. This Auditing Standard deals with the auditor’s responsibility to plan an audit of a financial report. This Auditing Standard is written in the context of recurring audits. Additional considerations in an initial audit engagement are separately identified. The Role and Timing of Planning 2. Planning an audit involves establishing the overall audit strategy for the engagement and developing an audit plan. Adequate planning benefits the audit of a financial report in several ways, including the following: (Ref: Para. A1‑A3) · Helping the auditor to devote appropriate attention to important areas of the audit. · Helping the auditor identify and resolve potential problems on a timely basis. · Helping the auditor properly organise and manage the audit engagement so that it is performed in an effective and efficient manner · Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to respond to anticipated risks, and the proper assignment of work to them. · Facilitating the direction and supervision of engagement team members and the review of their work. · Assisting, where applicable, in coordination of work done by auditors of components and experts. 3. [Deleted by the AUASB. Refer Aus 0.3] 4. The objective of the auditor is to plan the audit so that it will be performed in an effective manner. Involvement of Key Engagement Team Members 5. The engagement partner and other key members of the engagement team shall be involved in planning the audit, including planning and participating in the discussion among engagement team members. (Ref: Para. A4) Preliminary Engagement Activities 6. The auditor shall undertake the following activities at the beginning of the current audit engagement: (a) Performing procedures required by ASA 220 regarding the continuance of the client relationship and the specific audit engagement;[1] (b) Evaluating compliance with relevant ethical requirements, including independence, in accordance with ASA 220;[2] and (c) Establishing an understanding of the terms of the engagement, as required by ASA 210.[3] (Ref: Para. A5‑A7) Planning Activities 7. The auditor shall establish an overall audit strategy that sets the scope, timing and direction of the audit, and that guides the development of the audit plan. 8. In establishing the overall audit strategy, the auditor shall: (a) Identify the characteristics of the engagement that define its scope; (b) Ascertain the reporting objectives of the engagement to plan the timing of the audit and the nature of the communications required; (c) Consider the factors that, in the auditor’s professional judgement, are significant in directing the engagement team’s efforts; (d) Consider the results of preliminary engagement activities and, where applicable, whether knowledge gained on other engagements performed by the engagement partner for the entity is relevant; and (e) Ascertain the nature, timing and extent of resources necessary to perform the engagement. (Ref: Para. A8‑A11) 9. The auditor shall develop an audit plan that shall include a description of: (a) The nature, timing and extent of planned risk assessment procedures, as determined under ASA 315.[4] (b) The nature, timing and extent of planned further audit procedures at the assertion level, as determined under ASA 330.[5] (c) Other planned audit procedures that are required to be carried out so that the engagement complies with the Australian Auditing Standards. (Ref: Para. A12‑A14) 10. The auditor shall update and change the overall audit strategy and the audit plan as necessary during the course of the audit. (Ref: Para. A15) 11. The auditor shall plan the nature, timing and extent of direction and supervision of engagement team members and the review of their work. (Ref: Para. A15‑A17) 12. The auditor shall include in the audit documentation:[6] (a) The overall audit strategy; (b) The audit plan; and (c) Any significant changes made during the audit engagement to the overall audit strategy or the audit plan, and the reasons for such changes. (Ref: Para. A18‑A21) Additional Considerations in Initial Audit Engagements 13. The auditor shall undertake the following activities prior to starting an initial audit: (a) Performing procedures required by ASA 220 regarding the acceptance of the client relationship and the specific audit engagement;[7] and (b) Communicating with the predecessor auditor, where there has been a change of auditors, in compliance with relevant ethical requirements. (Ref: Para. A22) The Role and Timing of Planning (Ref: Para. 2) A1. The nature and extent of planning activities will vary according to the size and complexity of the entity, the key engagement team members’ previous experience with the entity, and changes in circumstances that occur during the audit engagement. A2. Planning is not a discrete phase of an audit, but rather a continual and iterative process that often begins shortly after (or in connection with) the completion of the previous audit and continues until the completion of the current audit engagement. Planning, however, includes consideration of the timing of certain activities and audit procedures that need to be completed prior to the performance of further audit procedures. For example, planning includes the need to consider, prior to the auditor’s identification and assessment of the risks of material misstatement, such matters as: · The analytical procedures to be applied as risk assessment procedures. · Obtaining a general understanding of the legal and regulatory framework applicable to the entity and how the entity is complying with that framework. · The determination of materiality. · The involvement of experts. · The performance of other risk assessment procedures. A3. The auditor may decide to discuss elements of planning with the entity’s management, or those charged with governance, to facilitate the conduct and management of the audit engagement (for example, to co‑ordinate some of the planned audit procedures with the work of the entity's personnel). Although these discussions often occur, the overall audit strategy and the audit plan remain the auditor's responsibility. When discussing matters included in the overall audit strategy or audit plan, care is required in order not to compromise the effectiveness of the audit. For example, discussing the nature and timing of detailed audit procedures with management, or those charged with governance, may compromise the effectiveness of the audit by making the audit procedures too predictable. Involvement of Key Engagement Team Members (Ref: Para. 5) A4. The involvement of the engagement partner and other key members of the engagement team in planning the audit draws on their experience and insight, thereby enhancing the effectiveness and efficiency of the planning process.[8] Preliminary Engagement Activities (Ref: Para. 6) A5. Performing the preliminary engagement activities specified in paragraph 6 at the beginning of the current audit engagement assists the auditor in identifying and evaluating events or circumstances that may adversely affect the auditor’s ability to plan and perform the audit engagement. A6. Performing these preliminary engagement activities enables the auditor to plan an audit engagement for which, for example: · The auditor maintains the necessary independence and ability to perform the engagement. · There are no issues with management integrity that may affect the auditor’s willingness to continue the engagement. · There is no misunderstanding with the client as to the terms of the engagement. A7. The auditor’s consideration of client continuance and relevant ethical requirements, including independence,* occurs throughout the audit engagement as conditions and changes in circumstances occur. Performing initial procedures on both client continuance and evaluation of relevant ethical requirements (including independence) at the beginning of the current audit engagement means that they are completed prior to the performance of other significant activities for the current audit engagement. For continuing audit engagements, such initial procedures often occur shortly after (or in connection with) the completion of the previous audit. The Overall Audit Strategy (Ref: Para. 7‑8) A8. The process of establishing the overall audit strategy assists the auditor to determine, subject to the completion of the auditor’s risk assessment procedures, such matters as: · The resources to deploy for specific audit areas, such as the use of appropriately experienced team members for high risk areas or the involvement of experts on complex matters; · The amount of resources to allocate to specific audit areas, such as the number of team members assigned to observe the inventory count at material locations, the extent of review of other auditors’ work in the case of group audits, or the audit budget in hours to allocate to high risk areas; · When these resources are to be deployed, such as whether at an interim audit stage or at key cut‑off dates; and · How such resources are managed, directed and supervised, such as when team briefing and debriefing meetings are expected to be held, how engagement partner and manager reviews are expected to take place (for example, on‑site or off‑site), and whether to complete engagement quality control reviews. A9. Appendix 1 lists examples of considerations in establishing the overall audit strategy. A10. Once the overall audit strategy has been established, an audit plan can be developed to address the various matters identified in the overall audit strategy, taking into account the need to achieve the audit objectives through the efficient use of the auditor’s resources. The establishment of the overall audit strategy and the detailed audit plan are not necessarily discrete or sequential processes, but are closely inter‑related since changes in one may result in consequential changes to the other. Considerations Specific to Smaller Entities A11. In audits of small entities, the entire audit may be conducted by a very small audit team. Many audits of small entities involve the engagement partner (who may be a sole practitioner) working with one engagement team member (or without any engagement team members). With a smaller team, co‑ordination of, and communication between, team members are easier. Establishing the overall audit strategy for the audit of a small entity need not be a complex or time‑consuming exercise; it varies according to the size of the entity, the complexity of the audit, and the size of the engagement team. For example, a brief memorandum prepared at the completion of the previous audit, based on a review of the working papers and highlighting issues identified in the audit just completed, updated in the current period based on discussions with the owner‑manager, can serve as the documented audit strategy for the current audit engagement if it covers the matters noted in paragraph 8. The Audit Plan (Ref: Para. 9) A12. The audit plan is more detailed than the overall audit strategy in that it includes the nature, timing and extent of audit procedures to be performed by engagement team members. Planning for these audit procedures takes place over the course of the audit as the audit plan for the engagement develops. For example, planning of the auditor's risk assessment procedures occurs early in the audit process. However, planning the nature, timing and extent of specific further audit procedures depends on the outcome of those risk assessment procedures. In addition, the auditor may begin the execution of further audit procedures for some classes of transactions, account balances and disclosures before planning all remaining further audit procedures. A13. Determining the nature, timing and extent of planned risk assessment procedures, and the further audit procedures, as they relate to disclosures is important in light of both the wide range of information and the level of detail that may be encompassed in those disclosures. Further, certain disclosures may contain information that is obtained from outside of the general and subsidiary ledgers, which may also affect the assessed risks and the nature, timing and extent of audit procedures to address them. A14. Consideration of disclosures early in the audit assists the auditor in giving appropriate attention to, and planning adequate time for, addressing disclosures in the same way as classes of transactions, events and account balances. Early consideration may also help the auditor to determine the effects on the audit of: · Significant new or revised disclosures required as a result of changes in the entity’s environment, financial condition or activities (for example, a change in the required identification of segments and reporting of segment information arising from a significant business combination); · Significant new or revised disclosures arising from changes in the applicable financial reporting framework; · The need for the involvement of an auditor’s expert to assist with audit procedures related to particular disclosures (for example, disclosures related to superannuation or other retirement benefit obligations); and · Matters relating to disclosures that the auditor may wish to discuss with those charged with governance.[9] Changes to Planning Decisions during the Course of the Audit (Ref: Para. 10) A15. As a result of unexpected events, changes in conditions, or the audit evidence obtained from the results of audit procedures, the auditor may need to modify the overall audit strategy and audit plan and thereby the resulting planned nature, timing and extent of further audit procedures, based on the revised consideration of assessed risks. This may be the case when information comes to the auditor’s attention that differs significantly from the information available when the auditor planned the audit procedures. For example, audit evidence obtained through the performance of substantive procedures may contradict the audit evidence obtained through tests of controls. Direction, Supervision and Review (Ref: Para. 11) A16. The nature, timing and extent of the direction and supervision of engagement team members and review of their work vary depending on many factors, including: · The size and complexity of the entity. · The area of the audit. · The assessed risks of material misstatement (for example, an increase in the assessed risk of material misstatement for a given area of the audit ordinarily requires a corresponding increase in the extent and timeliness of direction and supervision of engagement team members, and a more detailed review of their work). · The capabilities and competence of the individual team members performing the audit work. ASA 220 contains further guidance on the direction, supervision and review of audit work.[10] A17. If an audit is carried out entirely by the engagement partner, questions of direction and supervision of engagement team members and review of their work do not arise. In such cases, the engagement partner, having personally conducted all aspects of the work, will be aware of all material issues. Forming an objective view on the appropriateness of the judgements made in the course of the audit can present practical problems when the same individual also performs the entire audit. If particularly complex or unusual issues are involved, and the audit is performed by a sole practitioner, it may be desirable to consult with other suitably‑experienced auditors or the auditor’s professional body. Documentation (Ref: Para. 12) A18. The documentation of the overall audit strategy is a record of the key decisions considered necessary to properly plan the audit and to communicate significant matters to the engagement team. For example, the auditor may summarise the overall audit strategy in the form of a memorandum that contains key decisions regarding the overall scope, timing and conduct of the audit. A19. The documentation of the audit plan is a record of the planned nature, timing and extent of risk assessment procedures and further audit procedures at the assertion level in response to the assessed risks. It also serves as a record of the proper planning of the audit procedures that can be reviewed and approved prior to their performance. The auditor may use standard audit programs or audit completion checklists, tailored as needed to reflect the particular engagement circumstances. A20. A record of the significant changes to the overall audit strategy and the audit plan, and resulting changes to the planned nature, timing and extent of audit procedures, explains why the significant changes were made, and the overall strategy and audit plan finally adopted for the audit. It also reflects the appropriate response to the significant changes occurring during the audit. A21. As discussed in paragraph A11, a suitable, brief memorandum may serve as the documented strategy for the audit of a smaller entity. For the audit plan, standard audit programs or checklists (see paragraph A17) drawn up on the assumption of few controls[11], as is likely to be the case in a smaller entity, may be used provided that they are tailored to the circumstances of the engagement, including the auditor’s risk assessments. Additional Considerations in Initial Audit Engagements (Ref: Para. 13) A22. The purpose and objective of planning the audit are the same whether the audit is an initial or recurring engagement. However, for an initial audit, the auditor may need to expand the planning activities because the auditor does not ordinarily have the previous experience with the entity that is considered when planning recurring engagements. For an initial audit engagement, additional matters the auditor may consider in establishing the overall audit strategy and audit plan include the following: · Unless prohibited by law or regulation, arrangements to be made with the predecessor auditor, for example, to review the predecessor auditor’s working papers. · Any major issues (including the application of accounting principles or of auditing and reporting standards) discussed with management in connection with the initial selection as auditor, the communication of these matters to those charged with governance and how these matters affect the overall audit strategy and audit plan. · The audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances.[12] · Other procedures required by the firm’s system of quality control for initial audit engagements (for example, the firm’s system of quality control may require the involvement of another partner or senior individual to review the overall audit strategy prior to commencing significant audit procedures or to review reports prior to their issuance). (Ref: Para. 7‑8 and A8‑A11) Considerations in Establishing the Overall Audit Strategy This appendix provides examples of matters the auditor may consider in establishing the overall audit strategy. Many of these matters will also influence the auditor’s detailed audit plan. The examples provided cover a broad range of matters applicable to many engagements. While some of the matters referred to below may be required by other Auditing Standards, not all matters are relevant to every audit engagement and the list is not necessarily complete. Characteristics of the Engagement · The financial reporting framework on which the financial information to be audited has been prepared, including any need for reconciliations to another financial reporting framework. · Industry‑specific reporting requirements such as reports mandated by industry regulators. · The expected audit coverage, including the number and locations of components to be included. · The nature of the control relationships between a parent and its components that determine how the group is to be consolidated. · The extent to which components are audited by other auditors. · The nature of the business segments to be audited, including the need for specialised knowledge. · The reporting currency to be used, including any need for currency translation for the financial information audited. · The need for a statutory audit of a stand‑alone financial report in addition to an audit for consolidation purposes. · [Deleted by the AUASB. Refer Aus 0.4]# · Aus 0.4 Whether the entity has an internal audit function and if so, whether, in which areas and to what extent, the work of the function can be used for purposes of the audit. · The entity’s use of service organisations and how the auditor may obtain evidence concerning the design or operation of controls performed by them. · The expected use of audit evidence obtained in previous audits, for example, audit evidence related to risk assessment procedures and tests of controls. · The effect of information technology on the audit procedures, including the availability of data and the expected use of computer‑assisted audit techniques. · The co‑ordination of the expected coverage and timing of the audit work with any reviews of interim financial information and the effect on the audit of the information obtained during such reviews. · The availability of client personnel and data. Reporting Objectives, Timing of the Audit, and Nature of Communications · The entity's timetable for reporting, such as at interim and final stages. · The organisation of meetings with management and those charged with governance to discuss the nature, timing and extent of the audit work. · The discussion with management and those charged with governance regarding the expected type and timing of reports to be issued and other communications, both written and oral, including the auditor's report, management letters and communications to those charged with governance. · The discussion with management regarding the expected communications on the status of audit work throughout the engagement. · Communication with auditors of components regarding the expected types and timing of reports to be issued and other communications in connection with the audit of components. · The expected nature and timing of communications among engagement team members, including the nature and timing of team meetings and timing of the review of work performed. · Whether there are any other expected communications with third parties, including any statutory or contractual reporting responsibilities arising from the audit. Significant Factors, Preliminary Engagement Activities, and Knowledge Gained on Other Engagements · The determination of materiality in accordance with ASA 320[13] and, where applicable: o The determination of materiality for components and communication thereof to component auditors in accordance with ASA 600.[14] o The preliminary identification of significant components and material classes of transactions, account balances and disclosures. · Preliminary identification of areas where there may be a higher risk of material misstatement. · The impact of the assessed risk of material misstatement at the overall financial report level on direction, supervision and review. · The manner in which the auditor emphasises to engagement team members the need to maintain a questioning mind and to exercise professional scepticism in gathering and evaluating audit evidence. · Results of previous audits that involved evaluating the operating effectiveness of internal control, including the nature of identified deficiencies and action taken to address them. · The discussion of matters that may affect the audit with firm personnel responsible for performing other services to the entity. · Evidence of management's commitment to the design, implementation and maintenance of sound internal control, including evidence of appropriate documentation of such internal control. · Changes within the applicable financial reporting framework, such as changes in accounting standards, which may involve significant new or revised disclosures. · Volume of transactions, which may determine whether it is more efficient for the auditor to rely on internal control. · The process(es) management uses to identify and prepare the disclosures required by the applicable financial reporting framework, including disclosures containing information that is obtained from outside of the general and subsidiary ledgers. · Importance attached to internal control throughout the entity to the successful operation of the business. · Significant business developments affecting the entity, including changes in information technology and business processes, changes in key management, and acquisitions, mergers and divestments. · Significant industry developments such as changes in industry regulations and new reporting requirements. · Other significant relevant developments, such as changes in the legal environment affecting the entity. Nature, Timing and Extent of Resources · The selection of the engagement team (including, where necessary, the engagement quality control reviewer) and the assignment of audit work to the team members, including the assignment of appropriately experienced team members to areas where there may be higher risks of material misstatement. · Engagement budgeting, including considering the appropriate amount of time to set aside for areas where there may be higher risks of material misstatement. * Early adoption, in conjunction with ASA 315 Identifying and Assessing the Risks of Material Misstatement, permitted. [1] See ASA 220 Quality Control for an Audit of a Financial Report and Other Historical Financial Information, paragraphs 12‑13. [2] See ASA 220, paragraphs 9‑11. [3] See ASA 210 Agreeing the Terms of Audit Engagements, paragraphs 9‑13. [4] See ASA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment. [5] See ASA 330 The Auditor’s Responses to Assessed Risks. [6] See ASA 230 Audit Documentation, paragraphs 8‑11 and paragraph A6. [7] See ASA 220, paragraphs 12‑13. [8] ASA 315, paragraph 17, establishes requirements and provides guidance on the engagement team's discussion of the susceptibility of the entity to material misstatements of the financial report. ASA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of a Financial Report, paragraph 16, provides guidance on the emphasis given during this discussion to the susceptibility of the entity's financial report to material misstatement due to fraud. * See ASA 102 Compliance with Ethical Requirements when Performing Audits, Reviews and Other Assurance Engagements. [9] See ASA 260 Communication with Those Charged with Governance, paragraph A12. [10] See ASA 220, paragraphs 15‑17. [11] See ASA 315, paragraph 26(a). [12] See ASA 510 Initial Audit Engagements—Opening Balances. # See ASA 610 Using the Work of Internal Auditors, paragraph Aus 1.2. The use of internal auditors to provide direct assistance is prohibited in an audit or review conducted in accordance with the Australian Auditing Standards. [13] See ASA 320 Materiality in Planning and Performing an Audit. [14] See ASA 600 Special Considerations—Audits of a Group Financial Report (Including the Work of Component Auditors), paragraphs 21‑23 and 40(c).

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ORACLE CORP QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended November 30, 2009 TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF 500 Oracle Parkway Redwood City, California Indicate by check mark whether the registrant has submitted electronically and posted to its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ (Do not check if a smaller reporting company) The number of shares of registrant’s common stock outstanding as of December 15, 2009 was: 5,011,220,000. FORM 10-Q QUARTERLY REPORT Condensed Consolidated Balance Sheets as of November 30, 2009 and May 31, 2009 Condensed Consolidated Statements of Operations for the Three and Six Months Ended November 30, 2009 and 2008 2 Condensed Consolidated Statements of Cash Flows for the Six Months Ended November 30, 2009 and 2008 3 Submission of Matters to a Vote of Security Holders Item 1. Financial Statements (Unaudited) As of November 30, 2009 and May 31, 2009 November 30, 2009 May 31, Trade receivables, net of allowances of $265 and $270 as of November 30, 2009 and May 31, 2009 Non-current assets: Property, net Intangible assets: software support agreements and related relationships, net Intangible assets: other, net Notes payable, current and other current borrowings Accrued compensation and related benefits Non-current liabilities: Notes payable and other non-current borrowings Oracle Corporation stockholders’ equity: Preferred stock, $0.01 par value—authorized: 1.0 shares; outstanding: none Common stock, $0.01 par value and additional paid in capital—authorized: 11,000 shares; outstanding: 5,009 shares as of November 30, 2009 and 5,005 shares as of May 31, 2009 Total Oracle Corporation stockholders’ equity See notes to condensed consolidated financial statements. For the Three and Six Months Ended November 30, 2009 and 2008 November 30, Six Months Ended New software licenses Software license updates and product support Software revenues Acquisition related and other Non-operating income, net 565 530 1,003 896 Dividends declared per common share $ 0.05 $ — $ 0.10 $ — For the Six Months Ended November 30, 2009 and 2008 Tax benefits on the exercise of stock options Excess tax benefits on the exercise of stock options Changes in operating assets and liabilities, net of effects from acquisitions: Decrease in trade receivables, net Decrease in prepaid expenses and other assets Decrease in accounts payable and other liabilities Increase (decrease) in income taxes payable 59 (273 ) Decrease in deferred revenues Purchases of marketable securities and other investments Proceeds from maturities and sales of marketable securities and other investments Acquisitions, net of cash acquired Net cash used for investing activities Payments for repurchases of common stock Proceeds from issuances of common stock Payment of dividends to stockholders (501 ) — Proceeds from borrowings, net of issuance costs Repayments of borrowings — (4 ) Distributions to noncontrolling interests Net cash provided by (used for) financing activities 5,924 (909 ) Non-cash investing and financing transactions: Fair value of stock awards assumed in connection with acquisitions (Decrease) increase in unsettled repurchases of common stock $ (4 ) $ 152 1. BASIS OF PRESENTATION AND RECENT ACCOUNTING PRONOUNCEMENTS We have prepared the condensed consolidated financial statements included herein, without audit, pursuant to the rules and regulations of the U.S. Securities and Exchange Commission (SEC). Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. However, we believe that the disclosures are adequate to ensure the information presented is not misleading. These unaudited condensed consolidated financial statements should be read in conjunction with the audited financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended May 31, 2009. We believe that all necessary adjustments, which consisted only of normal recurring items, have been included in the accompanying financial statements to present fairly the results of the interim periods. The results of operations for the interim periods presented are not necessarily indicative of the operating results to be expected for any subsequent interim period or for our fiscal year ending May 31, 2010. In July 2009, the Financial Accounting Standards Board (FASB) issued the FASB Accounting Standards Codification (Codification), which we adopted in our second quarter of fiscal 2010. There were no changes to our consolidated financial statements and related disclosures contained in this Quarterly Report due to our adoption and implementation of the Codification, other than changes in reference in this Quarterly Report to the various authoritative accounting pronouncements contained within the Codification. During fiscal 2010, we adopted certain new accounting pronouncements that affected our significant accounting policies, including FASB Accounting Standards Codification (ASC) 805, Business Combinations. We disclosed our accounting policies for these new accounting pronouncements and all of our other significant accounting policies in Note 1 of Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the fiscal year ended May 31, 2009. There have been no other significant changes to our significant accounting policies that were disclosed in our Annual Report on Form 10-K for the fiscal year ended May 31, 2009 other than the aforementioned reference changes resulting from the Codification. As a result of our adoption of the FASB’s new accounting guidance for noncontrolling interests as contained in ASC 810, Consolidation, as of the beginning of fiscal 2010, we retrospectively classified noncontrolling interest positions of certain of our consolidated entities as a separate component of consolidated equity from the equity attributable to Oracle’s stockholders for all periods presented. The noncontrolling interests in our net income were not significant to our consolidated results for the periods presented and therefore have been included as a component of non-operating income, net in our condensed consolidated statements of operations. Certain other prior year balances have been reclassified to conform to the current year’s presentation. Such reclassifications did not affect total revenues, operating income or net income. In accordance with ASC 855, Subsequent Events, we evaluated subsequent events through the date and time our condensed consolidated financial statements were issued on December 21, 2009. Acquisition Related and Other Expenses Acquisition related and other expenses consist of personnel related costs for transitional and certain other employees, stock-based compensation expenses, integration related professional services, certain business combination adjustments after the measurement period or purchase price allocation period has ended, and certain other operating expenses, net. Stock-based compensation included in acquisition related and other expenses resulted from unvested options assumed from acquisitions whereby vesting was accelerated upon termination of the employees pursuant to the original terms of those options. As a result of our adoption of the FASB’s revised NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued) accounting guidance for business combinations as of the beginning of fiscal 2010, certain acquisition related and other expenses are now recorded as expenses in our statements of operations that had been historically included as a part of the consideration transferred and capitalized as a part of the accounting for our acquisitions pursuant to previous accounting rules, primarily direct transaction costs such as professional services fees. Transitional and other employee related costs $ 2 $ 4 $ 5 $ 31 — 6 — 11 Professional fees and other, net Business combination adjustments Total acquisition related and other expenses $ 10 $ 21 $ 16 $ 71 Non-operating income, net consists primarily of interest income, net foreign currency exchange gains (losses), the noncontrolling interests in the net profits of our majority-owned subsidiaries (Oracle Financial Services Software Limited and Oracle Japan), and net other income (losses), including net realized gains and losses related to all of our investments and net unrealized gains and losses related to the small portion of our investment portfolio that we classify as trading. $ 30 $ 97 $ 65 $ 185 Foreign currency losses, net (2 ) (22 ) (20 ) (12 ) Noncontrolling interests in income Other income (losses), net 21 (48 ) 30 (48 ) Total non-operating income, net $ 33 $ 8 $ 35 $ 90 Comprehensive income consists of the following, net of income tax effects: net income, net foreign currency translation gains and losses, net gains and losses related to certain of our derivative financial instruments that are reflected in Oracle Corporation stockholders’ equity and net unrealized gains and losses on marketable debt and equity securities that we classify as available-for-sale. The following table sets forth the calculation of comprehensive income: Foreign currency translation gains (losses), net 225 (440 ) 276 (683 ) Unrealized losses on derivative financial instruments, net Unrealized gains on marketable securities, net — 10 — 10 $ 1,658 $ 803 $ 2,827 $ 1,656 Revenue Recognition for Multiple-Element Arrangements: In October 2009, the FASB issued Accounting Standards Update No. 2009-13, Revenue Recognition (Topic 605) Multiple-Deliverable Revenue Arrangements (A Consensus of the FASB Emerging Issues Task Force) (ASU 2009-13), which amends existing accounting standards for revenue recognition for multiple-element arrangements. To the extent a deliverable within a multiple-element arrangement is not accounted for pursuant to other accounting standards, including ASC 985-605, Software-Revenue Recognition, ASU 2009-13 establishes a selling price hierarchy that allows for the use of an estimated selling price to determine the allocation of arrangement consideration to a deliverable in a multiple element arrangement where neither vendor-specific objective evidence nor third-party evidence is available for that deliverable. ASU 2009-13 is to be applied prospectively for revenue arrangements entered into or materially modified in our first quarter of fiscal 2012. Early adoption is permitted. If we were to adopt prior to the first quarter of fiscal 2012, we must apply ASU 2009-13 retrospectively to the beginning of the fiscal year of adoption or to all periods presented. We are currently evaluating the impact of the pending adoption of ASU 2009-13 on our consolidated financial statements. Revenue Recognition for Certain Arrangements that Include Software Elements: In October 2009, the FASB issued Accounting Standards Update 2009-14, Revenue Recognition (Topic 605)—Applicability of AICPA Statement of Position 97-2 to Certain Arrangements That Include Software Elements (ASU 2009-14). ASU 2009-14 excludes tangible products containing software components and non-software components that function together to deliver the product’s essential functionality from the scope of ASC 605-985, Software-Revenue Recognition. ASU 2009-14 shall be applied on a prospective basis to revenue arrangements entered into or materially modified in our first quarter of fiscal 2012. Early adoption is permitted. If we were to adopt prior to the first quarter of fiscal 2012, we must apply ASU 2009-14 retrospectively to the beginning of the fiscal year of adoption or to all periods presented. We are currently evaluating the impact of the pending adoption of ASU 2009-14 on our consolidated financial statements. Transfers of Financial Assets: In June 2009, the FASB issued a new accounting standard for the transfer of financial assets that eliminates the concept of a “qualifying special-purpose entity” and changes the requirements for derecognizing financial assets. We will adopt this new accounting standard in fiscal 2011 and are currently evaluating the impact of its pending adoption on our consolidated financial statements. Variable Interest Entities: In June 2009, the FASB issued a new accounting standard that amends the evaluation criteria to identify the primary beneficiary of a variable interest entity as provided pursuant to existing accounting standards and requires ongoing reassessments of whether an enterprise is the primary beneficiary of the variable interest entity. We will adopt this new accounting standard in fiscal 2011 and are currently evaluating the impact of its pending adoption on our consolidated financial statements. Proposed Acquisition of Sun Microsystems, Inc. On April 19, 2009, we entered into an Agreement and Plan of Merger (Merger Agreement) with Sun Microsystems, Inc. (Sun), a provider of enterprise computing systems, software and services. Pursuant to the Merger Agreement, our wholly owned subsidiary will merge with and into Sun and Sun will become a wholly owned subsidiary of Oracle. Upon the consummation of the merger, each share of Sun common stock will be converted into the right to receive $9.50 in cash. In addition, options to acquire Sun common stock, Sun restricted stock unit awards and other equity-based awards denominated in shares of Sun common stock outstanding immediately prior to the consummation of the merger will generally be converted into options, restricted stock unit awards or other equity-based awards, as the case may be, denominated in shares of Oracle common stock based on formulas contained in the Merger Agreement. The estimated total purchase price of Sun is approximately $7.4 billion. The Merger Agreement contains certain termination rights for both Sun and Oracle and further provides that, upon termination of the Merger Agreement under certain circumstances, Sun may be obligated to pay Oracle a termination fee of $260 million. Completion of this transaction is subject to customary closing conditions, including regulatory clearance under the applicable antitrust laws of the European Commission and other jurisdictions. On November 9, 2009, we received a Statement of Objections from the European Commission relating to our proposed acquisition of Sun. A hearing to consider the Statement of Objections and Oracle’s response to the Statement of Objections was held on December 10-11, 2009. Fiscal 2010 Acquisitions During the first six months of fiscal 2010, we acquired several companies and purchased certain technology and development assets to expand our product offerings. These acquisitions were not significant individually or in the aggregate. We have accounted for these acquisitions in accordance with the FASB’s revised accounting standard for business combinations, which we adopted as of the beginning of fiscal 2010. We have included the financial results of these companies in our consolidated results from their respective acquisition dates. The preliminary purchase price allocations for each of these acquisitions were based upon a preliminary valuation and our estimates and assumptions for certain of these acquisitions are subject to change as we obtain additional information for our estimates during the respective measurement periods. The primary areas of those purchase price allocations that are not yet finalized relate to identifiable intangible assets, certain legal matters, income and non-income based taxes and residual goodwill. During fiscal 2009, we acquired several companies and purchased certain technology and development assets to expand our product offerings. These acquisitions were not individually significant. We have included the financial results of these companies in our consolidated results from their respective acquisition dates. In the aggregate, the total purchase price for these acquisitions was approximately $1.2 billion, which consisted of approximately $1.2 billion in cash, $1 million for the fair value of stock awards assumed and $13 million for transaction costs. In allocating the total purchase price for these acquisitions based on estimated fair values, we preliminarily recorded $712 million of goodwill, $587 million of identifiable intangible assets, $100 million of net tangible liabilities (resulting primarily from deferred tax and restructuring liabilities assumed as a part of these transactions) and $10 million of in-process research and development. The preliminary allocation of purchase price for certain of these acquisitions were based upon preliminary valuations and our estimates and assumptions are subject to change. The primary areas of the purchase price allocations that are not yet finalized relate to certain restructuring liabilities, intangible assets, legal matters, income and non-income based taxes and residual goodwill. Unaudited Pro Forma Financial Information The unaudited pro forma financial information in the table below summarizes the combined results of operations for Oracle and certain other companies that we acquired since the beginning of fiscal 2009 (which were collectively significant for purposes of unaudited pro forma financial information disclosure) as though the companies were combined as of the beginning of fiscal 2009. The pro forma financial information for all periods presented also includes the business combination accounting effects resulting from these acquisitions including our amortization charges from acquired intangible assets, stock-based compensation charges for unvested stock awards assumed and the related tax effects as though the aforementioned companies were combined as of the beginning of fiscal 2009. The pro forma financial information as presented below is for informational purposes only and is not indicative of the results of operations that would have been achieved if the acquisitions had taken place at the beginning of fiscal 2009. The unaudited pro forma financial information for the three and six months ended November 30, 2009 combined the historical results of Oracle for the three and six months ended November 30, 2009 and the historical results for certain other companies that we acquired since the beginning of fiscal 2010 based upon their respective previous reporting periods and the dates that these companies were acquired by us, and the effects of the pro forma adjustments (some of which are based upon preliminary estimates) listed above. The unaudited pro forma financial information for the three and six months ended November 30, 2008 combined the historical results of Oracle for the three and six months ended November 30, 2008 and the historical results of certain other companies that we acquired since the beginning of fiscal 2009 based upon their respective previous reporting periods and the dates these companies were acquired by us, and the effects of the pro forma adjustments listed above. The unaudited pro forma financial information was as follows for the three and six months ended November 30, 2009 and 2008: We perform fair value measurements in accordance with the guidance provided by ASC 820, Fair Value Measurements and Disclosures. ASC 820 defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining the fair value measurements for assets and liabilities required to be recorded at fair value, we consider the principal or most advantageous market in which we would transact and consider assumptions that market participants would use when pricing the asset or liability, such as inherent risk, transfer restrictions, and risk of nonperformance. ASC 820 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. An asset’s or liability’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. ASC 820 establishes three levels of inputs that may be used to measure fair value: Level 1: quoted prices in active markets for identical assets or liabilities; Level 2: inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; or Level 3: unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. Assets and Liabilities Measured at Fair Value on a Recurring Basis Our assets and liabilities measured at fair value on a recurring basis, excluding accrued interest components, consisted of the following types of instruments (Level 1 and 2 inputs are defined above): Using Input Types Fair Value Measurements Using Input Types Level 1 Level 2 Total Level 1 Level 2 Total $ 1,597 $ — $ 1,597 $ 467 $ — $ 467 U.S. Treasury, U.S. government and U.S. government agency debt securities 4,852 — 4,852 4,078 — 4,078 Commercial paper debt securities — 4,335 4,335 — 1,365 1,365 Corporate debt securities and other — 27 27 — — — $ 6,449 $ 6,804 $ 13,253 $ 4,545 $ 2,700 $ 7,245 $ — $ 19 $ 19 $ — $ 35 $ 35 Our valuation techniques used to measure the fair values of our money market funds and U.S. Treasury, U.S. government and U.S. government agency debt securities were derived from quoted market prices as substantially all of these instruments have maturity dates (if any) within one year from our date of purchase and active markets for these instruments exist. Our valuation techniques used to measure the fair values of all other instruments listed in the table above, substantially all of which mature within one year and the counterparties to which have high credit ratings, were derived from the following: non-binding market consensus prices that are corroborated by observable market data; quoted market prices for similar instruments; or pricing models, such as discounted cash flow techniques, with all significant inputs derived from or corroborated by observable market data. Our discounted cash flow techniques use observable market inputs, such as LIBOR-based yield curves, and currency spot and forward rates. Our cash and cash equivalents, marketable securities and derivative financial instruments are recognized and measured at fair value in the condensed consolidated financial statements. Based on the trading prices of our $14.75 billion and $10.25 billion senior notes that were outstanding as of November 30, 2009 and May 31, 2009, respectively, and the interest rates we could obtain for other borrowings with similar terms at those dates, the estimated fair value of our borrowings at November 30, 2009 and May 31, 2009 was $15.98 billion and $10.79 billion, respectively. 4. INTANGIBLE ASSETS AND GOODWILL The changes in intangible assets for fiscal 2010 and the gross and net book value of intangible assets at November 30, 2009 and May 31, 2009 were as follows: Intangible Assets, Gross Accumulated Amortization Intangible Assets, Net Weighted May 31, 2009 Additions November 30, 2009 Expense November 30, 2009 November 30, Software support agreements and related relationships $ 5,012 $ 45 $ 5,057 $ (1,601 ) $ (280 ) $ (1,881 ) $ 3,411 $ 3,176 9 years Developed technology 3,844 87 3,931 (1,925 ) (360 ) (2,285 ) 1,919 1,646 5 years 1,502 32 1,534 (687 ) (130 ) (817 ) 815 717 6 years 1,284 14 1,298 (320 ) (78 ) (398 ) 964 900 8 years 273 4 277 (113 ) (19 ) (132 ) 160 145 7 years $ 11,915 $ 182 $ 12,097 $ (4,646 ) $ (867 ) $ (5,513 ) $ 7,269 $ 6,584 Total amortization expense related to our intangible assets was $436 million and $867 million for the three and six months ended November 30, 2009, respectively and $427 million and $839 million for the three and six months ended November 30, 2008, respectively. Estimated future amortization expense related to our intangible assets was $796 million for the remainder of fiscal 2010, $1.4 billion in fiscal 2011, $1.3 billion in fiscal 2012, $1.1 billion in fiscal 2013, $900 million in fiscal 2014, $706 million in fiscal 2015 and $381 million thereafter. The changes in the carrying amounts of goodwill, which is generally not deductible for tax purposes, for our software business operating segments and for our services business for the six months ended November 30, 2009 were as follows: Licenses Software Updates and Support Services Total Balances as of May 31, 2009 $ 5,716 $ 11,334 $ 1,792 $ 18,842 Goodwill from acquisitions Goodwill adjustments for acquisitions consummated prior to fiscal 2010(1) (7 ) (12 ) (1 ) (20 ) Balances as of November 30, 2009 Pursuant to our business combinations accounting policy, we record goodwill adjustments for the effect on goodwill of changes to net assets acquired during the measurement or purchase price allocation period (either of which can be up to one year from the date of an acquisition). 5. NOTES PAYABLE AND OTHER BORROWINGS In July 2009, we issued $4.5 billion of fixed rate senior notes comprised of $1.5 billion of 3.75% notes due July 2014 (2014 Notes), $1.75 billion of 5.00% notes due July 2019 (2019 Notes) and $1.25 billion of 6.125% notes due July 2039 (2039 Notes and, together with 2014 Notes and 2019 Notes, the Senior Notes). We issued the Senior Notes for general corporate purposes and future acquisitions, including our proposed acquisition of Sun and acquisition related expenses. The effective interest yields of the 2014 Notes, 2019 Notes and 2039 Notes at November 30, 2009 were 3.75%, 5.06% and 6.19%, respectively. In September 2009, we entered into interest rate swap agreements that have the economic effect of modifying the fixed interest obligations associated with the 2014 Notes so that the interest payable on these notes effectively became variable (1.38% at November 30, 2009; see Note 8 for additional information). The Senior Notes rank pari passu with any commercial paper notes that we may issue pursuant to our commercial paper program (see Note 7 of Notes to Consolidated Financial Statements included in our fiscal 2009 Annual Report on Form 10-K for further information on our commercial paper program) and all existing and future senior indebtedness of Oracle Corporation. All existing and future liabilities of the subsidiaries of Oracle Corporation will be effectively senior to the Senior Notes. We were in compliance with all debt-related covenants at November 30, 2009. Future principal payments of our borrowings at November 30, 2009 were as follows: $1.0 billion in fiscal 2010, $2.25 billion in fiscal 2011, none in fiscal 2012, $1.25 billion in fiscal 2013, none in fiscal 2014 and $10.25 billion thereafter. There have been no other significant changes in our notes payable and other borrowing arrangements that were disclosed in our Annual Report on Form 10-K for the fiscal year ended May 31, 2009. 6. RESTRUCTURING ACTIVITIES Fiscal 2009 Oracle Restructuring Plan During the third quarter of fiscal 2009, our management approved, committed to and initiated plans to restructure and further improve efficiencies in our Oracle-based operations (the 2009 Plan). Our management amended the 2009 Plan in the second quarter of fiscal 2010 to reflect additional actions that we expect to take over the course of fiscal 2010. The total estimated restructuring costs associated with the 2009 Plan are $453 million and will be recorded to the restructuring expense line item within our consolidated statements of operations as they are recognized. In the first half of fiscal 2010, we recorded $162 million of restructuring expenses in connection with the 2009 Plan, the majority of which were incurred in the second quarter of fiscal 2010. We expect to incur the majority of the approximately $206 million that is remaining during the last two quarters of fiscal 2010. Any changes to the estimates of executing the 2009 Plan will be reflected in our future results of operations. Acquisition Related Restructuring Plans Adopted Prior to Fiscal 2010 During the fourth quarter of fiscal 2008 and third quarter of fiscal 2006, our management approved, committed to and initiated plans to restructure certain pre-acquisition operations of BEA Systems, Inc. (BEA Restructuring Plan) and Siebel Systems, Inc. (Siebel Restructuring Plan), respectively. Our management initiated these plans in connection with our acquisitions of these companies in order to improve the cost efficiencies in our operations. These plans were initiated and approved prior to our adoption of the revised business combinations accounting guidance contained in ASC 805 as of the beginning of fiscal 2010. Costs related to these restructuring plans were originally recognized as liabilities assumed in each of the respective business combinations and included in the allocation of the cost to acquire these companies and, accordingly, have resulted in an increase to goodwill. Our restructuring expenses may change as our management executes the approved plans. Future decreases to the estimates of executing these acquisition related restructuring plans will be recorded as an adjustment to goodwill indefinitely. Increases to the estimates of the acquisition related restructuring plans will be recorded to operating expenses. The total restructuring costs associated with exiting activities of BEA were $203 million, consisting of severance, excess facilities obligations through fiscal 2017, as well as other restructuring costs. The total restructuring costs associated with exiting activities of Siebel were $592 million, consisting of severance, excess facilities obligations through fiscal 2022, and other restructuring costs. Summary of All Plans Accrued 2009(2) Six Months Ended November 30, 2009 Accrued Nov. 30, 2009(2) Total to Date Total Costs(3) Adj. to Cost(4) Cash Payments Others(5) $ 12 $ 60 $ 3 $ (34 ) $ 1 $ 42 $ 93 $ 162 — — — — — — 1 21 22 72 3 (37 ) 2 62 110 210 13 26 (2 ) (10 ) (1 ) 26 43 60 Total Fiscal 2009 Oracle Restructuring $ 47 $ 158 $ 4 $ (81 ) $ 2 $ 130 $ 247 $ 453 BEA Restructuring Plan $ 52 $ — $ (12 ) $ (5 ) $ 2 $ 37 $ 132 $ 132 33 — (3 ) (6 ) — 24 56 56 Contracts and other 8 — — (1 ) — 7 15 15 Total BEA Restructuring $ 93 $ — $ (15 ) $ (12 ) $ 2 $ 68 $ 203 $ 203 Siebel Restructuring Plan $ — $ — $ — $ — $ — $ — $ 59 $ 59 146 — 7 (15 ) 1 139 502 502 7 — (5 ) — — 2 31 31 Total Siebel Restructuring $ 153 $ — $ 2 $ (15 ) $ 1 $ 141 $ 592 $ 592 Total Other Restructuring Plans $ 96 $ 2 $ (9 ) $ (14 ) $ 13 $ 88 Total Restructuring Plans(6) $ 389 $ 160 $ (18 ) $ (122 ) $ 18 $ 427 Includes severance costs associated with research and development, general and administrative functions, and certain other facility related costs. Accrued restructuring at November 30, 2009 and May 31, 2009 was $427 million and $389 million, respectively. The balances include $259 million and $203 million recorded in other current liabilities and $168 million and $186 million recorded in other non-current liabilities in the accompanying condensed consolidated balance sheets at November 30, 2009 and May 31, 2009, respectively. Initial costs recorded for the respective restructuring plans. All plan adjustments are changes in estimates whereby all increases in costs are recorded to operating expenses in the period of adjustment with decreases in costs of Oracle-based plans recorded to operating expenses and decreases in costs of acquisition related plans adopted prior to fiscal 2010 recorded as adjustments to goodwill indefinitely. Represents foreign currency translation and other adjustments. Restructuring plans included in this footnote represent those plans that management has deemed significant. 7. DEFERRED REVENUES Deferred revenues consisted of the following: Deferred revenues, current Deferred revenues, non-current (in other non-current liabilities) Total deferred revenues Deferred software license updates and product support revenues represent customer payments made in advance for annual support contracts. Software license updates and product support contracts are typically billed on a per annum basis in advance and revenues are recognized ratably over the support periods. Deferred service revenues include prepayments for consulting, On Demand and education services. Revenue for these services is recognized as the services are performed. Deferred new software license revenues typically result from undelivered products or specified enhancements, customer specific acceptance provisions or software license transactions that cannot be segmented from consulting services, or certain extended payment term arrangements. In connection with the purchase price allocations related to our acquisitions, we have estimated the fair values of the support obligations assumed. The estimated fair values of the support obligations assumed were determined using a cost build-up approach. The cost build-up approach determines fair value by estimating the costs relating to fulfilling the obligations plus a normal profit margin. The sum of the costs and operating profit approximates, in theory, the amount that we would be required to pay a third party to assume the support obligations. These fair value adjustments reduce the revenues recognized over the support contract term of our acquired contracts and, as a result, we did not recognize software license updates and product support revenues related to support contracts assumed from our acquisitions in the amount of $14 million and $80 million for the three months ended November 30, 2009 and 2008, respectively, and $23 million and $171 million for the six months ended November 30, 2009 and 2008, respectively, which would have been otherwise recorded by our acquired businesses as independent entities. 8. DERIVATIVE FINANCIAL INSTRUMENTS On December 1, 2008, we adopted the new disclosure provisions that are included in ASC 815, Derivatives and Hedging, which had no impact on our consolidated financial position or results of operations and only required additional financial statement disclosures. We have applied the disclosure requirements of ASC 815 on a prospective basis from the date of adoption. Accordingly, disclosures related to interim periods prior to the date of adoption have not been presented. Interest Rate Swap Agreements We use an interest rate swap agreement to manage the economic effect of variable interest obligations associated with our senior notes due May 2010 (Floating Rate Notes) so that the interest payable on the Floating Rate Notes effectively became fixed at a rate of 4.59%, thereby reducing the impact of future interest rate changes on our future interest expense. The critical terms of the interest rate swap agreement and the Floating Rate Notes match, including the notional amounts, interest rate reset dates, maturity dates and underlying market indices. Accordingly, we have designated this swap agreement as a qualifying hedging instrument and are accounting for it as a cash flow hedge pursuant to ASC 815. The unrealized losses on this interest rate swap agreement are included in accumulated other comprehensive income and the corresponding fair value payables are included in other current liabilities in our consolidated balance sheets. The periodic interest settlements on this interest rate swap agreement, which occur at the same interval as the periodic interest settlements pursuant to the Floating Rate Notes, are recorded as interest expense. In September 2009, we entered into interest rate swap agreements that have the economic effect of modifying the fixed interest obligations associated with the 2014 Notes (as defined in Note 5) so that the interest payable on these notes effectively became variable based on LIBOR. The critical terms of the interest rate swap agreements and the 2014 Notes match, including the notional amounts and maturity dates. Accordingly, we have designated these swap agreements as qualifying hedging instruments and are accounting for them as fair value hedges pursuant to ASC 815. These transactions are characterized as fair value hedges for financial accounting purposes because they protect us against changes in the fair value of our fixed rate borrowings due to benchmark interest rate movements. The changes in fair value of these interest rate swap agreements are recognized as interest expense in our consolidated statements of operations with the corresponding amount included in other assets or other non-current liabilities in our consolidated balance sheets. The amount of net gain (loss) attributable to the risk being hedged is recognized as interest expense in our consolidated statement of operations with the corresponding amount included in notes payable and other non-current borrowings. The periodic interest settlements, which occur at the same interval as the 2014 Notes, will be recorded as interest expense. We do not use any interest rate swap agreements for trading purposes. Periodically, we hedge net assets of certain of our international subsidiaries using foreign currency forward contracts to offset the translation and economic exposures related to our foreign currency-based investments in these subsidiaries. These contracts have been designated as net investment hedges pursuant to ASC 815. We use the spot method to measure the effectiveness of our net investment hedges. Under this method for each reporting period, the change in fair value of the forward contracts attributable to the changes in spot exchange rates (the effective portion) is reported in accumulated other comprehensive income on our consolidated balance sheet and the remaining change in fair value of the forward contract (the ineffective portion, if any) is recognized in non-operating income, net, in our consolidated statement of operations. We record settlements under these forward contracts in a similar manner. The fair value of both the effective and ineffective portions is recorded to our consolidated balance sheet as prepaid expenses and other current assets for amounts receivable from the counterparties or other current liabilities for amounts payable to the counterparties. As of November 30, 2009, we had one net investment hedge in Japanese Yen. The Yen net investment hedge minimizes currency risk arising from net assets held in Yen as a result of equity capital raised during the initial public offering and subsequent offering of our majority owned subsidiary, Oracle Japan. As of November 30, 2009, the fair value of our net investment hedge in Japanese Yen was nominal and had a notional amount of $753 million. Foreign Currency Forward Contracts Not Designated as Hedges We transact business in various foreign currencies and have established a program that primarily utilizes foreign currency forward contracts to offset the risks associated with the effects of certain foreign currency exposures. Under this program, our strategy is to have increases or decreases in our foreign currency exposures offset by gains or losses on the foreign currency forward contracts to mitigate the risks and volatility associated with foreign currency transaction gains or losses. These foreign currency exposures typically arise from intercompany sublicense fees and other intercompany transactions. Our foreign currency forward contracts generally settle within 90 days. We do not use these forward contracts for trading purposes. We do not designate these forward contracts as hedging instruments pursuant to ASC 815. Accordingly, we record the fair value of these contracts as of the end of our reporting period to our consolidated balance sheet with changes in fair value recorded in our consolidated statement of operations. The balance sheet classification for the fair values of these forward contracts is prepaid expenses and other current assets for unrealized gains and other current liabilities for unrealized losses. The statement of operations classification for the fair values of these forward contracts is non-operating income, net, for both realized and unrealized gains and losses. As of November 30, 2009, the notional amounts of the forward contracts we held to purchase and sell U.S. Dollars in exchange for other major international currencies were approximately $1.3 billion and $302 million, respectively, and the notional amounts of the foreign currency forward contracts we held to purchase European Euros in exchange for other major international currencies were €217 million (approximately $326 million). The effects of derivative instruments on our condensed consolidated financial statements were as follows as of November 30, 2009 and for the three and six months then ended (amounts presented exclude any income tax effects): Fair Value of Derivative Instruments in Condensed Consolidated Balance Sheet Balance Sheet Location Interest rate swap agreement designated as cash flow hedge Other current liabilities $ 19 Other current liabilities $ 35 Interest rate swap agreements designated as fair value hedges Other assets $ 27 Not applicable $ — Other current liabilities $ — Other current liabilities $ — Effects of Derivative Instruments on Income and Other Comprehensive Income (OCI) Amount of Gain (Loss) Recognized in Accumulated OCI on Derivative (Effective Portion) Location and Amount of Gain (Loss) Reclassified from Accumulated OCI into Income (Effective Portion) Recognized in Income on Derivative (Ineffective Portion and Amount Excluded from Effectiveness Testing) Interest rate swap $ 9 $ 7 Interest Expense $ (11 ) $ (20 ) Non-operating Income, net $ — $ — Foreign currency forward contract $ (49 ) $ (60 ) Not Applicable $ — $ — Non-operating Income, net $ — $ 1 Location and Amount of Gain (Loss) on Hedged Item Recognized in Income Attributable to Risk Being Hedged Interest Expense $ 27 $ 27 Interest Expense $ (27 ) $ (27 ) Location and Amount of Gain (Loss) Recognized in Income on November 30, 2009 Six Months Derivatives Not Designated as Hedges: Foreign currency forward contracts Non-operating Income, net $ (34 ) $ (63 ) 9. STOCKHOLDERS’ EQUITY Our Board of Directors has approved a program for us to repurchase shares of our common stock. On October 20, 2008, we announced that our Board of Directors approved the expansion of our repurchase program by $8.0 billion and as of November 30, 2009, approximately $5.8 billion was available for share repurchases pursuant to our stock repurchase program. We repurchased approximately 23.0 million shares for $492 million during the six months ended November 30, 2009 (including approximately 0.4 million shares for $8 million that were repurchased but not settled at November 30, 2009) and approximately 140.1 million shares for $2.5 billion during the six months ended November 30, 2008 (including 11.0 million shares for $176 million that were repurchased but not settled at November 30, 2008) under the applicable repurchase programs authorized. Our stock repurchase authorization does not have an expiration date and the pace of our repurchase activity will depend on factors such as our working capital needs, our cash requirements for acquisitions and dividend payments, our debt repayment obligations or repurchase of our debt, our stock price, and economic and market conditions. Our stock repurchases may be effected from time to time through open market purchases or pursuant to a Rule 10b5-1 plan. Our stock repurchase program may be accelerated, suspended, delayed or discontinued at any time. During the first six months of fiscal 2010, our Board of Directors declared cash dividends of $0.10 per share of our outstanding common stock, which we paid during the same period. In December 2009, our Board of Directors declared a quarterly cash dividend of $0.05 per share of outstanding common stock payable on February 9, 2010 to stockholders of record as of the close of business on January 19, 2010. Future declarations of dividends and the establishment of future record and payment dates are subject to the final determination of our Board of Directors. Stock-Based Compensation Expense and Valuation of Awards Stock-based compensation is included in the following operating expense line items in our condensed consolidated statements of operations: Total stock-based compensation $ 104 $ 95 $ 188 $ 186 We estimate the fair value of our share-based payments using the Black-Scholes-Merton option-pricing model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models, including the Black-Scholes-Merton option-pricing model, require the input of assumptions, including stock price volatility. Changes in the input assumptions can materially affect the fair value estimates and ultimately how much we recognize as stock-based compensation expense. The fair values of our stock options were estimated at the date of grant or date of acquisition for options assumed in a business combination. The weighted average input assumptions used and resulting fair values were as follows for the three and six months ended November 30, 2009 and 2008: Expected life (in years) 2.5% 2.7% 2.5% 3.3% 0.9% — 1.0% — Weighted-average fair value per share of grants The expected life input is based on historical exercise patterns and post-vesting termination behavior, the risk-free interest rate input is based on United States Treasury instruments and the volatility input is calculated based on the implied volatility of our longest-term, traded options. Our expected dividend rate was zero prior to our first dividend declaration on March 18, 2009 as we did not historically pay cash dividends on our common stock and did not anticipate doing so for the foreseeable future for grants issued prior to March 18, 2009. For grants issued subsequent to March 18, 2009, we used an annualized dividend yield based on the per share dividend declared by our Board of Directors. 10. INCOME TAXES The effective tax rate for the periods presented is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. Our provision for income taxes differs from the tax computed at the U.S. federal statutory income tax rate due primarily to state taxes and earnings considered as indefinitely reinvested in foreign operations. Our effective tax rate was 27.9% and 28.0% for the three and six months ended November 30, 2009, respectively and 29.0% and 27.4% for the three and six months ended November 30, 2008, respectively. Domestically, U.S. federal and state taxing authorities are currently examining income tax returns of Oracle and various acquired entities for years through fiscal 2007. Our U.S. federal and, with some exceptions, our state income tax returns have been examined for all years prior to fiscal 2000, and we are no longer subject to audit for those periods. Internationally, tax authorities for numerous non-U.S. jurisdictions are also examining returns affecting unrecognized tax benefits. With some exceptions, we are generally no longer subject to tax examinations in non-U.S. jurisdictions for years prior to fiscal 1998. We believe that we have adequately provided for any reasonably foreseeable outcomes related to our tax audits and that any settlement will not have a material adverse effect on our consolidated financial position or results of operations; however, there can be no assurances as to the actual outcomes. We previously negotiated three unilateral Advance Pricing Agreements with the U.S. Internal Revenue Service (IRS) that cover many of our intercompany transfer pricing issues and preclude the IRS from making a transfer pricing adjustment within the scope of these agreements. These agreements are effective for fiscal years through May 31, 2006. We have submitted to the IRS a request for renewal of this Advance Pricing Agreement for the years ending May 31, 2007 through May 31, 2011. However, these agreements do not cover all elements of our transfer pricing and do not bind tax authorities outside the United States. We have finalized one bilateral Advance Pricing Agreement, which was effective for the years ending May 31, 2002 through May 31, 2006 and we have submitted a renewal for the years ending May 31, 2007 through May 31, 2011. There can be no guarantee that such negotiations will result in an agreement. We concluded an additional bilateral agreement to cover the period from June 1, 2001 through January 25, 2008. 11. SEGMENT INFORMATION ASC 280, Segment Reporting, establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance. Our chief operating decision maker is our Chief Executive Officer. We are organized geographically and by line of business. While our Chief Executive Officer evaluates results in a number of different ways, the line of business management structure is the primary basis for which the allocation of resources and financial results are assessed. We have two businesses, software and services, which are further divided into five operating segments. Our software business is comprised of two operating segments: (1) new software licenses and (2) software license updates and product support. Our services business is comprised of three operating segments: (1) consulting, (2) On Demand and (3) education. The new software licenses line of business is engaged in the licensing of database and middleware software as well as applications software. Database and middleware software includes database management software, application server software, business intelligence software, identification and access management software, content management software, portal and user interaction software, Service-Oriented Architecture and business process management software, data integration software and development tools. Applications software provides enterprise information that enables companies to manage their business cycles and provide intelligence in functional areas such as customer relationship management, financials, human resources, maintenance management, manufacturing, marketing, order fulfillment, product lifecycle management, enterprise project portfolio management, enterprise performance management, procurement, sales, services, enterprise resource planning and supply chain planning. The software license updates and product support line of business provides customers with rights to unspecified software product upgrades and maintenance releases, internet access to technical content, as well as internet and telephone access to technical support personnel during the support period. In addition, the software license updates and product support line of business offers customers Oracle Unbreakable Linux Support, which provides enterprise level support for the Linux operating system, and also offers support for Oracle VM server virtualization software. The consulting line of business provides services to customers in business strategy and analysis, business process simplification, solutions integration and the implementation, enhancement and upgrade of our database, middleware and applications software. On Demand includes Oracle On Demand and Advanced Customer Services. Oracle On Demand provides multi-featured software and hardware management and maintenance services for customers that deploy our database, middleware and applications software at our data center facilities, select partner data centers or customer facilities. Advanced Customer Services consists of solution lifecycle management services, database and application management services, industry-specific solution support centers and remote and on-site expert services. The education line of business provides instructor-led, media-based and internet-based training in the use of our database, middleware and applications software. We do not track our assets by operating segments. Consequently, it is not practical to show assets by operating segments results. The following table presents a summary of our businesses’ and operating segments’ results: New software licenses: Revenues(1) Sales and distribution expenses Margin(2) Software license updates and product support: Total software business: Consulting: $ 689 $ 836 $ 1,348 $ 1,694 $ 94 $ 152 $ 183 $ 254 On Demand: $ 57 $ 53 $ 114 $ 102 Total services business: $ 962 $ 1,134 $ 1,871 $ 2,296 Operating segment revenues differ from the external reporting classifications due to certain software license products that are classified as service revenues for management reporting purposes. Additionally, software license updates and product support revenues for management reporting included $14 million and $80 million of revenues that we did not recognize in the accompanying condensed consolidated statements of operations for the three months ended November 30, 2009 and 2008, respectively, and $23 million and $171 million for the six months ended November 30, 2009 and 2008, respectively. See Note 7 for an explanation of these adjustments and the following table for a reconciliation of operating segment revenues to total revenues. The margins reported reflect only the direct controllable costs of each line of business and do not include allocations of product development, information technology, marketing and partner programs, and corporate and general and administrative expenses incurred in support of the lines of business. Additionally, the margins do not reflect the amortization of intangible assets, acquisition related and other expenses, restructuring costs, or stock-based compensation. The following table reconciles operating segment revenues to total revenues as well as operating segment margin to income before provision for income taxes: Total revenues for reportable segments Software license updates and product support revenues(1) (14 ) (80 ) (23 ) (171 ) Total margin for reportable segments Product development and information technology expenses Marketing and partner program expenses Corporate and general and administrative expenses (114 ) (17 ) (162 ) (31 ) (104 ) (89 ) (188 ) (175 ) Software license updates and product support revenues for management reporting include $14 million and $80 million of revenues that we did not recognize in the accompanying condensed consolidated statements of operations for the three months ended November 30, 2009 and 2008, respectively and $23 million and $171 million for the six months ended November 30, 2009 and 2008, respectively. See Note 7 for an explanation of these adjustments and this table for a reconciliation of operating segment revenues to total revenues. Basic earnings per share is computed by dividing net income for the period by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income for the period by the weighted average number of common shares outstanding during the period, plus the dilutive effect of outstanding stock awards and shares issuable under the employee stock purchase plans using the treasury stock method. The following table sets forth the computation of basic and diluted earnings per share: Dilutive effect of employee stock plans Shares subject to anti-dilutive stock options excluded from calculation(1) These weighted shares relate to anti-dilutive stock options as calculated using the treasury stock method (described above) and could be dilutive in the future. 13. LEGAL PROCEEDINGS Securities Class Action Stockholder class actions were filed in the United States District Court for the Northern District of California against us and our Chief Executive Officer on and after March 9, 2001. Between March 2002 and March 2003, the court dismissed plaintiffs’ consolidated complaint, first amended complaint and a revised second amended complaint. The last dismissal was with prejudice. On September 1, 2004, the United States Court of Appeals for the Ninth Circuit reversed the dismissal order and remanded the case for further proceedings. The revised second amended complaint named our Chief Executive Officer, our then Chief Financial Officer (who currently is Chairman of our Board of Directors) and a former Executive Vice President as defendants. This complaint was brought on behalf of purchasers of our stock during the period from December 14, 2000 through March 1, 2001. Plaintiffs alleged that the defendants made false and misleading statements about our actual and expected financial performance and the performance of certain of our applications products, while certain individual defendants were selling Oracle stock in violation of federal securities laws. Plaintiffs further alleged that certain individual defendants sold Oracle stock while in possession of material non-public information. Plaintiffs also allege that the defendants engaged in accounting violations. On July 26, 2007, defendants filed a motion for summary judgment, and plaintiffs filed a motion for partial summary judgment against all defendants and a motion for summary judgment against our Chief Executive Officer. On August 7, 2007, plaintiffs filed amended versions of these motions. On October 5, 2007, plaintiffs filed a motion seeking a default judgment against defendants or various other sanctions because of defendants’ alleged destruction of evidence. A hearing on all these motions was held on December 20, 2007. On April 7, 2008, the case was reassigned to a new judge. On June 27, 2008, the court ordered supplemental briefing on plaintiffs’ sanctions motion. On September 2, 2008, the court issued an order denying plaintiffs’ motion for partial summary judgment against all defendants. The order also denied in part and granted in part plaintiffs’ motion for sanctions. The court denied plaintiffs’ request that judgment be entered in plaintiffs’ favor due to the alleged destruction of evidence, and the court found that no sanctions were appropriate for several categories of evidence. The court found that sanctions in the form of adverse inferences were appropriate for two categories of evidence: e-mails from our Chief Executive Officer’s account, and materials that had been created in connection with a book regarding our Chief Executive Officer. The court then denied defendants’ motion for summary judgment and plaintiffs’ motion for summary judgment against our Chief Executive Officer and directed the parties to revise and re-file these motions to clearly specify the precise contours of the adverse inferences that should be drawn, and to take these inferences into account with regard to the propriety of summary judgment. The court also directed the parties to address certain legal issues in the briefing. On October 13, 2008, the parties participated in a court-ordered mediation, which did not result in a settlement. On October 20, 2008, defendants filed a motion for summary judgment, and plaintiffs filed a motion for summary judgment against our Chief Executive Officer. The parties also filed several motions challenging the admissibility of the testimony of various expert witnesses. Opposition briefs were filed on November 17, 2008, and reply briefs were filed on December 12, 2008. A hearing on all these motions was held on February 13, 2009. On June 16, 2009, the court issued an order granting defendants’ motion for summary judgment and denying plaintiffs’ motion for summary judgment against our Chief Executive Officer, and it entered a judgment dismissing the entire case with prejudice. On July 14, 2009, plaintiffs filed a notice of appeal. Plaintiffs filed their opening appellate brief on November 30, 2009. Plaintiffs seek unspecified damages plus interest, attorneys’ fees and costs, and equitable and injunctive relief. EpicRealm/Parallel Networks Intellectual Property Litigation On June 30, 2006, we filed a declaratory judgment action against EpicRealm Licensing, LP (“EpicRealm”) in the United States District Court, District of Delaware, seeking a judicial declaration of noninfringement and invalidity of U.S. Patent Nos. 5,894,554 (the ‘554 Patent) and 6,415,335B1 (the ‘335 Patent). We filed the lawsuit following the resolution of an indemnification claim by one of our customers related to EpicRealm’s assertion of the ‘554 Patent and ‘335 Patent against the customer in a patent infringement case in the United States District Court for the Eastern District of Texas. On April 13, 2007, EpicRealm filed an Answer and Counterclaim in which it: (1) denies our noninfringement and invalidity allegations; (2) alleges that we have willfully infringed, and are willfully infringing, the ‘554 Patent and ‘335 Patent; and (3) requests a permanent injunction, an award of unspecified money damages, interest, attorneys’ fees, and costs. On May 7, 2007, we filed an Answer to EpicRealm’s infringement counterclaim, denying EpicRealm’s infringement allegations and asserting affirmative defenses. In August 2007, the patents-in-suit were sold to Parallel Networks, LLC, which thereafter substituted in as the defendant in place of EpicRealm. The parties have completed discovery and filed briefing on claim construction and summary judgment motions. A Markman hearing and oral argument on summary judgment motions were held October 3, 2008. A court-ordered mediation was held on October 8, 2008, which did not result in a settlement. On December 4, 2008, the court issued an order granting summary judgment that our Web Cache, Internet Application Server, and RAC Database do not infringe the patents. The court also denied our motion for summary judgment that the patents are invalid, and denied in part and granted in part Parallel Networks’s motion for summary judgment that certain prior art references do not invalidate the patents through anticipation. Trial was scheduled to begin on January 12, 2009, on issues of invalidity and inequitable conduct. On December 23, 2008, the parties reached an agreement allowing Parallel Networks to immediately appeal the court’s summary judgment order and preserving Oracle’s invalidity and inequitable conduct claims in the event that the matter is remanded for trial at a later time. On January 23, 2009, Parallel Networks filed a notice of appeal. After full briefing, the appellate court heard oral argument on December 10, 2009. The court has not yet issued a ruling. A court-ordered mediation was held on June 1, 2009, which did not result in a settlement. We will continue to pursue this action vigorously. SAP Intellectual Property Litigation On March 22, 2007, Oracle Corporation, Oracle USA, Inc. and Oracle International Corporation (collectively, Oracle) filed a complaint in the United States District Court for the Northern District of California against SAP AG, its wholly owned subsidiary, SAP America, Inc., and its wholly owned subsidiary, TomorrowNow, Inc., (collectively, the SAP Defendants) alleging violations of the Federal Computer Fraud and Abuse Act and the California Computer Data Access and Fraud Act, civil conspiracy, trespass, conversion, violation of the California Unfair Business Practices Act, and intentional and negligent interference with prospective economic advantage. Oracle alleged that SAP unlawfully accessed Oracle’s Customer Connection support website and improperly took and used Oracle’s intellectual property, including software code and knowledge management solutions. The complaint seeks unspecified damages and preliminary and permanent injunctive relief. On June 1, 2007, Oracle filed its First Amended Complaint, adding claims for infringement of the federal Copyright Act and breach of contract, and dropping the conversion and separately pled conspiracy claims. On July 2, 2007 the SAP Defendants’ filed their Answer and Affirmative Defenses, acknowledging that TomorrowNow had made some “inappropriate downloads” and otherwise denying the claims alleged in the First Amended Complaint. The parties are engaged in discovery and continue to negotiate a Preservation Order. At case management conferences held on February 12, 2008 and April 24, 2008, Oracle advised the Court that Oracle intended to file a Second Amended Complaint, based on new facts learned during the course of discovery. On July 28, 2008, Oracle filed a Second Amended Complaint, which added additional allegations based on facts learned during discovery. Among the new allegations contained in the Second Amended Complaint, Oracle alleges that TomorrowNow’s business model relied on illegal copies of Oracle’s underlying software applications and that TomorrowNow used these copies as generic software environments that TomorrowNow then used to create fixes and updates, to service customers and to train employees. The Second Amended Complaint also alleges that these practices may have extended to other Oracle products, including Siebel products. On October 8, 2008, Oracle filed a Third Amended Complaint pursuant to stipulation. The Third Amended Complaint made some changes relating to the Oracle plaintiff entities (removing Oracle Corporation and adding Oracle Systems Corporation, Oracle EMEA Ltd., and J.D. Edwards Europe Ltd.) but did not change the substantive allegations. On October 15, 2008, the SAP Defendants filed a motion to dismiss portions of the Third Amended Complaint, and after full briefing, the court heard oral argument on November 26, 2008. On December 15, 2008, the court issued an order granting in part and denying in part the motion. The court dismissed with prejudice the claims asserted by plaintiffs JD Edwards Europe Ltd. and Oracle Systems Corporation, and denied the motion in all other respects. The parties are in the process of concluding discovery. On July 15, 2009, Oracle filed a motion for leave to file a Fourth Amended Complaint to add claims for infringement of Oracle’s Siebel software and database programs. The Court granted Oracle’s motion and Oracle filed its Fourth Amended Complaint on August 18, 2009. The SAP Defendants filed an Answer to Oracle’s Fourth Amended Complaint on August 26, 2009. On August 26, 2009, the SAP Defendants filed an early motion for summary judgment directed to Oracle’s damages theory. After full briefing, the motion was heard on October 28, 2009. The court has not yet issued a ruling. On June 11, 2009, the court entered a Stipulated Revised Case Management and Pretrial Order, pursuant to which the court set a new trial date of November 2010. Other Litigation We are party to various other legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business, including proceedings and claims that relate to acquisitions we have completed or to companies we have acquired or are attempting to acquire. While the outcome of these matters cannot be predicted with certainty, we do not believe that the outcome of any of these claims or any of the above mentioned legal matters will have a materially adverse effect on our consolidated financial position, results of operations or cash flows. We begin Management’s Discussion and Analysis of Financial Condition and Results of Operations with an overview of our key operating business segments and significant trends. This overview is followed by a summary of our critical accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. We then provide a more detailed analysis of our results of operations and financial condition. In addition to historical information, this Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties that could cause our actual results to differ materially. When used in this report, the words “will,” “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward-looking statements. You should not place undue reliance on these forward-looking statements, which reflect our opinions only as of the date of this Quarterly Report. We undertake no obligation to publicly release any revisions to the forward-looking statements after the date of this document. You should carefully review the risk factors described in other documents we file from time to time with the U.S. Securities and Exchange Commission (SEC), including our Annual Report on Form 10-K for our fiscal year ended May 31, 2009 and our other Quarterly Reports on Form 10-Q to be filed by us in our fiscal year 2010, which runs from June 1, 2009 to May 31, 2010. We are the world’s largest enterprise software company. We develop, manufacture, market, distribute and service database and middleware software as well as applications software designed to help our customers manage and grow their business operations. We believe our internal, or organic, growth and continued innovation with respect to our software products and services offerings provide the foundation for our long-term strategic plan. We invest billions of dollars in research and development each year to enhance our existing portfolio of products and services and to develop new products, features and services. Our internally developed offerings have been enhanced by our acquisitions. We are organized into two businesses, software and services, which are further divided into five operating segments. Each of these operating segments has unique characteristics and faces different opportunities and challenges. Although we report our actual results in U.S. Dollars, we conduct a significant number of transactions in currencies other than U.S. Dollars. Therefore, we present constant currency information to provide a framework for assessing how our underlying businesses performed excluding the effect of foreign currency rate fluctuations. An overview of our two businesses and five operating segments follows. Software Business Our software business, which represented 83% of our total revenues on a trailing 4-quarter basis, is comprised of two operating segments: (1) new software licenses and (2) software license updates and product support. On a constant currency basis we expect that our software business revenues generally will continue to increase due to continued demand for our products, including the high percentage of customers that renew their software license update and product support contracts, and due to our acquisitions, which should allow us to grow our profits and continue to make investments in research and development. New Software Licenses: We license our database and middleware as well as our applications software to businesses of many sizes, government agencies, educational institutions and resellers. The growth in new software license revenues that we report is affected by the strength of general economic and business conditions, governmental budgetary constraints, the competitive position of our software products, our acquisitions and foreign currency fluctuations. Our new software license business is also characterized by long sales cycles. The timing of a few large software license transactions can substantially affect our quarterly new software license revenues. Since our new software license revenues in a particular quarter can be difficult to predict as a result of the timing of a few large software license transactions, we believe that analysis of new software license revenues on a trailing 4-quarter period provides additional visibility into the underlying performance of our new software license business. New software license revenues represented 30% of our total revenues on a trailing 4-quarter basis. Our new software license segment’s margins have historically trended upward over the course of the four quarters within a particular fiscal year due to the historical upward trend of our new software license revenues over the corresponding quarterly periods and because our costs are predominantly fixed in the short term. However, our new software license segment’s margins have been, and will continue to be, affected by the amortization of intangible assets associated with companies that we have acquired. Competition in the software business is intense. Our goal is to maintain a first or second position in each of our software product categories and certain industry segments as well as to grow our software revenues faster than our competitors. We believe that the features and functionality of our software products are as strong as they have ever been. We have focused on lowering the total cost of ownership of our software products by improving integration, decreasing installation times, lowering administration costs and improving the ease of use. In addition, our broad portfolio of product offerings (many of which have been acquired in recent years) helps us to offer customers the ability to gain efficiencies by consolidating their IT “software stack” with a single vendor, which reduces the number of disparate software vendors with which customers interact. Reducing the total cost of ownership of our products provides our customers with a higher return on their IT investments, which we believe creates more demand for our products and services and provides us with a competitive advantage. We have also continued to focus on improving the overall quality of our software products and service levels. We believe this will lead to higher customer satisfaction and loyalty and help us achieve our goal of becoming our customers’ leading technology advisor. Software License Updates and Product Support: Customers that purchase software license updates and product support are granted rights to unspecified product upgrades and maintenance releases issued during the support period, as well as technical support assistance. In addition, we offer Oracle Unbreakable Linux Support, which provides enterprise level support for the Linux operating system, and also offer support for our Oracle VM server virtualization software. Substantially all of our customers renew their software license updates and product support contracts annually. The growth of software license updates and product support revenues is primarily influenced by three factors: (1) the percentage of our support contract customer base that renews its support contracts, (2) the amount of new support contracts sold in connection with the sale of new software licenses, and (3) the amount of support contracts assumed from companies we have acquired. Our software license updates and product support operating segment, which represented approximately 53% of our total revenues on a trailing 4-quarter basis, is our highest margin operating segment. Our software license updates and product support margins over the trailing 4-quarters were 85%, and accounted for 83% of our total margins over the same period. Our software license update and product support margins have been affected by fair value adjustments relating to support obligations assumed in our acquisitions (described further below) and by the amortization of intangible assets. However, over the longer term, we believe that software license updates and product support revenues and margins will grow for the following reasons: substantially all of our customers, including customers from acquired companies, renew their support contracts when eligible for renewal; substantially all of our customers purchase software license updates and product support contracts when they buy new software licenses, resulting in a further increase in our support contract base. Even if new software license revenues growth was flat or declined modestly, software license updates and product support revenues would most likely continue to grow in comparison to the corresponding prior year periods assuming renewal and cancellation rates and foreign currency rates remained relatively constant since substantially all new software license transactions add to our support contract base; and our acquisitions have increased our support contract base, as well as the portfolio of products available to be licensed and supported. We record adjustments to reduce support obligations assumed in business combinations to their estimated fair values at the acquisition dates. As a result, as required by business combination accounting rules, we did not recognize software license updates and product support revenues related to support contracts that would have been otherwise recorded by the acquired businesses as independent entities in the amount of $14 million and $80 million for the three months ended November 30, 2009 and 2008, respectively, and $23 million and $171 million for the six months ended November 30, 2009 and 2008, respectively. To the extent underlying support contracts are renewed with us following an acquisition, we will recognize the revenues for the full values of the support contracts over the support periods, which are generally one year in duration. Our services business consists of our consulting, On Demand and education operating segments. Our services business, which represented 17% of our total revenues on a trailing 4-quarter basis, has significantly lower margins than our software business. Consulting: Our consulting line of business provides services to customers in business/IT strategy alignment; business process simplification; solution integration; and product implementation, enhancements, and upgrades of our database, middleware and applications software. The amount of consulting revenues recognized tends to lag new software license revenue recognition by several quarters since consulting services, if purchased, are typically performed after the purchase of new software licenses. Our consulting revenues are dependent upon general economic conditions and the level of new software license sales, particularly our application product sales. To the extent we are able to grow our new software license revenues, in particular our application product revenues, we would also generally expect to be able to eventually grow our consulting revenues. On Demand: Our On Demand operating segment includes Oracle On Demand and our Advanced Customer Services offerings. We believe that our On Demand offerings provide our customers flexibility in how they manage their IT environments and an additional opportunity to lower their total cost of ownership and can therefore provide us with a competitive advantage. Recently, we have maintained or grown the base of customers that have purchased certain of our On Demand services while managing our expenses to a consistent or lower level in comparison to the prior year periods. To the extent we are able to continue this trend, we would expect our On Demand revenues and margins to increase. We have made and plan to continue to make investments in our On Demand businesses to support current and future revenue growth, which historically have negatively impacted On Demand margins and could do so in the future. Education: The purpose of our education services is to further the adoption and usage of our software products by our customers and to create opportunities to grow our software revenues. Education revenues are impacted by general economic conditions, personnel reductions in our customers’ information technology departments, tighter controls over discretionary spending and greater use of outsourcing solutions. We believe the recent global economic environment has unfavorably affected customer demand for our education services in comparison to prior year periods, which has negatively impacted our revenues and margins. An active acquisition program is another important element of our corporate strategy. In recent years, we have invested billions of dollars to acquire a number of complementary companies, products, services and technologies. On April 19, 2009, we entered into an Agreement and Plan of Merger (Merger Agreement) with Sun Microsystems, Inc. (Sun), a provider of enterprise computing systems, software and services. Pursuant to the Merger Agreement, our wholly owned subsidiary will merge with and into Sun and Sun will become a wholly owned subsidiary of Oracle. Upon the consummation of the merger, each share of Sun common stock will be converted into the right to receive $9.50 in cash. In addition, options to acquire Sun common stock, Sun restricted stock unit awards and other equity-based awards denominated in shares of Sun common stock outstanding immediately prior to the consummation of the merger will generally be converted into options, restricted stock unit awards or other equity-based awards, as the case may be, denominated in shares of Oracle common stock based on formulas contained in the Merger Agreement. The estimated total purchase price of Sun is approximately $7.4 billion. Completion of this transaction is subject to customary closing conditions, including regulatory clearance under the applicable antitrust laws of the European Commission and other jurisdictions. On November 9, 2009, we received a Statement of Objections from the European Commission relating to our proposed acquisition of Sun. A hearing to consider the Statement of Objections and Oracle’s response to the Statement of Objections was held on December 10-11, 2009. We believe our acquisition program supports our long-term strategic direction, strengthens our competitive position, expands our customer base, provides greater scale to accelerate innovation, grows our revenues and earnings, and increases stockholder value. We expect to continue to acquire companies, products, services and technologies. See Note 2 of Notes to Condensed Consolidated Financial Statements for additional information related to our recent acquisitions. We believe we can fund our pending and future acquisitions with our internally available cash, cash equivalents and marketable securities, cash generated from operations, amounts available under our existing debt capacity, additional borrowings or from the issuance of additional securities. We estimate the financial impact of any potential acquisition with regard to earnings, operating margin, cash flow and return on invested capital targets before deciding to move forward with an acquisition. Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (GAAP) and consider the various staff accounting bulletins and other applicable guidance issued by the SEC. In July 2009, the Financial Accounting Standards Board (FASB) issued the FASB Accounting Standards Codification (Codification), which we adopted in our second quarter of fiscal 2010. There were no changes to our consolidated financial statements and related disclosures contained in this Quarterly Report due to the implementation of the Codification, other than changes in reference in this Quarterly Report to the various authoritative accounting pronouncements contained within the Codification. GAAP, as set forth within the Codification, requires us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The accounting policies that reflect our more significant estimates, judgments and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following: Business Combinations Goodwill and Intangible Assets—Impairment Assessments Accounting for Income Taxes Legal and Other Contingencies Allowances for Doubtful Accounts In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management’s judgment in its application. There are also areas in which management’s judgment in selecting among available alternatives would not produce a materially different result. Our senior management has reviewed these critical accounting policies and related disclosures with the Finance and Audit Committee of the Board of Directors. During the first half of fiscal 2010, we adopted certain new accounting pronouncements that affected our critical accounting policies and estimates, namely Accounting Standards Codification (ASC) 805, Business Combinations, which affected our Business Combinations and Accounting for Income Taxes policies. Please refer to Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended May 31, 2009 for a more complete discussion of our critical accounting policies and estimates for fiscal 2010. There were no other significant changes in our critical accounting policies and estimates in fiscal 2010 other than the aforementioned reference changes resulting from the Codification. Impact of Acquisitions The comparability of our operating results in the second quarter and first half of fiscal 2010 compared with the same periods in fiscal 2009 is impacted by our acquisitions. In our discussion of changes in our results of operations from the second quarter and first half of fiscal 2010 compared to the corresponding periods in the prior year, we quantify the contribution of our acquired products (for acquisitions that were completed since the beginning of the second quarter of fiscal 2009) to the growth in new software license revenues and to the growth in software license updates and product support revenues. We also present supplemental disclosures related to certain charges. Although certain revenue and expense contributions from our acquisitions are quantifiable, we are unable to identify the following: the contribution of the significant majority of our services revenues from acquired companies during the second quarter and first half of fiscal 2010 as the significant majority of these services had been fully integrated into our existing operations; and the contribution of the significant majority of the expenses associated with acquired products and services during the second quarter and first half of fiscal 2010 as the significant majority of these expenses had been fully integrated into our existing operations. We caution readers that, while pre- and post-acquisition comparisons as well as the quantified amounts themselves may provide indications of general trends, the information has inherent limitations for the following reasons: the quantifications cannot address the substantial effects attributable to our sales force integration efforts, in particular the effect of having a single sales force offer similar products. We believe that if our sales forces had not been integrated, the relative mix of products sold would have been different; our acquisitions in the periods presented did not result in our entry into a new line of business or product category—therefore, we provided multiple products with substantially similar features and functionality; and although substantially all of our customers, including customers from acquired companies, renew their software license updates and product support contracts when the contracts are eligible for renewal, amounts shown as support deferred revenues in our supplemental disclosure related to certain charges (presented below) are not necessarily indicative of revenue improvements we will achieve upon contract renewal to the extent customers do not renew. Our quarterly revenues have historically been affected by a variety of seasonal factors, including the structure of our sales force incentive compensation plans, which are common in the software industry. The operating margins of our businesses are affected by seasonal factors in a similar manner as our revenues (in particular, our new software licenses business) as certain expenses within our cost structure are relatively fixed in the short term. Constant Currency Presentation Our international operations have provided and will continue to provide a significant portion of our total revenues and expenses. As a result, total revenues and expenses including our non-operating income and expenses, will continue to be affected by changes in the U.S. Dollar against major international currencies. In order to provide a framework for assessing how our underlying businesses performed excluding the effect of foreign currency fluctuations, we compare the percent change in the results from one period to another period in this Quarterly Report using constant currency disclosure. To present this information, current and comparative prior period results for entities reporting in currencies other than U.S. Dollars are converted into U.S. Dollars at constant exchange rates (i.e. the rates in effect on May 31, 2009, which was the last day of our prior fiscal year) rather than the actual exchange rates in effect during the respective periods. For example, if an entity reporting in Euros had revenues of 1.0 million Euros from products sold on November 30, 2009 and November 30, 2008, our financial statements would reflect reported revenues of $1.50 million in the first half of fiscal 2010 (using 1.50 as the month-end average exchange rate for the period) and $1.30 million in the first half of fiscal 2009 (using 1.30 as the month-end average exchange rate for the period). The constant currency presentation would translate the results for the three and six months ended November 30, 2009 and 2008 using the May 31, 2009 exchange rate and indicate, in this example, no change in revenues during the period. In each of the tables below, we present the percent change based on actual, unrounded results in reported currency and in constant currency. Total Revenues and Operating Expenses Three Months Ended November 30, Six Months Ended November 30, Percent Change Percent Change 2009 Actual Constant 2008 2009 Actual Constant 2008 Total Revenues by Geography: $ 2,979 3% 1% $ 2,904 $ 5,650 1% 1% $ 5,591 EMEA(1) 1,976 5% -2% 1,881 3,618 -3% -2% 3,711 Asia Pacific(2) 903 10% -2% 822 1,643 0% -5% 1,636 5,858 4% 0% 5,607 10,911 0% -1% 10,938 Total Operating Margin $ 2,178 10% 2% $ 1,975 $ 3,918 12% 10% $ 3,496 Total Operating Margin % % Revenues by Geography: Total Revenues by Business: 958 -15% -19% 1,131 1,866 -19% -18% 2,290 $ 5,858 4% 0% $ 5,607 $ 10,911 0% -1% $ 10,938 % Revenues by Business: Comprised of Europe, the Middle East and Africa Asia Pacific includes Japan Fiscal Second Quarter 2010 Compared to Fiscal Second Quarter 2009: Our operating results for the second quarter of fiscal 2010 were impacted by the weakening of the U.S. Dollar relative to other major international currencies. These favorable currency variances resulted in an increase to our total revenues of 4 percentage points during the second quarter of fiscal 2010. On a constant currency basis, growth in total revenues for the second quarter of fiscal 2010 was flat as compared to the prior year period as our growth in total software revenues was offset by a reduction in our total services revenues. Excluding the effect of currency rate fluctuations, our total software revenues increased by 4% due to a 9% increase in our software license updates and product support revenues, while our total services revenues decreased by 19%, which we believe was caused by weaker demand for IT services due to the deterioration in global economic conditions in recent quarters. Excluding the effect of currency rate fluctuations, total revenues in the Americas increased by 1%, while total revenues in the EMEA and Asia Pacific regions each decreased by 2%. Total operating expenses were unfavorably affected by foreign currency rate fluctuations of 3 percentage points in the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, the 2% decrease in total operating expenses in the second quarter of fiscal 2010 is due to reductions in salary and external contractor expenses primarily in our services business, decreased travel and entertainment expenses (including rebillable travel and entertainment expenses) and bad debt expenses across all of our operating segments. These decreases were partially offset by an increase in our variable compensation and benefits expenses across all of our operating segments and an increase in our restructuring expenses. The increase in our benefits expenses was primarily due to a current quarter increase in our deferred compensation plan liability, which was offset by a gain in our deferred compensation plan assets (see additional discussion under “Non-Operating Income, net” below). Excluding the effects of favorable foreign currency variations of 8 percentage points, total operating margin and total operating margin as a percentage of total revenues increased during the second quarter of fiscal 2010 because our total operating expenses declined while our total revenues were flat in comparison to the prior year period. First Half Fiscal 2010 Compared to First Half Fiscal 2009: Excluding the effects of foreign currency rate fluctuations, total revenues decreased slightly in the first half of fiscal 2010 as growth in our total software revenues was offset by decreases in our total services revenues. Excluding the effect of currency rate fluctuations, our total software revenues increased by 4% due to a 10% increase in our software license updates and product support revenues, while our total services revenues decreased by 18%. Excluding the effect of currency rate fluctuations, total revenues in the Americas increased by 1%, while total revenues in the EMEA and Asia Pacific regions declined by 2% and 5%, respectively. On a constant currency basis, the net decrease in operating expenses was generally consistent with the reasons noted above, with the exception of variable compensation expense reductions, which also contributed to the decrease in our total operating expenses in the first half of fiscal 2010. On a constant currency basis, operating margin and operating margin as a percentage of revenues in the first half of fiscal 2010 increased due to decreases in our operating expenses. Supplemental Disclosure Related to Certain Charges To supplement our consolidated financial information we believe the following information is helpful to an overall understanding of our past financial performance and prospects for the future. You should review the introduction under “Impact of Acquisitions” (above) for a discussion of the inherent limitations in comparing pre- and post-acquisition information. Our operating results include the following business combination accounting adjustments and expenses related to acquisitions as well as certain other significant expense items: Support deferred revenues(1) Amortization of intangible assets(2) Acquisition related and other(3)(5) Restructuring(4) Stock-based compensation(5) Income tax effects(6) In connection with purchase price allocations related to our acquisitions, we have estimated the fair values of the support obligations assumed. Due to our application of business combination accounting rules, we did not recognize software license updates and product support revenues related to support contracts that would have otherwise been recorded by the acquired businesses as independent entities, in the amounts of $14 million and $80 million for the three months ended November 30, 2009 and 2008, respectively, and $23 million and $171 million for the six months ended November 30, 2009 and 2008, respectively. Approximately $18 million and $14 million of estimated software license updates and product support revenues related to support contracts assumed will not be recognized during the remainder of fiscal 2010 and fiscal 2011, respectively, that would have otherwise been recognized by the acquired businesses as independent entities due to the application of these business combination accounting rules. To the extent customers renew these support contracts, we expect to recognize revenues for the full contract value over the support renewal period. Represents the amortization of intangible assets acquired in connection with our acquisitions, primarily BEA Systems, Inc., Hyperion Solutions Corporation, Siebel Systems, Inc. and PeopleSoft, Inc. As of November 30, 2009, estimated future amortization expenses related to intangible assets, excluding the impact of additional intangible assets resulting from any subsequent acquisitions, such as from our proposed acquisition of Sun, were as follows (in millions): Remainder of Fiscal 2010 Acquisition related and other expenses primarily consist of personnel related costs for transitional and certain other employees, stock-based compensation expenses, integration related professional services, certain business combination adjustments after the measurement period or purchase price allocation period has ended, and certain other operating expenses, net. As a result of our adoption of ASC 805, Business Combinations, as of the beginning of fiscal 2010, certain acquisition related and other expenses are now recorded as expenses in our statements of operations that had been historically included as a part of the consideration transferred and capitalized as a part of our accounting for acquisitions pursuant to previous accounting rules, primarily direct transaction costs such as professional services fees (see further discussion in “Critical Accounting Policies and Estimates” in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended May 31, 2009). Restructuring expenses during the first half of fiscal 2010 relate primarily to Oracle employee severance and facility exit costs in connection with our Fiscal 2009 Oracle Restructuring Plan that was initiated in the third quarter of fiscal 2009, and amended in the first quarter of fiscal 2010. Restructuring expenses during the first half of fiscal 2009 relate to costs incurred pursuant to our Fiscal 2008 Oracle Restructuring Plan that was initiated in the second quarter of fiscal 2008. As a result of our fiscal 2010 adoption of ASC 805, Business Combinations, in connection with any acquisition that we close prospectively, we will record involuntary termination and other exit costs associated with the acquisition to restructuring expenses, which is a change in the required accounting in comparison to prior year periods (see further discussion in “Critical Accounting Policies and Estimates” in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended May 31, 2009). Stock-based compensation is included in the following operating expense line items of our condensed consolidated statements of operations (in millions): Stock-based compensation included in acquisition related and other expenses resulted from unvested stock awards assumed from acquisitions whose vesting was accelerated upon termination of the employees pursuant to the terms of those stock awards. The income tax effects presented in the table above were calculated as if the above described charges were not included in our results of operations for each of the respective periods presented. Income tax effects were calculated based on the applicable jurisdictional tax rates applied to the charges and resulted in an effective tax rate of 27.4% and 29.0% for the second quarter of fiscal 2010 and 2009, respectively, and 27.7% and 27.4% for the first half of fiscal 2010 and 2009, respectively. The differences in the income tax rates for the second quarter and first half of fiscal 2010, respectively, in comparison to the income tax rates derived per our condensed consolidated statements of operations were due to differences in jurisdictional tax rates and the related tax benefits attributable to our restructuring expenses in these periods. Our software business consists of our new software licenses segment and software license updates and product support segment. New Software Licenses: New software license revenues represent fees earned from granting customers licenses to use our database and middleware as well as our application software products. We continue to place significant emphasis, both domestically and internationally, on direct sales through our own sales force. We also continue to market our products through indirect channels. Sales and marketing expenses are largely personnel related and include commissions earned by our sales force for the sale of our software products, and also include marketing program costs and amortization of intangible assets. New Software License Revenues: $ 778 4% 1% $ 751 $ 1,274 -1% -1% $ 1,286 548 -2% -11% 557 862 -12% -14% 978 327 3% -8% 318 545 -9% -15% 599 Sales and marketing(1) 1,113 -1% -6% 1,130 2,057 -7% -8% 2,223 20 25% 25% 16 36 1% 1% 35 208 3% 3% 201 413 4% 4% 394 Total expense Total Margin $ 312 12% -7% $ 279 $ 175 -16% -40% $ 211 Total Margin % 19% 17% 6% 7% Revenues by Product: Database and middleware $ 1,163 1% -6% $ 1,146 $ 1,848 -10% -12% $ 2,034 478 2% -3% 469 795 -1% -2% 799 Total revenues by product Other revenues 12 10% 6% 11 38 28% 28% 30 Total new software license revenues $ 1,653 2% -5% $ 1,626 $ 2,681 -6% -9% $ 2,863 % Revenues by Product: Excluding stock-based compensation Included as a component of ‘Amortization of Intangible Assets’ in our condensed consolidated statements of operations Fiscal Second Quarter 2010 Compared to Fiscal Second Quarter 2009: New software license revenues were favorably affected by foreign currency rate fluctuations of 7 percentage points in the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, total new software license revenues decreased by 5% in the second quarter of fiscal 2010 due to decreases in the EMEA and Asia Pacific regions. Excluding the effect of favorable currency rate fluctuations of 7 percentage points, database and middleware revenues declined 6% in the second quarter of fiscal 2010 and 5% over the trailing 4-quarters. The decline in our database and middleware revenues was affected by the high growth rates in our database and middleware revenues against which the results for the aforementioned periods are compared and weaker global economic conditions that we believe impacted or delayed customers’ purchasing decisions. In addition, our database and middleware products are sold with or are embedded in a number of other products developed and marketed by other vendors, including products from other software applications vendors, and our revenues earned from certain of these vendors decreased in the second quarter of fiscal 2010 as these vendors’ own revenues decreased. In reported currency, our recently acquired products contributed an incremental $30 million to our database and middleware revenues in the second quarter of fiscal 2010. Excluding the effect of favorable currency rate fluctuations of 5 percentage points, applications new software license revenues decreased 3% in the second quarter of fiscal 2010 and 6% over the trailing 4-quarters due to weaker global economic conditions that we believe impacted or delayed customers’ purchasing decisions. In reported currency, our recently acquired products contributed an incremental $12 million to our applications revenues in the second quarter of fiscal 2010. In reported currency, new software license revenues earned from transactions over $0.5 million increased by 11% in the second quarter of fiscal 2010 and represented 51% of our new software license revenues in the second quarter of fiscal 2010 in comparison to 47% in the second quarter of fiscal 2009. Total sales and marketing expenses were unfavorably impacted by 3 percentage points of currency variations during the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, total sales and marketing expenses decreased in the second quarter of fiscal 2010 primarily due to a decrease in salaries expenses resulting from headcount reductions, lower travel and entertainment expenses due to cost management initiatives and lower bad debt expenses resulting from improved cash collections. Our new software license segment’s operating margin was impacted by 19 percentage points of favorable currency variations during the second quarter of fiscal 2010. Excluding the effects of currency rate fluctuations, total new software license margin and margin as a percentage of revenues decreased as our new software license revenues decreased while expenses related to amortization of intangible assets increased. First Half Fiscal 2010 Compared to First Half Fiscal 2009: Excluding the effect of favorable foreign currency rate fluctuations of 3 percentage points, total new software license revenues decreased by 9% in the first half of fiscal 2010 for similar reasons as noted above. In reported currency, recently acquired products contributed $36 million and $27 million to our database and middleware and applications revenues, respectively, in the first half of fiscal 2010. In reported currency, new software license revenues earned from transactions over $0.5 million decreased by 3% in the first half of fiscal 2010 and represented 48% of new software license revenues in the first half of fiscal 2010 in comparison to 46% in the first half of fiscal 2009. Excluding the effect of foreign currency rate fluctuations, total sales and marketing expenses decreased due to lower variable compensation expenses in addition to the reasons noted above. Excluding the effect of foreign currency rate fluctuations, new software license margin and margin as a percentage of revenues decreased in the first half of fiscal 2010 as our new software license revenues decreased at a faster rate than our related expenses. Software License Updates and Product Support: Software license updates grant customers rights to unspecified software product upgrades and maintenance releases issued during the support period. Product support includes internet access to technical content as well as internet and telephone access to technical support personnel in our global support centers. Expenses associated with our software license updates and product support line of business include the cost of providing the support services, largely personnel related expenses, and the amortization of our intangible assets associated with software support contracts and customer relationships obtained from our acquisitions. Software License Updates and Product Support Revenues: $ 1,734 10% 9% $ 1,576 $ 3,429 9% 10% $ 3,132 1,088 18% 11% 924 2,120 9% 12% 1,941 425 21% 9% 350 815 15% 8% 712 3,247 14% 9% 2,850 6,364 10% 10% 5,785 Software license updates and product support(1) 4 36% 36% 3 8 22% 22% 6 479 2% 0% 469 918 -4% -4% 956 $ 2,768 16% 11% $ 2,381 $ 5,446 13% 13% $ 4,829 Fiscal Second Quarter 2010 Compared to Fiscal Second Quarter 2009: The growth in our software license updates and product support revenues was favorably affected by foreign currency rate fluctuations of 5 percentage points in the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, software license updates and product support revenues increased in the second quarter of fiscal 2010 as a result of new software licenses sold (with substantially all customers electing to purchase support contracts) during the trailing 4-quarter period, the renewal of substantially all of the customer base eligible for renewal in the current fiscal year and, to a lesser extent, incremental revenues from recent acquisitions. Excluding the effect of currency rate fluctuations, the Americas contributed 51%, EMEA contributed 37% and Asia Pacific contributed 12% to the increase in software license updates and product support revenues. In reported currency, software license updates and product support revenues in the second quarter of fiscal 2010 include incremental revenues of $19 million from our recently acquired companies. As a result of our acquisitions, we recorded adjustments to reduce support obligations assumed to their estimated fair values at the acquisition dates. Due to our application of business combination accounting rules, software license updates and product support revenues related to support contracts in the amounts of $14 million and $80 million that would have been otherwise recorded by our acquired businesses as independent entities, were not recognized in the second quarter of fiscal 2010 and 2009, respectively. Historically, substantially all of our customers, including customers from acquired companies, renew their support contracts when such contracts are eligible for renewal. To the extent these underlying support contracts are renewed, we will recognize the revenues for the full value of these contracts over the support periods, the substantial majority of which are one year in duration. Total software license updates and product support expenses were unfavorably impacted by 2 percentage points of currency variations during the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, growth in software license updates and product support expenses was flat when compared to the prior year period’s expenses as decreases in bad debt expenses from improved collection efforts were offset by increases in salaries resulting from increased headcount and an increase in benefits expenses. A portion of the increase in our benefits expenses was attributable to an increase in our deferred compensation plan liability in the current year period, which was offset by a gain in our deferred compensation plan assets (refer to additional discussion under “Non-Operating Income, net” below). Excluding the effect of currency rate fluctuations, total software license updates and product support margin and margin as a percentage of revenues increased as our revenues grew while our expenses were flat. First Half Fiscal 2010 Compared to First Half Fiscal 2009: On a constant currency basis, the growth in our software license updates and product support revenues and expenses is primarily attributable to the same reasons as noted above. On a constant currency basis, the Americas contributed 52%, EMEA contributed 38% and Asia Pacific contributed 10% to the increase in software license updates and product support revenues. Software license updates and product support revenues in the first half of fiscal 2010 included incremental contributions of $44 million from recently acquired companies. Software license updates and product support revenues related to support contracts in the amounts of $23 million and $171 million that would have been otherwise recorded by our acquired businesses as independent entities, were not recognized in the first half of fiscal 2010 and 2009, respectively, due to business combination accounting rules. On a constant currency basis, software license updates and product support expenses decreased for similar reasons as noted above. Total software license updates and product support margin and margin as a percentage of revenues increased as our revenues grew while our expenses decreased. Our services business consists of our consulting, On Demand and education segments. Consulting: Consulting revenues are earned by providing services to customers in the design, implementation, deployment and upgrade of our database and middleware software products as well as applications software products. The cost of providing consulting services consists primarily of employee and external contractor related expenditures. Consulting Revenues: $ 335 -22% -24% $ 430 $ 695 -21% -20% $ 875 253 -16% -22% 303 472 -21% -20% 601 692 -18% -22% 842 1,355 -21% -21% 1,708 Cost of services(1) 2 1% 1% 2 4 6% 6% 3 10 -9% -9% 11 19 -9% -9% 21 $ 52 -56% -59% $ 121 $ 111 -42% -44% $ 193 8% 14% 8% 11% Fiscal Second Quarter 2010 Compared to Fiscal Second Quarter 2009: Consulting revenues were favorably affected by foreign currency rate fluctuations of 4 percentage points in the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, we believe the decline in our consulting revenues was generally due to weaker demand resulting from the deterioration of global economic conditions over recent quarters. Consulting expenses were unfavorably impacted by 4 percentage points of foreign currency rate variations during the second quarter of fiscal 2010. Excluding the effect of currency rate fluctuations, consulting expenses decreased during the second quarter due primarily to a reduction in employee expenses, including salaries, variable compensation and travel and entertainment, and external contractor related expenses. On a constant currency basis, consulting margin and margin as a percentage of revenues decreased in the second quarter of fiscal 2010 as our revenues declined at a greater rate than our expenses. First Half Fiscal 2010 Compared to First Half Fiscal 2009: Excluding the effect of currency rate fluctuations, the decline in consulting revenues, expenses, margin and margin as a percentage of revenues was generally due to similar reasons as noted above. On Demand: Our On Demand segment includes our Oracle On Demand and Advanced Customer Services offerings. Oracle On Demand provides multi-featured software and hardware management, and maintenance services for our database and middleware as well as our applications software delivered either at our data center facilities, at select partner data centers, or at customer facilities. Advanced Customer Services consists of solution lifecycle management services, database and application management services, industry-specific solution support centers and remote and on-site expert services. The cost of providing On Demand services consists primarily of personnel related expenditures, technology infrastructure expenditures and facilities costs. On Demand Revenues: $ 99 -5% -6% $ 104 $ 190 -9% -9% $ 210 58 1% -6% 58 116 -2% 0% 118 31 14% 3% 27 62 11% 7% 56 188 -1% -4% 189 368 -4% -4% 384 $ 46 34% 27% $ 34 $ 93 43% 42% $ 65 Excluding the effects of currency rate fluctuations, On Demand revenues declined modestly in the fiscal 2010 periods. On a constant currency basis, On Demand expenses decreased primarily due to lower employee related expenses in the fiscal 2010 periods. On a constant currency basis, On Demand margins and margins as a percentage of revenues improved during the fiscal 2010 periods due to expense reductions. Education: Education revenues are earned by providing instructor-led, media-based and internet-based training in the use of our database and middleware software products as well as our applications software products. Education expenses primarily consist of personnel related expenditures, facilities and external contractor costs. Education Revenues: $ 33 -23% -24% $ 43 $ 62 -29% -29% $ 87 29 -27% -32% 39 48 -35% -34% 74 78 -22% -26% 100 143 -28% -28% 198 63 -18% -22% 77 121 -24% -23% 159 On a constant currency basis, education revenues decreased in the fiscal 2010 periods as we experienced weaker demand for our educational services that we believe was the result of weaker global economic conditions. On a constant currency basis, education expenses declined in the fiscal 2010 periods as we reduced our employee related and external contractor expenses. Education margin and margin as a percentage of revenues decreased in the fiscal 2010 periods due to a reduction in our revenues, which declined at a higher rate than our expense reductions. Research and Development Expenses: Research and development expenses consist primarily of personnel related expenditures. We intend to continue to invest significantly in our research and development efforts because, in our judgment, they are essential to maintaining our competitive position. Research and development(1) $ 664 10% 8% $ 606 $ 1,292 1% 2% $ 1,278 $ 708 9% 7% $ 651 $ 1,368 1% 1% $ 1,360 % of Total Revenues On a constant currency basis, total research and development expenses increased during the fiscal 2010 periods primarily due to increased variable compensation plan expenses and an increase in our benefits expenses resulting from an increase in deferred compensation plan obligations during the second quarter of fiscal 2010 (refer to additional discussion under “Non-Operating Income, net” below). These increases were partially offset by a reduction in travel and entertainment and external contractor expenses in the fiscal 2010 periods presented. Our research and development headcount and constant currency salary expenses were relatively consistent with prior year periods. General and Administrative Expenses: General and administrative expenses primarily consist of personnel related expenditures for information technology, finance, legal and human resources support functions. General and administrative(1) $ 150 -1% -3% $ 152 $ 321 -4% -2% $ 333 33 51% 51% 22 62 35% 35% 46 $ 183 5% 3% $ 174 $ 383 1% 2% $ 379 Excluding the effect of currency rate fluctuations, total general and administrative expenses increased modestly during the fiscal 2010 periods as a result of higher stock-based compensation expenses resulting from higher fair values of our stock awards that were amortized and recognized as expense in the current year periods, which were partially offset by net decreases to certain other expenses. Our general and administrative headcount and constant currency salary expenses were relatively consistent with prior year periods. Amortization of Intangible Assets: 66 4% 4% 63 130 4% 4% 125 40 7% 7% 37 78 8% 8% 72 9 18% 18% 8 19 19% 19% 16 Total amortization of intangible assets Amortization of intangible assets increased in the fiscal 2010 periods presented above due to additional amortization from acquired intangibles for acquisitions that we consummated since the beginning of the second quarter of fiscal 2009. See Note 4 of Notes to Condensed Consolidated Financial Statements for additional information regarding our intangible assets (including weighted average useful lives) and related amortization. Acquisition Related and Other Expenses: Acquisition related and other expenses consist of personnel related costs for transitional and certain other employees, stock-based compensation expenses, integration related professional services, certain business combination adjustments after the measurement periods or purchase price allocation periods have ended, and certain other operating expenses, net. Stock-based compensation expenses included in acquisition related and other expenses resulted from unvested stock awards assumed from acquisitions whereby vesting was accelerated upon termination of the employees pursuant to the original terms of those stock awards. As a result of our adoption of the FASB’s revised accounting standard for business combinations as of the beginning of fiscal 2010, certain acquisition related and other expenses are now recorded as expenses in our statements of operations that had been historically included as a part of the consideration transferred and capitalized as a part of our accounting for acquisitions pursuant to previous accounting rules, primarily direct transaction costs such as professional services fees. $ 2 -39% -38% $ 4 $ 5 -82% -81% $ 31 — -100% -100% 6 — -100% -100% 11 4 -58% -54% 10 7 -66% -63% 19 4 163% 168% 1 4 -59% -50% 10 On a constant currency basis, acquisition related and other expenses decreased in the fiscal 2010 periods due primarily to lower transitional employee and stock-based compensation expenses, which were higher in the prior year periods due to BEA related integration costs (we acquired BEA in the fourth quarter of fiscal 2008). Restructuring expenses: Restructuring expenses consist of employee severance costs and may also include charges for duplicate facilities and other contract termination costs to improve our cost structure prospectively. Beginning in fiscal 2010, our adoption of the FASB’s revised accounting standard for business combinations required that, in connection with any prospective acquisition, we record involuntary employee termination and other exit costs associated with such acquisition to restructuring expenses in our consolidated financial statements (see further discussion in “Critical Accounting Policies and Estimates” in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal year ended May 31, 2009). For additional information regarding our Oracle-based and acquired company restructuring plans, please see Note 6 of Notes to Condensed Consolidated Financial Statements. 2009 Percent Change 2008 2009 Percent Change 2008 Actual Constant Actual Constant Restructuring expenses $ 114 561% 504% $ 17 $ 162 426% 414% $ 31 Restructuring expenses in the fiscal 2010 periods consisted primarily of expenses associated with the Oracle Fiscal 2009 Restructuring Plan (2009 Plan), which our management approved, committed to and initiated in order to restructure and further improve efficiencies in our Oracle-based operations. We amended the 2009 Plan in the first quarter of fiscal 2010 to reflect additional actions that we expect to take over the course of fiscal 2010. The total estimated restructuring costs associated with the 2009 Plan are $453 million and will be recorded to the restructuring expense line item within our consolidated statements of operations as the costs are recognized. In the second quarter and first half of fiscal 2010, we recorded $114 million and $162 million of restructuring expenses in connection with the 2009 Plan, respectively. We expect to incur the majority of the approximately $206 million that is remaining under the 2009 Plan during the last two quarters of fiscal 2010. Our estimated costs may be subject to change in future periods. Restructuring expenses in the fiscal 2009 periods consisted primarily of expenses associated with our Oracle Fiscal 2008 Restructuring Plan, for which substantially all costs were incurred through fiscal 2009. Interest Expense: 2009 Percent Change 2008 2009 Percent Change Actual Constant Actual Constant 2008 $ 188 20% 20% $ 157 $ 368 16% 16% $ 317 Interest expense increased in the fiscal 2010 periods due to higher average borrowings resulting from our issuance of $4.5 billion of senior notes in July 2009, and was partially offset by a reduction in interest expense associated with the maturity and repayment of $1.0 billion of senior notes and related variable to fixed interest rate swap agreement in May 2009. Non-Operating Income, net: Non-operating income, net consists primarily of interest income, net foreign currency exchange gains (losses), the noncontrolling interests in the net profits of our majority-owned subsidiaries (Oracle Financial Services Software Limited and Oracle Japan), and net other income (losses), including net realized gains and losses related to all of our investments and net unrealized gains and losses related to the small portion of our investment portfolio that we classify as trading. $ 30 -69% -71% $ 97 $ 65 -65% -65% $ 185 (2 ) 91% 95% (22 ) (20 ) -67% -42% (12 ) (16 ) 18% 20% (19 ) (40 ) -12% -12% (35 ) 21 142% 142% (48 ) 30 163% 163% (48 ) $ 33 315% 264% $ 8 $ 35 -62% -60% $ 90 Fiscal Second Quarter 2010 Compared to Fiscal Second Quarter 2009: On a constant currency basis, non-operating income, net increased in the second quarter of fiscal 2010 due to a reduction in foreign currency losses and an increase in other income, net that resulted primarily from favorable changes in the values of our marketable securities that we classify as trading and are held to support our deferred compensation plan obligations. These favorable variances in the values of our marketable securities offset the unfavorable variances in the obligations associated with our deferred compensation plan that are included in our operating expenses such that there is virtually no impact to our income before provision for income taxes during the second quarter of fiscal 2010 or any other period presented. The favorable variances to non-operating income, net caused by other income (losses), net were almost entirely offset by decreases in interest income resulting from a general decline in market interest rates that resulted in lower yields earned on our cash and marketable securities balances during the second quarter of fiscal 2010. First Half Fiscal 2010 Compared to First Half Fiscal 2009: On a constant currency basis, non-operating income, net decreased in the first half of fiscal 2010 due primarily to decreases in market yields that reduced our interest income. These decreases were partially offset by an increase in other income (losses), net resulting from favorable changes in asset values that support our deferred compensation plan obligations (described further above). Provision for Income Taxes: The effective tax rate in all periods is the result of the mix of income earned in various tax jurisdictions that apply a broad range of income tax rates. The provision for income taxes differs from the tax computed at the U.S. federal statutory income tax rate due primarily to state taxes and earnings considered as indefinitely reinvested in foreign operations. Future effective tax rates could be adversely affected if earnings are lower than anticipated in countries where we have lower statutory rates, by unfavorable changes in tax laws and regulations, or by adverse rulings in tax related litigation. $ 565 7% -2% $ 530 $ 1,003 12% 10% $ 896 Effective tax rate On a constant currency basis, the provision for income taxes decreased during the second quarter of fiscal 2010 primarily due to transfer pricing adjustments and differences in the mix of earnings when compared with the prior year period. These decreases were partially offset by the impact of higher current period earnings before tax, along with the U.S. research and development tax credit expiration in the current year combined with the retroactive reinstated tax benefit reported in the prior year. On a constant currency basis, provision for income taxes in the first half of fiscal 2010 increased, substantially due to higher income before taxes. 2009 Change May 31, $ 16,701 77% $ 9,432 $ 20,784 65% $ 12,624 Working capital: The increase in working capital as of November 30, 2009 in comparison to May 31, 2009 was primarily due to our issuance of $4.5 billion of long-term, senior notes in July 2009 and the favorable impact to our net current assets resulting from our net income generated during the first half of fiscal 2010, partially offset by cash used for acquisitions, repurchases of our common stock and cash used to pay dividends to our stockholders. Our working capital may be impacted by some or all of the aforementioned factors in future periods, certain amounts and timing of which are variable. Cash, cash equivalents and marketable securities: Cash and cash equivalents primarily consist of deposits held at major banks, money market funds, Tier-1 commercial paper, U.S. Treasury obligations, U.S. government agency and government sponsored enterprise obligations, and other securities with original maturities of 90 days or less. Marketable securities primarily consist of time deposits held at major banks, Tier-1 commercial paper, corporate notes, U.S. Treasury obligations and U.S. government agency and government sponsored enterprise obligations. The increase in cash, cash equivalents and marketable securities at November 30, 2009 in comparison to May 31, 2009 was due to the issuance of $4.5 billion of senior notes in July 2009 and an increase in cash generated from our operating activities. Cash, cash equivalents and marketable securities include $14.7 billion held by our foreign subsidiaries as of November 30, 2009. The amount of cash, cash equivalents and marketable securities that we report in U.S. Dollars for a significant portion of the cash held by these subsidiaries is subject to translation adjustments caused by changes in foreign currency exchange rates as of the end of each respective reporting period (the offset to which is recorded to accumulated other comprehensive income in our consolidated balance sheet). As the U.S. Dollar weakened against most major international currencies during the first half of fiscal 2010, the amount of cash, cash equivalents and marketable securities that we reported in U.S. Dollars for these subsidiaries increased as of November 30, 2009 relative to what we would have reported using a constant currency rate as of May 31, 2009. Our increase in cash, cash equivalents and marketable securities balances were partially offset by cash used for acquisitions, the repurchases of our common stock, and the payment of cash dividends to our stockholders. Days sales outstanding, which is calculated by dividing period end accounts receivable by average daily sales for the quarter, was 47 days at November 30, 2009 compared with 58 days at May 31, 2009. The days sales outstanding calculation excludes the adjustment that reduces our acquired software license updates and product support obligations to fair value. Our decline in days sales outstanding is primarily due to the collection, in our first half of fiscal 2010, of large license and support balances outstanding as of May 31, 2009. Six Months Ended November 30, 2009 Change 2008 $ 4,389 10% $ 3,990 Cash used for investing activities $ (2,589 ) 17% $ (2,207 ) Cash provided by (used for) financing activities $ 3,843 299% $ (1,928 ) Cash flows from operating activities: Our largest source of operating cash flows is cash collections from our customers following the purchase and renewal of their software license updates and product support agreements. Payments from customers for software license updates and product support agreements are generally received near the beginning of the contracts’ terms, which are generally one year in length. We also generate significant cash from new software license sales and, to a lesser extent, services. Our primary uses of cash from operating activities are for personnel related expenditures as well as payments related to taxes and leased facilities. Net cash provided by operating activities increased in the first half of fiscal 2010 primarily due to cash favorable working capital movements, including less cash used to settle lower accrued compensation liabilities and a reduction in cash used to pay income tax related liabilities during the first half of fiscal 2010 in comparison to the first half of fiscal 2009. Cash flows from investing activities: The changes in cash flows from investing activities primarily relate to acquisitions and the timing of purchases, maturities and sales of our investments in marketable securities. We also use cash to invest in capital and other assets to support our growth. Net cash used for investing activities increased in the first half of fiscal 2010 due to an increase in cash used to purchase marketable securities (net of proceeds received from sales and maturities), partially offset by a decrease in cash used for acquisitions, net of cash acquired, and a decrease in capital expenditures. Cash flows from financing activities: The changes in cash flows from financing activities primarily relate to borrowings and payments under debt facilities as well as stock repurchases, dividend payments and proceeds from stock option exercise activity. Net cash provided by financing activities in the first half of fiscal 2010 increased compared to cash used by financing activities in the first half of fiscal 2009 due to our issuance of $4.5 billion of senior notes and a reduction in our common stock repurchases. Free cash flow: To supplement our statements of cash flows presented on a GAAP basis, we use non-GAAP measures of cash flows on a trailing 4-quarter basis to analyze cash flows generated from our operations. We believe free cash flow is also useful as one of the bases for comparing our performance with our competitors. The presentation of non-GAAP free cash flow is not meant to be considered in isolation or as an alternative to net income as an indicator of our performance, or as an alternative to cash flows from operating activities as a measure of liquidity. We calculate free cash flows as follows: Trailing 4-Quarters Ended November 30, $ 8,654 7% $ 8,089 Capital expenditures(1) (230 ) -53% (486 ) Free cash flow as a percent of net income Represents capital expenditures as reported in cash flows from investing activities in our condensed consolidated statements of cash flows presented in accordance with U.S. generally accepted accounting principles. Long-Term Customer Financing: We offer certain of our customers the option to acquire our software products and service offerings through separate long-term payment contracts. We generally sell contracts that we have financed on a non-recourse basis to financial institutions. We record the transfers of amounts due from customers to financial institutions as sales of financial assets because we are considered to have surrendered control of these financial assets. In the first half of fiscal 2010 and 2009, $344 million and $442 million, respectively, or approximately 13% and 15%, respectively, of our new software license revenues were financed through our financing division. Recent Financing Activities: In July 2009, we issued $4.5 billion of fixed rate senior notes comprised of $1.5 billion of 3.75% notes due July 2014 (2014 Notes), $1.75 billion of 5.00% notes due July 2019 and $1.25 billion of 6.125% notes due July 2039. We issued these senior notes for general corporate purposes and for future acquisitions, including our proposed acquisition of Sun and acquisition related expenses. In September 2009, we entered into certain interest rate swap agreements related to our 2014 Notes that have the economic effect of modifying the fixed interest obligations associated with our 2014 Notes so that the interest obligations became variable based upon a LIBOR-based index. We are accounting for these interest rate swap agreements as fair value hedges pursuant to ASC 815, Derivatives and Hedging. Additional details regarding our senior notes and related interest rate swap agreements are included in Note 5 and Note 8 of Notes to Condensed Consolidated Financial Statements. There were no other significant changes in our financing activities in comparison to those disclosed in our Annual Report on Form 10-K for the fiscal year ended May 31, 2009. Contractual Obligations: The contractual obligations presented in the table below represent our estimates of future payments under fixed contractual obligations and commitments. Changes in our business needs, cancellation provisions, changing interest rates and other factors may result in actual payments differing from these estimates. We cannot provide certainty regarding the timing and amounts of payments. We have presented below a summary of the most significant assumptions used in our information within the context of our consolidated financial position, results of operations and cash flows. The following is a summary of our contractual obligations as of November 30, 2009: Year Ending May 31, Total 2010 2011 2012 2013 2014 2015 Thereafter Principal payments on borrowings(1) $ 14,750 $ 1,000 $ 2,250 $ — $ 1,250 $ — $ 1,500 $ 8,750 Capital leases(2) 1 1 — — — — — — Interest payments on borrowings(1) 7,914 375 691 577 577 515 504 4,675 Operating leases(3) 1,296 204 329 242 159 101 68 193 Purchase obligations(4) 169 115 27 12 3 3 3 6 Funding commitments(5)

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professional_accounting

Austria has an extensive network of income tax treaties, with 89 treaties currently in force (as of 1 January 2018). In addition, Austria has concluded seven tax information exchange agreements with Andorra, Gibraltar, Guernsey, Jersey, Mauritius, Monaco and St. Vincent & the Grenadines. Furthermore, the Convention on Mutual Administrative Assistance in Tax Matters is applicable. Austrian tax treaties generally follow the OECD Model Convention, with certain minor modifications. Double taxation of dividends, interest and royalties is mostly eliminated by the credit method under Austrian tax treaties, while double taxation of other income is avoided by the exemption method. Some of the tax treaties contain tax-sparing provisions for different types of income, such as royalties and interest. After ratification by the Austrian Federal President and the two chambers of Austrian parliament, tax treaties apply directly without further incorporation into domestic law. Austria has no general policy to include anti-avoidance rules in tax treaties that go beyond the rules in the OECD Model Convention, but Austrian courts rely on the general anti-abuse rules (see question 9.1 for further details). On the request of the tax treaty partner, a few treaties incorporate such rules. For example, the tax treaty concluded with the United States includes a limitation-on-benefits clause. In general, the tax treaty provisions prevail over domestic law as “lex specialis”. Technically, a provision introduced subsequently could override treaty law as “lex posterior”, but Austria has not enacted any tax treaty override legislation so far. However, Austrian tax authorities take the view that tax treaty law does not limit the application of domestic anti-abuse provisions. For example, the Annual Tax Act 2018 introduced CFC rules (see question 7.3) for permanent establishments (applicable for business years starting 1 January 2019) overriding the rules of treaties for permanent establishments. A corporation will be deemed tax-resident in Austria if either its legal seat (place which is designated as such in its articles of association) or its place of management is situated in Austria. The place of management is defined as the centre from which the activities of the company are effectively directed from a management perspective; whereas in the past the focus was mainly on where the relevant decisions are taken (usually proven by board meeting minutes), the tax authorities now increasingly also take into account where such decisions are communicated and implemented by the management. Resident companies are subject to unlimited taxation in Austria on their worldwide income. Based on the tax treaties concluded by Austria, a company is considered to be resident in the state in which the place of its effective management is located. In practice, the domestic term “place of management” is understood in the same way as “place of effective management”. The Austrian Stamp Duty Act (Gebührengesetz – “GebG”) contains an exhaustive list of legal transactions that are subject to Austrian stamp duty provided that a signed written deed is executed and a nexus to Austria exists. Legal transactions such as, inter alia, lease agreements, assignments, suretyships and mortgages are covered by the stamp duty provisions at rates of between 0.8% and 1% of the contract value. No stamp duty is levied on share transfer agreements, furthermore on loan and credit agreements signed after 31 December 2010. Signing a written deed on a stamp-dutiable transaction in Austria will trigger stamp duty. Due to a broad interpretation of the term “signed written deed”, even if the contract is not signed in Austria, bringing a written deed originally signed outside Austria into Austria may result in the necessary nexus to Austria for a stamp-dutiable transaction. In addition, any written reference to the contract/transaction that is signed by only one of the parties to the transaction but is then handed over (sent) to another party or (in certain circumstances) to a third party, could provide sufficient evidence of the transaction to give rise to stamp duty. The term “written deed” comprises even email communication carrying an electronic or digital signature (details are disputed), which gives evidence of a stamp-dutiable transaction (e.g. mentioning of a lease or assignment agreement by a party thereto). VAT is levied at all levels of the supply of goods and services with the right to deduct input VAT to the extent the recipient thereof qualifies as an entrepreneur. Austria’s VAT Act is based on the EU Council Directive on the common system of VAT. The standard rate is 20%. A reduced rate of 10% applies, inter alia, to food, books, newspapers and periodicals, passenger transport and renting of residential immovable property. As of 1 January 2016, a second reduced rate of 13% has been introduced (including accommodation in hotels (as of 1 May 2016), and various recreational and cultural services). There are two types of exemption from VAT: an exemption under which credit for input VAT is not possible; and an exemption which entitles the taxpayer to credit for input VAT. The first type of exemption includes banking, finance and insurance-related transactions, the disposal of shares, the leasing or letting of immovable property for commercial purposes, the supply of land and buildings, health and welfare services, and supplies by charitable organisations. For most of these transactions, there is an option for standard VAT treatment (i.e. VAT has to be charged, but with the benefit that credit for input VAT may be claimed). For the rental of land and buildings for commercial purposes, the option to charge VAT is only applicable if the tenant uses the object to render services that are subject to VAT. The second type of exemption includes exports, intra-community supplies, the supply of services consisting of work on movable property acquired or imported for the purpose of undergoing such work, and the supply of services when these are directly linked to the transit or the export of goods. The supply of services and the delivery of goods of an entrepreneur, who operates his business domestically and whose turnover does not exceed an amount of EUR 30,000 p.a. (regime for small entrepreneurs – Kleinunternehmerregelung), are exempt from VAT without credit for input VAT. A deduction or refund for input VAT is available to both resident and non-resident entrepreneurs, if the respective supplies are used to render supplies that are not VAT-exempt under the first type (without the entitlement to claim credit for input VAT), with financial institutions being the most relevant example. An entrepreneur is any person (individual or legal entity) conducting a business independently in order to realise earnings (though not necessarily profits), regardless of nationality or residence. If an entrepreneur renders both VAT-able and VAT-exempt supplies, only the input VAT attributable to the VAT-able supplies can be recovered. Input VAT deduction is only allowed if an invoice that fulfils certain formal requirements has been provided by the supplier. It should be noted that holding companies (including acquisition vehicles) are usually not entitled to claim credit for input VAT, unless they also provide VAT-able services, in which case input VAT may be claimed for the related expenses. Accordingly, holding entities often provide such VAT-able services (e.g. accounting, procurement or IT services) to other (group) entities, to recover some input VAT. The Austrian Value Added Tax Act provides that the effects of a VAT tax group are limited to the Austrian parts of the company. Therefore, it is possible, under current legislation, to include an Austrian permanent establishment of a foreign company (but not the entire company) into an Austrian VAT tax group. Services between the foreign head office and the domestic permanent establishment are thus taxable. The Austrian tax authorities interpret the provisions in place in line with the Skandia case. Real estate transfer tax is levied on every acquisition of domestic real estate and, in some cases, also if shares in corporations or interests in partnerships that directly own real estate are transferred. In particular, the transfer of buildings and land, building rights and buildings on third-party land falls within the scope of the Austrian real estate transfer tax, whereas the transfer of machinery and plants is not subject to real estate transfer tax. In short, the real estate transfer tax is 3.5% (reduced rates apply between specific family members and in the case of a transfer of shares in corporations or interests in partnerships or reorganisations) and it is irrelevant whether it is acquired by an Austrian or a foreign citizen or resident. In sale and purchase transactions, the tax base of the real estate transfer tax is the amount of consideration for the transfer (fair market value) – at least the value of the real estate. In the absence of a consideration (e.g. if shares are transferred), special rules determine the relevant tax base. In general, taxation is based on the fair market value of real estate property. In addition to real estate transfer tax, a registration duty for the land register at a rate of 1.1%, also based on the purchase price or the fair market value, is levied if a new owner is registered (i.e. not if shares are transferred, as the owner of the real estate does not change in such case). Austrian Capital Duty (a 1% tax on equity contributions by the direct shareholder) has been abolished as of 1 January 2016. Due to EU legislation, such capital duty cannot be reintroduced. Austrian Insurance Tax applies on the payment of insurance premiums for several types of insurance contracts. Dividends paid to a non-resident are subject to a withholding tax of 27.5%. A reduction or relief from withholding tax might be available based on a tax treaty or the EU Parent-Subsidiary Directive. According to the Austrian rules implementing the EU Parent-Subsidiary Directive, there is no withholding tax on dividends if (i) the parent company has a form listed in the EU Parent-Subsidiary Directive, (ii) the parent company owns (directly or indirectly) at least 10% of the capital in the subsidiary, and (iii) the shareholding has been held continuously for at least one year. Provided that certain documentation requirements (including a tax residence confirmation for the foreign recipient, which needs to be issued by the foreign tax authorities on a special tax form) are met, a reduction or relief can be granted at source. No relief at source is granted in cases of potential tax avoidance, e.g. in case of holding companies with little or no substance in the state of residence (i.e. if the recipient is a company that does not have an active trade or business, employees and business premises). If no reduction or relief was granted at source, companies can apply for a refund. In the course of the refund procedure, the company has to provide evidence that the interposition of the foreign company does not constitute an abusive arrangement. If such refund procedure was successful, a simplified procedure is applied in the following three years. As a further option, a refund of withholding tax on dividends can also be claimed by a foreign corporation resident in the EU to the extent that the Austrian company is not relieved from its withholding obligation, so long as the tax withheld is not creditable in the recipient’s home state under a double taxation treaty. Royalties paid to a non-resident are subject to a withholding tax of 20%. A reduction or relief from withholding tax might be available based on a tax treaty or the EU Interest and Royalties Directive. According to the Austrian rules implementing the EU Interest and Royalties Directive, there is no withholding tax on royalties if (i) the parent company has a form listed in the EU Interest and Royalties Directive, (ii) the parent company owns directly at least 25% of the capital in the subsidiary, and (iii) the capital holding has been held continuously for at least one year. The procedures for the application of reduction or relief, as well as for refund, are the same as for dividends. Interest paid to non-resident corporations is generally not subject to withholding tax. Despite the fact that there are no Austrian statutory rules on thin capitalisation, as a matter of administrative practice and case law, loans provided by related parties to an Austrian company may be considered “hidden” equity and thus not be treated as debt if the Austrian corporation is too thinly capitalised (taking into account debt provided by unrelated parties). In such case, interest payments are reclassified as dividends for Austrian tax purposes, and accordingly are not deductible and are subject to withholding tax. However, an interest barrier rule is foreseen under the Anti-BEPS Directive (national implementation is expected closer to the implementation deadline). While there is no official “safe harbour” rule, the Austrian tax authorities generally accept debt-to-equity ratios of around 4:1 to 3:1. However, this can only serve as guidance and the adequate debt-to-equity ratio has to be analysed on a case-by-case basis. Having said that, higher debt-to-equity ratios have also been accepted. No. However, debt provided by unrelated parties is to be taken into account when determining the debt-to-equity ratio. No, there are no other restrictions on tax-deductibility of interest paid to third (i.e. unrelated) parties. In cases of interest payments to related parties, limitations apply to avoid base erosion if the interest income is not sufficiently taxed abroad (see question 10.1). Although not limited to cross-border payments in other jurisdictions, one should note that Austria, as of today, has no interest barrier rule. Accordingly, interest payments made to third (i.e. unrelated) parties are always tax-deductible. However, as a result of the OECD BEPS project, it is worth noting that the Anti-BEPS Directive provides for such interest barrier rule to be implemented by the EU Member States before and applied as of 1 January 2019. The Austrian tax administration is of the opinion that the existing provisions in connection with interest payments to related parties are sufficient as national implementation. Such payments would not be subject to withholding tax, but the rental payments that relate to domestic real estate would be subject to limited taxation and the non-residents would be obliged to file a tax return for the rental payments. Austria has generally adopted the OECD Transfer Pricing Guidelines. The Austrian Ministry of Finance has issued transfer pricing guidelines as well, which are based on the OECD Guidelines. Therefore, transactions between related corporations, as well as profit attributions to permanent establishments, must be at arm’s length. There is also an obligation to prepare documentation for transfer prices in inter-group transactions. Under Austrian procedural law, a formalised advance ruling procedure can be filed to determine the applicable transfer prices. Furthermore, there are provisions about documentation obligations (as mentioned below at question 10.3). Generally, Austrian corporations are subject to the corporate income tax levied over their profits, at a rate of 25%. There is an annual minimum corporate income tax (i.e. which applies irrespective of the actual income and thus also in a loss situation) of EUR 500 p.a. for a limited liability company in the first five years after incorporation and EUR 1,000 p.a. during the next five years. Thereafter, the minimum corporate income tax is raised to EUR 1,750 p.a. The minimum corporate income tax for a stock corporation amounts to EUR 3,500 p.a. Companies are obliged to keep books according to the commercial law rules; the accounting profits based on Austrian generally accepted accounting principles (“GAAP”) then serve as the basis for determining the tax base. The accounting profits are then adjusted for certain positions as per the section below. differences in the calculation of provisions, in depreciation rates and regarding valuation (impairment) rules for other assets and liabilities. According to the Austrian group taxation regime, a group parent company can form a tax group with a subsidiary if the parent company exercises financial control over the subsidiary (i.e. the parent owns more than 50% of the capital and voting power in the subsidiary). Eligible group members include both resident companies and non-resident companies; in case of the latter, however, this is only if they are resident in an EU Member State or in a third state with which Austria has concluded a comprehensive administrative assistance agreement regarding the exchange of information. With regard to Austrian group members, 100% of the profit/loss of the company is attributed to and taxed at the level of the parent company (i.e. irrespective of the participation held), while losses of non-resident group members are only attributed to the group parent to the extent of the direct participation of the lowest resident group member in the non-resident group member (profits are not attributed at all). Losses attributed to the Austrian parent company in the past have to be recaptured in Austria if the non-resident group member offsets the losses with its own income in subsequent years (or fails to do so despite being entitled to) or if the non-resident group member exits the Austrian tax group. The foreign losses have to be calculated on the basis of Austrian tax law, but they can only be offset to the extent a loss also exists according to foreign tax law. Special rules for the recovery of losses apply in case of the liquidation of a non-resident group member. Additionally, foreign losses shall be deductible only to the extent of 75% of the total profit generated by all domestic group members and the parent company. In general, write-offs on participations in group members are not tax-deductible (the rationale is that losses can be offset from other profits anyway). For shares acquired in an Austrian target that became a group member, a goodwill amortisation over a period of 15 years (capped at 50% of the purchase price) was applied, leading to an additional tax deduction. For shares acquired after 28 February 2014, this option is no longer available. Goodwill amortisations from transactions before that date can be continued, if the goodwill amortisation influenced the purchase price of the shares. In this context, it should also be noted that the restriction of this goodwill amortisation to domestic targets violated EC law, according to case law. The tax loss carry-forwards of a corporation are, in general, not affected by a change of ownership. However, there are two exemptions. Loss carry-forwards can expire if the “economic identity” of the company is no longer given in connection with an acquisition of the shares for consideration (Mantelkauf). The law specifies that the “economic identity” is lost if there is a significant change of the shareholder structure, the organisational structure and the business structure of the company. Generally, all three criteria have to be met cumulatively in order to apply, taking into account not only the time of the acquisition, but also the following months (up to approximately one year). Furthermore, loss carry-forwards can expire in a reorganisation if the business unit that caused the losses does not exist anymore or is reduced in such a way that it cannot be considered comparable to the business unit in which the losses occurred. No. Both retained and distributed profits are taxed at the same rate at the level of the corporation (i.e. only corporate income tax), but additional taxes may apply at the shareholder level when the profits are then distributed. By comparison, in the case of a partnership, the profits are immediately taxed at the progressive income tax rate if the partner is an individual or at the rate of 25% corporate income tax if the partner is a corporation, irrespective of whether or not they are distributed, so that no further tax is triggered upon distribution to the partners. An annual real estate tax on all domestic immovable properties is levied at a basic federal rate, multiplied by a municipal coefficient on assessed value of real estate for tax purposes (Einheitswert). The basic federal rate is usually 0.2% and the municipal coefficient ranges up to 500%. Capital gains and losses derived from the sale or other disposal of business property are taxed as ordinary business income of a company at normal rates (in the case of individuals, reduced rates apply to certain capital gains). Capital gains derived from the sale of shares in a foreign corporation may be exempt under the International Participation Exemption (see question 7.2). By comparison, there is no exemption for capital gains derived from the sale of shares in a domestic corporation. No, there is no rollover relief available for companies in relation to capital gains. It should, however, be noted that the regime applicable to Austrian private foundations, which often are the shareholders of Austrian companies, provides for such relief if the private foundation reinvests within a period of 12 months. There is a withholding tax of 27.5% on proceeds from shares sold over a securities account at an Austrian credit institution. This does not apply to the sale of limited liability companies. For the sale of Austrian real estate, a withholding tax of 30% is levied. On 1 January 2016, the former capital duty of 1% levied on equity contributions was abolished, therefore no taxes are due upon formation. A branch will be taxed as a permanent establishment of the foreign head office, while a subsidiary is a separate taxable entity. The profits (subject to corporate income tax) of a permanent establishment can be remitted to the head office without any tax consequences. In contrast, the taxed profits of a subsidiary have to be distributed as a dividend (subject to withholding tax). Besides that, there are no further differences between the taxation of a local subsidiary and a local branch of a non/resident company. In particular, there is no branch profit tax in Austria. Transactions between the subsidiary and the foreign parent have to comply with the “arm’s length” principle. On the other hand, a permanent establishment cannot conclude contracts with the head office, as both are considered to be one legal entity. Therefore, it can be more burdensome in practice to determine and allocate an appropriate profit to the permanent establishment, as compared to a subsidiary. For the calculation of the taxable profit, a permanent establishment will be treated as a notional “independent enterprise”. A functional analysis has to be conducted, which is based on “significant people functions”. Functions, risks and assets, as well as an appropriate amount of capital, have to be allocated to the permanent establishment to determine the arm’s length profit of the permanent establishment. Besides a transfer pricing concept, there is also a requirement to have separate tax accounts for the permanent establishment (while, according to the prevailing view in legal writing, there is generally no such obligation under commercial law). The branch as such would not be entitled to tax treaty benefits, as it is not a legal person. Only the head office would be able to claim treaty protection. However, the branch can, in fact, in many cases benefit from treaty relief as a consequence of the anti-discrimination clauses contained in most Austrian tax treaties or on the basis of EC law. There is no such taxation in Austria. Austrian companies are taxed on their worldwide income, including income from overseas branches. In most cases, such income will be exempt in Austria based on an applicable double tax treaty (only very few Austrian treaties foresee the credit method for business profits). If there is no treaty in place with the respective country, relief from double taxation is granted via unilateral measures under certain circumstances. the anti-abuse provision is not applicable. Under the anti-abuse provision, the International Participation Exemption regime will not be applicable if there are reasons to suspect tax avoidance or tax abuse. Subsequently, the “switch-over” clause will be applicable, i.e. the income is fully taxable with a tax credit for the foreign corporate tax paid by the subsidiary. the income of the foreign subsidiary is not subject to a tax that is comparable to the Austrian corporate income tax (due to either a lower applicable tax rate or a reduced tax base (“low taxation”)). If the effective tax rate is 15% or lower, low taxation is deemed to occur. Furthermore, portfolio dividends (i.e. dividends from a participation under 10%; no minimum percentage or holding period is required) received from either a foreign corporation listed in the Annex to the EU Parent-Subsidiary Directive, or from a foreign corporation, which is comparable to an Austrian corporation, either resident in an EU Member State or resident in a jurisdiction which has a broad exchange of information clause in its double tax treaty with Austria, will be exempt from Austrian income tax as well. It should be noted that this exemption only applies to dividends, thus capital gains from a participation under 10% are always taxable. The above-mentioned portfolio dividends exemption is denied if the distributing corporation is “low-taxed” (i.e. if the effective rate of corporate income tax paid is below 15%) or if it benefits from substantial tax exemptions. There is no requirement that the foreign corporation earn (active) business rather than passive income, as is the case for the International Participation Exemption. Where income is low-taxed, a “switch-over” clause will be triggered. The participation exemption will not apply if the dividend distributed to the Austrian company is tax-deductible by the foreign corporation in its home jurisdiction. This is now also the standard under the EU Parent-Subsidiary Directive. As per the Annual Tax Act 2018, the current switchover mechanism for portfolio participations has been adapted and applies to low-taxed passive income of qualified international participations and qualified portfolio investments of at least 5%. Following this, the switchover to the credit-method will be triggered if (i) the foreign subsidiary predominantly achieves low-taxed passive income, and if (ii) the CFC legislation (see question 7.3) is not applicable. The amended switchover mechanism for portfolio participations applies for business years starting 1 January 2019. It is worth noting that interest expenses directly related to the debt financing of the acquisition of a participation are deductible even if the income is exempt under the participation exemption, if applicable. Currently, there are no statutory CFC rules in Austria. However, the Annual Tax Act 2018 implemented the standards set by the EC Anti-Tax Avoidance Directive and introduced CFC rules for “controlled foreign companies” and permanent establishments. According to these new provisions specific non-distributed passive income (e.g. interest payments, royalty payments, taxable dividend payments and income from the sale of shares, financial leasing income, and activities of insurances and banks) of a controlled foreign subsidiary is included in the corporate tax base of the Austrian parent company by applying the CFC rule. The preconditions for such attribution of income of the foreign company are that the subsidiary: (i) is directly or indirectly controlled (50% of voting rights or capital or rights to profit); (ii) is situated in a low-tax country (meaning that the effective corporate tax paid by the subsidiary is lower than 12.5% considering the foreign income calculated based on Austrian tax law and the factual paid foreign tax); and (iii) does not carry out any significant economic activity in terms of personnel, equipment, assets and premises. Low-taxed passive income shall only be attributed to the Austrian parent company if it amounts to more than one third of the income of the foreign company. To avoid any potential double taxation triggered by the CFC rules a tax credit for actually paid foreign taxes and a reduction of taxable capital gains by the amount of profits (forming part of such capital gain) which have already been subject to the Austrian tax pursuant to the CFC rules are provided. The new CFC rules apply for business years starting 1 January 2019. A non-resident company is taxed on the disposal of real estate located in Austria at a corporate income tax rate of 25%. A non-resident individual is taxed on the disposal of real estate located in Austria at a special tax rate of 30%. The transfer of an indirect interest in real estate does not trigger (corporate) income tax, but could trigger transfer tax. However, real estate transfer tax is triggered if 95% of the shares of a company that directly holds Austrian real estate are consolidated in the hands of one shareholder (Anteilsvereinigung) or a group of shareholders within the meaning of the Austrian group taxation regime. Furthermore, if within a period of five years 95% or more of the partnership interests of a partnership that directly holds real estate are transferred, this triggers real estate transfer tax (under the scope of this rule, this can include several transactions with different purchasers). In each case, the real estate transfer tax amounts to 0.5% of the fair market value of the real estate. Shares held by trustees are to be attributed to the trustor for the purposes of calculating the 95% threshold. If Austrian real estate is transferred in the course of a reorganisation (Umgründung) under the Umgründungssteuergesetz (UmgrStG), the real estate transfer tax will likewise be 0.5% of the fair market value of the real estate. A REIT that is established based on the Austrian Real Estate Investment Fund Act is subject to a special tax regime. Such special tax regime may also be applicable to REITs established under foreign law (Sec 42 of the Austrian Real Estate Investment Fund Act). The REIT itself is not treated as a taxable entity. Rather, it is treated as a transparent entity where the income earned is attributed to the unit owner, regardless of whether it is distributed or not (comparable to a partnership). Besides income from the renting of property, interest on liquid reserves and profit distributions from Austrian real estate companies, the profit of an Austrian REIT also includes valuation gains from the annual revaluation of the real estate properties of the funds, regardless of whether they are realised or not. Profits from a REIT or from the sale of the REIT certificates are generally subject to withholding tax at a rate of 27.5% as of 1 January 2016. Please note that several major Austrian real estate companies are not established as fund-type vehicles based on the Austrian Real Estate Investment Fund Act, but rather as non-transparent corporations subject to the ordinary tax regime. Sec 22 of the Austrian Federal Fiscal Code (Bundesabgabenordnung – “BAO”) provides that tax liability cannot be avoided by an abuse of legal forms or methods offered by civil law (“abuse of law”). This is assumed in cases where transactions are entered into, or entities are established, solely for the purpose of obtaining special tax advantages. If such an abuse has been established, the tax authorities may compute the tax as if such abuse had not occurred. Generally, tax abuse is only assumed in a multi-step situation (i.e. the taxpayer takes more than one step to avoid or reduce the tax). Furthermore, if a taxpayer can demonstrate substantial business reasons for a structure chosen, tax abuse may be rebutted. The Annual Tax Act 2018 introduced a legal definition of “misuse/abuse” in Sec 22 BAO based on EC Anti-Tax Avoidance Directive. Following this, abuse shall exist “when a legal arrangement, which may include one or more steps, or a sequence of legal arrangements, is inappropriate in terms of economic purpose. Inappropriate are those arrangements that, disregarding the associated tax savings, no longer make sense, because the essential purpose or one of the essential purposes is to obtain a tax advantage, which is contrary to the aim or purpose of the applicable tax law. There is no abuse, if there are valid economic reasons that reflect the economic reality”. The new definition of “misuse/abuse” applies to circumstances that will be implemented after 1 January 2019. Additionally, Sec 23 BAO provides that an act or transaction not seriously intended by the parties (“sham transaction”) but performed only to cover up facts that are relevant for tax purposes will be disregarded, and that taxation will be based on the facts the taxpayer sought to conceal. Furthermore, Sec 24 BAO provides specific provisions in connection with the attribution of business assets, in particular with regard to security ownership, trusteeship, beneficial ownership and joint ownership. This provision says that in general, assets are to be attributed to their beneficial owner. Here the “substance over form” principle applies. This is the case if a person is in a position to exercise those rights which are distinctive for ownership such as the use, consumption, amendment, pledge and sale of the assets, and if such person is simultaneously entitled to exclude any third party on a permanent basis from having an impact on the assets. No, currently there is no specific disclosure requirement for avoidance schemes. However, the EU Directive of 25 May 2018 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements provides for a reporting obligation in connection with international tax planning models and has to be implemented by the EU Member States until 31 December 2019. The Directive already provides for a reporting obligation for those tax planning models whose first implementation step took place after 25 June 2018. It is therefore to be expected that tax planning models already initiated in 2018 will also be affected by the obligation to notify. No, there are no special rules with regard to anyone who promotes, enables or facilitates tax avoidance. However, tax evasion (Abgabenhinterziehung) and tax fraud (Abgabenbetrug) are subject to criminal prosecution pursuant to the Austrian Fiscal Criminal Act (Finanzstrafgesetz). In the course of such criminal proceedings, persons who assist tax evasion and tax fraud are also subject to penalties. No, Austria does not encourage “co-operative compliance” and, therefore, there are no procedural benefits or reduction of tax provided. the interest or royalty payments in the state of residence of the receiving company are: (i) not subject to tax because of a personal or objective exemption; (ii) subject to tax at a rate lower than 10%; or (iii) subject to an effective tax at a rate lower than 10% due to any available tax reduction. It is not relevant whether the tax at a rate lower than 10% is based on the domestic law of the state of residence of the receiving company or the applicable double taxation treaty concluded between Austria and the respective state of residence. If the receiving entity is not the beneficial owner, the respective conditions have to be investigated at the level of the beneficial owner (e.g. in certain back-to-back refinancing scenarios). The new regulation is effective to all payments carried out since 28 February 2014, irrespective of when the corresponding contract was concluded. The Austrian government is of the opinion that the existing provisions in connection with interest payments to related parties is sufficient as national implementation of the EC Anti-Tax Avoidance Directive. Furthermore, hybrid structures have been substantially limited: the participation exemption will not apply if the dividend distributed to the Austrian company is tax-deductible by the foreign corporation in its home jurisdiction. This is now also the standard under the EU Parent-Subsidiary Directive. No, currently there are no legislative plans which go beyond what is recommended in the OECD’s BEPS reports besides the new regulations implemented by the Annual Tax Act 2018 (see questions 7.2, 7.3 and 9.1). The Austrian legislator adopted the Transfer Pricing Documentation Act, which includes documentation and reporting obligations for a multinational group of companies (CBCR). These obligations essentially apply for business years starting from 1 January 2016. No, there is no preferential tax regime such as a patent box. In this context, however, it should be noted that there are various tax incentives for research and development activities. No, currently there are no defined plans to tax digital activities or to expand the tax base to capture digital presence. However, in the course of the current Austrian EU Council Presidency taxation of digital activities is one of the agenda items. Yes, Austria’s government supports the European Commission’s interim proposal for a digital services tax.

{'timestamp': '2019-04-23T18:30:30Z', 'url': 'https://iclg.com/practice-areas/corporate-tax-laws-and-regulations/austria', 'language': 'en', 'source': 'c4'}

professional_accounting

Jack Ma emerges for first time in months since crackdown on Ant, Alibaba Alembic Pharma extends decline on mixed December quarter results Ceat rallies 10% in 2 days, hits fresh 52-week high on strong Q3 results Banking on Budget: The five areas of focus for FM Nirmala Sitharaman You are here » Home » Companies » Company Overview » Lakhotia Polyesters (India) Ltd Lakhotia Polyesters (India) Ltd. BSE: 535387 Sector: Industrials NSE: N.A. ISIN Code: INE191O01010 BSE 00:00 | 13 Jan 8.54 0 NSE 05:30 | 01 Jan Lakhotia Polyesters (India) Ltd Add to Watchlist | Add to Portfolio 52-Week high 9.05 52-Week low 8.54 P/E 142.33 Mkt Cap.(Rs cr) 9 Buy Price 8.54 Buy Qty 909.00 Sell Price 8.88 Sell Qty 29000.00 Buy Qty Sell Qty CLOSE 8.54 Chart Type Line OHLC Candle Stick Draw Trendline Benchmarks Sensex Nifty Clear Events Bonus Dividend Right Split Mkt Cap.(Rs cr) 8.94 Click here for interactive graph Bulk/Block Lakhotia Polyesters (India) Ltd. (LAKHOTIAPOLY) - Auditors Report Company auditors report To the Members of - Lakhotia Polyesters (India) Limited Report on the Audit of the Standalone Financial Statements We have audited the standalone financial statements of Lakhotia Polyesters (India)Limited ("the Company") which comprise the balance sheet as at 31st March 2019and the statement of Profit and Loss statement of changes in equity and statement of cashflows for the year then ended and notes to the financial statements including a summaryof significant accounting policies and other explanatory information. In our opinion and to the best of our information and according to the explanationsgiven to us the aforesaid standalone financial statements give the information requiredby the Act in the manner so required and give a true and fair view in conformity with theaccounting principles generally accepted in India of the state of affairs of the Companyas at March 31 2019 and loss changes in equity and its cash flows for the year ended onthat date. Basis for Opinion We conducted our audit in accordance with the Standards on Auditing (SAs) specifiedunder section 143(10) of the Companies Act 2013. Our responsibilities under thoseStandards are further described in the Auditor's Responsibilities for the Audit of theFinancial Statements section of our report. We are independent of the Company inaccordance with the Code of Ethics issued by the Institute of Chartered Accountants ofIndia together with the ethical requirements that are relevant to our audit of thefinancial statements under the provisions of the Companies Act 2013 and the Rulesthereunder and we have fulfilled our other ethical responsibilities in accordance withthese requirements and the Code of Ethics. We believe that the audit evidence we haveobtained is sufficient and appropriate to provide a basis for our opinion. Key Audit Matters Key audit matters are those matters that in our professional judgment were of mostsignificance in our audit of the financial statements of the current period. These matterswere addressed in the context of our audit of the financial statements as a whole and informing our opinion thereon and we do not provide a separate opinion on these matters. Management's Responsibility for the Standalone Financial Statements The Company's Board of Directors is responsible for the matters stated in section134(5) of the Companies Act 2013 ("the Act") with respect to the preparation ofthese standalone financial statements that give a true and fair view of the financialposition financial performance changes in equity and cash flows of the Company inaccordance with6 the accounting principles generally accepted in India including theaccounting Standards specified under section 133 of the Act. This responsibility alsoincludes maintenance of adequate accounting records in accordance with the provisions ofthe Act for safeguarding of the assets of the Company and for preventing and detectingfrauds and other irregularities; selection and application of appropriate accountingpolicies; making judgments and estimates that are reasonable and prudent; and designimplementation and maintenance of adequate internal financial controls that wereoperating effectively for ensuring the accuracy and completeness of the accountingrecords relevant to the preparation and presentation of the financial statement that givea true and fair view and are free from material misstatement whether due to fraud orerror. In preparing the financial statements management is responsible for assessing theCompany's ability to continue as a going concern disclosing as applicable mattersrelated to going concern and using the going concern basis of accounting unless managementeither intends to liquidate the Company or to cease operations or has no realisticalternative but to do so. Those Board of Directors are also responsible for overseeing the Company's financialreporting process. Auditor's Responsibilities for the Audit of the Financial Statements Our objectives are to obtain reasonable assurance about whether the financialstatements as a whole are free from material misstatement whether due to fraud or errorand to issue an auditor's report that includes our opinion. Reasonable assurance is a highlevel of assurance but is not a guarantee that an audit conducted in accordance with SAswill always detect a material misstatement when it exists. Misstatements can arise fromfraud or error and are considered material if individually or in the aggregate theycould reasonably be expected to influence the economic decisions of users taken on thebasis of these financial statements. Paragraph 40(b) of this SA explains that the shaded material below can be located in anAppendix to the auditor's report. Paragraph 40(c) explains that when law regulation orapplicable auditing standards expressly permit reference can be made to a website of anappropriate authority that contains the description of the auditor's responsibilitiesrather than including this material in the auditor's report provided that the descriptionon the website addresses and is not inconsistent with the description of the auditor'sresponsibilities below. As part of an audit in accordance with SAs we exercise professional judgment andmaintain professional skepticism throughout the audit. We also - • Identify and assess the risks of material misstatement of the financialstatements whether due to fraud or error design and perform audit procedures responsiveto those risks and obtain audit evidence that is sufficient and appropriate to provide abasis for our opinion. The risk of not detecting a material misstatement resulting fromfraud is higher than for one resulting from error as fraud may involve collusionforgery intentional omissions misrepresentations or the override of internal control. • Obtain an understanding of internal control relevant to the audit in order todesign audit procedures that are appropriate in the circumstances. Under section 143(3)(i)of the Companies Act 2013 we are also responsible for expressing our opinion on whetherthe company has adequate internal financial controls system in place and the operatingeffectiveness of such controls. • Evaluate the appropriateness of accounting policies used and the reasonablenessof accounting estimates and related disclosures made by management. • Conclude on the appropriateness of management's use of the going concern basisof accounting and based on the audit evidence obtained whether a material uncertaintyexists related to events or conditions that may cast significant doubt on the Company'sability to continue as a going concern. If we conclude that a material uncertainty existswe are required to draw attention in our auditor's report to the related disclosures inthe financial statements or if such disclosures are inadequate to modify our opinion.Our conclusions are based on the audit evidence obtained up to the date of our auditor'sreport. However future events or conditions may cause the Company to cease to continue asa going concern. • Evaluate the overall presentation structure and content of the financialstatements including the disclosures and whether the financial statements represent theunderlying transactions and events in a manner that achieves fair presentation. We communicate with those charged with governance regarding among other matters theplanned scope and timing of the audit and significant audit findings including anysignificant deficiencies in internal control that we identify during our audit. We also provide those charged with governance with a statement that we have compliedwith relevant ethical requirements regarding independence and to communicate with themall relationships and other matters that may reasonably be thought to bear on ourindependence and where applicable related safeguards. From the matters communicated with those charged with governance we determine thosematters that were of most significance in the audit of the financial statements of thecurrent period and are therefore the key audit matters. We describe these matters in ourauditor's report unless law or regulation precludes public disclosure about the matter orwhen in extremely rare circumstances we determine that a matter should not becommunicated in our report because the adverse consequences of doing so would reasonablybe expected to outweigh the public interest benefits of such communication. Report on Other Legal and Regulatory Requirements As required by the Companies (Auditor's Report) Order 2016 ("the Order")issued by the Central Government of India in terms of sub-section (11) of section 143 ofthe Companies Act 2013 we give in the Annexure a statement on the matters specified inparagraphs 3 and 4 of the Order to the extent applicable. As required by Section 143(3) of the Act we report that: (a) We have sought and obtained all the information and explanations which to the bestof our knowledge and belief were necessary for the purposes of our audit. (b) In our opinion proper books of account as required by law have been kept by theCompany so far as it appears from our examination of those books. (c) The Balance Sheet the Statement of Profit and Loss and the Cash Flow Statementdealt with by this Report are in agreement with the books of accounts. (d) In our opinion the aforesaid standalone financial statements comply with theAccounting Standards specified under Section 133 of the Act read with Rule 7 of theCompanies (Accounts) Rules 2014 (e) On the basis of the written representations received from the directors as on 31stMarch 2019 taken on record by the Board of Directors none of the directors isdisqualified as on 31st March 2019 from being appointed as a director in terms of Section164(2) of the Act. (f) With respect to the adequacy of the internal financial controls over financialreporting of the Company and the operating effectiveness of such controls refer to ourseparate Report in "Annexure A". (g) With respect to the other matters to be included in the Auditor's Report inaccordance with Rule 11 of the Companies (Audit and Auditors) Rules 2014 in our opinionand to the best of our information and according to the explanations given to us : 1. The Company has disclosed the impact of pending litigations on its financialposition in its financial statements - Refer Note 1(13) to the financial statements. 2. The Company did not have any long-term contracts including derivative contracts forwhich there were any material foreseeable. 3. There has been no delay in transferring amounts required to be transferred to theInvestor Education and Protection Fund by the Company For R R GUJRATHI & CO. Firm Registration No. 103382W Nashik Rohit Rajmal Bafana Partner 31.05.2019 Membership No. 113955 ANNEXURE TO AUDITOR'S REPORT Annexure referred to in paragraph "Report on Other Legal and RegulatoryRequirements" of Our Report of even date to the members of Lakhotia Polyesters(India) Limited on the accounts of the company for the year ended 31st March 2019. On the basis of such checks as we considered appropriate and according to theinformation and explanations given to us during the course of our audit we report that- (i) (a) The Company is maintaining proper records showing full particulars includingquantitative details and situation of fixed assets; (b) As explained to us fixed assets have been physically verified by the management atregular intervals; as informed to us no material discrepancies were noticed on suchverification. But the record relating to physical verification of fixed assets has notbeen maintained; (c) The title deeds of the immovable properties are held in the name of the company. (ii) The inventories at all business places have been physically verified by themanagement from time to time. In our opinion the frequency of verification is reasonable.As explained to us there were no material discrepancies noticed on physical verificationof inventories as compared to the books of accounts. But the record relating to physicalverification of inventories has not been maintained. (iii) (a) The company has granted loans to the 2 parties covered in the registermaintained under section 189 of the Companies Act 2013. Based upon the managementrepresentations as made to us we report that these advances are towards businesstransactions and in the normal course of business activity of the company. (b) These loans are repayable on demand and hence no schedule of repayment isprepared. Interest has not been charged on these loans/advances. (c) The due date for repayment of these advances is not fixed and hence the loan isnot overdue. (iv) The company has complied with the provisions of section 186 of the Act. But hasnot complied with the provisions of section 185 by advancing a sum to 2 parties havingsubstantial interest of the Managing Director of the company. (v) The Company has accepted deposits from its directors and relatives and has compliedwith the provisions of the Companies Act 2013. (vi) As informed to us the Central Government has not prescribed maintenance of costrecords under sub-section (1) of Section 148 of the Act. (vii) (a) According to the information and explanations given to us and based on therecords of the company examined by us the company is not regular in depositing theundisputed statutory dues including Provident Fund Employees' State Insurance Income-tax(TDS) Profession Tax as applicable with the appropriate authorities in India. Followingare the amounts due for more than six months but not paid - Particulars Amount Rs. Profession Tax 78875/- Service Tax 5038/- Income Tax - TDS 1033570/- GST - Reverse Charge 20030/- TDS - Late Fees & Interest 640810/- (b) According to the information and explanations given to us and based on the recordsof the company examined by us there are following disputed unpaid amounts - Particulars Amount Rs. in Lakhs Forum where dispute is pending Customs Duty 220.91 CESTAT Mumbai (viii) According to the records of the company examined by us and as per theinformation and explanations given to us the company has not defaulted in repayment ofdues to the banks. No debentures have been issued by the company and hence compliancewith the said clause is not applicable. (ix) In our opinion and according to the information and explanations given to us thecompany has neither raised any term loan nor collected money by way of initial or furtherpublic offer during the financial year. (x) During the course of our examination of the books and records of the companycarried in accordance with the auditing standards generally accepted in India we haveneither come across any instance of fraud on or by the Company noticed or reported duringthe course of our audit nor have we been informed of any such instance by the Management. (xi) The company has paid managerial remuneration in accordance with the provisions ofsection 197 of the Act. (xii) The company is not a nidhi company. (xiii) All transactions with the related parties are in compliance with sections 177and 178 of the Act and the details have been disclosed in the Financial Statements asrequired by the applicable Accounting Standards. (xiv) The company has not made any preferential allotment or private placement ofshares or fully or partly convertible debentures during the year under review. (xv) The company has not entered into non - cash transactions with directors or personsrelated to them in the nature prescribed under section 192 of the Act. (xvi) The company is not required to be registered under section 45 - IA of the ReserveBank of India Act 1934. FRN - 103382W Nashik Rohit Rajmal Bafna FCA Annexure B to the Independents Auditor's Report of even date on the standalonefinancial statements of M/s. Lakhotia Polyester (India) Limited Report on the Internal Financial Controls under Clause (i) of Sub-section 3 of Section143 of the Companies Act 2013 ("the Act") We have audited the internal financial controls over financial reporting of GrainotchIndustries Limited ("the Company") as of 31st March 2019 inconjunction with our audit of the standalone financial statements of the company for theyear ended on that date. Managements Responsibility for Internal Financial Controls The Company's management is responsible for establishing and maintaining internalfinancial controls based on the internal control over financial reporting criteriaestablished by the company considering the essential components of internal control statedin the Guidance Note on Audit of Internal Financial Controls over Financial Reporting("the Guidance Note") issued by the Institute of Chartered Accountants of India(‘ICAI'). These responsibilities include the design implementation and maintenanceof adequate internal financial controls that were operating effectively for ensuring theorderly and efficient conduct of the business including adherence to the Company'spolicies the safeguarding of its assets the prevention and detection of frauds anderrors the accuracy and completeness of the accounting records and the timely preparationof reliable financial information as required under the Act. Auditors Responsibility Our responsibility is to express an opinion on the company's internal financialcontrols over financial reporting based upon our audit. We have conducted our audit inaccordance with the Guidance Note and the Standards on Auditing issued by the ICAI anddeemed to be prescribed under section 143(10) of the Act to the extent applicable to anaudit of Internal Financial Controls both Applicable to an audit of Internal FinancialControls and both issued by the ICAI. Those standards and the Guidance Note require thatwe comply with ethical requirements and plan and perform the audit to obtain reasonableassurance about whether adequate internal financial controls over financial reporting wasestablished and maintained and if such controls operated effectively in all materialrespects. Our audit involves performing procedures to obtain audit evidence about the adequacy ofthe internal financial controls systems over financial reporting and their operatingeffectiveness. Our audit of internal financial controls over financial reporting includedobtaining an understanding of internal financial controls over financial reportingassessing the risk that a material weakness exists and testing and evaluating the designand operating effectiveness of internal control based on the assessed risk. The proceduresselected depend on the auditor's judgment including the assessment of the risks ofmaterial misstatement of the financial statement whether due to fraud or error. We believe that the audit evidence we have obtained is sufficient and appropriate toprovide a basis for our audit opinion on the company's internal financial controls systemover financial reporting. Meaning of Internal Financial Controls over Financial Reporting A company's internal financial control over financial reporting is a process designedto provide reasonable assurance regarding the reliability of financial reporting and thepreparation of financial statements for external purposes in accordance with the generallyaccepted accounting principles. A company's internal financial control over financialreporting includes those policies and procedures that - (i) Pertain to the maintenance of records that in reasonable detail accurately andfairly reflect the transactions and dispositions of the assets of the company. (ii) Provide reasonable assurance that the transactions are recorded as necessary topermit preparation of financial statements in accordance with generally acceptedaccounting principles and that receipts and expenditures of the company are being madeonly in accordance with authorizations of the management and directors of the company; and (iii) Provide reasonable assurance regarding prevention or timely detection ofunauthorized acquisition use or disposition of the company's assets that could have amaterial effect on the financial statements. Inherent Limitations of Internal Financial Controls over Financial Reporting Because of the inherent limitations of internal financial controls over financialreporting including the possibility of collusion or improper management override ofcontrols material misstatements due to error or fraud may occur and not be detected.Also projections of any evaluation of the internal financial controls over financialreporting to future periods are subject to the risk that the internal financial controlover financial reporting may become inadequate because of changes in conditions or thatthe degree of compliance with the policies or procedures may deteriorate. In our opinion the Company has in all material respect an adequate internalfinancial controls system over financial reporting and such internal financial controlsover financial reporting were operating effectively as at 31st March 2019based on the internal control over financial reporting criteria established by the Companyconsidering the essential components of internal control stated in the Guidance Noteissued by ICAI. 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professional_accounting

Subpart 31.2 - Contracts with Commercial Organizations Subpart31.031.131.231.331.631.7 Parent topic: Part 31 - Contract Cost Principles and Procedures 31.201-1 Composition of total cost. (a) The total cost, including standard costs properly adjusted for applicable variances, of a contract is the sum of the direct and indirect costs allocable to the contract, incurred or to be incurred, plus any allocable cost of money pursuant to 31.205-10, less any allocable credits. In ascertaining what constitutes a cost, any generally accepted method of determining or estimating costs that is equitable and is consistently applied may be used. (b) While the total cost of a contract includes all costs properly allocable to the contract, the allowable costs to the Government are limited to those allocable costs which are allowable pursuant to part 31 and applicable agency supplements. 31.201-2 Determining allowability. (a) A cost is allowable only when the cost complies with all of the following requirements: (1) Reasonableness. (2) Allocability. (3) Standards promulgated by the CAS Board, if applicable, otherwise, generally accepted accounting principles and practices appropriate to the circumstances. (4) Terms of the contract. (5) Any limitations set forth in this subpart. (b) Certain cost principles in this subpart incorporate the measurement, assignment, and allocability rules of selected CAS and limit the allowability of costs to the amounts determined using the criteria in those selected standards. Only those CAS or portions of standards specifically made applicable by the cost principles in this subpart are mandatory unless the contract is CAS-covered (see part 30). Business units that are not otherwise subject to these standards under a CAS clause are subject to the selected standards only for the purpose of determining allowability of costs on Government contracts. Including the selected standards in the cost principles does not subject the business unit to any other CAS rules and regulations. The applicability of the CAS rules and regulations is determined by the CAS clause, if any, in the contract and the requirements of the standards themselves. (c) When contractor accounting practices are inconsistent with this subpart 31.2, costs resulting from such inconsistent practices in excess of the amount that would have resulted from using practices consistent with this subpart are unallowable. (d) A contractor is responsible for accounting for costs appropriately and for maintaining records, including supporting documentation, adequate to demonstrate that costs claimed have been incurred, are allocable to the contract, and comply with applicable cost principles in this subpart and agency supplements. The contracting officer may disallow all or part of a claimed cost that is inadequately supported. 31.201-3 Determining reasonableness. (a) A cost is reasonable if, in its nature and amount, it does not exceed that which would be incurred by a prudent person in the conduct of competitive business. Reasonableness of specific costs must be examined with particular care in connection with firms or their separate divisions that may not be subject to effective competitive restraints. No presumption of reasonableness shall be attached to the incurrence of costs by a contractor. If an initial review of the facts results in a challenge of a specific cost by the contracting officer or the contracting officer’s representative, the burden of proof shall be upon the contractor to establish that such cost is reasonable. (b) What is reasonable depends upon a variety of considerations and circumstances, including- (1) Whether it is the type of cost generally recognized as ordinary and necessary for the conduct of the contractor’s business or the contract performance; (2) Generally accepted sound business practices, arm’s-length bargaining, and Federal and State laws and regulations; (3) The contractor’s responsibilities to the Government, other customers, the owners of the business, employees, and the public at large; and (4) Any significant deviations from the contractor’s established practices. 31.201-4 Determining allocability. A cost is allocable if it is assignable or chargeable to one or more cost objectives on the basis of relative benefits received or other equitable relationship. Subject to the foregoing, a cost is allocable to a Government contract if it- (a) Is incurred specifically for the contract; (b) Benefits both the contract and other work, and can be distributed to them in reasonable proportion to the benefits received; or (c) Is necessary to the overall operation of the business, although a direct relationship to any particular cost objective cannot be shown. 31.201-5 Credits. The applicable portion of any income, rebate, allowance, or other credit relating to any allowable cost and received by or accruing to the contractor shall be credited to the Government either as a cost reduction or by cash refund. See 31.205-6(j)(3) for rules governing refund or credit to the Government associated with pension adjustments and asset reversions. 31.201-6 Accounting for unallowable costs. (a) Costs that are expressly unallowable or mutually agreed to be unallowable, including mutually agreed to be unallowable directly associated costs, shall be identified and excluded from any billing, claim, or proposal applicable to a Government contract. A directly associated cost is any cost that is generated solely as a result of incurring another cost, and that would not have been incurred had the other cost not been incurred. When an unallowable cost is incurred, its directly associated costs are also unallowable. (b) Costs that specifically become designated as unallowable or as unallowable directly associated costs of unallowable costs as a result of a written decision furnished by a contracting officer shall be identified if included in or used in computing any billing, claim, or proposal applicable to a Government contract. This identification requirement applies also to any costs incurred for the same purpose under like circumstances as the costs specifically identified as unallowable under either this paragraph or paragraph (a) of this subsection. (1) The practices for accounting for and presentation of unallowable costs must be those described in 48 CFR 9904.405, Accounting for Unallowable Costs. (2) Statistical sampling is an acceptable practice for contractors to follow in accounting for and presenting unallowable costs provided the criteria in paragraphs (c)(2)(i), (c)(2)(ii), and (c)(2)(iii) of this subsection are met: (i) The statistical sampling results in an unbiased sample that is a reasonable representation of the sampling universe. (ii) Any large dollar value or high risk transaction is separately reviewed for unallowable costs and excluded from the sampling process. (iii) The statistical sampling permits audit verification. (3) For any indirect cost in the selected sample that is subject to the penalty provisions at 42.709, the amount projected to the sampling universe from that sampled cost is also subject to the same penalty provisions. (4) Use of statistical sampling methods for identifying and segregating unallowable costs should be the subject of an advance agreement under the provisions of 31.109 between the contractor and the cognizant administrative contracting officer or Federal official. The advance agreement should specify the basic characteristics of the sampling process. The cognizant administrative contracting officer or Federal official shall request input from the cognizant auditor before entering into any such agreements. (5) In the absence of an advance agreement, if an initial review of the facts results in a challenge of the statistical sampling methods by the contracting officer or the contracting officer’s representative, the burden of proof shall be on the contractor to establish that such a method meets the criteria in paragraph (c)(2) of this subsection. (d) If a directly associated cost is included in a cost pool that is allocated over a base that includes the unallowable cost with which it is associated, the directly associated cost shall remain in the cost pool. Since the unallowable costs will attract their allocable share of costs from the cost pool, no further action is required to assure disallowance of the directly associated costs. In all other cases, the directly associated costs, if material in amount, must be purged from the cost pool as unallowable costs. (1) In determining the materiality of a directly associated cost, consideration should be given to the significance of- (i) The actual dollar amount, (ii) The cumulative effect of all directly associated costs in a cost pool, and (iii) The ultimate effect on the cost of Government contracts. (2) Salary expenses of employees who participate in activities that generate unallowable costs shall be treated as directly associated costs to the extent of the time spent on the proscribed activity, provided the costs are material in accordance with paragraph (e)(1) of this subsection (except when such salary expenses are, themselves, unallowable). The time spent in proscribed activities should be compared to total time spent on company activities to determine if the costs are material. Time spent by employees outside the normal working hours should not be considered except when it is evident that an employee engages so frequently in company activities during periods outside normal working hours as to indicate that such activities are a part of the employee’s regular duties. (3) When a selected item of cost under 31.205 provides that directly associated costs be unallowable, such directly associated costs are unallowable only if determined to be material in amount in accordance with the criteria provided in paragraphs (e)(1) and (e)(2) of this subsection, except in those situations where allowance of any of the directly associated costs involved would be considered to be contrary to public policy. 31.201-7 Construction and architect-engineer contracts. Specific principles and procedures for evaluating and determining costs in connection with contracts and subcontracts for construction, and architect-engineer contracts related to construction projects, are in 31.105. The applicability of these principles and procedures is set forth in 31.000 and 31.100. 31.202 Direct costs. (a) No final cost objective shall have allocated to it as a direct cost any cost, if other costs incurred for the same purpose in like circumstances have been included in any indirect cost pool to be allocated to that or any other final cost objective. Direct costs of the contract shall be charged directly to the contract. All costs specifically identified with other final cost objectives of the contractor are direct costs of those cost objectives and are not to be charged to the contract directly or indirectly. (b) For reasons of practicality, the contractor may treat any direct cost of a minor dollar amount as an indirect cost if the accounting treatment- (1) Is consistently applied to all final cost objectives; and (2) Produces substantially the same results as treating the cost as a direct cost. 31.203 Indirect costs. (a) For contracts subject to full CAS coverage, allocation of indirect costs shall be based on the applicable provisions. For all other contracts, the applicable CAS provisions in paragraphs (b) through (h) of this section apply. (b) After direct costs have been determined and charged directly to the contract or other work, indirect costs are those remaining to be allocated to intermediate or two or more final cost objectives. No final cost objective shall have allocated to it as an indirect cost any cost, if other costs incurred for the same purpose, in like circumstances, have been included as a direct cost of that or any other final cost objective. (c) The contractor shall accumulate indirect costs by logical cost groupings with due consideration of the reasons for incurring such costs. The contractor shall determine each grouping so as to permit use of an allocation base that is common to all cost objectives to which the grouping is to be allocated. The base selected shall allocate the grouping on the basis of the benefits accruing to intermediate and final cost objectives. When substantially the same results can be achieved through less precise methods, the number and composition of cost groupings should be governed by practical considerations and should not unduly complicate the allocation. (d) Once an appropriate base for allocating indirect costs has been accepted, the contractor shall not fragment the base by removing individual elements. All items properly includable in an indirect cost base shall bear a pro rata share of indirect costs irrespective of their acceptance as Government contract costs. For example, when a cost input base is used for the allocation of G&A costs, the contractor shall include in the base all items that would properly be part of the cost input base, whether allowable or unallowable, and these items shall bear their pro rata share of G&A costs. (e) The method of allocating indirect costs may require revision when there is a significant change in the nature of the business, the extent of subcontracting, fixed-asset improvement programs, inventories, the volume of sales and production, manufacturing processes, the contractor’s products, or other relevant circumstances. (f) Separate cost groupings for costs allocable to offsite locations may be necessary to permit equitable distribution of costs on the basis of the benefits accruing to the several cost objectives. (g) A base period for allocating indirect costs is the cost accounting period during which such costs are incurred and accumulated for allocation to work performed in that period. (1) For contracts subject to full or modified CAS coverage, the contractor shall follow the criteria and guidance in 48 CFR9904.406 for selecting the cost accounting periods to be used in allocating indirect costs. (2) For contracts other than those subject to paragraph (g)(1) of this section, the base period for allocating indirect costs shall be the contractor’s fiscal year used for financial reporting purposes in accordance with generally accepted accounting principles. The fiscal year will normally be 12 months, but a different period may be appropriate (e.g., when a change in fiscal year occurs due to a business combination or other circumstances). (h) Special care should be exercised in applying the principles of paragraphs (c), (d), and (e) of this section when Government-owned contractor-operated (GOCO) plants are involved. The distribution of corporate, division or branch office G&A expenses to such plants operating with little or no dependence on corporate administrative activities may require more precise cost groupings, detailed accounts screening, and carefully developed distribution bases. (i) Indirect costs that meet the definition of "excessive pass-through charge" in 52.215-23, are unallowable. 31.204 Application of principles and procedures. (a) Costs are allowable to the extent they are reasonable, allocable, and determined to be allowable under 31.201, 31.202, 31.203, and 31.205. These criteria apply to all of the selected items that follow, even if particular guidance is provided for certain items for emphasis or clarity. (1) For the following subcontract types, costs incurred as reimbursements or payments to a subcontractor are allowable to the extent the reimbursements or payments are for costs incurred by the subcontractor that are consistent with this part: (i) Cost-reimbursement. (ii) Fixed-price incentive. (iii) Price redeterminable (i.e., fixed-price contracts with prospective price redetermination and fixed-ceiling-price contracts with retroactive price redetermination). (2) The requirements of paragraph (b)(1) of this section apply to any tier above the first firm-fixed-price subcontract or fixed-price subcontract with economic price adjustment provisions. (c) Costs incurred as payments under firm-fixed-price subcontracts or fixed-price subcontracts with economic price adjustment provisions or modifications thereto, for which subcontract cost analysis was performed are allowable if the price was negotiated in accordance with 31.102. (d) Section 31.205 does not cover every element of cost. Failure to include any item of cost does not imply that it is either allowable or unallowable. The determination of allowability shall be based on the principles and standards in this subpart and the treatment of similar or related selected items. When more than one subsection in 31.205 is relevant to a contractor cost, the cost shall be apportioned among the applicable subsections, and the determination of allowability of each portion shall be based on the guidance contained in the applicable subsection. When a cost, to which more than one subsection in 31.205 is relevant, cannot be apportioned, the determination of allowability shall be based on the guidance contained in the subsection that most specifically deals with, or best captures the essential nature of, the cost at issue. 31.205 Selected costs. 31.205-1 Public relations and advertising costs. (a) "Public relations" means all functions and activities dedicated to- (1) Maintaining, protecting, and enhancing the image of a concern or its products; or (2) Maintaining or promoting reciprocal understanding and favorable relations with the public at large, or any segment of the public. The term public relations includes activities associated with areas such as advertising, customer relations, etc. (b) "Advertising" means the use of media to promote the sale of products or services and to accomplish the activities referred to in paragraph (d) of this subsection, regardless of the medium employed, when the advertiser has control over the form and content of what will appear, the media in which it will appear, and when it will appear. Advertising media include but are not limited to conventions, exhibits, free goods, samples, magazines, newspapers, trade papers, direct mail, dealer cards, window displays, outdoor advertising, radio, and television. (c) Public relations and advertising costs include the costs of media time and space, purchased services performed by outside organizations, as well as the applicable portion of salaries, travel, and fringe benefits of employees engaged in the functions and activities identified in paragraphs (a) and (b) of this subsection. (d) The only allowable advertising costs are those that are- (1) Specifically required by contract, or that arise from requirements of Government contracts, and that are exclusively for- (i) Acquiring scarce items for contract performance; or (ii) Disposing of scrap or surplus materials acquired for contract performance; (2) Costs of activities to promote sales of products normally sold to the U.S. Government, including trade shows, which contain a significant effort to promote exports from the United States. Such costs are allowable, notwithstanding paragraphs (f)(1), (f)(3), (f)(4)(ii), and (f)(5) of this subsection. However, such costs do not include the costs of memorabilia (e.g., models, gifts, and souvenirs), alcoholic beverages, entertainment, and physical facilities that are used primarily for entertainment rather than product promotion; or (3) Allowable in accordance with 31.205-34. (e) Allowable public relations costs include the following: (1) Costs specifically required by contract. (2) Costs of- (i) Responding to inquiries on company policies and activities; (ii) Communicating with the public, press, stockholders, creditors, and customers; and (iii) Conducting general liaison with news media and Government public relations officers, to the extent that such activities are limited to communication and liaison necessary to keep the public informed on matters of public concern such as notice of contract awards, plant closings or openings, employee layoffs or rehires, financial information, etc. (3) Costs of participation in community service activities (e.g., blood bank drives, charity drives, savings bond drives, disaster assistance, etc.) (But see paragraph (f)(8) of this section.) (4) Costs of plant tours and open houses (but see paragraph (f)(5) of this subsection). (5) Costs of keel laying, ship launching, commissioning, and roll-out ceremonies, to the extent specifically provided for by contract. (f) Unallowable public relations and advertising costs include the following: (1) All public relations and advertising costs, other than those specified in paragraphs (d) and (e) of this subsection, whose primary purpose is to promote the sale of products or services by stimulating interest in a product or product line (except for those costs made allowable under 31.205-38(b)(5)), or by disseminating messages calling favorable attention to the contractor for purposes of enhancing the company image to sell the company’s products or services. (2) All costs of trade shows and other special events which do not contain a significant effort to promote the export sales of products normally sold to the U.S. Government. (3) Costs of sponsoring meetings, conventions, symposia, seminars, and other special events when the principal purpose of the event is other than dissemination of technical information or stimulation of production. (4) Costs of ceremonies such as- (i) Corporate celebrations and (ii) New product announcements. (5) Costs of promotional material, motion pictures, videotapes, brochures, handouts, magazines, and other media that are designed to call favorable attention to the contractor and its activities. (6) Costs of souvenirs, models, imprinted clothing, buttons, and other mementos provided to customers or the public. (7) Costs of memberships in civic and community organizations. (8) Costs associated with the donation of excess food to nonprofit organizations in accordance with the Federal Food Donation Act of 2008 ( 42 U.S.C. 1792, see subpart 26.4). 31.205-2 [Reserved] 31.205-3 Bad debts. Bad debts, including actual or estimated losses arising from uncollectible accounts receivable due from customers and other claims, and any directly associated costs such as collection costs, and legal costs are unallowable. 31.205-4 Bonding costs. (a) Bonding costs arise when the Government requires assurance against financial loss to itself or others by reason of the act or default of the contractor. They arise also in instances where the contractor requires similar assurance. Included are such bonds as bid, performance, payment, advance payment, infringement, and fidelity bonds. (b) Costs of bonding required pursuant to the terms of the contract are allowable. (c) Costs of bonding required by the contractor in the general conduct of its business are allowable to the extent that such bonding is in accordance with sound business practice and the rates and premiums are reasonable under the circumstances. 31.205-6 Compensation for personal services. (a) General. Compensation for personal services is allowable subject to the following general criteria and additional requirements contained in other parts of this cost principle: (1) Compensation for personal services must be for work performed by the employee in the current year and must not represent a retroactive adjustment of prior years’ salaries or wages (but see paragraphs (g), (h), (j), (k), (m), and (o) of this subsection). (2) The total compensation for individual employees or job classes of employees must be reasonable for the work performed; however, specific restrictions on individual compensation elements apply when prescribed. (3) The compensation must be based upon and conform to the terms and conditions of the contractor’s established compensation plan or practice followed so consistently as to imply, in effect, an agreement to make the payment. (4) No presumption of allowability will exist where the contractor introduces major revisions of existing compensation plans or new plans and the contractor has not provided the cognizant ACO, either before implementation or within a reasonable period after it, an opportunity to review the allowability of the changes. (5) Costs that are unallowable under other paragraphs of this subpart 31.2 are not allowable under this subsection 31.205-6 solely on the basis that they constitute compensation for personal services. (i) Compensation costs for certain individuals give rise to the need for special consideration. Such individuals include: (A) Owners of closely held corporations, members of limited liability companies, partners, sole proprietors, or members of their immediate families; and (B) Persons who are contractually committed to acquire a substantial financial interest in the contractor’s enterprise. (ii) For these individuals, compensation must- (A) Be reasonable for the personal services rendered; and (B) Not be a distribution of profits (which is not an allowable contract cost). (iii) For owners of closely held companies, compensation in excess of the costs that are deductible as compensation under the Internal Revenue Code ( 26 U.S.C.) and regulations under it is unallowable. (b) Reasonableness- (1) Compensation pursuant to labor-management agreements. If costs of compensation established under "arm’s length" labor-management agreements negotiated under the terms of the Federal Labor Relations Act or similar state statutes are otherwise allowable, the costs are reasonable unless, as applied to work in performing Government contracts, the costs are unwarranted by the character and circumstances of the work or discriminatory against the Government. The application of the provisions of a labor-management agreement designed to apply to a given set of circumstances and conditions of employment (e.g., work involving extremely hazardous activities or work not requiring recurrent use of overtime) is unwarranted when applied to a Government contract involving significantly different circumstances and conditions of employment (e.g., work involving less hazardous activities or work continually requiring use of overtime). It is discriminatory against the Government if it results in employee compensation (in whatever form or name) in excess of that being paid for similar non-Government work under comparable circumstances. (2) Compensation not covered by labor-management agreements. Compensation for each employee or job class of employees must be reasonable for the work performed. Compensation is reasonable if the aggregate of each measurable and allowable element sums to a reasonable total. In determining the reasonableness of total compensation, consider only allowable individual elements of compensation. In addition to the provisions of 31.201-3, in testing the reasonableness of compensation for particular employees or job classes of employees, consider factors determined to be relevant by the contracting officer. Factors that may be relevant include, but are not limited to, conformity with compensation practices of other firms- (i) Of the same size; (ii) In the same industry; (iii) In the same geographic area; and (iv) Engaged in similar non-Government work under comparable circumstances. (c) [Reserved] (d) Form of payment. (1) Compensation for personal services includes compensation paid or to be paid in the future to employees in the form of- (i) Cash; (ii) Corporate securities, such as stocks, bonds, and other financial instruments (see paragraph (d)(2) of this subsection regarding valuation); or (iii) Other assets, products, or services. (2) When compensation is paid with securities of the contractor or of an affiliate, the following additional restrictions apply: (i) Valuation placed on the securities is the fair market value on the first date the number of shares awarded is known, determined upon the most objective basis available. (ii) Accruals for the cost of securities before issuing the securities to the employees are subject to adjustment according to the possibilities that the employees will not receive the securities and that their interest in the accruals will be forfeited. (e) Income tax differential pay. (1) Differential allowances for additional income taxes resulting from foreign assignments are allowable. (2) Differential allowances for additional income taxes resulting from domestic assignments are unallowable. (However, payments for increased employee income or Federal Insurance Contributions Act taxes incident to allowable reimbursed relocation costs are allowable under 31.205-35(a)(10).) (f) Bonuses and incentive compensation. (1) Bonuses and incentive compensation are allowable provided the- (i) Awards are paid or accrued under an agreement entered into in good faith between the contractor and the employees before the services are rendered or pursuant to an established plan or policy followed by the contractor so consistently as to imply, in effect, an agreement to make such payment; and (ii) Basis for the award is supported. (2) When the bonus and incentive compensation payments are deferred, the costs are subject to the requirements of paragraphs (f)(1) and (k) of this subsection. (g) Severance pay. (1) Severance pay is a payment in addition to regular salaries and wages by contractors to workers whose employment is being involuntarily terminated. Payments for early retirement incentive plans are covered in paragraph (j)(6) of this subsection. (2) Severance pay is allowable only to the extent that, in each case, it is required by- (i) Law; (ii) Employer-employee agreement; (iii) Established policy that constitutes, in effect, an implied agreement on the contractor’s part; or (iv) Circumstances of the particular employment. (3) Payments made in the event of employment with a replacement contractor where continuity of employment with credit for prior length of service is preserved under substantially equal conditions of employment, or continued employment by the contractor at another facility, subsidiary, affiliate, or parent company of the contractor are not severance pay and are unallowable. (4) Actual normal turnover severance payments shall be allocated to all work performed in the contractor’s plant. However, if the contractor uses the accrual method to account for normal turnover severance payments, that method will be acceptable if the amount of the accrual is- (i) Reasonable in light of payments actually made for normal severances over a representative past period; and (ii) Allocated to all work performed in the contractor’s plant. (5) Abnormal or mass severance pay is of such a conjectural nature that accruals for this purpose are not allowable. However, the Government recognizes its obligation to participate, to the extent of its fair share, in any specific payment. Thus, the Government will consider allowability on a case-by-case basis. (6) Under 10 U.S.C. 3744(a)(13) and 41 U.S.C.4304(a)(13), the costs of severance payments to foreign nationals employed under a service contract performed outside the United States are unallowable to the extent that such payments exceed amounts typically paid to employees providing similar services in the same industry in the United States. Further, under 10 U.S.C. 3744(a)(14) and 41 U.S.C.4304(a)(14), all such costs of severance payments that are otherwise allowable are unallowable if the termination of employment of the foreign national is the result of the closing of, or the curtailment of activities at, a United States facility in that country at the request of the government of that country; this does not apply if the closing of a facility or curtailment of activities is made pursuant to a status-of-forces or other country-to-country agreement entered into with the government of that country before November 29, 1989. 10 U.S.C. 3744(b) and 41 U.S.C.4304(b) permit the head of the agency to waive these cost allowability limitations under certain circumstances (see 37.113 and the solicitation provision at 52.237-8). (h) Backpay. Backpay is a retroactive adjustment of prior years’ salaries or wages. Backpay is unallowable except as follows: (1) Payments to employees resulting from underpaid work actually performed are allowable, if required by a negotiated settlement, order, or court decree. (2) Payments to union employees for the difference in their past and current wage rates for working without a contract or labor agreement during labor management negotiation are allowable. (3) Payments to nonunion employees based upon results of union agreement negotiation are allowable only if- (i) A formal agreement or understanding exists between management and the employees concerning these payments; or (ii) An established policy or practice exists and is followed by the contractor so consistently as to imply, in effect, an agreement to make such payments. (i) Compensation based on changes in the prices of corporate securities or corporate security ownership, such as stock options, stock appreciation rights, phantom stock plans, and junior stock conversions. (1) Any compensation which is calculated, or valued, based on changes in the price of corporate securities is unallowable. (2) Any compensation represented by dividend payments or which is calculated based on dividend payments is unallowable. (3) If a contractor pays an employee in lieu of the employee receiving or exercising a right, option, or benefit which would have been unallowable under this paragraph (i), such payments are also unallowable. (j) Pension costs. (1) Pension plans are normally segregated into two types of plans: defined-benefit and defined-contribution pension plans. The contractor shall measure, assign, and allocate the costs of all defined-benefit pension plans and the costs of all defined-contribution pension plans in compliance with 48 CFR9904.412-Cost Accounting Standard for Composition and Measurement of Pension Cost, and 48 CFR9904.413-Adjustment and Allocation of Pension Cost. Pension costs are allowable subject to the referenced standards and the cost limitations and exclusions set forth in paragraph (j)(1)(i) and in paragraphs (j)(2) through (j)(6) of this subsection. (i) Except for nonqualified pension plans using the pay-as-you-go cost method, to be allowable in the current year, the contractor shall fund pension costs by the time set for filing of the Federal income tax return or any extension. Pension costs assigned to the current year, but not funded by the tax return time, are not allowable in any subsequent year. For nonqualified pension plans using the pay-as-you-go method, to be allowable in the current year, the contractor shall allocate pension costs in the cost accounting period that the pension costs are assigned. (ii) Pension payments must be paid pursuant to an agreement entered into in good faith between the contractor and employees before the work or services are performed and to the terms and conditions of the established plan. The cost of changes in pension plans are not allowable if the changes are discriminatory to the Government or are not intended to be applied consistently for all employees under similar circumstances in the future. (iii) Except as provided for early retirement benefits in paragraph (j)(6) of this subsection, one-time-only pension supplements not available to all participants of the basic plan are not allowable as pension costs, unless the supplemental benefits represent a separate pension plan and the benefits are payable for life at the option of the employee. (iv) Increases in payments to previously retired plan participants covering cost-of-living adjustments are allowable if paid in accordance with a policy or practice consistently followed. (2) Defined-benefit pension plans. The cost limitations and exclusions pertaining to defined-benefit plans are as follows: (A) Except for nonqualified pension plans, pension costs (see 48 CFR9904.412-40(a)(1)) assigned to the current accounting period, but not funded during it, are not allowable in subsequent years (except that a payment made to a fund by the time set for filing the Federal income tax return or any extension thereof is considered to have been made during such taxable year). However, any portion of pension cost computed for a cost accounting period, that exceeds the amount required to be funded pursuant to a waiver granted under the provisions of the Employee Retirement Income Security Act of1974 (ERISA), will be allowable in those future accounting periods in which the funding of such excess amounts occurs (see 48 CFR9904.412-50(c)(5)). (B) For nonqualified pension plans, except those using the pay-as-you-go cost method, allowable costs are limited to the amount allocable in accordance with 48 CFR9904.412-50(d)(2). (C) For nonqualified pension plans using the pay-as-you-go cost method, allowable costs are limited to the amounts allocable in accordance with 48 CFR9904.412-50(d)(3). (ii) Any amount funded in excess of the pension cost assigned to a cost accounting period is not allowable in that period and shall be accounted for as set forth at 48 CFR9904.412-50(a)(4). The excess amount is allowable in the future period to which it is assigned, to the extent it is not otherwise unallowable. (iii) Increased pension costs are unallowable if the increase is caused by a delay in funding beyond 30 days after each quarter of the year to which they are assignable. If a composite rate is used for allocating pension costs between the segments of a company and if, because of differences in the timing of the funding by the segments, an inequity exists, allowable pension costs for each segment will be limited to that particular segment’s calculation of pension costs as provided for in 48 CFR9904.413-50(c). The contractor shall make determinations of unallowable costs in accordance with the actuarial method used in calculating pension costs. (iv) The contracting officer will consider the allowability of the cost of indemnifying the Pension Benefit Guaranty Corporation (PBGC) under ERISA Section 4062 or 4064 arising from terminating an employee deferred compensation plan on a case-by-case basis, provided that if insurance was required by the PBGC under ERISA Section 4023, it was so obtained and the indemnification payment is not recoverable under the insurance. Consideration under the foregoing circumstances will be primarily for the purpose of appraising the extent to which the indemnification payment is allocable to Government work. If a beneficial or other equitable relationship exists, the Government will participate, despite the requirements of 31.205-19(c)(3) and (d)(3), in the indemnification payment to the extent of its fair share. (v) Increased pension costs resulting from the withdrawal of assets from a pension fund and transfer to another employee benefit plan fund, or transfer of assets to another account within the same fund, are unallowable except to the extent authorized by an advance agreement. If the withdrawal of assets from a pension fund is a plan termination under ERISA, the provisions of paragraph (j)(3) of this subsection apply. The advance agreement shall- (A) State the amount of the Government’s equitable share in the gross amount withdrawn or transferred; and (B) Provide that the Government receives a credit equal to the amount of the Government’s equitable share of the gross withdrawal or transfer. (3) Pension adjustments and asset reversions. (i) For segment closings, pension plan terminations, or curtailment of benefits, the amount of the adjustment shall be- (A) For contracts and subcontracts that are subject to full coverage under the Cost Accounting Standards (CAS) Board rules and regulations, the amount measured, assigned, and allocated in accordance with 48 CFR9904.413-50(c)(12); and (B) For contracts and subcontracts that are not subject to full coverage under the CAS, the amount measured, assigned, and allocated in accordance with 48 CFR9904.413-50(c)(12), except the numerator of the fraction at 48 CFR9904.413-50(c)(12)(vi) is the sum of the pension plan costs allocated to all non-CAS-covered contracts and subcontracts that are subject to subpart 31.2 or for which certified cost or pricing data were submitted. (ii) For all other situations where assets revert to the contractor, or such assets are constructively received by it for any reason, the contractor shall, at the Government’s option, make a refund or give a credit to the Government for its equitable share of the gross amount withdrawn. The Government’s equitable share shall reflect the Government’s participation in pension costs through those contracts for which certified cost or pricing data were submitted or that are subject to subpart 31.2. Excise taxes on pension plan asset reversions or withdrawals under this paragraph (j)(3)(ii) are unallowable in accordance with 31.205-41(b)(6). (4) Defined-contribution pension plans. In addition to defined-contribution pension plans, this paragraph also covers profit sharing, savings plans, and other such plans, provided the plans fall within the definition of a pension plan at 31.001. (i) Allowable pension cost is limited to the net contribution required to be made for a cost accounting period after taking into account dividends and other credits, where applicable. However, any portion of pension cost computed for a cost accounting period that exceeds the amount required to be funded pursuant to a waiver granted under the provisions of ERISA will be allowable in those future accounting periods in which the funding of such excess amounts occurs (see 48 CFR9904.412-50(c)(5)). (ii) The provisions of paragraphs (j)(2)(ii) and (iv) of this subsection apply to defined-contribution plans. (5) Pension plans using the pay-as-you-go cost method. When using the pay-as-you-go cost method, the contractor shall measure, assign, and allocate the cost of pension plans in accordance with 48 CFR9904.412 and 9904.413. Pension costs for a pension plan using the pay-as-you-go cost method are allowable to the extent they are not otherwise unallowable. (6) Early retirement incentives. An early retirement incentive is an incentive given to an employee to retire early. For contract costing purposes, costs of early retirement incentives are allowable subject to the pension cost criteria contained in paragraphs (j)(2)(i) through (iv) of this subsection provided- (i) The contractor measures, assigns, and allocates the costs in accordance with the contractor’s accounting practices for pension costs; (ii) The incentives are in accordance with the terms and conditions of an early retirement incentive plan; (iii) The contractor applies the plan only to active employees. The cost of extending the plan to employees who retired or were terminated before the adoption of the plan is unallowable; and (iv) The present value of the total incentives given to any employee in excess of the amount of the employee’s annual salary for the previous fiscal year before the employee’s retirement is unallowable. The contractor shall compute the present value in accordance with its accounting practices for pension costs. The contractor shall account for any unallowable costs in accordance with 48 CFR9904.412-50(a)(2). (k) Deferred compensation other than pensions. The costs of deferred compensation awards are allowable subject to the following limitations: (1) The costs shall be measured, assigned, and allocated in accordance with 48 CFR 9904.415, Accounting for the Cost of Deferred Compensation. (2) The costs of deferred compensation awards are unallowable if the awards are made in periods subsequent to the period when the work being remunerated was performed. (l) Compensation incidental to business acquisitions. The following costs are unallowable: (1) Payments to employees under agreements in which they receive special compensation, in excess of the contractor’s normal severance pay practice, if their employment terminates following a change in the management control over, or ownership of, the contractor or a substantial portion of its assets. (2) Payments to employees under plans introduced in connection with a change (whether actual or prospective) in the management control over, or ownership of, the contractor or a substantial portion of its assets in which those employees receive special compensation, which is contingent upon the employee remaining with the contractor for a specified period of time. (m) Fringe benefits. (1) Fringe benefits are allowances and services provided by the contractor to its employees as compensation in addition to regular wages and salaries. Fringe benefits include, but are not limited to, the cost of vacations, sick leave, holidays, military leave, employee insurance, and supplemental unemployment benefit plans. Except as provided otherwise in subpart 31.2, the costs of fringe benefits are allowable to the extent that they are reasonable and are required by law, employer-employee agreement, or an established policy of the contractor. (2) That portion of the cost of company-furnished automobiles that relates to personal use by employees (including transportation to and from work) is unallowable regardless of whether the cost is reported as taxable income to the employees (see 31.205-46(d)). (n) Employee rebate and purchase discount plans. Rebates and purchase discounts, in whatever form, granted to employees on products or services produced by the contractor or affiliates are unallowable. (o) Postretirement benefits other than pensions (PRB). (1) PRB covers all benefits, other than cash benefits and life insurance benefits paid by pension plans, provided to employees, their beneficiaries, and covered dependents during the period following the employees’ retirement. Benefits encompassed include, but are not limited to, postretirement health care; life insurance provided outside a pension plan; and other welfare benefits such as tuition assistance, day care, legal services, and housing subsidies provided after retirement. (2) To be allowable, PRB costs shall be incurred pursuant to law, employer-employee agreement, or an established policy of the contractor, and shall comply with paragraphs (o)(2)(i), (ii), or (iii) of this subsection. (i) Pay-as-you-go. PRB costs are not accrued during the working lives of employees. Costs are assigned to the period in which- (A) Benefits are actually provided; or (B) The costs are paid to an insurer, provider, or other recipient for current year benefits or premiums. (ii) Terminal funding. PRB costs are not accrued during the working lives of the employees. (A) Terminal funding occurs when the entire PRB liability is paid in a lump sum upon the termination of employees (or upon conversion to such a terminal-funded plan) to an insurer or trustee to establish and maintain a fund or reserve for the sole purpose of providing PRB to retirees. (B) Terminal funded costs shall be amortized over a period of 15 years. (iii) Accrual basis. PRB costs are accrued during the working lives of employees. Accrued PRB costs shall comply with the following: (A) Be measured and assigned in accordance with one of the following two methods described under paragraphs (o)(2)(iii)(A)(1) or (o)(2)(iii)(A)(2) of this subsection: (1) Generally accepted accounting principles. However, transitions from the pay-as-you-go method to the accrual accounting method must be handled according to paragraphs (o)(2)(iii)(A)(1)(i) through (iii) of this subsection. (i) In the year of transition from the pay-as-you-go method to accrual accounting for purposes of Government contract cost accounting, the transition obligation shall be the excess of the accumulated PRB obligation over the fair value of plan assets determined in accordance with subparagraph (E) of this section; the fair value must be reduced by the prepayment credit as determined in accordance with subparagraph (o)(2)(iii)(F) of this subsection. (ii) PRB cost attributable to the transition obligation assigned to the current year that is in excess of the amount assignable to accounting periods on the basis of a straight line amortization of the transition obligation over the average remaining working lives of active employees covered by the PRB plan or a 20-year period, whichever period is longer, is unallowable. However, if the plan is comprised of inactive participants only, the PRB cost attributable to the transition obligation assigned to the current year that is in excess of the amount assignable to accounting periods on a straight line amortization of the transition obligation over the average future life expectancy of the participants is unallowable. (iii) For a plan that transitioned from pay-as-you-go to accrual accounting for Government contract cost accounting prior to July 22, 2013, the unallowable amount of PRB cost attributable to the transition obligation amortization shall continue to be based on the cost principle in effect at the time of the transition until the original transition obligation schedule is fully amortized. (2) Contributions to a welfare benefit fund determined in accordance with applicable Internal Revenue Code. Allowable PRB costs based on such contributions shall- (i) Be measured using reasonable actuarial assumptions, which shall include a health care inflation assumption unless prohibited by the Internal Revenue Code provisions governing welfare benefit funds; (ii) Be assigned to accounting periods on the basis of the average working lives of active employees covered by the PRB plan or a 15 year period, whichever period is longer. However, if the plan is comprised of inactive participants only, the cost shall be spread over the average future life expectancy of the participants; and (iii) Exclude Federal income taxes, whether incurred by the fund or the contractor (including any increase in PRB costs associated with such taxes), unless the fund holding the plan assets is tax-exempt under the provisions of 26 USC 501(c). (B) Be paid to an insurer or trustee to establish and maintain a fund or reserve for the sole purpose of providing PRB to retirees. The assets shall be segregated in the trust, or otherwise effectively restricted, so that they cannot be used by the employer for other purposes. (C) Be calculated in accordance with generally accepted actuarial principles and practices as promulgated by the Actuarial Standards Board. (D) Eliminate from costs of current and future periods the accumulated value of any prior period costs that were unallowable in accordance with paragraph (o)(3) of this section, adjusted for interest under paragraph (o)(4) of this section. (E) Calculate the unfunded actuarial liability (unfunded accumulated postretirement benefit obligation) using the market (fair) value of assets that have been accumulated by funding costs assigned to prior periods for contract accounting purposes. (F) Recognize as a prepayment credit the market (fair) value of assets that were accumulated by deposits or contributions that were not used to fund costs assigned to previous periods for contract accounting purposes. (G) Comply with the following when changing from one accrual accounting method to another: the contractor shall- (1) Treat the change in the unfunded actuarial liability (unfunded accumulated postretirement benefit obligation) as a gain or loss; and (2) Present an analysis demonstrating that all costs assigned to prior periods have been accounted for in accordance with paragraphs (o)(2)(iii)(D), (E), and (F) of this section to ensure that no duplicate recovery of costs exists. Any duplicate recovery of costs due to the change from one method to another is unallowable. The analysis and new accrual accounting method may be a subject appropriate for an advance agreement in accordance with 31.109. (3) To be allowable, PRB costs must be funded by the time set for filing the Federal income tax return or any extension thereof, or paid to an insurer, provider, or other recipient by the time set for filing the Federal income tax return or extension thereof. PRB costs assigned to the current year, but not funded, paid or otherwise liquidated by the tax return due date as extended are not allowable in any subsequent year. (4) Increased PRB costs caused by delay in funding beyond 30 days after each quarter of the year to which they are assignable are unallowable. (5) The Government shall receive an equitable share of any amount of previously funded PRB costs which revert or inure to the contractor. Such equitable share shall reflect the Government’s previous participation in PRB costs through those contracts for which certified cost or pricing data were required or which were subject to subpart 31.2. (p) Limitation on allowability of compensation. Employee Compensation Limits Contract Award Date Applicable Agencies Covered Employees 31.205-6 Before June 24, 2014 Executive Agencies Other than DoD, NASA and Coast Guard Senior Executive (p)(2) Before December 31, 2011 DoD, NASA and Coast Guard Senior Executive (p)(2) On/after December 31, 2011, and before June 24, 2014 DoD, NASA, and Coast Guard All Employees (p)(3) On/after June 24, 2014 All Executive Agencies All Employees (p)(4) (1) Definitions. As used in this paragraph (p)- (i) "Compensation" means the total amount of wages, salary, bonuses, deferred compensation (see paragraph (k) of this subsection), and employer contributions to defined contribution pension plans (see paragraphs (j)(4) and (q) of this subsection), for the fiscal year, whether paid, earned, or otherwise accruing, as recorded in the contractor's cost accounting records for the fiscal year. (ii) "Senior executive" means– (A) Prior to January 2, 1999– (1) The Chief Executive Officer (CEO) or any individual acting in a similar capacity at the contractor's headquarters; (2) The four most highly compensated employees in management positions at the contractor's headquarters, other than the CEO; and (3) If the contractor has intermediate home offices or segments that report directly to the contractor's headquarters, the five most highly compensated employees in management positions at each such intermediate home office or segment. (B) Effective January 2, 1999, the five most highly compensated employees in management positions at each home office and each segment of the contractor, whether or not the home office or segment reports directly to the contractor's headquarters. (iii) Fiscal year means the fiscal year established by the contractor for accounting purposes. (iv) Contractor's headquarters means the highest organizational level from which executive compensation costs are allocated to Government contracts. (2) Senior executive compensation limit for contracts awarded before June 24, 2014. (i) Applicability. This paragraph (p)(2) applies to the following: (A) To all executive agencies, other than DoD, NASA and the Coast Guard, for contracts awarded before June 24, 2014; (B) To DoD, NASA, and the Coast Guard for contracts awarded before December 31, 2011; (ii) Costs incurred after January 1, 1998, for the compensation of a senior executive in excess of the benchmark compensation amount determined applicable for the contractor fiscal year by the Administrator, Office of Federal Procurement Policy (OFPP), under 41 U.S.C. 1127 as in effect prior to June 24, 2014, are unallowable ( 10 U.S.C. 3744(a)(16) and 41 U.S.C. 4304(a)(16), as in effect prior to June 24, 2014). This limitation is the sole statutory limitation on allowable senior executive compensation costs incurred after January 1, 1998, under contracts awarded before June 24, 2014, and applies whether or not the affected contracts were previously subject to a statutory limitation on such costs. (Note that pursuant to section 804 of Pub. L. 105-261, the definition of "senior executive" in paragraph (p)(1) of this section has been changed for compensation costs incurred after January 1, 1999.) See https://www.whitehouse.gov/wp-content/uploads/2017/11/ContractorCompensationCapContractsAwardedBeforeJune24.pdf. (3) All employee compensation limit for contracts awarded before June 24, 2014. (i) Applicability. This paragraph (p)(3) applies to DOD, NASA, and the Coast Guard for contracts awarded on or after December 31, 2011, and before June 24, 2014. (ii) Costs incurred after January 1, 2012, for the compensation of any contractor employee in excess of the benchmark compensation amount, determined applicable for the contractor fiscal year by the Administrator, Office of Federal Procurement Policy (OFPP) under 41 U.S.C. 1127 as in effect prior to June 24, 2014 are unallowable ( 10 U.S.C. 3744(a)(16) as in effect prior to June 24, 2014.) This limitation is the sole statutory limitation on allowable employee compensation costs incurred after January 1, 2012, under contracts awarded on or after December 31, 2011 and before June 24, 2014. (Note that pursuant to section 803 of Pub. L. 112-81, 10 U.S.C. 3744, Allowable costs under defense contracts, was amended by striking "senior executives" and inserting "any contractor employee", making unallowable the excess compensation costs incurred after January 1, 2012, under affected contracts.) See https://www.whitehouse.gov/wp-content/uploads/2017/11/ContractorCompensationCapContractsAwardedBeforeJune24.pdf. (4) All employee compensation limit for contracts awarded on or after June 24, 2014. (i) Applicability. This paragraph (p)(4) applies to all executive agency contracts awarded on or after June 24, 2014, and any subcontracts thereunder. (ii) Costs incurred on or after June 24, 2014, for the compensation of all employees in excess of the benchmark compensation amount determined applicable for the contractor fiscal year by the Administrator, Office of Federal Procurement Policy (OFPP) are unallowable under 10 U.S.C. 3744(a)(16) and 41 U.S.C 4304(a)(16), as in effect on or after June 24, 2014, pursuant to section 702 of Pub. L. 113-67. This limitation is the sole statutory limitation on allowable employee compensation costs incurred on or after June 24, 2014, under contracts awarded on or after June 24, 2014. See http://www.whitehouse.gov/omb/procurement/cecp. (iii) Exceptions. An agency head may establish one or more narrowly targeted exceptions for scientists, engineers, or other specialists upon a determination that such exceptions are needed to ensure that the executive agency has continued access to needed skills and capabilities. In making such a determination, the agency shall consider, at a minimum, for each contractor employee in a narrowly targeted excepted position- (A) The amount of taxpayer funded compensation to be received by each employee; and (B) The duties and services performed by each employee. (q) Employee stock ownership plans (ESOP). (1) An ESOP is a stock bonus plan designed to invest primarily in the stock of the employer corporation. The contractor’s contributions to an Employee Stock Ownership Trust (ESOT) may be in the form of cash, stock, or property. (2) Costs of ESOPs are allowable subject to the following conditions: (i) The contractor measures, assigns, and allocates costs in accordance with 48 CFR 9904.415. (ii) Contributions by the contractor in any oneyear that exceed the deductibility limits of the Internal Revenue Code for that year are unallowable. (iii) When the contribution is in the form of stock, the value of the stock contribution is limited to the fair market value of the stock on the date that title is effectively transferred to the trust. (iv) When the contribution is in the form of cash- (A) Stock purchases by the ESOT in excess of fair market value are unallowable; and (B) When stock purchases are in excess of fair market value, the contractor shall credit the amount of the excess to the same indirect cost pools that were charged for the ESOP contributions in the year in which the stock purchase occurs. However, when the trust purchases the stock with borrowed funds which will be repaid over a period of years by cash contributions from the contractor to the trust, the contractor shall credit the excess price over fair market value to the indirect cost pools pro rata over the period of years during which the contractor contributes the cash used by the trust to repay the loan. (v) When the fair market value of unissued stock or stock of a closely held corporation is not readily determinable, the valuation will be made on a case-by-case basis taking into consideration the guidelines for valuation used by the IRS. 31.205-7 Contingencies. (a) "Contingency," as used in this subpart, means a possible future event or condition arising from presently known or unknown causes, the outcome of which is indeterminable at the present time. (b) Costs for contingencies are generally unallowable for historical costing purposes because such costing deals with costs incurred and recorded on the contractor’s books. However, in some cases, as for example, terminations, a contingency factor may be recognized when it is applicable to a past period to give recognition to minor unsettled factors in the interest of expediting settlement. (c) In connection with estimates of future costs, contingencies fall into two categories: (1) Those that may arise from presently known and existing conditions, the effects of which are foreseeable within reasonable limits of accuracy; e.g., anticipated costs of rejects and defective work. Contingencies of this category are to be included in the estimates of future costs so as to provide the best estimate of performance cost. (2) Those that may arise from presently known or unknown conditions, the effect of which cannot be measured so precisely as to provide equitable results to the contractor and to the Government; e.g., results of pending litigation. Contingencies of this category are to be excluded from cost estimates under the several items of cost, but should be disclosed separately (including the basis upon which the contingency is computed) to facilitate the negotiation of appropriate contractual coverage. (See, for example, 31.205-6(g) and 31.205-19.) 31.205-8 Contributions or donations. Contributions or donations, including cash, property and services, regardless of recipient, are unallowable, except as provided in 31.205-1(e)(3). 31.205-10 Cost of money. (a) General. Cost of money- (1) Is an imputed cost that is not a form of interest on borrowings (see 31.205-20); (2) Is an "incurred cost" for cost-reimbursement purposes under applicable cost-reimbursement contracts and for progress payment purposes under fixed-price contracts; and (3) Refers to- (i) Facilities capital cost of money (48 CFR9904.414); and (ii) Cost of money as an element of the cost of capital assets under construction (48 CFR9904.417). (b) Cost of money is allowable, provided- (1) It is measured, assigned, and allocated to contracts in accordance with 48 CFR9904.414 or measured and added to the cost of capital assets under construction in accordance with 48 CFR9904.417, as applicable; (2) The requirements of 31.205-52, which limit the allowability of cost of money, are followed; and (3) The estimated facilities capital cost of money is specifically identified and proposed in cost proposals relating to the contract under which the cost is to be claimed. (c) Actual interest cost in lieu of the calculated imputed cost of money is unallowable. 31.205-11 Depreciation. (a) Depreciation on a contractor’s plant, equipment, and other capital facilities is an allowable contract cost, subject to the limitations contained in this cost principle. For tangible personal property, only estimated residual values that exceed 10 percent of the capitalized cost of the asset need be used in establishing depreciable costs. Where either the declining balance method of depreciation or the class life asset depreciation range system is used, the residual value need not be deducted from capitalized cost to determine depreciable costs. Depreciation cost that would significantly reduce the book value of a tangible capital asset below its residual value is unallowable. (b) Contractors having contracts subject to 48 CFR9904.409, Depreciation of Tangible Capital Assets, shall adhere to the requirement of that standard for all fully CAS-covered contracts and may elect to adopt the standard for all other contracts. All requirements of 48 CFR9904.409 are applicable if the election is made, and contractors must continue to follow it until notification of final acceptance of all deliverable items on all open negotiated Government contracts. (c) For contracts to which 48 CFR9904.409 is not applied, except as indicated in paragraphs (g) and (h) of this subsection, allowable depreciation shall not exceed the amount used for financial accounting purposes, and shall be determined in a manner consistent with the depreciation policies and procedures followed in the same segment on non-Government business. (d) Depreciation, rental, or use charges are unallowable on property acquired from the Government at no cost by the contractor or by any division, subsidiary, or affiliate of the contractor under common control. (e) The depreciation on any item which meets the criteria for allowance at price under 31.205-26(e) may be based on that price, provided the same policies and procedures are used for costing all business of the using division, subsidiary, or organization under common control. (f) No depreciation or rental is allowed on property fully depreciated by the contractor or by any division, subsidiary, or affiliate of the contractor under common control. However, a reasonable charge for using fully depreciated property may be agreed upon and allowed (but, see 31.109(h)(2)). In determining the charge, consideration shall be given to cost, total estimated useful life at the time of negotiations, effect of any increased maintenance charges or decreased efficiency due to age, and the amount of depreciation previously charged to Government contracts or subcontracts. (g) Whether or not the contract is otherwise subject to CAS the following apply: (1) The requirements of 31.205-52 shall be observed. (2) In the event of a write-down from carrying value to fair value as a result of impairments caused by events or changes in circumstances, allowable depreciation of the impaired assets is limited to the amounts that would have been allowed had the assets not been written down (see 31.205-16(g)). However, this does not preclude a change in depreciation resulting from other causes such as permissible changes in estimates of service life, consumption of services, or residual value. (i) In the event the contractor reacquires property involved in a sale and leaseback arrangement, allowable depreciation of reacquired property shall be based on the net book value of the asset as of the date the contractor originally became a lessee of the property in the sale and leaseback arrangement- (A) Adjusted for any allowable gain or loss determined in accordance with 31.205-16(b); and (B) Less any amount of depreciation expense included in the calculation of the amount that would have been allowed had the contractor retained title under 31.205-11(h)(1) and 31.205-36(b)(2). (ii) As used in this paragraph (g)(3), "reacquired property" is property that generated either any depreciation expense or any cost of money considered in the calculation of the limitations under 31.205-11(h)(1) and 31.205-36(b)(2) during the most recent accounting period prior to the date of reacquisition. (h) A "capital lease," as defined in Financial Accounting Standards Board’s Accounting Standards Codification (FASB ASC) 840, Leases, is subject to the requirements of this cost principle. (See 31.205-36 for Operating Leases.) FASB ASC 840 requires that capital leases be treated as purchased assets, i.e., be capitalized, and the capitalized value of such assets be distributed over their useful lives as depreciation charges or over the leased life as amortization charges, as appropriate, except that- (1) Lease costs under a sale and leaseback arrangement are allowable only up to the amount that would be allowed if the contractor retained title, computed based on the net book value of the asset on the date the contractor becomes a lessee of the property adjusted for any gain or loss recognized in accordance with 31.205-16(b); and (2) If it is determined that the terms of the capital lease have been significantly affected by the fact that the lessee and lessor are related, depreciation charges are not allowable in excess of those that would have occurred if the lease contained terms consistent with those found in a lease between unrelated parties. 31.205-12 Economic planning costs. Economic planning costs are the costs of general long-range management planning that is concerned with the future overall development of the contractor’s business and that may take into account the eventual possibility of economic dislocations or fundamental alterations in those markets in which the contractor currently does business. Economic planning costs are allowable. Economic planning costs do not include organization or reorganization costs covered by 31.205-27. See 31.205-38 for market planning costs other than economic planning costs. 31.205-13 Employee morale, health, welfare, food service, and dormitory costs and credits. (a) Aggregate costs incurred on activities designed to improve working conditions, employer-employee relations, employee morale, and employee performance (less income generated by these activities) are allowable, subject to the limitations contained in this subsection. Some examples of allowable activities are- (1) House publications; (2) Health clinics; (3) Wellness/fitness centers; (4) Employee counseling services; and (5) Food and dormitory services for the contractor’s employees at or near the contractor’s facilities. These services include- (i) Operating or furnishing facilities for cafeterias, dining rooms, canteens, lunch wagons, vending machines, living accommodations; and (ii) Similar types of services. (b) Costs of gifts are unallowable. (Gifts do not include awards for performance made pursuant to 31.205-6(f) or awards made in recognition of employee achievements pursuant to an established contractor plan or policy.) (c) Costs of recreation are unallowable, except for the costs of employees’ participation in company sponsored sports teams or employee organizations designed to improve company loyalty, team work, or physical fitness. (1) The allowability of food and dormitory losses are determined by the following factors: (i) Losses from operating food and dormitory services are allowable only if the contractor’s objective is to operate such services on a break-even basis. (ii) Losses sustained because food services or lodging accommodations are furnished without charge or at prices or rates which obviously would not be conducive to the accomplishment of the objective in paragraph (d)(1)(i) of this subsection are not allowable, except as described in paragraph (d)(1)(iii) of this subsection. (iii) A loss may be allowed to the extent that the contractor can demonstrate that unusual circumstances exist such that even with efficient management, operating the services on a break-even basis would require charging inordinately high prices, or prices or rates higher than those charged by commercial establishments offering the same services in the same geographical areas. The following are examples of unusual circumstances: (A) The contractor must provide food or dormitory services at remote locations where adequate commercial facilities are not reasonably available. (B) The contractor’s charged (but unproductive) labor costs would be excessive if the services were not available. (C) If cessation or reduction of food or dormitory operations will not otherwise yield net cost savings. (2) Costs of food and dormitory services shall include an allocable share of indirect expenses pertaining to these activities. (e) When the contractor has an arrangement authorizing an employee association to provide or operate a service, such as vending machines in the contractor’s plant, and retain the profits, such profits shall be treated in the same manner as if the contractor were providing the service (but see paragraph (f) of this subsection). (f) Contributions by the contractor to an employee organization, including funds from vending machine receipts or similar sources, are allowable only to the extent that the contractor demonstrates that an equivalent amount of the costs incurred by the employee organization would be allowable if directly incurred by the contractor.. 31.205-14 Entertainment costs. Costs of amusement, diversions, social activities, and any directly associated costs such as tickets to shows or sports events, meals, lodging, rentals, transportation, and gratuities are unallowable. Costs made specifically unallowable under this cost principle are not allowable under any other cost principle. Costs of membership in social, dining, or country clubs or other organizations having the same purposes are also unallowable, regardless of whether the cost is reported as taxable income to the employees. 31.205-15 Fines, penalties, and mischarging costs. (a) Costs of fines and penalties resulting from violations of, or failure of the contractor to comply with, Federal, State, local, or foreign laws and regulations, are unallowable except when incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the contracting officer. (b) Costs incurred in connection with, or related to, the mischarging of costs on Government contracts are unallowable when the costs are caused by, or result from, alteration or destruction of records, or other false or improper charging or recording of costs. Such costs include those incurred to measure or otherwise determine the magnitude of the improper charging, and costs incurred to remedy or correct the mischarging, such as costs to rescreen and reconstruct records. 31.205-16 Gains and losses on disposition or impairment of depreciable property or other capital assets. (a) Gains and losses from the sale, retirement, or other disposition (but see 31.205-19) of depreciable property shall be included in the year in which they occur as credits or charges to the cost grouping(s) in which the depreciation or amortization applicable to those assets was included (but see paragraph (f) of this subsection). However, no gain or loss shall be recognized as a result of the transfer of assets in a business combination (see 31.205-52). (b) Notwithstanding the provisions in paragraph (c) of this subsection, when costs of depreciable property are subject to the sale and leaseback limitations in 31.205-11(h)(1) or 31.205-36(b)(2)- (1) The gain or loss is the difference between the net amount realized and the undepreciated balance of the asset on the date the contractor becomes a lessee; and (2) When the application of (b)(1) of this subsection results in a loss- (i) The allowable portion of the loss is zero if the fair market value exceeds the undepreciated balance of the asset on the date the contractor becomes a lessee; and (ii) The allowable portion of the loss is limited to the difference between the fair market value and the undepreciated balance of the asset on the date the contractor becomes a lessee if the fair market value is less than the undepreciated balance of the asset on the date the contractor becomes a lessee. (c) Gains and losses on disposition of tangible capital assets, including those acquired under capital leases (see 31.205-11(h)), shall be considered as adjustments of depreciation costs previously recognized. The gain or loss for each asset disposed of is the difference between the net amount realized, including insurance proceeds from involuntary conversions, and its undepreciated balance. (d) The gain recognized for contract costing purposes shall be limited to the difference between the acquisition cost (or for assets acquired under a capital lease, the value at which the leased asset is capitalized) of the asset and its undepreciated balance (except see paragraphs (e)(2)(i) or (ii) of this subsection). (e) Special considerations apply to an involuntary con-version which occurs when a contractor’s property is destroyed by events over which the owner has no control, such as fire, windstorm, flood, accident, theft, etc., and an insurance award is recovered. The following govern involuntary conversions: (1) When there is a cash award and the converted asset is not replaced, gain or loss shall be recognized in the period of disposition. The gain recognized for contract costing purposes shall be limited to the difference between the acquisition cost of the asset and its undepreciated balance. (2) When the converted asset is replaced, the contractor shall either- (i) Adjust the depreciable basis of the new asset by the amount of the total realized gain or loss; or (ii) Recognize the gain or loss in the period of disposition, in which case the Government shall participate to the same extent as outlined in paragraph (e)(1) of this subsection. (f) Gains and losses on the disposition of depreciable property shall not be recognized as a separate charge or credit when- (1) Gains and losses are processed through the depreciation reserve account and reflected in the depreciation allowable under 31.205-11; or (2) The property is exchanged as part of the purchase price of a similar item, and the gain or loss is taken into consideration in the depreciation cost basis of the new item. (g) Gains and losses arising from mass or extraordinary sales, retirements, or other disposition other than through business combinations shall be considered on a case-by-case basis. (h) Gains and losses of any nature arising from the sale or exchange of capital assets other than depreciable property shall be excluded in computing contract costs. (i) With respect to long-lived tangible and identifiable intangible assets held for use, no loss shall be allowed for a write-down from carrying value to fair value as a result of impairments caused by events or changes in circumstances (e.g., environmental damage, idle facilities arising from a declining business base, etc.). If depreciable property or other capital assets have been written down from carrying value to fair value due to impairments, gains or losses upon disposition shall be the amounts that would have been allowed had the assets not been written down. 31.205-17 Idle facilities and idle capacity costs. (a) Definitions. As used in this subsection- Costs of idle facilities or idle capacity means costs such as maintenance, repair, housing, rent, and other related costs; e.g., property taxes, insurance, and depreciation. Facilities means plant or any portion thereof (including land integral to the operation), equipment, individually or collectively, or any other tangible capital asset, wherever located, and whether owned or leased by the contractor. Idle capacity means the unused capacity of partially used facilities. It is the difference between that which a facility could achieve under 100 percent operating time on a one-shift basis, less operating interruptions resulting from time lost for repairs, setups, unsatisfactory materials, and other normal delays, and the extent to which the facility was actually used to meet demands during the accounting period. A multiple-shift basis may be used in the calculation instead of a one-shift basis if it can be shown that this amount of usage could normally be expected for the type of facility involved. Idle facilities means completely unused facilities that are excess to the contractor’s current needs. (b) The costs of idle facilities are unallowable unless the facilities- (1) Are necessary to meet fluctuations in workload; or (2) Were necessary when acquired and are now idle because of changes in requirements, production economies, reorganization, termination, or other causes which could not have been reasonably foreseen. (Costs of idle facilities are allowable for a reasonable period, ordinarily not to exceed 1 year, depending upon the initiative taken to use, lease, or dispose of the idle facilities (but see 31.205-42)). (c) Costs of idle capacity are costs of doing business and are a factor in the normal fluctuations of usage or overhead rates from period to period. Such costs are allowable provided the capacity is necessary or was originally reasonable and is not subject to reduction or elimination by subletting, renting, or sale, in accordance with sound business, economics, or security practices. Widespread idle capacity throughout an entire plant or among a group of assets having substantially the same function may be idle facilities. (d) Any costs to be paid directly by the Government for idle facilities or idle capacity reserved for defense mobilization production shall be the subject of a separate agreement. 31.205-18 Independent research and development and bid and proposal costs. Applied research means that effort which (1) normally follows basic research, but may not be severable from the related basic research, (2) attempts to determine and exploit the potential of scientific discoveries or improvements in technology, materials, processes, methods, devices, or techniques, and (3) attempts to advance the state of the art. Applied research does not include efforts whose principal aim is design, development, or test of specific items or services to be considered for sale; these efforts are within the definition of the term "development," defined in this subsection. Basic research (see 2.101). Bid and proposal (B&P) costs means the costs incurred in preparing, submitting, and supporting bids and proposals (whether or not solicited) on potential Government or non-Government contracts. The term does not include the costs of effort sponsored by a grant or cooperative agreement, or required in the performance of a contract. Company means all divisions, subsidiaries, and affiliates of the contractor under common control. Development means the systematic use, under whatever name, of scientific and technical knowledge in the design, development, test, or evaluation of a potential new product or service (or of an improvement in an existing product or service) for the purpose of meeting specific performance requirements or objectives. Development includes the functions of design engineering, prototyping, and engineering testing. Development excludes- (1) Subcontracted technical effort which is for the sole purpose of developing an additional source for an existing product, or (2) Development effort for manufacturing or production materials, systems, processes, methods, equipment, tools, and techniques not intended for sale. Independent research and development (IR&D) means a contractor’s IR&D cost that consists of projects falling within the four following areas: (1) basic research, (2) applied research, (3) development, and (4) systems and other concept formulation studies. The term does not include the costs of effort sponsored by a grant or required in the performance of a contract. IR&D effort shall not include technical effort expended in developing and preparing technical data specifically to support submitting a bid or proposal. Systems and other concept formulation studies means analyses and study efforts either related to specific IR&D efforts or directed toward identifying desirable new systems, equipment or components, or modifications and improvements to existing systems, equipment, or components. (b) Composition and allocation of costs. The requirements of 48 CFR 9904.420, Accounting for independent research and development costs and bid and proposal costs, are incorporated in their entirety and shall apply as follows- (1) Fully-CAS-covered contracts. Contracts that are fully-CAS-covered shall be subject to all requirements of 48 CFR 9904.420. (2) Modified CAS-covered and non-CAS-covered contracts. Contracts that are not CAS-covered or that contain terms or conditions requiring modified CAS coverage shall be subject to all requirements of 48 CFR9904.420 except 48 CFR 9904.420-50(e)(2) and 48 CFR 9904.420-50(f)(2) , which are not then applicable. However, non-CAS-covered or modified CAS-covered contracts awarded at a time the contractor has CAS-covered contracts requiring compliance with 48 CFR 9904.420, shall be subject to all the requirements of 48 CFR 9904.420. When the requirements of 48 CFR 9904.420-50(e)(2) and 48 CFR 9904.420-50(f)(2) are not applicable, the following apply: (i) IR&D and B&P costs shall be allocated to final cost objectives on the same basis of allocation used for the G&A expense grouping of the profit center (see 31.001) in which the costs are incurred. However, when IR&D and B&P costs clearly benefit other profit centers or benefit the entire company, those costs shall be allocated through the G&A of the other profit centers or through the corporate G&A, as appropriate. (ii) If allocations of IR&D or B&P through the G&A base do not provide equitable cost allocation, the contracting officer may approve use of a different base. (c) Allowability. Except as provided in paragraphs (d) and (e) of this subsection, or as provided in agency regulations, costs for IR&D and B&P are allowable as indirect expenses on contracts to the extent that those costs are allocable and reasonable. (d) Deferred IR&D costs. (1) IR&D costs that were incurred in previous accounting periods are unallowable, except when a contractor has developed a specific product at its own risk in anticipation of recovering the development costs in the sale price of the product provided that- (i) The total amount of IR&D costs applicable to the product can be identified; (ii) The proration of such costs to sales of the product is reasonable; (iii) The contractor had no Government business during the time that the costs were incurred or did not allocate IR&D costs to Government contracts except to prorate the cost of developing a specific product to the sales of that product; and (iv) No costs of current IR&D programs are allocated to Government work except to prorate the costs of developing a specific product to the sales of that product. (2) When deferred costs are recognized, the contract (except firm-fixed-price and fixed-price with economic price adjustment) will include a specific provision setting forth the amount of deferred IR&D costs that are allocable to the contract. The negotiation memorandum will state the circumstances pertaining to the case and the reason for accepting the deferred costs. (e) Cooperative arrangements. (1) IR&D costs may be incurred by contractors working jointly with one or more non-Federal entities pursuant to a cooperative arrangement (for example, joint ventures, limited partnerships, teaming arrangements, and collaboration and consortium arrangements). IR&D costs also may include costs contributed by contractors in performing cooperative research and development agreements, or similar arrangements, entered into under- (i) Section 12 of the Stevenson-Wydler Technology Transfer Act of1980 ( 15 U.S.C.3710(a)); (ii) Sections203(c)(5) and (6) of the National Aeronautics and Space Act of1958, as amended ( 42 U.S.C.2473(c)(5) and (6)); (iii) 10 U.S.C. 4021 for the Defense Advanced Research Projects Agency; or (iv) Other equivalent authority. (2) IR&D costs incurred by a contractor pursuant to these types of cooperative arrangements should be considered as allowable IR&D costs if the work performed would have been allowed as contractor IR&D had there been no cooperative arrangement. (3) Costs incurred in preparing, submitting, and supporting offers on potential cooperative arrangements are allowable to the extent they are allocable, reasonable, and not otherwise unallowable. 31.205-19 Insurance and indemnification. (a) Insurance by purchase or by self-insuring includes- (1) Coverage the contractor is required to carry or to have approved, under the terms of the contract; and (2) Any other coverage the contractor maintains in connection with the general conduct of its business. (b) For purposes of applying the provisions of this subsection, the Government considers insurance provided by captive insurers (insurers owned by or under control of the contractor) as self-insurance, and charges for it shall comply with the provisions applicable to self-insurance costs in this subsection. However, if the captive insurer also sells insurance to the general public in substantial quantities and it can be demonstrated that the charge to the contractor is based on competitive market forces, the Government will consider the insurance as purchased insurance. (c) Whether or not the contract is subject to CAS, self-insurance charges are allowable subject to paragraph (e) of this subsection and the following limitations: (1) The contractor shall measure, assign, and allocate costs in accordance with 48 CFR9904.416, Accounting for Insurance Costs. (2) The contractor shall comply with (48 CFR) part 28. However, approval of a contractor’s insurance program in accordance with part 28 does not constitute a determination as to the allowability of the program’s cost. (3) If purchased insurance is available, any self-insurance charge plus insurance administration expenses in excess of the cost of comparable purchased insurance plus associated insurance administration expenses is unallowable. (4) Self-insurance charges for risks of catastrophic losses are unallowable (see 28.308(e)). (d) Purchased insurance costs are allowable, subject to paragraph (e) of this subsection and the following limitations: (1) For contracts subject to full CAS coverage, the contractor shall measure, assign, and allocate costs in accordance with 48 CFR9904.416. (2) For all contracts, premiums for insurance purchased from fronting insurance companies (insurance companies not related to the contractor but who reinsure with a captive insurer of the contractor) are unallowable to the extent they exceed the sum of- (i) The amount that would have been allowed had the contractor insured directly with the captive insurer; and (ii) Reasonable fronting company charges for services rendered. (3) Actual losses are unallowable unless expressly provided for in the contract, except- (i) Losses incurred under the nominal deductible provisions of purchased insurance, in keeping with sound business practice, are allowable; and (ii) Minor losses, such as spoilage, breakage, and disappearance of small hand tools that occur in the ordinary course of business and that are not covered by insurance, are allowable. (e) Self-insurance and purchased insurance costs are subject to the cost limitations in the following paragraphs: (1) Costs of insurance required or approved pursuant to the contract are allowable. (2) Costs of insurance maintained by the contractor in connection with the general conduct of its business are allowable subject to the following limitations: (i) Types and extent of coverage shall follow sound business practice, and the rates and premiums shall be reasonable. (ii) Costs allowed for business interruption or other similar insurance shall be limited to exclude coverage of profit. (iii) The cost of property insurance premiums for insurance coverage in excess of the acquisition cost of the insured assets is allowable only when the contractor has a formal written policy assuring that in the event the insured property is involuntarily converted, the new asset shall be valued at the book value of the replaced asset plus or minus adjustments for differences between insurance proceeds and actual replacement cost. If the contractor does not have such a formal written policy, the cost of premiums for insurance coverage in excess of the acquisition cost of the insured asset is unallowable. (iv) Costs of insurance for the risk of loss of Government property are allowable to the extent that- (A) The contractor is liable for such loss; (B) The contracting officer has not revoked the Government’s assumption of risk (see 45.104(b)); and (C) Such insurance does not cover loss of Government property that results from willful misconduct or lack of good faith on the part of any of the contractor’s managerial personnel (as described in FAR 52.245-1(h)(1)(ii)). (v) Costs of insurance on the lives of officers, partners, proprietors, or employees are allowable only to the extent that the insurance represents additional compensation (see 31.205-6). (3) The cost of insurance to protect the contractor against the costs of correcting its own defects in materials and workmanship is unallowable. However, insurance costs to cover fortuitous or casualty losses resulting from defects in materials or workmanship are allowable as a normal business expense. (4) Premiums for retroactive or backdated insurance written to cover losses that have occurred and are known are unallowable. (5) The Government is obligated to indemnify the contractor only to the extent authorized by law, as expressly provided for in the contract, except as provided in paragraph (d)(3) of this subsection. (6) Late premium payment charges related to employee deferred compensation plan insurance incurred pursuant to Section 4007 ( 29 U.S.C.1307) or Section 4023 ( 29 U.S.C.1323) of the Employee Retirement Income Security Act of1974 are unallowable. 31.205-20 Interest and other financial costs. Interest on borrowings (however represented), bond discounts, costs of financing and refinancing capital (net worth plus long-term liabilities), legal and professional fees paid in connection with preparing prospectuses, and costs of preparing and issuing stock rights are unallowable (but see 31.205-28). However, interest assessed by State or local taxing authorities under the conditions specified in 31.205-41(a)(3) is allowable. 31.205-21 Labor relations costs. (a) Costs incurred in maintaining satisfactory relations between the contractor and its employees (other than those made unallowable in paragraph (b) of this section), including costs of shop stewards, labor management committees, employee publications, and other related activities, are allowable. (b) As required by Executive Order 13494, Economy in Government Contracting, costs of any activities undertaken to persuade employees, of any entity, to exercise or not to exercise, or concerning the manner of exercising, the right to organize and bargain collectively through representatives of the employees’ own choosing are unallowable. Examples of unallowable costs under this paragraph include, but are not limited to, the costs of- (1) Preparing and distributing materials; (2) Hiring or consulting legal counsel or consultants; (3) Meetings (including paying the salaries of the attendees at meetings held for this purpose); and (4) Planning or conducting activities by managers, supervisors, or union representatives during work hours. 31.205-22 Lobbying and political activity costs. (a) Costs associated with the following activities are unallowable: (1) Attempts to influence the outcomes of any Federal, State, or local election, referendum, initiative, or similar procedure, through in kind or cash contributions, endorsements, publicity, or similar activities; (2) Establishing, administering, contributing to, or paying the expenses of a political party, campaign, political action committee, or other organization established for the purpose of influencing the outcomes of elections; (3) Any attempt to influence- (i) The introduction of Federal, state, or local legislation, or (ii) The enactment or modification of any pending Federal, state, or local legislation through communication with any member or employee of the Congress or state legislature (including efforts to influence state or local officials to engage in similar lobbying activity), or with any government official or employee in connection with a decision to sign or veto enrolled legislation; (ii) The enactment or modification of any pending Federal, state, or local legislation by preparing, distributing or using publicity or propaganda, or by urging members of the general public or any segment thereof to contribute to or participate in any mass demonstration, march, rally, fund raising drive, lobbying campaign or letter writing or telephone campaign; (5) Legislative liaison activities, including attendance at legislative sessions or committee hearings, gathering information regarding legislation, and analyzing the effect of legislation, when such activities are carried on in support of or in knowing preparation for an effort to engage in unallowable activities; or (6) Costs incurred in attempting to improperly influence (see 3.401), either directly or indirectly, an employee or officer of the Executive branch of the Federal Government to give consideration to or act regarding a regulatory or contract matter. (b) The following activities are excepted from the coverage of (a) of this section: (1) Providing a technical and factual presentation of information on a topic directly related to the performance of a contract through hearing testimony, statements or letters to the Congress or a state legislature, or subdivision, member, or cognizant staff member thereof, in response to a documented request (including a Congressional Record notice requesting testimony or statements for the record at a regularly scheduled hearing) made by the recipient member, legislative body or subdivision, or a cognizant staff member thereof; provided such information is readily obtainable and can be readily put in deliverable form; and further provided that costs under this section for transportation, lodging or meals are unallowable unless incurred for the purpose of offering testimony at a regularly scheduled Congressional hearing pursuant to a written request for such presentation made by the Chairman or Ranking Minority Member of the Committee or Subcommittee conducting such hearing. (2) Any lobbying made unallowable by paragraph (a)(3) of this subsection to influence state or local legislation in order to directly reduce contract cost, or to avoid material impairment of the contractor’s authority to perform the contract. (3) Any activity specifically authorized by statute to be undertaken with funds from the contract. (c) When a contractor seeks reimbursement for indirect costs, total lobbying costs shall be separately identified in the indirect cost rate proposal, and thereafter treated as other unallowable activity costs. (d) Contractors shall maintain adequate records to demonstrate that the certification of costs as being allowable or unallowable (see 42.703-2) pursuant to this subsection complies with the requirements of this subsection. (e) Existing procedures should be utilized to resolve in advance any significant questions or disagreements concerning the interpretation or application of this subsection. 31.205-23 Losses on other contracts. An excess of costs over income under any other contract (including the contractor’s contributed portion under cost-sharing contracts) is unallowable. 31.205-24 [Reserved] 31.205-25 Manufacturing and production engineering costs. (a) The costs of manufacturing and production engineering effort as described in (1) through (4) of this paragraph are all allowable: (1) Developing and deploying new or improved materials, systems, processes, methods, equipment, tools and techniques that are or are expected to be used in producing products or services; (2) Developing and deploying pilot production lines; (3) Improving current production functions, such as plant layout, production scheduling and control, methods and job analysis, equipment capabilities and capacities, inspection techniques, and tooling analysis (including tooling design and application improvements); and (4) Material and manufacturing producibility analysis for production suitability and to optimize manufacturing processes, methods, and techniques. (b) This cost principle does not cover- (1) Basic and applied research effort (as defined in 31.205-18(a)) related to new technology, materials, systems, processes, methods, equipment, tools and techniques. Such technical effort is governed by 31.205-18, Independent research and development and bid and proposal costs; and (2) Development effort for manufacturing or production materials, systems, processes, methods, equipment, tools, and techniques that are intended for sale is also governed by 31.205-18. (c) Where manufacturing or production development costs are capitalized or required to be capitalized under the contractor’s capitalization policies, allowable cost will be determined in accordance with the requirements of 31.205-11, Depreciation. 31.205-26 Material costs. (a) Material costs include the costs of such items as raw materials, parts, subassemblies, components, and manufacturing supplies, whether purchased or manufactured by the contractor, and may include such collateral items as inbound transportation and in-transit insurance. In computing material costs, the contractor shall consider reasonable overruns, spoilage, or defective work (unless otherwise provided in any contract provision relating to inspecting and correcting defective work). (b) The contractor shall- (1) Adjust the costs of material for income and other credits, including available trade discounts, refunds, rebates, allowances, and cash discounts, and credits for scrap, salvage, and material returned to vendors; and (2) Credit such income and other credits either directly to the cost of the material or allocate such income and other credits as a credit to indirect costs. When the contractor can demonstrate that failure to take cash discounts was reasonable, the contractor does not need to credit lost discounts. (c) Reasonable adjustments arising from differences between periodic physical inventories and book inventories may be included in arriving at costs; provided such adjustments relate to the period of contract performance. (d) When materials are purchased specifically for and are identifiable solely with performance under a contract, the actual purchase cost of those materials should be charged to the contract. If material is issued from stores, any generally recognized method of pricing such material is acceptable if that method is consistently applied and the results are equitable. (e) Allowance for all materials, supplies and services that are sold or transferred between any divisions, subdivisions, subsidiaries, or affiliates of the contractor under a common control shall be on the basis of cost incurred in accordance with this subpart. However, allowance may be at price when- (1) It is the established practice of the transferring organization to price interorganizational transfers at other than cost for commercial work of the contractor or any division, subsidiary or affiliate of the contractor under a common control; and (2) The item being transferred qualifies for an exception under 15.403-1(b) and the contracting officer has not determined the price to be unreasonable. (f) When a commercial product or commercial service under paragraph (e) of this section is sold or transferred at a price based on a catalog or market price, the contractor— (1) Should adjust the price to reflect the quantities being acquired; and (2) May adjust the price to reflect the actual cost of any modifications necessary because of contract requirements. 31.205-27 Organization costs. (a) Except as provided in paragraph (b) of this subsection, expenditures in connection with (1) planning or executing the organization or reorganization of the corporate structure of a business, including mergers and acquisitions, (2) resisting or planning to resist the reorganization of the corporate structure of a business or a change in the controlling interest in the ownership of a business, and (3) raising capital (net worth plus long-term liabilities), are unallowable. Such expenditures include but are not limited to incorporation fees and costs of attorneys, accountants, brokers, promoters and organizers, management consultants and investment counselors, whether or not employees of the contractor. Unallowable "reorganization" costs include the cost of any change in the contractor’s financial structure, excluding administrative costs of short-term borrowings for working capital, resulting in alterations in the rights and interests of security holders, whether or not additional capital is raised. (b) The cost of activities primarily intended to provide compensation will not be considered organizational costs subject to this subsection, but will be governed by 31.205-6. These activities include acquiring stock for- (1) Executive bonuses, (2) Employee savings plans, and (3) Employee stock ownership plans. 31.205-28 Other business expenses. The following types of recurring costs are allowable: (a) Registry and transfer charges resulting from changes in ownership of securities issued by the contractor. (b) Cost of shareholders’ meetings. (c) Normal proxy solicitations. (d) Preparing and publishing reports to shareholders. (e) Preparing and submitting required reports and forms to taxing and other regulatory bodies. (f) Incidental costs of directors’ and committee meetings. (g) Other similar costs. 31.205-29 Plant protection costs. Costs of items such as- (a) Wages, uniforms, and equipment of personnel engaged in plant protection, (b) Depreciation on plant protection capital assets, and (c) Necessary expenses to comply with military requirements, are allowable. 31.205-30 Patent costs. (a) The following patent costs are allowable to the extent that they are incurred as requirements of a Government contract (but see 31.205-33): (1) Costs of preparing invention disclosures, reports, and other documents. (2) Costs for searching the art to the extent necessary to make the invention disclosures. (3) Other costs in connection with the filing and prosecution of a United States patent application where title or royalty-free license is to be conveyed to the Government. (b) General counseling services relating to patent matters, such as advice on patent laws, regulations, clauses, and employee agreements, are allowable (but see 31.205-33). (c) Other than those for general counseling services, patent costs not required by the contract are unallowable. (See also 31.205-37.) 31.205-31 Plant reconversion costs. Plant reconversion costs are those incurred in restoring or rehabilitating the contractor’s facilities to approximately the same condition existing immediately before the start of the Government contract, fair wear and tear excepted. Reconversion costs are unallowable except for the cost of removing Government property and the restoration or rehabilitation costs caused by such removal. However, in special circumstances where equity so dictates, additional costs may be allowed to the extent agreed upon before costs are incurred. Care should be exercised to avoid duplication through allowance as contingencies, additional profit or fee, or in other contracts. 31.205-32 Precontract costs. Precontract costs means costs incurred before the effective date of the contract directly pursuant to the negotiation and in anticipation of the contract award when such incurrence is necessary to comply with the proposed contract delivery schedule. These costs are allowable to the extent that they would have been allowable if incurred after the date of the contract (see 31.109). 31.205-33 Professional and consultant service costs. (a) Definition. "Professional and consultant services," as used in this subsection, means those services rendered by persons who are members of a particular profession or possess a special skill and who are not officers or employees of the contractor. Examples include those services acquired by contractors or subcontractors in order to enhance their legal, economic, financial, or technical positions. Professional and consultant services are generally acquired to obtain information, advice, opinions, alternatives, conclusions, recommendations, training, or direct assistance, such as studies, analyses, evaluations, liaison with Government officials, or other forms of representation. (b) Costs of professional and consultant services are allowable subject to this paragraph and paragraphs (c) through (f) of this subsection when reasonable in relation to the services rendered and when not contingent upon recovery of the costs from the Government (but see 31.205-30 and 31.205-47). (c) Costs of professional and consultant services performed under any of the following circumstances are unallowable: (1) Services to improperly obtain, distribute, or use information or data protected by law or regulation (e.g., 52.215-1(e), Restriction on Disclosure and Use of Data). (2) Services that are intended to improperly influence the contents of solicitations, the evaluation of proposals or quotations, or the selection of sources for contract award, whether award is by the Government, or by a prime contractor or subcontractor. (3) Any other services obtained, performed, or otherwise resulting in violation of any statute or regulation prohibiting improper business practices or conflicts of interest. (4) Services performed which are not consistent with the purpose and scope of the services contracted for or otherwise agreed to. (d) In determining the allowability of costs (including retainer fees) in a particular case, no single factor or any special combination of factors is necessarily determinative. However, the contracting officer shall consider the following factors, among others: (1) The nature and scope of the service rendered in relation to the service required. (2) The necessity of contracting for the service, considering the contractor’s capability in the particular area. (3) The past pattern of acquiring such services and their costs, particularly in the years prior to the award of Government contracts. (4) The impact of Government contracts on the contractor’s business. (5) Whether the proportion of Government work to the contractor’s total business is such as to influence the contractor in favor of incurring the cost, particularly when the services rendered are not of a continuing nature and have little relationship to work under Government contracts. (6) Whether the service can be performed more economically by employment rather than by contracting. (7) The qualifications of the individual or concern rendering the service and the customary fee charged, especially on non-Government contracts. (8) Adequacy of the contractual agreement for the service (e.g., description of the service, estimate of time required, rate of compensation, termination provisions). (e) Retainer fees, to be allowable, must be supported by evidence that- (1) The services covered by the retainer agreement are necessary and customary; (2) The level of past services justifies the amount of the retainer fees (if no services were rendered, fees are not automatically unallowable); (3) The retainer fee is reasonable in comparison with maintaining an in-house capability to perform the covered services, when factors such as cost and level of expertise are considered; and (4) The actual services performed are documented in accordance with paragraph (f) of this subsection. (f) Fees for services rendered are allowable only when supported by evidence of the nature and scope of the service furnished (see also 31.205-38(c)). However, retainer agreements generally are not based on specific statements of work. Evidence necessary to determine that work performed is proper and does not violate law or regulation shall include- (1) Details of all agreements (e.g., work requirements, rate of compensation, and nature and amount of other expenses, if any) with the individuals or organizations providing the services and details of actual services performed; (2) Invoices or billings submitted by consultants, including sufficient detail as to the time expended and nature of the actual services provided; and (3) Consultants’ work products and related documents, such as trip reports indicating persons visited and subjects discussed, minutes of meetings, and collateral memoranda and reports. 31.205-34 Recruitment costs. (a) Subject to paragraph (b) of this subsection, the following costs are allowable: (1) Costs of help-wanted advertising. (2) Costs of operating an employment office needed to secure and maintain an adequate labor force. (3) Costs of operating an aptitude and educational testing program. (4) Travel costs of employees engaged in recruiting personnel. (5) Travel costs of applicants for interviews. (6) Costs for employment agencies, not in excess of standard commercial rates. (b) Help-wanted advertising costs are unallowable if the advertising- (1) Does not describe specific positions or classes of positions; or (2) Includes material that is not relevant for recruitment purposes, such as extensive illustrations or descriptions of the company’s products or capabilities. 31.205-35 Relocation costs. (a) Relocation costs are costs incident to the permanent change of assigned work location (for a period of 12 months or more) of an existing employee or upon recruitment of a new employee. The following types of relocation costs are allowable as noted, subject to the limitations in paragraphs (b) and (f) of this subsection: (1) Costs of travel of the employee and members of the employee’s immediate family (see 31.205-46) and transportation of the household and personal effects to the new location. (2) Costs of finding a new home, such as advance trips by the employee or the spouse, or both, to locate living quarters, and temporary lodging during the transition period for the employee and members of the employee’s immediate family. (3) Closing costs incident to the disposition of the actual residence owned by the employee when notified of the transfer (e.g., brokerage fees, legal fees, appraisal fees, points, and finance charges), except that these costs, when added to the costs described in paragraph (a)(4) of this subsection, shall not exceed 14 percent of the sales price of the property sold. (4) Continuing costs of ownership of the vacant former actual residence being sold, such as maintenance of building and grounds (exclusive of fixing up expenses), utilities, taxes, property insurance, and mortgage interest, after the settlement date or lease date of a new permanent residence, except that these costs, when added to the costs described in paragraph (a)(3) of this subsection, shall not exceed 14 percent of the sales price of the property sold. (5) Other necessary and reasonable expenses normally incident to relocation, such as disconnecting and connecting household appliances; automobile registration; driver’s license and use taxes; cutting and fitting rugs, draperies, and curtains; forfeited utility fees and deposits; and purchase of insurance against damage to or loss of personal property while in transit. (6) Costs incident to acquiring a home in the new work location, except that- (i) These costs are not allowable for existing employees or newly recruited employees who were not homeowners before the relocation; and (ii) The total costs shall not exceed 5 percent of the purchase price of the new home. (7) Mortgage interest differential payments, except that these costs are not allowable for existing or newly recruited employees who, before the relocation, were not homeowners and the total payments are limited to an amount determined as follows: (i) The difference between the mortgage interest rates of the old and new residences times the current balance of the old mortgage times 3 years. (ii) When mortgage differential payments are made on a lump-sum basis and the employee leaves or is transferred again in less than 3 years, the amount initially recognized shall be proportionately adjusted to reflect payments only for the actual time of the relocation. (8) Rental differential payments covering situations where relocated employees retain ownership of a vacated home in the old location and rent at the new location. The rented quarters at the new location must be comparable to those vacated, and the allowable differential payments may not exceed the actual rental costs for the new home, less the fair market rent for the vacated home times 3 years. (9) Costs of canceling an unexpired lease. (10) Payments for increased employee income or Federal Insurance Contributions Act ( 26 U.S.C.Chapter21) taxes incident to allowable reimbursed relocation costs. (11) Payments for spouse employment assistance. (b) The costs described in paragraph (a) of this subsection must also meet the following criteria to be considered allowable: (1) The move must be for the benefit of the employer. (2) Reimbursement must be in accordance with an established policy or practice that is consistently followed by the employer and is designed to motivate employees to relocate promptly and economically. (3) The costs must not be otherwise unallowable under subpart 31.2. (4) Amounts to be reimbursed shall not exceed the employee’s actual expenses, except as provided for in paragraphs (b)(5) and (b)(6) of this subsection. (5) For miscellaneous costs of the type discussed in paragraph (a)(5) of this subsection, a lump-sum amount, not to exceed $5,000, may be allowed in lieu of actual costs. (i) Reimbursement on a lump-sum basis may be allowed for any of the following relocation costs when adequately supported by data on the individual elements (e.g., transportation, lodging, and meals) comprising the build-up of the lump-sum amount to be paid based on the circumstances of the particular employee’s relocation: (A) Costs of finding a new home, as discussed in paragraph (a)(2) of this subsection. (B) Costs of travel to the new location, as discussed in paragraph (a)(1) of this subsection (but not costs for the transportation of household goods). (C) Costs of temporary lodging, as discussed in paragraph (a)(2) of this subsection. (ii) When reimbursement on a lump-sum basis is used, any adjustments to reflect actual costs are unallowable. (c) The following types of costs are unallowable: (1) Loss on the sale of a home. (2) Costs incident to acquiring a home in the new location as follows: (i) Real estate brokers’ fees and commissions. (ii) Costs of litigation. (iii) Real and personal property insurance against damage or loss of property. (iv) Mortgage life insurance. (v) Owner’s title policy insurance when such insurance was not previously carried by the employee on the old residence. (However, the cost of a mortgage title policy is allowable.) (vi) Property taxes and operating or maintenance costs. (3) Continuing mortgage principal payments on a residence being sold. (4) Costs incident to furnishing equity or nonequity loans to employees or making arrangements with lenders for employees to obtain lower-than-market rate mortgage loans. (d) If relocation costs for an employee have been allowed either as an allocable indirect or direct cost, and the employee resigns within 12 months for reasons within the employee’s control, the contractor shall refund or credit the relocation costs to the Government. (e) Subject to the requirements of paragraphs (a) through (d) of this section, the costs of family movements and of personnel movements of a special or mass nature are allowable. The cost, however, should be assigned on the basis of work (contracts) or time period benefited. (f) Relocation costs (both outgoing and return) of employees who are hired for performance on specific contracts or long-term field projects are allowable if- (1) The term of employment is 12 months or more; (2) The employment agreement specifically limits the duration of employment to the time spent on the contract or field project for which the employee is hired; (3) The employment agreement provides for return relocation to the employee’s permanent and principal home immediately prior to the outgoing relocation, or other location of equal or lesser cost; and (4) The relocation costs are determined under the rules of paragraphs (a) through (d) of this section. However, the costs to return employees, who are released from employment upon completion of field assignments pursuant to their employment agreements, are not subject to the refund or credit requirement of paragraph (d). 31.205-36 Rental costs. (a) This subsection is applicable to the cost of renting or leasing real or personal property acquired under "operating leases" as defined in Financial Accounting Standards Board’s Accounting Standards Codification (FASB ASC) 840, Leases. (See 31.205-11 for Capital Leases.) (b) The following costs are allowable: (1) Rental costs under operating leases, to the extent that the rates are reasonable at the time of the lease decision, after consideration of- (i) Rental costs of comparable property, if any; (ii) Market conditions in the area; (iii) The type, life expectancy, condition, and value of the property leased; (iv) Alternatives available; and (v) Other provisions of the agreement. (2) Rental costs under a sale and leaseback arrangement only up to the amount the contractor would be allowed if the contractor retained title, computed based on the net book value of the asset on the date the contractor becomes a lessee of the property adjusted for any gain or loss recognized in accordance with 31.205-16(b). (3) Charges in the nature of rent for property between any divisions, subsidiaries, or organizations under common control, to the extent that they do not exceed the normal costs of ownership, such as depreciation, taxes, insurance, facilities capital cost of money, and maintenance (excluding interest or other unallowable costs pursuant to part 31), provided that no part of such costs shall duplicate any other allowed cost. Rental cost of personal property leased from any division, subsidiary, or affiliate of the contractor under common control, that has an established practice of leasing the same or similar property to unaffiliated lessees shall be allowed in accordance with paragraph (b)(1) of this subsection. (c) The allowability of rental costs under unexpired leases in connection with terminations is treated in 31.205-42(e). 31.205-37 Royalties and other costs for use of patents. (a) Royalties on a patent or amortization of the cost of purchasing a patent or patent rights necessary for the proper performance of the contract and applicable to contract products or processes are allowable unless- (1) The Government has a license or the right to a free use of the patent; (2) The patent has been adjudicated to be invalid, or has been administratively determined to be invalid; (3) The patent is considered to be unenforceable; or (4) The patent is expired. (b) Care should be exercised in determining reasonableness when the royalties may have been arrived at as a result of less-than-arm’s-length bargaining; e.g.,royalties- (1) Paid to persons, including corporations, affiliated with the contractor; (2) Paid to unaffiliated parties, including corporations, under an agreement entered into in contemplation that a Government contract would be awarded; or (3) Paid under an agreement entered into after the contract award. (c) In any case involving a patent formerly owned by the contractor, the royalty amount allowed should not exceed the cost which would have been allowed had the contractor retained title. (d) See 31.109 regarding advance agreements. 31.205-38 Selling costs. (a) "Selling" is a generic term encompassing all efforts to market the contractor’s products or services, some of which are covered specifically in other subsections of 31.205. The costs of any selling efforts other than those addressed in this cost principle are unallowable. (b) Selling activity includes the following broad categories: (1) Advertising. Advertising is defined at 31.205-1(b), and advertising costs are subject to the allowability provisions of 31.205-1(d) and (f). (2) Corporate image enhancement. Corporate image enhancement activities, including broadly targeted sales efforts, other than advertising, are included within the definition of public relations at 31.205-1(a), and the costs of such efforts are subject to the allowability provisions at 31.205-1(e) and (f). (3) Bid and proposal costs. Bid and proposal costs are defined at 31.205-18 and are subject to the allowability provisions of that subsection. (4) Market planning. Market planning involves market research and analysis and general management planning concerned with development of the contractor’s business. Long-range market planning costs are subject to the allowability provisions of 31.205-12. Other market planning costs are allowable. (5) Direct selling. Direct selling efforts are those acts or actions to induce particular customers to purchase particular products or services of the contractor. Direct selling is characterized by person-to-person contact and includes such efforts as familiarizing a potential customer with the contractor’s products or services, conditions of sale, service capabilities, etc. It also includes negotiation, liaison between customer and contractor personnel, technical and consulting efforts, individual demonstrations, and any other efforts having as their purpose the application or adaptation of the contractor’s products or services for a particular customer’s use. The cost of direct selling efforts is allowable. (c) Notwithstanding any other provision of this subsection, sellers’ or agents’ compensation, fees, commissions, percentages, retainer or brokerage fees, whether or not contingent upon the award of contracts, are allowable only when paid to bona fide employees or established commercial or selling agencies maintained by the contractor for the purpose of securing business. 31.205-39 Service and warranty costs. Service and warranty costs include those arising from fulfillment of any contractual obligation of a contractor to provide services such as installation, training, correcting defects in the products, replacing defective parts, and making refunds in the case of inadequate performance. When not inconsistent with the terms of the contract, service and warranty costs are allowable. However, care should be exercised to avoid duplication of the allowance as an element of both estimated product cost and risk. 31.205-40 Special tooling and special test equipment costs. (a) The terms "special tooling" and "special test equipment" are defined in 2.101(b). (b) The cost of special tooling and special test equipment used in performing one or more Government contracts is allowable and shall be allocated to the specific Government contract or contracts for which acquired, except that the cost of- (1) Items acquired by the contractor before the effective date of the contract (or replacement of such items), whether or not altered or adapted for use in performing the contract, and (2) Items which the contract schedule specifically excludes, shall be allowable only as depreciation or amortization. (c) When items are disqualified as special tooling or special test equipment because with relatively minor expense they can be made suitable for general purpose use and have a value as such commensurate with their value as special tooling or special test equipment, the cost of adapting the items for use under the contract and the cost of returning them to their prior configuration are allowable. 31.205-41 Taxes. (a) The following types of costs are allowable: (1) Federal, State, and local taxes (see part 29), except as otherwise provided in paragraph (b) of this section that are required to be and are paid or accrued in accordance with generally accepted accounting principles. Fines and penalties are not considered taxes. (2) Taxes otherwise allowable under paragraph (a)(1) of this section, but upon which a claim of illegality or erroneous assessment exists; provided the contractor, before paying such taxes- (i) Promptly requests instructions from the contracting officer concerning such taxes; and (ii) Takes all action directed by the contracting officer arising out of paragraph (2)(i) of this section or an independent decision of the Government as to the existence of a claim of illegality or erroneous assessment, to- (A) Determine the legality of the assessment or (B) Secure a refund of such taxes. (3) Pursuant to paragraph (a)(2) of this section, the reasonable costs of any action taken by the contractor at the direction or with the concurrence of the contracting officer. Interest or penalties incurred by the contractor for non-payment of any tax at the direction of the contracting officer or by reason of the failure of the contracting officer to ensure timely direction after a prompt request. (4) The Environmental Tax found at section 59 A of the Internal Revenue Code, also called the "Superfund Tax." (b) The following types of costs are not allowable: (1) Federal income and excess profits taxes. (2) Taxes in connection with financing, refinancing, refunding operations, or reorganizations (see 31.205-20 and 31.205-27). (3) Taxes from which exemptions are available to the contractor directly, or available to the contractor based on an exemption afforded the Government, except when the contracting officer determines that the administrative burden incident to obtaining the exemption outweighs the corresponding benefits accruing to the Government. When partial exemption from a tax is attributable to Government contract activity, taxes charged to such work in excess of that amount resulting from application of the preferential treatment are unallowable. These provisions intend that tax preference attributable to Government contract activity be realized by the Government. The term "exemption" means freedom from taxation in whole or in part and includes a tax abatement or reduction resulting from mode of assessment, method of calculation, or otherwise. (4) Special assessments on land that represent capital improvements. (5) Taxes (including excises) on real or personal property, or on the value, use, possession or sale thereof, which is used solely in connection with work other than on Government contracts (see paragraph (c) of this section). (6) Any excise tax in subtitleD, Chapter 43 of the Internal Revenue Code of1986, as amended. That chapter includes excise taxes imposed in connection with qualified pension plans, welfare plans, deferred compensation plans, or other similar types of plans. (7) Income tax accruals designed to account for the tax effects of differences between taxable income and pretax income as reflected by the books of account and financial statements. (8) Any tax imposed under 26 U.S.C. 5000 C. (c) Taxes on property (see paragraph (b)(5) of this section) used solely in connection with either non-Government or Government work should be considered directly applicable to the respective category of work unless the amounts involved are insignificant or comparable results would otherwise be obtained; e.g., taxes on contractor-owned work-in-process which is used solely in connection with non-Government work should be allocated to such work; taxes on contractor-owned work-in-process inventory (and Government-owned work-in-process inventory when taxed) used solely in connection with Government work should be charged to such work. The cost of taxes incurred on property used in both Government and non-Government work shall be apportioned to all such work based upon the use of such property on the respective final cost objectives. (d) Any taxes, interest, or penalties that were allowed as contract costs and are refunded to the contractor shall be credited or paid to the Government in the manner it directs. If a contractor or subcontractor obtains a foreign tax credit that reduces its U.S. Federal income tax because of the payment of any tax or duty allowed as contract costs, and if those costs were reimbursed by a foreign government, the amount of the reduction shall be paid to the Treasurer of the United States at the time the Federal income tax return is filed. However, any interest actually paid or credited to a contractor incident to a refund of tax, interest, or penalty shall be paid or credited to the Government only to the extent that such interest accrued over the period during which the contractor had been reimbursed by the Government for the taxes, interest, or penalties. 31.205-42 Termination costs. Contract terminations generally give rise to the incurrence of costs or the need for special treatment of costs that would not have arisen had the contract not been terminated. The following cost principles peculiar to termination situations are to be used in conjunction with the other cost principles in subpart 31.2: (a) Common items. The costs of items reasonably usable on the contractor’s other work shall not be allowable unless the contractor submits evidence that the items could not be retained at cost without sustaining a loss. The contracting officer should consider the contractor’s plans and orders for current and planned production when determining if items can reasonably be used on other work of the contractor. Contemporaneous purchases of common items by the contractor shall be regarded as evidence that such items are reasonably usable on the contractor’s other work. Any acceptance of common items as allocable to the terminated portion of the contract should be limited to the extent that the quantities of such items on hand, in transit, and on order are in excess of the reasonable quantitative requirements of other work. (b) Costs continuing after termination. Despite all reasonable efforts by the contractor, costs which cannot be discontinued immediately after the effective date of termination are generally allowable. However, any costs continuing after the effective date of the termination due to the negligent or willful failure of the contractor to discontinue the costs shall be unallowable. (c) Initial costs. Initial costs, including starting load and preparatory costs, are allowable as follows: (1) Starting load costs not fully absorbed because of termination are nonrecurring labor, material, and related overhead costs incurred in the early part of production and result from factors such as- (i) Excessive spoilage due to inexperienced labor; (ii) Idle time and subnormal production due to testing and changing production methods; (iii) Training; and (iv) Lack of familiarity or experience with the product, materials, or manufacturing processes. (2) Preparatory costs incurred in preparing to perform the terminated contract include such costs as those incurred for initial plant rearrangement and alterations, management and personnel organization, and production planning. They do not include special machinery and equipment and starting load costs. (3) When initial costs are included in the settlement proposal as a direct charge, such costs shall not also be included in overhead. Initial costs attributable to only one contract shall not be allocated to other contracts. (4) If initial costs are claimed and have not been segregated on the contractor’s books, they shall be segregated for settlement purposes from cost reports and schedules reflecting that high unit cost incurred during the early stages of the contract. (5) If the settlement proposal is on the inventory basis, initial costs should normally be allocated on the basis of total end items called for by the contract immediately before termination; however, if the contract includes end items of a diverse nature, some other equitable basis may be used, such as machine or labor hours. (d) Loss of useful value. Loss of useful value of special tooling, and special machinery and equipment is generally allowable, provided- (1) The special tooling, or special machinery and equipment is not reasonably capable of use in the other work of the contractor; (2) The Government’s interest is protected by transfer of title or by other means deemed appropriate by the contracting officer; and (3) The loss of useful value for any one terminated contract is limited to that portion of the acquisition cost which bears the same ratio to the total acquisition cost as the terminated portion of the contract bears to the entire terminated contract and other Government contracts for which the special tooling, or special machinery and equipment was acquired. (e) Rental under unexpired leases. Rental costs under unexpired leases, less the residual value of such leases, are generally allowable when shown to have been reasonably necessary for the performance of the terminated contract, if- (1) The amount of rental claimed does not exceed the reasonable use value of the property leased for the period of the contract and such further period as may be reasonable; and (2) The contractor makes all reasonable efforts to terminate, assign, settle, or otherwise reduce the cost of such lease. (f) Alterations of leased property. The cost of alterations and reasonable restorations required by the lease may be allowed when the alterations were necessary for performing the contract. (g) Settlement expenses. (1) Settlement expenses, including the following, are generally allowable: (i) Accounting, legal, clerical, and similar costs reasonably necessary for- (A) The preparation and presentation, including supporting data, of settlement claims to the contracting officer; and (B) The termination and settlement of subcontracts. (ii) Reasonable costs for the storage, transportation, protection, and disposition of property acquired or produced for the contract. (iii) Indirect costs related to salary and wages incurred as settlement expenses in (i) and (ii); normally, such indirect costs shall be limited to payroll taxes, fringe benefits, occupancy costs, and immediate supervision costs. (2) If settlement expenses are significant, a cost account or work order shall be established to separately identify and accumulate them. (h) Subcontractor claims. Subcontractor claims, including the allocable portion of the claims common to the contract and to other work of the contractor, are generally allowable. An appropriate share of the contractor’s indirect expense may be allocated to the amount of settlements with subcontractors; provided, that the amount allocated is reasonably proportionate to the relative benefits received and is otherwise consistent with 31.201-4 and 31.203(d). The indirect expense so allocated shall exclude the same and similar costs claimed directly or indirectly as settlement expenses. 31.205-43 Trade, business, technical and professional activity costs. The following types of costs are allowable: (a) Memberships in trade, business, technical, and professional organizations. (b) Subscriptions to trade, business, professional, or other technical periodicals. (c) When the principal purpose of a meeting, convention, conference, symposium, or seminar is the dissemination of trade, business, technical or professional information or the stimulation of production or improved productivity- (1) Costs of organizing, setting up, and sponsoring the meetings, conventions, symposia, etc., including rental of meeting facilities, transportation, subsistence, and incidental costs; (2) Costs of attendance by contractor employees, including travel costs (see 31.205-46); and (3) Costs of attendance by individuals who are not employees of the contractor, provided- (i) Such costs are not also reimbursed to the individual by the employing company or organization, and (ii) The individuals attendance is essential to achieve the purpose of the conference, meeting, convention, symposium, etc. 31.205-44 Training and education costs. Costs of training and education that are related to the field in which the employee is working or may reasonably be expected to work are allowable, except as follows: (a) Overtime compensation for training and education is unallowable. (b) The cost of salaries for attending undergraduate level classes or part-time graduate level classes during working hours is unallowable, except when unusual circumstances do not permit attendance at such classes outside of regular working hours. (c) Costs of tuition, fees, training materials and textbooks, subsistence, salary, and any other payments in connection with full-time graduate level education are unallowable for any portion of the program that exceeds two school years or the length of the degree program, whichever is less. (d) Grants to educational or training institutions, including the donation of facilities or other properties, scholarships, and fellowships are considered contributions and are unallowable. (e) Training or education costs for other than bona fide employees are unallowable, except that the costs incurred for educating employee dependents (primary and secondary level studies) when the employee is working in a foreign country where suitable public education is not available may be included in overseas differential pay. (f) Contractor contributions to college savings plans for employee dependents are unallowable. 31.205-46 Travel costs. (a) Costs for transportation, lodging, meals, and incidental expenses. (1) Costs incurred by contractor personnel on official company business are allowable, subject to the limitations contained in this subsection. Costs for transportation may be based on mileage rates, actual costs incurred, or on a combination thereof, provided the method used results in a reasonable charge. Costs for lodging, meals, and incidental expenses may be based on per diem, actual expenses, or a combination thereof, provided the method used results in a reasonable charge. (2) Except as provided in paragraph (a)(3) of this subsection, costs incurred for lodging, meals, and incidental expenses (as defined in the regulations cited in (a)(2)(i) through (iii) of this section) shall be considered to be reasonable and allowable only to the extent that they do not exceed on a daily basis the maximum per diem rates in effect at the time of travel as set forth in the- (i) Federal Travel Regulations, prescribed by the General Services Administration, for travel in the contiguous United States, available on a subscription basis from the- Superintendent of Documents U.S. Government Publishing Office Stock No.922-002-00000-2; (ii) Joint Travel Regulation, Volume2, DoD Civilian Personnel, AppendixA, prescribed by the Department of Defense, for travel in Alaska, Hawaii, and outlying areas of the United States, available on a subscription basis from the- Stock No.908-010-00000-1; or (iii) Standardized Regulations (Government Civilians, Foreign Areas), Section 925, "Maximum Travel Per Diem Allowances for Foreign Areas," prescribed by the Department of State, for travel in areas not covered in (a)(2)(i) and (ii) of this paragraph, available on a subscription basis from the- Stock No.744-008-00000-0. (3) In special or unusual situations, actual costs in excess of the above-referenced maximum per diem rates are allowable provided that such amounts do not exceed the higher amounts authorized for Federal civilian employees as permitted in the regulations referenced in (a)(2)(i), (ii), or (iii) of this section. For such higher amounts to be allowable, all of the following conditions must be met: (i) One of the conditions warranting approval of the actual expense method, as set forth in the regulations referenced in paragraphs (a)(2)(i), (ii), or (iii) of this section, must exist. (ii) A written justification for use of the higher amounts must be approved by an officer of the contractor’s organization or designee to ensure that the authority is properly administered and controlled to prevent abuse. (iii) If it becomes necessary to exercise the authority to use the higher actual expense method repetitively or on a continuing basis in a particular area, the contractor must obtain advance approval from the contracting officer. (iv) Documentation to support actual costs incurred shall be in accordance with the contractor’s established practices, subject to paragraph (a)(7) of this section, and provided that a receipt is required for each expenditure of $75.00 or more. The approved justification required by paragraph (a)(3)(ii) of this section and, if applicable, paragraph (a)(3)(iii) of this section must be retained. (4) Paragraphs (a)(2) and (3) of this section do not incorporate the regulations cited in paragraphs (a)(2)(i), (ii), and (iii) of this section in their entirety. Only the maximum per diem rates, the definitions of lodging, meals, and incidental expenses, and the regulatory coverage dealing with special or unusual situations are incorporated herein. (5) An advance agreement (see 31.109) with respect to compliance with paragraphs (a)(2) and (3) of this subsection may be useful and desirable. (6) The maximum per diem rates referenced in paragraph (a)(2) of this subsection generally would not constitute a reasonable daily charge- (i) When no lodging costs are incurred; and/or (ii) On partial travel days (e.g., day of departure and return). Appropriate downward adjustments from the maximum per diem rates would normally be required under these circumstances. While these adjustments need not be calculated in accordance with the Federal Travel Regulation or Joint Travel Regulations, they must result in a reasonable charge. (7) Costs shall be allowable only if the following information is documented- (i) Date and place (city, town, or other similar designation) of the expenses; (ii) Purpose of the trip; and (iii) Name of person on trip and that person’s title or relationship to the contractor. (b) Airfare costs in excess of the lowest priced airfare available to the contractor during normal business hours are unallowable except when such accommodations require circuitous routing, require travel during unreasonable hours, excessively prolong travel, result in increased cost that would offset transportation savings, are not reasonably adequate for the physical or medical needs of the traveler, or are not reasonably available to meet mission requirements. However, in order for airfare costs in excess of the above airfare to be allowable, the applicable condition(s) set forth above must be documented and justified. (1) "Cost of travel by contractor-owned, -leased, or -chartered aircraft," as used in this paragraph, includes the cost of lease, charter, operation (including personnel), maintenance, depreciation, insurance, and other related costs. (2) The costs of travel by contractor-owned, -leased, or -chartered aircraft are limited to the allowable airfare described in paragraph (b) of this section for the flight destination unless travel by such aircraft is specifically required by contract specification, term, or condition, or a higher amount is approved by the contracting officer. A higher amount may be agreed to when one or more of the circumstances for justifying higher than allowable airfare listed in paragraph (b) of this section are applicable, or when an advance agreement under paragraph (c)(3) of this section has been executed. In all cases, travel by contractor-owned, -leased, or -chartered aircraft must be fully documented and justified. For each contractor-owned, -leased, or -chartered aircraft used for any business purpose which is charged or allocated, directly or indirectly, to a Government contract, the contractor must maintain and make available manifest/logs for all flights on such company aircraft. As a minimum, the manifest/log shall indicate- (i) Date, time, and points of departure; (ii) Destination, date, and time of arrival; (iii) Name of each passenger and relationship to the contractor; (iv) Authorization for trip; and (v) Purpose of trip. (3) Where an advance agreement is proposed (see 31.109), consideration may be given to the following: (i) Whether scheduled commercial airlines or other suitable, less costly, travel facilities are available at reasonable times, with reasonable frequency, and serve the required destinations conveniently. (ii) Whether increased flexibility in scheduling results in time savings and more effective use of personnel that would outweigh additional travel costs. (d) Costs of contractor-owned or -leased automobiles, as used in this paragraph, include the costs of lease, operation (including personnel), maintenance, depreciation, insurance, etc. These costs are allowable, if reasonable, to the extent that the automobiles are used for company business. That portion of the cost of company-furnished automobiles that relates to personal use by employees (including transportation to and from work) is compensation for personal services and is unallowable as stated in 31.205-6(m)(2). 31.205-47 Costs related to legal and other proceedings. Costs include, but are not limited to, administrative and clerical expenses; the costs of legal services, whether performed by in-house or private counsel; the costs of the services of accountants, consultants, or others retained by the contractor to assist it; costs of employees, officers, and directors; and any similar costs incurred before, during, and after commencement of a judicial or administrative proceeding which bears a direct relationship to the proceeding. Fraud means- (1) Acts of fraud or corruption or attempts to defraud the Government or to corrupt its agents; (2) Acts which constitute a cause for debarment or suspension under 9.406-2(a) and 9.407-2(a); and (3) Acts which violate the False Claims Act, 31 U.S.C., sections3729-3731, or 41 U.S.C. chapter 87, Kickbacks. Penalty does not include restitution, reimbursement, or compensatory damages. Proceeding includes an investigation. (b) Costs incurred in connection with any proceeding brought by: a Federal, State, local, or foreign government for a violation of, or failure to comply with, law or regulation by the contractor (including its agents or employees) ( 41 U.S.C. 4310 and 10 U.S.C. 3750); a contractor or subcontractor employee submitting a whistleblower complaint of reprisal in accordance with 41 U.S.C. 4712 or 10 U.S.C. 4701; or a third party in the name of the United States under the False Claims Act, 31 U.S.C.3730, are unallowable if the result is- (1) In a criminal proceeding, a conviction; (2) In a civil or administrative proceeding, either a finding of contractor liability where the proceeding involves an allegation of fraud or similar misconduct; or imposition of a monetary penalty, or an order issued by the agency head to the contractor or subcontractor to take corrective action under 41 U.S.C. 4712 or 10 U.S.C. 4701, where the proceeding does not involve an allegation of fraud or similar misconduct; (3) A final decision by an appropriate official of an executive agency to- (i) Debar or suspend the contractor; (ii) Rescind or void a contract; or (iii) Terminate a contract for default by reason of a violation or failure to comply with a law or regulation. (4) Disposition of the matter by consent or compromise if the proceeding could have led to any of the outcomes listed in paragraphs (b)(1) through (3) of this subsection (but see paragraphs (c) and (d) of this subsection); or (5) Not covered by paragraphs (b)(1) through (4) of this subsection, but where the underlying alleged contractor misconduct was the same as that which led to a different proceeding whose costs are unallowable by reason of paragraphs (b)(1) through (4) of this subsection. (1) To the extent they are not otherwise unallowable, costs incurred in connection with any proceeding under paragraph (b) of this subsection commenced by the United States that is resolved by consent or compromise pursuant to an agreement entered into between the contractor and the United States, and which are unallowable solely because of paragraph (b) of this subsection, may be allowed to the extent specifically provided in such agreement (i) In the event of a settlement of any proceeding brought by a third party under the False Claims Act in which the United States did not intervene, reasonable costs incurred by the contractor in connection with such a proceeding that are not otherwise unallowable by regulation or by separate agreement with the United States may be allowed if the contracting officer, in consultation with his or her legal advisor, determines that there was very little likelihood that the third party would have been successful on the merits. (ii) In the event of disposition by consent or compromise of a proceeding brought by a whistleblower for alleged reprisal in accordance with 41 U.S.C. 4712 or 10 U.S.C. 4701, reasonable costs incurred by a contractor or subcontractor in connection with such a proceeding that are not otherwise unallowable by regulation or by agreement with the United States may be allowed if the contracting officer, in consultation with his or her legal advisor, determined that there was very little likelihood that the claimant would have been successful on the merits. (d) To the extent that they are not otherwise unallowable, costs incurred in connection with any proceeding under paragraph (b) of this subsection commenced by a State, local, or foreign government may be allowable when the contracting officer (or other official specified in agency procedures) determines, that the costs were incurred either: (1) As a direct result of a specific term or condition of a Federal contract; or (2) As a result of compliance with specific written direction of the cognizant contracting officer. (e) Costs incurred in connection with proceedings described in paragraph (b) of this subsection, but which are not made unallowable by that paragraph, may be allowable to the extent that: (1) The costs are reasonable in relation to the activities required to deal with the proceeding and the underlying cause of action; (2) The costs are not otherwise recovered from the Federal Government or a third party, either directly as a result of the proceeding or otherwise; and (3) The percentage of costs allowed does not exceed the percentage determined to be appropriate considering the complexity of procurement litigation, generally accepted principles governing the award of legal fees in civil actions involving the United States as a party, and such other factors as may be appropriate. Such percentage shall not exceed 80 percent. Agreements reached under paragraph (c) of this subsection shall be subject to this limitation. If, however, an agreement described in paragraph (c)(1) of this subsection explicitly states the amount of otherwise allowable incurred legal fees and limits the allowable recovery to 80 percent or less of the stated legal fees, no additional limitation need be applied. The amount of reimbursement allowed for legal costs in connection with any proceeding described in paragraph (c)(2) of this subsection shall be determined by the cognizant contracting officer, but shall not exceed 80 percent of otherwise allowable legal costs incurred. (f) Costs not covered elsewhere in this subsection are unallowable if incurred in connection with: (1) Defense against Federal Government claims or appeals or the prosecution of claims or appeals against the Federal Government (see 2.101). (2) Organization, reorganization, (including mergers and acquisitions) or resisting mergers and acquisitions (see also 31.205-27). (3) Defense of antitrust suits. (4) Defense of suits brought by employees or ex-employees of the contractor under section 2 of the Major Fraud Act of1988 where the contractor was found liable or settled. (5) Costs of legal, accounting, and consultant services and directly associated costs incurred in connection with the defense or prosecution of lawsuits or appeals between contractors arising from either- (i) An agreement or contract concerning a teaming arrangement, a joint venture, or similar arrangement of shared interest; or (ii) Dual sourcing, coproduction, or similar programs, are unallowable, except when- (A) Incurred as a result of compliance with specific terms and conditions of the contract or written instructions from the contracting officer, or (B) When agreed to in writing by the contracting officer. (6) Patent infringement litigation, unless otherwise provided for in the contract. (7) Representation of, or assistance to, individuals, groups, or legal entities which the contractor is not legally bound to provide, arising from an action where the participant was convicted of violation of a law or regulation or was found liable in a civil or administrative proceeding. (8) Protests of Federal Government solicitations or contract awards, or the defense against protests of such solicitations or contract awards, unless the costs of defending against a protest are incurred pursuant to a written request from the cognizant contracting officer. (9) A Congressional investigation or inquiry into an issue that is the subject matter of a proceeding resulting in a disposition as described in paragraphs (b)(1) through (5) of this section (see 10 U.S.C. 3744(a)(17)). (g) Costs which may be unallowable under 31.205-47, including directly associated costs, shall be segregated and accounted for by the contractor separately. During the pendency of any proceeding covered by paragraph (b) and paragraphs (f)(4) and (f)(7) of this subsection, the contracting officer shall generally withhold payment of such costs. However, if in the best interests of the Government, the contracting officer may provide for conditional payment upon provision of adequate security, or other adequate assurance, and agreement by the contractor to repay all unallowable costs, plus interest, if the costs are subsequently determined to be unallowable. 31.205-48 Research and development costs. Research and development, as used in this subsection, means the type of technical effort described in 31.205-18 but sponsored by a grant or required in the performance of a contract. When costs are incurred in excess of either the price of a contract or amount of a grant for research and development effort, the excess is unallowable under any other Government contract. 31.205-49 Goodwill. Goodwill, an unidentifiable intangible asset, originates under the purchase method of accounting for a business combination when the price paid by the acquiring company exceeds the sum of the identifiable individual assets acquired less liabilities assumed, based upon their fair values. The excess is commonly referred to as goodwill. Goodwill may arise from the acquisition of a company as a whole or a portion thereof. Any costs for amortization, expensing, write-off, or write-down of goodwill (however represented) are unallowable. 31.205-51 Costs of alcoholic beverages. Costs of alcoholic beverages are unallowable. 31.205-52 Asset valuations resulting from business combinations. (a) For tangible capital assets, when the purchase method of accounting for a business combination is used, whether or not the contract or subcontract is subject to CAS, the allowable depreciation and cost of money shall be based on the capitalized asset values measured and assigned in accordance with 48 CFR9904.404-50(d), if allocable, reasonable, and not otherwise unallowable. (b) For intangible capital assets, when the purchase method of accounting for a business combination is used, allowable amortization and cost of money shall be limited to the total of the amounts that would have been allowed had the combination not taken place.

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professional_accounting

Tax Reform Update 3 By Candace Varner CPA Candace Varner, CPA Creative Planning Tax, LLC The House and Senate Republicans released their joint version of the Tax Cuts and Jobs Act on Friday. Both chambers will vote on the legislation this week and are expected to pass the bill, which will then be sent to the White House for the President’s signature. Below is information on many of the changes included in the bill. Most changes are effective January 1, 2018 and none will affect 2017 income tax returns filed during 2018. Individual Income Tax Rates: The number of income tax brackets remains the same, but the rates and applicable income thresholds are adjusted and the top rate is lowered from 39.6% to 37%. The individual income tax rates are effective beginning January 1, 2018 and are set to expire after 2025. The Alternative Minimum Tax is still in place for individuals, but with an increased exemption for tax years 2018-2025. The exemption is increased to $109,400 for married taxpayers filing jointly and $70,300 for all other taxpayers. The exemption phases out beginning at $1,000,000 and $500,000, respectively. The exemption and phase out amounts are indexed for inflation. Capital gain tax rates are unchanged at 0%, 15% and 20%. The brackets for capital gain income are unchanged as well, which means they will not follow the cut offs of brackets listed above. Instead, the rates apply to where previous brackets would have fallen. For 2018 the 0% rate will apply up to $77,200 for joint returns, $38,600 for single filers, 15% will apply up to $479,000 for joint returns, $425,800 for single filers, and 20% on income in excess of those amounts. These amounts are indexed for inflation. The net investment income tax remains unchanged at 3.8% for modified adjusted gross income over $250,000 for taxpayers filing jointly, $200,000 for taxpayers filing as single, and $12,500 for trusts & estates. Individual Taxpayer Deductions: The standard deduction is increased to $24,000 for taxpayers filing jointly and $12,000 for taxpayers filing single. The deductions were $12,700 and $6,350, respectively. The increased deduction is effective for 2018 through 2025. Personal exemptions are eliminated, effective 2018 through 2025. State and local income taxes, sales tax, real estate and personal property taxes are grouped together and deductible up to $10,000 per year in total. Previously there was no limit to the deductions. The limitation expires after 2025. For mortgage debt on personal residences originating after December 15, 2017, interest is deductible on principal up to $750,000 for tax years 2018-2025. Mortgages in place prior to that date retain deductions for interest on up to $1,000,000 of principal. Mortgages on up to two personal residences can still be deducted, under the total principal limits. Beginning in 2026 the law reverts to a limitation on interest for principal up to $1,000,000 for mortgages originated at any time. Additionally, deduction for any home equity debt interest is suspended for tax years 2018-2025. Medical expenses are deductible as an itemized deduction for any portion that exceed 7.5% of adjusted gross income, regardless of the taxpayer’s age. The reduction of this limitation is in place for 2017 and 2018 only. Charitable Donations: Cash charitable donations are limited to 60% of adjusted gross income, increased from 50%. No deduction is allowed for donations to higher education institutions when, in exchange, the payor receives the right to purchase tickets or seating at an athletic event. Qualified Charitable Distributions, which are distributions from a qualified retirement accounts directly to a charity by taxpayers over 70.5, remains unchanged and available up to $100,000. This method of charitable donations will be increasingly valuable as fewer taxpayer itemize their deductions and are therefore unable to benefit from cash or property donations. Miscellaneous itemized deductions are suspended for tax years 2018-2025. These include tax preparation fees, unreimbursed employee business expenses, investment expenses, professional and union dues. Deductions for casualty losses are limited to those attributable to federally declared disaster areas for tax years 2018 -2025. Expenses for a work related move are not deductible for tax years 2018-2025. During that same period qualified moving expenses paid by an employer are not excluded from the employee’s gross income. Overall limitations to itemized deductions are repealed for tax years 2018-2025. Payment of alimony pursuant to a divorce decree are not deductible by the payor for divorce or separation agreements executed after December 31, 2018. Income and deductions related to agreements exiting prior to that date will not be affected. Business Taxes: The top corporate tax rate is lowered from 35% to 21% beginning January 1, 2018. This applies to companies taxed as C-Corporations. The Alternative Minimum Tax is repealed for corporations and no change is made to the 35% rate applicable to personal service corporations. Qualified business income that is taxable on individual income tax returns, including partnerships, LLC’s, sole-proprietors and S-Corporation income, will receive a deduction of 20% of business income, subject to limitations. Qualified business income does not include wages or guaranteed payments paid from the business to the owners. The 20% deduction is phased out beginning when taxpayer’s total income is $315,000 for couples, $157,500 for taxpayer’s filing single, completely phasing out when income is $415,000 and $207,500, respectively. Once you are past the phase out amounts your total deduction begins to be limited to the lessor of qualified business income or, the greater of 50% of W-2 wages paid by the business, or the sum of 25% of the W-2 wages paid plus 2.5% of the unadjusted basis of all qualified property. Qualified property is defined as depreciable tangible property placed in service before the end of the taxable year, whose depreciable life is at least ten years and the depreciable life of the property has not ended prior to the close of the taxable year. Specified service businesses, which are any businesses which involves the performance of services, are eligible for the deduction only up to the phase out levels noted above. These include the fields of health, law, consulting, athletics, financial services, or any business where the reputation or skill of the employees and owners is a principal asset. The deduction is made from taxable income, it does not affect adjusted gross income. Net pass-through income after the 20% deduction is subject to taxpayer’s marginal income tax rates, listed above. If the taxpayer has a net qualified business loss, that loss will carry over to the next year and can be used to offset qualified business income in that year. Business Deductions: Business interest expense is now subject to a limitation for some taxpayers, while previously all business interest was deductible. Beginning in tax year 2018 business interest is limited to the sum of business interest income plus 30% of adjusted taxable income. Taxpayers with average annual gross receipts less than $25 million are exempt from the limitation. Any interest expense that is not deductible will be carried forward indefinitely. For pass-through entities the limitation is applied at the entity level rather than the individual level. Business interest does not include investment interest. Additional first year depreciation, or bonus depreciation, is expanded to be 100% of the cost of qualified assets placed in service September 27, 2017 through December 31, 2022. Beginning in 2023 the allowable bonus depreciation is reduced by 20% per year, making 80% bonus depreciation apply in 2023 and 0% bonus apply in 2027. Also, all property will now be eligible even if the original use does not commence with the taxpayer, previously only new assets qualified for bonus depreciation. Section 179 expensing is increased to $1,000,000 and the phase out is increased to begin at $2,500,000 of total assets placed in service. Expensing of sport utility vehicles is still limited to $25,000. All numbers are now indexed for inflation beginning in 2019. Passenger automobiles are subject to limited depreciation. The limits are increased to $10,000 the first year, up from $3,160 currently, $16,000 in the second year, $9,600 in the third year and $5,760 for fourth and later years for vehicles placed in service after 2017. Section 199 deduction for domestic production activities is repealed. Deductions for activities which are considered entertainment or recreation are no longer deductible. Previously 50% of these costs were deductible. Corporations with net operating loss deductions are now limited to 80% of taxable income for any losses arising after December 31, 2017. The Child Tax Credit will increase from $1,000 to $2,000 per child under age 17, with up to $1,400 being refundable. The credit begins phasing out when income is at $400,000 for joint tax returns, $200,000 for single taxpayers, and is completely phased out when income is $440,000 and $240,000, respectively. This change expires after 2025. Conversions of one type of IRA to another type, often traditional IRA’s to Roth IRA’s, can no longer be recharacterized back to their original account type beginning with conversions occurring January 1, 2018. The penalties for not having health insurance, which were a part of the Affordable Care Act, are eliminated beginning in 2019. Items That Are Not Changing: No changes are made to student loan interest deductions, retirement accounts, educator expenses or higher education expenses and credits. No changes are made to exclusions available on gains from the sale of personal residences. The credit available for adoption expenses remains in place. Original drafts of the bill included a provision to require securities to be sold a first-in-first-out basis, rather than specifically identifying the shares sold. This change is not included in the final bill. This is the largest tax law change the country has seen in decades. In addition to the items summarized here there are many additional provisions, most of which only apply to a very small group of taxpayers. Many of the changes follow what we anticipated would be included in the final bill and have discussed in previous newsletters. There is still time to plan and make any necessary changes before the end of the year. 5 Mistakes every investor makes and how to avoid them.

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professional_accounting

As filed with the Securities and Exchange Commission on October 10, 2017 Registration No. 333-212076​ Amendment No. 5 FORM S-1 REGISTRATION STATEMENT The Securities Act of 1933 OrthoPediatrics Corp. (Primary Standard Industrial Classification Code Number) Identification Number) 2850 Frontier Drive (Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices) Mark C. Throdahl President and Chief Executive Officer (Name, address, including zip code, and telephone number, including area code, of agent for service) Copies to: Charles Ruck, Esq. Christopher D. Lueking, Esq. Mark Weeks Divakar Gupta Brent B. Siler Approximate date of commencement of proposed sale to the public: As soon as practicable after this Registration Statement is declared effective. If any of the securities being registered on this form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. ☐ If this form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐ If this form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐ If this form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. ☐ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer ☐ ​ ​ Accelerated filer ​ ​ ☐ ​ Non-accelerated filer ☒ ​ ​ Smaller reporting company ​ ​ ☐ ​ (Do not check if a smaller reporting company) ​ ​ Emerging growth company ​ ​ ☒ ​ If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided to Section 7(a)(2)(B) of the Securities Act. ☒ CALCULATION OF REGISTRATION FEE Title of Each Class of Securities to be Registered Proposed Maximum Offering Price(1)(2) Amount of Fee(3) Common Stock, $0.00025 par value per share ​ ​ ​ $ 64,400,000 ​ ​ ​ ​ $ 7,463.96 ​ ​ Estimated solely for the purpose of computing the amount of the registration fee pursuant to Rule 457(o) under the Securities Act of 1933, as amended. Includes offering price of shares that the underwriters have the option to purchase. Calculated pursuant to Rule 457(o) based on an estimate of the proposed maximum aggregate offering price. Previously paid. The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine. The information in this prospectus is not complete and may be changed. We may not sell these securities until the Securities and Exchange Commission declares our registration statement effective. This prospectus is not an offer to sell these securities and we are not soliciting an offer to buy these securities in any state where the offer or sale is not permitted. Subject to completion, dated October 10, 2017 4,000,000 Shares ​ ORTHOPEDIATRICS CORP. ​ ​ $ per share OrthoPediatrics Corp. is offering 4,000,000 shares. We anticipate that the initial public offering price will be between $12.00 and $14.00 per share. This is our initial public offering and no public market currently exists for our shares. Proposed NASDAQ trading symbol: “KIDS.” This investment involves risks. See “Risk Factors” beginning on page 12. We are an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, and, as such, have elected to comply with certain reduced public company reporting requirements for this prospectus and future filings. ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Per Share Initial public offering price ​ ​ ​ $ ​ ​ ​ ​ ​ $ ​ ​ ​ Underwriting discount(1) ​ ​ ​ $ ​ ​ ​ ​ ​ $ ​ ​ ​ Proceeds, before expenses, to OrthoPediatrics Corp. ​ ​ ​ $    ​ ​ ​ ​ $    ​ ​ See “Underwriting” for additional information regarding underwriting compensation. The underwriters have an option to purchase up to 600,000 additional shares of common stock from us at the public offering price, less the underwriting discount, for 30 days after the date of this prospectus. Neither the Securities and Exchange Commission nor any state securities commission has approved or disapproved the securities described herein or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense. The underwriters expect to deliver the shares of common stock to investors on or about            , 2017. Piper Jaffray Stifel William Blair BTIG The date of this prospectus is            , 2017. TABLE OF CONTENTS​ Prospectus Summary ​ ​ ​ ​ 1 ​ ​ ​ ​ ​ ​ 12 ​ ​ Special Note Regarding Forward-Looking Statements Market and Industry Data Selected Consolidated Financial Data ​ ​ ​ ​ 107 ​ ​ Executive and Director Compensation Certain Relationships and Related Person Transactions Principal Stockholders Description of Capital Stock Shares Eligible for Future Sale Material U.S. Federal Income Tax Consequences to Non-U.S. Holders of Our Where You Can Find Additional Information Index to Consolidated Financial Statements ​ ​ ​ ​ F-1 ​ ​ We have not, and the underwriters have not, authorized anyone to provide any information or to make any representations other than those contained in this prospectus or in any free writing prospectuses prepared by or on behalf of us or to which we have referred you. We and the underwriters take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus or in any applicable free writing prospectus is current only as of its date, regardless of its time of delivery or any sale of shares of our common stock. Our business, financial condition, results of operations and prospects may have changed since that date. Until            , 2017 (25 days after the commencement of this offering), all dealers that buy, sell or trade shares of our common stock, whether or not participating in this offering, may be required to deliver a prospectus. This delivery requirement is in addition to the obligation of dealers to deliver a prospectus when acting as underwriters and with respect to their unsold allotments or subscriptions. We use various of our trademarks, including, without limitation, ORTHOPEDIATRICS, PEDIFLEX, PEDIFRAG, PEDILOC, PEDINAIL, PEDIPLATES and RESPONSE, in this prospectus. This prospectus also includes trademarks, trade names and service marks that are the property of other organizations. Solely for convenience, trademarks and trade names referred to in this prospectus appear without the ® and TM symbols, but those references are not intended to indicate, in any way, that we or the applicable owner will not assert, to the fullest extent under applicable law, our or its rights to these trademarks and trade names. For investors outside of the United States: We have not, and the underwriters have not, done anything that would permit this offering or possession or distribution of this prospectus in any jurisdiction where action for that purpose is required, other than in the United States. Persons outside of the United States who come into possession of this prospectus must inform themselves about, and observe any restrictions relating to, the offering of the shares of our common stock and the distribution of this prospectus outside of the United States. This summary highlights information contained elsewhere in this prospectus and does not contain all of the information you should consider before investing in our common stock. You should read this entire prospectus carefully, including the section entitled “Risk Factors” and our consolidated financial statements and the related notes thereto included elsewhere in this prospectus, before making an investment decision. Unless the context otherwise requires, references in this prospectus to “OrthoPediatrics,” “the Company,” “our company,” “we,” “us” and “our” refer to OrthoPediatrics Corp. together with its subsidiaries. OrthoPediatrics We are the only medical device company focused exclusively on providing a comprehensive product offering to the pediatric orthopedic market in order to improve the lives of children with orthopedic conditions. We design, develop and commercialize innovative orthopedic implants and instruments to meet the specialized needs of pediatric surgeons and their patients, who we believe have been largely neglected by the orthopedic industry. We currently serve three of the largest categories in this market. We estimate that the portion of this market that we currently serve represents a $2.5 billion opportunity globally, including over $1.1 billion in the United States. Children are not just small adults. Their skeletal anatomy and physiology differs significantly from that of adults, which affects the way in which children with orthopedic conditions are managed surgically. Historically, there have been a limited number of implants and instruments specifically designed for the unique needs of children. As a result, pediatric orthopedic surgeons often improvise with adult implants repurposed for use in children, resort to freehand techniques with adult instruments and use implants that can be difficult to remove after being temporarily implanted. These improvisations may lead to undue surgical trauma and morbidity. We address this unmet market need and sell the broadest product offering specifically designed for children with orthopedic conditions. We currently market 21 surgical systems that serve three of the largest categories within the pediatric orthopedic market: (i) trauma and deformity, (ii) complex spine and (iii) anterior cruciate ligament, or ACL, reconstruction procedures. We expect to expand our product offering to address additional categories of the pediatric orthopedic market, such as active growing implants for early onset scoliosis and limb length discrepancies, other sports-related injuries, patient-specific templates for spine surgical procedures and other orthopedic trauma and deformity applications. Our products have proprietary features designed to: protect a child’s growth plates; fit a wide range of pediatric anatomy; enable earlier surgical intervention; enable precise and reproducible surgical techniques; and ease implant removal. Our products are used by pediatric orthopedic surgeons, who, unlike orthopedic surgeons focused on treating adults, are, for the most part, generalists treating a wide range of congenital, developmental and traumatic orthopedic conditions. As a result, these surgeons generally represent a single call point for our broad range of products. We believe our products complement one another because they are often used by the same surgeons, and the successful use of one system may create demand for the others. In 2016, there were more than 1,200 members of the Pediatric Orthopedic Society of North America, or POSNA, and we estimate that 62% of U.S. pediatric trauma and deformity and complex spine surgeries in 2015 were performed in only 268 hospitals. Based on our experience, we believe that pediatric orthopedic procedures outside of the United States are also highly concentrated. ACL reconstruction procedures are less concentrated, and the vast majority are performed in ambulatory surgery centers. We have the only global sales organization focused exclusively on pediatric orthopedics. Our organization has a deep understanding of the unique nature of children’s clinical conditions and surgical procedures as well as an appreciation of the tremendous sense of responsibility pediatric orthopedic surgeons feel for the children whom parents have entrusted to their care. We provide these surgeons with dedicated support, both in and out of the operating room. As of June 30, 2017, our U.S. sales organization consisted of 33 independent sales agencies employing more than 110 sales representatives, 69 of whom were full-time equivalents devoted to OrthoPediatrics sales activities. Increasingly, these sales agencies are making us the anchor line in their businesses or representing us exclusively. Sales from such sales agencies represented 77% of our U.S. revenue in 2016. Outside of the United States, our sales organization consisted of 31 independent distributors in 35 countries. In April 2017, we began to supplement our use of independent distributors with direct sales programs in the United Kingdom, Ireland, Australia and New Zealand. In these markets, we work through sales agencies that are paid a commission. These new arrangements are expected to generate an increase in our international revenue and gross margin. We plan to continue to make similar transitions in select international markets that we believe would benefit from a sales agency model. We collaborate with pediatric orthopedic surgeons in developing new surgical systems that improve the quality of care. We have an efficient product development process that relies upon teams of engineers, commercial personnel and surgeon advisors. Since inception, our average clearance time with the U.S. Food and Drug Administration, or the FDA, has been 74 days, which we believe is less than half of the average approval time for all medical devices over the past five years. This is due in part to the impact of the Pediatric Medical Device Safety and Improvement Act of 2007, which encourages pediatric medical device research and development and aids the FDA in tracking the number and types of medical devices approved specifically for children. We believe our products are characterized by stable pricing, few reimbursement issues and attractive gross margins. We believe clinical education is critical to advancing the field of pediatric orthopedics. Cumulatively, we are the largest financial contributor to the five primary orthopedic surgical societies that conduct pediatric clinical education and research. We are a major sponsor of continuing medical education, or CME, courses in pediatric spine and pediatric orthopedics, which are focused on fellows and young surgeons. In 2016, we conducted over 200 training workshops. We believe these workshops help surgeons recognize our commitment to their field. We believe our commitment to clinical education has helped to increase our account presence while promoting familiarity with our products and loyalty among fellows and young surgeons. We have established a corporate culture built on the cause of improving the lives of children with orthopedic conditions. We believe our higher corporate purpose captures the hearts and minds of our employees and makes them committed to doing everything better, faster and at lower cost. This culture allows us to attract and retain talented, high-performing individuals. We have grown our revenue from approximately $10.2 million for the year ended December 31, 2011 to $37.3 million for the year ended December 31, 2016, reflecting a growth rate each year of at least 20%. For the years ended December 31, 2015 and 2016, our revenue was $31.0 million and $37.3 million, respectively, and our net loss was $7.9 million and $6.6 million, respectively. Our net loss for the year ended December 31, 2016 included a one-time charge of $2.0 million for costs related to our planned initial public offering. For the six months ended June 30, 2016 and 2017, our revenue was $17.7 million and $21.6 million, respectively, and our net loss was $2.1 million and $2.6 million, respectively. As of June 30, 2017, our accumulated deficit was $80.7 million. We believe we have a history of efficient capital utilization, and we intend to scale our business model by continuing to implement the successful strategy that has sustained our growth. Due to the high concentration of pediatric orthopedic surgeons in comparatively few hospitals, we believe we can accelerate the penetration of our addressable market in a capital-efficient manner and further strengthen our position as the category leader in pediatric orthopedics. The primary challenges to maintaining our growth in a market that has not historically relied on age-specific implants and instruments have been overcoming older surgeons’ familiarity with repurposing adult implants for use in children and our current lack of published long-term data supporting superior clinical outcomes by our products. We believe our efforts in surgeon training, collaboration and marketing address this inertia, particularly with younger surgeons. Unmet Market Needs Due to the size of the pediatric orthopedic market compared to the adult market, we believe that no other diversified orthopedic company has committed the resources necessary to develop a sales and product development infrastructure focused on this market, resulting in the following unmet needs: Lack of Commercial Infrastructure Dedicated to Pediatric Orthopedic Surgeons The lack of commercial infrastructure in pediatric orthopedics has the following implications: minimal dedicated sales presence for pediatric orthopedic surgeons and limited support during surgery; few opportunities for pediatric orthopedic surgeons to participate in new product development; and few opportunities for pediatric orthopedic surgeons early in their careers to obtain specialized training on new technologies and techniques. Relative Absence of Orthopedic Implants and Instruments Specifically Designed for Children We believe the relative absence of implants and instruments specifically designed for the unique skeletal anatomy and physiology of children has led surgeons to improvise with adult implants repurposed for use in children. The use of adult implants in children may: violate the growth plates, leading to growth arrest and subsequent deformities; not fit the greater curvature of pediatric bones, resulting in compromised clinical outcomes; have insufficient strength when used inappropriately in children, leading to implant failure or breakage; result in improper anatomical alignment of soft tissues, lengthen recovery times and lead to premature joint replacement; require freehand surgical techniques, leading to less accurate implant placement; be difficult to remove due to bony on-growth associated with the titanium typically used in adult implants, resulting in unnecessary surgical trauma; require lengthier and more invasive surgical approaches; and reduce the confidence of pediatric orthopedic surgeons in the accuracy and procedural consistency they require to achieve high standards of care. Our Exclusive Focus on Pediatric Orthopedic Surgery We believe we are the only company that has committed the resources necessary to create a global sales and product development infrastructure focused on the pediatric orthopedic implant market. Our goal is to build an enduring company committed to addressing this market’s unmet needs by providing the following: Only Commercial Infrastructure Dedicated to Pediatric Orthopedic Surgeons dedicated sales support to pediatric orthopedic surgeons; participation of pediatric orthopedic surgeons in new product development; and leading supporter of pediatric orthopedic surgical societies and clinical education. Comprehensive Portfolio of Products Specifically Designed for Children We have developed the only comprehensive portfolio of implants and instruments specifically designed to treat children with orthopedic conditions within the three categories of the pediatric orthopedic market that we currently serve. Our products include proprietary features designed to: enable precise and reproducible surgical techniques; ease implant removal; allow for less invasive surgical techniques; and enhance surgeon confidence. Our Competitive Strengths We believe our focus and experience in pediatric orthopedic surgery, combined with the following principal competitive strengths, will allow us to continue to grow our sales and expand our market opportunity. Exclusive Focus on Pediatric Orthopedics. We were founded with the mission of improving the lives of children with orthopedic conditions, a patient population which we believe has been largely neglected by the orthopedic industry. We believe our exclusive focus on pediatric orthopedics has generated strong brand equity in the pediatric orthopedic surgeon community. Partnership with Pediatric Orthopedic Surgeons and Pediatric Surgical Societies. We have devoted significant time and resources to developing deep relationships with pediatric orthopedic surgeons and supporting clinical education to advance the practice of pediatric orthopedic medicine. Our dedication to the pediatric orthopedic community is evidenced by our leading support of the five primary pediatric orthopedic surgical societies and sponsorship of training workshops and CME courses in pediatric spine and pediatric orthopedics. We believe collaborating with pediatric orthopedic surgeons has helped to promote familiarity with our products and loyalty among fellows and surgeons early in their careers. Comprehensive Portfolio of Innovative Orthopedic Products Designed Specifically for Children. We have developed the only comprehensive portfolio of implants and instruments specifically designed for children with orthopedic conditions. Our broad product offering has made us the only provider of comprehensive solutions to pediatric orthopedic surgeons within the three categories of the pediatric orthopedic market that we currently serve. Scalable Business Model. Our ability to identify and respond quickly to the needs of pediatric orthopedic surgeons and their patients is central to our culture and critical to our continued success. We estimate that 62% of U.S. pediatric trauma and deformity and complex spine procedures in 2015 were performed in only 268 hospitals. We believe that this high concentration of procedures and our focused sales organization will enable us to address the pediatric orthopedic surgery market in a capital-efficient manner. As we continue to broaden our product offering, we believe the scalability of our business model will allow us to simultaneously increase our reach, deepen our relationships with pediatric orthopedic surgeons and help us to achieve significant returns on our investments in implant and instrument sets, product development and commercial infrastructure. Unique Culture: A Different Kind of Orthopedic Company. We have established a results-oriented, people-focused corporate culture dedicated to improving the lives of children with orthopedic conditions. We believe this culture allows us to attract and retain talented, high performing professionals. We believe our focus and commitment to pediatric orthopedics has also enhanced our reputation among pediatric orthopedic surgeons as the only diversified orthopedic company focused on their field. We believe these sources of competitive advantage provide us with the means to expand and defend our position as category leader and constitute barriers to entry that would require significant time, focus and investment for a competitor to overcome. Our goal is to continue to enhance our leadership in the pediatric orthopedic surgery market and thereby improve the lives of children with orthopedic conditions. To achieve this goal, we have implemented a strategy that has five elements: increase investment in consigned implant and instrument sets to accelerate revenue growth; capitalize on our efficient product development process to expand our innovative products; strengthen our global sales and distribution infrastructure; deepen our partnerships with pediatric orthopedic surgeons through clinical education and research; and continue to develop an engaging culture of continuous improvement. We have developed the only comprehensive portfolio of implants and instruments specifically designed to treat children with orthopedic conditions within the three categories of the pediatric orthopedic market that we currently serve. We believe our innovative products promote improved surgical accuracy, increase consistency of patient outcomes and enhance surgeon confidence in achieving high standards of care. Selected examples of our product innovations include: Locking Proximal Femur and Locking Cannulated Blade Systems: the first cannulated implants and instruments specifically designed for the pediatric market that offer significant improvements over implants designed for adults, including improved fixation, more reproducible results and more stable constructs. RESPONSE Spinal Deformity System: a low-profile pedicle screw system designed for pediatric spinal deformity corrections that can withstand the significant lateral forces present in a child’s spine, has the flexibility to accept both 5.5mm and 6.0mm titanium or cobalt chromium stabilizing rods and has one-handed rod reduction and de-rotation instruments. PediNail Intramedullary Nail System: the smallest size nail on the market to meet the unique needs of pediatric patients. PediLoc Plating Systems: anatomically designed to conform to the curvature of pediatric bones and allow screws to remain parallel to the growth plate. ACL Reconstruction System: what we believe to be the only commercially available product that enables surgical intervention in children whose growth plates are open while also restoring the ligament to its anatomically correct position. We also have a large number of new product ideas under development and we aspire to launch one new surgical system and multiple line extension and product improvements every year. Risks Related to Our Business Our business is subject to numerous risks, including risks that may prevent us from achieving our business objectives or may adversely affect our business, financial condition, results of operations, cash flows and prospects, that you should consider before making an investment decision. Some of the more significant risks and uncertainties relating to an investment in our company are listed below. These risks are more fully described in the “Risk Factors” section of this prospectus immediately following this prospectus summary. We have incurred losses in the past and may be unable to achieve or sustain profitability in the future. We may need to raise additional capital to fund our existing commercial operations, develop and commercialize new products and expand our operations. Our long-term growth depends on our ability to commercialize our products in development and to develop and commercialize additional products through our research and development efforts, and if we fail to do so we may be unable to compete effectively. We may be unable to generate sufficient revenue from the commercialization of our products to achieve and sustain profitability. We lack published long-term data supporting superior clinical outcomes by our products, which could limit sales. If coverage and reimbursement from third-party payors for procedures using our products significantly decline, orthopedic surgeons, hospitals and other healthcare providers may be reluctant to use our products and our sales may decline. We may be unable to successfully demonstrate to orthopedic surgeons the merits of our products compared to those of our competitors. Our products and our operations are subject to extensive government regulation and oversight both in the United States and abroad, and our failure to comply with applicable requirements could harm our business. We rely on a network of third-party independent sales agencies and distributors to market and distribute our products, and if we are unable to maintain and expand this network, we may be unable to generate anticipated sales. If we are unable to adequately protect our intellectual property rights, or if we are accused of infringing on the intellectual property rights of others, our competitive position could be harmed or we could be required to incur significant expenses to enforce or defend our rights. Implications of Being an Emerging Growth Company As a company with less than $1.07 billion in revenue during our last fiscal year, we qualify as an “emerging growth company,” as defined in the Jumpstart Our Business Startups Act of 2012, or the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include, but are not limited to: being permitted to present only two years of audited financial statements and two years of related Management’s Discussion and Analysis of Financial Condition and Results of Operations; not being required to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002, as amended, or the Sarbanes-Oxley Act; reduced disclosure obligations regarding executive compensation in periodic reports, proxy statements and registration statements; and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. We may take advantage of these provisions until the last day of our fiscal year following the fifth anniversary of the completion of this offering. However, if certain events occur prior to the end of such five-year period, including if we become a “large accelerated filer,” our annual gross revenue exceeds $1.07 billion or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to the end of such five-year period. We have elected to take advantage of certain of the reduced disclosure obligations in this prospectus and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different from what you might receive from other public reporting companies in which you hold equity interests. In addition, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards until such time as those standards apply to private companies. We have irrevocably elected not to avail ourselves of this exemption from new or revised accounting standards and, therefore, we will be subject to the same new or revised accounting standards as other public companies that are not emerging growth companies. Corporate History and Information We were formed as a Delaware corporation in November 2007. Our principal executive offices are located at 2850 Frontier Drive, Warsaw, IN 46582, and our telephone number is (574) 268-6379. Our website address is www.orthopediatrics.com. The information contained in, or accessible through, our website does not constitute part of this prospectus. Squadron Capital LLC, or Squadron, has been an investor in our company since 2011. Squadron owns all of the outstanding shares of our Series A convertible preferred stock, $0.00025 par value, or our Series A Preferred Stock, and substantially all of the outstanding shares of our Series B convertible preferred stock, $0.00025 par value, or our Series B Preferred Stock. Immediately prior to the completion of this offering, all outstanding shares of Series A Preferred Stock and Series B Preferred Stock will convert into 3,649,475 shares of our common stock. Upon the conversion of all outstanding shares of our Series A Preferred Stock into shares of our common stock, Squadron is also entitled to a $16.0 million cash preference payment and approximately $8.9 million of accumulated and unpaid dividends (as of September 30, 2017), each of which it has agreed to convert into additional shares of our common stock at a conversion price equal to the initial public offering price. As a result, upon the completion of this offering, Squadron will own approximately 44.6% of our outstanding common stock, assuming an initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover of this prospectus. Upon the conversion of all outstanding shares of our Series B Preferred Stock into shares of our common stock immediately prior to the completion of this offering, Squadron and the other holders thereof are entitled to approximately $5.9 million of accumulated and unpaid dividends (as of September 30, 2017), which we intend to pay using a portion of the net proceeds from this offering. See “Use of Proceeds.” For more information on our relationship with Squadron, see “Certain Relationships and Related Person Transactions — Squadron.” Common stock offered by us Common stock to be outstanding after this offering 12,044,435 shares (or 12,644,435 shares if the underwriters exercise in full their option to acquire additional shares from us). Option to purchase additional shares of common stock The underwriters have a 30-day option to purchase up to a total of 600,000 additional shares of common stock from us. We intend to use the net proceeds received by us from this offering (i) to pay approximately $5.9 million of accumulated and unpaid dividends on our Series B Preferred Stock (as of September 30, 2017), (ii) to invest in implant and instrument sets for consignment to our customers, (iii) to fund research and development activities, (iv) to expand our sales and marketing programs and (v) for working capital and general corporate purposes. We may also use a portion of the net proceeds to acquire or invest in complementary products, technologies or businesses, but we currently have no agreements or commitments to do so. See “Use of Proceeds.” As a result of the payment of the accumulated and unpaid dividends on our Series B Preferred Stock, our affiliates, including Squadron, Mark C. Throdahl, our President, Chief Executive Officer and a member of our board of directors, and Bernie B. Berry, III, a member of our board of directors, will receive a portion of the net proceeds from this offering. See “Certain Relationships and Related Person Transactions.” You should read the “Risk Factors” section of this prospectus and other information included in this prospectus for a discussion of factors that you should consider carefully before deciding to invest in our common stock. Proposed NASDAQ Global Market trading symbol Directed Share Program At our request, the underwriters have reserved for sale at the initial public offering price up to 200,000 shares of our common stock, or approximately 5 % of the shares offered by this prospectus, for our employees, directors and other persons associated with us. The participants in the directed share program will be subject to the 180-day lock-up restriction described in the “Underwriting” section of this prospectus with respect to the directed shares sold to them. The number of shares of our common stock available for sale to the general public in this offering will be reduced by the number of shares sold pursuant to the directed share program. Any directed shares not so purchased will be offered by the underwriters to the general public on the same terms as the other shares offered by this prospectus. The directed share program will be arranged through Piper Jaffray & Co. The number of shares of our common stock to be outstanding after this offering set forth above is based on 2,481,607 shares outstanding as of June 30, 2017, and does not reflect: 243,369 shares of common stock issuable upon the exercise of outstanding options under our Amended and Restated 2007 Equity Incentive Plan, or the 2007 Plan, at a weighted average exercise price of $23.95 per share; 44,101 shares of common stock issuable upon the exercise of outstanding warrants at a weighted average exercise price of $27.01 per share; and 1,832,460 shares of our common stock issued or reserved for future issuance under our 2017 Incentive Award Plan that will go into effect immediately prior to the completion of this offering, or the 2017 Plan, which includes (i) 42,813 shares of restricted stock that we intend to grant under the 2017 Plan in connection with this offering and (ii) 39,992 shares reserved for future issuance under the Amended and Restated 2007 Equity Incentive Plan, or the 2007 Plan, that will be added to the shares reserved under the 2017 Plan upon its effectiveness. Except as otherwise indicated, all information in this prospectus: gives effect to the one-for-0.67 reverse stock split of our common stock that was consummated on October 5, 2017; gives effect to the filing of our amended and restated certificate of incorporation and the adoption of our amended and restated bylaws immediately prior to the completion of this offering; gives effect to the conversion of all outstanding shares of our Series A Preferred Stock and our Series B Preferred Stock into 3,649,475 shares of our common stock, each of which will occur immediately prior to the completion of this offering; gives effect to the conversion of the $16.0 million cash preference payment, and approximately $8.4 million of accumulated and unpaid dividends as of June 30, 2017 ($8.9 million as of September 30, 2017), on our Series A Preferred Stock into 1,913,353 shares of our common stock, at a conversion price equal to an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, which will occur immediately prior to the completion of this offering; assumes no exercise of the outstanding options and warrants described above; and assumes no exercise by the underwriters of their option to purchase additional shares of common stock. SUMMARY CONSOLIDATED FINANCIAL DATA This summary consolidated statement of operations data for the years ended December 31, 2014, 2015 and 2016 has been derived from our audited consolidated financial statements included elsewhere in this prospectus. This summary consolidated statement of operations data for the six months ended June 30, 2016 and 2017 and the summary consolidated balance sheet data as of June 30, 2017 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus. Our historical results are not necessarily indicative of the results to be expected for any future period. You should read this data together with our consolidated financial statements and the related notes thereto appearing elsewhere in this prospectus and the sections of this prospectus entitled “Selected Consolidated Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Year Ended December 31, Six Months Ended June 30, (in thousands, except share and per share information) Statement of operations data: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Net revenue ​ ​ ​ $ 23,684 ​ ​ ​ ​ $ 31,004 ​ ​ ​ ​ $ 37,298 ​ ​ ​ ​ $ 17,745 ​ ​ ​ ​ $ 21,564 ​ ​ ​ ​ ​ ​ 7,085 ​ ​ ​ ​ ​ 9,367 ​ ​ ​ ​ ​ 10,931 ​ ​ ​ ​ ​ 4,935 ​ ​ ​ ​ ​ 5,437 ​ ​ ​ ​ ​ ​ 16,599 ​ ​ ​ ​ ​ 21,637 ​ ​ ​ ​ ​ 26,367 ​ ​ ​ ​ ​ 12,810 ​ ​ ​ ​ ​ 16,127 ​ ​ Operating expenses: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ 12,185 ​ ​ ​ ​ ​ 15,033 ​ ​ ​ ​ ​ 16,661 ​ ​ ​ ​ ​ 8,106 ​ ​ ​ ​ ​ 9,491 ​ ​ ​ ​ ​ ​ 9,875 ​ ​ ​ ​ ​ 11,407 ​ ​ ​ ​ ​ 11,631 ​ ​ ​ ​ ​ 5,959 ​ ​ ​ ​ ​ 6,795 ​ ​ Initial public offering costs ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ 1,979 ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ ​ 1,683 ​ ​ ​ ​ ​ 1,789 ​ ​ ​ ​ ​ 2,223 ​ ​ ​ ​ ​ 1,096 ​ ​ ​ ​ ​ 1,355 ​ ​ Operating loss ​ ​ ​ ​ (7,144) ​ ​ ​ ​ ​ (6,592) ​ ​ ​ ​ ​ (6,127) ​ ​ ​ ​ ​ (2,351) ​ ​ ​ ​ ​ (1,514) ​ ​ Other expenses: ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ 2,549 ​ ​ ​ ​ ​ 1,230 ​ ​ ​ ​ ​ 1,476 ​ ​ ​ ​ ​ 657 ​ ​ ​ ​ ​ 1,095 ​ ​ Other expense (income) ​ ​ ​ ​ 67 ​ ​ ​ ​ ​ 31 ​ ​ ​ ​ ​ (1,031) ​ ​ ​ ​ ​ (915) ​ ​ ​ ​ ​ (58) ​ ​ Total other expenses ​ ​ ​ ​ 2,616 ​ ​ ​ ​ ​ 1,261 ​ ​ ​ ​ ​ 445 ​ ​ ​ ​ ​ (258) ​ ​ ​ ​ ​ 1,037 ​ ​ Net loss from continuing operations (Gain) loss from discontinued operations ​ ​ ​ ​ (211) ​ ​ ​ ​ ​ 38 ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ $ (9,549) ​ ​ ​ ​ $ (7,891) ​ ​ ​ ​ $ (6,572) ​ ​ ​ ​ $ (2,093) ​ ​ ​ ​ $ (2,551) ​ ​ Net loss attributable to common stockholders ​ ​ ​ $ (12,804) ​ ​ ​ ​ $ (12,688) ​ ​ ​ ​ $ (12,448) ​ ​ ​ ​ $ (4,754) ​ ​ ​ ​ $ (5,431) ​ ​ Weighted average shares – basic and diluted ​ ​ ​ ​ 1,744,295 ​ ​ ​ ​ ​ 1,744,356 ​ ​ ​ ​ ​ 1,744,356 ​ ​ ​ ​ ​ 1,744,356 ​ ​ ​ ​ ​ 1,745,390 ​ ​ Net loss per share attributable to common stockholders(1): ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ Basic and diluted ​ ​ ​ $ (7.34) ​ ​ ​ ​ $ (7.27) ​ ​ ​ ​ $ (7.14) ​ ​ ​ ​ $ (2.73) ​ ​ ​ ​ $ (3.11) ​ ​ Pro forma net loss per share (unaudited)(1): ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ $ (0.88) ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ $ (0.33) ​ ​ See note 11 to our consolidated financial statements included elsewhere in this prospectus for an explanation of the method used to calculate the historical and pro forma basic and diluted net loss per share. The effect of discontinued operations on loss per share has been excluded as it is not material. The following table presents summary balance sheet data as of June 30, 2017: on an actual basis; on a pro forma basis to give effect to: (i) the conversion of all outstanding shares of our Series A Preferred Stock and our Series B Preferred Stock into 3,649,475 shares of our common stock; (ii) the conversion of the $16.0 million cash preference payment, and approximately $8.4 million of accumulated and unpaid dividends as of June 30, 2017 ($8.9 million as of September 30, 2017), on our Series A Preferred Stock into 1,913,353 shares of our common stock at a conversion price equal to an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus; and (iii) the accrual of approximately $5.4 million of accumulated and unpaid dividends on our Series B Preferred Stock as of June 30, 2017 ($5.9 million as of September 30, 2017); and on a pro forma as adjusted basis to give further effect to: (i) the sale of 4,000,000 shares of common stock by us in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us; and (ii) our use of a portion of the net proceeds from this offering to pay approximately $5.4 million of accumulated and unpaid dividends on our Series B Preferred Stock ($5.9 million as of September 30, 2017). As Adjusted Balance sheet data: ​ ​ ​ ​ ​ ​ ​ $ 2,306 ​ ​ ​ ​ $ 2,306 ​ ​ ​ ​ $ 43,107 ​ ​ ​ ​ ​ ​ 18,405 ​ ​ ​ ​ ​ 13,006 ​ ​ ​ ​ ​ 59,206 ​ ​ Redeemable convertible preferred stock ​ ​ ​ ​ 74,183 ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ Total stockholders’ deficit ​ ​ ​ ​ (69,941) ​ ​ ​ ​ ​ (1,157) ​ ​ ​ ​ ​ 45,043 ​ ​ The pro forma as adjusted balance sheet data is illustrative only and will depend on the actual initial public offering price, the number of shares we sell in this offering and other terms of this offering determined at pricing. Each $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share would increase (decrease) the pro forma as adjusted amount of each of cash, working capital, total assets and total stockholders’ equity by $3.7 million, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting estimated underwriting discounts and commissions and estimated offering expenses payable by us. Similarly, each increase (decrease) of 1.0 million in the number of shares offered by us at the assumed initial public offering price would increase (decrease) the pro forma as adjusted amount of each of cash and cash equivalents, working capital, total assets and total stockholders’ equity by $12.1 million, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. Any increase or decrease in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would decrease or increase the number of shares of our common stock into which the $16.0 million cash preference payment, and the approximately $8.4 million of accumulated and unpaid dividends ($8.9 million as of September 30, 2017), on our Series A Preferred Stock would be converted and, accordingly, the number of shares of our common stock to be outstanding following this offering. See ‘‘Related Party Transactions — Squadron — Conversion of Series A Preferred Stock Preference Payment and Dividends.’’ Investing in our common stock involves a high degree of risk. You should carefully consider the risks and uncertainties described below and the other information contained in this prospectus before deciding whether to invest in our common stock. The occurrence of any of the events or developments described below could harm our business, financial condition, results of operations and prospects. As a result, the market price of our common stock could decline, and you may lose all or part of your investment. Risks Related to Our Financial Condition and Capital Requirements We incurred net losses in all fiscal years since inception. We incurred net losses of $9.5 million, $7.9 million and $6.6 million for the years ended December 31, 2014, 2015 and 2016, respectively, and $2.1 million and $2.6 million for the six months ended June 30, 2016 and 2017, respectively. Our net loss for the year ended December 31, 2016 included a one-time charge of $2.0 million for costs related to our planned initial public offering. As a result of ongoing losses, as of June 30, 2017, we had an accumulated deficit of $80.7 million. We expect to continue to incur significant product development, clinical and regulatory, sales and marketing and other expenses. In addition, our general and administrative expenses will increase following this offering due to the additional costs associated with being a public company. The net losses we incur may fluctuate significantly from quarter to quarter. We will need to generate significant additional revenue to achieve and sustain profitability, and even if we achieve profitability, we cannot be sure that we will remain profitable for any substantial period of time. Our failure to achieve or maintain profitability could negatively impact the value of our common stock. At present, we rely solely on the commercialization of our products to generate revenue, and we expect to generate substantially all of our revenue in the foreseeable future from sales of these products. In order to successfully commercialize our products, we will need to continue to expand our marketing efforts to develop new relationships and expand existing relationships with customers, to obtain regulatory clearances or approvals for our products in additional countries, to achieve and maintain compliance with all applicable regulatory requirements and to develop and commercialize our products with new features or for additional indications. If we fail to successfully commercialize our products, we may never receive a return on the substantial investments in product development, sales and marketing, regulatory compliance, manufacturing and quality assurance we have made, as well as further investments we intend to make, which may cause us to fail to generate revenue and gain economies of scale from such investments. In addition, potential customers may decide not to purchase our products, or our customers may decide to cancel orders due to changes in treatment offerings, research and development plans, adverse clinical outcomes, difficulties in obtaining coverage or reimbursement for procedures using our products, difficulties obtaining approval from a hospital, complications with manufacturing or the utilization of technology developed by other parties, all of which are circumstances outside of our control. In addition, demand for our products may not increase as quickly as we predict, and we may be unable to increase our revenue levels as we expect. Even if we succeed in increasing adoption of these systems by physicians, hospitals and other healthcare providers, maintaining and creating relationships with our existing and new customers and developing and commercializing new features or indications for these systems, we may be unable to generate sufficient revenue to achieve or sustain profitability. Based on our current business plan, we believe our current cash, borrowing capacity under our loan agreements, cash receipts from sales of our products and net proceeds from this offering will be sufficient to meet our anticipated cash requirements for at least the next 12 months. If our available cash balances, borrowing capacity, net proceeds from this offering and anticipated cash flow from operations are insufficient to satisfy our liquidity requirements, including because of lower demand for our products as a result of the risks described in this prospectus, we may seek to sell common or preferred equity or convertible debt securities, enter into an additional credit facility or another form of third-party funding or seek other debt financing. We may consider raising additional capital in the future to expand our business, to pursue strategic investments, to take advantage of financing opportunities or for other reasons, including to: increase our sales and marketing efforts to increase market adoption of our products and address competitive developments; provide for supply and inventory costs associated with plans to accommodate potential increases in demand for our products; fund development and marketing efforts of any future products or additional features to then-current products; acquire, license or invest in new technologies; acquire or invest in complementary businesses or assets; and finance capital expenditures and general and administrative expenses. Our present and future funding requirements will depend on many factors, including: our ability to achieve revenue growth and improve gross margins; our rate of progress in establishing coverage and reimbursement arrangements with domestic and international commercial third-party payors and government payors; the cost of expanding our operations and offerings, including our sales and marketing efforts; our rate of progress in, and cost of the sales and marketing activities associated with, establishing adoption of our products; the cost of research and development activities; the effect of competing technological and market developments; costs related to international expansion; and the potential cost of and delays in product development as a result of any regulatory oversight applicable to our products. Additional capital may not be available at such times or in amounts as needed by us. Even if capital is available, it might be available only on unfavorable terms. Any additional equity or convertible debt financing into which we enter could be dilutive to our existing stockholders. Any future debt financing into which we enter may impose covenants upon us that restrict our operations, including limitations on our ability to incur liens or additional debt, pay dividends, repurchase our stock, make certain investments and engage in certain merger, consolidation or asset sale transactions. Any debt financing or additional equity that we raise may contain terms that are not favorable to us or our stockholders. If we raise additional funds through collaboration and licensing arrangements with third parties, it may be necessary to relinquish some rights to our technologies or our products, or grant licenses on terms that are not favorable to us. If access to sufficient capital is not available as and when needed, our business will be materially impaired and we may be required to cease operations, curtail one or more product development or commercialization programs, or we may be required to significantly reduce expenses, sell assets, seek a merger or joint venture partner, file for protection from creditors or liquidate all our assets. Our sales volumes and our results of operations may fluctuate over the course of the year. We have experienced and continue to experience meaningful variability in our sales and gross profit among quarters, as well as within each quarter, as a result of a number of factors, which may include, among other things: the number of products sold in the quarter; the unpredictability of sales of full sets of implants and instruments to our international distributors; the demand for, and pricing of, our products and the products of our competitors; the timing of or failure to obtain regulatory clearances or approvals for our products; the costs, benefits and timing of new product introductions; increased competition; the availability and cost of components and materials; the number of selling days in the quarter; fluctuation and foreign currency exchange rates; or impairment and other special charges. Our loan and security agreement with Squadron Capital LLC contains covenants that may restrict our business and financing activities. In April 2017, we entered into a third amended and restated loan and security agreement, or the Loan Agreement, with Squadron Capital LLC, or Squadron. Pursuant to the Loan Agreement, Squadron has provided us with two term loan credit facilities in an aggregate principal amount of $34.4 million ($18.4 million of which was made available pursuant to what we refer to as the Term Note A and up to $16.0 million of which was or will be made available pursuant to what we refer to as the Term Note B). Of the $16.0 million that was or will be made available pursuant to the Term Note B: $9.0 million is currently available; $6.0 million will be made available on January 1, 2018, subject to our achieving certain revenue goals for the year ended December 31, 2017; and $1.0 million is payable as a fee in three equal installments (the first installment was borrowed and paid at closing, and the second and third installments will, if an initial public offering is not completed prior to such time, become available and payable on the first and second anniversary thereof). As of June 30, 2017, we had approximately $24.0 million in outstanding indebtedness under the Loan Agreement. The Loan Agreement restricts our ability to, among other things: dispose of or sell our assets; modify our organizational documents; merge with or acquire other entities or assets; incur additional indebtedness; create liens on our assets; pay dividends; and make investments. We cannot assure you that we will meet the revenue goals necessary to access the additional $6.0 million of available borrowings under the Term Note B. In addition, the covenants in the Loan Agreement, as well as any future financing agreements into which we may enter, may restrict our ability to finance our operations and engage in, expand or otherwise pursue our business activities and strategies. Our ability to comply with these covenants may be affected by events beyond our control, and future breaches of any of these covenants could result in a default under the Loan Agreement. If not waived, future defaults could cause all of the outstanding indebtedness under the Loan Agreement to become immediately due and payable and terminate all commitments to extend further credit. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Indebtedness — Loan Agreement.” If we do not have or are unable to generate sufficient cash available to repay our debt obligations when they become due and payable, either upon maturity or in the event of a default, we may be unable to obtain additional debt or equity financing on favorable terms, if at all, which may negatively impact our ability to operate and continue our business as a going concern. Risks Related to Our Business and Strategy In order to increase our market share in the pediatric orthopedic markets, we must successfully commercialize our current products in development, enhance our existing product offerings and introduce new products in response to changing customer demands and competitive pressures and technologies. Our industry is characterized by intense competition, rapid technological changes, new product introductions and enhancements and evolving industry standards. Our business prospects depend in part on our ability to develop and commercialize new products and applications for our technology, including in new markets that develop as a result of technological and scientific advances, while improving the performance and cost-effectiveness of our products. New technologies, techniques or products could emerge that might offer better combinations of price and performance than our products. It is important that we anticipate changes in technology and market demand, as well as physician, hospital and healthcare provider practices to successfully develop, obtain clearance or approval, if required, and successfully introduce new, enhanced and competitive technologies to meet our prospective customers’ needs on a timely and cost-effective basis. We might be unable to successfully commercialize our current products with domestic or international regulatory clearances or approvals or develop or obtain regulatory clearances or approvals to market new products. Additionally, these products and any future products might not be accepted by the orthopedic surgeons or the third-party payors who reimburse for the procedures performed with our products or may not be successfully commercialized due to other factors. The success of any new product offering or enhancement to an existing product will depend on numerous factors, including our ability to: properly identify and anticipate clinician and patient needs; develop and introduce new products or product enhancements in a timely manner; adequately protect our intellectual property and avoid infringing upon the intellectual property rights of third parties; demonstrate the safety and efficacy of new products; and obtain the necessary regulatory clearances or approvals for new products or product enhancements. If we do not develop and obtain regulatory clearances or approvals for new products or product enhancements in time to meet market demand, or if there is insufficient demand for these products or enhancements, our results of operations will suffer. Our research and development efforts may require a substantial investment of time and resources before we are adequately able to determine the commercial viability of a new product, technology, material or other innovation. In addition, even if we are able to develop enhancements or new generations of our products successfully, these enhancements or new generations of products may not produce sales in excess of the costs of development and they may be quickly rendered obsolete by changing customer preferences or the introduction by our competitors of products embodying new technologies or features. Nevertheless, we must carefully manage our introduction of new products. If potential customers believe such products will offer enhanced features or be sold for a more attractive price, they may delay purchases until such products are available. We may also have excess or obsolete inventory as we transition to new products, and we have no experience in managing product transitions. If the quality of our products does not meet the expectations of physicians or patients, then our brand and reputation could suffer and our business could be adversely impacted. In the course of conducting our business, we must adequately address quality issues that may arise with our products, as well as defects in third-party components included in our products. Furthermore, a malfunction by one of our products may not be detected for an extended period of time, which may result in delay or failure to remedy the condition for which the product was prescribed. Although we have established internal procedures to minimize risks that may arise from quality issues, we may be unable to eliminate or mitigate occurrences of these issues and associated liabilities. We operate in a very competitive business environment and if we are unable to compete successfully against our existing or potential competitors, our sales and operating results may be negatively affected and we may not grow. Our currently marketed products are, and any future products we develop and commercialize will be, subject to intense competition. The industry in which we operate is intensely competitive, subject to rapid change and highly sensitive to the introduction of new products or other market activities of industry participants. Our ability to compete successfully will depend on our ability to develop products that reach the market in a timely manner, receive adequate coverage and reimbursement from third-party payors, and are safer, less invasive and more effective than competing products and treatments. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing products. We have competitors in each of our three product categories, including the DePuy Synthes Companies (a subsidiary of Johnson and Johnson), Medtronic plc and Smith & Nephew plc. At any time, these and other potential market entrants may develop new devices or treatment alternatives that may render our products obsolete or uncompetitive. In addition, they may gain a market advantage by developing and patenting competitive products or processes earlier than we can or by obtaining regulatory clearances or market registrations more rapidly than we can. Many of our current and potential competitors have substantially greater sales and financial resources than we do. In addition, these companies may have more established distribution networks, entrenched relationships with orthopedic surgeons and greater experience in launching, marketing, distributing and selling products. In addition, new market participants continue to enter the orthopedic industry. Many of these new competitors specialize in a specific product or focus on a particular market sector, making it more difficult for us to increase our overall market position. The frequent introduction by competitors of products that are or claim to be superior to our products or that are alternatives to our existing or planned products may also create market confusion that may make it difficult to differentiate the benefits of our products over competing products. In addition, the entry of multiple new products and competitors may lead some of our competitors to employ pricing strategies that could adversely affect the pricing of our products and pricing in the orthopedic surgery market generally. We also face a particular challenge of overcoming the long-standing practices by some orthopedic surgeons of using the products of our larger, more established competitors. Orthopedic surgeons who have completed many successful, complex surgeries using the products made by these competitors may be disinclined to adopt new products with which they are less familiar. Further, orthopedic surgeons may choose to use the products of our larger, more established competitors because of their broad and comprehensive adult orthopedic offerings. If these orthopedic surgeons do not adopt our products, then our revenue growth may slow or decline and our stock price may decline. Our competitors may also develop and patent processes or products earlier than we can or obtain domestic or international regulatory clearances or approvals for competing products more rapidly than we can, which could impair our ability to develop and commercialize similar processes or products. We also compete with our competitors in acquiring technologies and technology licenses complementary to our products or advantageous to our business. In addition, we compete with our competitors to engage the services of independent sales agencies and distributors, both those presently working with us and those with whom we hope to work as we expand. We provide implant and instrument sets for nearly all surgeries performed using our products, and maintaining sufficient levels of inventory could consume a significant amount of our resources, reduce our cash flows and lead to inventory impairment charges. We are required to maintain significant levels of implant and instrument sets for consignment to our customers. The amount of this investment is driven by the number of orthopedic surgeons or hospitals using our products, and as the number of different orthopedic surgeons and hospitals that use our products increases, the number of implant and instrument sets required to meet this demand will increase. Because we do not have the sales volume of some larger companies, we may be unable to utilize our instrument sets as often and our return on assets may be lower when compared to such companies. In addition, because fewer than all of the components of each set are used in a typical surgery, certain portions of the set may become obsolete before they can be used. In the event that a substantial portion of our inventory becomes obsolete, the resulting costs associated with the inventory impairment charges and costs required to replace such inventory could have a material adverse effect on our earnings and cash flows. In addition, as we introduce new products, new implant and instrument sets may be required, with a significant initial investment required to accommodate the launch of the product. The provision of loaned instrument sets to our customers may implicate certain federal and state fraud and abuse laws. In the United States, we typically loan instrument sets for each surgery performed using our products at no additional charge to the customer. The provision of these instruments at no charge to our customers may implicate certain federal and state fraud and abuse laws. Because the provision of loaned instrument sets may result in a benefit to our customers, the government could view this practice as a prohibited transfer of value intended to induce customers to purchase our products that are used in procedures reimbursed by a federal healthcare program. For further discussion of these laws, see “— Risks Related to Regulatory Matters — We are subject to certain federal, state and foreign fraud and abuse laws and health information privacy and security laws, which, if violated, could subject us to substantial penalties. Additionally, any challenge to or investigation into our practices under these laws could cause adverse publicity and be costly to respond to, and thus could harm our business.” We may seek to grow our business through acquisitions or investments in new or complementary businesses, products or technologies, through the licensing of products or technologies from third parties or other strategic alliances, and the failure to manage acquisitions, investments, licenses or other strategic alliances, or the failure to integrate them with our existing business, could have a material adverse effect on our operating results, dilute our stockholders’ ownership, increase our debt or cause us to incur significant expense. Our success depends on our ability to continually enhance and broaden our product offerings in response to changing customer demands, competitive pressures, technologies and market pressures. Accordingly, from time to time we may consider opportunities to acquire, make investments in or license other technologies, products and businesses that may enhance our capabilities, complement our current products or expand the breadth of our markets or customer base. Potential and completed acquisitions, strategic investments, licenses and other alliances involve numerous risks, including: difficulty assimilating or integrating acquired or licensed technologies, products or business operations; issues maintaining uniform standards, procedures, controls and policies; unanticipated costs associated with acquisitions or strategic alliances, including the assumption of unknown or contingent liabilities and the incurrence of debt or future write-offs of intangible assets or goodwill; diversion of management’s attention from our core business and disruption of ongoing operations; adverse effects on existing business relationships with suppliers and customers; risks associated with entering new markets in which we have limited or no experience; potential losses related to investments in other companies; potential loss of key employees of acquired businesses; and increased legal and accounting compliance costs. We do not know if we will be able to identify acquisitions or strategic relationships we deem suitable, whether we will be able to successfully complete any such transactions on favorable terms or at all or whether we will be able to successfully integrate any acquired business, product or technology into our business or retain any key personnel, suppliers or distributors. Our ability to successfully grow through strategic transactions depends upon our ability to identify, negotiate, complete and integrate suitable target businesses, technologies or products and to obtain any necessary financing. These efforts could be expensive and time-consuming and may disrupt our ongoing business and prevent management from focusing on our operations. Foreign acquisitions involve unique risks in addition to those mentioned above, including those related to integration of operations across different cultures, languages and legal and regulatory environments, currency risks and the particular economic, political and regulatory risks associated with specific countries. To finance any acquisitions, investments or strategic alliances, we may choose to issue shares of our common stock as consideration, which could dilute the ownership of our stockholders. Additional funds may not be available on terms that are favorable to us, or at all. If the price of our common stock is low or volatile, we may be unable to consummate any acquisitions, investments or strategic alliances using our stock as consideration. We may be unable to gain the support of leading hospitals and key opinion leaders, which may make it difficult to establish our products as a standard of care and achieve market acceptance. Our strategy includes educating leading hospitals and key opinion leaders in the industry. If these hospitals and key opinion leaders determine that alternative technologies are more effective or that the benefits offered by our products are not sufficient to justify their higher cost, or if we encounter difficulty promoting adoption or establishing these systems as a standard of care, our ability to achieve market acceptance of the products we introduce could be significantly limited. Orthopedic surgeons play a significant role in determining the course of treatment and, ultimately, the type of products that will be used to treat a patient. As a result, our success depends, in large part, on our ability to effectively market to them and demonstrate to orthopedic surgeons the merits of our products compared to those of our competitors for use in treating patients. Acceptance of our products depends on educating orthopedic surgeons as to the distinctive characteristics, perceived clinical benefits, safety and cost-effectiveness of our products as compared to our competitors’ products, and on training orthopedic surgeons in the proper use of our products. If we are not successful in convincing orthopedic surgeons of the merits of our products or educating them on the use of our products, they may not use our products or use them effectively and we may be unable to increase our sales, sustain our growth or achieve and sustain profitability. Furthermore, we believe many orthopedic surgeons may be hesitant to adopt our products unless they determine, based on experience, clinical data and published peer-reviewed journal articles, that our products provide benefits or are attractive alternatives to our competitors’ products. Orthopedic surgeons may be hesitant to change their surgical treatment practices for the following reasons, among others: lack of experience with our products; existing relationships with competitors and sales distributors that sell competitive products; lack or perceived lack of evidence supporting additional patient benefits; perceived liability risks generally associated with the use of new products and procedures; less attractive availability of coverage and reimbursement within healthcare payment systems compared to procedures using other products and techniques; costs associated with the purchase of new products and equipment; and the time commitment that may be required for training. In addition, we believe recommendations and support of our products by influential orthopedic surgeons are essential for market acceptance and adoption. If we do not receive support from such orthopedic surgeons or long-term data does not show the benefits of using our products, orthopedic surgeons may not use our products. In such circumstances, we may not achieve expected sales, growth or profitability. If orthopedic surgeons fail to safely and appropriately use our products, or if we are unable to train orthopedic surgeons on the safe and appropriate use of our products, we may be unable to achieve our expected growth. An important part of our sales process includes the ability to screen for and identify orthopedic surgeons who have the requisite training and experience to safely and appropriately use our products. If orthopedic surgeons are not properly trained, they may misuse or ineffectively use our products. This may also result in unsatisfactory patient outcomes, patient injury, negative publicity or lawsuits against us. If we are unable to successfully identify orthopedic surgeon customers who will be able to successfully deploy our products, we may be unable to achieve our expected growth. There is a learning process involved for orthopedic surgeons to become proficient in the use of our products. It is critical to the success of our commercialization efforts with respect to future products to train a sufficient number of orthopedic surgeons and to provide them with adequate instruction in the use of our products. This training process may take longer than expected and may therefore affect our ability to increase sales. Convincing orthopedic surgeons to dedicate the time and energy necessary for adequate training is challenging, and we may not be successful in these efforts. Although we believe our interactions with orthopedic surgeons are conducted in compliance with FDA, federal and state fraud and abuse and other applicable laws and regulations developed both nationally and in foreign countries, if the FDA or other competent authority determines that any of our activities constitute promotion of an unapproved use or promotion of an intended purpose not covered by FDA approved labeling or the current European Union product certification, or CE Mark, affixed to our product, they could request that we modify our activities, issue corrective advertising or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty. It is also possible that other federal, state or foreign enforcement authorities might take action under other regulatory authority, such as false claims laws, if they consider our business activities to constitute promotion of an off-label use, which could result in significant penalties, including, but not limited to, criminal, civil and administrative penalties, damages, fines, disgorgement, exclusion from participation in government healthcare programs and the curtailment of our operations. We have a limited operating history and may face difficulties encountered by early stage companies in new and evolving markets. We began operations in 2007. Accordingly, we have a limited operating history upon which to base an evaluation of our business and prospects. In assessing our prospects, you must consider the risks and difficulties frequently encountered by early stage companies in new and evolving markets. These risks include our ability to: manage rapidly changing and expanding operations; establish and increase awareness of our brand and strengthen customer loyalty; increase the number of our independent sales agencies and international distributors to expand sales of our products in the United States and in targeted international markets; implement and successfully execute our business and marketing strategy; respond effectively to competitive pressures and developments; continue to develop and enhance our products and products in development; obtain regulatory clearance or approval to commercialize new products and enhance our existing products; expand our presence in existing and commence operations in new international markets; and attract, retain and motivate qualified personnel. Our business is subject to seasonal fluctuations. Our business is subject to seasonal fluctuations in that our revenue is typically higher in the summer months and holiday periods, driven by higher sales of our complex spine and trauma and deformity products, which is influenced by the higher incidence of pediatric surgeries during these periods due to recovery time provided by breaks in the school year. Additionally, our complex spine patients tend to have additional health challenges that make scheduling their procedures variable in nature. As a result of these factors, our financial results for any single quarter or for periods of less than a year are not necessarily indicative of the results that may be achieved for a full fiscal year. If we are unable to convince hospital facilities to approve the use of our products, our sales may decrease. In the United States, in order for orthopedic surgeons to use our devices, the hospital facilities where these orthopedic surgeons treat patients will typically require us to obtain approval from the facility’s value analysis committee, or VAC. VACs typically review the comparative effectiveness and cost of medical devices used in the facility. The makeup and evaluation processes for VACs vary considerably, and it can be a lengthy, costly and time-consuming effort to obtain approval by the relevant VAC. For example, even if we have an agreement with a hospital system for the purchase of our products, in most cases, we must obtain VAC approval by each hospital within the system to sell at that particular hospital. Additionally, hospitals typically require separate VAC approval for each specialty in which our products are used, which may result in multiple VAC approval processes within the same hospital even if such product has already been approved for use by a different specialty group. We may need VAC approval for each different device to be used by the orthopedic surgeons in that specialty. In addition, hospital facilities and group purchasing organizations, or GPOs, which manage purchasing for multiple facilities, may also require us to enter into a purchase agreement and satisfy numerous elements of their administrative procurement process, which can also be a lengthy, costly, and time-consuming effort. If we do not obtain access to hospital facilities in a timely manner, or at all, via these VAC and purchase contract processes, or otherwise, or if we are unable to secure contracts in a timely manner, or at all, our operating costs will increase, our sales may decrease, and our operating results may be harmed. Furthermore, we may expend significant effort in these costly and time-consuming processes and still may not obtain VAC approval or a purchase contract from such hospitals or GPOs. We have limited experience in marketing and selling our products, and if we are unable to successfully expand our sales infrastructure and adequately address our customers’ needs, it could negatively impact sales and market acceptance of our products and we may never generate sufficient revenue to achieve or sustain profitability. We have limited experience in marketing and selling our products. We began selling our products in the United States in 2008 and internationally in 2011. As of June 30, 2017, our sales organization consisted of 31 independent stocking distributors in 35 countries. In April 2017, we began to supplement our use of independent distributors with direct sales programs in the United Kingdom, Ireland, Australia and New Zealand. In these markets, we work through sales agencies that are paid a commission. Our operating results are directly dependent upon the sales and marketing efforts of our independent sales agencies and distributors. If our independent sales agencies or distributors fail to adequately promote, market and sell our products, our sales could significantly decrease. In addition, our future sales will largely depend on our ability to increase our marketing efforts and adequately address our customers’ needs. We believe it is necessary to utilize a sales force that includes sales agencies with specific technical backgrounds that can support our customers’ needs. We will also need to attract independent sales personnel and attract and develop marketing personnel with industry expertise. Competition for such independent sales agencies, distributors and marketing employees is intense and we may be unable to attract and retain sufficient personnel to maintain an effective sales and marketing force. If we are unable to adequately address our customers’ needs, it could negatively impact sales and market acceptance of our products, and we may not generate sufficient revenue to sustain profitability. As we launch new products and increase our marketing efforts with respect to existing products, we will need to expand the reach of our marketing and sales networks. Our future success will depend largely on our ability to continue to hire, train, retain and motivate skilled independent sales agencies and distributors with significant technical knowledge in various areas. New hires require training and take time to achieve full productivity. If we fail to train new hires adequately, or if we experience high turnover in our sales force in the future, new hires may not become as productive as may be necessary to maintain or increase our sales. If we are unable to expand our sales and marketing capabilities domestically and internationally, we may be unable to effectively commercialize our products. We lack published long-term data supporting superior clinical outcomes enabled by our products, which could limit sales. We lack published long-term data supporting superior clinical outcomes enabled by our products. For this reason, orthopedic surgeons and other clinicians may be slow to adopt our products, we may not have comparative data that our competitors have or are generating, and we may be subject to greater regulatory and product liability risks. Further, future patient studies or clinical experience may indicate that treatment with our products does not improve patient outcomes. Such results would slow the adoption of our products by orthopedic surgeons, would significantly reduce our ability to achieve expected sales and could prevent us from achieving and maintaining profitability. In addition, because certain of our products have only been on the market for a few years, we have limited data with respect to treatment using these products. If future patient studies or clinical testing do not support our belief that our products offer a more advantageous treatment for a broad spectrum of pediatric orthopedic conditions, market acceptance of our products could fail to increase or could decrease. In the United States, healthcare providers who purchase our products generally rely on third-party payors, including Medicare, Medicaid and private health insurance plans, to pay for all or a portion of the cost of our products in the procedures in which they are employed. Because there is often no separate reimbursement for products used in surgical procedures, the additional cost associated with the use of our products can impact the profit margin of the hospital or surgery center where the surgery is performed. Some of our target customers may be unwilling to adopt our products in light of the additional associated cost. Further, any decline in the amount payors are willing to reimburse our customers for the procedures using our products may make it difficult for existing customers to continue using, or to adopt, our products and could create additional pricing pressure for us. We may be unable to sell our products on a profitable basis if third-party payors deny coverage or reduce their current levels of reimbursement. To contain costs of new technologies, governmental healthcare programs and third-party payors are increasingly scrutinizing new and existing treatments by requiring extensive evidence of favorable clinical outcomes. Orthopedic surgeons, hospitals and other healthcare providers may not purchase our products if they do not receive satisfactory reimbursement from these third-party payors for the cost of the procedures using our products. Payors continue to review their coverage policies carefully for existing and new therapies and can, without notice, deny coverage for treatments that include the use of our products. If third-party payors issue non-coverage policies or if our customers are not reimbursed at adequate levels, this could adversely affect sales of our products. In addition to uncertainties surrounding coverage policies, there are periodic changes to reimbursement rates and policies. Third-party payors regularly update reimbursement amounts and also from time to time revise the methodologies used to determine reimbursement amounts. This includes routine updates to payments to physicians, hospitals and ambulatory surgery centers for procedures during which our products are used. These updates could directly impact the demand for our products. For example, the Medicare Access and CHIP Reauthorization Act of 2015, or MACRA, provided for a 0.5% annual increase in payment rates under the Medicare Physician Fee Schedule, or PFS, through 2019, but no annual update from 2020 through 2025. MACRA also introduced a Quality Payment Program, or QPP, for Medicare physicians, nurses and other “eligible clinicians” beginning in 2019. At this time, it is unclear how the introduction of the QPP will impact overall reimbursement under the PFS. While MACRA applies only to Medicare reimbursement, Medicaid and private payors often follow Medicare payment limitations in setting their own reimbursement rates, and any reduction in Medicare reimbursement may result in a similar reduction in payments from private payors, which may result in reduced demand for our products. However, there is no uniform policy of coverage and reimbursement among payors in the United States. Therefore, coverage and reimbursement for procedures can differ significantly from payor to payor. Moreover, some healthcare providers in the United States have adopted or are considering a managed care system in which the providers contract to provide comprehensive healthcare for a fixed cost per person. Healthcare providers may attempt to control costs by authorizing fewer surgical procedures or by requiring the use of the least expensive clinically appropriate products available. Additionally, as a result of reform of the U.S. healthcare system, changes in reimbursement policies or healthcare cost containment initiatives may limit or restrict coverage and reimbursement for our products and cause our revenue to decline. Outside of the United States, reimbursement systems vary significantly by country. Many foreign markets have government-managed healthcare systems that govern reimbursement for orthopedic implants and procedures. Additionally, some foreign reimbursement systems provide for limited payments in a given period and therefore result in extended payment periods. If adequate levels of reimbursement from third-party payors outside of the United States are not obtained, international sales of our products may decline. The marketability of our products may suffer if government and commercial third-party payors fail to provide adequate coverage and reimbursement. Even if favorable coverage and reimbursement status is attained, less favorable coverage policies and reimbursement rates may be implemented in the future. Our employees, consultants, independent sales agencies and distributors and other commercial partners may engage in misconduct or other improper activities, including non-compliance with regulatory standards and requirements. We are exposed to the risk that our employees, consultants, independent sales agencies and distributors and other commercial partners may engage in fraudulent or illegal activity. Misconduct by these parties could include intentional, reckless or negligent conduct or other unauthorized activities that violate the regulations of the FDA and other U.S. healthcare regulators, as well as non-U.S. regulators, including those laws requiring the reporting of true, complete and accurate information to such regulators, manufacturing standards, healthcare fraud and abuse laws and regulations in the United States and abroad or laws that require the true, complete and accurate reporting of financial information or data. In particular, sales, marketing and business arrangements in the healthcare industry, including the sale of medical devices, are subject to extensive laws and regulations intended to prevent fraud, misconduct, kickbacks, self-dealing and other abusive practices. These laws and regulations may restrict or prohibit a wide range of pricing, discounting, marketing and promotion, sales commission, customer incentive programs and other business arrangements. It is not always possible to identify and deter misconduct by our employees, sales agencies, distributors and other third parties, and the precautions we take to detect and prevent this activity may not be effective in controlling unknown or unmanaged risks or losses or in protecting us from governmental investigations or other actions or lawsuits stemming from a failure to comply with these laws or regulations. If any such actions are instituted against us and we are not successful in defending ourselves or asserting our rights, those actions could result in the imposition of significant fines or other sanctions, including the imposition of civil, criminal and administrative penalties, damages, monetary fines, possible exclusion from participation in government healthcare programs, contractual damages, reputational harm, diminished profits and future earnings and curtailment of operations. Whether or not we are successful in defending against such actions or investigations, we could incur substantial costs, including legal fees, and divert the attention of management in defending ourselves against any of these claims or investigations. Our insurance policies are expensive and protect us only from some business risks, which will leave us exposed to significant uninsured liabilities. We do not carry insurance for all categories of risk that our business may encounter. Some of the policies we currently maintain include general liability, foreign liability, employee benefits liability, property, umbrella, workers’ compensation, products liability and directors’ and officers’ insurance. We do not know, however, if these policies will provide us with adequate levels of coverage. Any significant uninsured liability may require us to pay substantial amounts, which would adversely affect our cash position and results of operations. We bear the risk of warranty claims on our products. While we have no history of warranty claims, have no warranty reserves and had no warranty expense for the years ended December 31, 2015 or 2016 or the six months ended June 30, 2017, we bear the risk of warranty claims on the products we supply. We may not be successful in claiming recovery under any warranty or indemnity provided to us by our suppliers or vendors in the event of a successful warranty claim against us by a customer or that any recovery from such vendor or supplier would be adequate. In addition, warranty claims brought by our customers related to third-party components may arise after our ability to bring corresponding warranty claims against such suppliers expires, which could result in costs to us. The proliferation of physician-owned distributorships could result in increased pricing pressure on our products or harm our ability to sell our products to physicians who own or are affiliated with those distributorships. Physician-owned distributorships, or PODs, are product distributors that are owned, directly or indirectly, by physicians. PODs derive a portion, or substantially all, of their revenue from selling, or arranging for the sale of, products ordered by the physician-owners for use in procedures the physician-owners perform on their own patients at hospitals and other facilities that purchase from or through the POD, or otherwise generate revenue based directly or indirectly on product orders arranged for by physician-owners. On March 26, 2013, the Office of Inspector General of the U.S. Department of Health and Human Services, or the DHHS, issued a special fraud alert on PODs and stated that it views PODs as inherently suspect under the federal Anti-Kickback Statute and is concerned about the proliferation of PODs. Notwithstanding the DHHS’s concern about PODs, the number of PODs in the spinal surgery industry may continue to grow as economic pressures increase throughout the industry, hospitals, insurers and physicians search for ways to reduce costs and, in the case of the physicians, search for ways to increase their incomes. PODs and the physicians who own, or partially own, them have significant market knowledge and access to the orthopedic surgeons who use our products and the hospitals that purchase our products and thus the growth of PODs may reduce our ability to compete effectively for business from orthopedic surgeons who own such distributorships. Risks Related to Administrative, Organizational and Commercial Operations and Growth We may be unable to manage our anticipated growth effectively, which could make it difficult to execute our business strategy. We have been growing rapidly and have a relatively short history of operating as a commercial company. For example, our revenue grew from $23.7 million for the year ended December 31, 2014 to $37.3 million for the year ended December 31, 2016, and from $17.7 million for the six months ended June 30, 2016 to $21.6 million for the six months ended June 30, 2017. We intend to continue to grow our business operations and may experience periods of rapid growth and expansion. This anticipated growth could create a strain on our organizational, administrative and operational infrastructure, including our supply chain operations, quality control, technical support and customer service, sales force management and general and financial administration. We may be unable to maintain the quality of or delivery timelines of our products or satisfy customer demand as it grows. Our ability to manage our growth properly will require us to continue to improve our operational, financial and management controls, as well as our reporting systems and procedures. We may implement new enterprise software systems in a number of areas affecting a broad range of business processes and functional areas. The time and resources required to implement these new systems is uncertain and failure to complete this in a timely and efficient manner could harm our business. As our commercial operations and sales volume grow, we will need to continue to increase our workflow capacity for our supply chain, customer service, billing and general process improvements and expand our internal quality assurance program, among other things. These increases in scale or expansion of personnel may not be successfully implemented. The loss of our senior management or our inability to attract and retain highly skilled salespeople and engineers could negatively impact our business. Our success depends on the skills, experience and performance of the members of our executive management team. The individual and collective efforts of these employees will be important as we continue to develop our products and as we expand our commercial activities. We believe there are only a limited number of individuals with the requisite skills to serve in many of our key positions, and the loss or incapacity of existing members of our executive management team could negatively impact our operations if we experience difficulties in hiring qualified successors. We do not maintain key man life insurance with any of our employees. We have employment agreements with each of the members of our senior management; however, the existence of these employment agreement does not guarantee our retention of these employees for any period of time. Our commercial, supply chain and research and development programs and operations depend on our ability to attract and retain highly skilled salespeople and engineers. We may be unable to attract or retain qualified managers, salespeople or engineers in the future due to the competition for qualified personnel among medical device businesses. We also face competition from universities and public and private research institutions in recruiting and retaining highly qualified scientific personnel. Recruiting and retention difficulties can limit our ability to support our commercial, supply chain and research and development programs. All of our employees are at-will, which means that either we or the employee may terminate his or her employment at any time. The loss of key employees, the failure of any key employee to perform or our inability to attract and retain skilled employees, as needed, or an inability to effectively plan for and implement a succession plan for key employees could harm our business. We face risks associated with our international business. We market and sell our products in 35 countries outside of the United States. For the years ended December 31, 2015 and 2016 and for the six months ended June 30, 2016 and 2017, approximately 20%, 23%, 23% and 23% of our revenue was attributable to our international customers, respectively. These customers are generally allowed to return products, and some are thinly capitalized. The sale and shipment of our products across international borders, as well as the purchase of components and products from international sources, subjects us to extensive U.S. and other foreign governmental trade, import and export and customs regulations and laws. Compliance with these regulations and laws is costly and exposes us to penalties for non-compliance. We expect our international activities will be dynamic over the foreseeable future as we continue to pursue opportunities in international markets. Our international business operations are subject to a variety of risks, including: difficulties in staffing and managing foreign and geographically dispersed operations; having to comply with various U.S. and international laws, including export control laws and the U.S. Foreign Corrupt Practices Act of 1977, or the FCPA, and anti-money laundering laws; differing regulatory requirements for obtaining clearances or approvals to market our products; changes in, or uncertainties relating to, foreign rules and regulations that may impact our ability to sell our products, perform services or repatriate profits to the United States; tariffs and trade barriers, export regulations and other regulatory and contractual limitations on our ability to sell our products in certain foreign markets; fluctuations in foreign currency exchange rates; imposition of limitations on or increase of withholding and other taxes on remittances and other payments by foreign subsidiaries or joint ventures; differing multiple payor reimbursement regimes, government payors or patient self-pay systems; imposition of differing labor laws and standards; economic, political or social instability in foreign countries and regions; an inability, or reduced ability, to protect our intellectual property, including any effect of compulsory licensing imposed by government action; and availability of government subsidies or other incentives that benefit competitors in their local markets that are not available to us. We expect we will continue expanding into other international markets; however, our expansion plans may not be realized, or if realized, may not be successful. We expect each market to have particular regulatory and funding hurdles to overcome and future developments in these markets, including the uncertainty relating to governmental policies and regulations, could harm our business. We could be negatively impacted by violations of applicable anti-corruption laws or violations of our internal policies designed to ensure ethical business practices. We operate in a number of countries throughout the world, including in countries that do not have as strong a commitment to anti-corruption and ethical behavior that is required by U.S. laws or by corporate policies. We are subject to the risk that we, our U.S. employees or our employees located in other jurisdictions or any third parties such as our sales agencies and distributors that we engage to do work on our behalf in foreign countries may take action determined to be in violation of anti-corruption laws in any jurisdiction in which we conduct business, including the FCPA and the Bribery Act of 2010, or the U.K. Anti-Bribery Act. The FCPA generally prohibits covered entities and their intermediaries from engaging in bribery or making other prohibited payments, offers or promises to foreign officials for the purpose of obtaining or retaining business or other advantages. In addition, the FCPA imposes recordkeeping and internal controls requirements on publicly traded corporations and their foreign affiliates, which are intended to, among other things, prevent the diversion of corporate funds to the payment of bribes and other improper payments, and to prevent the establishment of “off books” slush funds from which such improper payments can be made. As a substantial portion of our revenue is, and we expect will continue to be, from jurisdictions outside of the United States, we face significant risks if we fail to comply with the FCPA and other laws that prohibit improper payments, offers or promises of payment to foreign governments and their officials and political parties by us and other business entities for the purpose of obtaining or retaining business or other advantages. In many foreign countries, particularly in countries with developing economies, it may be a local custom that businesses operating in such countries engage in business practices that are prohibited by the FCPA or other laws and regulations. Although we have implemented a company policy requiring our employees and consultants to comply with the FCPA and similar laws, such policy may not be effective at preventing all potential FCPA or other violations. Although our agreements with our international distributors clearly state our expectations for our distributors’ compliance with U.S. laws, including the FCPA, and provide us with various remedies upon any non-compliance, including the ability to terminate the agreement, our distributors may not comply with U.S. laws, including the FCPA. In addition, we operate in certain countries in which the government may take an ownership stake in an enterprise and such government ownership may not be readily apparent, thereby increasing potential anti-corruption law violations. Any violation of the FCPA and U.K. Anti-Bribery Act or any similar anti-corruption law or regulation could result in substantial fines, sanctions, civil and/or criminal penalties and curtailment of operations in certain jurisdictions and might harm our business, financial condition or results of operations. In addition, we have internal ethics policies with which we require our employees to comply in order to ensure that our business is conducted in a manner that our management deems appropriate. If these anti-corruption laws or internal policies were to be violated, our reputation and operations could also be substantially harmed. Further, detecting, investigating and resolving actual or alleged violations is expensive and can consume significant time and attention of our senior management. As a result of our focus on managing our growth, our development of infrastructure designed to identify FCPA matters and monitor compliance is at an early stage. Our results may be impacted by changes in foreign currency exchange rates. We have international operations and, as a result, an increase in the value of the U.S. dollar relative to foreign currencies could require us to reduce our selling price or risk making our products less competitive in international markets or our costs could increase. Also, if our international sales increase, we may enter into a greater number of transactions denominated in non-U.S. dollars, which could expose us to foreign currency risks, including changes in currency exchange rates. We do not currently engage in any hedging transactions. If we are unable to address these risks and challenges effectively, our international operations may not be successful and our business could be harmed. We will incur significant costs as a result of operating as a public company and our management expects to devote substantial time to public company compliance programs. As a public company, we will incur significant legal, accounting and other expenses due to our compliance with regulations and disclosure obligations applicable to us, including compliance with the Sarbanes-Oxley Act, as well as rules implemented by the Securities and Exchange Commission, or the SEC, and The NASDAQ Global Market, or NASDAQ. We estimate that our incremental cost from operating as a public company may be between $1.5 million and $2.0 million per year. Stockholder activism, the current political environment and the current high level of government intervention and regulatory reform may lead to substantial new regulations and disclosure obligations, which may lead to additional compliance costs and impact, in ways we cannot currently anticipate, the manner in which we operate our business. Our management and other personnel will devote a substantial amount of time to these compliance programs and monitoring of public company reporting obligations and as a result of the new corporate governance and executive compensation related rules, regulations and guidelines prompted by the Dodd-Frank Wall Street Reform and Consumer Protection Act, and further regulations and disclosure obligations expected in the future, we will likely need to devote additional time and costs to comply with such compliance programs and rules. These rules and regulations will cause us to incur significant legal and financial compliance costs and will make some activities more time-consuming and costly. As a result of becoming a public company, we will be obligated to develop and maintain proper and effective internal controls over financial reporting and any failure to maintain the adequacy of these internal controls may adversely affect investor confidence in our company and, as a result, the value of our common stock. To comply with the requirements of being a public company, we will likely need to undertake various actions, including implementing new internal controls and procedures and hiring new accounting or internal audit staff. The Sarbanes-Oxley Act requires that we maintain effective disclosure controls and procedures and internal control over financial reporting. We are continuing to develop and refine our disclosure controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file with the SEC is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and that information required to be disclosed in reports under the Securities Exchange Act of 1934, or the Exchange Act, is accumulated and communicated to our principal executive and financial officers. Our current controls and any new controls that we develop may become inadequate and weaknesses in our internal control over financial reporting may be discovered in the future. Any failure to develop or maintain effective controls when we become subject to this requirement could negatively impact the results of periodic management evaluations and annual independent registered public accounting firm attestation reports regarding the effectiveness of our internal control over financial reporting that we may be required to include in our periodic reports we will file with the SEC under Section 404 of the Sarbanes-Oxley Act, harm our operating results, cause us to fail to meet our reporting obligations or result in a restatement of our prior period financial statements. In the event that we are not able to demonstrate compliance with the Sarbanes-Oxley Act, that our internal control over financial reporting is perceived as inadequate or that we are unable to produce timely or accurate financial statements, investors may lose confidence in our operating results and the price of our common stock could decline. In addition, if we are unable to continue to meet these requirements, we may be unable to remain listed on NASDAQ. Our independent registered public accounting firm will not be required to formally attest to the effectiveness of our internal control over financial reporting until the later of our second annual report or the first annual report required to be filed with the SEC following the date we are no longer an “emerging growth company,” as defined in the JOBS Act, depending on whether we choose to rely on certain exemptions set forth in the JOBS Act. In preparing our financial statements for the fiscal year ended December 31, 2015, we identified a material weakness in our internal control over financial reporting, which we believe has been properly remediated. However, the identification of any other material weaknesses in the future could result in material misstatements in our financial statements. Our management is responsible for establishing and maintaining adequate internal control over financial reporting for our company. Our management identified a material weakness in our internal control over financial reporting as of December 31, 2015. A material weakness is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. The material weakness identified as of December 31, 2015 resulted from the fact that we did not have sufficient financial reporting and accounting controls over complex accounting transactions to address complex U.S. generally accepted accounting principles, or GAAP, considerations and applicable SEC rules and regulations. As of December 31, 2016, we had implemented remedial measures designed to address this material weakness, including: (i) the hiring of additional personnel with the appropriate financial reporting experience to expand our financial management and reporting infrastructure and further develop and document our accounting policies and financial reporting procedures with respect to complex accounting transactions; (ii) the retention of an additional accounting firm, as needed, to provide technical consulting services with respect to complex accounting transactions; and (iii) the establishment and implementation of policies and procedures to ensure adherence to accounting policies, rules and regulations and to provide enhanced financial analysis and quality control with respect to complex accounting transactions. As of December 31, 2016, we believe this material weakness had been properly remediated. However, if additional material weaknesses or significant deficiencies in our internal control are discovered or occur in the future, our consolidated financial statements may contain material misstatements and we could be required to restate our financial results. If we experience significant disruptions in our information technology systems, our business may be adversely affected. We depend on our information technology systems for the efficient functioning of our business, including accounting, data storage, compliance, purchasing and inventory management. We do not have redundant systems at this time. While we will attempt to mitigate interruptions, we may experience difficulties in implementing some upgrades, which would impact our business operations, or experience difficulties in operating our business during the upgrade, either of which could disrupt our operations, including our ability to timely ship and track product orders, project inventory requirements, manage our supply chain and otherwise adequately service our customers. In the event we experience significant disruptions as a result of the current implementation of our information technology systems, we may be unable to repair our systems in an efficient and timely manner. Accordingly, such events may disrupt or reduce the efficiency of our entire operation and have a material adverse effect on our results of operations and cash flows. We are increasingly dependent on sophisticated information technology for our infrastructure. Our information systems require an ongoing commitment of significant resources to maintain, protect and enhance existing systems. Failure to maintain or protect our information systems and data integrity effectively could have a materially adverse effect on our business. For example, third parties may attempt to hack into our systems and obtain proprietary information. We may be subject to various litigation claims and legal proceedings. We, as well as certain of our officers and distributors, may be subject to other claims or lawsuits. Regardless of the outcome, these lawsuits may result in significant legal fees and expenses and could divert management’s time and other resources. If the claims contained in these lawsuits are successfully asserted against us, we could be liable for damages and be required to alter or cease certain of our business practices or product lines. If product liability lawsuits are brought against us, our business may be harmed, and we may be required to pay damages that exceed our insurance coverage. Our business exposes us to potential product liability claims that are inherent in the testing, manufacture and sale of medical devices for orthopedic surgery procedures. These surgeries involve significant risk of serious complications, including bleeding, nerve injury, paralysis and even death. Furthermore, if orthopedic surgeons are not sufficiently trained in the use of our products, they may misuse or ineffectively use our products, which may result in unsatisfactory patient outcomes or patient injury. We could become the subject of product liability lawsuits alleging that component failures, malfunctions, manufacturing flaws, design defects or inadequate disclosure of product-related risks or product-related information resulted in an unsafe condition or injury to patients. We have had, and continue to have, a small number of product liability claims relating to our products, and in the future, we may be subject to additional product liability claims. Regardless of the merit or eventual outcome, product liability claims may result in: decreased demand for our products; injury to our reputation; significant litigation costs; substantial monetary awards to or costly settlements with patients; product recalls; material defense costs; loss of revenue; the inability to commercialize new products or product candidates; and diversion of management attention from pursuing our business strategy. Our existing product liability insurance coverage may be inadequate to protect us from any liabilities we might incur. If a product liability claim or series of claims is brought against us for uninsured liabilities or in excess of our insurance coverage, our business could suffer. Any product liability claim brought against us, with or without merit, could result in the increase of our product liability insurance rates or the inability to secure coverage in the future. In addition, a recall of some of our products, whether or not the result of a product liability claim, could result in significant costs and loss of customers. In addition, we may be unable to maintain insurance coverage at a reasonable cost or in sufficient amounts or scope to protect us against losses. Any claims against us, regardless of their merit, could severely harm our financial condition, strain our management and other resources and adversely affect or eliminate the prospects for commercialization or sales of a product or product candidate that is the subject of any such claim. Our operations are vulnerable to interruption or loss due to natural or other disasters, power loss, strikes and other events beyond our control. A major earthquake, fire or other disaster (such as a major flood, tsunami, volcanic eruption or terrorist attack) affecting our facilities, or those of our suppliers, could significantly disrupt our operations, and delay or prevent product shipment or installation during the time required to repair, rebuild or replace our suppliers’ damaged manufacturing facilities; these delays could be lengthy and costly. If any of our customers’ facilities are negatively impacted by a disaster, shipments of our products could be delayed. Additionally, customers may delay purchases of our products until operations return to normal. Even if we are able to quickly respond to a disaster, the ongoing effects of the disaster could create some uncertainty in the operations of our business. In addition, our facilities may be subject to a shortage of available electrical power and other energy supplies. Any shortages may increase our costs for power and energy supplies or could result in blackouts, which could disrupt the operations of our affected facilities and harm our business. In addition, concerns about terrorism, the effects of a terrorist attack, political turmoil or an outbreak of epidemic diseases could have a negative effect on our operations, those of our suppliers and customers and the ability to travel. Risks Related to Regulatory Matters Our products and operations are subject to extensive government regulation and oversight both in the United States and abroad, and our failure to comply with applicable requirements could harm our business. We and our products are subject to extensive regulation in the United States and elsewhere, including by the FDA and its foreign counterparts. The FDA and foreign regulatory agencies regulate, among other things, with respect to medical devices: design, development and manufacturing; testing, labeling, content and language of instructions for use and storage; clinical trials; product safety; marketing, sales and distribution; premarket clearance and approval; record keeping procedures; advertising and promotion; recalls and field safety corrective actions; post-market surveillance, including reporting of deaths or serious injuries and malfunctions that, if they were to recur, could lead to death or serious injury; post-market approval studies; and product import and export. The regulations to which we are subject are complex and have tended to become more stringent over time. Regulatory changes could result in restrictions on our ability to carry on or expand our operations, higher than anticipated costs or lower than anticipated sales. The FDA enforces these regulatory requirements through periodic unannounced inspections. We do not know whether we will pass any future FDA inspections. Failure to comply with applicable regulations could jeopardize our ability to sell our products and result in enforcement actions such as: warning letters; fines; injunctions; civil penalties; termination of distribution; recalls or seizures of products; delays in the introduction of products into the market; total or partial suspension of production; refusal to grant future clearances or approvals; withdrawals or suspensions of current clearances or approvals, resulting in prohibitions on sales of our products; and in the most serious cases, criminal penalties. We may not receive the necessary clearances or approvals for our future products, and failure to timely obtain necessary clearances or approvals for our future products would adversely affect our ability to grow our business. An element of our strategy is to continue to upgrade our products, add new features and expand clearance or approval of our current products to new indications. In the United States, before we can market a new medical device, or a new use of, new claim for or significant modification to an existing product, we must first receive either clearance under Section 510(k) of the Federal Food, Drug, and Cosmetic Act, or the FDCA, or approval of a premarket approval application, or PMA, from the FDA, unless an exemption applies. In the 510(k) clearance process, before a device may be marketed, the FDA must determine that a proposed device is “substantially equivalent” to a legally-marketed “predicate” device, which includes a device that has been previously cleared through the 510(k) process, a device that was legally marketed prior to May 28, 1976 (pre-amendments device), a device that was originally on the U.S. market pursuant to an approved PMA and later down-classified, or a 510(k)-exempt device. To be “substantially equivalent,” the proposed device must have the same intended use as the predicate device, and either have the same technological characteristics as the predicate device or have different technological characteristics and not raise different questions of safety or effectiveness than the predicate device. Clinical data are sometimes required to support substantial equivalence. In the PMA process, the FDA must determine that a proposed device is safe and effective for its intended use based, in part, on extensive data, including, but not limited to, technical, pre-clinical, clinical trial, manufacturing and labeling data. The PMA process is typically required for devices that are deemed to pose the greatest risk, such as life-sustaining, life-supporting or implantable devices. Modifications to products that are approved through a PMA application generally require FDA approval. Similarly, certain modifications made to products cleared through a 510(k) may require a new 510(k) clearance. Both the PMA approval and the 510(k) clearance process can be expensive, lengthy and uncertain. The FDA’s 510(k) clearance process usually takes from three to 12 months, but can last longer. The process of obtaining a PMA is much more costly and uncertain than the 510(k) clearance process and generally takes from one to three years, or even longer, from the time the application is filed with the FDA. In addition, a PMA generally requires the performance of one or more clinical trials. Despite the time, effort and cost, a device may not be approved or cleared by the FDA. Any delay or failure to obtain necessary regulatory approvals could harm our business. Furthermore, even if we are granted regulatory clearances or approvals, they may include significant limitations on the indicated uses for the device, which may limit the market for the device. In the United States, we have obtained 510(k) premarket clearance from the FDA to market each of our products requiring such clearance. Any modifications to these existing products may require new 510(k) clearance; however, future modifications may be subject to the substantially more costly, time-consuming and uncertain PMA process. If the FDA requires us to go through a lengthier, more rigorous examination for future products or modifications to existing products than we had expected, product introductions or modifications could be delayed or canceled, which could cause our sales to decline. The FDA can delay, limit or deny clearance or approval of a device for many reasons, including: we may be unable to demonstrate to the FDA’s satisfaction that the product or modification is substantially equivalent to the proposed predicate device or safe and effective for its intended use; the data from our pre-clinical studies and clinical trials may be insufficient to support clearance or approval, where required; and the manufacturing process or facilities we use may not meet applicable requirements. In addition, the FDA may change its clearance and approval policies, adopt additional regulations or revise existing regulations, or take other actions, which may prevent or delay approval or clearance of our future products under development or impact our ability to modify our currently cleared products on a timely basis. Such policy or regulatory changes could impose additional requirements upon us that could delay our ability to obtain new 510(k) clearances, increase the costs of compliance or restrict our ability to maintain our current clearances. For example, in response to industry and healthcare provider concerns regarding the predictability, consistency and rigor of the 510(k) clearance process, the FDA initiated an evaluation, and in January 2011, announced several proposed actions intended to reform the 510(k) clearance process. The FDA intends these reform actions to improve the efficiency and transparency of the clearance process, as well as bolster patient safety. In addition, as part of the Food and Drug Administration Safety and Innovation Act, or FDASIA, enacted in 2012, Congress reauthorized the Medical Device User Fee Amendments with various FDA performance goal commitments and enacted several “Medical Device Regulatory Improvements” and miscellaneous reforms, which are further intended to clarify and improve medical device regulation both pre- and post-clearance and approval. Some of these proposals and reforms could impose additional regulatory requirements upon us that could delay our ability to obtain new 510(k) clearances, increase the costs of compliance or restrict our ability to maintain our current clearances. In order to sell our products in member countries of the EEA our products must comply with the essential requirements of the EU Medical Devices Directive (Council Directive 93/42/EEC). Compliance with these requirements is a prerequisite to be able to affix the CE Mark to our products, without which they cannot be sold or marketed in the EEA. To demonstrate compliance with the essential requirements we must undergo a conformity assessment procedure, which varies according to the type of medical device and its classification. Except for low-risk medical devices (Class I non-sterile, non-measuring devices), where the manufacturer can issue an EC Declaration of Conformity based on a self-assessment of the conformity of its products with the essential requirements of the EU Medical Devices Directive, a conformity assessment procedure requires the intervention of an organization accredited by a Member State of the EEA to conduct conformity assessments, or a Notified Body. Depending on the relevant conformity assessment procedure, the Notified Body would typically audit and examine the technical file and the quality system for the manufacture, design and final inspection of our devices. The Notified Body issues a certificate of conformity following successful completion of a conformity assessment procedure conducted in relation to the medical device and its manufacturer and their conformity with the essential requirements. This certificate entitles the manufacturer to affix the CE Mark to its medical devices after having prepared and signed a related EC Declaration of Conformity. As a general rule, demonstration of conformity of medical devices and their manufacturers with the essential requirements must be based, among other things, on the evaluation of clinical data supporting the safety and performance of the products during normal conditions of use. Specifically, a manufacturer must demonstrate that the device achieves its intended performance during normal conditions of use, that the known and foreseeable risks, and any adverse events, are minimized and acceptable when weighed against the benefits of its intended performance, and that any claims made about the performance and safety of the device are supported by suitable evidence. If we fail to remain in compliance with applicable European laws and directives, we would be unable to continue to affix the CE Mark to our surgical systems, which would prevent us from selling them within the EEA. We or our distributors will also need to obtain regulatory approval in other foreign jurisdictions in which we plan to market and sell our products. Modifications to our products may require new 510(k) clearances or PMA approvals, and may require us to cease marketing or recall the modified products until clearances are obtained. Any modification to a 510(k)-cleared product that could significantly affect its safety or effectiveness, or that would constitute a major change in its intended use, design or manufacture, requires a new 510(k) clearance or, possibly, approval of a PMA. The FDA requires every manufacturer to make this determination in the first instance, but the FDA may review any manufacturer’s decision. The FDA may not agree with our decisions regarding whether new clearances or approvals are necessary. We have made modifications to our products in the past and have determined based on our review of the applicable FDA regulations and guidance that in certain instances new 510(k) clearances were not required. We may make similar modifications or add additional features in the future that we believe do not require a new 510(k) clearance or approval of a PMA. If the FDA disagrees with our determination and requires us to submit new 510(k) notifications or PMAs for modifications to our previously cleared products for which we have concluded that new clearances or approvals are unnecessary, we may be required to cease marketing or to recall the modified product until we obtain clearance or approval, and we may be subject to significant regulatory fines or penalties. In addition, the FDA may not approve or clear our products for the indications that are necessary or desirable for successful commercialization or could require clinical trials to support any modifications. Any delay or failure in obtaining required clearances or approvals would adversely affect our ability to introduce new or enhanced products in a timely manner, which in turn would harm our future growth. Furthermore, the FDA’s ongoing review of the 510(k) clearance process may make it more difficult for us to make modifications to our previously cleared products, either by imposing more strict requirements on when a new 510(k) notification for a modification to a previously cleared product must be submitted, or applying more onerous review criteria to such submissions. For example, the FDA is currently reviewing its guidance describing when it believes a manufacturer is obligated to submit a new 510(k) for modifications or changes to a previously cleared device. The FDA is expected to issue revised guidance, originally issued in 1997, to assist device manufacturers in making this determination. It is unclear whether the FDA’s approach in this new guidance will result in substantive changes to existing policy and practice regarding the assessment of whether a new 510(k) is required for changes or modifications to existing devices. The FDA continues to review its 510(k) clearance process, which could result in additional changes to regulatory requirements or guidance documents, which could increase the costs of compliance or restrict our ability to maintain current clearances. Our products must be manufactured in accordance with federal and state regulations, and we could be forced to recall our installed systems or terminate production if we fail to comply with these regulations. The methods used in, and the facilities used for, the manufacture of our products must comply with the FDA’s Quality System Regulation, or QSR, which is a complex regulatory scheme that covers the procedures and documentation of the design, testing, production, process controls, quality assurance, labeling, packaging, handling, storage, distribution, installation, servicing and shipping of medical devices. Furthermore, we are required to verify that our suppliers maintain facilities, procedures and operations that comply with our quality standards and applicable regulatory requirements. The FDA enforces the QSR through periodic announced or unannounced inspections of medical device manufacturing facilities, which may include the facilities of subcontractors. Our products are also subject to similar state regulations and various laws and regulations of foreign countries governing manufacturing. Our third-party manufacturers may not take the necessary steps to comply with applicable regulations, which could cause delays in the delivery of our products. In addition, failure to comply with applicable FDA requirements or later discovery of previously unknown problems with our products or manufacturing processes could result in, among other things: warning letters or untitled letters; fines, injunctions or civil penalties; suspension or withdrawal of approvals or clearances; seizures or recalls of our products; total or partial suspension of production or distribution; administrative or judicially imposed sanctions; the FDA’s refusal to grant pending or future clearances or approvals for our products; clinical holds; refusal to permit the import or export of our products; and criminal prosecution of us or our employees. Any of these actions could significantly and negatively impact supply of our products. If any of these events occurs, our reputation could be harmed, we could be exposed to product liability claims and we could lose customers and suffer reduced revenue and increased costs. If treatment guidelines for the orthopedic conditions we are targeting change or the standard of care evolves, we may need to redesign and seek new marketing authorization from the FDA for one or more of our products. If treatment guidelines for the orthopedic conditions we are targeting or the standard of care for such conditions evolves, we may need to redesign the applicable product and seek new clearances or approvals from the FDA. Our 510(k) clearances from the FDA are based on current treatment guidelines. If treatment guidelines change so that different treatments become desirable, the clinical utility of one or more of our products could be diminished and our business could suffer. The misuse or off-label use of our products may harm our reputation in the marketplace, result in injuries that lead to product liability suits or result in costly investigations, fines or sanctions by regulatory bodies if we are deemed to have engaged in the promotion of these uses, any of which could be costly to our business. Our products have been cleared by the FDA for specific indications. We train our marketing personnel and independent sales agencies and distributors to not promote our products for uses outside of the FDA-cleared indications for use, known as “off-label uses.” We cannot, however, prevent a physician from using our products off-label, when in the physician’s independent professional medical judgment he or she deems it appropriate. There may be increased risk of injury to patients if physicians attempt to use our products off-label. Furthermore, the use of our products for indications other than those cleared by the FDA or approved by any foreign regulatory body may not effectively treat such conditions, which could harm our reputation in the marketplace among physicians and patients. If the FDA or any foreign regulatory body determines that our promotional materials or training constitute promotion of an off-label use, it could request that we modify our training or promotional materials or subject us to regulatory or enforcement actions, including the issuance or imposition of an untitled letter, which is used for violators that do not necessitate a warning letter, injunction, seizure, civil fine or criminal penalties. It is also possible that other federal, state or foreign enforcement authorities might take action under other regulatory authority, such as false claims laws, if they consider our business activities to constitute promotion of an off-label use, which could result in significant penalties, including, but not limited to, criminal, civil and administrative penalties, damages, fines, disgorgement, exclusion from participation in government healthcare programs and the curtailment of our operations. Our products may cause or contribute to adverse medical events that we are required to report to the FDA, and if we fail to do so, we would be subject to sanctions that could harm our reputation, business, financial condition and results of operations. The discovery of serious safety issues with our products, or a recall of our products either voluntarily or at the direction of the FDA or another governmental authority, could have a negative impact on us. We are subject to the FDA’s medical device reporting regulations and similar foreign regulations, which require us to report to the FDA when we receive or become aware of information that reasonably suggests that one or more of our products may have caused or contributed to a death or serious injury or malfunctioned in a way that, if the malfunction were to recur, it could cause or contribute to a death or serious injury. The timing of our obligation to report is triggered by the date we become aware of the adverse event as well as the nature of the event. We may fail to report adverse events of which we become aware within the prescribed timeframe. We may also fail to recognize that we have become aware of a reportable adverse event, especially if it is not reported to us as an adverse event or if it is an adverse event that is unexpected or removed in time from the use of the product. If we fail to comply with our reporting obligations, the FDA could take action, including warning letters, untitled letters, administrative actions, criminal prosecution, imposition of civil monetary penalties, revocation of our device clearance, seizure of our products or delay in clearance of future products. The FDA and foreign regulatory bodies have the authority to require the recall of commercialized products in the event of material deficiencies or defects in design or manufacture of a product or in the event that a product poses an unacceptable risk to health. The FDA’s authority to require a recall must be based on a finding that there is reasonable probability that the device could cause serious injury or death. We may also choose to voluntarily recall a product if any material deficiency is found. We have in the past conducted several voluntary recalls of devices with lot-specific quality issues. A government-mandated or voluntary recall by us could occur as a result of an unacceptable risk to health, component failures, malfunctions, manufacturing defects, labeling or design deficiencies, packaging defects or other deficiencies or failures to comply with applicable regulations. Product defects or other errors may occur in the future. Depending on the corrective action we take to redress a product’s deficiencies or defects, the FDA may require, or we may decide, that we will need to obtain new approvals or clearances for the device before we may market or distribute the corrected device. Seeking such approvals or clearances may delay our ability to replace the recalled devices in a timely manner. Moreover, if we do not adequately address problems associated with our devices, we may face additional regulatory enforcement action, including FDA warning letters, product seizure, injunctions, administrative penalties or civil or criminal fines. Companies are required to maintain certain records of recalls and corrections, even if they are not reportable to the FDA. We may initiate voluntary withdrawals or corrections for our products in the future that we determine do not require notification of the FDA. If the FDA disagrees with our determinations, it could require us to report those actions as recalls and we may be subject to enforcement action. A future recall announcement could harm our reputation with customers, potentially lead to product liability claims against us and negatively affect our sales. If we or our distributors do not obtain and maintain international regulatory registrations or approvals for our products, we will be unable to market and sell our products outside of the United States. Sales of our products outside of the United States are subject to foreign regulatory requirements that vary widely from country to country. In addition, the FDA regulates exports of medical devices from the United States. While the regulations of some countries may not impose barriers to marketing and selling our products or only require notification, others require that we or our distributors obtain the approval of a specified regulatory body. Complying with foreign regulatory requirements, including obtaining registrations or approvals, can be expensive and time-consuming, and we or our distributors may not receive regulatory approvals in each country in which we plan to market our products or we may be unable to do so on a timely basis. The time required to obtain registrations or approvals, if required by other countries, may be longer than that required for FDA clearance, and requirements for such registrations, clearances or approvals may significantly differ from FDA requirements. If we modify our products, we or our distributors may need to apply for additional regulatory approvals before we are permitted to sell the modified product. In addition, we may not continue to meet the quality and safety standards required to maintain the authorizations that we or our distributors have received. If we or our distributors are unable to maintain our authorizations in a particular country, we will no longer be able to sell the applicable product in that country. Regulatory clearance or approval by the FDA does not ensure clearance or approval by regulatory authorities in other countries, and clearance or approval by one or more foreign regulatory authorities does not ensure clearance or approval by regulatory authorities in other foreign countries or by the FDA. However, a failure or delay in obtaining regulatory clearance or approval in one country may have a negative effect on the regulatory process in others. Legislative or regulatory reforms in the United States or the EU may make it more difficult and costly for us to obtain regulatory clearances or approvals for our products or to manufacture, market or distribute our products after clearance or approval is obtained. From time to time, legislation is drafted and introduced in Congress that could significantly change the statutory provisions governing the regulation of medical devices. In addition, FDA regulations and guidance are often revised or reinterpreted by the FDA in ways that may significantly affect our business and our products. Any new statutes, regulations or revisions or reinterpretations of existing regulations may impose additional costs or lengthen review times of any future products or make it more difficult to manufacture, market or distribute our products. We cannot determine what effect changes in regulations, statutes, legal interpretation or policies, when and if promulgated, enacted or adopted may have on our business in the future. Such changes could, among other things, require: additional testing prior to obtaining clearance or approval; changes to manufacturing methods; recall, replacement or discontinuance of our products; or additional record keeping. In September 2012, the European Commission published proposals for the revision of the EU regulatory framework for medical devices. The proposal would replace the EU Medical Devices Directive and the Active Implantable Medical Devices Directive with a new regulation, the Medical Devices Regulation. Unlike the Directives that must be implemented into national laws, the Regulation would be directly applicable in all EEA Member States and so is intended to eliminate current national differences in regulation of medical devices. In October 2013, the European Parliament approved a package of reforms to the European Commission’s proposals. Under the revised proposals, only designated “special notified bodies” would be entitled to conduct conformity assessments of high-risk devices. These special notified bodies will need to notify the European Commission when they receive an application for a conformity assessment for a new high-risk device. The European Commission will then forward the notification and the accompanying documents on the device to the Medical Devices Coordination Group, or MDCG (a new, yet to be created body chaired by the European Commission and representatives of certain European states), for an opinion. These new procedures may result in a longer or more burdensome assessment of our new products. The Medical Devices Regulation, or MDR, entered into force in May 2017 and will become applicable in 2020. The MDR imposes additional reporting requirements on manufacturers of high-risk medical devices, imposes an obligation on manufacturers to appoint a “qualified person” responsible for regulatory compliance and provides for more strict clinical evidence requirements. We are subject to certain federal, state and foreign fraud and abuse laws, health information privacy and security laws and transparency laws, which, if violated, could subject us to substantial penalties. Additionally, any challenge to or investigation into our practices under these laws could cause adverse publicity and be costly to respond to, and thus could harm our business. There are numerous U.S. federal and state, as well as foreign, laws pertaining to healthcare fraud and abuse, including anti-kickback, false claims and physician transparency laws. Our business practices and relationships with providers and hospitals are subject to scrutiny under these laws. We may also be subject to patient information privacy and security regulation by both the federal government and the states and foreign jurisdictions in which we conduct our business. The healthcare laws and regulations that may affect our ability to operate include: the federal Anti-Kickback Statute, which prohibits, among other things, persons and entities from knowingly and willfully soliciting, offering, receiving or providing remuneration, directly or indirectly, in cash or in kind, to induce either the referral of an individual or furnishing or arranging for a good or service, for which payment may be made, in whole or in part, under federal healthcare programs, such as Medicare and Medicaid. A person or entity does not need to have actual knowledge of the statute or specific intent to violate it to have committed a violation. Moreover, the government may assert that a claim including items or services resulting from a violation of the federal Anti-Kickback Statute constitutes a false or fraudulent claim for purposes of the federal civil False Claims Act. Violations of the federal Anti-Kickback Statute may result in substantial civil or criminal penalties, civil penalties under the Civil Monetary Penalties Law, civil penalties under the federal False Claims Act and exclusion from participation in government healthcare programs, including Medicare and Medicaid; the federal civil and criminal false claims laws and civil monetary penalties laws, including the federal civil False Claims Act, which prohibit, among other things, individuals or entities from knowingly presenting, or causing to be presented, claims for payment from Medicare, Medicaid or other federal healthcare programs that are false or fraudulent. Private individuals can bring False Claims Act “qui tam” actions, on behalf of the government and such individuals, commonly known as “whistleblowers,” may share in amounts paid by the entity to the government in fines or settlement. When an entity is determined to have violated the federal civil False Claims Act, the government may impose civil penalties, including treble damages, and exclude the entity from participation in Medicare, Medicaid and other federal healthcare programs; the federal Civil Monetary Penalties Law, which prohibits, among other things, offering or transferring remuneration to a federal healthcare beneficiary that a person knows or should know is likely to influence the beneficiary’s decision to order or receive items or services reimbursable by the government from a particular provider or supplier; the Health Insurance Portability and Accountability Act of 1996, or HIPAA, which created additional federal criminal statutes that prohibit, among other things, executing a scheme to defraud any healthcare benefit program and making false statements relating to healthcare matters. Similar to the federal Anti-Kickback Statute, a person or entity does not need to have actual knowledge of the statute or specific intent to violate it to have committed a violation; the federal Physician Sunshine Act under the Patient Protection and Affordable Care Act, as amended by the Health Care and Education Reconciliation Act, collectively referred to as the Affordable Care Act, which require certain manufacturers of drugs, devices, biologics and medical supplies for which payment is available under Medicare, Medicaid or the Children’s Health Insurance Program, or CHIP, to report annually to the DHHS Centers for Medicare and Medicaid Services, or CMS, information related to payments and other transfers of value to physicians, which is defined broadly to include other healthcare providers and teaching hospitals, and applicable manufacturers and group purchasing organizations, to report annually ownership and investment interests held by physicians and their immediate family members. Manufacturers are required to submit annual reports to CMS and failure to do so may result in civil monetary penalties for all payments, transfers of value or ownership or investment interests not reported in an annual submission, and may result in liability under other federal laws or regulations; HIPAA, as amended by the Health Information Technology for Economic and Clinical Health Act of 2009, or HITECH, and their respective implementing regulations, which impose requirements on certain covered healthcare providers, health plans and healthcare clearinghouses as well as their business associates that perform services for them that involve individually identifiable health information, relating to the privacy, security and transmission of individually identifiable health information without appropriate authorization, including mandatory contractual terms as well as directly applicable privacy and security standards and requirements. Failure to comply with the HIPAA privacy and security standards can result in civil monetary penalties, and, in certain circumstances, criminal penalties. State attorneys general can also bring a civil action to enjoin a HIPAA violation or to obtain statutory damages on behalf of residents of his or her state; and analogous state and foreign law equivalents of each of the above federal laws, such as anti-kickback and false claims laws which may apply to items or services reimbursed by any third-party payor, including commercial insurers or patients; state laws that require device companies to comply with the industry’s voluntary compliance guidelines and the applicable compliance guidance promulgated by the federal government or otherwise restrict payments that may be made to healthcare providers and other potential referral sources; state laws that require device manufacturers to report information related to payments and other transfers of value to physicians and other healthcare providers or marketing expenditures; state laws governing the privacy and security of health information in certain circumstances, many of which differ from each other in significant ways and may not have the same effect, thus complicating compliance efforts; and state laws related to insurance fraud in the case of claims involving private insurers. These laws and regulations, among other things, constrain our business, marketing and other promotional activities by limiting the kinds of financial arrangements, including sales programs, we may have with hospitals, physicians or other potential purchasers of our products. We have a variety of arrangements with our customers that could implicate these laws, including, among others, our consignment arrangements and our practice of loaning instrument sets to customers at no additional cost. We have also entered into consulting agreements and royalty agreements with physicians, including some who have ownership interests in us and/or influence the ordering of or use our products in procedures they perform. Compensation under some of these arrangements includes the provision of stock or stock options. We could be adversely affected if regulatory agencies determine our financial relationships with such physicians to be in violation of applicable laws. Due to the breadth of these laws, the narrowness of statutory exceptions and regulatory safe harbors available, and the range of interpretations to which they are subject, it is possible that some of our current or future practices might be challenged under one or more of these laws. To enforce compliance with the healthcare regulatory laws, certain enforcement bodies have recently increased their scrutiny of interactions between healthcare companies and healthcare providers, which has led to a number of investigations, prosecutions, convictions and settlements in the healthcare industry. Responding to investigations can be time-and resource-consuming and can divert management’s attention from the business. Additionally, as a result of these investigations, healthcare providers and entities may have to agree to additional compliance and reporting requirements as part of a consent decree or corporate integrity agreement. Any such investigation or settlement could increase our costs or otherwise have an adverse effect on our business. Even an unsuccessful challenge or investigation into our practices could cause adverse publicity, and be costly to respond to. If our operations are found to be in violation of any of the healthcare laws or regulations described above or any other healthcare regulations that apply to us, we may be subject to penalties, including administrative, civil and criminal penalties, damages, fines, exclusion from participation in government healthcare programs, such as Medicare and Medicaid, imprisonment, contractual damages, reputational harm, disgorgement and the curtailment or restructuring of our operations. Healthcare policy changes, including recently enacted legislation reforming the U.S. healthcare system, could harm our cash flows, financial condition and results of operations. In March 2010, the Affordable Care Act was enacted in the United States, which made a number of substantial changes in the way healthcare is financed by both governmental and private insurers. Among other ways in which it may impact our business, the Affordable Care Act: imposed an annual excise tax of 2.3% on any entity that manufactures or imports medical devices offered for sale in the United States, with limited exceptions (described in more detail below), although the effective rate paid may be lower. Under the Consolidated Appropriations Act, 2016, the excise tax has been suspended from January 1, 2016 to December 31, 2017, and, absent further legislative action, will be reinstated starting January 1, 2018; established a new Patient-Centered Outcomes Research Institute to oversee and identify priorities in comparative clinical effectiveness research in an effort to coordinate and develop such research; implemented payment system reforms including a national pilot program on payment bundling to encourage hospitals, physicians and other providers to improve the coordination, quality and efficiency of certain healthcare services through bundled payment models; and expanded the eligibility criteria for Medicaid programs. We do not yet know the full impact that the Affordable Care Act will have on our business. The Trump Administration and the U.S. Congress may take further action regarding the Affordable Care Act, including, but not limited to, repeal or replacement. Additionally, all or a portion of the Affordable Care Act and related subsequent legislation may be modified, repealed or otherwise invalidated through judicial challenge, which could result in lower numbers of insured individuals, reduced coverage for insured individuals and adversely affect our business. In addition, other legislative changes have been proposed and adopted since the Affordable Care Act was enacted. On August 2, 2011, the Budget Control Act of 2011 was signed into law, which, among other things, reduced Medicare payments to providers by 2% per fiscal year, effective on April 1, 2013 and, due to subsequent legislative amendments to the statute, will remain in effect through 2025 unless additional Congressional action is taken. On January 2, 2013, the American Taxpayer Relief Act of 2012 was signed into law, which, among other things, reduced Medicare payments to several providers, including hospitals, and increased the statute of limitations period for the government to recover overpayments to providers from three to five years. We expect additional state and federal healthcare reform measures to be adopted in the future, any of which could limit reimbursement for healthcare products and services, which could result in reduced demand for our products or additional pricing pressure. Our business involves the use of hazardous materials and we and our third-party manufacturers must comply with environmental laws and regulations, which may be expensive and restrict how we do business. Our third-party manufacturers’ activities may involve the controlled storage, use and disposal of hazardous materials. Our manufacturers are subject to federal, state, local and foreign laws and regulations governing the use, generation, manufacture, storage, handling and disposal of these hazardous materials. We currently carry no insurance specifically covering environmental claims relating to the use of hazardous materials, but we do reserve funds to address these claims at both the federal and state levels. Although we believe the safety procedures of our manufacturers for handling and disposing of these materials and waste products comply with the standards prescribed by these laws and regulations, we cannot eliminate the risk of accidental injury or contamination from the use, storage, handling or disposal of hazardous materials. In the event of an accident, state or federal or other applicable authorities may curtail our use of these materials and interrupt our business operations. In addition, if an accident or environmental discharge occurs, or if we discover contamination caused by prior operations, including by prior owners and operators of properties we acquire, we could be liable for cleanup obligations, damages and fines, which could be substantial. Risks Related to Our Reliance on Third Parties We rely on our network of independent sales agencies and distributors to market and distribute our products in both the United States and international markets. In the United States, our products are primarily sold by a network of 33 independent sales agencies. We may not be successful in maintaining strong relationships with our independent sales agencies. In addition, our independent sales agencies are not required to sell our products on an exclusive basis and also are not required to purchase any minimum quantity of our products. The failure of our network of independent sales agencies to generate U.S. sales of our products and promote our brand effectively would impair our business and results of operations. We also sell our products in international markets, primarily through a network of 31 independent distributors. We sell our products in 35 countries outside of the United States, and we expect a significant amount of our revenue to come from international sales for the foreseeable future. In the past, we have experienced issues collecting payments from certain of our independent distributors and we may again experience such issues in the future. We face significant challenges and risks in managing our geographically dispersed distribution network and retaining the individuals who make up that network. We cannot control the efforts and resources our third-party sales agencies and distributors will devote to marketing our products. Our sales agencies and distributors may be unable to successfully market and sell our products and may not devote sufficient time and resources to support the marketing and selling efforts that enable the products to develop, achieve or sustain market acceptance in their respective jurisdictions. Additionally, in some international jurisdictions, we rely on our distributors to manage the regulatory process, while complying with all applicable rules and regulations, and we are dependent on their ability to do so effectively. If we are unable to attract additional international distributors, our international revenue may not grow. If any of our independent sales agencies or distributors were to cease to do business with us, our sales could be adversely affected. Some of our independent sales agencies and distributors have historically accounted for a material portion of our sales volume. Sales to one of our independent sales agencies accounted for 10.4% of our revenue in 2015. Sales to two of our independent sales agencies accounted for 10.7% and 10.1%, respectively, of our revenue in 2016. Sales to one of our independent sales agencies accounted for 10.9% of our revenue in the first six months of 2017. If any such agency or distributor were to cease to sell and market our products, our sales could be adversely affected. In addition, if a dispute arises with a sales agency or distributor or if a sales agency or distributor is terminated by us or goes out of business, it may take time to locate an alternative sales agency or distributor, to seek appropriate regulatory approvals and to train new personnel to market our products, and our ability to sell those systems in the region formerly serviced by such terminated agent or distributor could be harmed. Any of our sales agencies or distributors could become insolvent or otherwise become unable to pay amounts owed to us when due. Any of these factors could reduce our revenue from affected markets, increase our costs in those markets or damage our reputation. If an independent sales agency or distributor were to depart and be retained by one of our competitors, we may be unable to prevent them from helping competitors solicit business from our existing customers, which could further adversely affect our sales. In any such situation in which we lose the services of an independent sales agency or distributor, we may need to seek alternative sales agencies or distributors, and our sales may be adversely affected. Because of the intense competition for their services, we may be unable to recruit or retain additional qualified independent sales agencies or distributors to work with us. We may be unable to enter into agreements with them on favorable or commercially reasonable terms, if at all. Failure to hire or retain qualified independent sales agencies or distributors would prevent us from expanding our business and generating sales. As a result of our reliance on third-party sales agencies and distributors, we may be subject to disruptions and increased costs due to factors beyond our control, including labor strikes, third-party error and other issues. If the services of any of these third-party sales agencies or distributors become unsatisfactory, including the failure of such sales agencies or distributors to properly train orthopedic surgeons in the utilization of our products, we may experience delays in meeting our customers’ product demands and we may be unable to find a suitable replacement on a timely basis or on commercially reasonable terms. Any failure to deliver products in a timely manner may damage our reputation and could cause us to lose current or potential customers. We rely on third-party contract manufacturers to assemble our products, and a loss or degradation in performance of these contract manufacturers could have a material adverse effect on our business and financial condition. We rely on a small number of third-party contract manufacturers in the United States to assemble our products. If any of these contract manufacturers fails to adequately perform, our revenue and profitability could be adversely affected. Inadequate performance could include, among other things, the production of products that do not meet our quality standards, which could cause us to seek additional sources of manufacturing. Additionally, our contract manufacturers may decide in the future to discontinue or reduce the level of business they conduct with us. If we are required to change contract manufacturers due to any termination of our relationships with our contract manufacturers, we may lose revenue, experience manufacturing delays, incur increased costs or otherwise suffer impairment to our customer relationships. We cannot guarantee that we will be able to establish alternative manufacturing relationships on similar terms or without delay. Furthermore, our contract manufacturers could require us to move to another one of their production facilities. This could disrupt our ability to fulfill orders during a transition and impact our ability to utilize our current supply chain. In addition, we currently use Structure Medical, LLC, a Squadron-affiliated entity, as a supplier for components of our products. See “Certain Relationships and Related Person Transactions — Squadron — Supply Relationships.” Performance issues, service interruptions or price increases by our shipping carriers could adversely affect our business and harm our reputation and ability to provide our services on a timely basis. Expedited, reliable shipping is essential to our operations. We rely heavily on providers of transport services for reliable and secure point-to-point transport of our products to our customers and for tracking of these shipments. Should a carrier encounter delivery performance issues such as loss, damage or destruction of any systems, it would be costly to replace such systems in a timely manner and such occurrences may damage our reputation and lead to decreased demand for our products and increased cost and expense to our business. In addition, any significant increase in shipping rates could adversely affect our operating margins and results of operations. Similarly, strikes, severe weather, natural disasters or other service interruptions affecting delivery services we use would adversely affect our ability to process orders for our products on a timely basis. We rely on a limited number of third-party suppliers for the majority of our products and may be unable to find replacements or immediately transition to alternative suppliers. We rely on several suppliers for the majority of our products, with whom we do not have long-term supply contracts. These suppliers may be unwilling or unable to supply these products to us reliably and at the prices and levels we anticipate or are required by the market. For us to be successful, our suppliers must be able to provide us with products in substantial quantities, in compliance with regulatory requirements, in accordance with agreed upon specifications, at acceptable costs and on a timely basis. An interruption in our commercial operations could occur if we encounter delays or difficulties in securing these products, and if we cannot obtain an acceptable substitute. If we are required to transition to new third-party suppliers for certain products, the use of products furnished by these alternative suppliers could require us to alter our operations. Furthermore, if we are required to change the manufacturer of our products, we will be required to verify that the new manufacturer maintains facilities, procedures and operations that comply with our quality and applicable regulatory requirements, which could further impede our ability to manufacture our products in a timely manner. Transitioning to a new supplier could be time-consuming and expensive, may result in interruptions in our operations and product delivery, could affect the performance specifications of our products or could require that we modify the design of those products. If the change in manufacturer results in a significant change to any product, a new 510(k) clearance from the FDA or similar international regulatory authorization may be necessary before we implement the change, which could cause substantial delays. The occurrence of any of these events could harm our ability to meet the demand for our products in a timely or cost-effective manner. Risks Related to Intellectual Property Our commercial success will depend in part on our success in obtaining and maintaining issued patents and other intellectual property rights in the United States and elsewhere and protecting our proprietary technology. If we do not adequately protect our intellectual property and proprietary technology, competitors may be able to use our technologies and erode or negate any competitive advantage we may have, which could harm our business and ability to achieve profitability. We own numerous issued patents and pending patent applications that relate to our platform technology. As of June 30, 2017, we owned nine issued U.S. patents and 12 issued foreign patents and we had eight pending U.S. patent applications and 11 pending foreign patent applications. Assuming all required fees are paid, issued U.S. patents owned by us will expire between 2024 and 2034. We cannot provide any assurances that any of our patents have, or that any of our pending patent applications that mature into issued patents will include, claims with a scope sufficient to protect our products, any additional features we develop for our products or any new products. Other parties may have developed technologies that may be related or competitive to our platform, may have filed or may file patent applications and may have received or may receive patents that overlap or conflict with our patent applications, either by claiming the same methods or devices or by claiming subject matter that could dominate our patent position. The patent positions of medical device companies, including our patent position, may involve complex legal and factual questions, and, therefore, the scope, validity and enforceability of any patent claims that we may obtain cannot be predicted with certainty. Patents, if issued, may be challenged, deemed unenforceable, invalidated or circumvented. Proceedings challenging our patents could result in either loss of the patent or denial of the patent application or loss or reduction in the scope of one or more of the claims of the patent or patent application. In addition, such proceedings may be costly. Thus, any patents that we may own may not provide any protection against competitors. Furthermore, an adverse decision in an interference proceeding can result in a third party receiving the patent right sought by us, which in turn could affect our ability to commercialize our products. Furthermore, though an issued patent is presumed valid and enforceable, its issuance is not conclusive as to its validity or its enforceability and it may not provide us with adequate proprietary protection or competitive advantages against competitors with similar products. Competitors may also be able to design around our patents. Other parties may develop and obtain patent protection for more effective technologies, designs or methods. We may be unable to prevent the unauthorized disclosure or use of our technical knowledge or trade secrets by consultants, suppliers, vendors, former employees and current employees. The laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States, and we may encounter significant problems in protecting our proprietary rights in these countries. Our ability to enforce our patent rights depends on our ability to detect infringement. It may be difficult to detect infringers who do not advertise the components that are used in their products. Moreover, it may be difficult or impossible to obtain evidence of infringement in a competitor’s or potential competitor’s product. We may not prevail in any lawsuits that we initiate and the damages or other remedies awarded if we were to prevail may not be commercially meaningful. In addition, proceedings to enforce or defend our patents could put our patents at risk of being invalidated, held unenforceable or interpreted narrowly. Such proceedings could also provoke third parties to assert claims against us, including that some or all of the claims in one or more of our patents are invalid or otherwise unenforceable. If any of our patents covering our products are invalidated or found unenforceable, or if a court found that valid, enforceable patents held by third parties covered one or more of our products, our competitive position could be harmed or we could be requierd to incur significant expenses to enforce or defend our rights. The degree of future protection for our proprietary rights is uncertain, and we cannot ensure that: any of our patents, or any of our pending patent applications, if issued, will include claims having a scope sufficient to protect our products; any of our pending patent applications may not issue as patents; we will be unable to successfully commercialize our products on a substantial scale, if approved, before our relevant patents we may have expire; we were the first to make the inventions covered by each of our patents and pending patent applications; we were the first to file patent applications for these inventions; others will not develop similar or alternative technologies that do not infringe our patents; any of our patents will be found to ultimately be valid and enforceable; any patents issued to us will provide a basis for an exclusive market for our commercially viable products, will provide us with any competitive advantages or will not be challenged by third parties; we will develop additional proprietary technologies or products that are separately patentable; or our commercial activities or products will not infringe upon the patents of others. We rely upon unpatented trade secrets, unpatented know-how and continuing technological innovation to develop and maintain our competitive position, which we seek to protect, in part, by confidentiality agreements with our employees and our collaborators and consultants. We also have agreements with our employees and selected consultants that obligate them to assign their inventions to us and have non-compete agreements with some, but not all, of our consultants. It is possible that technology relevant to our business will be independently developed by a person that is not a party to such an agreement. Furthermore, if the employees and consultants who are parties to these agreements breach or violate the terms of these agreements, we may not have adequate remedies for any such breach or violation, and we could lose our trade secrets through such breaches or violations. Further, our trade secrets could otherwise become known or be independently discovered by our competitors. Litigation or other proceedings or third-party claims of intellectual property infringement could require us to spend significant time and money and could prevent us from selling our products or impact our stock price. Our commercial success will depend in part on not infringing the patents or violating the other proprietary rights of others. Significant litigation regarding patent rights occurs in our industry. Our competitors in both the United States and abroad, many of which have substantially greater resources and have made substantial investments in patent portfolios and competing technologies, may have applied for or obtained or may in the future apply for and obtain, patents that will prevent, limit or otherwise interfere with our ability to make, use and sell our products. We do not always conduct independent reviews of patents issued to third parties. In addition, patent applications in the United States and elsewhere can be pending for many years before issuance, or unintentionally abandoned patents or applications can be revived, so there may be applications of others now pending or recently revived patents of which we are unaware. These applications may later result in issued patents, or the revival of previously abandoned patents, that will prevent, limit or otherwise interfere with our ability to make, use or sell our products. Third parties may, in the future, assert claims that we are employing their proprietary technology without authorization, including claims from competitors or from non-practicing entities that have no relevant product revenue and against whom our own patent portfolio may have no deterrent effect. As we continue to commercialize our products in their current or updated forms, launch new products and enter new markets, we expect competitors may claim that one or more of our products infringe their intellectual property rights as part of business strategies designed to impede our successful commercialization and entry into new markets. The large number of patents, the rapid rate of new patent applications and issuances, the complexities of the technology involved, and the uncertainty of litigation may increase the risk of business resources and management’s attention being diverted to patent litigation. We have, and we may in the future, receive letters or other threats or claims from third parties inviting us to take licenses under, or alleging that we infringe, their patents. See “Business — Legal Proceedings.” Moreover, we may become party to future adversarial proceedings regarding our patent portfolio or the patents of third parties. Such proceedings could include supplemental examination or contested post-grant proceedings such as review, reexamination, interference or derivation proceedings before the U.S. Patent and Trademark Office and challenges in U.S. District Court. Patents may be subjected to opposition, post-grant review or comparable proceedings lodged in various foreign, both national and regional, patent offices. The legal threshold for initiating litigation or contested proceedings may be low, so that even lawsuits or proceedings with a low probability of success might be initiated. Litigation and contested proceedings can also be expensive and time-consuming, and our adversaries in these proceedings may have the ability to dedicate substantially greater resources to prosecuting these legal actions than we can. Any lawsuits resulting from such allegations could subject us to significant liability for damages and invalidate our proprietary rights. Any potential intellectual property litigation also could force us to do one or more of the following: stop making, selling or using products or technologies that allegedly infringe the asserted intellectual property; lose the opportunity to license our technology to others or to collect royalty payments based upon successful protection and assertion of our intellectual property rights against others; incur significant legal expenses; pay substantial damages or royalties to the party whose intellectual property rights we may be found to be infringing; pay the attorney’s fees and costs of litigation to the party whose intellectual property rights we may be found to be infringing; redesign those products that contain the allegedly infringing intellectual property, which could be costly, disruptive and infeasible; and attempt to obtain a license to the relevant intellectual property from third parties, which may not be available on reasonable terms or at all, or from third parties who may attempt to license rights that they do not have. Any litigation or claim against us, even those without merit, may cause us to incur substantial costs, and could place a significant strain on our financial resources, divert the attention of management from our core business and harm our reputation. If we are found to infringe the intellectual property rights of third parties, we could be required to pay substantial damages (which may be increased up to three times of awarded damages) and/or substantial royalties and could be prevented from selling our products unless we obtain a license or are able to redesign our products to avoid infringement. Any such license may not be available on reasonable terms, if at all, and there can be no assurance that we would be able to redesign our products in a way that would not infringe the intellectual property rights of others. We could encounter delays in product introductions while we attempt to develop alternative methods or products. If we fail to obtain any required licenses or make any necessary changes to our products or technologies, we may have to withdraw existing products from the market or may be unable to commercialize one or more of our products. In addition, we generally indemnify our customers and international distributors with respect to infringement by our products of the proprietary rights of third parties. Third parties may assert infringement claims against our customers or distributors. These claims may require us to initiate or defend protracted and costly litigation on behalf of our customers or distributors, regardless of the merits of these claims. If any of these claims succeed or settle, we may be forced to pay damages or settlement payments on behalf of our customers or distributors or may be required to obtain licenses for the products they use. If we cannot obtain all necessary licenses on commercially reasonable terms, our customers may be forced to stop using our products. If we are unable to protect the confidentiality of our trade secrets, our business and competitive position could be harmed. In addition to patent protection, we also rely upon copyright and trade secret protection, as well as non-disclosure agreements and invention assignment agreements with our employees, consultants and third parties, to protect our confidential and proprietary information. In addition to contractual measures, we try to protect the confidential nature of our proprietary information using commonly accepted physical and technological security measures. Such measures may not, for example, in the case of misappropriation of a trade secret by an employee or third party with authorized access, provide adequate protection for our proprietary information. Our security measures may not prevent an employee or consultant from misappropriating our trade secrets and providing them to a competitor, and recourse we take against such misconduct may not provide an adequate remedy to protect our interests fully. Unauthorized parties may also attempt to copy or reverse engineer certain aspects of our products that we consider proprietary. Enforcing a claim that a party illegally disclosed or misappropriated a trade secret can be difficult, expensive and time-consuming, and the outcome is unpredictable. Even though we use commonly accepted security measures, trade secret violations are often a matter of state law, and the criteria for protection of trade secrets can vary among different jurisdictions. In addition, trade secrets may be independently developed by others in a manner that could prevent legal recourse by us. If any of our confidential or proprietary information, such as our trade secrets, were to be disclosed or misappropriated, or if any such information was independently developed by a competitor, our business and competitive position could be harmed. We may be unable to enforce our intellectual property rights throughout the world. The laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States. Many companies have encountered significant problems in protecting and defending intellectual property rights in certain foreign jurisdictions. This could make it difficult for us to stop infringement of our foreign patents, if obtained, or the misappropriation of our other intellectual property rights. For example, some foreign countries have compulsory licensing laws under which a patent owner must grant licenses to third parties. In addition, some countries limit the enforceability of patents against third parties, including government agencies or government contractors. In these countries, patents may provide limited or no benefit. Patent protection must ultimately be sought on a country-by-country basis, which is an expensive and time-consuming process with uncertain outcomes. Accordingly, we may choose not to seek patent protection in certain countries, and we will not have the benefit of patent protection in such countries. Proceedings to enforce our patent rights in foreign jurisdictions could result in substantial costs and divert our efforts and attention from other aspects of our business. Accordingly, our efforts to protect our intellectual property rights in such countries may be inadequate. In addition, changes in the law and legal decisions by courts in the United States and foreign countries may affect our ability to obtain adequate protection for our technology and the enforcement of our intellectual property. Third parties may assert ownership or commercial rights to inventions we develop. Third parties may in the future make claims challenging the inventorship or ownership of our intellectual property. We have written agreements with collaborators that provide for the ownership of intellectual property arising from our collaborations. In addition, we may face claims by third parties that our agreements with employees, contractors or consultants obligating them to assign intellectual property to us are ineffective or in conflict with prior or competing contractual obligations of assignment, which could result in ownership disputes regarding intellectual property we have developed or will develop and interfere with our ability to capture the commercial value of such intellectual property. Litigation may be necessary to resolve an ownership dispute, and if we are not successful, we may be precluded from using certain intellectual property or may lose our exclusive rights in that intellectual property. Either outcome could harm our business and competitive position. Third parties may assert that our employees or consultants have wrongfully used or disclosed confidential information or misappropriated trade secrets. We employ individuals who previously worked with other companies, including our competitors or potential competitors. Although we try to ensure that our employees and consultants do not use the proprietary information or know-how of others in their work for us, we may be subject to claims that we or our employees, consultants or independent contractors have inadvertently or otherwise used or disclosed intellectual property, including trade secrets or other proprietary information, of a former employer or other third party. Litigation may be necessary to defend against these claims. If we fail in defending any such claims or settling those claims, in addition to paying monetary damages or a settlement payment, we may lose valuable intellectual property rights or personnel. Even if we are successful in defending against such claims, litigation could result in substantial costs and be a distraction to management and other employees. Recent changes in U.S. patent laws may limit our ability to obtain, defend and/or enforce our patents. Recent patent reform legislation could increase the uncertainties and costs surrounding the prosecution of our patent applications and the enforcement or defense of our issued patents. The Leahy-Smith America Invents Act, or the Leahy-Smith Act, includes a number of significant changes to U.S. patent law. These include provisions that affect the way patent applications are prosecuted and also affect patent litigation. The U.S. Patent and Trademark Office recently developed new regulations and procedures to govern administration of the Leahy-Smith Act, and many of the substantive changes to patent law associated with the Leahy-Smith Act, and in particular, the first to file provisions, which became effective on March 16, 2013. The first to file provisions limit the rights of an inventor to patent an invention if not the first to file an application for patenting that invention, even if such invention was the first invention. Accordingly, it is not clear what, if any, impact the Leahy-Smith Act will have on the operation of our business. However, the Leahy-Smith Act and its implementation could increase the uncertainties and costs surrounding the enforcement and defense of our issued patents. For example, the Leahy-Smith Act provides that an administrative tribunal known as the Patent Trial and Appeals Board, or PTAB, provides a venue for challenging the validity of patents at a cost that is much lower than district court litigation and on timelines that are much faster. Although it is not clear what, if any, long-term impact the PTAB proceedings will have on the operation of our business, the initial results of patent challenge proceedings before the PTAB since its inception in 2013 have resulted in the invalidation of many U.S. patent claims. The availability of the PTAB as a lower-cost, faster and potentially more potent tribunal for challenging patents could increase the likelihood that our own patents will be challenged, thereby increasing the uncertainties and costs of maintaining and enforcing them. Risks Related to This Offering and Ownership of Our Common Stock The price of our common stock may be volatile, and you may be unable to resell your shares at or above the initial public offering price. Prior to this offering, there was no public market for shares of our common stock. The initial public offering price for the shares of our common stock sold in this offering will be determined by negotiation between the underwriters and us. This price may not reflect the market price of our common stock following this offering. You may be unable to sell your shares of common stock at or above the initial public offering price due to fluctuations in the market price of our common stock. In addition, the trading price of our common stock may be highly volatile and could be subject to wide fluctuations in response to various factors, some of which are beyond our control. Factors that could cause volatility in the market price of our common stock include, but are not limited to: actual or anticipated fluctuations in our financial condition and operating results; actual or anticipated changes in our growth rate relative to our competitors; commercial success and market acceptance of our products; success of our competitors in developing or commercializing products; ability to commercialize or obtain regulatory approvals for our products, or delays in commercializing or obtaining regulatory approvals; strategic transactions undertaken by us; additions or departures of key personnel; product liability claims; prevailing economic conditions; disputes concerning our intellectual property or other proprietary rights; FDA or other U.S. or foreign regulatory actions affecting us or the healthcare industry; healthcare reform measures in the United States; sales of our common stock by our officers, directors or significant stockholders; future sales or issuances of equity or debt securities by us; business disruptions caused by earthquakes, fires or other natural disasters; and issuance of new or changed securities analysts’ reports or recommendations regarding us. In addition, the stock markets in general, and the markets for companies like ours in particular, have from time to time experienced extreme volatility that have has been often unrelated to the operating performance of the issuer. A certain degree of stock price volatility can be attributed to being a newly public company. These broad market and industry fluctuations may negatively impact the price or liquidity of our common stock, regardless of our operating performance. We may be subject to securities litigation, which is expensive and could divert our management’s attention. The market price of our securities may be volatile, and in the past companies that have experienced volatility in the market price of their securities have been subject to securities class action litigation. We may be the target of this type of litigation in the future. Securities litigation against us could result in substantial costs and divert our management’s attention from other business concerns. We are an “emerging growth company” and the reduced disclosure requirements applicable to emerging growth companies could make our common stock less attractive to investors. We are an “emerging growth company,” as defined in the JOBS Act. We may remain an emerging growth company until as late as December 31, 2022, though we may cease to be an emerging growth company earlier under certain circumstances, including (i) if the market value of our common stock that is held by non-affiliates exceeds $700.0 million as of any June 30, in which case we would cease to be an emerging growth company as of the following December 31, or (ii) if our gross revenue exceeds $1.07 billion in any fiscal year. “Emerging growth companies” may take advantage of certain exemptions from various reporting requirements that are applicable to other public companies, including not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and stockholder approval of any golden parachute payments not previously approved. Investors could find our common stock less attractive because we may rely on these exemptions. If some investors find our common stock less attractive as a result, there may be a less active trading market for our common stock and our stock price may be more volatile. In addition, Section 102 of the JOBS Act also provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act of 1933, as amended, or the Securities Act, for complying with new or revised accounting standards. An emerging growth company can therefore delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. However, we are choosing to “opt out” of such extended transition period, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision to opt out of the extended transition period for complying with new or revised accounting standards is irrevocable. Future sales of our common stock or securities convertible or exchangeable for our common stock may cause our stock price to decline. If our existing stockholders or optionholders sell, or indicate an intention to sell, substantial amounts of our common stock in the public market after the lock-up and legal restrictions on resale discussed in this prospectus lapse, the price of our common stock could decline. The perception in the market that these sales may occur could also cause the price of our common stock to decline. Based on shares of common stock outstanding as of June 30, 2017, and assuming an initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, upon the completion of this offering, we will have outstanding a total of 12,044,435 shares of common stock. Of these shares, the 4,000,000 shares of common stock sold by us in this offering, plus any shares sold upon exercise of the underwriters’ option to purchase additional shares of common stock, will be freely tradable without restriction, unless held by our affiliates, in the public market immediately following this offering. After the lock-up agreements expire, approximately 8.0 million shares of common stock will be eligible for sale in the public market, subject in certain instances to volume limitations under Rule 144 under the Securities Act, with respect to shares held by directors, executive officers and other affiliates. The underwriters may, however, in their sole discretion, permit our directors, our executive officers and other stockholders and the holders of our outstanding options who are subject to the lock-up agreements to sell shares prior to the expiration of the lock-up agreements. Sales of these shares, or perceptions that they will be sold, could cause the price of our common stock to decline. In addition, based on the number of shares subject to outstanding awards under the 2007 Plan, as of June 30, 2017, and including the initial reserves under the 2017 Plan, 1,832,460 shares of common stock that are either subject to outstanding options, outstanding but subject to vesting or reserved for future issuance under the 2017 Plan will become eligible for sale in the public market to the extent permitted by the provisions of various vesting schedules, the lock-up agreements and Rule 144 and Rule 701 under the Securities Act. We also plan to file a registration statement permitting shares of common stock issued in the future pursuant to the 2017 Plan to be freely resold by plan participants in the public market, subject to the lock-up agreements, applicable vesting schedules and, for shares held by directors, executive officers and other affiliates, volume limitations under Rule 144 under the Securities Act. If the shares we may issue from time to time under the 2017 Plan are sold, or if it is perceived that they will be sold, by the award recipients in the public market, the price of our common stock could decline. Approximately 5.4 million shares of common stock will be entitled to rights with respect to registration under the Securities Act, subject to the lock-up agreements described above. Such registration would result in these shares becoming fully tradable without restriction under the Securities Act when the applicable registration statement is declared effective. Sales of such shares could cause the price of our common stock to decline. See “Description of Capital Stock — Registration Rights” for additional information. If there is no viable public market for our common stock, you may be unable to sell your shares at or above the initial public offering price. Prior to this offering there has been no public market for shares of our common stock. Although we expect our common stock will be approved for listing on NASDAQ, an active trading market for our shares may never develop or be sustained following this offering. You may be unable to sell your shares quickly or at the market price if trading in shares of our common stock is not active. The initial public offering price for our common stock will be determined through negotiations with the underwriters, and the negotiated price may not be indicative of the market price of the common stock after the offering. As a result of these and other factors, you may be unable to resell your shares of our common stock at or above the initial public offering price. Further, an inactive market may also impair our ability to raise capital by selling shares of our common stock and may impair our ability to enter into strategic partnerships or acquire companies or products by using our shares of common stock as consideration. Investors in this offering will suffer immediate and substantial dilution of their investment. If you purchase common stock in this offering, you will pay more for your shares than our pro forma as adjusted net tangible book value per share. Based upon an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, you will incur immediate and substantial dilution of $9.38 per share, representing the difference between our assumed initial public offering price and our pro forma as adjusted net tangible book value per share. Based upon the assumed initial public offering price of $13.00 per share, purchasers of common stock in this offering will have contributed approximately 38.0% of the aggregate purchase price paid by all purchasers of our stock and will own approximately 33.2 % of our common stock outstanding after this offering. To the extent outstanding stock options or warrants are exercised, new investors may incur further dilution. For information on how the foregoing amounts were calculated, see the section titled “Dilution.” Our operating results for a particular period may fluctuate significantly or may fall below the expectations of investors or securities analysts, each of which may cause our stock price to fluctuate or decline. We expect our operating results to be subject to fluctuations. Our operating results will be affected by numerous factors, including: variations in the level of expenses related to our products or future development programs; level of underlying demand for our products; addition or termination of clinical trials; our execution of any collaborative, licensing or similar arrangements, and the timing of payments we may make or receive under these arrangements; any intellectual property infringement lawsuit or opposition, interference or cancellation proceeding in which we may become involved; and regulatory developments affecting our products or our competitors. If our operating results for a particular period fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Furthermore, any fluctuations in our operating results may, in turn, cause the price of our common stock to fluctuate substantially. We believe comparisons of our financial results from various reporting periods are not necessarily meaningful and should not be relied upon as an indication of our future performance. We will have broad discretion in the use of the net proceeds from this offering and may invest or spend the proceeds in ways which you do not agree or that may not yield a return. We discuss our plan for the use of the net proceeds from this offering in the sections titled “Use of Proceeds” and “Business.” However, within the scope of our plan, and in light of the various risks to our business that are set forth in this section, our management will have broad discretion over the use of a substantial portion of the net proceeds from this offering. Because of the number and variability of factors that will determine our use of such proceeds, you may not agree with how we allocate or spend the proceeds from this offering. We may pursue commercialization and product development strategies, clinical trials, regulatory approvals or collaborations that do not result in an increase in the market value of our common stock and that may increase our losses. Our failure to allocate and spend the net proceeds from this offering effectively could harm our business, financial condition and results of operations. Until the net proceeds are used, they may be placed in investments that do not produce significant investment returns or that may lose value. Our principal stockholders and management own a significant percentage of our stock and will be able to exert control over matters subject to stockholder approval. Based on the beneficial ownership of our common stock as of June 30, 2017, after giving effect to the conversion of all outstanding shares of our Series A Preferred Stock and our Series B Preferred Stock, as well as the $16.0 million cash preference payment, and the approximately $8.4 million of accumulated and unpaid dividends, on our Series A Preferred Stock as of June 30, 2017 ($8.9 million as of September 30, 2017), each of which will occur immediately prior to the completion of this offering, and the issuance of common stock by us in this offering, our officers and directors, together with holders of 5% or more of our outstanding common stock before this offering and their respective affiliates, will beneficially own approximately 49.6 % of our outstanding common stock. Accordingly, these stockholders will continue to have significant influence over the outcome of corporate actions requiring stockholder approval, including the election of directors, merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction. The interests of these stockholders may not be the same as or may even conflict with your interests. For example, these stockholders could attempt to delay or prevent a change in control of the company, even if such a change in control would benefit our other stockholders, which could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of the company or our assets and might affect the prevailing price of our common stock. The significant concentration of stock ownership may negatively impact the price of our common stock due to investors’ perception that conflicts of interest may exist or arise. In addition, Squadron currently has the right to designate four members of our board of directors and will continue to have certain board representation rights following the completion of this offering. See “Certain Relationships and Related Person Transactions — Squadron — Stockholders Agreement.” Provisions of our charter documents or Delaware law could delay or prevent an acquisition of the company, even if the acquisition would be beneficial to our stockholders, which could make it more difficult for you to change management. Provisions in our amended and restated certificate of incorporation and our amended and restated bylaws that will become effective upon the completion of this offering may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which stockholders might otherwise receive a premium for their shares. In addition, these provisions may frustrate or prevent any attempt by our stockholders to replace or remove our current management by making it more difficult to replace or remove our board of directors. These provisions include: a classified board of directors so that not all directors are elected at one time; a prohibition on stockholder action through written consent; no cumulative voting in the election of directors; the exclusive right of our board of directors to elect a director to fill a vacancy created by the expansion of the board of directors or the resignation, death or removal of a director; a requirement that special meetings of stockholders be called only by the board of directors, the chairman of the board of directors, the chief executive officer or, in the absence of a chief executive officer, the president; an advance notice requirement for stockholder proposals and nominations; the authority of our board of directors to issue preferred stock with such terms as our board of directors may determine; and a requirement of approval of not less than 662∕3% of all outstanding shares of our capital stock entitled to vote to amend any bylaws by stockholder action, or to amend specific provisions of our amended and restated certificate of incorporation. In addition, Delaware law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person who, together with its affiliates, owns, or within the last three years has owned, 15% or more of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. Accordingly, Delaware law may discourage, delay or prevent a change in control of our company. Provisions in our charter documents and other provisions of Delaware law could limit the price that investors are willing to pay in the future for shares of our common stock. Our amended and restated certificate of incorporation provides that the Court of Chancery of the State of Delaware will be the exclusive forum for substantially all disputes between us and our stockholders, which could limit our stockholders’ ability to obtain a favorable judicial forum for disputes with us or our directors, officers or employees. Our amended and restated certificate of incorporation that will become effective upon the completion of this offering provides that the Court of Chancery of the State of Delaware is the exclusive forum for (i) any derivative action or proceeding brought on our behalf, (ii) any action asserting a claim of breach of a fiduciary duty or other wrongdoing by any of our directors, officers, employees or agents to us or our stockholders, (iii) any action asserting a claim arising pursuant to any provision of the DGCL or our amended and restated certificate of incorporation or amended and restated bylaws, (iv) any action to interpret, apply, enforce or determine the validity of our amended and restated certificate of incorporation or amended and restated bylaws or (v) any action asserting a claim governed by the internal affairs doctrine. This choice of forum provision may limit a stockholder’s ability to bring a claim in a judicial forum that it finds favorable for disputes with us or our directors, officers or other employees, which may discourage such lawsuits against us and our directors, officers and other employees. Alternatively, if a court were to find the choice of forum provision contained in our amended and restated certificate of incorporation to be inapplicable or unenforceable in an action, we may incur additional costs associated with resolving such action in other jurisdictions. We do not anticipate paying any cash dividends on our common stock in the foreseeable future; therefore, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future. We intend to use a portion of the net proceeds from this offering to pay the accumulated and unpaid dividends on our Series B Preferred Stock. See “Use of Proceeds.” We have never declared or paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain all available funds and any future earnings to finance the growth and development of our business. In addition, the Loan Agreement contains, and the terms of any future credit agreements we enter into may contain, terms prohibiting or limiting the amount of dividends that may be declared or paid on our common stock. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future. If securities or industry analysts do not publish research, or publish inaccurate or unfavorable research, about our business, our stock price and trading volume could decline. The trading market for our common stock will depend, in part, on the research and reports that securities or industry analysts publish about us or our business. Securities and industry analysts do not currently, and may never, publish research on the company. If no securities or industry analysts commence coverage of the company, the price for our common stock could be negatively impacted. In the event securities or industry analysts initiate coverage, if one or more of the analysts who cover us downgrade our common stock or publish inaccurate or unfavorable research about our business, our stock price could decline. In addition, if our operating results fail to meet the forecast of analysts, our stock price could decline. If one or more of these analysts cease coverage of the company or fail to publish reports on us regularly, demand for our common stock could decrease, which might cause our stock price and trading volume to decline. TABLE OF CONTENTS​​ This prospectus contains forward-looking statements. All statements other than statements of historical facts contained in this prospectus, including statements regarding our future results of operations and financial position, business strategy, current and prospective products, product approvals, research and development costs, prospective collaborations, timing and likelihood of success, plans and objectives of management for future operations and future results of anticipated products, are forward-looking statements. These statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “could,” “intend,” “target,” “project,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition and results of operations. These forward-looking statements speak only as of the date of this prospectus and are subject to a number of risks, uncertainties and assumptions described under the sections in this prospectus entitled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this prospectus. The events and circumstances reflected in our forward-looking statements may not be achieved or occur and actual results could differ materially from those projected in the forward-looking statements. Moreover, we operate in an evolving environment. New risk factors and uncertainties may emerge from time to time, and it is not possible for us to predict all risk factors and uncertainties. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained herein, whether as a result of any new information, future events, changed circumstances or otherwise. Unless otherwise indicated, information contained in this prospectus concerning our industry and the markets in which we operate, including our general expectations and market position, market opportunity and market share, is based on information from our own management estimates and research, as well as from industry and general publications and research, surveys and studies conducted by third parties. Management estimates are derived from publicly available information, our knowledge of our industry and assumptions based on such information and knowledge, which we believe to be reasonable. This data involves a number of assumptions and limitations. Life Science Intelligence, Inc., the primary source for ACL reconstruction procedural data included in this prospectus, was commissioned by us to compile this information. In addition, assumptions and estimates of our and our industry’s future performance are necessarily subject to a high degree of uncertainty and risk due to a variety of factors, including those described in “Risk Factors.” These and other factors could cause our future performance to differ materially from our assumptions and estimates. We estimate that our net proceeds from our sale of 4,000,000 shares of common stock in this offering will be $46.2 million, or $53.5 million if the underwriters exercise their option to purchase additional shares in full, based on an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. Each $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) the net proceeds to us from this offering by $3.7 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. We may also increase or decrease the number of shares we are offering. Each increase (decrease) of 1.0 million in the number of shares we are offering would increase (decrease) the net proceeds to us from this offering, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, by $12.1 million, assuming the assumed initial public offering price stays the same. We currently intend to use the net proceeds from this offering as follows: approximately $5.9 million to pay accumulated and unpaid dividends on our Series B Preferred Stock (as of September 30, 2017); approximately $19.5 million to invest in implant and instrument sets for consignment to our customers; approximately $6.7 million to fund research and development activities; approximately $4.1 million to expand our sales and marketing programs; and the remainder for working capital and general corporate purposes. We may also use a portion of the net proceeds from this offering to acquire or invest in complementary products, technologies or businesses, although we have no present agreements or commitments to do so. We have approximately $5.9 million of accumulated and unpaid dividends on our Series B Preferred Stock (as of September 30, 2017), which we intend to pay out of the net proceeds from this offering. Shares of our Series B Preferred Stock are held by certain of our affiliates and, in connection with the payment of these dividends as described above, such affiliates will receive a portion of the net proceeds from this offering. See “Certain Relationships and Related Person Transactions.” The amounts and timing of our actual expenditures will depend on numerous factors, including the rate of adoption of our products, the expenses we incur in selling and marketing efforts, the scope of research and development efforts and other factors described under “Risk Factors” in this prospectus, as well as the amount of cash used in our operations. We therefore cannot estimate the amount of net proceeds to be used for all of the purposes described above. We may find it necessary or advisable to use the net proceeds for other purposes, and we will have broad discretion in the application of the net proceeds. Pending the uses described above, we intend to invest the net proceeds from this offering in short- and intermediate-term, interest-bearing obligations, investment-grade instruments, certificates of deposit or direct or guaranteed obligations of the U.S. government. We intend to use a portion of the net proceeds from this offering to pay the accumulated and unpaid dividends on our Series B Preferred Stock. See “Use of Proceeds.” We have never declared or paid any cash dividends on our common stock and do not intend to do so in the foreseeable future. We currently intend to retain all available funds and any future earnings to support operations and to finance the growth and development of our business. In addition, the Loan Agreement contains, and the terms of any future credit agreements we enter into may contain, terms prohibiting or limiting the amount of dividends that may be declared or paid on our common stock. The following table sets forth our cash and capitalization as of June 30, 2017: on a pro forma as adjusted basis to give further effect to: (i) the sale of 4,000,000 shares of common stock by us in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us; and (ii) our use of a portion of the net proceeds from this offering to pay approximately $5.4 million of accumulated and unpaid dividends on our Series B Preferred Stock ($5.9 million as of September 30, 2017). You should read this information in conjunction with the information contained elsewhere in this prospectus, including “Use of Proceeds,” “Selected Consolidated Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and the related notes thereto. As of June 30, 2017 (in thousands, except share and per share information) ​ ​ ​ $ 2,306 ​ ​ ​ ​ $ 2,306 ​ ​ ​ ​ $ 43,107 ​ ​ ​ $ 25,541 ​ ​ ​ ​ $ 25,541 ​ ​ ​ ​ $ 25,541 Preferred stock, $0.00025 par value; no shares authorized, issued or outstanding, actual; 5,000,000 shares authorized, no shares issued or outstanding, pro forma and pro forma as adjusted ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — Series A preferred stock, $0.00025 par value; 1,000,000 shares authorized, issued and outstanding, actual; no shares authorized, issued or outstanding, pro forma and pro forma as adjusted ​ ​ ​ ​ 24,386 ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — Series B preferred stock, $0.00025 par value; 6,000,000 shares authorized, 4,446,978 shares issued and outstanding, actual; no shares authorized, issued or outstanding, pro forma and pro forma as adjusted Stockholders’ equity (deficit): ​ ​ ​ ​ Common stock; $0.00025 par value; 8,040,000 shares authorized, 2,481,607 shares issued and outstanding, actual; 50,000,000 shares authorized, 8,044,435 shares issued and outstanding, pro forma; 50,000,000 shares authorized, 12,044,435 shares issued and outstanding, pro forma as adjusted ​ ​ ​ ​ 1 ​ ​ ​ ​ ​ 1 ​ ​ ​ ​ ​ 1 ​ ​ ​ ​ 10,671 ​ ​ ​ ​ ​ 79,455 ​ ​ ​ ​ ​ 125,655 ​ ​ ​ ​ (80,685) ​ ​ ​ ​ ​ (80,685) ​ ​ ​ ​ ​ (80,685) ​ ​ ​ ​ 72 ​ ​ ​ ​ ​ 72 ​ ​ ​ ​ ​ 72 Total stockholders’ (deficit) equity ​ ​ ​ ​ (69,941) ​ ​ ​ ​ ​ (1,157) ​ ​ ​ ​ ​ 45,043 Total capitalization The pro forma as adjusted data is illustrative only, and our capitalization following this offering will depend on the actual initial public offering price, the number of shares we sell in this offering and other terms of this offering determined at pricing. Each $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) our pro forma as adjusted cash, additional paid-in capital, total stockholders equity and total capitalization by $3.7 million, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. We may also increase or decrease the number of shares we are offering. Each increase (decrease) of 1.0 million in the number of shares we are offering would increase (decrease) our pro forma as adjusted cash, additional paid-in capital, total stockholders equity and total capitalization by $12.1 million, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, assuming the assumed initial public offering price stays the same. Any increase or decrease in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would decrease or increase the number of shares of our common stock into which the $16.0 million cash preference payment, and the approximately $8.9 million of accumulated and unpaid dividends (as of September 30, 2017), on our Series A Preferred Stock would be converted and, accordingly, the number of shares of our common stock to be outstanding following this offering. See “Related Party Transactions — Squadron — Conversion of Series A Preferred Stock Preference Payment and Dividends.” The number of shares of our common stock outstanding shown in the foregoing table and calculations excludes: 243,369 shares of common stock issuable upon the exercise of options outstanding at a weighted average exercise price of $23.95 per share; 1,832,460 shares of our common stock issued or reserved for future issuance under the 2017 Plan, which includes (i) 42,813 shares of restricted stock that we intend to grant under the 2017 Plan in connection with this offering and (ii) 39,992 shares of common stock reserved for future issuance under the 2007 Plan that will be added to the shares reserved under the 2017 Plan upon its effectiveness. If you invest in our common stock in this offering, your ownership interest will be immediately diluted to the extent of the difference between the initial public offering price per share of our common stock and the pro forma as adjusted net tangible book value per share of our common stock after this offering. As of June 30, 2017, our net tangible book value was $2.8 million, or $1.11 per share. We calculate net tangible book value by taking the amount of our total tangible assets, reduced by the amount of our total liabilities, and then dividing that amount by the total number of shares of common stock outstanding. As of June 30, 2017, our pro forma net tangible book value would have been $(2.6) million, or $(0.33) per share, after giving effect to the conversion of all outstanding shares of our Series A Preferred Stock and our Series B Preferred Stock into 3,649,475 shares of our common stock, the conversion of the $16.0 million cash preference payment, and the approximately $8.4 million of accumulated and unpaid dividends as of June 30, 2017 ($8.9 million as of September 30, 2017), on our Series A Preferred Stock into 1,913,353 shares of our common stock, at a conversion price equal to the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, each of which will occur immediately prior to the completion of this offering. As of June 30, 2017, our pro forma as adjusted net tangible book value would have been $43.6 million, or $3.62 per share, after giving effect to our sale of 4,000,000 shares in this offering at an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us, and our use of a portion of the net proceeds from this offering to pay approximately $5.4 million of accumulated and unpaid dividends on our Series B Preferred Stock as of June 30, 2017 ($5.9 million as of September 30, 2017). This amount represents an immediate increase in net tangible book value of $3.95 per share to existing stockholders and an immediate dilution in net tangible book value of $9.38 per share to new investors purchasing shares in this offering at the initial public offering price. We determine dilution by subtracting pro forma as adjusted net tangible book value per share of common stock from the initial public price per share of common stock. The following table illustrates this dilution on a per share basis: Assumed initial public offering price per share ​ ​ ​ ​ ​ ​ ​ ​ ​ $ 13.00 ​ ​ Net tangible book value per share as of June 30, 2017 ​ ​ ​ $ 1.11 ​ ​ ​ ​ ​ ​ ​ ​ Decrease in net tangible book value per share attributable to conversion of preferred stock ​ ​ ​ ​ (1.44) ​ ​ ​ ​ ​ ​ ​ ​ Pro forma net tangible book value per share as of June 30, 2017 ​ ​ ​ ​ (0.33) ​ ​ ​ Increase in pro forma net tangible book value per share attributable to new investors purchasing shares in this offering ​ ​ ​ ​ 3.95 ​ ​ ​ ​ ​ ​ ​ ​ Pro forma as adjusted net tangible book value per share as of June 30, 2017 ​ ​ ​ ​ ​ ​ ​ ​ ​ ​ 3.62 ​ ​ Dilution per share to new investors in this offering ​ ​ ​ ​ ​ ​ ​ ​ ​ $ 9.38 ​ ​ Each $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) the pro forma as adjusted net tangible book value per share after this offering by $0.35, and dilution in pro forma net tangible book value per share to new investors by $0.65, assuming that the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and the estimated offering expenses payable by us. We may also increase or decrease the number of shares we are offering. An increase of 1.0 million in the number of shares offered by us would increase our pro forma as adjusted net tangible book value per share after this offering by $0.65 and decrease the dilution to investors participating in this offering by $0.65 per share, assuming that the assumed initial public offering price remains the same. Similarly, a decrease of 1.0 million in the number of shares offered by us, as set forth on the cover page of this prospectus, would decrease the pro forma as adjusted net tangible book value per share after this offering by $0.77 and increase the dilution to investors participating in this offering by $0.77 per share, assuming that the assumed initial public offering price remains the same. If the underwriters exercise their option to purchase 600,000 additional shares of our common stock in full, the pro forma as adjusted net tangible book value after the offering would be $4.02 per share, the increase in pro forma as adjusted net tangible book value per share to existing stockholders would be $4.35 per share and the dilution per share to new investors would be $8.98 per share, in each case assuming an initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus. The following table summarizes, on the pro forma as adjusted basis described above, as of June 30, 2017, the differences between the number of shares of common stock purchased from us, the total consideration paid to us and the average price per share paid by existing stockholders and by new investors in this offering. As the table shows, new investors purchasing shares in this offering will pay a price per share substantially higher than the average price our existing stockholders paid. The table below gives effect to the sale of new shares of common stock in this offering at the initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, before deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us: Shares Purchased Total Consideration Price Per Share Existing stockholders ​ ​ ​ ​ 8,044,435 ​ ​ ​ ​ ​ 66.8% ​ ​ ​ ​ $ 84,854,000 ​ ​ ​ ​ ​ 62.0% ​ ​ ​ ​ $ 10.55 ​ ​ Investors participating in this offering ​ ​ ​ ​ 4,000,000 ​ ​ ​ ​ ​ 33.2 ​ ​ ​ ​ ​ 52,000,000 ​ ​ ​ ​ ​ 38.0 ​ ​ ​ ​ ​ 13.00 ​ ​ ​ ​ ​ ​ 12,044,435 ​ ​ ​ ​ ​ 100.0% ​ ​ ​ ​ $ 136,854,000 ​ ​ ​ ​ ​ 100.0% ​ ​ ​ ​ ​ ​ ​ ​ If the underwriters exercise their option to purchase additional shares of our common stock in full, the percentage of shares of common stock held by existing stockholders will decrease to 63.6% of the total number of shares of our common stock outstanding after this offering, and the number of shares held by new investors will increase to 4,600,000, or 36.4%, of the total number of shares of our common stock outstanding after this offering. Each $1.00 increase (decrease) in the assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover page of this prospectus, would increase (decrease) total consideration paid by new investors, total consideration paid by all stockholders and the average price per share paid by all stockholders by $4.0 million, $4.0 million and $0.46, respectively, assuming the number of shares offered by us, as set forth on the cover page of this prospectus, remains the same and before deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. An increase or decrease of 1.0 million in the number of shares we are offering would increase or decrease the total consideration paid by new investors by $13.0 million and, in the case of an increase, would increase the percentage of total consideration paid by new investors by 5.0 percentage points and, in the case of a decrease, would decrease the percentage of total consideration paid by new investors by 7.0 percentage points, assuming no change in the assumed public offering price per share. The foregoing tables and calculations exclude: 243,369 shares of common stock issuable upon the exercise of options under the 2007 Plan at a weighted average exercise price of $23.95 per share; 1,832,460 shares of our common stock reserved for future issuance under the 2017 Plan, which includes (i) 42,813 shares of restricted stock that we intend to grant under the 2017 Plan in connection with this offering and (ii) 39,992 shares of common stock reserved for future grant or issuance under the 2007 Plan that will be added to the shares reserved under the 2017 Plan upon its effectiveness. This selected consolidated statement of operations data for each of the three years in the period ended December 31, 2016 and this selected consolidated balance sheet data as of December 31, 2015 and 2016 have been derived from our audited consolidated financial statements included elsewhere in this prospectus. This selected consolidated statement of operations data for the six months ended June 30, 2016 and 2017 and this selected consolidated balance sheet data as of June 30, 2017 have been derived from our unaudited condensed consolidated financial statements included elsewhere in this prospectus. Our historical results are not necessarily indicative of the results to be expected for any future period. You should read this data together with our consolidated financial statements and related notes appearing elsewhere in this prospectus and the section of this prospectus entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Statement of operations data: ​ ​ ​ ​ ​ ​ Operating expenses: ​ ​ ​ ​ ​ ​ Other expenses: ​ ​ ​ ​ ​ ​ Net loss from continuing ​ ​ ​ ​ ​ ​ June 30, ​ ​ ​ $ 3,878 ​ ​ ​ ​ $ 1,609 ​ ​ ​ ​ $ 2,306 ​ ​ ​ ​ ​ ​ (54,112) ​ ​ ​ ​ ​ (65,309) ​ ​ ​ ​ ​ (69,941) ​ ​ MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations together with our consolidated financial statements and the related notes thereto and other financial information included elsewhere in this prospectus. Some of the information contained in this discussion and analysis or set forth elsewhere in this prospectus, including information with respect to our plans and strategy for our business, includes forward-looking statements that involve risks and uncertainties. You should review the ‘‘Risk Factors’’ section of this prospectus for a discussion of important factors that could cause our actual results to differ materially from the results described in or implied by the forward-looking statements contained in the following discussion and analysis. We sell implants and instruments to our customers for use by pediatric orthopedic surgeons to treat orthopedic conditions in children. We provide our implants in sets that consist of a range of implant sizes and include the instruments necessary to perform the surgical procedure. In the United States, our customers typically expect us to have full sets of implants and instruments on site at each hospital but do not purchase the implants until they are used in surgery. Accordingly, we must make an up-front investment in inventory of consigned implants and instruments before we can generate revenue from a particular hospital and we maintain substantial levels of inventory at any given time. We currently market 21 surgical systems that serve three of the largest categories within the pediatric orthopedic market: (i) trauma and deformity, (ii) complex spine and (iii) ACL reconstruction. We rely on a broad network of third parties to manufacture the components of our products, which we then inspect and package. We believe our innovative products promote improved surgical accuracy, increase consistency of outcomes and enhance surgeon confidence in achieving high standards of care. In the future, we expect to expand our product offering within these categories, as well as to address additional categories of the pediatric orthopedic market. The majority of our revenue has been generated in the United States, where we sell our products through a network of 33 independent sales agencies employing more than 110 sales representatives specifically focused on pediatrics, 69 of whom were full-time equivalents devoted to OrthoPediatrics sales activities. These independent sales agents are trained by us, distribute our products and are compensated through sales-based commissions and performance bonuses. We do not sell our products through or participate in physician-owned distributorships, or PODs. We market and sell our products internationally in 35 countries through independent stocking distributors. Our independent distributors manage the billing relationship with each hospital in their respective territories and are responsible for servicing the product needs of their surgeon customers. In April 2017, we began to supplement our use of independent distributors with direct sales programs in the United Kingdom, Ireland, Australia and New Zealand. In these markets, we work through sales agencies that are paid a commission, similar to our U.S. sales model. We expect these arrangements to generate an increase in revenue and gross margin. For the years ended December 31, 2015 and 2016 and the six months ended June 30, 2016 and 2017, international sales accounted for approximately 20%, 23%, 23% and 23% of our revenue, respectively. We believe there are significant opportunities for us to strengthen our position in U.S. and international markets by increasing investments in consigned implant and instrument sets, strengthening our global sales and distribution infrastructure and expanding our product offering. We have grown our revenue from approximately $10.2 million for the year ended December 31, 2011 to $37.3 million for the year ended December 31, 2016, reflecting a growth rate each year of at least 20%. For the years ended December 31, 2014, 2015 and 2016, our revenue was $23.7 million, $31.0 million and $37.3 million, respectively, and our net loss was $9.5 million, $7.9 million and $6.6 million, respectively. Our net loss for the year ended December 31, 2016 inlcuded a one-time charge of $2.0 million for costs related to our planned initial public offering. For the six months ended June 30, 2016 and 2017, our revenue was $17.7 million and $21.6 million, respectively, and our net loss was $2.1 million and $2.6 million, respectively. As of June 30, 2017, our accumulated deficit was $80.7 million. Components of our Results of Operations In the United States, we generate revenue primarily from the sale of our implants, and to a much lesser extent, from the sale of our instruments. We primarily consign our implants and instrument sets to independent sales agencies, who in turn deliver them to hospitals for use in procedures. We then supply these independent sales agencies with products to replace the consigned inventory as it is used in surgeries. We primarily recognize revenue when the products are used by the hospital for surgeries on a case by case basis. On rare occasions, hospitals purchase products for their own inventory, and revenue is recognized when the products are shipped and the title and risk of loss passes to the hospital customer. Outside of the United States, we sell our products through independent stocking distributors and, more recently, through independent sales agencies. Our distributors are generally allowed to return products, and some are thinly capitalized. Based on our history of collections and returns from international distributors, we have concluded that collectability is not reasonably assured at the time of delivery. Accordingly, for sales made through distributors, we do not recognize revenue and associated cost of revenue at the time title transfers, but rather when cash has been received from the distributor in payment. Until such payment, the cost of revenue is recorded as inventory held by international distributors, net of estimated unreturnable inventory on the balance sheet. In the case of our international sales made directly through sales agencies, our sales model is similar to that for U.S. sales. We consign sets to hospitals, ship replacement products, bill and collect receivables. Our revenue recognition is also similar, with revenue being recognized when our products are used by the hospital for surgeries on a case by case basis. We expect that our U.S. and international sales will grow in the near term across all three of our product categories as we continue to introduce new product line extensions, consign more implant and instrument sets in the United States, open new international markets and expand the number of our clinical training programs. We also expect to increase our revenue by expanding our customer base both in the United States and internationally by strengthening our global sales and distribution infrastructure. Cost of Revenue and Gross Margin Our cost of revenue consists primarily of products purchased from third-party suppliers, inbound freight, excess and obsolete inventory adjustments and royalties. Our implants and instruments are manufactured to our specifications by third-party suppliers. The majority of our implants and instruments are produced in the United States. We recognize cost of revenue for consigned implants at the time the implant is used in surgery and the related revenue is recognized. Prior to their use in surgery, the cost of consigned implants is recorded as inventory in our balance sheet. The costs of instruments are typically capitalized and not included in cost of revenue. We expect our cost of revenue to increase in absolute dollars due primarily to increased sales volume and changes in the geographic mix of our sales as our international operations tend to have a higher cost of revenue as a percentage of sales. Our gross profit is calculated by subtracting our cost of revenue from revenue and is expected to increase in absolute dollars due primarily to increased sales volume and sales mix to customers based in the United States. Our gross profit as a percentage of total revenue, or gross margin, was similar across all periods presented. Our gross margin is impacted by the mix of revenue between the United States, where we earn a higher gross margin that is required to pay sales commissions, and international, where we earn a lower gross margin because the distributor is responsible for paying sales commissions. Our sales and marketing expenses primarily consist of commissions to our domestic and international independent sales agencies, as well as compensation, commissions, benefits and other related personnel costs. Commissions and bonuses are generally based on a percentage of sales. Our international independent distributors purchase implant and instrument sets and replenishment stock for resale, and we do not pay commissions or any other sales-related costs for international sales. We expect our sales and marketing expenses to continue to increase in absolute dollars with the commercialization of our current and pipeline products and continued investment in our global sales organization to reach new customers. General and Administrative Expenses Our general and administrative expenses primarily consist of compensation, benefits and other related costs for personnel employed in our executive management, administration, finance, legal, quality and regulatory, product management, warehousing, information technology and human resources departments, including stock-based compensation for all personnel, as well as facility costs. We include insurance expenses in general and administrative expenses, as well as costs related to the maintenance and protection of our intellectual property portfolio. Our general and administrative expenses also include the depreciation of our capitalized instrument sets, which represented $1.3 million, $1.6 million, $1.5 million, $0.7 million and $0.9 million for the years ended December 31, 2014, 2015 and 2016 and the six months ended June 30, 2016 and 2017, respectively. We expect our general and administrative expenses to continue to increase in absolute dollars as we hire additional personnel to support the growth of our business. In addition, we expect to incur increased expenses as a result of being a public company. We expect the growth rate of our general and administrative expenses will be lower than the growth rate of our revenue. During the year ended December 31, 2016, we incurred approximately $2.0 million of expenses associated with our registration statement on Form S-1. Our planned initial public offering, or our IPO, was postponed for a period in excess of 90 days and, as a result, it was deemed an abandoned offering. Any additional costs related to our planned IPO that are incurred in 2017 will be deferred on the balance sheet until the completion of the IPO. Our research and development expenses primarily consist of costs associated with engineering, product development, consulting services, outside prototyping services, outside research activities, materials and development of our intellectual property portfolio. We also include related personnel and consultants’ compensation expense. We expect research and development expenses to continue to increase both in absolute dollars and as a percentage of revenue as we continue to develop new products to expand our product offering, broaden our intellectual property portfolio and add research and development personnel. Our other expenses primarily consist of borrowing costs and expenses related to long-term debt. Discontinued Operations In 2014, we made a strategic business decision to no longer sell biologics products. The revenue, cost of revenue and expenses from this product line were netted together and the gain or loss was reported as (gain) loss from discontinued operations on our statement of operations. As of December 31, 2015, the entire biologics product line was liquidated. Below is a summary of the discontinued operations financial results for the years ended December 31, 2014 and 2015. The effect of discontinued operations for subsequent periods has been excluded as it is not material. ​ ​ ​ $ 845 ​ ​ ​ ​ $ — ​ ​ ​ ​ ​ ​ 634 ​ ​ ​ ​ ​ — ​ ​ Results from operating activities Loss on sale of assets held for sale ​ ​ ​ ​ — ​ ​ ​ ​ ​ 38 ​ ​ ​ ​ ​ $ (211) ​ ​ ​ ​ $ 38 ​ ​ Six Months Ended June 30, 2016 and 2017 (unaudited) The following table sets forth our results of operations for the six months ended June 30, 2016 and 2017: Six Months Ended % Increase (in thousands, except percentages) ​ ​ ​ $ 17,745 ​ ​ ​ ​ $ 21,564 ​ ​ ​ ​ $ 3,819 ​ ​ ​ ​ ​ 22% ​ ​ ​ ​ ​ ​ 4,935 ​ ​ ​ ​ ​ 5,437 ​ ​ ​ ​ ​ 502 ​ ​ ​ ​ ​ 10 ​ ​ ​ ​ ​ ​ 8,106 ​ ​ ​ ​ ​ 9,491 ​ ​ ​ ​ ​ 1,385 ​ ​ ​ ​ ​ 17 ​ ​ Other (income) expenses ​ ​ ​ ​ (258) ​ ​ ​ ​ ​ 1,037 ​ ​ ​ ​ ​ 1,295 ​ ​ ​ ​ ​ 502 ​ ​ ​ ​ ​ $ (2,093) ​ ​ ​ ​ $ (2,551) ​ ​ ​ ​ $ 458 ​ ​ ​ ​ ​ 22 ​ ​ The following tables set forth our revenue by geography and product category for the six months ended June 30, 2016 and 2017: Revenue by Geography % of revenue ​ ​ ​ $ 13,691 ​ ​ ​ ​ ​ 77% ​ ​ ​ ​ $ 16,529 ​ ​ ​ ​ ​ 77% ​ ​ ​ ​ ​ ​ 4,054 ​ ​ ​ ​ ​ 23 ​ ​ ​ ​ ​ 5,035 ​ ​ ​ ​ ​ 23 ​ ​ ​ ​ ​ $ 17,745 ​ ​ ​ ​ ​ 100% ​ ​ ​ ​ $ 21,564 ​ ​ ​ ​ ​ 100% ​ ​ Revenue by Product Category Trauma and deformity Complex spine ACL reconstruction/other ​ ​ ​ ​ 518 ​ ​ ​ ​ ​ 3 ​ ​ ​ ​ ​ 602 ​ ​ ​ ​ ​ 3 ​ ​ Revenue increased $3.8 million, or 22%, from $17.7 million for the six months ended June 30, 2016 to $21.6 million for the six months ended June 30, 2017. The increase was due primarily to trauma and deformity sales growth of $2.6 million, or 20%, primarily driven by sales of our PediPlate product, complex spine sales growth of $1.1 million, or 27%, primarily driven by sales of our RESPONSE and BandLoc products, and ACL reconstruction/other sales growth of $0.1 million, or 16%. Nearly all the increase in each category was due to an increase in the unit volume sold and not a result of price changes. Cost of revenue increased $0.5 million, or 10%, from $4.9 million for the six months ended June 30, 2016 to $5.4 million for the six months ended June 30, 2017. The increase was due primarily to the increase in unit volume sold. Gross margin was 72% for the six months ended June 30, 2016 and 75% for the six months ended June 30, 2017. The increase was due primarily to increased sales and greater cost control. Sales and marketing expenses increased $1.4 million, or 17%, from $8.1 million for the six months ended June 30, 2016 to $9.5 million for the six months ended June 30, 2017. The increase was due primarily to increased sales commission expenses, driven by the increase in unit volume sold, and marketing expenses. General and administrative expenses increased $0.8 million, or 14%, from $6.0 million for the six months ended June 30, 2016 to $6.8 million for the six months ended June 30, 2017. The increase was due primarily to the addition of personnel and resources to support the growth of our business. Depreciation and amortization expenses increased $0.2 million, or 21%, from $0.9 million for the six months ended June 30, 2016 to $1.1 million for the six months ended June 30, 2017. The increase was primarily due to prior increased investments in consigned surgical instrument sets and amortization on intangible licenses. Research and development expenses increased $0.3 million, or 24%, from $1.1 million for the six months ended June 30, 2016 to $1.4 million for the six months ended June 30, 2017. The increase was due to the addition of personnel to support our product pipeline and the growth of our business. Other (income) expenses were $(0.3) million and $1.0 million for the six months ended June 30, 2016 and 2017, respectively. In June 2016, we recognized $0.9 million of income related to the expiration of a research and development fee obligation for our first generation RESPONSE spine system. The remaining expense in both of these periods consisted primarily of interest expense on long-term debt. Years Ended December 31, 2015 and 2016 The following table sets forth our results of operations for the years ended December 31, 2015 and 2016: (Decrease) ​ ​ ​ ​ 9,367 ​ ​ ​ ​ ​ 10,931 ​ ​ ​ ​ ​ 1,564 ​ ​ ​ ​ ​ 17 ​ ​ ​ ​ ​ ​ 15,033 ​ ​ ​ ​ ​ 16,661 ​ ​ ​ ​ ​ 1,628 ​ ​ ​ ​ ​ 11 ​ ​ ​ ​ ​ ​ 11,407 ​ ​ ​ ​ ​ 11,631 ​ ​ ​ ​ ​ 224 ​ ​ ​ ​ ​ 2 ​ ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ 1,979 ​ ​ ​ ​ ​ 1,979 ​ ​ ​ ​ ​ 100 ​ ​ ​ ​ ​ ​ 1,261 ​ ​ ​ ​ ​ 445 ​ ​ ​ ​ ​ (816) ​ ​ ​ ​ ​ (65) ​ ​ ​ ​ ​ $ (7,853) ​ ​ ​ ​ $ (6,572) ​ ​ ​ ​ $ (1,281) ​ ​ ​ ​ ​ (16) ​ ​ The following tables set forth our revenue by geography and product category for the years ended December 31, 2015 and 2016: ​ ​ ​ ​ 1,083 ​ ​ ​ ​ ​ 3 ​ ​ ​ ​ ​ 1,105 ​ ​ ​ ​ ​ 3 ​ ​ Revenue increased $6.3 million, or 20%, from $31.0 million for the year ended December 31, 2015 to $37.3 million for the year ended December 31, 2016. The increase was due primarily to trauma and deformity sales growth of $4.4 million, or 19%, primarily driven by sales of our PediNail and PediPlate products and complex spine sales growth of $1.9 million, or 26%, due to increased sales of our 5.5mm/​6.0mm RESPONSE spine system. Nearly all of the increase was due to the increase in unit volume sold and not a result of price changes. Cost of revenue increased $1.6 million, or 17%, from $9.4 million for the year ended December 31, 2015 to $10.9 million for the year ended December 31, 2016. The increase was due primarily to the increase in unit volume sold. Gross margin was 70% and 71% for the years ended December 31, 2015 and 2016, respectively. Sales and marketing expenses increased $1.6 million, or 11%, from $15.0 million for the year ended December 31, 2015 to $16.6 million for the year ended December 31, 2016. The increase was due primarily to increased sales commission and shipping expenses, both driven by the increase in unit volume sold. General and administrative expenses increased $0.2 million, or 2%, from $11.4 million for the year ended December 31, 2015 to $11.6 million for the year ended December 31, 2016. The increase was due primarily to an increase in cash bonus compensation, non-cash stock-based compensation and other expenses to support the growth of our business. Depreciation expenses remained flat at $1.9 million for the years ended December 31, 2015 and 2016. During the year ended December 31, 2016, we incurred approximately $2.0 million of expenses associated with our registration statement on Form S-1. Our planned initial public offering was postponed for a period in excess of 90 days and, as a result, it was deemed an abandoned offering. Research and development expenses increased $0.4 million, or 24%, from $1.8 million for the year ended December 31, 2015 to $2.2 million for the year ended December 31, 2016. The increase was due primarily to our continued investment in new product development in the trauma and deformity and complex spine product categories. Other expenses were $1.3 million and $0.4 million for the years ended December 31, 2015 and 2016, respectively. Other expenses for the year ended December 31, 2015 consisted primarily of interest expense on long-term debt. The decrease was primarily driven by the recognition of $0.9 million of income related to the expiration of a research and development fee obligation during the year ended December 31, 2016. ​ ​ ​ ​ 1,683 ​ ​ ​ ​ ​ 1,789 ​ ​ ​ ​ ​ 106 ​ ​ ​ ​ ​ 6 ​ ​ ​ ​ ​ ​ 2,616 ​ ​ ​ ​ ​ 1,261 ​ ​ ​ ​ ​ (1,355) ​ ​ ​ ​ ​ (52) ​ ​ ​ ​ ​ ​ 803 ​ ​ ​ ​ ​ 3 ​ ​ ​ ​ ​ 1,083 ​ ​ ​ ​ ​ 3 ​ ​ Revenue increased $7.3 million, or 31%, from $23.7 million for the year ended December 31, 2014 to $31.0 million for the year ended December 31, 2015. The increase was due primarily to complex spine sales growth of $3.9 million, or 109%, which was primarily driven by the launch of our 5.5mm/6.0mm RESPONSE spine system in May 2015, trauma and deformity sales growth of $3.1 million, or 16%, which was driven by continued clinical education and sales effectiveness, and ACL reconstruction/other sales growth of $0.3 million, or 35%. Nearly all of the increase was due to the increase in unit volume sold and not a result of price changes. Cost of revenue increased $2.3 million, or 32%, from $7.1 million for the year ended December 31, 2014 to $9.4 million for the year ended December 31, 2015. The increase was due primarily to the increase in unit volume sold. Gross margin was 70% for both of the years ended December 31, 2014 and 2015. General and administrative expenses increased $1.5 million, or 16%, from $9.9 million for the year ended December 31, 2014 to $11.4 million for the year ended December 31, 2015. The increase was due primarily to an increase in cash bonus compensation, non-cash stock based compensation and other expenses to support the growth of our business. Depreciation expenses increased $0.3 million, or 19%, from $1.6 million for the year ended December 31, 2014 to $1.9 million for the year ended December 31, 2015. The increase in depreciation expenses was primarily a result of prior increased investments in consigned surgical instrument sets. Research and development expenses increased $0.1 million, or 6%, from $1.7 million for the year ended December 31, 2014 to $1.8 million for the year ended December 31, 2015. The increase was due primarily to our continued investment in new product development in the trauma and deformity and complex spine product categories. Other expenses were $2.6 million and $1.3 million for the years ended December 31, 2014 and 2015, respectively. Other expenses for both of these periods consisted primarily of interest expense on long-term debt. The decrease was primarily driven by a refinancing event in May 2014, pursuant to which $22.0 million of debt was converted to redeemable convertible preferred equity. We have incurred operating losses since inception and negative cash flows from operating activities of $9.9 million, $0.9 million, $1.1 million, $2.3 million and $4.2 million for the years ended December 31, 2014, 2015 and 2016 and the six months ended June 30, 2016 and 2017, respectively. As of June 30, 2017, we had an accumulated deficit of $80.7 million. We anticipate that our losses will continue in the near term as we continue to expand our product portfolio and invest in additional consigned implant and instrument sets to support our expansion into existing and new markets. Since inception, we have funded our operations primarily with proceeds from the sales of our common and preferred stock, convertible securities and debt, as well as through sales of our products. As of June 30, 2017 we had cash and cash equivalents of $2.3 million. We believe our existing cash and cash equivalents, amounts available under the Loan Agreement, cash receipts from sales of our products and net proceeds from this offering will be sufficient to meet our anticipated cash requirements for at least the next 12 months. Nonetheless, from time to time, we may seek additional financing sources to meet our working capital requirements, make continued research and development investments and make capital expenditures needed for us to maintain and grow our business. We may not be able to obtain additional financing on terms favorable to us, if at all. It is also possible that we may allocate significant amounts of capital toward products or technologies for which market demand is lower than anticipated and, as a result, abandon such efforts. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, or if we expend capital on products or technologies that are unsuccessful, our ability to continue to support our business growth and to respond to business challenges could be significantly limited, or we may have to scale back our operations. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution, and any new equity securities we issue could have rights, preferences and privileges superior to those of holders of our common stock, including the shares of common stock sold in this offering. The following table sets forth our cash flows from operating, investing and financing activities for the periods indicated: Net cash used in operating activities ​ ​ ​ $ (9,922) ​ ​ ​ ​ $ (892) ​ ​ ​ ​ $ (1,119) ​ ​ ​ ​ $ (2,308) ​ ​ ​ ​ $ (4,234) ​ ​ ​ ​ ​ ​ 19,721 ​ ​ ​ ​ ​ (98) ​ ​ ​ ​ ​ 3,604 ​ ​ ​ ​ ​ 1,422 ​ ​ ​ ​ ​ 8,003 ​ ​ Effect of exchange rate change on cash ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ — ​ ​ ​ ​ ​ 72 ​ ​ Net increase (decrease) in cash and cash equivalents ​ ​ ​ $ 6,523 ​ ​ ​ ​ $ (2,703) ​ ​ ​ ​ $ (2,269) ​ ​ ​ ​ $ (2,681) ​ ​ ​ ​ $ 697 ​ ​ Cash Used in Operating Activities Net cash used in operating activities was $9.9 million, $0.9 million and $1.1 million for the years ended December 31, 2014, 2015 and 2016, respectively. The primary use of this cash was to fund our operations related to the development and commercialization of our products in each of these years. The improvement of approximately $9.0 million in net cash used in operations for 2015 was primarily due to a $1.7 million improvement in our net loss and a $6.0 million improvement in cash flow from inventories and inventories held by international distributors. Net cash provided by (used for) working capital was $(2.7) million, $3.9 million and $3.2 million for the years ended December 31, 2014, 2015 and 2016, respectively. During 2014, the primary driver of working capital cash use was a $2.3 million increase in inventories held by international distributors as we shipped sets and finished goods inventory to new distributors. During 2015, the primary driver of working capital cash generation was a $1.6 million reduction in inventories held by international distributors as we did not establish new distributor relationships and we returned some sets and finished goods inventory from new distributors that lacked sufficient capital. During 2016, we increased warehouse inventory by $1.0 million and decreased other working capital by $4.2 million as we refocused on cash preservation. We had a net loss of $9.5 million, $7.9 million and $6.6 million for the years ended December 31, 2014, 2015 and 2016, respectively, which drove a difference in the use of operating cash between the periods. Our net loss for the year ended December 31, 2016 included a one-time charge of $2.0 million for costs related to our planned initial public offering. Net cash used in operating activities was $2.3 million and $4.2 million for the six months ended June 30, 2016 and 2017, respectively. The primary use of this cash was to fund our operations related to the development and commercialization of our products. Net cash used for working capital was $0.9 million and $3.5 million for the six months ended June 30, 2016 and 2017, respectively. In both periods, inventory management drove the largest impact to working capital cash usage. In the six months ended June 30, 2017, our warehouse inventory increased using $3.6 million in cash as we assembled additional sets for deployment. We had a net loss of $2.1 million for the six months ended June 30, 2016, as compared to a net loss of $2.6 million for the six months ended June 30, 2017, which partially offset the use of cash in such periods. Net cash used in investing activities was $3.3 million, $1.7 million and $4.8 million for the years ended December 31, 2014, 2015 and 2016, respectively. Net cash used in investing activities consisted primarily of purchases of instrument sets, which were consigned in the United States, of $3.1 million, $2.2 million and $4.3 million for the years ended December 31, 2014, 2015 and 2016, respectively. In 2014 and 2015, these amounts were partially offset by cash collected for assets held for sale related to our discontinued business operations. In 2016, we purchased an additional $0.4 million in new product licenses. Net cash used in investing activities was $1.8 million and $3.1 million for the six months ended June 30, 2016 and 2017, respectively. Net cash used in investing activities consisted primarily of purchases of instrument sets, which were consigned in the United States, of $1.8 million and $2.8 million for the six months ended June 30, 2016 and 2017, respectively. In 2017, we purchased an additional $0.3 million in new product licenses. Net cash provided by (used in) financing activities was $19.7 million, $(0.1) million and $3.6 million for the years ended December 31, 2014, 2015 and 2016, respectively. Net cash used in financing activities during 2015 consisted primarily of mortgage payments. Net cash provided by financing activities during 2014 consisted primarily of proceeds from the issuance of preferred stock of $16.9 million and proceeds from the issuance of debt of $4.0 million, which was partially offset by payments on promissory notes and convertible term notes of $1.1 million. Net cash provided by financing activities during 2016 consisted primarily of proceeds of $4.5 million from the issuance of debt to an affiliate, offset by the payment of $0.8 million of deferred costs related to our planned initial public offering and $0.1 million in mortgage payments. Net cash provided by financing activities was $1.4 million and $8.0 million for the six months ended June 30, 2016 and 2017, respectively. Net cash used in financing activities consisted primarily of mortgage payments in both periods, as well as payments of deferred offering costs during the six months ended June 30, 2016. Additionally, in 2017, $8.0 million of debt was borrowed from Squadron. Loan Agreement In April 2017, we entered into a third amended and restated loan agreement, or the Loan Agreement, with Squadron. Pursuant to the Loan Agreement, Squadron has provided us with term loan credit facilities in an aggregate principal amount of approximately $34.4 million ($18.4 million of which was made available pursuant to the Term Note A and up to $16.0 million of which was or will be made available pursuant to the Term Note B). Of the $16.0 million that was or will be made available pursuant to the Term Note B: $9.0 million is currently available; $6.0 million will be made available on January 1, 2018, subject to our achieving certain revenue goals for the year ended December 31, 2017; and $1.0 million is payable as a fee in three equal installments (the first installment was borrowed and paid at closing, and the second and third installments will, if an initial public offering is not completed prior to such time, become available and payable on the first and second anniversary thereof). The largest principal amount outstanding under the Term Note A and the Term Note B at any time since April 2017 was $18.4 million and $7.5 million, respectively. As of June 30, 2017, we had approximately $24.0 million in outstanding indebtedness under the Loan Agreement. Borrowings under the Loan Agreement are secured by substantially all of our assets and are unconditionally guaranteed by each of our subsidiaries. There are no financial covenants associated with the Loan Agreement. However, there are negative covenants that prohibit us from, among other things, transferring any of our material assets, merging with or acquiring another entity, entering into a transaction that would result in a change of control, incurring additional indebtedness, creating any lien on our property, making investments in third parties and redeeming stock or paying dividends, in each case subject to certain exceptions as further detailed in the Loan Agreement. The Loan Agreement includes events of default, the occurrence and continuation of any of which provides Squadron with the right to exercise remedies against us and the collateral securing the loans, including cash. These events of default include, among other things, the failure to pay amounts due under the credit facilities, insolvency, the occurrence of a material adverse event, which includes a material adverse change in our business, operations or properties (financial or otherwise) or a material impairment of the prospect of repayment of any portion of the obligations, the occurrence of any default under certain other indebtedness and a final judgment against us in an amount greater than $250,000. The occurrence of a material adverse change could result in the acceleration of payment of the debt. We are obligated to make monthly interest-only payments on the term loan facilities until the earlier of: (i) a transaction pursuant to which any person acquires (a) shares of our capital stock possessing the voting power to elect a majority of our board of directors or (b) all or substantially all of our assets on a consolidated basis; or (ii) May 31, 2019, subject to an automatic extension to May 31, 2020 if we meet certain revenue goals, at which point the term loan credit facilities, plus all accrued, unpaid interest thereon, will become due. The Term Note A and the Term Note B bear interest at an annual rate of 10% and 11%, respectively. Following the maturity of the term loan credit facilities, or the earlier occurrence and continuation of an event of default, such borrowings will bear interest at an annual rate of 18%. We may prepay the term loan facility in whole or in part without premium or penalty upon ten days’ prior written notice to Squadron. Mortgage Note In August 2013, pursuant to the purchase of our office and warehouse space, we entered into a mortgage note payable to Tawani Enterprises Inc., the owner of which is a member of Squadron’s Managing Committee. Pursuant to the terms of the mortgage note, we pay Tawani Enterprises Inc. monthly principal and interest installments of $15,543, with interest compounded at 5% until maturity in August 2028, at which time a final payment of remaining principal and interest will become due. The mortgage is secured by the related real estate and building. The mortgage balance was $1.7 million, $1.6 million and $1.6 million as of December 31, 2015 and 2016 and June 30, 2017, respectively. Pediatric Orthopedic Business Seasonality Our revenue is typically higher in the summer months and holiday periods, driven by higher sales of our trauma and deformity and complex spine products, which is influenced by the higher incidence of pediatric surgeries during these periods due to recovery time provided by breaks in the school year. Additionally, our complex spine patients tend to have additional health challenges that make scheduling their procedures variable in nature. Critical Accounting Policies and Significant Judgments and Estimates This management’s discussion and analysis of financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue and expenses during the reporting periods. We monitor and analyze these items for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions. While our significant accounting policies are more fully described in the notes to our audited consolidated financial statements appearing elsewhere in this prospectus, we believe the following accounting policies are most critical to understanding and evaluating our reported financial results. In the United States, we primarily sell our implants, and to a much lesser extent our instruments, through third-party independent sales agencies to medical facilities and hospitals. For such sales, revenue and associated cost of revenue is recognized when a product is used in a procedure. In a few cases, hospitals purchase our products for their own inventory, and such revenue and associated cost of revenue is recognized when a product is shipped or delivered and the title and risk of loss passes to the customer. International sales are through independent stocking distributors. Generally, these distributors are allowed to return products, can be thinly capitalized and in some cases do not pay for our products until they have been resold. Based on our history of collections and returns from international distributors, we have concluded that collectability is not reasonably assured. Accordingly, we recognize international revenue and associated cost of revenue when cash is received from the distributor. In the case of international sales made directly through sales agencies, we recognize revenue when our products are used by the hospital for surgeries on a case by case basis. We have invoiced international sales to distributors that have not been recognized as revenue totaling $5.2 million, $1.7 million and $1.5 million as of December 31, 2015 and 2016 and June 30, 2017, respectively. Associated cost of revenue, which is reported as inventory held by distributors until the related revenue is recognized, was $2.8 million, $0.9 million, $1.7 million and $0.8 million as of December 31, 2015 and 2016 and June 30, 2016 and 2017, respectively. Inventory Valuation Inventory is stated at the lower of cost or market, with cost determined using the first-in-first-out method. Inventory, which consists of implants and instruments included in deployed sets in the field or held in our warehouse, is considered finished goods and is purchased from third parties. We evaluate the carrying value of our inventory in relations to the estimated forecast of product demand, which takes into consideration the life cycle of the products. A significant decrease in demand could result in an increase in the amount of excess inventory on hand, which could lead to additional charges for excess and obsolete inventory. The need to maintain substantial levels of inventory impacts our estimates for excess and obsolete inventory. Each of our systems are designed to include implantable products that come in different sizes and shapes to accommodate the surgeon’s needs. Typically, a small number of the set components are used in each surgical procedure. Certain components within each set may become obsolete before other components based on the usage patterns. We adjust inventory values to reflect these usage patterns and life cycle. In addition, we continue to introduce new products, which we believe will increase our revenue. As a result, we may be required to take additional charges for excess and obsolete inventory in the future. Income taxes include federal and state income taxes and deferred income taxes. We recognize deferred tax assets and liabilities for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. We measure deferred tax assets and liabilities using enacted tax rates expected to apply to taxable income in the year in which such items are expected to be received or settled. We recognize the effect on deferred tax assets and liabilities of a change in tax rates in the period that includes the enactment date. We establish a valuation allowance to offset any deferred tax assets if, based upon available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. Currently, we have recorded a full valuation allowance against the deferred tax assets, as we have incurred losses to date. We recognize compensation costs related to stock options granted to employees based on the estimated fair value of the stock options on the date of the grant using the Black-Scholes option pricing model. The grant date fair value of such options is expensed on a straight-line basis over the period during which the employee grantee is required to provide service in exchange for the award, which is generally the vesting period. No stock options were granted during the years ended December 31, 2014, 2015 and 2016 or the six months ended June 30, 2016 and 2017 and compensation costs related to previously granted stock options during such periods were immaterial. We recognize compensation costs related to restricted stock granted to employees based on the estimated fair value of the awards on the date of the grant, net of estimated forfeitures, amortized over the restriction period. Historically, for all periods prior to this offering, the fair values of the shares of common stock underlying our restricted stock and stock option awards were estimated on each grant date by management and approved by the board of directors. In order to determine the fair value of our common stock underlying such grants, we consider multiple inputs to value our common stock, including the value of equity, enterprise value and key price points in our capital structure. Given the absence of a public trading market for our common stock, we exercised reasonable judgment and considered a number of objective and subjective factors to determine the best estimate of the fair value of our common stock, including the preferences and dividends of our redeemable convertible preferred stock relative to those of our common stock; our operating results and financial conditions, including our level of available capital resources; equity market conditions affecting comparable public companies; general U.S. market conditions and the lack of marketability of our common stock. In valuing our common stock, we used the market approach, which is based on the assumption that the value of an asset is equal to the value of a substitute asset with the same characteristics. In using the market approach, we have considered both the guideline public company method and the precedent transaction method. We allocated the enterprise value across our classes of capital stock to determine the fair value of our common stock at each valuation date. After the equity value was allocated to the share classes, we applied a discount for lack of marketability to our common shares because we were valuing a minority interest in our company as a closely held, non-public company with no liquid market for its shares. We also considered the various rights and privileges of our redeemable convertible preferred stock relative to our common stock, including anti-dilution protection, cumulative dividend rights, protective provisions in our certificate of incorporation and rights to participate in future rounds of financing. For stock-based awards granted after the completion of this offering, our board of directors intends to determine the fair value of each share of underlying common stock based on the closing price of our common stock as reported on the date of grant. We recorded total stock-based compensation expenses of $0.7 million, $1.2 million, $1.2 million, $0.7 million and $0.7 million for the years ended December 31, 2014, 2015 and 2016 and the six months ended June 30, 2016 and 2017, respectively. We expect to continue to grant restricted stock and other equity-based awards in the future, and to the extent that we do, our stock-based compensation expenses in future periods will likely increase. The intrinsic value of all outstanding options and warrants as of June 30, 2017 was $0.02 million, based on an assumed initial public offering price of $13.00 per share, the midpoint of the price range set forth on the cover of this prospectus. The following table summarizes our contractual obligations as of June 30, 2017: Payments Due by Period(1) Long-term debt ​ ​ ​ $ 25,541 ​ ​ ​ ​ $ 110 ​ ​ ​ ​ $ 24,320 ​ ​ ​ ​ $ 423 ​ ​ ​ ​ $ 688 ​ ​ Minimum royalty payments ​ ​ ​ ​ 4,300 ​ ​ ​ ​ ​ 300 ​ ​ ​ ​ ​ 1,500 ​ ​ ​ ​ ​ 1,500 ​ ​ ​ ​ ​ 1,000 ​ ​ The table excludes the redemption preference of our redeemable convertible preferred stock, which is redeemable on or after May 30, 2019 at the option of the holders. The value of the accumulated redemption amount as of June 30, 2017 was $74.2 million. We do not have any off-balance sheet arrangements, as defined by applicable regulations of the SEC, that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources. As of June 30, 2017, we had federal and state tax net operating loss carryforwards, or NOLs, of approximately $64.5 million, which begin to expire in 2028 unless previously utilized. The deferred tax assets were fully offset by a valuation allowance as of December 31, 2015 and 2016 and June 30, 2017, and no income tax benefit has been recognized in our consolidated statements of operations. Pursuant to Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, annual use of our pre-change NOLs may be limited in the post-change period in the event that an ‘‘ownership change’’ occurs, which is generally defined as a cumulative change in equity ownership by ‘‘5% shareholders’’ that exceeds 50 percentage points over a rolling three-year period. We determined that an ownership change occurred on May 30, 2014, resulting in a limitation of approximately $1.1 million per year being imposed on the use of our pre-change NOLs of approximately $49.0 million. This limitation will be increased in the first five years after the ownership change by the amounts of recognized built-in gains as determined under the tax rules, which increase should be approximately $2.3 million in each such year. A discussion of recent accounting pronouncements is included in note 2 to our consolidated financial statements appearing elsewhere in this prospectus. Interest Rate Risk Our cash balances as of December 31, 2015 and 2016 and June 30, 2017 consisted of cash held in an operating account that earns nominal interest income. We are exposed to market risk related to fluctuations in interest rates and bond market prices. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates. However, because of the nature of our cash holdings, a sudden change in market interest rates would not be expected to have a material impact on our financial condition or results of operation. Because our long-term debt under the Loan Agreement bears interest at a fixed rate, a change in market interest rate would not impact our financial condition and results of operations. While we operate in countries other than the United States, we bill all of our sales outside of the United States in U.S. dollars. We therefore believe the risk of a significant impact on our operating income from foreign currency fluctuations is not significant. We do not currently hedge our exposure to foreign currency exchange rate fluctuations, but we may choose to do so in the future. We estimate that an immediate 10% adverse change in foreign exchange rates not currently pegged to the U.S. dollar would have decreased our reported net income by a de minimis amount for the years ended December 31, 2014, 2015 and 2016 and the six months ended June 30, 2016 and 2017. Other Company Information As a company with less than $1.07 billion in revenue during our last fiscal year, we qualify as an ‘‘emerging growth company,’’ as defined in the JOBS Act. An emerging growth company may take advantage of reduced reporting requirements that are otherwise applicable to public companies. These provisions include: being permitted to present only two years of audited financial statements and only two years of related Management’s Discussion and Analysis of Financial Condition and Results of Operations in this prospectus; not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act; reduced disclosure obligations regarding executive compensation in this prospectus and in our periodic reports, proxy statements and registration statements; and We may take advantage of these provisions until the last day of our fiscal year following the fifth anniversary of the completion of this offering. However, if certain events occur prior to the end of such five-year period, including if we become a ‘‘large accelerated filer,’’ our annual gross revenue exceeds $1.07 billion or we issue more than $1.0 billion of non-convertible debt in any three-year period, we will cease to be an emerging growth company prior to the end of such five-year period. We have elected to take advantage of certain of the reduced disclosure obligations in this registration statement and may elect to take advantage of other reduced reporting requirements in future filings. As a result, the information that we provide to our stockholders may be different from what you might receive from other public reporting companies in which you hold equity interests. Internal Control over Financial Reporting In accordance with the provisions of the Sarbanes-Oxley Act, neither we nor our independent registered public accounting firm has performed an evaluation of our internal control over financial reporting during any period included in this prospectus. However, in preparing our financial statements for the fiscal year ended December 31, 2015, we and our independent registered public accounting firm identified a material weakness in our internal control over financial reporting. A material weakness is defined as a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our financial statements will not be prevented or detected on a timely basis. The material weakness identified resulted from the fact that we did not have sufficient financial reporting and accounting controls over complex accounting transactions to address complex GAAP considerations and applicable SEC rules and regulations. As of December 31, 2016, we had implemented numerous steps to remediate the underlying causes of the material weakness, including: (i) the hiring of additional personnel with the appropriate financial reporting experience to expand our financial management and reporting infrastructure and further develop and document our accounting policies and financial reporting procedures with respect to complex accounting transactions; (ii) the retention of an additional accounting firm, as needed, to provide technical consulting services with respect to complex accounting transactions; and (iii) the establishment and implementation of policies and procedures to ensure adherence to accounting policies, rules and regulations and to provide enhanced financial analysis and quality control with respect to complex accounting transactions. As of December 31, 2016, we believe the material weakness had been properly remediated. Children are not just small adults. Their skeletal anatomy and physiology differs significantly from that of adults, which affects the way in which children with orthopedic conditions are managed surgically. Children’s bones are smaller, are more curved and have growth plates that cannot be violated without causing potential bone growth arrest and subsequent deformity. Furthermore, children may suffer from complex disorders such as cerebral palsy, which may pose clinical challenges and require multiple surgeries into adulthood. Historically, there have been a limited number of implants and instruments specifically designed for the unique needs of children. As a result, pediatric orthopedic surgeons often improvise with adult implants repurposed for use in children, resort to freehand techniques with adult instruments and use implants that can be difficult to remove after being temporarily implanted. These improvisations may lead to undue surgical trauma and morbidity. We address this unmet market need and sell the broadest product offering specifically designed for children with orthopedic conditions. We currently market 21 surgical systems that serve three of the largest categories within the pediatric orthopedic market: (i) trauma and deformity, (ii) complex spine and (iii) anterior cruciate ligament, or ACL, reconstruction procedures. Our products have proprietary features designed to: We believe our innovative products promote improved surgical accuracy, increase consistency of patient outcomes and enhance surgeon confidence in achieving high standards of care. In the future, we expect to expand our product offering to address additional categories of the pediatric orthopedic market, such as active growing implants for early onset scoliosis and limb length discrepancies, other sports-related injuries, patient-specific templates for spine surgical procedures and other orthopedic trauma and deformity applications. We have the only global sales organization focused exclusively on pediatric orthopedics. Our organization has a deep understanding of the unique nature of children’s clinical conditions and surgical procedures as well as an appreciation of the tremendous sense of responsibility pediatric orthopedic surgeons feel for the children whom parents have entrusted to their care. We provide these surgeons with dedicated support, both in and out of the operating room. As of June 30, 2017, our U.S. sales organization consisted of 33 independent sales agencies employing more than 110 sales representatives, 69 of whom were full-time equivalents devoted to OrthoPediatrics sales activities. Increasingly, these sales agencies are making us the anchor line in their businesses or representing us exclusively. Sales from such sales agencies represented 77% of our U.S. revenue in 2016. Outside of the United States, our sales organization consisted of 31 independent distributors in 35 countries. In addition, beginning in April 2017, we began to supplement the use of distributors with direct sales programs in select international markets where we work through sales agencies that are paid a commission. These new arrangements are expected to generate an increase in revenue and gross margin. We believe clinical education is critical to advancing the field of pediatric orthopedics. Cumulatively, we are the largest financial contributor to the five primary pediatric orthopedic surgical societies that conduct pediatric clinical education and research. We are a major sponsor of continuing medical education, or CME, courses in pediatric spine and pediatric orthopedics, which are focused on fellows and young surgeons. In 2016, we conducted more than 200 training workshops. We believe these workshops help surgeons recognize our commitment to their field. We believe our commitment to clinical education has helped to increase our account presence while promoting familiarity with our products and loyalty among fellows and young surgeons. We have grown our revenue from approximately $10.2 million for the year ended December 31, 2011 to $37.3 million for the year ended December 31, 2016, reflecting a growth rate each year of at least 20%. For the years ended December 31, 2015 and 2016, our revenue was $31.0 million and $37.3 million, respectively. For the six months ended June 30, 2016 and 2017, our revenue was $17.7 million and $21.6 million, respectively, and our net loss was $2.1 million and $2.6 million, respectively. As of June 30, 2017, our accumulated deficit was $80.7 million. We believe we have a history of efficient capital utilization, and we intend to scale our business model by continuing to implement the successful strategy that has sustained our growth. This strategy includes increasing investment in consigned implant and instrument sets in the United States and select international markets, expanding our innovative product line by leveraging our efficient product development process, strengthening our global sales and distribution infrastructure, broadening our commitment to clinical education and research and deepening our culture of continuous improvement. Due to the high concentration of pediatric orthopedic surgeons in comparatively few hospitals, we believe we can accelerate the penetration of our addressable market a capital-efficient manner and further strengthen our position as the category leader in pediatric orthopedics. The primary challenges to maintaining our growth in a market that has not historically relied on age-specific implants and instruments have been overcoming older surgeons’ familiarity with repurposing adult implants for use in children and our current lack of published long-term data supporting superior clinical outcomes by our products. We believe our efforts in surgeon training, collaboration and marketing address this inertia, particularly with younger surgeons. Children Have Unique Skeletal Characteristics Children are not just small adults. Their skeletal anatomy and physiology differs significantly from adults, which affect the way in which children with orthopedic conditions are managed surgically. These differences include: Children’s Bones Are Smaller. Children’s bones are significantly smaller than adult bones. Bone size and strength increases rapidly during childhood and adolescence. Children’s Bones Are Growing. Children’s bones contain growth plates, or physes, that consist of developing cartilage tissue at the end of the bone, enabling skeletal growth. Bones grow lengthwise from the ends of the growth plates until skeletal maturity is reached and the growth plates close. As this occurs, some bones fuse together, reducing the 270 bones children have at birth to 206 bones by adulthood. Injury to the growth plates, including fracture or surgical trauma, can lead to growth arrest and subsequent deformity. The Composition and Vasculature of Children’s Bones Is Unique. Children’s bones are more porous and respond to injury and infection differently than adult bones. Children also have blood vessels that supply oxygen and nutrients to bones as they grow, which disappear when the growth plates close and the child reaches adulthood. Trauma to these blood vessels during surgery may cut off blood supply to the bone, resulting in death of the bone tissue. Children’s Bones Change Shape as They Grow. Children’s bones are more curved than adult bones. As children grow into adulthood, their bones change shape to accommodate the biomechanical forces exerted upon the body. For example, the curvature of the femur decreases up to 30% as a child matures. Complex Disorders in Children Pose Unique Clinical Challenges. Complex disorders such as cerebral palsy, scoliosis, brittle bone disease and hip disorders can pose significant challenges for surgical treatment. The most common such disorder is cerebral palsy, which affects approximately 500,000 children under the age of 18 in the United States and approximately three out of every 1,000 live births. Spastic cerebral palsy is the most common form, making up the majority of all cerebral palsy cases. Spastic cerebral palsy can produce skeletal deformities such as curvature of the spine, hip dislocation, gait abnormalities and other conditions involving joints and bones. Children suffering from these disorders often require multiple surgeries into adulthood. We believe the challenges resulting from the unique characteristics of children’s skeletal anatomy and physiology, as well as the complex disorders affecting them, are best addressed by the use of implants and instruments specifically designed for the treatment of children. Pediatric Orthopedic Surgeons Are Generalists Unlike orthopedic surgeons focused on treating adults, pediatric orthopedic surgeons are, for the most part, generalists treating a wide range of congenital, developmental and traumatic orthopedic conditions, including limb and spine deformities, gait abnormalities, bone and joint infections, sports injuries and orthopedic trauma cases. Accordingly, they generally represent a single call point for our broad range of pediatric orthopedic implants and instruments. In 2016, there were more than 1,200 members of POSNA, as compared to approximately 33,400 practicing orthopedic surgeons in the United States focused on the treatment of adults. The number of fellowships in pediatric orthopedics continues to grow. As generalists, these surgeons have a deep understanding of the unique nature of children’s clinical conditions and surgical procedures. We believe they feel a tremendous sense of responsibility for the children whom parents have entrusted to their care. Market Opportunity We currently serve a portion of the pediatric orthopedic implant market that we estimate represents a $2.5 billion opportunity globally, including over $1.1 billion in the United States. The chart below provides the estimated sizes of the four categories of our U.S. addressable market opportunity, based on third-party data (including data compiled by IMS Health, Inc. and Life Science Intelligence, Inc. in studies that we commissioned) regarding the number of procedures performed in 2015 and our average revenue per procedure or, in the case of smart implants, our estimated average revenue per procedure based on industry data. Trauma and Deformity U.S. Pediatric Orthopedic Implant Market We estimate that the United States represented approximately 55% of the total global orthopedic implant market, both adult and pediatric, and that this geographic segmentation similarly applies to the global pediatric orthopedic implant market. Overviews of the three categories of the trauma and deformity, complex spine and sports medicine markets that we currently serve, and the smart implant market that we are planning to enter, are as follows: Trauma and deformity procedures involve placing metal plates and screws on the outside of the bone or long nails inside the canal of the bone, known as intramedullary nails, to stabilize fractures and allow them to heal. Trauma and deformity procedures also include osteotomies, or surgical cutting of the bone, and the use of metal implants to correct angular bone deformities or limb length discrepancies. Complex spine procedures involve the use of spinal implants, such as pedicle screws and rods, to correct curvature of the spine as a result of scoliosis, trauma or tumors. Sports medicine procedures include anterior cruciate ligament, or ACL, and medial patellofemoral ligament, or MPFL, reconstruction procedures. These reconstruction procedures refer to the replacement of the ACL or MPFL ligaments, as applicable, with a surgical tissue graft to restore function to the knee after injury. According to Life Science Intelligence, Inc., in a study that we commissioned, approximately 29% of ACL reconstruction procedures completed in the United States in 2015 were in patients under the age of 18. The vast majority of these procedures were performed in ambulatory surgery centers. Smart Implants We are developing a new generation of adjustable implant systems, which we refer to as our Active Growing Implants, which will utilize a mechanized motor and be adjustable at the time of implantation and non-invasively over the course of treatment to accomodate the clinical needs of patients with early onset scoliosis and limb length discrepancies, or LLDs, as they heal, grow and age. Early onset scoliosis refers to severe spinal deformities in skeletally immature patients under the age of ten. Despite its low incidence rate, early onset scoliosis is a challenging health issue and can lead to significant morbidity such as failure to thrive and death. LLDs can occur for a variety of reasons, including congenital deformities and previous injury to the bone. Larger LLDs often result in debilitating pain and difficulty to walk. High Procedural Concentration in Trauma and Deformity and Complex Spine According to IMS Health, Inc., 3,425 hospitals performed pediatric trauma and deformity or complex spine procedures in the United States in 2014. Only 268 of these hospitals performed 62% of all pediatric trauma and deformity and complex spine procedures. Further, of these hospitals, 62 are children’s hospitals and performed 21% of all pediatric trauma and deformity and complex spine procedures. We believe that this high concentration of pediatric trauma and deformity and complex spine procedures and our focused sales organization will enable us to address the pediatric orthopedic surgery market in a capital-efficient manner. In the future, we expect to expand our market opportunity by addressing additional categories of the pediatric orthopedic market, such as craniomaxilloacial, elbow, proximal humerus, pelvis and other sports-related injuries. Children are not just small adults. Their skeletal anatomy and physiology require specialized implants and instruments designed to treat their orthopedic disorders appropriately. Significant investment in product development and clinical, regulatory and commercial infrastructure is required to bring a medical device to market. Due to the size of the pediatric orthopedic market compared to the adult market, we believe that no other diversified orthopedic company has committed the resources necessary to develop a sales and product development infrastructure focused on this market, resulting in the following unmet needs: Historically, without pediatric-specific products, some conditions in children would go untreated. For example, tears of the ACL are common sports-related injuries. Because attempting an ACL repair on a child whose growth plates have not closed can cause growth disturbances in the leg, young athletes would often go untreated and remain sidelined until puberty. We believe we are the only company that has committed the resources necessary to create a global sales and product development infrastructure focused on the pediatric orthopedic implant market. Our goal is to build an enduring company committed to addressing this market’s unmet needs. Dedicated Sales Support to Pediatric Orthopedic Surgeons. Our sales and marketing personnel provide dedicated sales support to pediatric orthopedic surgeons, both in and out of the operating room, to guide them through the optimal selection and use of implants and instruments to achieve desired clinical outcomes. Participation of Pediatric Orthopedic Surgeons in New Product Development. With the assistance of our Chief Medical Officer, or CMO, a highly respected former pediatric orthopedic surgeon, and the Surgeon Advisory Board he chairs, we engage with pediatric orthopedic surgeons to understand their clinical needs and develop new implants, instruments and surgical techniques that will allow them to better serve their patients. We also respond to surgeons’ requests for customized implants and instruments to improve their workflows and enhance their clinical outcomes. Leading Supporter of Pediatric Orthopedic Surgical Societies and Clinical Education. Cumulatively, we donate more than any of our competitors to the five primary pediatric orthopedic surgical societies that conduct pediatric clinical education and research. In 2016, we conducted more than 200 training workshops focused on fellows and surgeons early in their careers. We believe our commitment to clinical education advances pediatric orthopedic surgery and increases our account presence, while promoting familiarity with our products and loyalty among fellows and young surgeons. We aspire to be viewed as the partner of pediatric orthopedic surgeons around the world. Protect a Child’s Growth Plates. Some of our implants include patented features that are specifically designed to enable appropriate fixation to the bone and protect a child’s growth plates. Fit a Wide Range of Pediatric Anatomy. Our implants are specifically designed to fit the unique curvature of children’s bones, which changes with age. Enable Earlier Surgical Intervention. Our implants and instruments allow surgical treatment of sports-related knee injuries in young children, enable natural anatomical alignment of the ligament and avoid long-term clinical complications. Enable Precise and Reproducible Surgical Techniques. Where appropriate, our products are designed to be positioned over a guidewire. This enhances the precision of placement from traditional, freehand techniques and promotes the reproducibility of the surgical procedure. Ease Implant Removal. Where appropriate, our implants are made of stainless steel, which discourages bony on-growth and enables easier surgical removal than does the titanium typically used for adult implants. Allow For Less Invasive Surgical Techniques. Our instruments are specifically designed for use in children and are often smaller than adult instruments. This enables pediatric orthopedic surgeons in many cases to treat their patients with less invasive surgical techniques. Enhance Surgeon Confidence. Our implants and instruments promote improved surgical accuracy, increase consistency of outcomes and, we believe, enhance surgeon confidence in achieving high standards of care. Locking Proximal Femur and Locking Cannulated Blade Systems Through our Locking Proximal Femur Plate and Locking Cannulated Blade systems, we were the first to offer cannulated implants and instruments to the pediatric market. They are designed for hip osteotomies, where a bone is cut to shorten, lengthen or change its alignment or orientation. These systems include a locking screw to secure the resulting bone fragment. These plates have a small hole, or cannula, drilled through the length of the implant. This allows the implant and its screws to fit over a guidewire and, with the use of a specialized alignment instrument, ensure optimal placement. These systems offer significant improvements over those designed for adults because they improve fixation, offer more reproducible results and create a more stable construct, thereby minimizing the risk of improper placement from traditional freehand techniques. These systems are available in multiple sizes and angles to restore the mechanical axis of the skeletal anatomy. RESPONSE Spinal Deformity System Our RESPONSE Spinal Deformity system is designed to treat adolescent idiopathic scoliosis. It is based on a pedicle screw specifically designed for pediatric patients, rather than one developed for adult lumbar fixation. Pedicle screws are attached directly to vertebrae and provide a means to anchor rods, which are used to realign, or reduce, and de-rotate the spine. Our system’s proprietary design can withstand the significant lateral forces present when reducing and de-rotating a child’s spine. This minimizes the common problem of set screws cross threading or dissociating from the head of the pedicle screw. Furthermore, our RESPONSE screws are among the lowest profile screws commercially available and are 20% shorter than those in the market-leading system, which minimizes patient discomfort. Our system has the flexibility to accept both 5.5mm and 6.0mm titanium or cobalt chromium stabilizing rods within the same pedicle screw, giving the surgeon significant flexibility during the procedure to strengthen the construct without replacing the screws. Our rod reduction instrument provides ergonomic one-handed clip-on and off, as well as powerful rod reduction and de-rotation in one instrument. This system is approved for use in both children and adults. PediNail Intramedullary Nail System Our PediNail Intramedullary Nail system treats fractures and deformities of the femur and includes the smallest size nail on the market to meet the unique needs of pediatric patients. Our novel design incorporates a complex shape that enables simplified insertion, reducing the likelihood of damage to blood vessels of the femoral head and subsequent death of the bone tissue. PediLoc Plating Systems Our PediLoc Plating systems are anatomically designed to treat fractures and correct deformities at different points of the femur and tibia. Our PediLoc systems conform to the curvature of pediatric bones and minimize the need for bending, contouring and other repurposing of adult implants during surgery, while providing superior fixation with either locking or non-locking screws. In addition, some of our patented screw seatings allow the screw to enter the bone and remain parallel to the growth plate in order to prevent damage to the growth plate. Our PediLoc systems are available in a range of sizes and contours, improve surgical precision and ease-of-use and we believe enhance surgeon confidence in treating patients with varying skeletal maturities. ACL Reconstruction System Tears of the ACL are common sports-related injuries. Because attempting an ACL repair on a child whose growth plates have not closed can cause growth disturbances in the leg, young athletes would historically go untreated and remain sidelined until puberty. We believe our ACL system is the only commercially available product that enables surgical intervention in children whose growth plates are open while also restoring the ligament to its anatomically correct position. We developed our ACL system in collaboration with leading pediatric sports medicine surgeons to be the only comprehensive reconstruction system designed for the full spectrum of patients, from high-performance athletes to young children with open growth plates. Our ACL system is approved for ligament and tendon reconstruction in both children and adults. We believe this system expands the addressable market for sports medicine surgeries, and we are currently investigating its use in other sports medicine applications. Exclusive Focus on Pediatric Orthopedics. We were founded with the mission of improving the lives of children with orthopedic conditions, a patient popu

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professional_accounting

Students are required to research into the rationale for the new auditing standard ASA 701, explain clearly what it is and select an industry, eg. Banking, mining, etc. and analyses Key Audit Matters in the Independent Auditor’s reports of all companies in that industry in ASX Top 100 listed companies as part of your evaluation of this new standard. The Key audit matters as defined by this new standard ASA 701 of the AUASB committee are those matters which as per the personal judgment of the auditor were of crucial importance in the audit of the financial report of the company in that particular period. The key audit matters are those which are selected form many to those who manage the governance of the company. This new standard is made so that the audit companies and the directors pay more attention to the matter of showing key audit matters and also discuss the important matters with the auditors so that a consistency can be maintained in the annual reports. The main purpose behind all this is to present the people with better disclosures by the companies so that they can make decisions in an easy way. The new standard has been made so that the auditing standards can conform with the international auditing standards ISA 701. This is the main purpose behind the starting of this new standard by the companies. The industry which is chosen is mining and in this the annual reports of some of the companies would be looked into to know about that how the companies have analyzed the key audit matters in their reports. All the analysis is done based on the annual reports of the companies for the year ending 2017. The auditors have specified the procedure they followed for ascertaining the 40% investment of the company in AWAC. The auditors checked the completeness and appropriateness of the US GAAP which was started by the company to have done. Then they considered all the differences which existed between US GAAP and that of AAS. They considered this as a key audit matter as the magnitude of the investment made by the company was high and also the complexity was involved in the conversion of the amounts to US GAAP (Aluminalimited.com, 2018). The investment made by the company was $2.3 billion in this so the auditors checked that the amount invested in this could be impaired and for this they performed many processes and they assumed the long term price of alumina for this. They also compared the Group’s value with that of the market value and studied about any internal or external sources using which the values could be impaired. But the auditors found no such evidence in the impairment of such investment by Alumina. They valued the assets and this was done as this constituted to about 72% of the assets of the Group. Even the Group reported of having some kind of material weaknesses in relation to the processes and the controls involved in the impairment of the assets (Bhp.com, 2018). This also increased the focus of threadworms on such valuation. They did this by following a detailed process in which they tested the key controls in the valuation of the assets, evaluated the commodity prices which could be forecasted, exalted the objectivity and competency of the experts and considered many other factors which affected the valuation of the assets of the company. This is another key audit matter as the company has its operations in many parts of the world which have different tax structures. Then the company also engages in doing cross border sales. So the auditors were cautious in relation to the estimation of the associated provision of tax, expenses and the contingent liabilities. They used procedures like tested key controls, worked with tax specialists of the countries in which the company had its major operations. They also tried to study the consistency among different countries and assesses that whether Group has made significant discourses to the interest of the investors. BHP Billiton has reported losses due to failure of dam project in the company. So many accounting judgement actions of the company needed to be judged which included the determination of the legal status of claims, legal obligation of BHP Billiton, contingent liabilities disclosures and many more. There was high degree of uncertainty involved in this case so this became part of key audit matter the company. They followed a comprehensive policy to check about all the things which went in this Samarco case. They assessed the key assumptions which were made by the company, checked the completeness of the disclosures made by both the companies in the process. They after the process found out that level of disclosures and the provision to be acceptable. The Group is also involved in the restoring, rehabilitation and closing the sites. As the volume of such transaction was very high and this was expected to have huge effect on the result of the company so this needed to be considered as a key audit matter as this is bound to affect the future cash flows of the company. They worked with specialists to ascertain about the life of the reserves and mines and assessed the work of the specialists of mine closures to assess the likely and timing cost. They even checked the time value of money and foreign exchange rates for checking the effects and after this they found that the rehabilitation provisioning was acceptable. The auditors have stated that they have studied the accounting treatment for the interest which the company acquired in another mine. The acquisition had a lot of financial significance on the company. The auditors focused on all the assessments on the key transaction documents which needed to be studied in this. They also checked that sufficient disclosures were made by the company or not as the company applied judgements as to when the sales of different commodities could be considered as revenue (Evolutionmining.com.au, 2018). They used a revenue recognition policy in which they assessed the terms of all the transaction documents. The Group recognized deferred tax assets of an amount of about $57.74 million and this as per the Australian Standards has to be recognized only to a certain extent. So the auditors have to check this as this was used in the recognition of the deferred tax assists. They assessed the ability of the Group by following steps like they assessed the reasonability of the taxable income, revaluated the balances of deferred tax assets and many more. Impairment reversal of Mt Carlton’s non-current assets: The Group in past in 2003 has reported impairment losses of $148.6 million in relation to Mt Carlton’s assets but now they’re considering the reversal of such impairment. This matter was significantly considered by the auditors as it had bound to effect the financial statements of the company significantly. They then came up with a conclusion of not doing impairment testing by using many procedures in which they analyzed the market data, compared gold rates and many more steps were taken to do this. The company has recognized a product liability provision to the amount of $ 312.4 million and such a provision was subject to many judgments. The auditors considered examining the complexity and the size of the provision. They assessed the independence and the competence of the external experts in this matter. They made enquiries, broke down the liabilities sarong Australia and USA and assured them about every single component of such provision. Then the company also recorded their assets at a very high price which was subject to the application of many assumptions like inflation, growth rates, forecast changes and many more. They took this as an audit key matter as a lot of judgments were involved in the forecasting of the future cash flows of such assets. The auditors along with many valuation specialists did many procedures in evaluating the process which the management of the company in the impairment of such assets and the key assumption were also checked. Some of the rates were also tested on the sample basis. They assessment the appropriateness of the impairment testing models which are used by the companies. This way the company’s auditors took all the care to check the ammeters which may materially effect the performance of the company. The Group in the year 2017 had reported a revenue of $8335 million from the sale of iron ore. This was so taken up as a key matter as the amount involved was significant. They used an audit approach in which they included a focus on two of the non-cash adjustment made to the revenue. They remeasured the provisional sales and also the deferred income accruing to the Group (Fmgl.com.au, 2018). They related some of the provisional pricing adjustment and found them to be consisting with the commodity data prevailing externally. Even for the prepayments they obtained the confirmations from the customers of the Group. Then the Group has entered into a contract for getting a financing arrangement to be of the carrier of the company. In this arrangement the Group received a funding of about $234Million and as the financial tarnation involved a huge money so it had found to effect the company in a material form. The authors have stated that they checked the transaction costs, inspected the financial arrangements between the companies. Then the group also recognized an asset of about $813 million in 2017 and such recognitions often involve a lot of judgement by the people. they focused on the judgment of the Group that IBJV has remained an evaluation and exploration asset which has not been categories as a development asset. The auditors held discussions with the Group management and checked that if the Group had a right to tenure the assets or not. They also visited many of the IBJV sites to know about the current status of the project. They found that the treatment of the company with such assets are consistent to the existing status of this.

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professional_accounting

Enviva Reports Third-Quarter 2021 Results, Increases Distribution, and Announces First Industrial Contract By: Enviva Partners, LP via Business Wire News Releases November 03, 2021 at 16:14 PM EDT Enviva Partners, LP (NYSE: EVA) (“Enviva,” “we,” “us,” or “our”) today announced financial and operating results for the third quarter of 2021, declared its 25th consecutive quarterly distribution increase, and announced its first direct contract with an industrial customer, a European counterparty that processes solid biomass into refined liquids that ultimately become high-grade renewable fuels like sustainable aviation fuel (“SAF”) and biodiesel. For the third quarter of 2021, Enviva declared a distribution of $0.840 per common unit, an 8.4% increase over the third quarter of 2020 and its 25th consecutive quarterly distribution increase since its IPO. Enviva expects to distribute $3.30 and $3.62 per share for full-year 2021 and 2022, respectively For the third quarter of 2021, Enviva reported a net loss of $0.1 million, adjusted net income of $28.3 million, and adjusted EBITDA of $62.9 million. Adjusted EBITDA increased by 15.6% over the same period in 2020 On October 15, 2021, Enviva announced the acquisition of its former sponsor, Enviva Holdings, LP (“Holdings”), and the elimination of incentive distributions rights (the “Simplification Transaction”). Enviva also announced plans to convert from a master limited partnership to a corporation under the name of Enviva Inc. by the end of the year (the “Conversion”); a unitholder meeting is now scheduled to be held on December 17, 2021 Enviva announced the signing of a new 10-year take-or-pay off-take contract to supply an industrial customer with up to approximately 1.2 million metric tons per year (“MTPY”) of wood pellets, to be refined into feedstock for the production of SAF and other renewable fuels, with initial annual deliveries of 60,000 MTPY expected to commence in 2023 “For the third quarter of 2021, Enviva delivered financial and operational results that represent an important step forward for us, and we are positioned for a solid finish to what has been an incredible year for our company, our team, and our equity holders,” said John Keppler, Chairman and Chief Executive Officer. “Today, we are very pleased to announce our inaugural contract in the rapidly growing industrial sector, with a customer who will process our solid biomass into refined liquids that ultimately become high-grade renewable fuels like sustainable aviation fuel and biodiesel. We expect this important milestone to be just the first of many as we work with large industrial customers who can use our products to make difficult-to-decarbonize industries less GHG-intensive and more sustainable.” “The future has never been brighter for Enviva. With our transformative Simplification Transaction and Conversion, along with our expanding production capacity underpinned by our existing assets, the plant expansions underway, and the commissioning of the Lucedale plant and the Pascagoula terminal, we are entering 2022 with increased size and scale, a significantly improved cost of capital, and a broadening customer base. With the potential of exponential growth ahead for our product, driven by global commitments to ‘net zero,’ we are continuing to build a company and a platform that delivers real climate change benefits, today, while consistently and sustainably delivering superior returns to our stakeholders.” On November 3, 2021, Enviva’s board of directors declared a distribution of $0.840 per common unit for the third quarter of 2021, an increase of 8.4% over the corresponding period in 2020. This distribution represents the 25th consecutive distribution increase since Enviva’s IPO. The quarterly distribution will be paid on Friday, November 26, 2021, to unitholders of record as of the close of business on Monday, November 15, 2021. Third-Quarter 2021 Financial Results $ millions, unless noted Adjusted Gross Margin (0.2 Net Income (Loss) (107.1 Adjusted EBITDA Adjusted Gross Margin $/metric ton Net revenue increased by $11.8 million, or 5.2%, for the third quarter of 2021 as compared to the third quarter of 2020, substantially due to an increase in product sales. The increase in net revenue and product sales volumes was temporarily dampened as a result of labor-related and other challenges associated with COVID-19 experienced by our contractors and supply chain partners that had a temporal, but more pronounced than anticipated, impact on our operations and project execution schedule. Based on the actions we have taken and the plans we have in place, we believe these issues are beginning to be behind us Gross margin for the third quarter of 2021 decreased by $0.4 million, or 1.6%, as compared to the third quarter of 2020, principally due to higher revenue being offset by higher cost of goods sold Adjusted gross margin for the third quarter of 2021 was flat as compared to the third quarter of 2020, and adjusted gross margin per metric ton for the third quarter of 2021 decreased by $1.75, or 3.5%, as compared to the third quarter of 2020, primarily due to the factors impacting net revenue as described above Enviva generated a net loss of $0.1 million for the third quarter of 2021 as compared to net income of $1.4 million for the corresponding period in 2020. Adjusted net income for the third quarter of 2021 increased by $12.2 million, or 75.8%, as compared to the corresponding period in 2020 Adjusted EBITDA for the third quarter of 2021 was $62.9 million, an increase of $8.5 million, or 15.6%, as compared to the third quarter of 2020, and DCF was $49.5 million, an increase of $7.3 million, or 17.4%, for the third quarter of 2021 as compared to the corresponding period in 2020; both increases were primarily due to the Lucedale plant and Pascagoula terminal acquisitions Based on the declared distribution of $0.84 per unit, Enviva’s distribution coverage ratio on a cash basis for the third quarter of 2021 was 1.13 times Enviva’s liquidity as of September 30, 2021, which included cash on hand and availability under its $525.0 million revolving credit facility, was $191.9 million Simplification Transaction and Corporate Conversion Details As previously announced on October 15, 2021, Enviva completed the Simplification Transaction, whereby Enviva acquired 100% of the ownership interests of Holdings, and eliminated all outstanding incentive distribution rights in exchange for 16 million common units of EVA. Enviva did not assume or issue any debt, or incur any significant drawings under its revolving credit facility, in connection with the Simplification Transaction. Consistent with the terms of the transaction, former owners of Holdings are now direct investors in Enviva and have agreed to reinvest all dividends related to 9 million of the 16 million new units during the period beginning with the distribution for the third quarter of 2021 through the dividend for the fourth quarter of 2024. Enviva expects the Conversion to take effect as of December 31, 2021. As noted in a press release issued earlier today, the board has established November 19, 2021 as the record date for the unitholder meeting, which will be held on December 17, 2021. “Following on the heels of our successfully completed Simplification Transaction, we are very excited about our pending Conversion to a traditional corporation,” said Keppler. “By evolving our same great business into an even better corporate structure, we believe we are creating a unique opportunity for investors across the globe to participate in the step-change accretion we have ahead of us, whether by directly investing in Enviva Inc. or investing passively through one of the many indices in which we will become eligible for inclusion.” 2021 and 2022 Guidance Update The table and narrative below include Enviva’s guidance for 2021 and 2022. Our guidance for full-year 2021 is based on our actual performance on a stand-alone basis from January 1, 2021 through October 14, 2021 (the closing date of the Simplification Transaction), and our expected performance on a consolidated basis, inclusive of the assets and operations acquired as part of the Simplification Transaction, from the closing date through the balance of the year ending December 31, 2021. This full-year 2021 guidance does not, however, reflect a potential recast of our historical results, which may be required under GAAP due to the Simplification Transaction. If recast, our results would reflect the acquisition of our former sponsor for the three-year period beginning January 1, 2019, even though the acquisition closed on October 14, 2021. We expect the addition of our former sponsor’s development-related expenses and the elimination of intercompany transactions, including the MSA Fee Waivers and other forms of sponsor support, would cause our 2021 GAAP results on a recast basis to be significantly different from and lower than the 2021 guidance described below. We believe our 2021 guidance provides investors with the best and most relevant information to evaluate the company’s financial and operating performance because it reflects Enviva’s actual and historically reported performance on a stand-alone basis through the closing date of the Simplification Transaction and expected performance on a consolidated basis from the closing date until year-end. We are currently unable to reconcile the 2021 guidance set forth below to the closest GAAP financial measures because we have neither prepared such a recast nor concluded it will be required; however, for purposes of comparability and transparency, we plan to measure our 2021 results on a non-recast basis against our 2021 guidance, which we are reaffirming. Dividend per Common Unit/Share $3.30/unit $3.62/share On October 15, 2021, Enviva updated full-year 2021 and 2022 guidance as a result of the Simplification Transaction and Conversion. Updated guidance for full-year 2021 includes the expected post-closing results of the assets and operations acquired as part of the Simplification Transaction, including approximately $15 million to $20 million of incremental selling, general, and administrative expenses (“SG&A”). For full-year 2022, Enviva expects SG&A related to activities acquired in the Simplification Transaction to range from $37 million to $43 million. The SG&A noted above includes costs associated with the market and asset development activities formerly conducted by our sponsor, now expensed by Enviva, which include the creation and maintenance of our global customer contract pipeline and the development of potential new asset sites. Given the quality and size of our current customer contract pipeline, we believe we will be able to support the addition of at least six new fully contracted wood pellet production plants and several highly accretive expansion projects, which over approximately the next five years would roughly double the size of our current production capacity. With the benefit of the capabilities, resources, and activities now housed within Enviva, we expect to construct our new fully contracted wood pellet production plants at an approximately 5x adjusted EBITDA project investment multiple as compared to a historic drop-down acquisition multiple of roughly 7.5x. Actual amounts reported for SG&A may vary due to the level of capitalization of development costs associated with new plant construction and expansion projects. Importantly, we expect SG&A resulting from the Simplification Transaction to decline over time as we benefit from synergies and execute streamlining initiatives, with the expectation that we will reduce these expenses by approximately $5 million on an annual run-rate basis commencing in 2023. Contracting and Market Update Significant progress is being made by regulators, policymakers, utilities, power generators, and difficult-to-decarbonize industries towards achieving net-zero emissions. This progress, combined with favorable legislative and policy recommendations supporting substantial incremental utilization of sustainably sourced biomass, continues to reinforce the growing long-term market opportunity for Enviva’s product around the world. Today, Enviva announced the signing of a new 10-year take-or-pay off-take contract to supply our first direct industrial customer with 60,000 MTPY of wood pellets to be used as a feedstock in the refining process for SAF and other renewable fuels like biodiesel. Deliveries under the initial tranche of the contract are scheduled to commence in 2023, with volumes potentially increasing to approximately 1.2 million MTPY by 2027, through a series of additional 10-year take-or-pay tranches, as the customer builds incremental production capacity. Enviva will be the sole supplier of this customer’s incremental wood pellet needs. The initial tranche's conditions precedent, are expected to be met during 2022. As of October 1, 2021, and including the initial 60,000 MTPY tranche related to the recently announced industrial contract as well as the recently announced contracts with Drax Group PLC and a large Japanese trading house, Enviva’s total weighted-average remaining term of off-take contracts is approximately 14.5 years, with a total contracted revenue backlog of over $21 billion. This contracted revenue backlog of over $21 billion is complemented by a similarly large and growing customer pipeline consisting of long-term off-take opportunities in our traditional markets for biomass-fired power and heat generation in geographies ranging from the United Kingdom to the European Union (including emerging opportunities in Germany and Poland), and from Asia (including incremental demand in Japan, emerging potential in Taiwan, and maturing opportunities in South Korea) to developing industrial segments across the globe (including steel, cement, lime, chemicals, SAF, and biodiesel). Over the next 12 months, we expect to progress negotiations and convert numerous contract pipeline opportunities, as well as previously signed exclusive memoranda of understanding, into binding contracts. Shaping a secure and sustainable energy future continues to be at the forefront of the global energy dialogue and, in mid-October 2021, the International Energy Agency (“IEA”) published a special edition of the World Energy Outlook 2021 report to assist decision-makers at the United Nations Climate Change Conference (“COP26”) in Glasgow, Scotland. The report warns that current progress on clean energy remains “far too slow to put global emissions into sustained decline towards net zero.” In laying out a more rapid energy transition plan, the report states: “Modern bioenergy plays a key role in meeting net zero pledges.” To achieve net-zero carbon emissions by 2050, the report calls for coal to be phased out of the global power sector at a more rapid pace and replaced with low emissions energy sources that complement each other, such as wind, solar, nuclear, hydropower, and bioenergy. The report further states: “There is a growing role for alternative, low emissions fuels such as modern bioenergy and hydrogen-based fuels in all scenarios … These play a key role in the achievement of net zero targets …” “The IEA report echoes the sentiment of the UN Intergovernmental Panel on Climate Change report issued just a few months ago that time is running out to put in place the measures needed to prevent further irreversible damage from climate change to our planet,” said Keppler. “While there is no silver bullet to achieve net zero, sustainable wood bioenergy is a proven technology that can be expanded at scale – today – to accelerate the energy transition. I am very excited to have accepted an invitation to present next week at COP26 to respected climate and energy authorities and policymakers from around the world about the important and well-recognized role modern bioenergy plays as a part of the global solution to climate change.” Net Zero Promise Enviva is making significant progress toward its goal to achieve net zero greenhouse gas emissions in its operations by 2030, in part by using 100% renewable energy at our facilities. Recently, we announced a supply contract with GreenGasUSA, an integrated renewable natural gas (“RNG”) solutions provider, which includes a 10-year RNG off-take agreement to decarbonize natural gas-related emissions in our operations. The methane captured and emissions eliminated as a result of this contract are expected to offset approximately 75% of Enviva’s current direct emissions from its manufacturing operations, or Scope 1 emissions, on an annual basis for the duration of the 10-year agreement, which includes renewal options for an additional 10 years. Asset Update Construction of the Lucedale plant is nearing completion, and we expect commissioning to commence in late fourth-quarter 2021. Our terminal at the Port of Pascagoula also remains on track to receive, store, and load production from the Lucedale plant once the plant is operational. The Northampton expansion is complete and the Southampton expansion continues its commissioning ramp. Construction on the Greenwood expansion is also nearing completion. Further, we have made significant investments in the “Multi-Plant Expansions,” commencing at Enviva’s Sampson and Hamlet plants, with Cottondale to follow. As part of the Simplification Transaction, Enviva acquired projects at 15 plant sites, all in various stages of evaluation and development. One of these acquired sites is the fully contracted Epes plant, which is currently under development. We expect to commence construction in early 2022, with an in-service date scheduled for mid-2023. The Epes plant is designed and permitted to produce more than one million MTPY of wood pellets, which would make it the largest wood pellet production plant in the world. A prospective production plant in Bond, Mississippi is the next most likely to be constructed, and is being developed to produce between 750,000 and more than 1 million MTPY of wood pellets. The Bond plant's proximity to the Port of Pascagoula positions us to transport its production efficiently by truck from the plant to our terminal at the port. We expect construction of the Bond plant to commence once the Epes plant is operational, but timing of construction could be expedited depending on the schedule and delivery requirements of additional off-take contract opportunities under negotiation and general market conditions. Third-Quarter 2021 Earnings Call Details Enviva will host a webcast and conference call on Thursday, November 4, at 10 a.m. Eastern time to discuss third-quarter 2021 results. Conference call numbers for North American participation are 1 (877) 883-0383, and +1 (412) 902-6506 for international callers. The passcode number is 4195252. Alternatively, the call can be accessed online through a webcast link provided on Enviva’s Events & Presentations website page, located at ir.envivabiomass.com. About Enviva Enviva (NYSE: EVA) aggregates a natural resource, wood fiber, and processes it into a transportable form, wood pellets. Enviva sells a significant majority of its wood pellets through long-term, take-or-pay off-take contracts with creditworthy customers in the United Kingdom, the European Union, and Japan. Enviva owns and operates 10 plants with a combined production capacity of approximately 6.2 million metric tons per year in Virginia, North Carolina, South Carolina, Georgia, Florida, and Mississippi. In addition, Enviva exports wood pellets through its marine terminals at the Port of Chesapeake, Virginia, the Port of Wilmington, North Carolina, and the Port of Pascagoula, Mississippi, and from third-party marine terminals in Savannah, Georgia, Mobile, Alabama, and Panama City, Florida. To learn more about Enviva, please visit our website at envivabiomass.com. Follow Enviva on social media @Enviva. This press release is intended to be a qualified notice under Treasury Regulation Section 1.1446-4(b)(4). Brokers and nominees should treat 100 percent of the Partnership’s distributions to non-U.S. investors as being attributable to income that is effectively connected with a United States trade or business. Accordingly, the Partnership’s distributions to non-U.S. investors are subject to federal income tax withholding at the highest applicable effective tax rate. ENVIVA PARTNERS, LP AND SUBSIDIARIES (In thousands, except number of units) Related-party receivables, net Prepaid expenses and other current assets Property, plant and equipment, net Operating lease right-of-use assets Other long-term assets Liabilities and Partners’ Capital Accrued and other current liabilities Interest payable Current portion of long-term debt and finance lease obligations Long-term debt and finance lease obligations Long-term operating lease liabilities Deferred tax liabilities, net Other long-term liabilities Partners’ capital: Limited partners: Common unitholders—public (31,430,928 and 26,209,862 units issued and outstanding at September 30, 2021 and December 31, 2020, respectively) Common unitholder—sponsor (13,586,375 units issued and outstanding at September 30, 2021 and December 31, 2020) General partner (1) (no outstanding units) Accumulated other comprehensive income (loss) Total Enviva Partners, LP partners’ capital Noncontrolling interests Total partners’ capital Total liabilities and partners’ capital Includes incentive distribution rights Condensed Consolidated Statements of Operations (In thousands, except per unit amounts) Three Months Ended September 30, Nine Months Ended September 30, Loss on disposal of assets Total cost of goods sold General and administrative expenses Related-party management services agreement fee Total general and administrative expenses Other (expense) income, net Total other expense, net Net (loss) income before income tax benefit Income tax benefit Net (loss) income Less net income attributable to noncontrolling interest Net (loss) income attributable to Enviva Partners, LP Net loss per limited partner common unit: Weighted-average number of limited partner common units outstanding: Distributions declared per limited partner common unit MSA Fee Waivers Amortization of debt issuance costs, debt premium and original issue discounts Unit-based compensation Fair value changes in derivatives Unrealized (losses) gains on foreign currency transactions, net Change in operating assets and liabilities: Accounts and other receivables Related-party activity, net Prepaid expenses and other current and long-term assets Accounts payable, accrued liabilities and other current liabilities Operating lease liabilities Net cash provided by operating activities Purchases of property, plant and equipment Payments in relation to the Lucedale-Pascagoula Drop-Down, net of cash acquired Payments in relation to the Greenwood Drop-Down, net of cash acquired Payments in relation to the Georgia Biomass Acquisition, net of cash acquired Net cash used in investing activities Proceeds from senior secured revolving credit facility, net Proceeds from debt issuance Principal payments on other long-term debt and finance lease obligations Cash paid related to debt issuance costs and deferred offering costs Proceeds from common unit issuances, net Payments in relation to the Hamlet Drop-Down Distributions to unitholders, distribution equivalent rights and incentive distribution rights holder Payment for withholding tax associated with Long-Term Incentive Plan vesting Net increase (decrease) in cash, cash equivalents and restricted cash Cash, cash equivalents and restricted cash, beginning of period Cash, cash equivalents and restricted cash, end of period Condensed Consolidated Statements of Cash Flows (continued) Non-cash investing and financing activities: Property, plant and equipment acquired included in accounts payable and accrued liabilities Supplemental information: Interest paid, net of capitalized interest Non-GAAP Financial Measures In addition to presenting our financial results in accordance with accounting principles generally accepted in the United States (“GAAP”), we use adjusted net income, adjusted gross margin, adjusted gross margin per metric ton, adjusted EBITDA, and distributable cash flow to measure our financial performance. In addition, we have included herein 2021 estimated financial results (the “2021 Guidance”), which include the expected post-closing results of the assets and operations acquired as part of the Simplification Transaction, but do not reflect any recast of our historical financials as a result of the Simplification Transaction. If GAAP requires a recast of our historical financials as a result of the Simplification Transaction, the 2021 Guidance will constitute a Non-GAAP measure. Our management uses our 2021 Guidance as a supplemental measure to represent the financial results of the assets and operations of the publicly traded entity. We define adjusted net income as net income excluding interest expense associated with incremental borrowings related to a fire that occurred in February 2018 at the Chesapeake terminal (the “Chesapeake Incident”) and Hurricanes Florence and Michael (the “Hurricane Events”), early retirement of debt obligation, and acquisition and integration and other costs, adjusting for the effect of certain sales and marketing, scheduling, sustainability, consultation, shipping, and risk management services (collectively, “Commercial Services”), and including, for periods prior to the Simplification Transaction, certain non-cash waivers of fees for management services provided to us by our sponsor (collectively, “MSA Fee Waivers”) and, for periods after the Simplification Transaction, certain payments under the Support Agreement entered into in connection therewith (“Support Payments”). We believe that adjusted net income enhances investors’ ability to compare the past financial performance of our underlying operations with our current performance separate from certain items of gain or loss that we characterize as unrepresentative of our ongoing operations. Adjusted Gross Margin and Adjusted Gross Margin per Metric Ton We define adjusted gross margin as gross margin excluding loss on disposal of assets, depreciation and amortization, changes in unrealized derivative instruments related to hedged items included in gross margin, non-cash unit compensation expenses, and acquisition and integration costs and other costs included in this expense category, adjusting for the effect of Commercial Services, and including, for periods prior to the Simplification Transaction, the MSA Fee Waivers and, for periods after the Simplification Transaction, the Support Payments. We define adjusted gross margin per metric ton as adjusted gross margin per metric ton of wood pellets sold. We believe adjusted gross margin and adjusted gross margin per metric ton are meaningful measures because they compare our revenue-generating activities to our operating costs for a view of profitability and performance on a total-dollar and a per-metric ton basis. Adjusted gross margin and adjusted gross margin per metric ton will primarily be affected by our ability to meet targeted production volumes and to control direct and indirect costs associated with procurement and delivery of wood fiber to our wood pellet production plants and our production and distribution of wood pellets. We define adjusted EBITDA as net income excluding depreciation and amortization, interest expense, income tax expense (benefit), early retirement of debt obligations, non-cash unit compensation expense, loss on disposal of assets, changes in unrealized derivative instruments related to hedged items included in gross margin and other income and expense, and acquisition and integration costs and other costs included in this expense category, adjusting for the effect of Commercial Services, and including, for periods prior to the Simplification Transaction, the MSA Fee Waivers and, for periods after the Simplification Transaction, the Support Payments. Adjusted EBITDA is a supplemental measure used by our management and other users of our financial statements, such as investors, commercial banks, and research analysts, to assess the financial performance of our assets without regard to financing methods or capital structure. Distributable Cash Flow We define distributable cash flow as adjusted EBITDA less maintenance capital expenditures, cash income tax expenses, and interest expense net of amortization of debt issuance costs, debt premium, original issue discounts, and the impact from incremental borrowings related to the Chesapeake Incident and Hurricane Events. We use distributable cash flow as a performance metric to compare our cash-generating performance from period to period and to compare the cash-generating performance for specific periods to the cash distributions (if any) that are expected to be paid to our unitholders. We do not rely on distributable cash flow as a liquidity measure. Limitations of Non-GAAP Financial Measures Adjusted net income, adjusted gross margin, adjusted gross margin per metric ton, adjusted EBITDA, and distributable cash flow are not financial measures presented in accordance with GAAP. We believe that the presentation of these non-GAAP financial measures provides useful information to investors in assessing our financial condition and results of operations. Our non-GAAP financial measures should not be considered as alternatives to the most directly comparable GAAP financial measures. Each of these non-GAAP financial measures has important limitations as an analytical tool because they exclude some, but not all, items that affect the most directly comparable GAAP financial measures. You should not consider adjusted net income, adjusted gross margin, adjusted gross margin per metric ton, adjusted EBITDA, or distributable cash flow in isolation or as substitutes for analysis of our results as reported under GAAP. Our definitions of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies, thereby diminishing their utility. The estimated incremental adjusted EBITDA that can be expected from the development of new wood pellet plant capacity by Enviva following the Simplification Transaction is based on an internal financial analysis of the anticipated benefit from the incremental production capacity and cost savings we expect to realize as compared to drop-down acquisitions. Such estimates are based on numerous assumptions and are inherently uncertain and subject to significant business, economic, financial, regulatory, and competitive risks that could cause actual results and amounts to differ materially from such estimates. A reconciliation of the estimated incremental adjusted EBITDA expected to be generated by a new wood pellet production plant constructed by Enviva to the closest GAAP financial measure, net income, is not provided because net income expected to be generated thereby is not available without unreasonable effort, in part because the amount of estimated incremental interest expense related to the financing of such a plant and depreciation is not available at this time. The following tables present a reconciliation of adjusted net income, adjusted gross margin, adjusted gross margin per metric ton, adjusted EBITDA, and distributable cash flow to the most directly comparable GAAP financial measures, as applicable, for each of the periods indicated. Nine Months Ended Reconciliation of net (loss) income to adjusted net income: Acquisition and integration costs and other Interest expense from incremental borrowings related to Chesapeake Incident and Hurricane Events (in thousands, except per metric ton) Reconciliation of gross margin to adjusted gross margin and adjusted gross margin per metric ton: Non-cash unit compensation expense Changes in unrealized derivative instruments Metric tons sold Adjusted gross margin per metric ton Reconciliation of net (loss) income to adjusted EBITDA: Interest expense, net of amortization of debt issuance costs, debt premium, original issue discount, and impact from incremental borrowings related to Chesapeake Incident and Hurricane Events Maintenance capital expenditures Distributable cash flow attributable to Enviva Partners, LP Less: Distributable cash flow attributable to incentive distribution rights Distributable cash flow attributable to Enviva Partners, LP limited partners Cash distributions declared attributable to Enviva Partners, LP limited partners Distribution coverage ratio Distribution coverage ratio for the third quarter of 2021 is calculated on a cash basis, which means the unit count includes 7 million of the 16 million units issued on October 14, 2021. The 7 million units are not part of the dividend reinvestment commitment and therefore receive cash distributions on a quarterly basis. The following table provides a reconciliation of the estimated range of adjusted EBITDA and DCF to the estimated range of net income for Enviva for the twelve months ending December 31, 20211 (in millions): Twelve Months Ending Estimated net income Non-cash share-based compensation expense MSA Fee Waivers and Support Payments Acquisition and integration costs Other non-cash expenses Estimated adjusted EBITDA Interest expense net of amortization of debt issuance costs, debt premium, and original issue discount Cash income tax expense Estimated distributable cash flow The 2021 measures set forth in the table include the expected post-closing results of the assets and operations acquired as part of the Simplification Transaction, but do not reflect a potential recast of our historical results of operations that may result from the Simplification Transaction The following table provides a reconciliation of the estimated range of adjusted EBITDA and DCF to the estimated range of net income for Enviva for the twelve months ending December 31, 2022 (in millions): Support Payments Important Information for Unitholders This communication does not constitute a solicitation of any vote or approval. In connection with the Conversion, Enviva filed a proxy statement with the U.S. Securities and Exchange Commission (the “SEC”). Enviva also plans to file other documents with the SEC regarding the Conversion. After the proxy statement has been cleared by the SEC, a definitive proxy statement will be mailed to the unitholders of Enviva. UNITHOLDERS OF ENVIVA ARE URGED TO READ THE PROXY STATEMENT (INCLUDING ALL AMENDMENTS AND SUPPLEMENTS THERETO) AND OTHER DOCUMENTS RELATING TO THE CONVERSION THAT WILL BE FILED WITH THE SEC CAREFULLY AND IN THEIR ENTIRETY WHEN THEY BECOME AVAILABLE BECAUSE THEY WILL CONTAIN IMPORTANT INFORMATION ABOUT THE CONVERSION. Unitholders will be able to obtain free copies of the proxy statement and other documents containing important information once such documents are filed with the SEC, through the website maintained by the SEC at http://www.sec.gov. Participants in the Solicitation Enviva and its general partner’s directors and executive officers may be deemed to be participants in the solicitation of proxies from the unitholders of Enviva in connection with the proposed transaction. Information about such directors and executive officers is set forth in Enviva’s Annual Report on Form 10-K filed with the SEC on February 25, 2021. Other information regarding the participants in the proxy solicitation and a description of their direct and indirect interests, by security holdings or otherwise, will be contained in the proxy statement and other relevant materials to be filed with the SEC when they become available. Cautionary Note Concerning Forward-Looking Statements The information included herein and in any oral statements made in connection herewith include “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements, other than statements of present or historical fact included herein, regarding the Conversion, Enviva’s ability to consummate the Conversion, the benefits of the Conversion, and Enviva’s future financial performance following the Conversion, as well as Enviva’s strategy, future operations, financial position, estimated revenues and losses, projected costs, prospects, plans, and objectives of management are forward-looking statements. When used herein, including any oral statements made in connection herewith, the words “could,” “should,” “will,” “may,” “believe,” “anticipate,” “intend,” “estimate,” “expect,” “project,” the negative of such terms, and other similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain such identifying words. These forward-looking statements are based on management’s current expectations and assumptions about future events and are based on currently available information as to the outcome and timing of future events. Except as otherwise required by applicable law, Enviva disclaims any duty to revise or update any forward-looking statements, all of which are expressly qualified by the statements in this section, to reflect events or circumstances after the date hereof. Enviva cautions you that these forward-looking statements are subject to risks and uncertainties, most of which are difficult to predict and many of which are beyond the control of Enviva. These risks include, but are not limited to: (i) the volume and quality of products that we are able to produce or source and sell, which could be adversely affected by, among other things, operating or technical difficulties at our wood pellet production plants or deep-water marine terminals; (ii) the prices at which we are able to sell our products; (iii) our ability to successfully negotiate, complete, and integrate acquisitions, including the associated contracts, or to realize the anticipated benefits of such acquisitions; (iv) failure of our customers, vendors, and shipping partners to pay or perform their contractual obligations to us; (v) our inability to successfully execute our project development, expansion, and construction activities on time and within budget; (vi) the creditworthiness of our contract counterparties; (vii) the amount of low-cost wood fiber that we are able to procure and process, which could be adversely affected by, among other things, disruptions in supply or operating or financial difficulties suffered by our suppliers; (viii) changes in the price and availability of natural gas, coal, or other sources of energy; (ix) changes in prevailing economic conditions; (x) unanticipated ground, grade, or water conditions; (xi) inclement or hazardous environmental conditions, including extreme precipitation, temperatures, and flooding; (xii) fires, explosions, or other accidents; (xiii) changes in domestic and foreign laws and regulations (or the interpretation thereof) related to renewable or low-carbon energy, the forestry products industry, the international shipping industry, or power, heat, or combined heat and power generators; (xiv) changes in the regulatory treatment of biomass in core and emerging markets; (xv) our inability to acquire or maintain necessary permits or rights for our production, transportation, or terminaling operations; (xvi) changes in the price and availability of transportation; (xvii) changes in foreign currency exchange or interest rates, and the failure of our hedging arrangements to effectively reduce our exposure to the risks related thereto; (xviii) risks related to our indebtedness; (xix) our failure to maintain effective quality control systems at our wood pellet production plants and deep-water marine terminals, which could lead to the rejection of our products by our customers; (xx) changes in the quality specifications for our products that are required by our customers; (xxi) labor disputes, unionization, or similar collective actions; (xxii) our inability to hire, train, or retain qualified personnel to manage and operate our business and newly acquired assets; (xxiii) the Conversion may not occur, and even if it were to be completed, we may fail to realize the anticipated benefits; (xxiv) the possibility of cyber and malware attacks; (xxv) our inability to borrow funds and access capital markets; and (xxvi) viral contagions or pandemic diseases, such as COVID-19. Should one or more of the risks or uncertainties described herein and in any oral statements made in connection therewith occur, or should underlying assumptions prove incorrect, actual results and plans could different materially from those expressed in any forward-looking statements. Additional information concerning these and other factors that may impact Enviva’s expectations and projections can be found in Enviva’s periodic filings with the SEC. Enviva’s SEC filings are available publicly on the SEC’s website at www.sec.gov. Enviva Partners LP

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Global tax guide to doing business in Singapore Singapore has a territorial, and to a limited extent, remittance basis of taxation. Under the Income Tax Act (Cap 134) (ITA), income that is sourced in Singapore or received in Singapore from outside Singapore is subject to income tax in Singapore, unless specifically exempted by the ITA. Singapore resident companies may enjoy tax exemptions on certain types of foreign-sourced income received in Singapore, including dividends, branch profits and service income, provided the qualifying conditions are met. Singaporean residents are not taxed on foreign sourced income that is not received in Singapore. There is also no tax on capital gains. Singapore imposes withholding tax on certain categories of payments made to non-residents, including interest, royalties, rent for movable property, management fees and technical assistance fees. However, Singapore has an extensive network of avoidance of double-taxation treaties (DTT), which may provide for tax relief, such as reduced withholding tax rates or foreign tax credits. In order to avail treaty benefits, a Certificate of Residence (COR) must be obtained to prove that the taxpayer is Singapore resident. Goods and services tax (GST) is chargeable on certain supplies of goods and services in Singapore, and stamp duty is levied on the transfer of stocks, shares and immovable property in Singapore. Employers are required to make mandatory contributions to the Central Provident Fund (CPF) in respect of employees who are Singaporean citizens or who have permanent resident status. Download the Singapore chapter Financing a corporate subsidiary Singapore operates under a common law legal system, which can be traced back to the English legal system. Its sources of law are the Constitution, legislation, subsidiary legislation (e.g., Rules and Regulations) and judge-made law. The judiciary in Singapore is comprised of the Supreme Court, the state courts and the family justice courts. In this regard, Singapore is known for its commitment to the rule of law and vigilance against corruption. Singapore is also a leading center for arbitration and international commercial dispute resolution, where parties may submit their disputes to the Singapore International Arbitration Centre or the Singapore International Commercial Courts. Singapore’s tax system is administered by the Inland Revenue Authority of Singapore (IRAS). The functions of the IRAS include collecting taxes and representing the Singaporean government in tax treaty negotiations, drafting tax legislation and providing advice on property valuation to the government. The types of business vehicles in Singapore include a company, sole proprietorship, partnership, branch, representative office and business trust. A general partnership, other than a limited liability partnership, is not a separate legal entity and is not treated as a separate assessable entity for tax purposes. Individual partners are assessed separately on their respective shares of income from the partnership on the relevant personal income tax rate, and corporate partners are taxed based on the prevailing corporate tax rate. A non-resident partner of a partnership regardless of whether the partner is a corporation or an individual conducting business in Singapore is assessed on their share of income computed in accordance with the general provisions of the ITA. Resident individual partners are taxed at the applicable marginal individual income tax rates. However, the graduated rates of tax do not apply to a non-resident. A non-resident individual partner is taxed at a flat rate of 22% on every dollar of partnership income accrued to him. An LLP registered in Singapore has the advantage of a being a separate legal entity and providing limited liability protection for its partners. At the same time, an LLP retains the flexibility and tax transparency of a general partnership as it is not treated as a separate assessable entity for Singaporean tax purposes. If the LLP does not make any profit, various deductions— such as capital allowances, trade losses and donations—can be set off against the partners’ own income from other sources (if any), subject to certain restrictions. The amount which is set off for a particular Year of Assessment is subject to a restriction based generally on the contributed capital of the partner. However, as the LLP is not considered a taxable entity, it is not entitled to any benefit under Singapore’s double- taxation treaties. Only Singaporean resident partners are able to claim treaty benefits. Limited partnership (LP) LPs are relatively new business vehicles, only having come into operation in 2009. An LP consists of both general partners and limited partners and is not considered a legal entity for corporate law purposes. However, only the general partner is personally liable for all debts, liabilities and obligations of the LP; the limited partner’s liability is limited to the amount contributed. For tax purposes, the tax treatment of LPs is similar to that of general partnerships and LLPs, whereby the LP is not taxed separately. Instead, each partner of the LP is taxed on their share of the LP’s income, although the tax treatment of a general partner is different from the tax treatment of a limited partner. The general partner is taxed in the same manner as the partners in a general partnership, whereas the limited partner is taxed in the same manner as the partners in an LLP. Incorporating a company in Singapore is relatively straightforward. The Accounting and Corporate Regulatory Authority of Singapore generally requires the submission of a company’s constitution, identification of the corporate officers and establishment of the company’s name before the incorporation will take effect. However several considerations ought to be taken into account before incorporating a company, some of which are elaborated below. A company with a share capital, generally, could be a public or a private company. There are two material differences between a private and a public company: The first difference is restrictions on the right to transfer shares. The Companies Act has made it a prerequisite that, before any private company can be incorporated, the company has to ensure that its constitution restricts the right to transfer its shares. Public companies do not require the same restrictions but might also have such restrictions. While the specific prohibition on the right to transfer shares is not legislated, the usual practice is to give other members the right to buy the shares first, before an existing shareholder can transfer the shares to non-members, known as preemptive rights The second material difference is a limitation on the number of members. A private company cannot have more than 50 members. Company limited by guarantee (CLG) A CLG is a public company by virtue of the fact that it does not have share capital. Only companies that have share capital may be formed as a private company. In a CLG, as the name suggests, the members’ liability is limited to the amount stated in the constitution, which they undertake to contribute to the assets of the company in the event of its winding up. CLGs have limited fundraising abilities, given their lack of share capital. Therefore, such companies are usually employed by persons who wish to carry out nonprofit ventures, such as for charitable, educational or religious purposes. CLGs that are registered as a charity under the Charities Act may be exempt from tax. Some conditions must be met to qualify for registration, including having a charitable purpose. Unlimited liability company Unlimited liability companies are a rarity in Singapore. This is because people usually incorporate companies to benefit from the separate legal entity doctrine, which in turn gives members limited liability. In unlimited liability companies, the members’ liability is unlimited. The only difference between an unlimited liability company and a normal partnership is that, given the separate legal entity doctrine, creditors cannot pursue the members directly, even though they are, in principle, guarantors of the company’s debts. Given the drastic nature of unlimited liability, such companies are usually incorporated when mandated by law or rules. Foreign corporation (with or without a Singaporean branch) Under the ITA, a taxpayer is either resident or non-resident in Singapore. While both residents and non-residents are subject to the same basis of taxation (i.e., on source and remittance), the concept of residence is important as it impacts the tax treatment of the taxpayer in question. For example, the applicable tax rates may differ, and certain exemptions of income and the applicability of foreign tax credits are only available to residents. Further, payments of income sourced in Singapore but made to non-residents are generally subject to withholding tax in Singapore. The tax residency of a company is not dependent on the location where the company is incorporated or registered. A company will be deemed resident in Singapore for tax purposes if the control and management of its business is exercised in Singapore. It may also change depending on the location its control and management is exercised for the applicable Year of Assessment. The term “control and management” refers to the executive level of decision-making and policy-forming functions, which are normally carried out by the company’s board of directors. It does not refer to the company’s day-to-day business operations. Since a branch is not a legal entity separate from the head office, a branch will be considered controlled and managed where the head-office management is located. As such, a Singaporean branch of a foreign corporation would, in most circumstances, be treated as a non-resident for tax purposes. Consequently, a payment of specified income made to a Singaporean branch derived from the business activities of the Singaporean branch will normally be subject to withholding tax. However, it was announced in 2014 that withholding would generally not be required on payments made to branches on or after February 21, 2014. Singaporean branches of non- resident companies are, however, still taxed on such payments directly and are required to declare them in their annual income tax returns. Business trusts registered under the Business Trust Act are treated like a company under the one-tier system. This is because the economic purposes, structure and operation of a registered business trust are similar to those of a company. The income of a registered business trust is assessed on the trustee- manager. Unit holders of the registered business trust are not taxed on their share of the statutory income of the trustee-manager to which they are entitled (whether distributed or not) and no credit is allowed to unit holders for the tax paid by the trustee-manager. Apart from business trusts, most other trusts are tax transparent in most situations, except in certain circumstances. This means that the trust will not be taxed, but beneficiaries who are entitled to the relevant income may be taxed. A number of tax incentives are available in relation to trusts, such as foreign trusts, foreign charitable trusts and locally administered trusts. These incentives are designed to promote the trust industry in Singapore and encourage the use of Singaporean trusts. The contributed capital of a company is defined under the ITA as the aggregate amounts received by the company, whether in cash or in another form of valuable consideration, for shares that the company has issued. There are generally no income tax implications on an issuance by a Singaporean company of shares, although depending on the nature of the rights of the shares issued, certain types of shares may be treated as debt for tax purposes. Dividends issued in respect of shares held in a Singapore-resident company are not taxable in the hands of the shareholders, under the one-tier corporate tax system in Singapore. Distributions of paid-up capital The Singapore Companies Act contains limitations as to the reduction of share capital by a company. Generally, court approval is required before the company’s share capital may be reduced. This is to protect the interests of the creditors; given the separate legal personality, creditors may only turn to the company for the full satisfaction of their debts. There are generally no income tax implications of a reduction of a company’s share capital. Whether the share capital reduction is deemed as a payment of dividend by the company to the shareholders or a payment of capital, there are no income tax implications given that there is no tax on capital gains nor on dividends under the one-tier corporate tax system in Singapore. There are no thin capitalization rules in Singapore. Loans entered into between related parties are, however, subject to transfer pricing rules, under which interest is to be determined for tax purposes at an arm’s length rate. Interest payments are tax deductible against income if wholly and exclusively incurred in producing the income. Stamp duty is payable on a conveyance of Singaporean immovable property, stock or shares, pursuant to the Stamp Duties Act. There are also additional stamp duty issues in transferring shares of a company whose assets consist primarily of Singaporean residential property. All companies are taxed at a flat rate of 17% on both Singapore-sourced income and foreign-sourced income received in Singapore (unless otherwise exempted). This is unlike resident individuals, who are taxed at progressive rates up to 22%. Various government bodies administer tax incentives that award eligible taxpayers who derive qualifying income a concessionary tax rate or a tax exemption on their qualifying income. Some of the examples are listed below: Financial Sector Incentive (FSI): Companies engaged in qualifying activities in the provision of financial services may apply for FSI status. Approval is conditional on certain items, including a minimum number of professional staff stationed in Singapore to perform the qualifying activities. Foreign trusts and foreign accounts of charitable purpose trusts (including any eligible holding company owned under the trust or account) are generally exempt from tax on their investment income. The trusts have to be administered by approved trustee companies. For foreign investors seeking to locate manufacturing operations or the performance of high value-added services in Singapore, the Pioneer or Pioneer Services Incentives, as well as the Development and Expansion Incentive (DEI), are available. Pioneer status entitles the Singaporean entity to full tax exemption, whereas the DEI entitles it to a concessionary tax rate as low as 5% on income exceeding the average corresponding annual income for the three years before the commencement of the incentive. There is presently no capital gains tax in Singapore. However, gains from trading activities may not be treated as capital gains. Whether a gain is characterized as income or capital gain is a matter of fact and is to be determined on a case-by-case basis, based on various factors. Computation of taxable income Singapore adopts an annual, preceding-year basis of assessment. For example, the basis year in which income tax is calculated and charged for Year of Assessment 2012 is January 1, 2011, to December 31, 2011. Taxable base Taxable income generally refers to gains or profits from any trade, business or profession or vocation less deductions, allowances and approved donations. Generally, the deductibility of expenses is governed by subsection 14(1) of the ITA, which provides that, for the purpose of ascertaining the income of any person for any period from any source chargeable with tax, there shall be deducted all outgoings and expenses wholly and exclusively incurred in the production of income chargeable with Singaporean income tax. Capital gains are not subject to tax in Singapore. Conversely, capital expenses are generally not deductible against taxable income in Singapore. However, under the ITA, if a company incurs a capital expenditure in acquiring certain capital assets, it is allowed to claim capital allowances, which is similar to tax depreciation. Capital allowances may be claimed against the taxable income of the company. Capital assets which are eligible for capital allowances include certain buildings and structures, plant, machinery or equipment used by the company to carry on its trade. Income tax reporting The ITA provides for the Comptroller of Income Tax to issue a notice requiring the taxpayer to furnish a return of total income and all relevant information. The government announced in 2016 that the e-filing of corporate income tax returns will be made mandatory by Year of Assessment 2020. Currently, it applies only to companies with turnover of more than S$1 million in the Year of Assessment 2018. Transfer pricing refers to the pricing of goods, services and intangibles between related parties. The ITA contains provisions and regulations governing transfer pricing in Singapore, and the Comptroller is allowed to make adjustments to inter-company transactions if they are not made at arm’s length. The adjustments may be made through the income, deductions or losses of the taxpayer. From 2019 onwards, it will be mandatory for companies, firms (which include partnerships) and trusts with turnover exceeding S$10 million for the basis period concerned to keep contemporaneous transfer pricing documentation. The law requires the pricing documentation for each transaction to be kept in safe custody for a period of at least five years from the end of the basis period in which the transaction took place. Noncompliance without reasonable excuse will attract a financial penalty. Generally, certain categories of payments made to non-residents will be subject to withholding tax. Payments that are subject to withholding tax, as stipulated under the ITA, include interest, royalties, rent for movable property, management fees and technical assistance fees. In most cases, the applicable domestic rate for withholding tax is 17%. However, for interest, royalties or rent, if the income is not derived from any trade, business, profession or vocation carried on or exercised by the recipient in Singapore, and is not effectively connected with a permanent establishment of the recipient in Singapore, it will be subject to a 15% final withholding tax, except in the case of royalties, where the withholding tax rate is 10%. In the case of the 17% rate, the withholding tax is not final and partial refunds can be claimed by filing tax returns and claiming deductions for expenses incurred in earning the income in question. Withholding tax rates may be reduced under any of the more than 80 DTTs to which Singapore is a party, if applicable. Central Provident Fund contributions The CPF was established as a compulsory savings scheme in Singapore in 1955. Under the CPF Act, employers have to make mandatory contributions to the CPF accounts of each employee who is a Singaporean citizen or who is a Singaporean permanent resident, based on the level of wages earned by each employee. CPF contributions are prohibited for expatriate employees. The use of CPF funds by the account holders are generally restricted to purchase of residential properties, and health care costs for either themselves or their immediate family members. The CPF Act governs the use of the CPF funds by the account holders. GST is a tax on the domestic supply of goods and services. It is a multi-stage tax where the tax burden is intended to fall on the final consumer. Effective from July 1, 2007, the GST rate is 7%. However the Singaporean government announced in 2018 that the GST rate may be increased from 7% to 9% sometime in the future from 2021 to 2025. Generally, the GST charged on outputs is known as the output tax, and the GST paid on inputs is known as the input tax. The different between the output tax and the input tax is the amount payable to the IRAS. When the output tax is lower than the input tax however, IRAS will refund the difference to the person or entity. GST is chargeable on taxable supplies only, which is defined under the GST Act as a supply of goods or services made in Singapore other than an exempt supply. Generally, the exempt categories are the sale and lease of residential properties, financial services and the supply and import of investment precious metals. Certain taxable supplies are zero- rated supplies (GST chargeable at 0%), namely, exports of goods and provision of international services. GST is also chargeable on imports into Singapore. Import GST applies on most goods (subject to specific reliefs, exemptions or special schemes). To level the GST treatment for all services consumed in Singapore, the Minister for Finance announced in Budget 2018 that import GST will also be imposed on imported services from January 1, 2020, through (i) a reverse charge regime for business- to-business supplies of imported services and (ii) an overseas vendor registration regime for business- to-consumer supplies of imported digital services. Customs and exercise duties All “dutiable goods” imported into or manufactured in Singapore are subject to customs duty and/or excise duty. Customs duty is duty levied on goods imported into Singapore, excluding excise duty. Excise duty is duty levied on goods manufactured in, or imported into Singapore. The duties are based on ad valorem or specific rates. The law presently provides for four categories of dutiable goods: liquor, tobacco, petroleum products and motor vehicles. In Singapore, property taxes apply on property ownership with rates differing depending on whether the property is commercial or residential, and if residential, whether the property is owner- occupied, rented out or left vacant. For residential properties, owner- occupier tax rates range from 0% to 16% and non–owner occupied rates range from 10% to 20%. The applicable tax rates depend on the relevant “Annual Value” bands. Commercial (non-residential) properties are taxed at 10% of the Annual Value of the property. The Annual Value is the estimated annual rent of the property. Purchasers of commercial properties are also liable to pay GST of 7% on the market value of the property purchased. The sale and lease of residential properties are however exempt from GST. As mentioned in section 5.3 above, stamp duty is applicable on instruments for the sale, purchase or lease of immovable property in Singapore. For a sale of residential properties, the following duties apply: Buyer’s stamp duty (BSD) Additional buyer’s stamp duty (ABSD) Seller’s stamp duty (SSD) for residential property Effective March 11, 2017, additional conveyance duties also apply in a purchase or sale of shares or units ("equity interests") in property-holding entities that own primarily residential properties in Singapore. For a sale of non-residential properties, the following duties apply: SSD for industrial property Edmund Leow, SC Edmund Leow, SC Senior Partner, SingaporeSingaporeD +65 6885 3613 [email protected] Jia Xian Seow Jia Xian Seow Partner, SingaporeSingaporeD +65 6885 3658 [email protected]

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professional_accounting

Public Policy and Technical Alert, May 2020 As part of the Center for Audit Quality’s (CAQ) ongoing effort to keep members and stakeholders informed on significant public policy and accounting matters, we are pleased to offer the Public Policy and Technical Alert (PPTA). Each month, the PPTA highlights and examines the regulatory, standard-setting, legislative, and broader financial reporting developments impacting the public company audit profession. Please note that the PPTA is intended as general information and should not be relied upon as being definitive or all-inclusive. The CAQ encourages member firms to refer to the rules, standards, guidance, and other resources in their entirety at the hyperlinks provided below. All entities should carefully evaluate which requirements apply to their respective organizations. SEC provides temporary, conditional relief to allow small businesses to pursue expedited crowdfunding offerings SEC’s Chairman, Jay Clayton, announces additions to executive staff COVID-19 Market Monitoring Group — update and current efforts SEC announces new Investor Advisory Committee members SEC staff to host July 9 roundtable on Emerging Markets SEC adopts amendments to financial disclosures about acquisitions and dispositions of businesses PCAOB update on operations in light of COVID-19 PCAOB posts Spotlight on Data and Technology Research Project PCAOB posts Spotlight on audits involving Cryptoassets FAF issues 2019 Annual Report FASB: Hillary H. Salo named Technical Director of the FASB FRC: Update on the transformation program IESBA: Stavros Thomadakis extends term as Chairman IASB proposes deferring IAS 1 amendments’ effective date due to COVID-19 FRC: COVID-19 update May 2020 IESBA staff release COVID-19 Q&As highlighting ethics and independence considerations FRC issues editorial updates to 2018 Guidance on the Strategic Report FRC: Guidance for companies on interim reports IASB: Sustainability reporting and its relevance to the IFRS Foundation IASB issues package of narrow-scope amendments to IFRS Standards FRC: Corporate governance update FRC: Additional information on company filings and AGMs during COVID-19 IAASB publishes COVID-19 related Guidance on Audit Considerations for Subsequent Events IAASB releases revised Work Plan Table for 2020-2021 FRC: Additional company guidance on reporting of exceptional items and APMs FRC: Chair to step down FRC: Government introduces Corporate and Insolvency Bill IAASB releases COVID-19 related guidance for auditor reporting IOSCO: Financial policymakers discuss responses to COVID-19 with the private sector IASB issues amendment to IFRS Standard on leases to help lessees accounting for COVID-19-related rent concessions IOSCO consults on outsourcing principles to ensure operational resilience FRC: Amendments to UK accounting standards IAASB: ISA 540 (Revised) implementation: Illustrative examples for auditing simple and complex accounting estimates IOSCO encourages issuers’ fair disclosure about COVID-19 related impacts CAQ Updates CAQ COVID-19 Resources CAQ Statement on recent ESG disclosure discussions at the SEC The SEC announced that it is providing temporary, conditional relief for established smaller companies affected by COVID-19 that may look to meet their urgent funding needs through a Regulation Crowdfunding offering. The relief will apply to offerings launched between the effective date of the temporary rules (May 4, 2020) and Aug. 31, 2020. The SEC released an updated roster of the executive staff of Chairman Jay Clayton, including several individuals who have recently joined the office. The SEC announced the formation of an internal, interdisciplinary COVID-19 Market Monitoring Group. This temporary, senior-level group was formed to assist the Commission and its various divisions and offices in (1) developing Commission and staff analyses and actions related to the effects of COVID-19 on markets, issuers and investors—including in particular the SEC’s long-term Main Street investors, and (2) responding to requests for information, analyses and assistance from other regulators and other public sector partners on market matters arising from the effects of COVID-19. The SEC announced the appointment of six new members to its Investor Advisory Committee. The new members of the Investor Advisory Committee are: Cien Asoera, Financial Advisor, Edward Jones Theodore “Ted” Daniels, Founder and President, Society for Financial Education and Professional Development Elissa Germaine, Professor, Pace Law School; Executive Director, John Jay Legal Services, and Director, Investor Rights Clinic, at Pace Law School Satyam Khanna, Resident Fellow, NYU School of Law Institute for Corporate Governance and Finance (who will join the Committee on July 5, 2020) Lori Lucas, CFA, President and CEO, Employee Benefit Research Institute Christopher Mirabile, Senior Managing Director and Board Member, Launchpad Venture Group; Chair Emeritus, Angel Capital Association The SEC announced July 9 as the date for its roundtable to hear the views of investors, other market participants, regulators, and industry experts on the risks of investing in emerging markets, including China. The roundtable will explore ways to raise investor awareness of these risks and potential additional steps that can be taken to mitigate them. The roundtable will be held by remote means, will be open to the public via live webcast, and will be archived for later viewing. The SEC announced that it has voted to adopt amendments to its rules and forms related to financial information about acquired or disposed businesses. The amendments to the rules and forms impact determinations of whether a subsidiary or an acquired or disposed business is significant and updates the financial disclosure requirements applicable to acquisitions and dispositions of businesses, including real estate operations and investment companies. The amendments will be effective on Jan. 1, 2021; however, voluntary compliance will be permitted in advance of the effective date. The PCAOB provided an update on current operations and activities in light of COVID-19. This update included a statement that the previously announced 45-day relief period, which provided audit firms the opportunity to pause inspection activity in full or in part, has now concluded. The PCAOB’s Office of the Chief Auditor previously established a research project on data and technology to assess whether there is a need for guidance, changes to PCAOB standards, or other regulatory actions. The work also is informed by the PCAOB Data and Technology Task Force, whose members provide additional insights into the use of technology by auditors and preparers. This Spotlight document shares certain observations from the PCAOB’s research and outreach activities related to data and technology. The PCAOB posted a Spotlight document on Audits Involving Cryptoassets – Information for Auditors and Audit Committees. The document highlights considerations for addressing certain responsibilities under PCAOB standards for auditors of issuers who are transacting in, or who hold cryptoassets. The document also suggests questions that audit committee members could consider asking their auditors when transactions involving cryptoassets or holdings of cryptoassets are material to the issuer’s financial statements. The Financial Accounting Foundation (FAF) released its 2019 Annual Report online. The annual report provides an overview of the FASB’s key activities for 2019 and FAF’s 2019 financial statements. The FASB announced the appointment of Hillary H. Salo to the role of director of technical activities and chair of the Emerging Issues Task Force. Ms. Salo, will join the FASB in August from the New York City office of KPMG LLP, where she was a partner in the audit practice and engagement partner for a large global financial services organization. The Financial Reporting Council (FRC) provided an update on its progress towards becoming the Audit Reporting and Governance Authority. This update provides some details about the progress made so far and the expected next steps. The International Ethics Standards Board for Accountants (IESBA) announced the extension of Dr. Stavros Thomadakis as IESBA Chairman until the end of 2021. This appointment was proposed by the International Federation of Accountants Nominating Committee and recently approved by the Public Interest Oversight Board. The International Accounting Standards Board (IASB) has proposed to defer by one year the effective date, for annual reporting periods beginning on or after January 1, 2022, of Classification of Liabilities as Current or Non-current, which amends IAS 1 Presentation of Financial Statements. IASB is not proposing any changes to the original amendments other than the deferral of the effective date. Comments were due by June 3, 2020. The FRC provided a COVID-19 update on their range of activities during the COVID-19 crisis. FRC staff continue to work from home. The Audit Quality Review, Corporate Reporting and Professional Oversight teams resumed their full program of supervisory work beginning May 11. This includes correspondence from the Corporate Reporting Team to companies in relation to their financial statements. The FRC l also resumed their inspection and supervisory work with audit firms. The staff of IESBA released a Question and Answer publication, COVID-19: Ethics and Independence Considerations, which highlights aspects of the International Code of Ethics for Professional Accountants (including International Independence Standards) that can be relevant in navigating ethics and independence challenges as a result of the COVID-19 pandemic. The FRC issued an editorial change to Appendix II and Appendix III of the 2018 Guidance on the Strategic Report. It includes a clarification that a public company must include a section 172(1) statement in its Strategic Report, even if it meets the medium sized company size criteria. The FRC has updated its guidance for companies in relation to interim results. The guidance highlights some key areas of focus for boards in maintaining strong corporate governance and provides high-level guidance on some of the most significant issues when preparing annual reports and other corporate reporting. IFRS Foundation Trustee Teresa Ko provided the following prepared remarks at the inaugural meeting of the Green and Sustainable Finance Cross-Agency Steering Group earlier in May. The group was established by the Hong Kong Monetary Authority and the Securities and Futures Commission to coordinate the management of climate and environmental risks to the financial sector in Hong Kong. In her remarks, she outlines possible future roles the IFRS Foundation could play in supporting progress towards the development of high-quality, internationally recognized standards for sustainability reporting. The IASB issued several amendments to IFRS standards. The package of amendments includes narrow-scope amendments to three standards as well as the Board’s Annual Improvements, which are changes that clarify the wording or correct minor conflicts between requirements in the standards. The three standards impacted by the narrow-scope amendments are as follows: IFRS 3 Business Combinations IAS 16 Property, Plant and Equipment IAS 37 Provisions, Contingent Liabilities and Contingent Assets All amendments are effective January 1, 2022. The FRC’s Corporate Governance and Stewardship team is currently monitoring corporate governance and Audit General Meeting (AGM) reporting and practices, and in the summer will publish its initial assessment of good practice. This will be followed by the FRC’s annual review of corporate governance later in the year, which will focus on evaluating the quality of reporting and practice on the main areas of change to the UK Corporate Governance Code. To provide companies with additional information upon which to plan activities over the coming months with respect to company filings, AGMs and other general meetings during COVID-19, a Q&A has been jointly produced by the UK Department for Business, Energy & Industrial Strategy and the FRC. The International Auditing and Assurance Standards Board (IAASB) published guidance on auditor considerations when undertaking procedures relating to subsequent events in light of the changing environment due to the COVID-19 pandemic. To account for COVID-19’s impact on the IAASB’s work, the IAASB has reconsidered the timelines for its projects in 2020. The revised Detailed Work Plan Table for 2020-2021 sets out a description of the changes that have been made and the revised timelines for 2020 and 2021 (as applicable). The FRC updated its guidance for companies on corporate reporting to explain how they should report exceptional items and alternative performance measures (APMs) in their reports and accounts, in the context of the COVID-19 crisis. Mr. Simon Dingemans intends to step down from his role as the Chair of the FRC at the end of May. The UK Government has introduced the Corporate and Insolvency Bill to put in place a series of measures to amend insolvency and company law to support businesses impacted by COVID-19. The IAASB released COVID-19 pandemic-related guidance for auditors to consider when issuing an auditor’s report. Financial policymakers which included the International Organization of Securities Commissions (IOSCO) and other international standard setters met virtually with private sector executives to discuss international policy responses to COVID-19. The meeting explored the effectiveness of prudential and other financial policy measures taken to date, including experiences with their implementation. Participants also discussed policy issues going forward, notably how financial institutions can better cope with the challenges resulting from rising solvency risks and exchanged views on potential areas that may warrant further policy coordination. The IASB issued an amendment to IFRS 16 Leases to make it easier for lessees to account for COVID-19-related rent concessions such as rent holidays and temporary rent reductions. The amendment exempts lessees from having to consider individual lease contracts to determine whether rent concessions occurring as a direct consequence of the COVID-19 pandemic are lease modifications and allows lessees to account for such rent concessions as if they were not lease modifications. It applies to COVID-19-related rent concessions that reduce lease payments due on or before June 30, 2021. IOSCO is requesting feedback on proposed updates to its principles for regulated entities that outsource tasks to service providers. The consultation period ends on October 1, 2020. The FRC completed its annual review of Financial Reporting Standard (FRS) 101 Reduced Disclosure Framework and made amendments to the disclosure exemptions relating to the statement of cash flows. The FRC has also issued Financial Reporting Exposure Draft 74 Draft amendments to FRS 102 – Interest rate benchmark reform (Phase 2). The effective date proposed is January 1, 2021 with early application permitted. The comment period ends on September 30, 2020. The IAASB’s International Standard on Auditing (ISA) 540 (Revised) Implementation Working Group has prepared illustrative examples for auditing simple and complex accounting estimates. The examples are designed to illustrate how an auditor could address certain requirements of ISA 540 (Revised), and have been developed to assist the auditor in understanding how ISA 540 (Revised) may be applied to a: Simple Accounting Estimate – Provision on Inventory Impairment, and Complex Accounting Estimate – Provision on Property, Plant and Equipment Impairment. IOSCO issued a public statement highlighting the importance to investors and other stakeholders of having timely and high-quality information about the impact of COVID-19 on issuers´ operating performance, financial position and prospects. IOSCO states that the pandemic and the uncertainty it has caused have material implications for financial reporting and auditing, including issuers’ disclosures of current and reliable information material to investment decisions. IOSCO acknowledges that the current circumstances may make disclosures outside the financial statements more challenging and hence make high quality disclosures that much more important. In May, the CAQ published two COVID-19 specific resources: Auditing Accounting Estimates in the COVID-19 Environment: This publication is intended to assist auditors in navigating through the complexities of auditing accounting estimates during COVID-19 by providing a high-level overview of auditor’s responsibilities related to the auditing of estimates and to highlight COVID-19 related considerations. Data Ethics and Governance with COVID-19 Considerations: This publication explores the implications of data ethics and governance for mitigating fraud risk, protecting data privacy, and navigating disruption during the COVID-19 crisis. The SEC’s Investor Advisory Committee recently issued a recommendation stating that the time has come for the Commission to begin in earnest an effort to update public company reporting requirements to include material, decision-useful information on environmental, social, and governance (ESG) practices. Read the CAQ Statement in response to the SEC’s Investor Advisory Committee activities. June 11-12 PLI 35th Midyear SEC Reporting & FASB Forum, Virtual Conference IAASB Board Meeting, Virtual Conference ACFE Global Fraud Conference, Virtual Conference August 7-12 AAA Annual Meeting, Virtual Conference IAASB Board Meeting, New York, NY November 9-10 FEI Corporate Financial Reporting Insights Conference, New York, NY December 7-9 AICPA Conference on Current SEC and PCAOB Developments, Washington, DC December 7-11 IAASB Board Meeting, Madrid, Spain ICGN Annual Conference, Toronto, Canada The Center for Audit Quality is an autonomous, nonpartisan, nonprofit organization dedicated to enhancing investor confidence and public trust in the global capital markets by fostering high-quality public company audits; collaborating with other stakeholders to advance the discussion of critical issues; and advocating policies and standards that promote public company auditors’ objectivity, effectiveness and responsiveness to dynamic market conditions. Based in Washington, D.C., the CAQ is affiliated with the American Institute of CPAs. For more information, visit www.thecaq.org. The CAQ Public Policy and Technical Alert (PPTA) is intended as general information and should not be relied upon as being definitive or all-inclusive. As with all other CAQ resources, this is not authoritative and readers are urged to refer to relevant rules and standards. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The CAQ makes no representations, warranties, or guarantees about, and assumes no responsibility for, the content or application of the material contained herein and expressly disclaims all liability for any damages arising out of the use of, reference to, or reliance on such material. This publication does not represent an official position of the CAQ, its board or its members. Questions and comments about the PPTA can be addressed to: [email protected]. CAQ Alert 2022-01: Addendum to November 6, 2021 International Practices Task Force DOCUMENT FOR DISCUSSION Monitoring Inflation in Certain Countries Audit Planning Alert for Auditors of Brokers and Dealers

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professional_accounting

NIFTY 11633.70 -53.8 -0.46 | SENSEX 39047.25 -168.39 -0.43 18-Jul-19 14:18 OK Play India Ltd Auditors Report. To the Members of OK PLAY INDIA LIMITED Report on the Consolidated Financial Statements We have audited the accompanying consolidated financial statements of OK PLAY INDIA LIMITED (“the Holding Company”) and its subsidiary (the Holding Company and its subsidiary together referred to as “the Group”) comprising of the Consolidated Balance Sheet as at March 31, 2018, the Consolidated Statement of Profit and Loss, Consolidated Statement of Changes in Equity and the Consolidated Cash Flow Statement for the year then ended, and a summary of the significant accounting policies and other explanatory information (hereinafter referred to as “the Consolidated Ind AS Financial Statements”). Managements Responsibility forthe Ind AS Financial Statements The Holding Companys Board of Directors is responsible for the preparation of these Consolidated Ind AS Financial Statements in terms of the requirements of the Companies Act, 2013 (hereinafter referred to as “the Act”) that give a true and fair view of the consolidated financial position, consolidated financial performance including other comprehensive income, consolidated changes in equity and consolidated cash flows of the Group in accordance with the accounting principles generally accepted in India, including the Indian Accounting Standards specified under Section 133 of the Act, read with Rule 7 of the Companies (Accounts) Rules, 2014. The respective Board of Directors of the companies included in the Group are responsible for maintenance of adequate accounting records in accordance with the provisions of the Act for safeguarding the assets of the Group and for preventing and detecting frauds and other irregularities; the selection and application of appropriate accounting policies; making judgments and estimates that are reasonable and prudent; and design, implementation and maintenance of adequate internal financial controls, that were operating effectively for ensuring the accuracy and completeness of the accounting records, relevant to the preparation and presentation of the Ind AS financial statements that give a true and fair view and are free from material misstatement, whether due to fraud or error, which have been used for the purpose of preparation of the Consolidated Ind AS Financial Statements by the Board of Directors of the Holding Company, as aforesaid. Auditors Responsibility Our responsibility is to express an opinion on these Consolidated Ind AS Financial Statements based on our audit. While conducting the audit, we have taken into account the provisions of the Act, the accounting and auditing standards and matters which are required to be included in the audit report under the provisions of the Act and the Rules made thereunder. We conducted our audit in accordance with the Standards on Auditing specified under Section 143(10) of the Act. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the Consolidated Ind AS Financial Statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the Consolidated Ind AS Financial Statements. The procedures selected depend on the auditors judgment, including the assessment of the risks of material misstatement of the consolidated Ind AS financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal financial control relevant to the Holding Companys preparation of the Consolidated Ind AS Financial Statements that give a true and fair view in order to design audit procedures that are appropriate in the circumstances. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of the accounting estimates made by the Holding Companys Board of Directors, as well as evaluating the overall presentation of the Consolidated Ind AS Financial Statements. We believe that the audit evidence obtained by us is sufficient and appropriate to provide a basis for our audit opinion on the consolidated Ind AS financial statements. In our opinion and to the best of our information and according to the explanations given to us, the aforesaid Consolidated Ind AS Financial Statements give the information required by the Act in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India, of the consolidated state of affairs of the Group as at 31stMarch, 2018, their consolidated profit/loss, consolidated changes in equity and their consolidated cash flows for the year ended on that date. Report on Other Legal and Regulatory Requirements As required by Section 143(3) of the Act, we report, to the extent applicable, that: a. We have sought and obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purposes of our audit of the aforesaid Consolidated Ind AS Financial Statements; b. In our opinion, proper books of account as required by law relating to preparation of the aforesaid Consolidated Ind AS Financial Statements have been kept by the Company so far as it appears from our examination of those books; c. The Consolidated Balance Sheet, the Consolidated Statement of Profit and Loss and the Consolidated Cash Flow Statement dealt with by this Report are in agreement with the relevant books of account maintained for the purpose of preparation of the Consolidated Ind AS Financial Statements; d. In our opinion, the aforesaid Consolidated Ind AS Financial Statements comply with the Indian Accounting Standards specified under Section 133 of the Act, read with Rule 7 of the Companies (Accounts) Rules, 2014; e. On the basis of written representations received from the directors of the Holding Company and the Subsidiary Company as on March 31,2018 and taken on record by the Board of Directors of the respective companies, none of the directors of the Group companies is disqualified as on March 31,2018, from being appointed as a director in terms of Section 164(2) of the Act; f. With respect to the adequacy of the internal financial controls over financial reporting of the Group and the operating effectiveness of such controls, refer to our separate report in “Annexure". g. With respect to the other matters to be included in the Auditors Report in accordance with Rule 11 of the Companies (Audit and Auditors) Rules, 2014, in our opinion and to the best of our information and according to the explanations given to us: (i) The Consolidated Ind AS Financial Statements disclose the impact of pending litigations on the consolidated financial position of the Group as referred to in Note 29(3) to the Consolidated Ind AS Financial Statements; (ii) The Group did not have any material foreseeable losses on long term contracts including derivative contracts; (iii) There were no amounts which were required to be transferred to the Investor Education and Protection Fund by the Holding Company and its subsidiary; For D. S. CHADHA & ASSOCIATES (FRN 026723-N) -Sd- D. S. CHADHA Place : New Delhi d : 30th May, 2018 PROPRIETOR M.N.015727 QuickLinks for OK Play India Ltd.

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professional_accounting

FDBLD Dashboard 10-Q Filing Friendable (FDBLD) 10-Q2021 Q3 Quarterly report Filed: 10 Nov 21, 4:48pm Constraining Litigous H.S. junior Avg New words: absence, acquisition, arrangement, book, compatible, expand, explained, intending, leaving, local, maximum, permit, permitted, prepay, prepayment, presence, reach, Republik, resolution, scope, seek, single, Spotify, Subtopic Removed: absolute, approach, circumvented, collusion, commencement, Committee, conceived, continued, design, deteriorate, discounted, error, establishing, expect, external, fact, faulty, fraud, lease, lessee, likelihood, mistake, modified, opening, operated, override, paragraph, people, prevent, recast, recognize, reliability, resource, responsible, retrospective, simple, Sponsoring, succeed, system, transition, Treadway 10-Q Quarterly report 31.1 Certification of the Principal Executive Officer of the Registrant Pursuant to 18 U.s.c. Section 1350, As Adopted Pursuant to Section 31.2 Certification of the Principal Financial Officer of the Registrant Pursuant to 18 U.s.c. Section 1350, As Adopted Pursuant to Section 32.1 Certification of the Principal Executive Officer and Principal Financial Officer of the Registrant Pursuant to 18 U.s.c. Section 1350, FDBLD similar filings 2022 Q2 Quarterly report (amended) x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended: September 30, 2021 o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ________ to ________ Commission File Number: 000-52917 FRIENDABLE, INC. Nevada 98-0546715 (State or other jurisdiction of incorporation) (I.R.S. Employer Identification No.) 1821 S Bascom Ave., Suite 353, Campbell, California 95008 (Registrant’s telephone number, including area code) (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). x Yes o No Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. Large accelerated filer o Accelerated filer o Non-accelerated filer o (Do not check if a smaller reporting company) Smaller reporting company x Emerging growth company o If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). o Yes x No Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: 475,998,393 shares of common stock outstanding as of November 5, 2021, of which 6,324,453 are issuable as of the date of this report. PART I - FINANCIAL INFORMATION 1 ITEM 1. FINANCIAL STATEMENTS 1 ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 31 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 35 ITEM 4. CONTROLS AND PROCEDURES 36 PART II - OTHER INFORMATION 37 ITEM 1. LEGAL PROCEEDINGS 37 ITEM 1A. RISK FACTORS 37 ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS 38 ITEM 3. DEFAULTS UPON SENIOR SECURITIES 38 ITEM 4. MINE SAFETY DISCLOSURES 38 ITEM 5. OTHER INFORMATION 38 ITEM 6. EXHIBITS 39 SIGNATURES 40 As used in this report, the term “the Company” means Friendable, Inc., formerly known as iHookup Social, Inc., and its subsidiary, unless the context clearly indicates otherwise. Special Note Regarding Forward-Looking Information This quarterly report on Form 10-Q contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The use of words such as “anticipates,” “estimates,” “expects,” “intends,” “plans” and “believes,” among others, generally identify forward-looking statements. These forward-looking statements include, among others, statements relating to: the Company’s future financial performance, the Company’s business prospects and strategy, anticipated trends and prospects in the industries in which the Company’s businesses operate and other similar matters. These forward-looking statements are based on the Company’s management’s expectations and assumptions about future events as of the date of this quarterly report, which are inherently subject to uncertainties, risks and changes in circumstances that are difficult to predict. Actual results could differ materially from those contained in these forward-looking statements for a variety of reasons, including, among others, the risk factors set forth below. Other unknown or unpredictable factors that could also adversely affect the Company’s business, financial condition and results of operations may arise from time to time. In light of these risks and uncertainties, the forward-looking statements discussed in this quarterly report may not prove to be accurate. Accordingly, you should not place undue reliance on these forward-looking statements, which only reflect the views of the Company’s management as of the date of this quarterly report. The Company does not undertake to update these forward-looking statements In this quarterly report on Form 10-Q, unless otherwise specified, all dollar amounts are expressed in United States dollars and all references to “common shares” refer to the common shares in the Company’s capital stock. An investment in the Company’s common stock involves a number of very significant risks. You should carefully consider the following risks and uncertainties in addition to other information in this quarterly report on Form 10-Q in evaluating the Company and its business before purchasing shares of the Company’s common stock. The Company’s business, operating results and financial condition could be seriously harmed as a result of the occurrence of any of the following risks. You could lose all or part of your investment due to any of these risks. You should invest in the Company’s common stock only if you can afford to lose your entire investment. PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. Consolidated Balance Sheets as of September 30, 2021 (unaudited) and December 31, 2020 2 Consolidated Statements of Operations for the three and nine months ended September 30, 2021 and 2020 (unaudited) 3 Consolidated Statements of Stockholders’ Deficit for the three and nine months ended September 30, 2021 and 2020 (unaudited) 4-5 Consolidated Statements of Cash Flows for the nine months ended September 30, 2021 and 2020 (unaudited) 6 Notes to the Consolidated Financial Statements 7-30 September 30, December 31, Cash $ 446,884 $ 52,702 Accounts receivable - 12,500 Total Current Assets 463,741 148,601 Total Assets $ 463,741 $ 148,601 LIABILITIES AND STOCKHOLDERS’ DEFICIT Accounts payable and accrued expenses $ 2,731,409 $ 2,447,706 Accounts payable - related party 55,821 190,320 Short term loans 61,000 61,000 Convertible debentures and convertible promissory notes, net of discounts 92,608 143,957 Mandatorily redeemable Series C convertible Preferred stock, 1,000,000 designated, 441,375 and 173,100 issued and outstanding at September 30, 2021 and December 31, 2020, including a premium of $179,434 and $74,701 respectively (liquidation value $454,155 at September 30, 2021) 633,590 285,605 Derivative liabilities 237,900 1,320,000 Liability to be settled in common stock 988,375 988,375 Total Current Liabilities 4,800,703 5,436,963 Commitments and contingencies (Note 7) SHAREHOLDERS’ DEFICIT: Preferred stock, 50,000,000 authorized at par value $0.0001: Series A convertible Preferred stock, 25,000 shares designated at par value of $0.0001 19,684 and 19,786 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively 2 2 Series B convertible Preferred stock, 1,000,000 shares designated at par value of $0.0001 284,000 and 284,000 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively. (Liquidation value $284,000) 28 28 Series D convertible Preferred stock, 500,000 shares designated at par value of $10.00 40,524 and 0 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively 405,240 - Common stock, $0.0001 par value, 2,000,000,000 shares authorized, 417,753,740 and 51,665,821 shares issued and outstanding at September 30, 2021 and December 31, 2020, respectively 41,775 5,167 Common stock issuable, $0.0001 par value, 11,548,528 and 103,547,079 shares at September 30, 2021 and December 31, 2020, respectively 1,154 10,354 Additional paid-in capital 33,754,754 31,269,833 Common stock subscription receivable - (4,500 ) Accumulated deficit (38,539,915 ) (36,569,246 ) Total Stockholders’ Deficit (4,336,962 ) (5,288,362 ) Total Liabilities and Stockholders’ Deficit $ 463,741 $ 148,601 See accompanying notes to consolidated financial statements For the Three Months Ended For the Nine Months Ended September 30, September 30, Technology services $ - $ 109,500 $ - $ 319,331 Subscription and merchandising sales 1,866 1,892 4,780 3,340 Revenue 1,866 111,392 4,780 322,671 OPERATING EXPENSES: App hosting 7,500 12,000 22,500 33,000 Commissions 247 191 605 625 General and administrative 315,672 224,401 962,281 605,458 Software development and support-related party 252,500 105,790 575,000 460,102 Artists’ performance fees - 425,058 - 425,058 Revenue shares 920 402 2,124 402 Investor relations 58,118 3,921 104,968 140,527 Sales and marketing 127,269 30,081 393,321 82,335 Total operating expenses 762,226 801,844 2,060,799 1,747,507 LOSS FROM OPERATIONS (760,360 ) (690,452 ) (2,056,019 ) (1,424,836 ) OTHER INCOME(EXPENSE): Accretion and interest expense (426,200 ) (38,423 ) (936,113 ) (266,710 ) Gain on foreign exchange - - - 2,580 Initial derivative expense - - (1,796,835 ) (419,000 ) Gain (loss) on settlement of derivatives - 257,317 - (640,821 ) Derivative income (expense) 867,298 263,000 2,818,298 259,000 Total other income (expense), net 441,098 481,894 85,350 (1,064,951 ) NET LOSS $ (319,262 ) $ (208,558 ) $ (1,970,669 ) $ (2,489,787 ) NET LOSS PER COMMON SHARE: Basic and Diluted $ (0.001 ) $ (0.002 ) $ (0.01 ) $ (0.04 ) WEIGHTED AVERAGE COMMON SHARES OUTSTANDING : Basic and Diluted 309,158,542 121,819,362 233,457,551 66,468,267 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ DEFICIT For the three and nine months ended September 30, 2021 Series A Preferred Series B Preferred Series D Preferred Common Stock Additional Common Stock Total Shares Shares Shares Shares Shares Paid In Subscription Accumulated Stockholders’ Issued Amount Issued Amount Issued Amount Issued Amount Issuable Amount Capital Receivable Deficit Deficit Balance, December 31, 2020 19,786 $ 2 284,000 $ 28 - - 51,665,821 $ 5,167 103,547,079 $ 10,354 $ 31,269,833 $ (4,500 ) $ (36,569,246 ) $ (5,288,362 ) Conversion of convertible notes - - - - - - 31,532,405 3,153 - - 164,590 - - 167,743 Common shares issued in payment of loan commitment fee - - - - - - 3,500,000 350 - - 11,574 - - 11,924 Issuance of common stock previously issuable - - - - - - 40,766,310 4,077 (40,766,310 ) (4,077 ) - - - - Common shares issued on conversion of Series C preferred - - - - - - 5,500,894 550 - - 50,039 - - 50,589 Common stock warrants issued, related to loans - - - - - - - - - - 301,411 - - 301,411 Settlement of share subscription receivable - - - - - - - - - - - 4,500 - 4,500 Amortization of value of employee stock options - - - - - - - - - - 20,988 - - 20,988 Net loss - - - - - - - - - - - - (2,484,956 ) (2,484,956 ) Balance, March 31, 2021 19,786 $ 2 284,000 $ 28 - - 132,965,430 $ 13,297 62,780,769 $ 6,277 $ 31,818,435 $ - $ (39,054,202 ) $ (7,216,163 ) Sale of Series D preferred - - - - 85,000 850,000 - - - - - - - 850,000 Common shares issued on conversion of Series C preferred - - - - - - 11,496,360 1,150 - - 136,403 - - 137,553 Common shares issued on conversion of Series A preferred (50 ) - - - - - 2,555,738 255 - - (255 ) - - - Common shares issued on conversion of Series D preferred - - - - (44,970 ) (449,700 ) 31,029,932 3,103 - - 446,597 - - - Regulation A expense - - - - - - - - - - (31,309 ) - - $ (31,309 ) Net Income - - - - - - - - - - - - 833,549 833,549 Balance, June 30, 2021 19,736 $ 2 284,000 $ 28 40,030 $ 400,300 220,570,060 $ 22,057 20,258,169 $ 2,025 $ 32,391,889 $ - $ (38,220,653 ) $ (5,404,352 ) Conversion of convertible notes - - - - - - 42,352,994 $ 4,235 - - $ 329,216 - - $ 333,451 Common stock issued for services - - - - - - 2,000,000 200 - - 17,200 - - 17,400 Issuance of common stock previously issuable - - - - - - 8,709,641 871 (8,709,641 ) (871 ) - - - - Common stock issued to debenture holder to be offset against holder’s convertible debt - - - - - - 7,290,359 729 - - 90,400 - - 91,129 Common shares issued on conversion of Series D preferred - - - - (75,506 ) (755,060 ) 114,102,488 11,410 - - 743,650 - - - Net Loss - - - - - - - - - - - - (319,262 ) (319,262 ) Balance, September 30, 2021 19,684 $ 2 284,000 $ 28 40,524 $ 405,240 417,753,740 $ 41,775 11,548,528 $ 1,154 $ 33,754,754 $ - $ (38,539,915 ) $ (4,336,962 ) Series A Preferred Stock Series B Preferred Common Stock Additional Common Stock Total Issued Amount Issuable Amount Issued Amount Issued Amount Issuable Amount Capital Receivable Deficit Deficit Balance, December 31, 2019 19,789 $ 2 - $ - 284,000 $ 28 4,398,114 $ 438 8,518,335 $ 852 $ 16,476,758 $ (4,500 ) $ (32,443,883 ) $ (15,970,305 ) Common shares cancelled - - - - - - (2,000 ) - - - (500 ) - - (500 ) Conversion of convertible notes - - - - - - 362,595 36 - - 19,914 - - 19,950 Common stock issuable under debt restructuring agreement - - - - - - - - 36,193,098 3,620 8,415,518 - - 8,419,138 Common shares issued for services - - - - - - 600,000 60 - - 89,940 - - 90,000 Conversion of Series A preferred into common stock (3 ) - - - - - 54,076 5 - - (5 ) - - - Balance, March 31, 2020 19,786 $ 2 - $ - 284,000 $ 28 7,988,531 $ 797 42,135,687 $ 4,214 $ 25,001,625 $ (4,500 ) $ (33,991,499 ) $ (8,989,333 ) Conversion of convertible notes - - - - - - 2,211,445 221 - - 56,299 - - 56,520 Common shares issued for services - - - - - - 78,000 8 206,667 21 27,579 - - 27,608 Series A preferred shares issuable to talent agencies in exchange for services - - 118 - - - - - - - 135,617 - - 135,617 Return of Series A preferred shares to treasury (118 ) - - - - - - - - - - - - - Common stock issued for cash - - - - - - - - 1,750,000 175 34,825 - - 35,000 Balance, June 30, 2020 19,668 $ 2 118 - 284,000 $ 28 10,277,976 $ 1,026 44,092,354 $ 4,410 $ 25,255,945 $ (4,500 ) $ (34,725,112 ) $ (9,468,201 ) Common stock issuable for stock issued for cash - - - - - - - - 500,000 50 24,950 - - 25,000 Common shares issued towards settlement of lawsuit - - - - - - 750,000 75 - - 16,550 - - 16,625 Common shares issued for services - - - - - - 5,058,333 506 - - 427,936 - - 428,442 Common stock issued on conversion of Series C preferred - - - - - - 3,822,958 383 - - 134,660 - - 135,043 Reclassification of common stock previously issuable - - - - - - 1,309,165 132 (1,309,165 ) (132 ) - - - - Reclassification of Series A preferred previously issuable 118 - (118 ) - - - - - - - - - - Balance, September 30, 2020 19,786 $ 2 - $ - 284,000 $ 28 21,218,432 $ 2,122 106,558,432 $ 10,656 $ 30,909,397 $ (4,500 ) $ (34,933,670 ) $ (4,015,965 ) For the Nine Months Ended September 30, Net Loss $ (1,970,669 ) $ (2,489,787 ) Adjustments to reconcile net loss to net cash (used in) provided by operating activities: Common stock issued for services 17,400 575,500 Loss on settlement of derivative - 640,821 Non-cash loan fees expensed 29,000 - Debt conversion fees charged to expense 8,600 - Stock option expense 65,024 - Amortization of debt discount 467,101 45,095 Initial derivative expense 1,796,835 419,000 (Gain) Loss on change in fair value of derivative (2,818,298 ) (259,000 ) Accrual of dividend on Preferred C Stock - 24,666 �� Interest on convertible debentures and promissory note 171,156 Premium, dividends and accretion on Series C preferred stock 281,654 - Change in operating assets and liabilities: Accounts receivable 12,500 (12 ) Due from related party - 30,083 Accounts payable - related party (134,499 ) 141,803 Accounts payable and accrued expenses 335,176 409,744 NET CASH USED IN OPERATING ACTIVITIES (1,843,633 ) (260,931 ) Proceeds from sale of convertible Series C preferred stock 515,900 33,000 Redemption of Series C preferred stock (95,150 ) - Payment of Series C preferred stock dividends (3,625 ) - Proceeds from sale convertible Series D preferred stock from Regulation A offering 1,610,000 - Offering costs of convertible Series D preferred stock (31,310 ) - Refund on canceled common stock subscription - (500 ) Proceeds from issuance of convertible notes 358,500 105,000 Prepayment of convertible note (116,500 ) Proceeds from short-term loans - 61,000 Proceeds from sale of common stock - 60,000 NET CASH PROVIDED BY FINANCING ACTIVITIES 2,237,815 258,500 NET INCREASE IN CASH AND CASH EQUIVALENTS 394,182 (2,431 ) CASH AND CASH EQUIVALENTS - beginning of period 52,702 11,282 CASH AND CASH EQUIVALENTS - end of period $ 446,884 $ 8,851 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the period for: Interest $ - $ - Income taxes $ - $ - Non-cash investing and financing activities: Settlement of stock subscription receivable $ 4,500 $ - Conversion of convertible notes to common stock $ 401,949 $ 59,175 Conversion of accrued interest to common stock $ 46,970 $ 17,295 Conversion of Series C redeemable preferred shares to common stock $ 350,789 $ - Conversion of Series D preferred stock to common stock $ 1,204,700 $ - Series A shares granted for fee and recorded as prepaid asset $ - $ 135,617 Premiums on Series C redeemable preferred shares $ - $ 135,042 Reduction of liability to be settled with common stock $ - $ 16,625 Recording of debt discount on convertible debt $ 446,700 $ 105,000 Reduction of derivative liability based on reset common shares issuable $ - $ 13,474,521 Cash consists of : Cash $ 446,884 $ 8,851 September 30, 2021 and 2020 1. NATURE OF BUSINESS AND GOING CONCERN Friendable, Inc., a Nevada corporation (the “Company”), was incorporated in the State of Nevada. Friendable, Inc. is a mobile-focused technology and marketing company, connecting and engaging users through two distinctly branded applications. The Company initially released its flagship product Friendable, as a social application where users can create one-on-one or group-style meetups. In 2019 the Company moved the Friendable app closer to a traditional dating application with its focus on building revenue, as well as reintroducing the brand as a non-threatening, all-inclusive place where “Everything starts with Friendship”…meet, chat & date. On June 28, 2017, the Company formed a wholly owned Nevada subsidiary called Fan Pass, Inc. Fan Pass is the Company’s most recent or second app/brand, released on July 24, 2020. Fan Pass believes in connecting Fans of their favorite celebrity or artist, to an exclusive VIP or Backstage experience, right from their smartphone or other connected devices. Fan Pass allows an artist’s fanbase to experience something they would otherwise never have the opportunity to afford or geographically attend. The Company aims to establish both Friendable and Fan Pass as premier brands and mobile platforms that are dedicated to connecting and engaging users from anywhere around the World. Presently, until our apps gain greater adoption from paying subscribers through increased awareness, coupled with additional compelling and exclusive digital content to produce higher revenue levels, though December 31, 2020 the Company had largely supported its operations through the sale of its software services, and specifically its app development services, under a contractual relationship since inception with a third party. This services contract ended in 2020 and has not yet been replaced with any other similar software services with another customer. Presently, the Company’s only revenue is from its own Fan Pass and Friendable apps, which have various revenue streams tested for long term and/or recurring monthly viability. The Company has developed an enhanced version of its Fan Pass application (v2.0) with improved features and attributes which it released on July 24, 2021. This upgrade includes all new UI/UX attributes, upgraded feature sets for artists and fans, an accelerated artist on boarding process and enhanced dashboard features. On August 5, 2021 the Company announced the approval of the Fan Pass v2.0 livestream artist platform by both the Apple App and Google Play Stores. The mobile applications can be downloaded by users worldwide, and Fan Pass v2.0 is also accessible via desktop and web applications. On August 8, 2019 the Company filed a Designation of Series B convertible Preferred Stock with the state of Nevada, designating 1,000,000 shares of the Series B Preferred Stock with a stated value of $1.00 per share. A holder of Series B Preferred Stock has the right to convert their Series B Preferred Stock into fully paid and non-assessable shares of Common Stock. Initially, the conversion price for the Series B Preferred Stock is $0.25 per share, subject to standard anti-dilution adjustments. Additionally, each share of Series B Preferred Stock shall be entitled to, as a dividend, a pro rata portion of an amount equal to 10% (Ten Percent) of the Net Revenues (“Net Revenues” being “Gross Sales” minus “Cost of Goods Sold” as defined in the agreements) derived from the subscriptions and other sales, but excluding and net of Vimeo fees, processing fees and up sells, generated by Fan Pass Inc., the wholly-owned subsidiary of the Corporation. The Series B Dividend shall be calculated and paid on a monthly basis in arrears starting on the day 30 days following the first day of the month following the initial issuance of the Series B Preferred and continuing for a period of 60 (Sixty) months. The holders of Series B Preferred stock shall have no voting rights. The holders of Series B Preferred stock shall not be entitled to receive any dividends. In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company or deemed liquidation event, the holders of shares of Series B Preferred Stock shall be entitled to be paid the liquidation amount, as defined out of the assets of the Company available for distribution to its shareholders, after distributions to holders of the Series A Preferred Stock and before distributions to holders of Common Stock. On November 25, 2019 the Company filed a Designation of Series C convertible Preferred Stock with the state of Nevada, designating 1,000,000 shares of the Series C Preferred Stock with a stated value of $1.00 per share. The Series C Preferred Stock will, with respect to dividend rights and rights upon liquidation, winding-up or dissolution, rank: (a) senior with respect to dividends with the Company’s common stock, par value $0.0001 per share (“Common Stock”)(the Series C Preferred Stock will convert into common stock immediately upon liquidation and be pari passu with the common stock in the event of litigation), and (b) junior with respect to dividends and right of liquidation to all existing and future indebtedness of the Company. The Series C Preferred Stock does not have any voting rights. Each share of Series C Preferred Stock will carry an annual dividend in the amount of eight percent (8%) of the Stated Value of $1.00 (the “Divided Rate”), which shall be cumulative and compounded daily, payable solely upon redemption, liquidation or conversion and increase to 22% upon an event of default as defined. In the event of any default other than the Company’s failure to issue shares upon conversion, the stated price will be $1.50. In the event that a default event occurs where the Company fails to issue shares upon conversion, the stated price will be $2.00. The holder shall have the right six months following the issuance date, to convert all or any part of the outstanding Series C Preferred Stock into shares of common stock of the Company. The conversion price shall equal the Variable Conversion Price. The “Variable Conversion Price” shall mean 71% multiplied by the market price, representing a discount rate of 29%. Market price means the average of the two lowest trading prices for the Company’s common stock during the twenty trading day period ending on the latest complete trading day prior to the conversion date. Upon any liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, or upon any deemed liquidation event, after payment or provision for payment of debts and other liabilities of the Company, and after payment or provision for any liquidation preference payable to the holders of any Preferred Stock ranking senior upon liquidation to the Series C Preferred Stock, if any, but prior to any distribution or payment made to the holders of Common Stock or the holders of any Preferred Stock ranking junior upon liquidation to the Series C Preferred Stock by reason of their ownership thereof, the Holders will be entitled to be paid out of the assets of the Company available for distribution to its stockholders. The Company will have the right, at the Company’s option, to redeem all or any portion of the shares of Series C Preferred Stock, exercisable on not more than three trading days prior written notice to the Holders, in full, in accordance with Section 6 of the designations at a premium of up to 35% for up to six months. Company’s mandatory redemption: On the earlier to occur of (i) the date which is twenty-four (24) months following the Issuance Date and (ii) the occurrence of an Event of Default (the “Mandatory Redemption Date”), the Company shall redeem all of the shares of Series C Preferred Stock of the Holders (which have not been previously redeemed or converted). In conjunction with the Company’s intention to raise financing of up to $5 million through an offering of up to 500,000 Series D convertible Preferred Stock at the offering price of $10.00 per share, on March 29, 2021 the Company received a Notice of Qualification from the Securities and Exchange Commission indicating approval from the Company to proceed with the offering pursuant to Tier 2 of Regulation A of the Securities Act, which provides exemption from registration of such securities. Each Series D preferred share is convertible, at the option of the holder, at any time, into nonassessable common shares. The conversion right, of 80% of the average closing price reported on OTCMarkets, was initially based through June 30, 2021 on the average closing price of the Company’s common stock for the 20 trading days preceding conversion. Effective July 1, 2021 this basis was amended to the average closing price of the Company’s common stock for the 10 trading days preceding conversion. On April 5, 2021 the Company filed the necessary Certificate of Designation with the state of Nevada to designate 500,000 shares of Series D Preferred stock from the Company’s total authorized and unissued Preferred Stock. Through September 30, 2021, the Company has sold 161,000 Series D convertible Preferred Stock and received cash of $1,610,000. Of these stock sales, a total of 120,476 Series D Preferred shares were subsequently converted to 145,132,420 common shares at an average conversion rate of $0.0111 per common share, resulting in a remaining balance at September 30, 2021 of 40,524 Series D Preferred. Effective July 1, 2021 the Company increased its authorized common shares from 1 billion (1,000,000,000) to 2 billion (2,000,000,000) of $0.0001 par value each. The accompanying unaudited consolidated financial statements have been prepared assuming the Company will continue as a going concern, which implies that the Company would continue to realize its assets and discharge its liabilities in the normal course of business. As of September 30, 2021, the Company has a working capital deficiency of $4,336,962, an accumulated deficit of $38,539,915 and has a stockholder’s deficit of $4,336,962 and its operations continue to be funded primarily from sales of its stock, the issuance of convertible debentures and short-term loans. During the three and nine months ended September 30, 2021 the Company had a net loss of $319,262 and a net loss of $1,970,669, respectively, and net cash used in operations for the nine months ended September 30, 2021 and September 30, 2020 of $1,843,633 and $260,931, respectively. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the issuance of this report. The ability of the Company to continue as a going concern is dependent on the Company’s ability to obtain the necessary financing through the issuance of convertible notes and equity instruments. The unaudited consolidated financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. Management plans to continue to raise financing through equity sales and the issuance of convertible notes, and to continue to expand its revenue from its FanPass app and seek the acquisition of compatible businesses that will be beneficial to the Company. No assurance can be given that any such additional financing will be available, or that it can be obtained on terms acceptable to the Company and its stockholders. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation and Principles of Consolidation The unaudited consolidated financial statements include all the accounts of the Company and all of its wholly owned subsidiaries. All material intercompany accounts and transactions have been eliminated in consolidation. The Company’s fiscal year end is December 31. The accompanying unaudited consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the United States of America (the “U.S. GAAP”) for interim financial information. Operating results for interim periods are not necessarily indicative of results that may be expected for the fiscal year as a whole. These unaudited consolidated financial statements should be read in conjunction with the summary of significant accounting policies and notes to the consolidated financial statements for the year ended December 31, 2020 of the Company which were included in the Company’s annual report on Form 10-K as filed with the Securities and Exchange Commission April 28, 2021. Use of Estimates The preparation of these statements in accordance with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses in the reporting period. The Company regularly evaluates estimates and assumptions related to valuation of convertible debenture conversion options, derivative instruments, deferred income tax asset valuations, financial instrument valuations, share-based payments, other equity-based payments, and loss contingencies. The Company bases its estimates and assumptions on current facts, historical experience and various other factors that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the accrual of costs and expenses that are not readily apparent from other sources. The actual results experienced by the Company may differ materially and adversely from the Company’s estimates. To the extent there are material differences between the estimates and the actual results, future results of operations will be affected. In accordance with ASC 606, revenue is recognized when the following criteria have been met; valid contracts are identified with specific customers, performance obligations have been identified, price is determinable, price is allocated to performance obligations, and the Company has satisfied the performance obligations. Revenue generally is recognized net of allowances for returns and any taxes collected from customers and subsequently remitted to governmental authorities. During the three and nine months ended September 30, 2021 the Company derived its only revenue of $1,866 and $4,780, respectively, from subscription fees and merchandising sales from its Friendable and Fan Pass apps, which revenues were recognized when received. During the three and nine months ended September 30, 2020 the Company derived revenue primarily from the development of apps for a third party of $109,500 and $319,331, respectively, which was recognized upon completion of services, and secondarily from subscription fees from the Friendable and Fan Pass apps totaling $1,892 and $3,340, respectively, which was recognized when received. Subsequent to the launch of the Fan Pass app in July, 2020 and pursuant to various agreements between Fan Pass, Inc. and music artists, managers, talent agencies, partners and/or record labels and certain round one investors and convertible noteholders (collectively, “Revenue Share Participants”) such individuals and/or entities are eligible to receive a share of net proceeds derived by the Company from subscription receipts from the Fan Pass app and from merchandise sales. The Company has established an “Artist Pool” equal to 40% of net Fan Pass “Fan Subscriptions” received, in which the “pool” is paid out to individual artists based on fan activity or “Content Views” within an artist’s channel on the Fan Pass app. Additionally, a standard 50% of net merchandise sales (created by Fan Pass for each artist) received or sold by each artist is shared with each artist. In some instances, the Company may adjust the sharing percentage for special situation artists or “Mega Stars” who may command a different merchandise split. Certain investors, along with Series B Preferred stockholders, are entitled to proportionately participate in an “Investor Pool” equal to approximately 4% of net subscription and net merchandising sales receipts. In addition, as compensation for bringing music artists to perform for the initial Fan Pass app launch, Eclectic Artists is eligible receive 5% of Fan Pass net revenue, and the holder of a convertible note is entitled to receive a prorated share of 20% of Fan Pass net revenue up to $70,000 and, thereafter, a prorated share of 5% of Fan Pass net revenue for 5 years. Net revenue is defined as gross receipts, minus source commissions and other cost of goods sold as defined in the agreements, including deduction for the cost of merchandise, hosting, streaming and other platform and processing fees. During the three and nine months ended September 30, 2021 the Company incurred a revenue sharing expense of $920 and $2,124, respectively, and had a revenue share liability of $2,308 at September 30, 2021, which is included in accounts payable and accrued expenses. Sales and Marketing Costs The Company’s policy regarding sales and marketing costs is to expense such costs when incurred. During the three and nine months ended September 30, 2021, the Company incurred $127,269 and $393,321 respectively (2020: $30,081 and $82,335) in sales and marketing costs, primarily for social media promotion programs and amortization of deferred expense (see Page 23, Eclectic Artists Series A Preferred stock). The Company considers all highly liquid instruments purchased with a maturity of three months or less to be cash equivalents. Impairment of Long-Lived Assets The Company continually monitors events and changes in circumstances that could indicate carrying amounts of long-lived assets may not be recoverable. When such events or changes in circumstances are present, the Company assesses the recoverability of long-lived assets by determining whether the carrying value of such assets will be recovered through undiscounted expected future cash flows. If the total of the future cash flows is less than the carrying amount of those assets, the Company recognizes an impairment loss based on the excess of the carrying amount over the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or the fair value less costs to sell. Derivative liabilities The Company has a financial instrument associated with a debt restructuring agreement and conversion options embedded in convertible debt. The Company evaluates all its financial instruments to determine if those contracts or any potential embedded components of those contracts qualify as derivatives to be separately accounted for in accordance with ASC 815-10 – Derivative and Hedging – Contract in Entity’s Own Equity. This accounting treatment requires that the carrying amount of any derivatives be recorded at fair value at issuance and marked-to-market at each balance sheet date. In the event that the fair value is recorded as a liability, as is the case with the Company, the change in the fair value during the period is recorded as either other income or expense. Upon conversion, exercise or repayment, the respective derivative liability is marked to fair value at the conversion, repayment or exercise date and then the related fair value amount is reclassified to other income or expense partly as part of gain or loss on debt extinguishment and partly included in the gain or loss on change in fair value of derivatives. In July 2017, FASB issued ASU No. 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features. These amendments simplify the accounting for certain financial instruments with down-round features. The amendments require companies to disregard the down-round feature when assessing whether the instrument is indexed to its own stock, for purposes of determining liability or equity classification. The guidance was adopted as of January 1, 2019 and the adoption did not have any impact on its consolidated financial statement and there was no cumulative effect adjustment. Stock-based Compensation The Company records stock-based compensation in accordance with ASC 718, Compensation – Stock Based Compensation. ASC 718 requires companies to estimate the fair value of share-based awards on the date of grant using an option-pricing model. The Company uses the Black-Scholes option pricing model as its method in determining fair value. This model is affected by the Company’s stock price as well as assumptions regarding a number of subjective variables. These subjective variables include but are not limited to the Company’s expected stock price volatility over the terms of the awards, and actual and projected employee stock option exercise behaviors. The value of the portion of the award that is ultimately expected to vest is recognized as an expense in the statement of operations over the requisite service period. During January 2021, the Company awarded stock options to its 5 employees totaling 5 million common shares vesting quarterly over 2 years and 10 million common shares vesting quarterly over 3 years, both sets of options are exercisable at a price of $0.014 per share. In addition, during January 2021, stock options on 1.5 million common shares, vesting quarterly over 3 years, were issued to a prospective employee, at the exercise price of $0.015 per share. Applying the Black-Scholes valuation method, the total cost of these options is $194,700 and $24,750 respectively, which is being amortized to general and administrative expense over their lifetime. Of this total, the Company incurred a stock option expense of $65,024 for the nine months ended September 30, 2021 (2020: $0). All transactions in which goods or services are the consideration received for the issuance of equity instruments are accounted for based on the fair value of the consideration received or the fair value of the equity instrument issued, whichever is more reliably measurable. Accounts Receivable and Allowance for Doubtful Accounts The Company monitors its outstanding receivables for timely payments and potential collection issues. At September 30, 2021 and December 31, 2020, the Company did not have any allowance for doubtful accounts. Financial assets and financial liabilities are recognized in the balance sheet when the Company has become party to the contractual provisions of the instruments. The Company’s financial instruments consist of accounts receivable, accounts payable, convertible debentures, stock settled debt, derivatives, mandatorily redeemable Series C Preferred stock and promissory notes. The fair values of these financial instruments approximate their carrying value, due to their short-term nature, and current market rates for similar financial instruments. Fair value of a financial instrument is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company’s financial instruments recorded at fair value in the balance sheets are categorized based upon the level of judgment associated with the inputs used to measure their fair value. In each of the two years in the period ended December 31, 2020 the Company derived approximately 99% of its revenue from one client by providing certain project based software development services. That project was completed by the end of 2020. Since January 1, 2021 the Company’s sole source of revenue has been minimal receipts from subscribers to the Friendable and Fan Pass apps and from Fan Pass related merchandising sales. There are inherent risks whenever a large percentage of total revenues are concentrated with one primary client. It is not possible for us to predict the future level of demand for our services that will be generated by this client or the future demand for technology and software products and services from other similar clients. Until revenues generated from the Friendable and Fan Pass apps increase significantly the loss of this primary client, or the failure to retain similar clients, will negatively affect our revenues and results of operations and/or trading price of our common stock. The Company computes net loss per share in accordance with ASC 260, Earnings per Share. ASC 260 requires presentation of both basic and diluted earnings per share (EPS) on the face of the statement of operations. Basic EPS is computed by dividing net income (loss) available to common stockholders (numerator) by the weighted average number of shares outstanding (denominator) during the period. Diluted EPS gives effect to all dilutive potential common shares outstanding during the period using the treasury stock method and convertible preferred stock using the if-converted method. In computing diluted EPS, the average stock price for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options or warrants. Diluted EPS excludes all dilutive potential shares if their effect is anti-dilutive. As of September 30, 2021, there were approximately 4,190,838,922 potentially dilutive common shares outstanding, as follows. Potential dilutive shares 88,797,769 Warrants and Stock Options outstanding 56,083,822 Common shares issuable upon conversion of convertible debt 3,863,720,412 Common shares issuable upon conversion of Preferred Series A shares 1,136,000 Common shares issuable upon conversion of Preferred Series B shares 103,170,150 Common shares issuable upon conversion of Preferred Series C shares 77,930,769 Common shares issuable upon conversion of Preferred Series D shares The Company accounts for income taxes using the asset and liability method in accordance with ASC 740, Income Taxes. The asset and liability method provides that deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial reporting and tax bases of assets and liabilities and for operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using the currently enacted tax rates and laws that will be in effect when the differences are expected to reverse. The Company records a valuation allowance to reduce deferred tax assets to the amount that is believed more likely than not to be realized. Recent Accounting Pronouncements In August 2020, the FASB issued ASU 2020-06, Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40)—Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity. The ASU simplifies accounting for convertible instruments by removing major separation models required under current GAAP. Consequently, more convertible debt instruments will be reported as a single liability instrument with no separate accounting for embedded conversion features. The ASU removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception, which will permit more equity contracts to qualify for the exception. The ASU also simplifies the diluted net income per share calculation in certain areas. The new guidance is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, and early adoption is permitted for fiscal years beginning after December 15, 2020. The Company is currently evaluating the impact of the adoption of the standard on the consolidated financial statements. 3. RELATED PARTY TRANSACTIONS AND BALANCES During the nine months ended September 30, 2021, the Company incurred $480,884 (September 30, 2020: $369,558) in salaries and payroll taxes to officers, directors, and other related family employees with such costs being recorded as general and administrative expenses. During the nine months ended September 30, 2021, the Company incurred $22,500, $575,000, and $45,000 (September 30, 2020: $33,000, $332,834, and $45,000) in app hosting, software development and support and office rent to a company with two officers and directors in common with such costs being recorded as app hosting, software development and support and general and administrative expenses. As of December 31, 2020, the Company had a stock subscription receivable totaling $4,500 from an officer and director and from a company with an officer and director in common. This receivable was settled during the 3 months ended March 31, 2021 against the amount payable in accrued salaries to current directors and officers of the Company (see below). As of September 30, 2021 accounts payable, related party includes $55,821 (December 31, 2020: $190,320) due to a company with two officers and directors in common, and $1,138,908 (December 31, 2020: $918,408) payable in salaries to current directors and officers of the Company, which is included in accounts payable and accrued expenses. The amounts are unsecured, non-interest bearing and are due on demand. 4. CONVERTIBLE DEBENTURES On March 26, 2019 the Company entered into a Debt Restructuring Agreement (the “Agreement”) with Robert A. Rositano Jr. (“Robert Rositano”), Dean Rositano (“Dean Rositano”), Frank Garcia (“Garcia”), Checkmate Mobile, Inc. (“Checkmate”), Alpha 019 Capital Anstalt (“Alpha”), Coventry Enterprises, LLC (“Coventry”), Palladium Capital Advisors, LLC (“Palladium”), EMA Financial, LLC (“EMA”), Michael Finkelstein (“Finkelstein”), and Barbara R. Mittman (“Mittman”), each being a debt holder of the Company. Subsequent to March 26, 2019 Alpha sold all of its convertible debentures to Ellis International LP (“Ellis”). The debt holders agreed to convert their debt of approximately $6.3 million and accrued interest of approximately $1.8 million into an initial 5,902,589 shares of common stock as set forth in the Agreement upon the Company meeting certain milestones including but not limited to: the Company effecting a reverse stock split and maintaining a stock price of $1.00 per share; being current with its periodic report filings pursuant to the Securities Exchange Act; certain vendors and Company employees forgiving an aggregate of $1,000,000 in amounts owed to them; the Company raising not less than $400,000 in common stock at a post-split price of not less than $.20 per share; and certain other things as further set forth in the Agreement. The debt holders will be subject to certain lock up and leak out provisions as contained in the Agreement. As part of the Agreement the parties signed a Rights to Shares Agreement. Whereas the Agreement called for all the shares to be delivered at closing, the holders are generally restricted to beneficial ownership of up to 4.99% of the company’s common shares outstanding. The Rights to Shares Agreement allows for the Company to issue shares to each holder up the 4.99% limitation while preserving the holders’ rights to the total shares in schedule A of the Agreement. Accordingly, the 5,902,589 common shares were recorded as issuable in equity. On December 26, 2019, all parties signed an amendment to the Agreement which set forth, among other things, the following: Company Principals have given Holders notice that it has satisfied all conditions of closing. The Agreement is considered Closed as of November 5, 2019 (“Settlement Date”) and any conditions of closing not satisfied are waived. Reset Dates. The “Reset Dates” as set forth in Section 1(h) of the Agreement shall be as follows: March 4, 2020 and July 2, 2020. As of the reset dates the holders can convert all or part of the settled note amounts at the lower of (i) 75% of the closing bid price for the Common Stock on such respective Reset Date, or (ii) the VWAP for the Company’s Common Stock for the 7 trading days immediately preceding and including such respective Reset Dates. This reset provision provides for the issuance of additional shares above the initial 5,902,589 shares for no additional consideration as measured at each of the two reset dates. On March 4, 2020 the Company became obligated to issue an additional 36,193,098 shares of common stock and on July 2, 2020 it became obligated to issue an additional 63,275,242 shares, for a total amount of shares due of 105,370,930. The Company determined that the reset provision represents a standalone derivative liability. Accordingly, this debt restructure transaction was accounted for in 2019 as an extinguishment of debt for consideration equal to the $2,384,646 value of the 5,902,589 common shares issuable, based on the $0.404 quoted trading price of the Company’s common stock price on the settlement date, and the initial fair value of the derivative liability of $12,653,000, resulting in a loss on debt extinguishment of $6,954,920. Through the final reset date discussed below the Company adjusted its derivative liability to fair value at each reporting and settlement date, with changes in fair value reported in the statement of operations. The Company estimated the fair value of the obligations to issue common stock pursuant to the Debt Restructuring Agreement, as amended, using Monte Carlo simulations and the following assumptions: November 5, 2019 December 31, 2019 June 30, 2020 Volatility 617% 738.1% 293.6% Risk Free Rate 1.59% 1.6% .13% Expected Term 0.66 0.5 0.01 On the second (and final) reset date of July 2, 2020 the Company determined that the total common shares issuable to fully settle this debt amounted to 105,370,930 and a derivative liability no longer exists. The Company recognized a final loss on settlement of $640,821 which represents the difference between the fair value of the 105,370,936 common shares due and the fair value of the derivatives settled. On September 21, 2020, Ellis International LP (as successor to Alpha Capital Anstalt) submitted a request to drawdown and, on September 29, 2020, was issued 687,355 common shares against its entitlement above and reclassified from issuable shares in the accompanying balance sheet and statement of changes in stockholder deficit. On November 9, 2020 and on December 9, 2020 Coventry Enterprises requested and was issued 915,000 and 1,262,000 common shares respectively, and on November 23, 2020 Barbara Mittman requested and was issued 1,134,353 (net) common shares against their respective entitlement under the debt settlement agreement, which was reclassified from issuable shares. During the three months ended March 31, 2021 Ellis International LP requested and was issued a total of 28,211,310 common shares, Coventry Enterprises requested and was issued a total of 9,375,000 common shares, and Barbara Mittman requested and was issued a 3,180,000 common shares, all against their respective entitlements under the debt settlement agreement, which were reclassified from issuable shares. During the three months ended June 30, 2021 Ellis International LP requested and was issued a total of 21,000,000 common shares, Coventry Enterprises requested and was issued a total of 15,500,000 common shares, and Barbara Mittman requested and was issued 6,022,600 common shares, all against their respective entitlements under the debt settlement agreement, which were reclassified from issuable shares. During the three months ended September 30, 2021 Ellis International LP requested and was issued a total of 16,000,000 common shares. However, Ellis was only entitled to drawdown a total of 8,709,641 common shares to reach its maximum common shares allocation from its convertible debenture. The excess balance of 7,290,359 common shares, which carried a fair value of $91,129 based on the Company’s trading stock price of $0.0125 per share at the drawdown date, has been applied against the outstanding principal of $100,000 on the Ellis convertible note. The Company accounts for its obligation to issue common stock (“Reset Provision”) as derivative instruments in accordance with ASC Topic 815, “Derivatives and Hedging” which are reflected as liabilities at fair value on the consolidated balance sheet, with changes in fair value reported in the consolidated statement of operations. Fair value is defined as the price to sell an asset or transfer a liability in an orderly transaction between willing and able market participants. The number of shares of common stock the Company could be obligated to issue, is based on future trading prices of the Company’s common stock. To reflect this uncertainty in estimating the fair value of the potential obligation to issue common stock, the Company uses a Monte Carlo model that considers the reporting date trading price, historical volatility of the Company’s common stock, and risk-free rate in estimating the fair value of the potential obligation to issue common stock. The results of the Monte Carlo simulation model are most sensitive to inputs for expected volatility. Depending on the availability of observable inputs and prices, different valuation models could produce materially different fair value estimates. The estimated fair values may not represent future fair values and may not be realizable. We categorize our fair value estimates in accordance with ASC 820 based on the hierarchical framework associated with the three levels of price transparency utilized in measuring financial instruments at fair value as discussed above. The following is a summary of activity related to the reset provision derivative liability through the final reset date of July 2, 2020: Balance, Derivative Liability at December 31, 2019 $ 12,778,000 Record obligation to issue additional shares (13,474,821 ) Loss on settlement of derivative 640,821 Loss on change in fair value of derivative 56,000 Balance, Reset provision derivative liability at December 31, 2020 and September 30, 2021 $ - 5. CONVERTIBLE PROMISSORY NOTES The following is a summary of Convertible Promissory Notes at September 30, 2021: Issuance Principal Accrued Principal and Date Outstanding Interest Accrued interest J.P.Carey Inc. May 20, 2020 $ 60,000 $ 19,767 $ 79,767 J.P.Carey Inc. June 11, 2020 10,000 - 10,000 J.P.Carey Inc. March 3, 2021 150,000 8,671 158,671 Ellis International LP October 13, 2020 100,000 9,669 109,669 Anvil Financial Management LLC January 1, 2021 9,200 550 9,750 Total 329,200 $ 38,657 $ 367,857 Less: J.P.Carey Inc excess debt conversions to be allocated against other outstanding notes (80,129 ) Less: Ellis International LP excess common stock drawdown to be offset against Ellis convertible note (91,129 ) Less: Unamortized discounts (65,334 ) Net carrying value: September 30, 2021 $ 92,608 The following is a summary of Convertible Promissory Notes at December 31, 2020: Issuance: Principal Accrued Principal and J.P. Carey Inc. March 30, 2017 - $ 20,029 $ 20,029 J.P. Carey Inc May 20, 2020 $ 60,000 8,996 68,996 J.P. Carey Inc June 11, 2020 10,000 - 10,000 Green Coast Capital International April 6, 2020 10,755 848 11,603 Trillium Partners LP December 3, 2020 21,436 258 21,694 Total $ 229,691 $ 32,466 $ 262,157 Net carrying value December 31, 2020 $ 143,957 The derivative fair value of the above at September 30, 2021 and at December 31, 2020 is $237,900 and $1,320,000, respectively. Further information concerning the above Notes is as follows: JP Carey Convertible Note dated March 30, 2017 and assignments. On April 7, 2017, the Company entered into a Settlement Agreement with Joseph Canouse (the “Agreement”). The Company and Mr. Canouse had been in a dispute regarding what amount, if any, was owed pursuant to a consulting agreement between the parties signed in April 2014. In December 2016, Mr. Canouse obtained a judgment in state court in Georgia and the right to garnish the Company’s bank accounts. Pursuant to the Settlement Agreement, the Company agreed to issue an 8% Convertible Note in the principal amount of $82,931 (the “Note”). The Note was issued to J.P. Carey LLC an entity controlled by Mr. Canouse. Although the Note is dated March 30, 2017, it was issued on April 7, 2017. The note maturity date was September 30, 2017. In return for the issuance of the Note, Mr. Canouse filed a Consent Motion to Withdraw Judgment, dismiss all garnishments, and cease all collection activities. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date at the lower of (i) the closing sale price of the common stock on the trading day immediately preceding the closing date, which was $20.00 per share, and (ii) 50% of the lowest sale price for the common stock during the twenty-five (25) consecutive trading days immediately preceding the conversion date or the closing bid price, whichever is lower. Mr. Canouse does not have the right to convert the Note, to the extent that he would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date of September 30, 2017 and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 24% per annum and the Note becomes immediately due and payable. The Company defaulted by not paying the principal and interest on September 30, 2017 and has been recording interest at the 24% default rate. The Company also defaulted by being late with filing the Form 10-K on May 29, 2020. During the year ended December 31, 2019, J.P. Carey converted $1,002 of principal into 120,000 shares of the Company’s common stock at a price of $0.0084 and J.P. Carey assigned $10,000 of the note to World Market Ventures, LLC and assigned $6,000 of the note to Anvil Financial Management Ltd LLC. The assignments carry the same conversion rights as the original note. World Market Ventures converted $6,000 of principal into 120,000 shares of the Company’s common stock at a price of $0.05. Anvil converted $6,000 of principal into 120,000 shares of the Company’s common stock at a price of $0.05. At December 31, 2019, the J.P. Carey note balance including accrued interest of $51,980 was $121,910, including the portion assigned to World Market Ventures of $4,000. During the year ended December 31, 2020: J.P. Carey converted $30,930 of principal and $18,020 of interest into 1,642,162 shares of the Company’s common stock at a price of $0.029. World Market Ventures converted the remaining balance of $4,000 of principal into 72,595 shares of the Company’s common stock at a price of $0.0551. On April 6, 2020 JP Carey assigned $35,000 of the note to Green Coast Capital International. The assignment carries the same conversion rights as the original note. During the year ended December 31, 2020 Green Coast converted $24,245 of principal into 859,283 shares of common stock of the Company at an average price of $0.029 and the Company incurred $414 of interest on the assigned note. As of December 31, 2020 and June 30, 2021 the assigned note had a principal balance of $10,755 and an accrued interest balance of $848 and $1,275, respectively, which has been accounted for as having a derivative liability due to the variable conversion price. On August 10, 2021 Green Coast exercised its right to convert the principal balance of $10,755 and accrued interest of $1,389 into 3,238,544 common shares in full settlement. On December 3, 2020 JP Carey assigned $25,000 of the accrued interest balance to Trillium Partners LP. The assignment carried the same conversion rights as the original note. On December 23, 2020 Trillium converted $3,564 of principal, $214 of interest and $1,025 conversion fee into 1,372,200 common stock at an average price of $0.0035. As of December 31, 2020 the assigned note had a principal balance of $21,436 and an accrued interest balance of $258. On January 18, 2021 Trillium converted $8,317 of principal, $310 of interest and $1,025 conversion fee into 2,413,023 common stock at an average price of $0.004 and on January 27, 2021 Trillium converted the remaining balance of $13,119 of principal, $95 of interest and $1,025 conversion fee into 2,819,582 common stock at an average price of $0.00505. As of March 31, 2021 therefore, this assigned note has been fully converted to common shares by Trillium. As of December 31, 2020 the remaining accrued interest on the original JP Carey note was $20,029. During the three months ended March 31, 2021 JPCarey claimed a total of six additional conversions to common stock totaling $120,580, represented $116,080 in accrued interest and $4,500 in conversion fees, and received a total of 22,515,748 common shares at an average price of $0.0545 to fully convert the remaining balance on the note. Adjusting for additional interest expense, the Company believes that a cumulative amount of $80,129 has been received by JPCarey in excess of the remaining balance due. The Company is presently in negotiation with JPCarey to apply this excess to additionally retire the two outstanding JP Carey notes of $60,000 and $10,000, together with all accrued interest thereon. Green Coast Capital International Securities Purchase Agreement and Convertible Note dated April 8, 2020 On April 8, 2020, the Company entered into a Securities Purchase Agreement (the “SPA”) with Green Coast whereby the Company agreed to sell to the holder convertible notes in amounts up to $150,000. The note holder shall be entitled to a pro rata share of 20% of the net revenues (excluding Brightcove) derived from subscriptions and other sales of Fan Pass, Inc., a wholly owned subsidiary of the Company. The pro rata 20% pays out two times the initial investment and continues at 5% for a period of five years. On April 8, 2020, pursuant to the Securities Purchase Agreement, the Company issued a 0% note to Green Coast with a maturity date of October 8, 2020 and received $35,000 in cash. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date at $0.02 per share. On the date of issuance, the Company recorded a derivative liability of $228,000, resulting in derivative expense of $193,000 and a discount against the note of $35,000 to be amortized into interest expense through the maturity date of October 8, 2020. Green Coast exercised its conversion right on November 17, 2020 and received 175,000 common shares in full settlement of the outstanding principal. JP Carey Securities Purchase Agreement and Convertible Note dated May 20, 2020 On May 20, 2020, the Company entered into a Securities Purchase Agreement (the “SPA”) whereby the Company agreed to sell to the holder convertible notes in amounts up to $60,000. The note holder shall be entitled to a pro rata share of 20% of the net revenues (excluding Brightcove) derived from subscriptions and other sales of Fan Pass, Inc., a wholly owned subsidiary of the Company. The 20% pays out two times the initial investment and continues at 5% for a period of five years. On May 20, 2020 the Company issued a 0% interest rate note to JP Carey under this SPA with a maturity date of January 1, 2021 and received $60,000 in cash in three closings; $30,000 on April 9, 2020, $15,000 on May 13, 2020, and $15,000 on May 20, 2020. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date at $0.02 per share. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.9% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 24% per annum and the note becomes immediately due and payable. Under certain default events the Company may incur a penalty of 20% to 50% of the note principal. Further, if the Company fails to comply with the exchange act the conversion price is the lowest price quoted on the trade exchange during the delinquency period. Upon certain default events the conversion price may change. Therefore, the embedded conversion option is bifurcated and treated as a derivative liability. On the date of issuance, the Company recorded a derivative liability of $233,000, resulting in derivative expense of $173,000 and a discount against the note of $60,000 to be amortized into interest expense through the maturity date. The Company defaulted by being late with filing the Form 10-K on May 29, 2020. The Company accrued $19,767 of interest at the default rate of 24% for the period from May 29, 2020 to September 30, 2021. JP Carey Convertible Note dated June 11, 2020. On June 11, 2020, the issued a 0% note to JP Carey with a maturity date of January 15, 2021 and received $10,000 in cash. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date at $0.01 per share. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 9.9% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 24% per annum and the note becomes immediately due and payable. Under certain default events the Company may incur a penalty of 20% to 50% of the note principal. Further, if the Company fails to comply with the exchange act the conversion price is the lowest price quoted on the trade exchange during the delinquency period. Upon certain default events the conversion price may change. Therefore, the embedded conversion option is bifurcated and treated as a derivative liability. On the date of issuance, the Company recorded a derivative liability of $63,000, resulting in derivative expense of $53,000 and a discount against the note of $10,000 to be amortized into interest expense through the maturity date. Ellis International LP Convertible Note dated October 13, 2020. On October 13, 2020, the Company issued a 10% convertible note in the principal amount of $100,000 to Ellis International LP with a maturity date of October 13, 2022 and received cash of $95,000 (net of $5,000 deducted for the noteholder’s legal fees). The Note is convertible into common stock, subject to Rule 144, at any time after the issue date. The Conversion Price shall be 75% of the 3 day VWAP as reported by Bloomberg LP for the 3 trading days preceding conversion. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 18% per annum and the note becomes immediately due and payable. At September 30, 2021 and at December 31, 2020 the outstanding balance on the note was $100,000 principal and $9,669 and $2,190 accrued interest, respectively. During the three months ended September 30, 2021 Ellis International LP requested and was issued a total of 16,000,000 common shares against its Convertible Debenture settlement (see Note 4). However, Ellis was only entitled to drawdown a total of 8,709,641 common shares to reach its maximum common shares allocation from its settlement. The excess balance of 7,290,359 common shares, which carried a fair value of $91,129 at the drawdown date based on the Company’s trading price of $0.0125 on that date, has been applied as an offset against the outstanding principal of $100,000 on the Ellis convertible note pending resolution of this issue with Ellis. Trillium Partners LP Convertible Note dated December 8, 2020 On December 8, 2020, the Company issued a 8% convertible note in the principal amount of $27,500 to Trillium Partners LP with a maturity date of December 8, 2021 and received cash of $25,000 (net of $2,500 deducted for the noteholder’s legal fees). The Note is convertible into common stock, subject to Rule 144, at any time after the issue date The Conversion Price shall be equal to the lower of: (i) the Fixed Price of $0.001 per share; and (ii) the Variable Conversion Price, being 50% of the lowest trading price for the common stock during the 30 trading day period prior to conversion. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 18% per annum and the note becomes immediately due and payable. On February 4, 2021 and March 10, 2021 Trillium exercised its right of conversion on a total of $21,000 principal, $222 accrued interest and $2,050 conversion fees, and received a total of 3,784,052 of the Company’s common shares, at an average of $0.00615 per share, leaving an outstanding principal balance of $6,500 and accrued interest of $1,111 at June 30, 2021. On September 15, 2021 the Company paid off in cash the remaining note liability of $6,500 principal and accrued interest, together with a prepayment penalty of $3,477. Anvil Financial Management, LLC Convertible Note dated January 1, 2021 On January 1, 2021 Company issued a 8% convertible note in the principal amount of $9,200 to Anvil Financial Management, LLC with a maturity date of July 1, 2021 in payment of introducing financing to the Company. The Note was recorded as a discount to be amortized over the debt term. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date. The Conversion Price shall be equal to the lower of: (i) the Fixed Price of $0.10 per share; and (ii) the Variable Conversion Price, being 60% of the average of the two lowest bid closing trading prices for the common stock during the 10 trading day period prior to conversion. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 9.99% of our outstanding common stock. As additional compensation, Anvil was issued a 5 year warrant to purchase 92,000 of the Company’s common stock at a price of $0.25 per share. In accordance with Black Scholes valuation requirements, this Purchase Warrant has a fair value of $2,015, but the relative fair value was recorded as a discount as discussed below. At September 30, 2021 the outstanding balance on the note was $9,200 principal and $550 accrued interest. Trillium Partners LP Convertible Note dated January 22, 2021 On January 22, 2021, the Company issued a 8% convertible note in the principal amount of $27,500 to Trillium Partners LP with a maturity date of January 22, 2022 and received cash of $25,000 (net of $2,500 expense deducted for the noteholder’s legal fees). The Note is convertible into common stock, subject to Rule 144, at any time after the issue date. The Conversion Price shall be equal to the lower of: (i) the Fixed Price of $0.001 per share; and (ii) the Variable Conversion Price, being 50% of the lowest trading price for the common stock during the 30 trading day period prior to conversion. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the amount of principal and interest not paid when due bear default interest at the rate of 18% per annum and the note becomes immediately due and payable. On August 16, 2021 Trillium exercised its right of conversion on the $27,500 principal and $1,218 accrued interest, and received a total of 7,557,245 of the Company’s common shares at an average of $0.0038 per share, in full settlement of the note. Trillium Partners LP Secured Convertible Note dated March 3, 2021 On March 3, 2021, the Company issued a 10% convertible note in the principal amount of $150,000 to Trillium Partners LP with a maturity date of March 3, 2022 and received cash of $122,500 (net of Original Issue Discount of $15,000 and $12,500 expense deducted for the noteholder’s legal fees). The $15,000 was recorded as debt discount to be amortized over the debt term. The Note is convertible into common stock, subject to Rule 144, at any time after the issue date. The Conversion Price shall be equal to the Fixed Price of $0.005 per share. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the Conversion Price becomes the lower of $0.005 per share or 50% of the lowest trading price during the trading day immediately preceding the Conversion Date. In addition, in the event of default where the amount of principal and interest is not paid when due shall bear default interest at the rate of 22% per annum until paid. The note, together with accrued interest, may be prepaid prior to maturity at premiums of between 110% and 135%. The Original Issue Discount of $15,000, deducted from note proceeds, is being amortized to interest expense over the 12 month term of the note. The principal amount and interest is defined under the note agreement as being “Senior ” with priority in right of payment over all other indebtedness of the Company outstanding as of March 3, 2021. In addition, the obligations under the note are secured by a first lien and security interest in all of the assets of the Company pursuant to the terms of a Security Agreement. As further inducement for Trillium to agree to the terms of the note, on March 3, 2021 the Company issued a 5 year Common Stock Purchase Warrant to Trillium for 30,000,000 fully paid and nonassessable shares of the Company’s common stock at an exercise price of $0.005 per share. In accordance with Black Scholes valuation requirements, this Purchase Warrant has a fair value of $741,000, but the relative fair value was recorded as a debt discount, as discussed below. On September 10, 2021 and September 23, 2021 Trillium exercised its right of conversion on the $150,000 principal and $7,562 accrued interest, and received a total of 31,551,205 of the Company’s common shares, at the rate of $0.005 per share in full settlement of the note. JP Carey Secured Convertible Note dated March 3, 2021 On March 3, 2021, the Company issued a 10% convertible note in the principal amount of $150,000 to JP Carey Enterprises, Inc. with a maturity date of March 3, 2022 and received cash of $122,500 (net of Original Issue Discount of $15,000 and $12,500 expense deducted for the noteholder’s legal fees). The Note is convertible into common stock, subject to Rule 144, at any time after the issue date. The Conversion Price shall be equal to the Fixed Price of $0.005 per share. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the Conversion Price becomes the lower of $0.005 per share or 50% of the lowest trading price during the trading day immediately preceding the Conversion Date. In addition, in the event of default where the amount of principal and interest is not paid when due shall bear default interest at the rate of 22% per annum until paid. As further inducement for JP Carey to agree to the terms of the note, on March 3, 2021 the Company issued a 5 year Common Stock Purchase Warrant to JP Carey for 30,000,000 fully paid and nonassessable shares of the Company’s common stock at an exercise price of $0.005 per share. In accordance with Black Scholes valuation requirements, this Purchase Warrant has a fair value of $741,000, but the relative fair value was recorded as a debt discount, as discussed below. At September 30, 2021 the outstanding balance on the note was $150,000 principal and $8,671 accrued interest. FirstFire Global Opportunities Fund LLC note dated March 9, 2021 On March 9, 2021, the Company issued a 10% convertible note in the principal amount of $110,000 to FirstFire Global Opportunities Fund LLC with a maturity date of March 9, 2022 and received cash of $88,500 (net of Original Issue Discount of $10,000, a finder’s fee of $10,000 to Primary Capital LLC and $1,500 expense deducted for the noteholder’s legal fees). The Company recorded $20,000 of the fees as discounts and expensed $1,500. The Note is convertible into common stock, subject to Rule 144, at any time after 180 days from the issue date. The Conversion Price shall be equal to the Fixed Price of $0.01 per share. The holder does not have the right to convert the note, to the extent that the holder would beneficially own in excess of 4.99% of our outstanding common stock. The note defines several events that constitute default including failure to pay principal and interest by the maturity date and failure to comply with the exchange act. In the event of default, the Conversion Price becomes $0.005 per share. In addition, in the event of default where the amount of principal and interest is not paid when due shall bear default interest at the rate of 20% per annum until paid. The note, together with accrued interest, may be prepaid prior to maturity at a premium of 115%. As further inducement for FirstFire to agree to the terms of the note, on March 10, 2021 the Company issued 3,500,000 common shares to FirstFire as payment for a commitment fee, which had a fair value of $62,300 at time of issuance, but the relative fair value was recorded as debt discount as discussed below. In addition, on March 9, 2021 the Company issued a 3-year Common Stock Purchase Warrant to FirstFire on 3,500,000 fully paid and nonassessable shares of the Company’s common stock at an exercise price of $0.025 per share. In accordance with Black Scholes valuation requirements, this Purchase Warrant has a fair value of $66,500, but the relative fair value was recorded as debt discount as discussed below. On March 11, 2021, in addition to the above mentioned finder’s fee, Primary Capital LLC was also issued a 3 year Common Stock Purchase Warrant for 1,000,000 fully paid and nonassessable shares of the Company’s common stock at an exercise price of $0.01 per share and a 3 year Common Stock Purchase Warrant on 350,000 fully paid and nonassessable shares of the Company’s common stock at an exercise price of $0.025 per share. In accordance with Black Scholes valuation requirements, the fair value of these Purchase Warrants was $18,000 and $6,300 respectively, but the relative fair value was recorded as debt discount as discussed below. On September 20, 2021 the Company exercised its right to prepay the note and remitted cash totaling $130,000 to FirstFire, representing the prepayment of $110,000 principal, accrued interest of $5,816 and prepayment penalty of $14,184. As discussed above, the Company determined that the conversion options embedded in certain convertible debt meet the definition of a derivative liability. The Company estimated the fair value of the conversion options at the date of issuance, and at September 30, 2021, using Monte Carlo simulations and the following range of assumptions: Volatility 139.96% – 234.97% Risk Free Rate 0.04% – 0.09% Expected Term 0.25 – 1.04 Loss on Conversion of Convertible Notes in the Three Months Ended September 30, 2021 The fair value of common shares issued upon conversion of convertible notes during the three months ended September 30, 2021 was $333,451 based on the quoted trading prices of the Company’s common stock on conversion dates. The total notes and accrued interest converted was $198,648, resulting in a loss on conversion of $134,803 which is included in derivative expense in the accompanying Statement of Operations. Warrants Issued Related to Notes The Company recorded a relative fair value of $301,411 for all the warrants issued with Notes or issued as finder’s fees relating to Notes issued in the three months ended March 31, 2021. The discounts are being amortized over the respective Note terms. The following is a summary of activity related to the embedded conversion options derivative liabilities for the nine months ended September 30, 2021. Balance, December 31, 2020 $ 1,320,000 Initial derivative liabilities charged to operations 1,796,835 Initial derivative liabilities recorded as debt discount 74,165 Gain on settlement of derivatives upon conversion and change in fair value of derivatives (2,953,100 ) Balance, September 30, 2021 $ 237,900 6. SHORT TERM LOANS The Company received short term, interest free, loans of $10,000, $16,000, $15,000 and $20,000 (total $61,000) on July 9, 2020, August 13, 2020, September 2, 2020 and September 28, 2020 respectively, from Joseph Canouse, the provider of the J.P. Carey Inc. convertible promissory notes. The balance was $61,000 at September 30, 2021 and December 31, 2020. 7. COMMITMENTS AND CONTINGENCIES The following summarizes the Company’s commitments and contingencies as of September 30, 2021: (12) Employment agreements with related parties. On April 3, 2019, the Company entered into employment agreements with three officers. Pursuant to the agreements, the Company shall pay officers an aggregate annual salary amount of $400,000. Upon a successful launch of the Company’s Fan Pass mobile app or website, and the Company achieving various levels of subscribers, the officers are eligible to receive additional bonuses and salary increases. With mutual agreement with the Company, effective August 31, 2020 one of the officers chose early termination of his employment, which reduced the annual commitment for the remaining officers to $300,000. (ii) Lawsuit Contingency-Integrity Media, Inc. Integrity Media, Inc. (“Integrity”) had previously filed a lawsuit against the Company and the CEO of the Company for $500,000 alleging breach of contract alleging the Company failed to deliver marketable securities in exchange for services. The Company answered the allegations in court and Integrity filed a motion attacking the Company’s answers. While the court did not strike those responses, the clerk of the court entered a default judgment against the Company in the amount of $1,192,875 plus 10% interest. On May 8, 2019, the Company received a tentative ruling on the Company’s motion to vacate the default judgement whereby the previously entered default judgement was voided and a trial date of August 26, 2019 was set. On September 19, 2019, the Company entered into a Settlement Agreement, as Amended, with Integrity Media settling the civil action known as Integrity Media, Inc. vs. Friendable, Inc. et al., Orange County Case No. 30-2016-00867956-CU-CO-CJC. Pursuant to the Settlement Agreement, the Company agreed to issue to Integrity 750,000 shares of its common stock to be issued in tranches every 30 days or according to the instructions of Integrity, in exchange for 275 of the Company’s preferred shares held by Integrity and the cash payment of $30,000 for costs. Robert Rositano, the Company’s CEO, has also personally guaranteed the Company’s compliance with the terms of the Settlement Agreement. The cash payment is to be made within 6 months of the date of the Settlement Agreement. However, at the date of this filing both the $30,000 cash payment has not been made and the preferred shares have not been returned. Additionally, Integrity will be entitled to additional shares if (i) the price of the Company’s common stock is below $1.34 at either the 120 day or 240 day reset dates set forth in the Company’s Debt Restructure Agreement as amended entered into with various debt holders on March 26, 2019 effective November 5, 2019. The Company determined that a total of 4,275,000 additional shares would be issuable on the first “reset” date of March 4, 2020 based on a share price of $0.20 on that date and a total of 7,537,500 additional shares would be issuable on the second “reset” date of July 2, 2020 based on a share price of $0.08 on that date, for a total of 12,562,500 shares. Integrity will also be entitled to a “true-up” by the issuance of additional common shares on the issuance date should the share price of the Company’s common stock on the issuance date be below $1.00. It was determined by the Company that its liability was $1,005,000 ($750,000 plus a premium of $255,000), in accordance with ASC 480. On August 28, 2020 Integrity requested and was issued 750,000 common shares, which Integrity advised the Company realized $16,625 when sold. Accordingly, at December 31, 2020 the Company reduced its liability payable in common stock from $1,005,000 to $988,375. On October 14, 2020 the Company filed a “Declaration” with the Santa Clara County Courts challenging Integrity’s future ability to convert additional shares based on “Stock Market Manipulation” designed to harm the Company’s share price, valuation and number of shares issuable to Integrity following its sales. Additionally, the Company contended that Integrity disregarded the volume limitation set forth in its settlement for the Company’s thinly traded securities and caused a potential third party capital investment of $150,000 to be rescinded. The court agreed with the Company’s declaration that Integrity should have filed a motion so the Company would have the opportunity to present all arguments and evidence in opposition to deny Integrity’s application to enter judgment. On June 29, 2021 Integrity Media’s attempt to again obtain a motion for entry and enforcement of the judgement was denied in favor of an entirely separate lawsuit, if any, to be brought to try to resolve any disputes with either the original settlement agreement or with the entry of stipulated judgement itself. The matter therefore continues, unresolved. (iii) Lawsuit Contingency- Infinity Global Consulting Group Inc Infinity Global Consulting Group Inc. had previously filed a default judgement on May 29, 2018 in the 11th Judicial Circuit, Miami-Dade County, Florida court alleging that it was owed a services fee of $97,000, plus an entitlement to a warrant to purchase 5 million of the Company’s common shares at $0.03 per share. The Company believes that this claim is without merit since service on the Company was defective and the Company never received an actual notice of the lawsuit. Accordingly, on November 16, 2020 the Company filed a motion to set aside the default judgement. At the date of this filing, the motion still awaits a hearing and no accrued expense at September 30, 2021 has been established. (iv) Claim asserted by StockVest On March 11, 2021 the Company received claims asserted by StockVest for (a) the issuance of 1,054,820 common shares (market value of approximately $19,000) representing anti-dilution stock as additional compensation for services provided to the Company pursuant to a certain Consulting, Public Relations and Marketing Letter Agreement dated July 6, 2017, and (b) because said additional stock had not been issued by the Company, StockVest asserted an additional claim for liquidated damages of $155,000. The Company believes that these asserted claims are without merit. Accordingly, no accrued expense at September 30, 2021 has been established for these claims. COVID-19 Disclosure The coronavirus pandemic has at times adversely affected the Company’s business and is expected to continue to adversely affect certain aspects of our merchandise offerings and custom artist collections of merchandise specifically. This impact on our operations, supply chains and distribution systems may also impair our ability to raise capital. There is uncertainty around the duration and breadth of the COVID-19 pandemic and, as a result, uncertainty on the ultimate impact on our business. Such impact on the Company’s financial condition and operating results cannot be reasonably estimated at this time, since the extent of such impact is dependent on future developments, which are highly uncertain and cannot be predicted. 8. COMMON AND PREFERRED STOCK Common Stock: During the year ended December 31, 2020, the Company: Cancelled 2,000 shares of common stock valued at $500 previously issued to an investor under a securities purchase agreement and returned the $500 to the investor. Issued 7,005,855 shares of common stock on conversion of $127,524 of convertible notes, and accrued interest, at a fair value of the shares of $215,015, based on the quoted trading price on the conversion dates resulting in a loss on extinguishment of $87,491. Issued 5,736,333 shares of common stock and recorded the obligation to issue a further 506,667 common shares, collectively valued at $552,050 based on the quoted price on the grant dates, in payment for services primarily to music artists providing live performances for the July 24, 2020 launch of the Fan Pass app. Recorded the obligation to issue 36,193,098 and 63,275,243 additional shares of common stock based on the first and second reset dates in accordance with the debt restructuring agreement (See note 5). Issued 750,000 common shares to Integrity Media pursuant to the Company’s settlement agreement, which Integrity Media advised had a realized value of $16,625. Issued 7,196,264 common shares to parties where the original liability required the obligation to record such shares as issuable. Issued 54,076 common shares to the Company’s founder upon conversion of 3 Series A Preferred Shares to meet their personal commitment to transfer certain common shares to the investors. Recorded the obligation to issue 2,250,000 common shares in consideration for $60,000 received in cash. Issued 26,527,179 common shares upon conversion of Series C preferred stock having a value of $353,678. During the three months ended March 31, 2021, the Company: Issued 31,532,405 shares of common stock to two convertible note holders for partial conversion of an aggregate of $167,743 of the notes and accrued interest at an average price of approximately $0.0053. Granted 3,500,000 shares of common stock to a noteholder as a commitment fee valued at its relative fair value of $11,924. Issued, from issuable, an additional 40,766,310 shares of common stock based on the second reset date of July 2, 2020 in accordance with the debt restructuring agreement (See Note 5). Issued a total of 5,500,894 common shares on conversion of 23,500 Preferred Series C shares having a redemption value of $36,190, including accrued dividend, plus a premium of $14,399, for an aggregate of $50,589. Settled the common stock subscription receivable of $4,500 against the amount payable in accrued salaries to current directors and officers of the Company. During the three months ended June 30, 2021, the Company: Issued a total of 42,522,600 common shares to the holders of convertible debentures, which were recorded as reclassifications from issuable to issued common shares. Issued 2,555,738 common shares upon conversion of 50 Series A preferred stock Issued 31,029,932 common shares upon conversion of 44,970 Series D preferred stock During the three months ended September 30, 2021, the Company: Issued a total of 8,709,641 common shares to the holders of convertible debentures, which were recorded as reclassifications from issuable to issued common shares. Issued 7,290,359 common shares to a convertible debenture holder in excess of their entitlement valued at $91,129 , which will be offset against a separate convertible note also issued to that holder. Issued 17,799,687 common shares upon conversion of Series C preferred stock having a book value of $162,654. Issued 114,102,488 common shares upon conversion of 75,506 Series D preferred stock Issued 42,352,994 common shares with a fair value of $333,451 upon conversion of convertible notes with bifurcated derivatives and accrued interest, resulting in a loss on conversion of $134,803 which is included in derivative expense. Issued 2,000,000 common shares in payment of services valued at a total of $17,400 based on the quoted trade price of $0.0087 on the grant date. For sales of Series D preferred stock see page 26. Preferred Stock: Series A: The Series A Preferred Stock was authorized in 2014 and is convertible into nine (9) times the number of common stock outstanding at time of conversion until the closing of a Qualified Financing (Through June 30, 2021 “Qualified Financing” was defined as the sale and issuance of the Company’s equity securities that results in gross proceeds in excess of $2,500,000. Effective July 1, 2021 this was amended so that “Qualified Financing” is now defined as the sale and issuance of the Company’s equity securities that results in gross proceeds in excess of $10,000,000.). The number of shares of common stock issued on conversion of Series A preferred stock is based on the ratio of the number of shares of Series A preferred stock converted to the total number of shares of preferred stock outstanding at the date of conversion multiplied by nine (9) times the number of common stock outstanding at the date of conversion. After the qualified financing the conversion shares issuable shall be the original issue price of the Series A preferred stock divided by $0.002. The holders of Series A Preferred stock are entitled to receive non-cumulative dividends when and if declared at a rate of 6% per year. On all matters presented to the stockholders for action the holders of Series A Preferred stock shall be entitled to cast votes equal to the number of shares the holder would be entitled to if the Series A Preferred stock were converted at the date of record. During the year ended December 31, 2019, 588 shares of Series A preferred stock were converted to common stock by two related parties who donated them to the Diocese of Monterey. In addition, 890 Series A shares were converted into 2,018,746 common shares by parties related to the two directors. The 2,018,746 common shares were issuable as of December 31, 2019 and were subsequently issued during the six months ended June 30, 2020. During the six months ended June 30, 2020 two directors converted 3 shares of Series A Preferred Stock into 54,076 shares of common stock. On June 3, 2020 the Company and Eclectic Artists LLC (“E Artists”) entered into a Partner Agreement and Stock Subscription Agreement, pursuant to which E Artists will engage musical artists and other talent to engage on the Company’s FanPass platform, providing live streaming events available through the FanPass mobile application for a term of 18 months. As compensation for bringing the artists to the FanPass platform, E Artists will receive 5% of net revenue attributable to the Fan Pass platform, initially for a period of 18 months. In addition, E Artists will receive Series A preferred stock such that when converted would be equal to 5% of the outstanding common stock. The number of Series A preferred shares was calculated at 118 shares valued at $135,617 based on the quoted trading price of the Company’s common stock of $0.0605 on the agreement date and 2,241,596 equivalent common shares. The Company recorded a prepaid expense of $135,617 and has amortized a total of $97,010 as sales and marketing expense for the period through June 30, 2021, which includes amortization of $44,793 for the six months ended June 30, 2021 (2020 $6,682). Concurrent with the issuance of the Series A Shares to E Artists, Robert Rositano, Jr., the Company’s CEO and Dean Rositano, the Company’s president, returned an aggregate of 118 Series A Preferred shares to the Company’s treasury. On May 6, 2021 50 Series A Preferred shares held by a third party were converted to 2,555,738 common shares. After this conversion the total issued and outstanding Series A Preferred shares were reduced from 19,786 to 19,736. On September 2, 2021 52 Series A Preferred shares held by a third party were converted to 4,928,511 common shares. After this conversion the total issued and outstanding Series A Preferred shares were further reduced from 19,736 to 19,684. Series B: On August 8, 2019 the Company filed a Designation of Series B convertible Preferred Stock with the state of Nevada, designating 1,000,000 shares of the Series B Preferred Stock with a stated value of $1.00 per share. A holder of Series B Preferred Stock has the right to convert their Series B Preferred Stock into fully paid and non-assessable shares of Common Stock. Initially, the conversion price for the Series B Preferred Stock is $.25 per share, subject to standard anti-dilution adjustments. Additionally, each share of Series B Preferred Stock shall be entitled to, as a dividend, a pro rata portion of an amount equal to 10% (Ten Percent) of the Net Revenues (“Net Revenues” being Gross Sales minus Cost of Goods Sold) derived from the subscriptions and other sales, but excluding and net of Vimeo fees, processing fees and up sells, generated by Fan Pass Inc., the wholly-owned subsidiary of the Corporation. The Series B Dividend shall be calculated and paid on a monthly basis in arrears starting on the day 30 days following the first day of the month following the initial issuance of the Series B Preferred and continuing for a period of 60 (Sixty) months. The holders of Series B Preferred stock shall have no voting rights. The holders of Series B Preferred stock shall not be entitled to receive any dividends other than noted above. In the event of any voluntary or involuntary liquidation, dissolution or winding up of the Company or deemed liquidation event, the holders of shares of Series B Preferred Stock shall be entitled to be paid the liquidation amount, as defined out of the assets of the Company available for distribution to its shareholders, after distributions to holders of the Series A Preferred Stock and before distributions to holders of Common Stock. During the year ended December 31, 2019, the Company entered into Security Purchase Agreements with various investors for the purchase of 205,000 shares Series B convertible Preferred stock and received $205,000 in cash. Each Series B Preferred share is convertible into 4 shares of common stock valued at $0.25. During the year ended December 31, 2019, The Company entered into a Security Purchase Agreements with a related party for the purchase of 79,000 shares Series B Preferred stock. The $79,000 was settled against accounts payable owed to the related party. Each Series B Preferred share is convertible into 4 shares of common stock valued at $0.25. Series C: On November 25, 2019 the Company filed a Designation of Series C convertible Preferred Stock with the state of Nevada, designating 1,000,000 shares of the Series C Preferred Stock with a stated value of $1.00 per share. The Series C Preferred Stock will, with respect to dividend rights and rights upon liquidation, winding-up or dissolution, rank: (a) senior with respect to dividends with the Company’s common stock, par value 0.0001 per share (“Common Stock”) (the Series C Preferred Stock will convert into common stock immediately upon liquidation and be pari passu with the common stock in the event of litigation), and (b) junior with respect to dividends and right of liquidation to all existing and future indebtedness of the Company. The Series C Preferred Stock does not have any voting rights. Each share of Series C Preferred Stock will carry an annual dividend in the amount of eight percent (8%) of the Stated Value of $1.00 (the “Divided Rate”), which shall be cumulative and compounded daily, payable solely upon redemption, liquidation or conversion and increase to 22% upon an event of default as defined. In the event of any default other than the Company’s failure to issue shares upon conversion, the stated price will be $1.50. In a default event where the Company fails to issue shares upon conversion, the stated price will be $2.00. The holder shall have the right six months following the issuance date, to convert all or any part of the outstanding Series C Preferred Stock into shares of common stock of the Company. The conversion price shall equal the Variable Conversion Price. The “Variable Conversion Price” shall mean 71% multiplied by the market price, representing a discount rate of 29%. Market price means the average of the two lowest trading prices for the Company’s common stock during the twenty trading day period ending on the latest complete trading day prior to the conversion date. Upon any liquidation, dissolution or winding up of the Company, whether voluntary or involuntary, or upon any deemed liquidation event, after payment or provision for payment of debts and other liabilities of the Company, and after payment or provision for any liquidation preference payable to the holders of any Preferred Stock ranking senior upon liquidation to the Series C Preferred Stock, if any, but prior to any distribution or payment made to the holders of Common Stock or the holders of any Preferred Stock ranking junior upon liquidation to the Series C Preferred Stock by reason of their ownership thereof, the Holders will be entitled to be paid out of the assets of the Company available for distribution to its stockholders. The Company will have the right, at the Company’s option, to redeem all or any portion of the shares of Series C Preferred Stock, exercisable on not more than three trading days prior written notice to the Holders, in full, in accordance with Section 6 of the designations at a premium of up to 35% for up to six months. Company’s mandatory redemption: On the earlier to occur of (i) the date which is twenty-four (24) months following the Issuance Date and (ii) the occurrence of an Event of Default (the “Mandatory Redemption Date”), the Company shall redeem all of the shares of Series C Preferred Stock of the Holders (which have not been previously redeemed or converted). During the year ended December 31, 2019, 149,300 shares of Series C convertible preferred stock were issued to an investor under preferred stock purchase agreements at a price of approximately $0.91 per share for a total of $136,000. Due to the mandatory redemption feature, these shares are reflected as a current liability at December 31, 2019. Furthermore, because these shares are convertible at 71% of the common shares market price around the time of the conversion date, they are treated as a stock settled debt under ASC 480 with a premium of $55,549 recorded and charged to interest expense. The total amount is reflected at $191,549 at December 31, 2019. As of June 30, 2020, the Company has revalued the shares and premiums at the stated value of $1.50 per share in accordance with the events discussed below. On May 29, 2020 the Company defaulted on the shares by being late with the filing of the Form 10-K, thereby increasing the dividend rate to 22% and the stated value to $1.50 per share. During the three months ended March 31, 2020, 38,000 shares of Series C convertible preferred stock were issued to an investor under preferred stock purchase agreements at a price of approximately $0.87 per share for a total of $33,000. Because Series C preferred shares are convertible at 71% of the common shares market price around the time of the conversion date, they are treated as a stock settled debt under ASC 480 with a total premium of $114,755 recorded as of June 30, 2020. In addition, the Company recorded a cumulative dividend payable of $11,885 as of June 30,2020 to the mandatorily redeemable Series C convertible preferred stock liability with this amount being recorded as interest expense since the Series C liability must be reflected at redemption value. During the three months ended September 30, 2020 the holder of the Series C converted 62,500 Series C shares to 3,822,958 common shares for a redemption value of $96,750 including accrued dividends plus premium of $38,292, which totaled $135,042 recorded into equity. During the three months ended December 31, 2020 a holder of the Series C converted 101,300 Series C shares to 22,704,221 common shares for a redemption value of $218,655 including accrued dividends, plus premium, recorded into equity. In addition, during the three months ended December 31,2020 a total of 149,600 shares of Series C convertible preferred stock were issued to two investors under preferred stock purchase agreements, at a price of approximately $0.91 per share, for a total of $136,000 cash and premiums totaling $60,302 were recorded during this period with respect to these issuances. At December 31, 2020 the remaining liability totals $285,605, represented by a remaining balance of $184,850 in redeemable Series C stock, together with the related premium of $74,701 and accrued dividends of $26,054. During the three months ended March 31, 2021 a holder of the Series C converted 23,500 Series C shares to 5,500,894 common shares for a redemption value of $50,589 including accrued dividends, plus premium, recorded into equity. In addition, during the three months ended March 31, 2021 a total of 296,450 shares of Series C convertible preferred stock were issued to two investors under preferred stock purchase agreements, at a price of approximately $0.91 per share, for a total of $269,350 cash and premiums totaling $121,084 were recorded during this period with respect to these issuances. At March 31, 2021 the remaining liability totals $634,143 represented by a remaining balance of $446,050 in redeemable Series C stock, together with the related premium of $181,385 and accrued dividends of $6,708. During the three months ended June 30, 2021 the Company elected to redeem and cancelled 36,300 Series C shares through the payment of $50,938, which represented 135% of the outstanding principal of $36,300 and accrued dividend of $1,432. A holder of the Series C converted 84,700 Series C shares to 11,496,360 common shares for a redemption value of $137,553 including accrued dividends, plus premium, recorded into equity. In addition, during the three months ended June 30, 2021 a total of 92,125 shares of Series C convertible preferred stock were issued to an investors under preferred stock purchase agreements, at a price of approximately $0.91 per share, for a total of $83,750 cash and premiums totaling $37,629 were recorded during this period with respect to these issuances. At June 30, 2021 the remaining liability totals $597,490 represented by a remaining balance of $417,175 in redeemable Series C stock, together with the related premium of $169,550 and accrued dividends of $10,765. During the three months ended September 30, 2021 the Company elected to redeem and cancelled 58,850 Series C shares through the payment of $82,408, which represented 135% of the outstanding principal of $58,850 and accrued dividend of $2,192. A holder of the Series C converted 95,700 Series C shares to 17,799,687 common shares for a redemption value of $162,654 including accrued dividends, plus premium, recorded into equity. In addition, during the three months ended September 30, 2021 a total of 178,750 shares of Series C convertible preferred stock were issued to an investor under preferred stock purchase agreements, at a price of approximately $0.91 per share, for a total of $162,500 cash and premiums totaling $73,011 were recorded during this period with respect to these issuances. At September 30, 2021 the remaining liability totals $633,590 represented by a remaining balance of $441,375 in redeemable Series C stock, together with the related premium of $179,435 and accrued dividends of $12,780. In conjunction with the Company’s intention to raise future financing of up to $5 million through an offering of up to 500,000 Series D convertible Preferred Stock at the offering price of $10.00 per share, on March 29, 2021 the Company received a Notice of Qualification from the Securities and Exchange Commission indicating approval from the Company to proceed with the offering pursuant to Tier 2 of Regulation A of the Securities Act, which provides exemption from registration of such securities. Each Series D preferred share is convertible, at the option of the holder, at any time, into nonassessable common shares at 80% of the average closing price reported on OTCMarkets (a) for the 20 trading days preceding conversion through June 30, 2021 and (b) for the 10 trading days preceding conversion effective July 1, 2021. On April 5, 2021 the Company filed the necessary Certificate of Designation with the state of Nevada to designate 500,000 shares of Series D Preferred stock from the Company’s total authorized and unissued Preferred Stock. During the three months ended June 30, 2021 the Company received a total of $850,000 from the sale of 85,000 Series D Convertible Preferred Stock, and incurred offering costs of $31,309. In addition, during that period 44,970 Series D Preferred shares were subsequently converted to 31,029,932 common shares at an average conversion rate of $0.01449 per common share, resulting in a remaining balance at June 30, 2021 of 40,030 Series D Preferred. During the three months ended September 30, 2021 the Company received a total of $760,000 from the sale of 76,000 Series D Convertible Preferred Stock. In addition, during that period 75,506 Series D Preferred shares were subsequently converted to 114,102,488 common shares at an average conversion rate of $0.00662 per common share, resulting in a remaining balance at September 30, 2021 of 40,524 Series D Preferred. 9. SHARE PURCHASE WARRANTS Activity in 2021 is as follows: Common stock warrants Number of Weighted Average Weighted Average Warrants Exercise Price $ Remaining Life (Years) Balance outstanding, December 31, 2020 60,908 72.00 0.3 Expired (60,908 ) (72.00 ) (0.3 ) Granted 65,567,000 0.0065 4.18 Balance outstanding, September 30, 2021 65,567,000 $ 0.0065 4.18 Preferred Series D warrants Balance outstanding, December 31, 2020 - - - Granted 3,500 10.00 4.18 Balance outstanding, September 30, 2021 3,500 10.00 4.18 The Preferred Series D warrants, when exercised at the price of $10.00 per share, are then convertible to common shares at 80% of the Company’s average closing stock price over 10 trading days prior to conversion, which would equal 6,730,769 common shares at September 30, 2021. On January 1, 2021 the Company issued warrants to Anvil Financial Management LLC to purchase up to 92,000 shares of the Company’s common stock (the “Warrants”) in part consideration for providing financing advice. The warrants are exercisable at any time on or after the date of issuance at the price of $0.25 per share and entitles Anvil to purchase the Company’s common stock for a period of up to 5 years from January 1, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the relative fair value of the warrants was recorded as a debt discount and an increase to paid-in capital. See Note 5 “Warrants Issued Related to Notes”. On March 9, 2021 the Company issued warrants to First Fire Global Opportunities Fund LLC to purchase up to 3,500,000 shares of the Company’s common stock (the “Warrants”) in connection with providing the Company with financing through a Convertible Promissory Note with the principal value of $110,000. The warrants are exercisable at any time on or after the date of issuance at the price of $0.025 per share and entitles First Fire to purchase the Company’s common stock for a period of up to 3 years from March 9, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the relative fair value of the warrants was recorded as a debt discount and an increase to paid-in capital. See Note 5 “Warrants issued related to Notes”. On March 11, 2021 the Company issued warrants to Robert Nathan/Primary Capital, LLC to purchase up to 1,350,000 shares of the Company’s common stock (the “Warrants”) in part consideration as a finder’s fee in introducing First Fire to the Company. Warrants on 350,000 common shares are exercisable at any time on or after the date of issuance at the price of $0.025 per share and entitles the holder to purchase the Company’s common stock for a period of up to 3 years from March 11, 2021. Warrants on 1,000,000 common shares are exercisable at any time on or after the date of issuance at the price of $0.01 per share and also entitles the holder to purchase the Company’s common stock for a period of up to 3 years from March 11, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the relative fair value of the warrants was recorded as a debt discount and an increase to paid-in capital. See Note 5 “Warrants Issued Related to Notes”. On March 3, 2021 the Company issued warrants to JP Carey Enterprises, Inc. to purchase up to 30,000,000 shares of the Company’s common stock (the “Warrants”) in connection with providing the Company with financing through a Convertible Promissory Note with the principal value of $150,000. The warrants are exercisable at any time on or after the date of issuance at the price of $0.005 per share and entitles JPCarey to purchase the Company’s common stock for a period of up to 5 years from March 3, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the relative fair value of the warrants was recorded as a debt discount and an increase to paid-in capital. See Note 5 “Warrants issued related to Notes”. On March 3, 2021 the Company issued warrants to Trillium Partners LP to purchase up to 30,000,000 shares of the Company’s common stock (the “Warrants”) in connection with providing the Company with financing through a Convertible Promissory Note with the principal value of $150,000. The warrants are exercisable at any time on or after the date of issuance at the price of $0.005 per share and entitles Trillium to purchase the Company’s common stock for a period of up to 5 years from March 3, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the fair value of the warrants was recorded as a debt discount and an increase to paid-in capital. See Note 5 “Warrants issued related to Notes”. On May 6, 2021 the Company issued warrants to Robert Nathan/Primary Capital, LLC to purchase up to 2,500 shares of the Company’s Series D Preferred stock (the “Warrants”) in part consideration as a finder’s fee in connection with the purchase by FirstFire of 25,000 Series D Preferred stock. Warrants on 2,500 Series D Preferred stock common shares are exercisable at any time on or after the date of issuance at the price of $10.00 per share and entitles the holder to purchase the Company’s Series D Preferred stock for a period of up to 5 years from May 6, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the fair value of the warrants was $25,000. However, there is no accounting entry since the cost of these warrants was treated as an offering cost against the proceeds of the Series D Preferred stock offering. On August 9, 2021 the Company issued warrants to Robert Nathan/Primary Capital, LLC to purchase up to 1,000 shares of the Company’s Series D Preferred stock (the “Warrants”) in part consideration as a finder’s fee in connection with the purchase by FirstFire of 10,000 Series D Preferred stock on July 23, 2021. Warrants on 1,000 Series D Preferred stock common shares are exercisable at any time on or after the date of issuance at the price of $10.00 per share and entitles the holder to purchase the Company’s Series D Preferred stock for a period of up to 5 years from August 9, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the fair value of the warrants was $10,000. However, there is no accounting entry since the cost of these warrants was treated as an offering cost against the proceeds of the Series D Preferred stock offering. On September 10, 2021 the Company issued warrants to Robert Nathan/Primary Capital, LLC to purchase up to 625,000 shares of the Company’s common stock (the “Warrants”) in part consideration as a finder’s fee in connection with the purchase by FirstFire of 12,500 Series D Preferred stock on August 31, 2021. Warrants on 1,000 Series D Preferred stock common shares are exercisable at any time on or after the date of issuance at the price of $10.00 per share and entitles the holder to purchase the Company’s Series D Preferred stock for a period of up to 5 years from September 10, 2021. On the initial measurement date, applying the applicable Black Scholes valuation, the fair value of the warrants was $6,250. However, there is no accounting entry since the cost of these warrants was treated as an offering cost against the proceeds of the Series D Preferred stock offering. 10. STOCK-BASED COMPENSATION Number of Stock Weighted Average Exercise Price Weighted Average Remaining Life Options $ (Years) Granted 16,500,000 $ 0.0141 2.0 Balance outstanding, September 30, 2021 16,500,000 $ 0.0141 2.0 On November 22, 2011, the Board of Directors of the Company approved a stock option plan (“2011 Stock Option Plan”), the purpose of which is to enhance the Company’s stockholder value and financial performance by attracting, retaining and motivating the Company’s officers, directors, key employees, consultants and its affiliates and to encourage stock ownership by such individuals by providing them with a means to acquire a proprietary interest in the Company’s success through stock ownership. Under the 2011 Stock Option Plan, officers, directors, employees and consultants who provide services to the Company may be granted options to acquire common shares of the Company. The aggregate number of options authorized by the plan shall not exceed 4,974 shares of common stock of the Company. There are 7 shares of common stock reserved for issuance under the 2014 Plan. The Board shall have the power and authority to make grants of stock options to employees, directors, consultants and independent contractors who serve the Company and its affiliates. Any stock options granted under the 2014 Plan shall have an exercise price equal to or greater than the fair market value of the Company’s shares of common stock. Unless otherwise determined by the Board of Directors, stock options shall vest over a four-year period with 25% being vested after the end of one (1) year of service and the remainder vesting equally over a 36-month period. The Board may award options that may vest based upon the achievement of certain performance milestones. As of September 30, 2020, no options have been awarded under the 2014 Plan. Effective August 27, 2019, the Company effected a reverse split of the common stock of 1 for 18,000 (Note 1) which eliminated all the options which were previously outstanding. During January, 2021 the Company awarded stock options to its 5 employees totaling 5 million common shares vesting quarterly over 2 years and 10 million common shares vesting quarterly over 3 years, both sets of option are exercisable at a price of $0.014 per share. In addition, during January, 2021 stock options on a further 1.5 million common shares, vesting quarterly over 3 years at the exercise price of $0.015 per share. Applying the Black-Scholes valuation method, the total cost of these options is $194,700 and $24,750 respectively, which is being amortized to general and administrative expense over their lifetime. Of this total, the Company incurred a stock option expense of $65,024 for the nine months ended September 30, 2021 (2020: $0). 11. FAIR VALUE MEASUREMENTS ASC 820, Fair Value Measurements and Disclosures, require an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. ASC 820 establishes a fair value hierarchy based on the level of independent, objective evidence surrounding the inputs used to measure fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. ASC 820 prioritizes the inputs into three levels that may be used to measure fair value: Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities. Valuations are based on quoted prices that are readily and regularly available in an active market and do not entail a significant degree of judgment. Level 2 applies to assets or liabilities for which there are other than Level 1 observable inputs such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data. Level 2 instruments require more management judgment and subjectivity as compared to Level 1 instruments. For instance: determining which instruments are most similar to the instrument being priced requires management to identify a sample of similar securities based on the coupon rates, maturity, issuer, credit rating and instrument type, and subjectively select an individual security or multiple securities that are deemed most similar to the security being priced; and determining whether a market is considered active requires management judgment. Level 3 applies to assets or liabilities for which there are unobservable inputs to the valuation methodology that are significant to the measurement of the fair value of the assets or liabilities. The determination of fair value for Level 3 instruments requires the most management judgment and subjectivity. Pursuant to ASC 825, cash is based on Level 1 inputs. The Company believes that the recorded values of accounts receivable and accounts payable approximate their current fair values because of their nature or respective relatively short durations. The fair value of the Company’s convertible debentures and promissory note approximates their carrying values as the underlying imputed interest rates approximates the estimated current market rate for similar instruments. As of September 30, 2021 there were derivatives measured at fair value on a recurring basis (see note 5) presented on the Company’s balance sheet, as follows: Liabilities at Fair Value Level 1 Level 2 Level 3 Total Embedded conversion options derivative liabilities - - $ 237,900 $ 237,900 12. SUBSEQUENT EVENTS Subsequent to September 30, 2021 the Company received $250,000 from the sales of 25,000 Series D Convertible Preferred Stock at $10.00 per share. In connection with these sales, the Company paid Primary Capital finder’s fees totaling $12,500 and issued 5 year Warrants on 1,250,000 common shares at an exercise price of $0.01 per share. Subsequent to September 30, 2021 the Company issued 5,224,075 common shares to the holder of convertible debentures, which were recorded as reclassifications from issuable to issued common shares. Subsequent to September 30, 2021 the Company issued 7,519,927 common shares on conversion of 50 Series A preferred stock. Subsequent to September 30, 2021 the Company issued a total of 26,574,626 common shares on conversion of 13,892 Series D Preferred Stock, an at average conversion of $0.00523 per share. Subsequent to September 30, 2021 the Company issued a total of 12,581,572 common shares to a holder of Series C preferred stock on conversion of $42,625 principal and $1,705 accrued dividends at an average conversion rate of $0.00352 per share. On October 21, 2021 the Company signed a non-binding Letter of Intent to acquire all of the assets of Artist Republik, Inc. in consideration for the issuance of common stock of the Company equal to 37% of the common stock issued and outstanding (presently estimated to be 37% of 457,072,368, or 169,116,776 common shares). The transaction is scheduled to close in November, 2021. ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis of the Company’s financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto included in Item 1 “Financial Statements” in this Quarterly Report on Form 10-Q. This discussion contains forward-looking statements that involve risks and uncertainties. The Company’s actual results could differ materially from those discussed below. Factors that could cause or contribute to such differences include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included elsewhere in this Quarterly Report on Form 10-Q. Friendable, Inc., a Nevada corporation (the “Company”), was incorporated in the State of Nevada Friendable Inc. (FDBL) is a mobile technology and marketing company focused on connecting and engaging users through its proprietary mobile and desktop applications. The Company’s first app, the “Friendable” subscription app, was a traditional dating application with its focus on building revenue, as well as reintroducing the brand as a non-threatening, all-inclusive place where “Everything starts with Friendship”…meet, chat & date. Launched July 24, 2020, the Company’s “Fan Pass” flagship subscription app is designed to help artists engage with their fans around the world and earn revenue while doing so. The Live Streaming platform supports artists at all levels, providing exclusive artist content “channels,” live event streaming, promotional support, fan subscriptions and custom merchandise designs, all of which are revenue streams for each artist. With Fan Pass, artists can offer exclusive content channels to their fans, who can simply use their smartphones to gain access to their favorite artists as well as an all-access pass, giving them access to all artists on the platform. Additionally, the Fan Pass team will deploy social broadcasters to capture exclusive VIP experiences, interviews and behind-the-scenes content featuring their favorite artists – all available to fan subscribers for free on a trial basis. Thereafter, subscriptions are billed monthly, providing VIP access at a fraction of the cost of traditional face-to-face meetups. Presently, Fan Pass has signed more than 5,300 music artists, of which more than 750 artists have been on boarded with their own “broadcast” music Channel available on the Fan Pass app for live streaming and pre-recorded music content. Friendable Inc. was founded by Robert A. Rositano Jr. and Dean Rositano, two brothers with over 25 years of experience working together on technology-related ventures. The Company maintains websites at www.Friendable.com and www.fanpasslive.com. The information on these app websites is not incorporated herein. Additionally, you can download the Fan Pass app from the Apple app Store or Google Play Stores. What precisely does Fan Pass Live do? For starters, Fan Pass breaks down the barrier between artists and fans, with artists broadcasting their events, concerts, and announcements to supporters directly from the Fan Pass mobile application or desktop. More importantly, it gives back to artists a way to remain relevant to their fan base and earn revenue. Fan Pass Live offers artists at all levels and genres, the opportunity to engage fans from one location, removing the need for multiple sharing platforms. It conveniently provides Exclusive Artist “Channels” jam-packed with all their relevant content from videos, photos, interviews, and past and upcoming events. While Fan Pass charges the fans a small transaction fee for ticket sales, artists keep the money earned from ticket sales. The handling of merchandise is also taken care of by the company and once it’s approved by the artist, all merchandising is released within the artist’s Channel. For artists there are tools available to help them “up their game” such as the creation of custom logos and merchandising, live chat options, promotional aids that provide the ability to live stream, post photos, audio and video with ease. For subscribers, fans can browse for upcoming events, shop merchandising, search by music genre and create dashboards. They can also view notifications, discussions and their favorite music artists in one app. While it’s free for the artists to join, Fan Pass monetizes its business model by using an “ALL ACCESS VIP” Offering. Commencing with the release of Fan Pass v2.0 on July 24, 2021, this offering is priced at a $2.99 monthly subscription ($25.99 annual subscription), paid by fans through its website, Apple App Store or Google Play Stores, with a three-day free trial. Fan Pass also offers an “Artist Pro” monthly subscription of $8.99 which offers the “ALL ACCESS VIP”, plus advanced dashboard analytics, merchandising store access and promotion of scheduled music events, On August 5, 2021 the Company announced the approval of the Fan Pass v2.0 livestream artist platform by both the Apple App and Google Play Stores. The mobile applications can be downloaded by users worldwide, and Fan Pass v2.0 is also accessible via desktop and web applications. How sweet does it get for the artists? These revenues are proportionately shared with all Channel artists according to fan views and downloads. In exchange for its platform features, live streaming tools, bandwidth, processing, and handling, Fan Pass also earns platform fees on each separately ticketed event, as well as splits with each artist on subscriber fees and merchandise designed and sold on the platform. Fan Pass v2.0 contains all new UI/UX user interface attributes, updated feature sets for artists and fan, as well as an accelerated onboarding process for artists and artists’ content, and enhanced dashboard features. The Company aims to establish Fan Pass as its premier brand and mobile platform that is dedicated to connecting and engaging users from anywhere around the World. Fan Pass Live provides fans exclusive access into the lives of their favorite artists, and provides artists a ‘virtual stage’ to perform, earn revenues, and engage with fans from around the world. We previously advised that on April 7, 2021 the Company had entered into a letter of understanding with Santo Mining Corp. (“SMC”) to form a joint venture to pursue the development and sale of NFT’s ( non-fungible tokens of verifiable, tradable assets of digital art, music”) or other content or collectibles originating through the Company’s exploitation of the content associated with and from the Fan Pass app. However, the Company has not been able to conclude a definitive agreement with SMC and accordingly is no longer proceeding with this arrangement. Nonetheless, the Company is pursuing other opportunities for the distribution of its potential NFT’s. On October 21, 2021 the Company signed a non-binding Letter of Intent to acquire all of the assets of Artist Republik, Inc. in consideration for the issuance of common stock of the Company equal to 37% of the common stock issued and outstanding (presently estimated to be 37% of 469,673,940, or 173,779,358 common stock). The transaction is scheduled to close in November, 2021. Started in early 2020, Artist Republik provides the tools for Music Artists to produce, distribute and market their original music on a variety of digital streaming platforms, including Spotify and Apple Music, together with providing Artists with the ability to find and book local venues and shows. Artist Republik presently serves 100,000 Artists and shares a portion of its revenue with the Artists. Closing the acquisition will complete the Company’s presence in the music industry by directly serving both independent Artists in the distribution of music content and the connection and participation with their fans. Our two founders are a team of Entrepreneurs who have over 25 years of tech related startup experience, recruiting talent, building teams and turning ideas into big business opportunities, as well as exits for investors. Together raising over $40M in capital, spanning various companies, with a history dating back to the first ever Internet IPO (Netcom Online Communications – 1993), as well as the development of the first ever World Wide Web Directory (sold to McMillan Publishing 1995) and even deploying a first mover social network by the name of nettaxi.com – 1998 – 2002, which was prior to Facebook and resulted in a top 10 most trafficked web site in the World, with a market cap of approximately $700M upon exiting the public company. Relationships developed over the years include such companies as Apple, eBay and AT&T, as well as joint ventures with Music Industry Giants, including Nocturne Productions, Herbie Herbert (Manager of the Band Journey) and Music.com; an early adopter offering digital music downloads. Results of Operations For the Three Months Ended For the Nine Months Ended REVENUES: 1,866 111,392 4,780 322,671 Software development and support 252,500 105,790 575,000 460,102 Derivatives income (expense) 867,298 263,000 2,818,298 259,000 441,098 481,894 85,350 (1,064,951 ) For the three months ended September 30, 2021 compared to September 30, 2020 The Company had revenues of $1,866 and $111,392 for the three months ended September 30, 2021 and 2020 respectively. Revenues in 2021 related entirely to subscriber and merchandising revenue from the Company’s Fan Pass and Friendable apps. (2020 $1,892). Revenues for the three months ended September 30, 2020 includes $109,500 from technology services provided under a contract with a third party, which expired at the end of 2020 (2021 $0). No new third-party technology services contract has been obtained to date in 2021. The Company had operating expenses of $762,226 and $801,844 for the three months ended September 30, 2021 and 2020 respectively. The decrease in operating expenses was due primarily to Artists’ performance fees of $425,058 incurred in 2020 in connection with the initial launch of the Fan Pass app.in July, 2020, offset by higher salary costs of full time employees, higher software development costs to build and launch Fan Pass V 2.0 in July 2021 and higher sales and marketing costs to promote the Fan Pass app. in 2021. Other Income and Expense The Company had other net income of $441,098 for the three months ended September 30, 2021, compared to other income of $481,894 for the three months ended September 30, 2020. Higher interest expense in 2021 was offset by higher derivatives income. The Company had a net loss of $319,262 for the three months ended September 30, 2021, compared to a net loss of $208,558 for the three months ended September 30, 2020. The increase in net loss was due primarily to the decline in revenues in 2021 explained above. For the nine months ended September 30, 2021 compared to September 30, 2020 The Company had revenues of $4,780 and $322,671 for the nine months ended September 30, 2021 and 2020 respectively. The decrease was due to the end of a contract to develop a third-party app at the end of 2020, which was not replaced by a new third-party app. development contract in 2021. Revenue in 2021 related entirely to subscriber and merchandising revenue from the Company’s own Fan Pass and Friendable apps. The Company had operating expenses of $2,060,799 and $1,747,507 for the nine months ended September 30, 2021 and 2020 respectively. The increase in operating expenses of $313,292 was due primarily to an increase of $356,823 in general and administrative expenses arising primarily from higher legal fees and increased salaries, and an increase in sales and marketing expenses of $310,986 in 2021 to support the Fan Pass 2.0 app. launch, partially offset by the absence of Artists; performance fees of $425,058 incurred in 2020 in support of the initial launch of the Fan Pass app in July, 2020. The Company had other net income of $85,350 for the nine months ended September 30, 2021 compared with other expense of $1,064,951 for the nine months ended September 30, 2020. The change was due primarily to higher a derivatives income of $2,818,298, less interest expense and loss on initial derivative expense of $2,732,948 in 2021, compared with much smaller derivatives income $259,000 and loss on settlement of derivatives $640,821 and initial derivative expense $419,000 in 2020. The Company had net losses of $1,970,669 and $2,489,787 for the nine months ended September 30, 2021 and 2020 respectively. The decrease in net loss was due primarily to the absence in 2021 of Artists’ performance fees totaling $425,058 incurred in 2020 to support the initial launch of the Fan Pass app. Liquidity and Capital Resources Current Assets $ 463,741 $ 148,601 Current Liabilities $ 4,800,703 $ 5,436,963 Working Capital (Deficiency) $ (4,336,962 ) $ (5,288,362 ) Current assets at September 30, 2021 increased compared to December 31, 2020 primarily due to higher cash from the Company’s Regulation A capital raise program, offset by a reduction in accounts receivable and prepaid expenses. Current liabilities at September 30, 2021 decreased compared to December 31, 2020 primarily due to the reduction in derivative liabilities from convertible note conversions in 2021 and changes in the fair value of derivatives, offset by an increase in accounts payable and accrued expenses and an increase in the liability for mandatorily redeemable Series C convertible preferred stock from additional capital raises. Nine months Nine months Ended Ended Net Cash Used in Operating Activities $ (1,843,633 ) $ (260,931 ) Net Increase (Decrease) in Cash $ 394,182 $ (2,431 ) Net Cash Used in Operating Activities Our cash used in operating activities was $1,843,633 for the nine month period ended September 30, 2021 compared to $260,931 for the nine month period ended September 30, 2020. Net loss was $1,970,669 and $2,489,787 for the nine month periods ending September 30, 2021 and 2020 respectively. In 2021, adjustments to reconcile the net loss to net cash used primarily included a loss on initial derivative expense of $1,796,835, offset by a gain from the change in fair value of derivatives of $2,818,298. In 2020, adjustments to reconcile the net loss to net cash used included adjustment for loss on settlement of derivative of $640,822, and loss on initial derivative expense of $419,000. In 2021, changes in operating assets and liabilities included a reduction in amount due to related party of $134,499 and an increase to accounts payable and accrued expenses of $335,173. In 2020 changes in operating assets and liabilities included an increase to accounts payable and accrued expenses of $409,743 and an increase due to related party $30,083. Net Cash Provided by Financing Activities Our cash provided by financing activities of $2,237,815 for the nine month period ended September 30, 2021 included the issuance of Series C preferred stock sold for cash of $515,900 offset by a redemption payments of Series C preferred stock totaling $95,150, issuance of Series D preferred stock under Regulation A of $1,610,000 less offering costs of $31,310, and net proceeds from the issuance of convertible notes of $358,500 and repayment of convertible notes of $116,500. Our cash provided by financing activities of $258,500 for the nine month period ended September 30, 2020 included the issuance of Series C preferred stock sold for cash of $33,000, net proceeds from the issuance of convertible notes of $105,000 and proceeds of $60,000 from the sale of common stock. The Company derives the majority of its financing by issuing convertible notes or stock to investors. The investors have the right to convert the notes and certain preferred stock into common shares of the Company after the requisite Rule 144 waiting period. The notes generally call for the shares to be issued at a deep discount to the market price at the time of conversion. In addition, investors purchasing Series D preferred stock have the right to convert that stock to common shares. The accompanying unaudited consolidated financial statements have been prepared assuming the Company will continue as a going concern, which implies that the Company would continue to realize its assets and discharge its liabilities in the normal course of business. As of September 30, 2021, the Company has a working capital deficiency of $4,336,962, has an accumulated deficit of $38,539,915 and has a stockholder’s deficit of $4,336,962 and its operations continue to be funded primarily from sales of its stock. During the nine months ended September 30, 2021 the Company had a net loss and net cash used in operations of $1,970,669 and $1,843,633. These factors raise substantial doubt about the Company’s ability to continue as a going concern for a period of twelve months from the issuance of this report. The ability of the Company to continue as a going concern is dependent on the Company’s ability to obtain the necessary financing through short term loans and the issuance of convertible notes and equity instruments. The unaudited consolidated financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. Management plans to continue raising financing through equity sales of Series C and Series D Preferred stock, while intending to reduce and/or eliminate its convertible debt. No assurance can be given that any such additional financing will be available, or that it can be obtained on terms acceptable to the Company and its stockholders. Off-Balance Sheet Arrangements As of September 30, 2021, the Company had no off-balance sheet arrangements. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. This Item 3 is not applicable to us as a smaller reporting company and has been omitted. ITEM 4. CONTROLS AND PROCEDURES. Disclosure Controls and Procedures We maintain “disclosure controls and procedures,” as that term is defined in Rule 13a-15(e), promulgated by the SEC pursuant to the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including the principal executive officer and principal financial officer, to allow timely decisions regarding required disclosure. Our management, with the participation of the principal executive officer and principal financial officer, evaluated our disclosure controls and procedures as of the end of the period covered by this quarterly report on Form 10-Q. Based on this evaluation, our principal executive officer and principal financial officer concluded that as of September 30, 2021, our disclosure controls and procedures were not effective. As reported in Item 9A of our Annual Report on Form 10-K for the year ended December 31, 2020, our management concluded that our internal control over financial reporting was not effective as of that date because of material weaknesses which are indicative of many small companies with small staff: (i) inadequate segregation of duties and ineffective risk assessment; (ii) insufficient written policies and procedures for accounting and financial reporting with respect to the requirements and application of both US GAAP and SEC guidelines; (iii) and inadequate technical skills of accounting personnel. To remediate such weaknesses, we believe we would need to implement the following changes: (i) appoint additional qualified personnel to address inadequate segregation of duties and ineffective risk management; and (ii) adopt sufficient written policies and procedures for accounting and financial reporting. The remediation efforts set out in (i) and (ii) are largely dependent upon our securing additional financing to cover the costs of implementing the changes required. If we are unsuccessful in securing such funds, remediation efforts may be adversely affected in a material manner. Until we have the required funds, we do not anticipate implementing these remediation steps. A material weakness is a deficiency or a combination of control deficiencies in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Changes in Internal Control Over Financial Reporting There were no changes in our internal control over financial reporting during the quarter ended September 30, 2021 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS i) Integrity Media, Inc. (“Integrity”) had previously filed a lawsuit against the Company and the CEO of the Company for $500,000 alleging breach of contract alleging the Company failed to deliver marketable securities in exchange for services. The Company answered the allegations in court and Integrity filed a motion attacking the Company’s answers. While the court did not strike those responses, the clerk of the court entered a default judgment against the Company in the amount of $1,192,875 plus 10% interest. On May 8, 2019, the Company received a tentative ruling on the Company’s motion to vacate the default judgement whereby the previously entered default judgement was voided and a trial date of August 26, 2019 was set. On September 19, 2019, the Company entered into a Settlement Agreement, as Amended, with Integrity Media settling the civil action known as Integrity Media, Inc. vs. Friendable, Inc. et al., Orange County Case No. 30-2016-00867956-CU-CO-CJC. Pursuant to the Settlement Agreement, the Company agreed to issue to Integrity 750,000 shares of its common stock to be issued in tranches every 30 days or according to the instructions of Integrity, in exchange for 275 of the Company’s preferred shares held by Integrity and the cash payment of $30,000 for costs. Robert Rositano, the Company’s CEO, has also personally guaranteed the Company’s compliance with the terms of the Settlement Agreement. At the date of this filing the $30,000 cash payment has not been made and the preferred shares have not been returned. On August 28, 2020 Integrity requested and was issued 750,000 common shares, which Integrity advised the Company realized $16,625 when sold. Accordingly, at September 30,2021 and December 31, 2020 the Company reduced its liability payable in common stock from $1,005,000 to $988,375 and retained $30,000 as an accrued liability for costs. (ii) Infinity Global Consulting Group Inc. Infinity Global Consulting Group Inc. had previously filed a default judgement on May 29, 2018 in the 11th Judicial Circuit, Miami-Dade County, Florida court alleging that it was owed a services fee of $97,000, plus an entitlement to a warrant to purchase 5 million of the Company’s common shares at $0.03 per share. The Company believes that this claim is without merit since service on the Company was defective and the Company never received an actual notice of the lawsuit. Accordingly, on November 16, 2020 the Company filed a motion to set aside the default judgement. At the date of this filing, the motion still awaits a hearing and no accrued expense at September 30, 2021 or at December 31, 2020 has been established. ITEM 1A. RISK FACTORS. There are no changes that constitute material changes from the risk factors previously disclosed in our Annual Report on Form 10-K, filed with the SEC on April 28, 2021. ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS. During the three months ended March 31, 2021: Issued 5,500,894 common shares on conversion of 23,500 Series C preferred stock plus accrued dividend, valued $50,589. Issued 31,532,405 shares of common stock on conversion of $158,516 of convertible notes, accrued interest and conversion fees, at a conversion value of $167,743. Issued 3,500,000 common shares as payment of a commitment fee to a convertible debtholder valued at $62,300. Issued 40,766,310 additional shares of common stock based on first and second reset dates in accordance with the debt restructuring agreement (See note 5). During the three months ended June 30, 2021: Issued 11,496,360 common shares on conversion of 84,700 Series C preferred stock plus accrued dividend, valued $137,553. Issued 31,029,932 shares of common stock on conversion of 44,970 Series D preferred stock at a conversion value of $449,700. Issued 2,555,738 common shares to a third party on conversion of 50 Series A preferred stock. During the three months ended September 30, 2021: Issued 17,799,687 common shares on conversion of 95,700 Series C preferred stock plus accrued dividend with a book value of $162,654. Issued 114,102,488 shares of common stock on conversion of 75,506 Series D preferred stock at a conversion value of $755,060. Issued 8,709,641 additional shares of common stock based on first and second reset dates in accordance with the debt restructuring agreement. Issued 7,290,359 common shares to a convertible debenture holder for offset against the holder’s convertible note, valued at $91,129. Issued 42,352,994 common shares on conversion of convertible notes and accrued interest, at a fair value of $333,451. Issued 2,000,000 common shares for services provided, valued at a fair value of $17,400. The shares above were issued pursuant to an exemption from registration pursuant to Section 4(a)(2) of the Securities Act of 1933 (the “Act”). ITEM 3. DEFAULTS UPON SENIOR SECURITIES. On May 29, 2020 the Company defaulted on the outstanding Series C preferred stock previously issued by being late with the December 31, 2019 Form 10-K filing on the extended date. Under the default provision of the Series C preferred stock the dividend rate increases from 8% to 22% and the stated price increases from $1.00 to $1.50. The Company also defaulted on four convertible notes, one dated March 30, 2017 having no principal outstanding and accrued interest of $48,228, one dated April 8, 2020 in the amount of $35,000, one dated May 20, 2020 in the amount of $60,000 and another one dated June 11, 2020 of $10,000, causing the interest rate to increase to 24%. ITEM 4. MINE SAFETY DISCLOSURES. ITEM 5. OTHER INFORMATION. There is no other information required to be disclosed under this item which was not previously disclosed. ITEM 6. EXHIBITS The exhibits listed on the Exhibit Index immediately preceding such exhibits, which is incorporated herein by reference, are filed or furnished as part of this Quarterly Report on Form 10-Q. Exhibit Number Description (31) Rule 13a-14(a)/15d-14(a) Certification 31.1* Certification of the Principal Executive Officer of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2* Certification of the Principal Financial Officer of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. (32) Section 1350 Certification 32.1+ Certification of the Principal Executive Officer and Principal Financial Officer of the Registrant pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (101) Interactive Data File 101.INS* Inline XBRL Instance Document (the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document) 101.SCH* Inline XBRL Taxonomy Extension Schema 101.CAL* Inline XBRL Taxonomy Extension Calculation Linkbase 101.DEF* Inline XBRL Taxonomy Extension Definition Linkbase 101.LAB* Inline XBRL Taxonomy Extension Label Linkbase 101.PRE* Inline XBRL Taxonomy Extension Presentation Linkbase 104* Cover Page Interactive Data File (embedded within the Inline XBRL document) * Filed herewith. + In accordance with SEC Release 33-8238, Exhibits 32.1 is being furnished and not filed. Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: November 10, 2021 By : /s/ Robert Rositano, Jr. Name: Robert Rositano, Jr. Title: CEO, Secretary, and Director (Principal Executive Officer) Date: November 10, 2021 By: /s/ Robert Rositano, Jr Name: Robert Rositano, Jr Title: Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer)

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professional_accounting

Consolidated Financial Statements, Supplemental Schedules and ... Consolidated Financial Statements, Supplemental Schedules and Report of Independent Certified Public Accountants ACCION International December 31, 2013 and 2012 vandien Transcript of Consolidated Financial Statements, Supplemental Schedules and ... Consolidated Financial Statements, Supplemental Schedules and Report of Independent Certified Public Accountants ACCION International December 31, 2013 and 2012 Report of Independent Certified Public Accountants 3 Consolidated Statements of Financial Position 5 Consolidated Statement of Activities 2013 6 Consolidated Statement of Functional Expenses 2013 8 Consolidated Statements of Cash Flows 10 Notes to Consolidated Financial Statements 11 Supplemental Schedules Consolidating Schedule of Financial Position 31 Consolidating Schedule of Activities 33 Basis for qualified opinion The Organizations investment in Banco Solidario S.A. (BancoSol), a foreign affiliate accounted for under the equity method of accounting, is carried at $43,842,764 and $33,310,836 on the consolidated statement of financial position as of December 31, 2013 and 2012, respectively, and the Organization included its share of BancoSols net income in the consolidated change in net assets with an increase of $9,427,128 and a decrease of $8,852,273, respectively, for the years then ended. We were unable to obtain, through our own work or the use of the work of BancoSols auditors, sufficient appropriate audit evidence regarding the carrying amount of the Organizations investment in BancoSol as of December 31, 2013 and 2012 and the Organizations share of BancoSols net income for the years then ended, because our access to the financial information, management, and the auditors of BancoSol is restricted by circumstances that cannot be overcome within a reasonable period of time. Consequently, we were unable to determine whether any adjustments to these amounts were necessary. Qualified opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of ACCION International and subsidiaries as of December 31, 2013 and 2012, and the results of their operations and their cash flows for the years then ended in accordance with accounting principles generally accepted in the United States of America. Other matter - supplementary information Our audits were conducted for the purpose of forming an opinion on the consolidated financial statements as a whole. The consolidated statement of functional expenses, and the consolidating schedules of financial position and schedules of activities are presented for purposes of additional analysis, rather than to present the financial position, results of operations, and cash flows of the individual entities, and is not a required part of the consolidated financial statements. Such supplementary information is the responsibility of management and was derived from and relates directly to the underlying accounting and other records used to prepare the consolidated financial statements. The information has been subjected to the auditing procedures applied in the audit of the consolidated financial statements and certain additional procedures. These additional procedures included comparing and reconciling the information directly to the underlying accounting and other records used to prepare the consolidated financial statements or to the consolidated financial statements themselves, and other additional procedures in accordance with auditing standards generally accepted in the United States of America. In our opinion, except for the possible effects on the supplementary information of the matter resulting in the qualified opinion on the consolidated financial statements described above, the consolidating information is fairly stated, in all material respects, in relation to the consolidated financial statements as a whole. Boston, Massachusetts October 31, 2014 ACCION INTERNATIONAL AND SUBSIDIARIESConsolidated Statements of Financial PositionDecember 31, 2013 and 2012 CURRENT ASSETS:Cash and cash equivalents $ 19,790,095 $ 40,449,646 Short-term investments 86,837,478 80,652,713 Notes receivable from affiliates 3,000,000 200,671 Grants receivable - net 1,609,017 3,916,877 Contributions receivable - net 490,087 328,359 Contracts receivable - net 938,739 428,810 Microloans receivable- net 19,452,197 11,305,042 Prepaid expenses 1,136,688 1,201,701 Deposits, advances and other receivables 1,025,343 652,179 NON-CURRENT ASSETS:Cash restricted by foundation for long-term purposes 702,623 1,440,639 Grants receivable - net 1,550,030 2,806,348 Contributions receivable - net 624,445 9,525 Global Bridge Guarantee Program investments 7,305,722 7,494,309 Investments in affiliates 204,861,544 172,797,536 Notes receivable from affiliates - 2,000,000 Property and equipment - net 1,197,087 790,123 Total assets $ 350,521,095 $ 326,474,478 LIABILITIES AND NET ASSETS CURRENT LIABILITIES:Accounts payable and accrued liabilities $ 4,960,327 $ 3,346,177 Deferred revenue 293,863 209,223 Bank line of credit - 22,585 Deposit from investor (Note B) 6,349,106 6,349,106 Notes payable 1,271,435 1,507,211 Total current liabilities 12,874,731 11,434,302 NON-CURRENT LIABILITIES:Notes payable - net of current portion 4,750,669 4,562,875 Total non-current liabilities 4,750,669 4,562,875 Total liabilities 17,625,400 15,997,177 NET ASSETS:Unrestricted: Accion 320,419,592 299,514,988 Non-controlling interest in SCM (Note B) 440,597 771,305 Non-controlling interest in Accion Investment in Nigeria (Note B) 3,833,276 - Total unrestricted net assets 324,693,465 300,286,293 Temporarily restricted 8,202,230 10,191,008 Total net assets 332,895,695 310,477,301 Total liabilities and net assets $ 350,521,095 $ 326,474,478 See notes to consolidated financial statements. ACCION INTERNATIONAL AND SUBSIDIARIESConsolidated Statement of ActivitiesYear ended December 31, 2013 TemporarilyUnrestricted restricted Total REVENUES:Contributions and grants $ 3,804,609 $ 7,428,888 $ 11,233,497 Dividend and interest income from program investments 10,938,979 15,818 10,954,797 Dividend and interest income from short-term investments 2,698,295 - 2,698,295 Contract revenues and training fees 4,488,187 - 4,488,187 Net assets released from restrictions 9,432,204 (9,432,204) - Total revenues 31,362,274 (1,987,498) 29,374,776 FUNCTIONAL EXPENSES:Program services: Global Programs 18,198,564 - 18,198,564 Microlending 6,342,512 - 6,342,512 Global Investments 6,297,867 - 6,297,867 ACCION Investment Management Company 7,448 - 7,448 Center for Financial Inclusion 6,015,264 - 6,015,264 Communications 1,948,186 - 1,948,186 Total program services 38,809,841 - 38,809,841 Supporting servicesGeneral and administrative 5,266,266 - 5,266,266 Fundraising 2,588,954 - 2,588,954 Total supporting services 7,855,220 - 7,855,220 Total functional expenses 46,665,061 - 46,665,061 Change in net assets from operations (15,302,787) (1,987,498) (17,290,285) Income taxes (Note F) (85,649) - (85,649) Equity in income of equity investments 9,530,056 - 9,530,056 Purchase of interest in SCM by noncontrolling shareholder (Note B) 629,221 - 629,221 Purchase of interest in Accion Investment in Nigeria by noncontrolling shareholder (Note B) 3,839,389 - 3,839,389 Net unrealized gain on investments 8,311,700 - 8,311,700 Net realized gain on investments 17,577,622 - 17,577,622 Foreign currency translation losses, net (92,380) (1,280) (93,660) Change in net assets 24,407,172 (1,988,778) 22,418,394 Net assets - Beginning of year 300,286,293 10,191,008 310,477,301 Net assets - End of year $ 324,693,465 $ 8,202,230 $ 332,895,695 See notes to consolidated financial statements. REVENUES:Contributions and grants $ 4,496,216 $ 7,676,943 $ 12,173,159 Dividend and interest income from program investments 6,311,683 3,578 6,315,261 Dividend and interest income from short-term investments 3,337,685 - 3,337,685 Management fees (Note F) 11,007,515 - 11,007,515 Contract revenues and training fees 3,027,438 - 3,027,438 Net assets released from restrictions 8,841,803 (8,841,803) - Global Programs 17,305,359 - 17,305,359 Microlending 4,247,532 - 4,247,532 Global Investments 5,632,415 - 5,632,415 ACCION Investment Management Company 2,801,514 - 2,801,514 Center for Financial Inclusion 4,031,672 - 4,031,672 Communications 1,856,366 - 1,856,366 Change in net assets from operations (7,172,777) (1,161,282) (8,334,059) Income taxes (Note F) (3,121,031) - (3,121,031) Change in equity income of equity investments (6,075,778) - (6,075,778) Purchase of interest in SCM by noncontrolling shareholder (Note B) 786,543 - 786,543 Net unrealized loss on investments (10,967,811) - (10,967,811) Net realized gain on investments 23,509,673 - 23,509,673 Foreign currency translation losses, net (298,672) (11,347) (310,019) Change in net assets (3,339,853) (1,172,629) (4,512,482) Net assets - End of year $ 300,286,293 $ 10,191,008 $ 310,477,301 ACCION INTERNATIONAL AND SUBSIDIARIESConsolidated Statement of Functional ExpensesYear ended December 31, 2013 Program Services Supporting ServicesACCION Investment Center forGlobal Global Management Financial General and Total Programs Microlending Investments Company Inclusion Communications Administrative Fundraising Expenses FUNCTIONAL EXPENSES:Salaries and related expenses $ 9,622,798 $ 3,163,951 $ 2,879,808 $ 5,197 $ 2,486,785 $ 1,061,245 $ 3,283,646 $ 2,074,454 $ 24,577,884 Professional services 2,055,333 858,022 2,296,973 6,274 1,312,261 325,814 900,148 109,581 7,864,406 Travel and conferences 1,774,662 177,432 604,196 (5,545) 1,662,141 209,442 302,518 128,441 4,853,287 Office and occupancy 1,248,371 557,944 297,796 (75) 377,828 330,890 689,876 223,202 3,725,832 Awards and grants 1,516,806 - - - 70,000 - - - 1,586,806 Provision for doubtful accounts 1,671,289 835,164 - - 50,490 - - - 2,556,943 Taxes and penalties 101,069 487,160 15,802 295 - - 4,698 - 609,024 Depreciation 118,725 87,992 17,682 - 24,938 10,993 39,576 15,391 315,297 Interest and fees 22,055 55,604 170,342 1,302 4,469 - 43,687 18,237 315,696 Miscellaneous 67,459 119,243 15,268 - 26,352 9,802 2,117 19,648 259,889 Total $ 18,198,567 $ 6,342,512 $ 6,297,867 $ 7,448 $ 6,015,264 $ 1,948,186 $ 5,266,266 $ 2,588,954 $ 46,665,064 FUNCTIONAL EXPENSES:Salaries and related expenses $ 8,683,469 $ 2,025,659 $ 2,058,357 $ 2,418,221 $ 2,203,535 $ 785,556 $ 3,465,277 $ 2,045,963 $ 23,686,037 Professional services 3,370,510 735,654 2,650,562 119,376 634,985 602,933 808,584 287,065 9,209,669 Travel and conferences 2,045,245 120,730 465,792 141,954 884,321 167,253 183,831 109,941 4,119,067 Office and occupancy 1,053,444 450,869 240,926 81,963 270,616 288,972 815,216 513,372 3,715,378 Awards and grants 1,843,804 - - - 3,320 - - - 1,847,124 Provision for doubtful accounts 55,134 386,052 - - - - - - 441,186 Taxes and penalties 49,950 308,454 19,833 - - - 6,038 - 384,275 Depreciation 136,385 46,642 16,436 - 18,612 6,264 44,896 16,673 285,908 Interest and fees 36,608 23,814 156,837 2,380 1,115 - 39,824 25,231 285,809 Miscellaneous 30,810 149,658 23,672 37,620 15,168 5,388 (55,529) 13,877 220,664 Total $ 17,305,359 $ 4,247,532 $ 5,632,415 $ 2,801,514 $ 4,031,672 $ 1,856,366 $ 5,308,137 $ 3,012,122 $ 44,195,117 ACCION INTERNATIONAL AND SUBSIDIARIESConsolidated Statements of Cash FlowsYears ended December 31, 2013 and 2012 2013 2012CASH FLOWS FROM OPERATING ACTIVITIES: Change in net assets $ 22,418,394 $ (4,512,482) Adjustments to reconcile change in net assets to net cash used in operating activities:Unrealized loss on investments (8,311,700) 10,967,811 Realized gain on sale of investments (17,577,622) (23,509,673) Provision for doubtful accounts 1,581,940 441,186 Depreciation and amortization 315,297 285,907 Equity in income of investments (9,530,056) 6,075,778 Investment by non-controlling interests 4,468,610 786,543 Foreign currency translation gains 463,518 244,400 Increase (decrease) in cash and cash equivalents as a result of a change in: Prepaid expenses 2,982 (596,747) Grants receivable 3,559,831 313,266 Contributions receivable (776,648) 238,236 Deposits, advances and other receivables (374,287) 179,272 Contract payments receivable (1,267,680) (139,875) Cash restricted by foundation 738,016 1,089,252 Accounts payable and accrued liabilities 1,724,319 268,116 Deferred revenue 90,066 151,327 Net cash used in operating activities (2,475,020) (7,717,683) CASH FLOWS FROM INVESTING ACTIVITIES:Purchase of property and equipment (786,979) (312,749) Purchase (sale) of short-term investments (8,354,975) (3,379,687) Purchase of investments (17,977,878) (26,261,980) Proceeds from sale of investments 17,633,379 24,992,202 Dividends received from investments in affiliates 1,273,801 6,807,415 Net loan originations and principal repayments (9,295,351) (6,255,113) Net cash (used in) provided by investing activities (17,508,003) (4,409,912) CASH FLOWS FROM FINANCING ACTIVITIES:Notes payable received 525,690 820,899 Proceeds from deposit from investors - 6,349,106 Notes payable paid (573,672) (708,000) Line of credit borrowing (repayment) (21,139) (183,986) Net cash provided by (used in) financing activities (69,121) 6,278,019 EFFECT OF EXCHANGE RATE CHANGES ON CASH (607,407) (246,534) INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (20,659,551) (6,096,110) CASH AND CASH EQUIVALENTS - Beginning of year 40,449,646 46,545,756 CASH AND CASH EQUIVALENTS - End of year $ 19,790,095 $ 40,449,646 Supplemental disclosureInterest paid $ 110,640 $ 132,020 Taxes paid $ 439,687 $ 3,452,949 ACCION INTERNATIONAL AND SUBSIDIARIES Notes to Consolidated Financial Statements As of and for the years ended December 31, 2013 and 2012 NOTE A - NATURE OF ORGANIZATION ACCION International and its subsidiaries (Accion) is headquartered in Boston, Massachusetts with offices in Washington, D.C., Accra, Ghana and Manaus, Brazil and subsidiaries in Bangalore, India, Bogot, Colombia, Beijing and Chifeng, China, Ebne, Republic of Mauritius and Manaus, Brazil. Accion is an independent, nonprofit microfinance organization dedicated to promoting economic development around the world by providing people in impoverished and developing areas the financial tools they need - small business loans, training, and related financial services - to work their way out of poverty. NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Principles of Consolidation The consolidated financial statements include the accounts of Accion and the following entities: Fundacin Centro Accin Microempresarial (Centro) Centro is a non-profit foundation and was incorporated in Bogot, Colombia as a Latin American training and technical support arm of Accion. The accounts of Centro reflect total assets and liabilities of $507,335 and $2,081,289 at December 31, 2013, and $830,410 and $792,648 at December 31, 2012. In 2012, Centro launched a new activity, Avanza, providing loan origination services to Colombian microfinance institutions in exchange for a fee. ACCION Gateway Fund, LLC (Gateway) Gateway is a wholly owned subsidiary of Accion and was created as a limited liability company in Delaware to hold several investments in affiliates. ACCION Investment Management Company, LLC (AIMCO) AIMCO is a wholly owned subsidiary and was created as a limited liability company in Delaware for the purpose of providing investment management services for ACCION Investments in Microfinance, SPC (AINV), a separate legal entity. In 2012, AINV was sold and AIMCO has since then been inactive. The accounts of AIMCO reflect total assets and liabilities of $65,248 and $0 at December 31, 2013, and $5,067,213 and $16,400 at December 31, 2012. ACCION Technical Advisors, India (ATA) ATA is a wholly owned subsidiary of Accion. ATA is a nonprofit company according to Section 25 of the Indian Companies Act of 1956 and is the training and technical support arm of Accion in India. The accounts of ATA reflect total assets and liabilities of $222,151 and $187,705 at December 31, 2013, and $407,569 and $222,434 at December 31, 2012. ACCION Beijing Consultation Services Company, Ltd (ACC) - ACC was created as a wholly owned subsidiary of Accion as the training and technical arm of Accion in China. ACC is a for-profit company operating in the Peoples Republic of China. The accounts of ACC reflect total assets and liabilities of $284,319 and $313,179 at December 31, 2013, and $64,688 and $210,655 at December 31, 2012. Chifeng City Yuanbaoshan District ACCION Micro-Credit Company, Ltd (AMC) AMC was created as a wholly owned subsidiary of Accion and is a for-profit microfinance company operating in the Peoples Republic of China. A contribution of $3,236,500 and $7,978,953 was made by Accion in 2013 and 2012, respectively. The accounts of AMC reflect total assets and liabilities of $18,510,543 and $346,195 at December 31, 2013, and $13,440,951 and $124,531 at December 31, 2012. In November 2012, Accion received a cash deposit of $6,349,106 from an investor interested in purchasing shares of AMC. The sale of shares in AMC had not occurred as of December 31, 2013 and the deposit is presented as a liability on the statement of financial position. See Footnote N for a subsequent event in 2014. ACCION INTERNATIONAL AND SUBSIDIARIES Notes to Consolidated Financial Statements Continued As of and for the years ended December 31, 2013 and 2012 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Continued Principles of Consolidation - Continued ACCION Africa-Asia Investment Company (AAIC) AAIC is a wholly owned subsidiary of Accion. AAIC was created as a for-profit company incorporated in the Republic of Mauritius to own several investments in affiliates in Asia and Africa. ACCIN Microfinanas Sociedade de Crdito ao Microempreendedor e Empresa de Pequeno Porte, S.A. (SCM) SCM was created between Accion, an international governmental organization and an individual investor. SCM is a for-profit microfinance company operating in Manaus, Amazonas, Brazil. Accion is the majority shareholder and owns 92.31% of SCMs shares. An additional $4,058,140 and $2,480,657 was contributed in 2013 and 2012, respectively. The non-controlling interest in SCMs equity is $440,597 and $771,305 at December 31, 2013 and 2012, respectively, as presented on the statement of financial position. The accounts of SCM reflect total assets and liabilities of $3,963,690 and $818,425 at December 31, 2013, and $3,677,721 and $1,822,649 at December 31, 2012. Accion Investments in Microfinance Nigeria (AINV Nigeria) AINV Nigeria is a 51% owned subsidiary of Accion. AINV Nigeria was created as a for-profit company incorporated in the Cayman Islands to own an investment in Nigeria in partnership with one minority shareholder. The following provides changes in total unrestricted net assets attributable to the non-controlling interests, as well as total unrestricted net assets under Accions control: Controlling Non-controllingInterest Interest Total Balance at December 31, 2011 $ 303,339,317 $ 286,829 $ 303,626,146 Purchase of interest in SCM by outside party - 786,543 786,543 Change in net assets (3,824,329) (302,067) (4,126,396) Balance at December 31, 2012 299,514,988 771,305 300,286,293 Purchase of interest in SCM by outside party - 636,221 636,221 Purchase of interest in AINV Nigeria by outside party - 3,839,389 3,839,389 Change in net assets 21,879,604 (973,042) 20,906,562 Balance at December 31, 2013 $ 321,394,592 $ 4,273,873 $ 325,668,465 All intercompany balances and transactions involving the subsidiaries above have been eliminated in consolidation. NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Continued Basis of Presentation The accompanying consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America using the Not-for-Profit Organizations Audit Guide issued by the American Institute of Certified Public Accountants. Net assets, revenues, and expenses are classified based on the existence or absence of donor-imposed restrictions. Accordingly, the net assets of Accion and the changes thereof are classified and reported as follows: Unrestricted Net Assets - Net assets that are not subject to donor-imposed restrictions. Temporarily Restricted Net Assets - Contributions, grants, and income whose use by Accion has been limited by donors or grantors to a specific time period or purpose. Permanently Restricted Net Assets - Net assets subject to donor-imposed stipulations that are maintained permanently by Accion. Accion had no permanently restricted net assets at December 31, 2013 and 2012. Cash and cash equivalents include all highly liquid investments with original maturities of three months or less when purchased, excluding amounts restricted by donors for long-term purposes. At times, the cash balances maintained at a single institution may exceed federally insured limits, insured by the Federal Deposit Insurance Corporation. Accion has not experienced any losses in these accounts. Accion holds $702,623 and $1,440,639 in cash restricted by a foundation for long term purposes as of December 31, 2013 and 2012, respectively. Total cash held in foreign accounts was $2,608,142 and $6,114,318 at December 31, 2013 and 2012, respectively. Short-term investments consist of investments in certificates of deposit, commercial paper, corporate bonds, government reserves funds, mutual funds and US treasury bonds, which invest primarily in securities rated BBB or better, as determined by Standard & Poors Corporation. These investments are carried at fair value, determined as the price that would be received to sell the asset. The changes in fair value are reflected in the consolidated statement of activities. Global Bridge Guarantee Program Investments Investments in marketable equity securities with readily determinable fair values, and all investments in debt securities, are reported at fair value, determined as the price that would be received to sell the asset, with gains and losses included in the consolidated statement of activities. Investments in Affiliates With the exception of Accions investment in Gentera, formerly known as Compartamos, whose stock trades on the Mexican Stock exchange, investments in affiliates do not have a readily determinable fair value and, as such, are recorded at cost or under the equity method of accounting whenever Accion can exercise significant influence which is generally indicated when its equity position in the affiliate equals or exceeds 20% and does not exceed 50%. Under the equity method, Accion records its proportional share of the net income in the investment at each measurement date. Under the equity method, Accion records dividends as decreases in the investments. Investments in affiliates carried at cost are reviewed periodically to determine whether the underlying value of the affiliate has been impaired. If impairment has been identified and such impairment is deemed to be other than temporary, the carrying value of the investment is written down to the impaired value. Accion did not identify any investments requiring an impairment adjustment in 2013 or 2012. Contract Revenue and Training Fees Contract revenue and training fees consist of mission-related consulting agreements with microfinance institutions. Revenue is recognized based on the proportional performance method. As of December 31, 2013 and 2012, the provision for bad debt was $57,178 and $8,938, respectively. Contributions and Grants Contributions and grants are received from individuals, private industry, foundations, and government agencies. Contributions and grants may be designated by the donor for a specific purpose or given on an unrestricted basis. All contributions and grants are considered to be available for general use unless specifically restricted by the donor. Contributions and grants, including unconditional promises to give, are recorded at fair value when received. Fair value is determined as the amount to be received less the net present value, using a risk adjusted interest rate. Contributions and grants restricted for purposes which have not been fulfilled at the measurement date are accounted for as temporarily restricted revenue. Amounts received which are required by the donor to be passed on to other organizations are recorded as a liability and reflected in accounts payable and accrued liabilities in the consolidated statements of financial position until the transfer is made. Conditional promises to give are not included in revenues until the conditions are substantially met. Any assets contributed before the conditions are substantially met would be accounted for as a refundable advance and reflected in accounts payable and accrued liabilities in the consolidated statements of financial position. No conditional promises met this definition as of December 31, 2013 and 2012. As of December 31, 2013 and 2012, Accion had $881,000 and $1,925,417, respectively, in conditional promises to give. NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Contributions and Grants - Continued Grants and contributions receivable at December 31, 2013 and 2012 include amounts due in future years. Grants and contributions receivable are expected to be collected during the following periods: 2013 2012Due in one year or less $ 2,124,104 $ 4,285,236 Due in one to five years 2,328,490 3,026,348 Provision (25,000) (40,000) 4,427,594 7,271,584 Present value discount (approx 5%) (154,008) (210,475) Net contributions receivable $ 4,273,586 $ 7,061,109 Microloans Receivable Loans are stated at their principal balance net of the allowance for loan losses. Interest on loans is included in interest and dividend income from program investments as earned based upon interest rates applied to unpaid principal. Accrual of interest on loans is discontinued when, in the judgment of management, the collectability of principal or interest becomes doubtful. Past due status is based on the contractual terms of the loan. Interest subsequently received on nonaccrual loans is either applied against principal or recorded as income based on managements judgment as to the collectability of principal. Interest accruals are resumed on such loans only when they are brought fully current as to principal and interest and when, in the judgment of management, the loans are estimated to be fully collectible. The allowance for loan losses is established as losses are estimated to have occurred through a provision for doubtful accounts charged to functional expenses. Loan losses are charged against the allowance when management believes the un-collectability of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance. The adequacy of the allowance for loan losses is evaluated on a periodic basis by management. Factors considered in evaluating the adequacy of the allowance include current economic conditions and their effect on borrowers, the composition and size of the loan portfolio, and experience with other microlending entities. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available. Microloans receivable consisted of the following at December 31: Microloans receivable $ 20,890,240 $ 11,965,620 Allowance for doubtful accounts (1,438,043) (660,578) Microloans receivable, net $ 19,452,197 $ 11,305,042 NOTE B - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES - Continued Changes in the allowance for loan losses were as follows for the years ended December 31: Balance at beginning of year $ 660,578 $ 322,610 Write-offs and exchange rate fluctuation (57,699) (48,084) Provision for loan losses 835,164 386,052 Balance at end of year $ 1,438,043 $ 660,578 Furniture, fixtures, and equipment are recorded at cost and depreciated on a straight-line basis over their useful lives, which range from 3 to 10 years. Leasehold improvements are recorded at cost and amortized on a straight-line basis over the shorter of the life of the lease or estimated useful life of the improvement. Donated equipment is recorded at the fair market value as of the date the gift is made and amortized over its useful life. Donated Services Donated services which are specialized and which would otherwise need to be purchased are reflected as contribution revenue and expensed or capitalized, as appropriate, at their fair market values at the date of receipt. Fair market value is determined as the price at which services would have been purchased. Included in contributions and grant revenue, global programs, global investments, and general administrative expenses are donated services, computer equipment, and legal services having an aggregate value of $1,461,359 and $2,033,383 in fiscal 2013 and 2012, respectively. Foreign Currency Translation The functional currency of Centro is the local currency, which is the Colombian peso. The functional currency of ATA is the local currency, which is the Indian rupee. The functional currency of ACC and AMC is the Chinese Yuan Renminbi. The functional currency of SCM is the Brazilian Real. The functional currency of Accions branch in Ghana is the Cedi, and the functional currency of Accions branch in Brazil is the Brazilian Real. Assets and liabilities of these subsidiaries are translated into U.S. dollars using the current exchange rates at the date of the statement of financial position. Changes in net assets are translated using the average rate for the fiscal year. Foreign currency exchange transaction gains and losses are recorded in the statements of activities. Income Tax Accion is a tax-exempt organization as described in Section 501(c)(3) of the Internal Revenue Code and is generally exempt from income taxes pursuant to Section 501(a). Centro and ATA are registered charitable organizations in Colombia and India, respectively. Gateway, as a single member limited liability company which has not made a Form 8832 election, reports all of its taxable income or loss directly through its single member, Accion. Gateway is fully consolidated on Accions federal income tax return. ACC AAIC, AIMCO, AINV in Nigeria, AMC and SCM are taxable subsidiaries of Accion, filing their own tax returns. The income tax consequences, if any, are reflected in the financial statements, Footnote I, and do not have a material effect, individually or in the aggregate, upon Accions financial statements. Accion believes it has taken no uncertain tax positions. Risks and Uncertainties Accion facilitates access to letters of credit for affiliates outside the United States, which may involve significant risks not present in domestic transactions. For example, foreign companies usually are not bound by uniform accounting, auditing, and financial reporting requirements and standards of practice comparable to those applicable to domestic companies. Other risks include political or financial instability or diplomatic and other developments which could affect foreign operations and investments in foreign-based entities. Non-controlling Interest A non-controlling interest is defined as the portion of the net assets in a subsidiary not attributable, directly or indirectly, to a parent. Revenues, expenses, gains, losses and change in net assets are reported in the consolidated financial statements at the consolidated amounts, which include the amounts attributable to the non-controlling interest. The consolidated statement of activities separately presents Accion, as well as the change in net assets attributable to Accion and the non-controlling interest. NOTE C - FAIR VALUE OF FINANCIAL INSTRUMENTS As required by existing guidance, Accion reports certain assets at fair value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value. The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements). The three levels of the fair value hierarchy are described below: Level 1 - Unadjusted quoted prices in active markets that are accessible at the measurement date for identical unrestricted assets or liabilities; Level 2 - Quoted prices in markets that are not active, or inputs that are observable, either directly or indirectly, for substantially the full term of the asset or liability; Level 3 - Unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Level 3 includes values determined using pricing models, discounted cash flow methodologies, or similar techniques reflecting Accions own assumptions. NOTE C - FAIR VALUE OF FINANCIAL INSTRUMENTS - Continued A financial instruments level within the fair value hierarchy is based on the lowest level of input that is significant to the fair value measurement. The following is a description of the valuation methodologies used for assets recorded at fair value: Contributions and Grants Receivable Contributions and grants receivable are reported based on non-recurring fair value measurements. Multi-year pledges are recorded at the present value of future cash flows using a discount rate, adjusted for market conditions, to estimate fair value. Investments whose values are based on quoted market prices in active markets are classified as Level 1 assets. These investments primarily include money market funds, U.S. Treasury, and equity securities. Investments whose values are based on quoted prices in markets that are not active, inputs that are not observable, and for prices obtained from comparable securities of issuers with similar credit ratings, are classified as Level 2 assets. These investments include certificate of deposits and corporate bonds. The following table sets forth, by level within the fair value hierarchy, the financial assets and liabilities recorded at fair value on a recurring basis as of December 31, 2013 and 2012: Level 1 Level 2 Level 3 TotalShort-term investments: U.S. Treasury $ 26,703,590 $ - $ - $ 26,703,590 Certificate of deposits - 7,000,000 - 7,000,000 Corporate bonds - 53,133,888 - 53,133,888 Investment in affiliate at fair value 116,506,547 - - 116,506,547 Global Bridge Guarantee Program investments:Cash and cash equivalents 4,998,443 - - 4,998,443 Certificate of deposits - 252,214 - 252,214 Corporate bonds - 2,055,065 - 2,055,065 $ 148,208,580 $ 62,441,167 $ - $ 210,649,747 Accion recognizes transfers between fair value hierarchy levels at the approximate date or change in circumstances that cause the transfer. There were no significant transfers between fair value hierarchy levels during the years ended December 31, 2013 and 2012. The following are Accions assets accounted for at fair value on a non-recurring basis as of December 31, 2013 and 2012: Level 1 Level 2 Level 3 Total AssetsContribution and grant receivables $ - $ - $ 4,273,579 $ 4,273,579 $ - $ - $ 4,273,579 $ 4,273,579 NOTE D - PROPERTY AND EQUIPMENT Property and equipment at December 31, 2013 and 2012 consist of the following: Furniture, fixtures, equipment and software $ 2,493,497 $ 1,938,311 Leasehold improvements 764,470 710,273 Subtotal 3,257,967 2,648,584 Less accumulated depreciation (2,060,880) (1,858,461) Property and equipment net $ 1,197,087 $ 790,123 Depreciation expense as of December 31, 2013 and 2012 was $315,297 and $285,908, respectively, as reported on the consolidated statement of functional expenses. NOTE E - INVESTMENTS IN AFFILIATES Investments in affiliates at December 31, 2013 and 2012 consist of the following: 2013 2012 Investments in microfinance institutions with greater than20% participation (equity method) Akiba Commercial Bank (Tanzania) $ 2,206,999 $ 1,635,243 Banco Solidario S.A (Bolivia) 43,842,764 33,310,836 Swadhaar Finserve (India) 2,755,675 2,996,662 Saija (India) 1,867,666 1,817,733 Other (Various) 180,143 - $ 50,853,247 $ 39,760,474 Investments in microfinance institutions with less than20% participation Gentera SAB de C.V. (formerly Compartamos) (Mexico) (Fair Value) $ 116,506,547 $ 102,611,355 Finamrica Compania de Financiamiento Comercial (Colombia) (Cost) 1,448,673 1,366,373 Grupo BanDelta Holding Corp., Inc. (Panama) (Cost) 2,542,500 2,542,500 Banco de la Microempresa S.A. (Mibanco) (Peru) (Cost) 4,210,438 4,210,438 Microfinance Growth Fund, LLC (USA) (Cost) 1,000,000 1,000,000 ACCION Investments in Microfinance, 1,821,909 4,317,819 Sub-Sahara Africa Segregated Portfolio (Africa) (Cost)ACCION Microfinance Bank (Nigeria) (Cost) 7,819,882 - Desarrolladora e Impulsora de Negocios (CrediConfia) (Mexico) (Cost) 3,723,776 905,020 Other (Various) (Cost) 739,001 1,056,939 $ 139,812,726 $ 118,010,444 Investments in mission-related non microfinance institutionswith less than 20% participation (Cost Method) GloboKas Peru SAC (Peru) $ 1,959,043 $ 1,659,043 Leapfrog Financial Inclusion Fund (USA) 2,043,273 1,864,733 Lok Capital LLC (Mauritius) 1,470,706 2,184,406 MFX Solutions (USA) 1,250,000 1,250,000 Zoona Transactions International (Zambia) 1,626,557 1,626,557 ParaLife Holdings Inv (Switzerland) 244,000 1,200,000 Shubham Housing Development Finance Company (India) 1,924,105 1,924,105 ZonaMovil, Inc (Tiaxa) (USA) 3,500,014 3,000,014 Other (Various) 177,873 317,760 Total investments in affiliates $ 204,861,544 $ 172,797,536 NOTE E - INVESTMENTS IN AFFILIATES - Continued AKIBA Commercial Bank Ltd. (ACB) ACB is a private commercial bank focused on serving micro, small and medium enterprises and low income households in Tanzania. In 2012, Accion purchased 1,649,464 shares of ACB, representing 20% of ACBs total common shares. The accounts of ACB reflect total assets and total liabilities of $76.7 and $77.2 million and $65.7 and $63.4 million, respectively, at December 31, 2013 and 2012. Banco Solidario S.A. (BancoSol) BancoSol is a private commercial bank focused on microenterprises in Bolivia. Accions investment in BancoSol as of December 31, 2013 and 2012 represented 47.56% of BancoSols total common shares for both years. In 2012, Accion purchased 1,165,481 and sold 133,040 shares of BancoSol. In 2013, Accion purchased 163,512 shares of BancoSol. For the years ended December 31, 2013 and 2012, Accion received dividends of $1,273,801 and $873,971, respectively, and reported its share of BancoSols equity with an increase of $9,427,128 and a decrease of $8,852,273, respectively. The accounts of BancoSol reflect total assets and total liabilities of $1,098,147,732 and $1,005,963,620, and $911,745,553 and $841,705,947, at December 31, 2013 and 2012, respectively. Swadhaar FinServe (Swadhaar) Swadhaar is a nonbank microfinance institution operating in Mumbai, India. Accions investment in Swadhaar as of December 31, 2013 and 2012 represented 35.94% and 38% of Swadhaars total common shares, respectively. For the years ended December 31, 2013 and 2012, Accion reported its share of Swadhaars net loss of $240,988 and $29,584, respectively. The accounts of Swadhaar reflect total assets and total liabilities of $31,943,525 and $24,276,098, and $18,851,442 and $10,970,026, respectively, at December 31, 2013 and 2012. Saija Finance (Saija) Saija is a nonbank microfinance institution operating in Bihar, India. During 2012, Accion purchased 10,762,808 shares of Saija. Accions investment in Saija as of December 31, 2013 and 2012 represented 40.60% and 41% of Saijas total common shares, respectively. For the years ended December 31, 2013 and 2012, Accion reported its share of Saijas net gain of $49,933 and net loss of $592,581, respectively. The accounts of Saija reflect total assets and total liabilities of $7,932,422 and $3,633,490, and $4,951,664 and $475,202, respectively, at December 31, 2013 and 2012. Gentera SAB de C.V (Gentera) Gentera, formerly known as Banco Compartamos Institucin de Banca Mltiple (Compartamos) is the largest microfinance institution operating in Mexico. Accion accounts for its investment in Gentera at fair market value based on quoted market prices on the Mexican exchange. As of December 31, 2013 and 2012, Accions investment in Gentera represented 4.38% and 4.36% of Genteras common shares, respectively. In 2013, Accion sold 10 million shares, equal to 14% of its holdings and realized a gain of approximately $17 million. In 2012, Accion sold 20,028,399 shares, equal to 22% of its holdings and realized a gain of approximately $25 million. For the years ended December 31, 2013 and 2012, Accion received dividends of $5,360,488 and $1,975,518, respectively. For the years ended December 31, 2013 and 2012, Accion reported an unrealized gain of approximately $14 million and unrealized loss of approximately $10 million on investment, respectively. Finamrica Compania de Financiamiento Comercial (Finamrica) Finamrica is a nonbank microfinance institution operating in Colombia. Accions investment in Finamrica as of December 31, 2013 and 2012 represented 6.43 and 6.30% of Finamricas total common shares, respectively. For the year ended December 31, 2013 and 2012, Accion received dividends of $0 and $387,354, respectively. Grupo BanDelta Holding Corp., Inc. (BanDelta) BanDelta is the holding company of Banco Delta S.A., a microfinance-specialized bank in Panama. Accions investment in BanDelta as of December 31, 2013 and 2012 represented 11.33% and 11.38% of BanDeltas total common shares, respectively. For the years ended December 31, 2013 and 2012, Accion received dividends of $46,932 and $50,137, respectively. Banco de la Microempresa S.A. (Mibanco) Mibanco is Peru's first for-profit, fully-regulated commercial bank dedicated to microenterprise. Accions investment in Mibanco as of December 31, 2013 and 2012 represented 6.33% of Mibancos total common shares, respectively. For the years ended December 31, 2013 and 2012, Accion received dividends of $479,725 and $749,942, respectively. Microfinance Growth Fund, LLC (MIGROF) MIGROF, a Delaware company, provides loans to microfinance institutions which facilitate funding to small and micro enterprises in Latin America and the Caribbean. In 2012, Accion made a capital contribution of $187,624. Accions investment in MIGROF as of December 31, 2013 and 2012 represented 3.60 % ownership for both years. ACCION Investments in Microfinance Sub-Sahara Africa Segregated Portfolio (AINV Africa) AINV, a segregated portfolio of a Cayman Islands holding company, owns investments in African microfinance institutions. In October 2012, Accion purchased 2,335 Class B Shares of AINV Africa, representing 51% of the total portfolio and indirectly 12.24% of Accion Microfinance Bank Limited in Nigeria (AMfB); 15.30% of EB-Accion Savings & Loans in Ghana (EASL); and 15.30% of EB-Accion Microfinance in Cameroon (EAMF). In July 2013, Accion transferred AMfBs shares to AINV Nigeria, an Accion subsidiary. In August 2013, Accion purchased indirectly 324 shares of EAMF. As of December 31, 2013, Accion owned indirectly 15.30% of EASL and 16.62% of EAMF. ACCION Microfinance Bank Ltd. (AMfB) AMfB is a Nigerian Microfinance institution. In July 2013, shares of AMfB were transferred from AINV Africa to Accion Investment in Microfinance Nigeria (AINV Nigeria), a 51% Accion owned entity. In August 2013, AINV Nigeria purchased 74,184,039 additional shares. AINV Nigerias investment in AMfB as of December 31, 2013 represented 18.24% of AMfBs total shares. NOTE E - INVESTMENTS IN AFFILIATES - Continued Desarrolladora e Impulsora de Negocios, S.A.P.I. de C.V., SOFOM., E.N.R (CrediConfia) CrediConfia is a Mexican microfinance institution. In May 2012, Accion purchased 131,912 common shares and agreed to provide technical assistance over three years in exchange for 341,655 common shares. Through this agreement Accion acquired 102,497 shares in 2012 and 26,854 shares in 2013. In June 2013, Accion provided a loan of $208,716 to CrediConfia at an interest rate of 17.5%. In November 2013, Accion converted the loan to shares and invested an additional $2.5 million, totaling a $2.7 million investment, towards future capitalizations of tier one capital. Accions investment in Crediconfia as of December 31, 2013 and 2012 represented 5% and 4.46% of Crediconfias total common shares, respectively. GloboKas Peru SAC (GKN) GKN, the Peruvian subsidiary of GTV GlobokasNet LLC. GKN is a provider of business and financial transaction data transmission services, including processing and settlement services to banks, microfinance institutions, NGOs and corporations seeking cashless payment solutions. In 2012, Accion purchased 234,375 of preferred shares (Series C). As of December 31, 2013 and 2012 Accions investment in GKN represented 16.31% of GKNs total shares for both years. In 2013, Accion invested $300,000 in warrants with the option to convert the warrants into equity shares at a discount price of up to 20%. Leapfrog Financial Inclusion Fund (Leapfrog) Leapfrog, incorporated in Mauritius, is a global investment fund focused exclusively on micro-insurance and other financial products to meet the financial needs beyond working-capital credit of low-income people in developing countries. As of December 31, 2013 and 2012, Accions total investment in Leapfrog represented 2.2% of Leapfrogs total shares for both years. Lok Capital LLC (Lok) Lok is a Mauritius-based venture fund dedicated to providing equity investments to microfinance institutions in India. In 2013 and 2012, Accion redeemed 7,137 and 895 shares, respectively. In 2012, Accion purchased an additional 544 shares. Accions investment in Lok as of December 31, 2013 and 2012 represented 11.36% of Loks total common shares, for both years. MFX Solutions (MFX) MFX is a US-based for-profit enterprise providing microfinance lenders with the expertise to quantify currency risk along with affordable and accessible hedging instruments to mitigate currency risk. Accions investment in MFX as of December 31, 2013 and 2012 represented 10.61% of MFXs total common shares for both years. Zoona Transactions International (Zoona) Formerly known as Mobile Transactions International, Zoona is a third-party provider of an array of mobile payment solutions in Zambia. The bulk of Zoona s revenue is earned through its core product offerings of money transfers, ordering & supplier payments, and agent payments. Accions investment in Zoona as of December 31, 2013 and 2012 represented 18.16% of Zoonas total common shares for both years. ParaLife Holdings Inv (ParaLife) ParaLife is a Swiss-based for-profit enterprise offering life insurance and other micro-insurance products to low-income people in developing nations with a special emphasis on people with disabilities and their families. Accions investment in ParaLife as of December 31, 2013 and 2012 represented 3.70% and 3.85% of ParaLifes total common shares, respectively. Shubham Housing Development Finance Company (Shubham) Shubham focuses on mortgage lending for quality affordable urban and semi-urban housing in India. Shubham targets informal sector workers (vegetable vendors, rickshaw pullers, etc), slum rehabilitation program customers, and anyone who does not have access to regular home loans (under/un-banked). In 2012, Accion purchased 198,410 Series B Compulsory Convertible Preferred Shares (CCCPs) and 10 Class A Series B shares representing 10% of Shubhams total shares as of December 31, 2013 and 2012. Zonamovil, Inc (Tiaxa) Tiaxa is a business solutions provider for Mobile Network Operators (MNOs). Tiaxa is currently focused on Latin America and South East Asia. Tiaxa offers turnkey solutions for real-time pricing and billing of pre-paid mobile phone transactions, as well as value added and business intelligence services to help MNOs and corporations market more effectively to their customers. In 2012, Accion purchased 652,773 shares of Series F Preferred Stock. As of December 31, 2013 and 2012, Accions investment in Tiaxa represented 3.74 % and 4.11% of Tiaxas total shares, respectively. In 2013, Accion invested $500,000 in a bond with an annual coupon of 15% and a maturity date of November 2017. Accion invests in several other microfinance institutions or other organizations providing products and technologies to support and complement the development of microfinance. The investments are individually under $1 million and are recorded at cost net of any recorded temporary impairment. For the years ended December 31, 2013 and 2012, Accion received dividends from these investments of $221,341 and $342,644, respectively. NOTE F - RELATED PARTY TRANSACTIONS ACCION, the US Network (the US Network) is a network of microfinance institutions in the U.S. related to Accion through a brand licensing agreement. Accion provides accounting and information technology support to the US Network through a shared services agreement and through Accions membership in the US Network. Under the agreement, certain salaries incurred by Accion are charged to the US Network. Such amounts aggregated $32,843 in 2013 and are reflected as contract revenue in the accompanying consolidated statements of activities. ACCION East, formerly known as ACCION USA and a member of the US Network, shares office space with Accion in Boston, Massachusetts. The use and cost allocation of this shared office space as well as administrative support is administered through a shared services agreement. Under the agreement, certain salaries and occupancy expenses incurred by Accion are charged to ACCION EAST. Such amounts aggregated to $231,901 in 2013 and $326,150 in 2012, and are reflected as contract revenue in the accompanying consolidated statements of activities. On December 5, 2013, Accion provided a secured loan to ACCION Texas, a member of the US Network. The outstanding principal amount of $1,000,000 is maturing on December 5, 2014 at a fixed rate of 3% and is reported as note receivable from affiliates in the statement of financial position. AIMCO was created for the purpose of providing investment services for AINV, an equity method investment holding of Accion. AIMCO received investment management fees from AINV of $11,007,515 for the year 2012. On October 30, 2012, AINV closed its fund and compensated AIMCO with a closing management fee of $9,879,126. Income tax expense included $85,649 and $3,121,032 income taxes on AIMCOs management fees income related to the sale of ACCION Investment in Microfinance, SPC (See note B) for the years ended December 31, 2013 and 2012, respectively. NOTE G - GLOBAL BRIDGE GUARANTEE PROGRAM INVESTMENTS Global Bridge Guarantee Program investments (at fair value) at December 31, 2013 and 2012 consist of the following: 2013 2012Global Bridge Guarantee Program investments: Cash and cash equivalents $ 4,998,443 $ 1,734,865 Certificate of deposits 252,214 252,214 Corporate bonds 2,055,065 5,507,230 The Global Bridge Guarantee Program borrows funds by issuing notes payable and utilizing the proceeds to purchase investments rated BBB or better. These investments serve as collateral for letters of credit issued in favor of banks which lend funds to independent microfinance institutions in their counties. The microfinance institutions then lend those funds to self-employed, low-income individuals who would not otherwise have access to bank loans. There are cash or cash equivalents held within Global Bridge Guarantee Program investments to reserve against potential loan losses totaling $1,259,405 and $1,252,762 at December 31, 2013 and 2012, respectively. NOTE H - NOTES PAYABLE Notes payable as of December 31, 2013 and 2012 consist of the following: Total notes payable $ 6,022,103 $ 6,070,086 Global Bridge Guarantee Program - unsecured notes payable tofoundations, institutions, individuals, and religious organizations; variousinterest rates from 0% to 5% per annum; due in varying amounts through2023 The scheduled principal repayments under these notes as of December 31, 2013, are as follows: 2014 $ 1,271,435 2015 2,224,212 2016 1,221,456 2017 300,000 2018 255,000 Thereafter 750,000 NOTE I - INCOME TAXES The provision for income taxes for the years ended December 31, 2013 and 2012 is comprised of the following: 2013 2012Current provision Federal $ 66,652 $ 2,473,009 State 18,997 648,023 Foreign 334,482 98,732 Deferred provision (benefit) (279,927) (15,274) Provision (benefit) for income taxes $ 140,204 $ 3,204,490 NOTE I - INCOME TAXES - Continued Deferred income tax assets at December 31, 2013 and 2012 consist of the following: 2013 2012Deferred income tax assets Net operating loss carryforwards $ 934,000 $ 495,000 Provision for doubtful accounts 324,587 44,660 Less: valuation allowance (934,000) (495,000) $ 324,587 $ 44,660 The available net operating loss carryforwards at December 31, 2013 and 2012 are $6,225,000 and $3,303,000, respectively. Deferred income tax assets and liabilities are attributed to temporary differences between financial and taxable reports applying a blended income tax rate of 15%. Management has concluded that it is more likely than not that a portion of its deferred tax asset as of December 31, 2013 and 2012 will not be realized and as such a valuation allowance has been recorded. NOTE J - COMMITMENTS AND CONTINGENCIES In order to obtain letters of credit used as collateral on bank loans made to affiliates globally, Accion has placed investments in certain accounts as a guarantee. These accounts are included in bridge fund and loan fund investments in the consolidated statements of financial position (see Note G). At December 31, 2013 and 2012, the Global Bridge Guarantee Program was contingently liable for letters of credit in the amount of $4,750,000 and $3,500,000, respectively. At December 31, 2013, Accion had a $4,000,000 loan facility with Bank of America. The loan facility includes a line of credit at a rate of interest of LIBOR plus 1.75% plus an annual fixed fee and a sublimit working capital agreement of $1,000,000 for the benefit of ACCION Technical Advisors India at a fixed rate of 15.25%. There was no balance outstanding in both years under the line of credit and there was a balance of $0 and $22,585 outstanding under the India sublimit agreement at December 31, 2013 and 2012, respectively. The loan facility expired on July 31, 2013 and was not renewed. At December 31, 2013, SCM had a $212,000 overdraft loan facility with Bradesco Bank at a fixed rate of 29.38%. There was no outstanding balance under the line of credit as of December 31, 2013 and 2012. NOTE J - COMMITMENTS AND CONTINGENCIES - Continued Capital Calls For the years ended December 31, 2013 and 2012, Accion had approximately $3.7 million and $3 million, respectively, in capital call commitments with investment affiliates. The balance will be disbursed on an as-needed basis during the commitment period, which extends through 2014. Accion leases office space in various countries in which they operate. These leases expire over periods ranging from July 2012 through June 2024. The remaining net minimum payment obligation under these leases is as follows: $ 911,951 760,341 779,065 2017 808,438 2018 634,998 Thereafter 3,333,659 Total $ 7,228,452 Rent expense was approximately $1,582,000 and $1,640,000 for the years ended December 31, 2013 and 2012, respectively. Contractual Repurchase Commitment As part of the Avanza loan origination services, Centro is under a contractual commitment to repurchase, from its customer, loans over 90 days past due. In 2013, Centro repurchased a total of $445,000 and recorded an allowance for repurchases of $1,203,000 resulting in a total bad debt expense of $1,648,000. Due to the various assumptions built into the loans repurchase estimate, future actual repurchases might defer from the estimated allowance. As of December 31, 2013, the total outstanding loans originated by Centro totaled $8,645,000 and this amount represented Centros maximum possible repurchase commitment. Due to the uncertainty of various assumptions built into the loan repurchase estimate, future actual repurchases may differ from the estimated allowance. NOTE K - EMPLOYEE BENEFIT PLAN Accion has established a defined contribution retirement plan which is available to substantially all salaried employees. Accions contribution to this plan is based on a percentage of participant salaries and totaled $585,331 and $551,503 in 2013 and 2012, respectively. NOTE L - TEMPORARILY RESTRICTED NET ASSETS Temporarily restricted net assets have been restricted by donors to be used in a specific time period, for a specific location, or scope of work. Temporarily restricted net assets are available as of December 31, 2013 and 2012, for the following purposes: Global programs $ 2,664,521 $ 3,805,200 Global investments 494,152 343,074 Fundraising 790,947 Center for financial inclusion 4,252,610 6,042,734 Total $ 8,202,230 $ 10,191,008 NOTE M - CONCENTRATIONS OF CREDIT RISK Financial instruments that potentially subject Accion to concentrations of credit risk are investments, cash equivalents, and other interest-bearing investments. Approximately 58% of Accions investments in affiliates are invested in the common stock of Gentera, a Mexican-based bank (see Note E). In addition, one donor represents 84% of contributions receivable. NOTE N - SUBSEQUENT EVENTS Management has evaluated subsequent events through October 31, 2014, which is the date financial statements were available for issuance. Other than the items disclosed below, there were no subsequent events that required adjustments or disclosure in the financial statements. On February 19, 2014, Accion sold 355,731 shares of BancoSol, representing 8.58% of its holdings, for $10,296,660. On February 24, 2014, Accion sold 9,182 shares of Financiera El Comercio, representing 100% of its holding, for $5,773,593, and realized a capital gain of $5,264,365. On June 4, 2014, Accion sold 30,489,398 shares of Mibanco, representing 100% of its holding, for $18,707,521, and realized a capital gain of $14,526,124. On September 23, 2014, Accion purchased 5,921,963 shares of Credinka for $4,979,176. In 2014, Accion sold 13,438,480 shares of Gentera (formerly known as Compartamos), representing 21.53% of its holdings, for $26,190,277, and realized a capital gain of $26,240,789. On May 20, 2014 Accion became an indirect minority shareholder of AMC by transferring its full ownership interest in AMC in exchange for a minority portion of equity shares of a newly created parent company of AMC. ACCION INTERNATIONAL AND SUBSIDIARIESConsolidating Schedule of Financial PositionDecember 31, 2013 ACCION Microlending Elimination International* Subsidiaries** Entries Consolidated CURRENT ASSETS:Cash and cash equivalents $ 17,737,474 $ 2,052,621 $ - $ 19,790,095 Investments 86,837,478 - - 86,837,478 Notes receivable from affiliates 3,500,486 - (500,486) 3,000,000 Grants receivable - net 1,609,017 - - 1,609,017 Contributions receivable - net 490,087 - - 490,087 Contract receivables - net 938,739 - - 938,739 Microloans receivable- net - 19,452,197 - 19,452,197 Prepaid expenses 938,321 198,367 - 1,136,688 Deposits, advances and other receivables 700,756 324,587 - 1,025,343 Total current assets 112,752,358 22,027,772 (500,486) 134,279,644 NON-CURRENT ASSETS:Cash restricted by foundation for long-term purposes 702,623 - - 702,623 Grants receivable - net 1,550,030 - - 1,550,030 Contributions receivable - net 624,445 - - 624,445 Global Bridge Guarantee Program investments 7,305,722 - - 7,305,722 Investments in affiliates 204,861,544 - - 204,861,544 Investments in subsidiaries 24,624,670 - (24,624,670) - Property and equipment - net 750,626 446,461 - 1,197,087 Total non-current assets 240,419,660 446,461 (24,624,670) 216,241,451 Total assets $ 353,172,018 $ 22,474,233 $ (25,125,156) $ 350,521,095 CURRENT LIABILITIES:Accounts payable and accrued liabilities $ 4,296,193 $ 664,134 $ - $ 4,960,327 Deferred revenue 293,863 - - 293,863 Deposit from investor 6,349,106 - - 6,349,106 Notes payable 1,271,435 - - 1,271,435 Total current liabilities 12,210,597 664,134 - 12,874,731 NON-CURRENT LIABILITIES:Notes payable - net of current portion 4,750,669 500,486 (500,486) 4,750,669 Total non-current liabilities 4,750,669 500,486 (500,486) 4,750,669 Total liabilities 16,961,266 1,164,620 (500,486) 17,625,400 NET ASSETS:Capital - 24,624,670 (24,624,670) - Unrestricted: ACCION 328,018,766 (3,325,301) (4,273,873) 320,419,592 Non-controlling interest in SCM (Note B) - - 440,597 440,597 Non-controlling interests in Accion Investment in Nigeria (Note B) - - 3,833,276 3,833,276 Total unrestricted net assets 328,018,766 (3,325,301) - 324,693,465 Temporarily restricted 8,191,986 10,244 - 8,202,230 Total net assets 336,210,752 21,309,613 (24,624,670) 332,895,695 Total liabilities and net assets $ 353,172,018 $ 22,474,233 $ (25,125,156) $ 350,521,095 ACCION International includes Centro ACCION Microempresarial, ACCION Gateway Fund, LLC, ACCION Investment Management Company LLC, ACCION Technical Advisors, ACCION Beijing Consultation Services Company, Ltd, ACCION Africa Asia Investment Company, and Accion Investments in Microfinance Nigeria.Microlending subsidiaries include Chifeng City Yuanbaoshan District ACCION Micro-Credit Company Ltd and ACCION Microfinancas-Sociedade de Credito ao Microempreendor e a Empresa de Pequeno Porte, SA. CURRENT ASSETS:Cash and cash equivalents $ 35,231,067 $ 5,218,579 $ - $ 40,449,646 Investments 80,652,713 - - 80,652,713 Notes receivable from affiliates 200,671 - - 200,671 Grants receivable - net 3,916,877 - - 3,916,877 Contributions receivable - net 328,359 - - 328,359 Contract receivables - net 428,810 - - 428,810 Microloans receivable- net - 11,305,042 - 11,305,042 Prepaid expenses 1,075,101 126,600 - 1,201,701 Deposits, advances and other receivables 525,688 126,491 - 652,179 Total current assets 122,359,286 16,776,712 - 139,135,998 NON-CURRENT ASSETS:Cash restricted by foundation for long-term purposes 1,440,639 - - 1,440,639 Grants receivable - net 2,806,348 - - 2,806,348 Contributions receivable - net 9,525 - - 9,525 Global Bridge Guarantee Program investments 7,494,309 - - 7,494,309 Investments in affiliates 172,797,536 - - 172,797,536 Investments in subsidiaries 17,330,030 - (17,330,030) - Notes receivable from affiliates - net of current portion 3,400,000 - (1,400,000) 2,000,000 Property and equipment - net 448,163 341,960 - 790,123 CURRENT LIABILITIES:Accounts payable and accrued liabilities $ 3,043,162 $ 303,015 $ - $ 3,346,177 Deferred revenue 209,223 - - 209,223 Bank line of credit (221,580) 244,165 - 22,585 Deposit from investor 6,349,106 - - 6,349,106 Notes payable 1,507,211 - - 1,507,211 NON-CURRENT LIABILITIES:Notes payable - net of current portion 4,562,875 1,400,000 (1,400,000) 4,562,875 Total non-current liabilities 4,562,875 1,400,000 (1,400,000) 4,562,875 Total liabilities 15,449,997 1,947,180 (1,400,000) 15,997,177 ACCION 302,456,648 (2,170,355) (771,305) 299,514,988 Non-controlling interests in SCM (Note B) - - 771,305 771,305 Total unrestricted net assets 302,456,648 (2,170,355) - 300,286,293 Temporarily restricted 10,179,191 11,817 - 10,191,008 ACCION INTERNATIONAL AND SUBSIDIARIESConsolidating Schedule of ActivitiesYear ended December 31, 2013 ACCION International* Microlending Subsidiaries** Elimination Entries Consolidated REVENUES:Contributions and grants $ 11,014,274 $ 219,223 $ - $ 11,233,497 Dividend and interest income from program services 6,866,238 4,202,912 (114,353) 10,954,797 Dividend and interest income from short-term investments 2,617,691 80,604 - 2,698,295 Contract revenues and training fees 4,750,708 - (262,521) 4,488,187 Total revenues 25,248,911 4,502,739 (376,874) 29,374,776 Global Programs 18,198,564 - - 18,198,564 Microlending 376,874 6,342,512 (376,874) 6,342,512 Global Investments 6,297,867 - - 6,297,867 ACCION Investment Management Company 7,448 - - 7,448 Center for Financial Inclusion 6,015,264 - - 6,015,264 Communications 1,948,186 - - 1,948,186 Total program services 32,844,203 6,342,512 (376,874) 38,809,841 Supporting servicesGeneral and administrative 5,266,266 - - 5,266,266 Fundraising 2,588,954 - - 2,588,954 Total supporting services 7,855,220 - - 7,855,220 Total functional expenses 40,699,423 6,342,512 (376,874) 46,665,061 Change in net assets from operations (15,450,512) (1,839,773) - (17,290,285) Income taxes (85,649) - - (85,649) Equity in income of equity investments 9,530,056 - - 9,530,056 Purchase of interest in SCM from noncontrolling shareholder - 629,221 - 629,221 Purchase of interest in Accion Investment in Nigeria 3,839,389 - - 3,839,389 by noncontrolling shareholder (Note B)Change in net unrealized gain on investments 8,311,700 - - 8,311,700 Net realized gain on investments 17,587,361 (9,739) - 17,577,622 Foreign currency translation gains, net (157,432) 63,772 - (93,660) Change in net assets 23,574,913 (1,156,519) - 22,418,394 Net assets - Beginning of year 312,635,839 (2,158,538) - 310,477,301 Net assets - End of year:Unrestricted 328,018,766 (3,325,301) - 324,693,465 Temporary restricted 8,191,986 10,244 - 8,202,230 Net assets - End of year $ 336,210,752 $ (3,315,057) $ - $ 332,895,695 ACCION International includes Centro ACCION Microempresarial, ACCION Gateway Fund, LLC, ACCION Investment Management Company LLC, ACCION Technical Advisors, ACCION Beijing Consultation Services Company, Ltd, ACCION Africa Asia Investment Company, and Accion Investments in Microfinance Nigeria.Microlending subsidiaries include Chifeng City Yuanbaoshan District ACCION Micro-Credit Company Ltd and ACCION Microfinancas-Sociedade deCredito ao Microempreendor e a Empresa de Pequeno Porte, SA. REVENUES:Contributions and grants $ 12,036,750 $ 136,409 $ - $ 12,173,159 Dividend and interest income from program services 4,279,143 2,289,688 (253,570) 6,315,261 Dividend and interest income from short-term investments 3,196,342 141,343 - 3,337,685 Management fees 11,007,515 - - 11,007,515 Contract revenues and training fees 3,242,720 3,600 (218,882) 3,027,438 Global Programs 17,305,359 - - 17,305,359 Microlending 215,282 4,504,702 (472,452) 4,247,532 Global Investments 5,632,415 - - 5,632,415 ACCION Investment Management Company 2,801,514 - - 2,801,514 Center for Financial Inclusion 4,031,672 - - 4,031,672 Communications 1,856,366 - - 1,856,366 Change in net assets from operations (6,400,397) (1,933,662) - (8,334,059) Income taxes (3,121,031) - - (3,121,031) Change in equity income of equity investments (6,075,778) - - (6,075,778) Purchase of interest in SCM from noncontrolling shareholder - 786,543 - 786,543 Change in net unrealized gain on investments (10,967,811) - - (10,967,811) Net realized gain on investments 23,509,673 - - 23,509,673 Foreign currency translation gains, net (71,987) (238,032) - (310,019) Change in net assets (3,127,331) (1,385,151) - (4,512,482) Net assets - Beginning of year 315,763,170 (773,387) - 314,989,783 Net assets - End of year:Unrestricted 302,456,648 (2,170,355) - 300,286,293 Temporary restricted 10,179,191 11,817 - 10,191,008 ACCION International includes Centro ACCION Microempresarial, ACCION Gateway Fund, LLC, ACCION Investment Management Company LLC, ACCION Technical Advisors, ACCION Beijing Consultation Services Company, Ltd, ACCION Africa Asia Investmen FINCA International, Inc.€¦ · FINCA International, Inc. Consolidated Financial Statements as of and for the Year Ended December 31, 2014, Supplemental Schedules as of and for SUPPLEMENTAL SCHEDULES FOR © 2010 … SCHEDULES FOR © 2010 WithumSmith+Brown, PC REPORTABLE TRANSACTIONS When is a supplemental schedule of reportable transactions (line 4j… UNITED STATES CONFERENCE OF CATHOLIC … STATES CONFERENCE OF CATHOLIC BISHOPS AND AFFILIATE Consolidated Financial Statements with Supplemental Schedules December 31, 2015 and 2014 CONSOLIDATED TRANSMISSION OWNERS AGREEMENT RATE SCHEDULE ... · Rate Schedules --> TOA-42 Rate Schedule FERC No. 42 Effective Date: 4/16/2012 - Docket #: ER12-1095-000 - Page 1 CONSOLIDATED u.s.bancorp1Q 2003 Supplemental Business Line Schedules Consolidated Financial Statements and Schedules Related to … · 2020. 5. 18. · preparation and fair presentation of the consolidated financial statements in order to design audit Consolidated Financial Statements and … MISSIONARIES OF OUR LADY HEALTH SYSTEM, INC. AND AFFILIATED ORGANIZATIONS Consolidated Financial Statements and Supplemental Schedules June u.s.bancorp2Q 2003 Earnings Release and Supplemental Analyst Schedules Combined Financial Statements, Supplemental Schedules and … · 2018. 1. 23. · Foreign currency translation (622,016) - (622,016) Other revenue 107,014 - 107,014 Net earned revenue Financial Statements and Supplemental Schedules and Report ... Q4 FY 2020 SUPPLEMENTAL SLIDES · 2020. 10. 15. · Q4 FY20 Supplemental Slides | October 15, 2020 6 CONSOLIDATED OPERATING RESULTS –QUARTERLY Q4 ’19 Q1 ’20 Q2 ’20 Q3 ’20 Annual Report Supplemental Schedules Supplemental Schedules - Clemson University · Supplemental Schedules For the Year Ended June 30, 2016 Clemson, south Carolina A component unit of the State of South Carolina ~ 1 Supplemental Schedules - COnnecting REpositories · International visitors fees 1,050 Sales tax discount 3,000 Copier services proceeds 4,664 Merchandise sales 5,240 Student Sustainability Schedules Consolidated Financial 08 09 Schedulu Supplemental Information for the Consolidated Financial ... Financial Statements with Supplemental Schedules · Statement No. 39, Determining Whether Certain Organizations Are Component Units. The Foundation’s financial statements include Schedules to the Consolidated Financial Statements for the … · · 2010-05-13Schedules to the Consolidated Financial Statements ... Inc, USA ("Infosys Public Servies") and controlled

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professional_accounting

The accompanying unaudited condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the SEC. Certain information or footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted, pursuant to the rules and regulations of the SEC for interim financial reporting. Accordingly, they do not include all the information and footnotes necessary for a complete presentation of financial position, results of operations, or cash flows. In the opinion of management, the accompanying unaudited condensed financial statements include all adjustments, consisting of a normal recurring nature, which are necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented. The accompanying unaudited condensed financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the period ended December 31, 2021, as filed with the SEC. The interim results for the three and six months ended June 30, 2022 are not necessarily indicative of the results to be expected for the year ending December 31, 2022 or for any future periods. The preparation of financial statements in conformity with GAAP requires the Company’s management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Making estimates requires management to exercise significant judgment. It is at least reasonably possible that the estimate of the effect of a condition, situation or set of circumstances that existed at the date of the financial statements, which management considered in formulating its estimate, could change in the near term due to one or more future confirming events. Accordingly, the actual results could differ significantly from those estimates. The Company considers all short-term investments with an original maturity of three months or less when purchased to be cash equivalents. The Company did not have any cash equivalents as of June 30, 2022 and December 31, 2021. Common Stock Subject to Possible Redemption The Company accounts for its common stock subject to possible redemption in accordance with the guidance in Accounting Standards Codification (“ASC”) Topic 480 “Distinguishing Liabilities from Equity.” Common stock subject to mandatory redemption is classified as a liability instrument and is measured at fair value. Conditionally redeemable common stock (including common stock that features redemption rights that are either within the control of the holder or subject to redemption upon the occurrence of uncertain events not solely within the Company’s control) is classified as temporary equity. At all other times, common stock is classified as stockholders’ equity. The Company’s common stock features certain redemption rights that are considered to be outside of the Company’s control and subject to occurrence of uncertain future events. Accordingly, at June 30, 2022 and December 31, 2021, common stock subject to possible redemption is presented at redemption value as temporary equity, outside of the stockholders’ equity section of the Company’s balance sheets. The Company recognizes changes in redemption value immediately as they occur and adjusts the carrying value of redeemable common stock to equal the redemption value at the end of each reporting period. Immediately upon the closing of the Initial Public Offering, the Company recognized the accretion from initial book value to redemption amount value. The change in the carrying value of redeemable common stock resulted in a charge against additional paid-in capital. At June 30, 2022 and December 31, 2021, the common stock subject to possible redemption reflected in the balance sheets is reconciled in the following table: The Company accounts for income taxes under ASC 740, “Income Taxes.” ASC 740, Income Taxes, requires the recognition of deferred tax assets and liabilities for both the expected impact of differences between the unaudited condensed financial statements and tax basis of assets and liabilities and for the expected future tax benefit to be derived from tax loss and tax credit carry forwards. ASC 740 additionally requires a valuation allowance to be established when it is more likely than not that all or a portion of deferred tax assets will not be realized. As of June 30, 2022 and December 31, 2021, the Company’s deferred tax asset had a full valuation allowance recorded against it. The effective tax rate was 62.64% and 0.00% for the three months ended June 30, 2022 and 2021, respectively, and 14.52% and 0.00% for the six months ended June 30, 2022 and 2021, respectively. The effective tax rate differs from the statutory tax rate of 21% for the three and six months ended June 30, 2022 and 2021, due to the valuation allowance on the deferred tax assets. ASC 740 also clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. ASC 740 also provides guidance on derecognition, classification, interest and penalties, accounting in interim period, disclosure and transition. The Company recognizes accrued interest and penalties related to unrecognized tax benefits as income tax expense. There were no unrecognized tax benefits and no amounts accrued for interest and penalties as of June 30, 2022 and December 31, 2021. The Company is currently not aware of any issues under review that could result in significant payments, accruals or material deviation from its position. The Company has identified the United States as its only “major” tax jurisdiction. The Company is subject to income taxation by major taxing authorities since inception. These examinations may include questioning the timing and amount of deductions, the nexus of income among various tax jurisdictions and compliance with federal and state tax laws. The Company’s management does not expect that the total amount of unrecognized tax benefits will materially change over the next twelve months. Net Income (Loss) per Common Share The Company complies with accounting and disclosure requirements of FASB ASC Topic 260, “Earnings Per Share.” The Company has two types of common stock – redeemable common stock and non-redeemable common stock. The Company calculates its earnings per share to allocate net income (loss) pro rata to redeemable and non-redeemable common stock. This presentation contemplates a Business Combination as the most likely outcome, in which case, both classes of common stock share pro rata in the income (loss) of the Company. In order to determine the net income (loss) attributable to both the redeemable and non-redeemable common stock, the Company first considered the total income (loss) allocable to both sets of shares. This is calculated using the total net income (loss) less any dividends paid. For the purposes of calculating net income (loss) per share, any remeasurement of the accretion to redemption value of the redeemable common stock subject to redemption is considered to be dividends paid to the holders of the redeemable common stock. The calculation of diluted income (loss) per common share does not consider the effect of the warrants issued in connection with the (i) Initial Public Offering, and (ii) the private placement since the exercise of the warrants is contingent upon the occurrence of future events. The warrants are exercisable to purchase 5,980,750 shares of common stock in the aggregate. As a result, diluted net income (loss) per common share is the same as basic net income (loss) per common share for the periods presented. Concentration of Credit Risk Financial instruments that potentially subject the Company to concentrations of credit risk consist of a cash account in a financial institution, which, at times, may exceed the Federal Depository Insurance Corporation coverage limit of $250,000. The Company has not experienced losses on this account and management believes the Company is not exposed to significant risks on such account. Fair Value of Financial Instruments The fair value of the Company’s assets and liabilities, which qualify as financial instruments under ASC 820, “Fair Value Measurement,” approximates the carrying amounts represented in the accompanying balance sheets, primarily due to their short-term nature. Warrant Classification The Company accounts for warrants as either equity-classified instruments or liability-classified instruments based on an assessment of the warrant’s specific terms and applicable authoritative guidance in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification(“ASC”) 480, Distinguishing Liabilities from Equity (“ASC 480”) and ASC 815, Derivatives and Hedging (“ASC 815”). The assessment considers whether the warrants are freestanding financial instruments pursuant to ASC 480, meet the definition of a liability pursuant to ASC 480, and whether the warrants meet all of the requirements for equity classification under ASC 815, including whether the warrants are indexed to the Company’s own common stock, among other conditions for equity classification. This assessment, which requires the use of professional judgment, is conducted at the time of warrant issuance and as of each subsequent quarterly period end date while the warrants are outstanding. For issued or modified warrants that meet all of the criteria for equity classification, the warrants are required to be recorded as a component of additional paid-in capital at the time of issuance. For issued or modified warrants that do not meet all the criteria for equity classification, the warrants are required to be recorded at their initial fair value on the date of issuance, and each balance sheet date thereafter. Changes in the estimated fair value of the warrants are recognized as a non-cash gain or loss on the statements of operations. The Company’s has analyzed the Public Warrants and Private Warrants and determined they are considered to be freestanding instruments and do not exhibit any of the characteristics in ASC 480 and therefore are not classified as liabilities under ASC 480 or ASC 815. Recent Accounting Standards In August 2020, the FASB issued ASU No. 2020-06, “Debt—Debt with Conversion and Other Options (Subtopic 470-20) and Derivatives and Hedging—Contracts in Entity’s Own Equity (Subtopic 815-40): Accounting for Convertible Instruments and Contracts in an Entity’s Own Equity” (“ASU 2020-06”), which simplifies accounting for convertible instruments by removing major separation models required under current GAAP. ASU 2020-06 removes certain settlement conditions that are required for equity contracts to qualify for the derivative scope exception and it also simplifies the diluted earnings per share calculation in certain areas. ASU 2020-06 is effective for fiscal years beginning after December 15, 2023, including interim periods within those fiscal years, with early adoption permitted. The impact of the adoption of ASU 2020-06 is being assessed by the Company; however, no significant impact on the financial statements is anticipated. Management does not believe that any other recently issued, but not yet effective, accounting standards, if currently adopted, would have a material effect on the Company’s financial statements. The disclosure of accounting policy for temporary equity. Name: rocl_TemporaryEquityPolicyPolicyTextBlock Disclosure of accounting policy for basis of accounting, or basis of presentation, used to prepare the financial statements (for example, US Generally Accepted Accounting Principles, Other Comprehensive Basis of Accounting, IFRS). Name: us-gaap_BasisOfAccountingPolicyPolicyTextBlock Disclosure of accounting policy for cash and cash equivalents, including the policy for determining which items are treated as cash equivalents. Other information that may be disclosed includes (1) the nature of any restrictions on the entity's use of its cash and cash equivalents, (2) whether the entity's cash and cash equivalents are insured or expose the entity to credit risk, (3) the classification of any negative balance accounts (overdrafts), and (4) the carrying basis of cash equivalents (for example, at cost) and whether the carrying amount of cash equivalents approximates fair value. Name: us-gaap_CashAndCashEquivalentsPolicyTextBlock Disclosure of accounting policy for credit risk. -URI https://asc.fasb.org/extlink&oid=99393423&loc=d3e5967-108592 Name: us-gaap_ConcentrationRiskCreditRisk Disclosure of accounting policy for its derivative instruments and hedging activities. -Paragraph 1A -URI https://asc.fasb.org/extlink&oid=125515794&loc=SL5579245-113959 -Subparagraph (SX 210.4-08(n)) Name: us-gaap_DerivativesPolicyTextBlock Disclosure of accounting policy for computing basic and diluted earnings or loss per share for each class of common stock and participating security. Addresses all significant policy factors, including any antidilutive items that have been excluded from the computation and takes into account stock dividends, splits and reverse splits that occur after the balance sheet date of the latest reporting period but before the issuance of the financial statements. Name: us-gaap_EarningsPerSharePolicyTextBlock Disclosure of accounting policy for determining the fair value of financial instruments. -URI https://asc.fasb.org/extlink&oid=7493716&loc=d3e21868-110260 Name: us-gaap_FairValueOfFinancialInstrumentsPolicy Disclosure of accounting policy for income taxes, which may include its accounting policies for recognizing and measuring deferred tax assets and liabilities and related valuation allowances, recognizing investment tax credits, operating loss carryforwards, tax credit carryforwards, and other carryforwards, methodologies for determining its effective income tax rate and the characterization of interest and penalties in the financial statements. Name: us-gaap_IncomeTaxPolicyTextBlock Disclosure of accounting policy pertaining to new accounting pronouncements that may impact the entity's financial reporting. Includes, but is not limited to, quantification of the expected or actual impact. Name: us-gaap_NewAccountingPronouncementsPolicyPolicyTextBlock Disclosure of accounting policy for the use of estimates in the preparation of financial statements in conformity with generally accepted accounting principles. Name: us-gaap_UseOfEstimates

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professional_accounting

Computers - Software Medium & Small / Visesh Infotechnics Ltd. BSE: 532411 | NSE: VISESHINFO | Shares falling in the `Trade-to-Trade` or `T-segment` are traded in this series and no intraday is allowed. This means trades can only be settled by accepting or giving the delivery of shares. Series: BE | ISIN: INE861A01058 | SECTOR: Computers - Software Medium & SmallComputers - Software Medium & Small Visesh Infotec | BSE 0.19 0.00 (0.00%) | NSE 0.10 0.05 (100.00%) | TTrade Now | Add 0.19 0.00 (0.00%) 0.10 0.05 (100.00%) 0.10 (11394558) For Year : Download Annual Report in PDF format 2018 2016 2015 2014 2013 2012 2011 2010 2009 Annual Report 2018 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007 2006 Report on the IND AS Financial Statements We have audited the accompanying standalone IND AS Financial Statements of MPS Infotecnics Limited New Delhi (“the Company”), which comprise the Balance Sheet as at March 31, 2018, and the Statement of Profit and Loss (including other comprehensive income )and Cash Flow Statement for the year then ended and Statement of Changes in Equity and a summary of significant accounting policies and other explanatory information. Management’s Responsibility for the IND AS Financial Statements The Company® Board of Directors is responsible for the matters in section 134 (5) of the Companies Act,2013 (the Act) with respect to the preparation of these standalone IND AS Financial Statements that give a true and fair view of the state of affairs (financial position) and financial performance and Cash Flow Statement of the Company in accordance with the accounting principles generally accepted in India, including the Accounting Standards specified under Section 133 of the Act, read with Rule 7 of the Companies (Accounts) Rules, 2014. This responsibility also includes the maintenance of adequate accounting records in accordance with the provision of the Act for safeguarding of the assets of the Company and for preventing and detecting the frauds and other irregularities; selection and application of appropriate accounting policies; making judgments and estimate that are reasonable and prudent; and design, implementation and maintenance of adequate internal financial control, that were operating effectively for ensuring the accuracy and completeness of the accounting records, relevant to the preparation and presentation of the IND AS Financial Statements that give a true and fair view and are free from material misstatement, whether due to fraud or error. Our responsibility is to express an opinion on these standalone IND AS Financial Statements based on our audit. We have taken into account the provisions of the Act, the accounting and auditing standards and matters which are required to be included in the audit report under the provisions of the Act and the Rules made there under. We conducted our audit of standalone statements in accordance with the Standards on Auditing specified under section 143(10) of the Act. Those Standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the IND AS Financial Statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the IND AS Financial Statements. The procedures selected depend on the auditors judgment, including the assessment of the risks of material misstatement of the standalone IND AS Financial Statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal financial control relevant to the Company’s preparation of the standalone IND AS Financial Statements that give a true and fair view in order to design audit procedures that are appropriate in the circumstances [but not for the purpose of expressing an opinion on whether the Company has in place an adequate internal financial controls system over financial reporting and the effectiveness of such controls]. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of the accounting estimates made by the Company® Directors, as well as evaluating the overall presentation of the standalone IND AS Financial Statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion on the standalone IND AS Financial Statements. Basis of Qualified Opinion 1. The company has shown in the balance sheet, bank balance in Banco Efisa (Lisbon Portugal) amounting to Rs. 347,892,163/- (in USD8883210.75) which the Bank has adjusted and the matter is in court of law. Consequently the bank balance shown in balance sheet is overstated by Rs. 347,892,163/- (Refer Note No. 7(b). 2. The Company has increased its authorised capital from Rs. 52.45 Crores to Rs. 377.50 Crores during the period From FY 2010-11 to FY 2012-13, ROC fees of Rs.4.88 Crores towards the same stands payable, under the head “Other Current Liabilities” in the IND AS Financial Statements. (Refer Note No.9 and 14). Income tax for the AY 2013-14 amounting to Rs. 20.80 lacs and intrest thereon is Payable. Qualified Opinion In our opinion, except for the effects of the matter described in the Basis of Qualified Opinion paragraph, and to the best of our information and according to the explanations given to us, the IND AS Financial Statements give the information required by the Act in the manner so required and give a true and fair view in conformity with the accounting principles generally accepted in India: a) In the case of the Balance Sheet, of the state of affairs of the Company as at March 31, 2018; b) In the case of the Statement of Profit and Loss (including Other Comprehensive), of the profit for the year ended on that date; and c) In the case of the Cash Flow Statement, of the cash flows for the year ended on that date. d) In statement of changes in equities , of the changes in equities for the year ended . 1. As required by the Companies (Auditors Report) Order, 2016 (the Order) issued by the Central Government of India in terms of sub-section (11) of section 143 of the Companies Act, 2013 we give in the Annexure A statement on the matters specified in paragraphs 3 and 4 of the Order, to the extent applicable. a. We have sought and obtained all the information and explanations which to the best of our knowledge and belief were necessary for the purpose of our audit; b. In our opinion proper books of account as required by law have been kept by the Company so far as appears from our examination of those books; c. The Balance Sheet, Statement of Profit and Loss, and Cash Flow Statement dealt with by this Report are in agreement with the books of account. d. In our opinion, the aforesaid standalone IND AS Financial Statements comply with the Accounting Standards specified under Section 133 of the Act, read with Rule 7 of the Companies (Accounts) Rules, 2016 and the Companies(Indian Accounting Standards) Amendment Rules, 2016 e. On the basis of the written representations received from the directors we on March 31, 2018 and taken on record by the board of director, none of the director of this company is disqualified as on 31 March,2018 from being appointed as a director in terms of Section 164(2) of the Act. f. With respect to the adequacy of the internal financial controls over financial reporting of the Company and the operating effectiveness of such controls, refer to our separate Report in “Annexure B” to this report. g. With respect to the other matters included in the Auditors Report and to the best of our information and according to the explanation given to us : I. Detail of pending litigation which are having financial impact is given below: Details of the Case Pending with (Authority name) Amount in INR AY 2006-07, Demand is outstanding under Income Tax Act, against which appeal no. 193/08-09 dated 29.01.2009 has been filed CIT (Appeal)-III, Bangalore Refer note 9 of Basis of Qualified Opinion regarding ROC fees for increase in authorised share capital. Hon''ble High Court Delhi DGCEI imposed a Service Tax demand against which Rs. 10 Lacs has been paid without prejudice CCE (Appeals) Visesh Infotechnics Ltd. V/s Benco Efisa, filed by Company for recovery (Refer note 7 b(1) of IND AS Financial Statements 10th Civil Court, Lisbon, Portugal USD 888 3210.75 and interest thereon II. As per information furnished to us, the Company does not have any long-term contracts including derivatives contracts for which there were any material foreseeable losses. III. There were no amounts which required to be transferred to the investor Education and Protection Fund by the Company. MPS Infotecnics Limited “Annexure A” to the Independent Auditors’ Report Referred to in paragraph 1 under the heading ‘Report on Other Legal & Regulatory Requirement’ of our report of even date to the IND AS Financial Statements of the Company for the year ended March 31, 2018. On the basis of such checks as we considered appropriate and in terms of the information and explanations given to us, we further state as under: 1. (a) The Company is maintaining proper records showing full particulars including quantitative details and situation of its fixed assets (b) All the assets have been physically verified by management during the year but there is The Company has conducted physical verification at a reasonable interval of its fixed assets during the period covered under our audit. We are informed that no material discrepancies were noticed on such verification. (c) The title deeds of immovable properties are held in the name of the company. 2. (a) The management has conducted the physical verification of inventory at reasonable intervals. (b) The discrepancies noticed on physical verification of the inventory as compared to books records which has been properly dealt with in the books of account were not material. 3. The Company has not granted any loans, secured or unsecured to companies, firms, Limited Liability partnerships or other parties covered in the Register maintained under section 189 of the Act. Accordingly, the provisions of clause 3 (iii) (a) to (C) of the Order are not applicable to the Company. 4. In our opinion and according to the information and explanations given to us, the company has complied with the provisions of section 185 and I86 of the Companies Act, 2013 In respect of loans, investments, guarantees, and security. 5. The Company has not accepted any deposits from the public and hence the directives issued by the Reserve Bank of India and the provisions of Sections 73 to 76 or any other relevant provisions of the Companies Act and the Companies (Acceptance of Deposit) Rules, 2015 with regard to the deposits accepted from the public are not applicable. 6. As informed to us, the maintenance of Cost Records has not been specified by the Central Government under sub-section (1) of Section 148 of the Act, in respect of the activities carried on by the company. 7. (a) According to information and explanations given to us and on the basis of our examination of the books of account, and records, the Company has been generally regular in depositing undisputed statutory dues including Provident Fund, Employees State Insurance, Income-Tax, Sales tax, Service Tax, Duty of Customs, Duty of Excise, Value added Tax, Cess and any other statutory dues with the appropriate authorities. According to the information and explanations given to us, no undisputed amounts payable in respect of the above were in arrears as at March 31, 2018 fora period of more than six months from the date on when they become payable except GST. b) According to the information and explanation given to us, there are statutory dues which have not been deposited on account of any dispute, detail is given below:- Nature of Statutory Dues Income Tax AY 2006-07 8. According to the information and explanations given to us and based on the documents and records produced to us, the company has defaulted in repayment of dues to Allahabad Bank, South Extension, New Delhi Branch against working capital limit for which the company has entered into one time settlement agreement on 14, Jan, 2016 and has settled for a sum of Rs. 1186.50 lakhs plus interest thereon from the date of settlement to the date of payment. Further the company has paid a sum of Rs. 10,27,40,318/- till 31.05.2017 and further re entered into an OTS of Rs. 266.00 Lacs and paid a sum of Rs. 13.30 lacs. 9. Based upon the audit procedures performed and the information and explanations given by the management, the company has not raised moneys by way of initial public offer or further public offer including debt instruments and term Loans. Accordingly, the provisions of clause 3 (ix) of the Order are not applicable to the Company and hence not commented upon. 10. Based upon the audit procedures performed and the information and explanations given by the management, we report that no fraud by the Company or on the company by its officers or employees has been noticed or reported during the year. 11. Based upon the audit procedures performed and the information and explanations given by the management, the managerial remuneration has been paid or provided in accordance with the requisite approvals mandated by the provisions of section 197 read with Schedule V to the Companies Act; 12. The Company is not a Nidhi Company. Hence this clause is not applicable on it. 13. In our opinion, all transactions with the related parties are in compliance with section177 and 188 of Companies Act, 2013 and the details have been disclosed in the IND AS Financial Statements as required by the applicable accounting standards. 14. Based upon the audit procedures performed and the information and explanations given by the management, the company has not made any preferential allotment or private placement of shares or fully or partly convertible debentures during the year under review. Accordingly, the provisions of clause 3(xiv) of the Order are not applicable to the Company. 15. Based upon the audit procedures performed and the information and explanations given by the management, the company has not entered into any non-cash transactions with directors or persons connected with him. Accordingly, the provisions of clause 3(xv) of the Orders are not applicable to the company 16. In our opinion, the company is not required to be registered under section 45 IA of the Reserve Bank of India Act, 1934. Accordingly, the provisions of clause 3(xvi) of the Orders are not applicable to the company “Annexure B” to the Independent Auditor’s Report of even date on the Standalone IND AS Financial Statements of MPS INFOTECNICS LIMITED (Formerly known as Visesh Infotecnics Ltd.) Report on the Internal Financial Controls under Clause (i) of Sub-section 3 of Section 143 of the Companies Act, 2013 (“the Act”) We have audited the internal financial controls over financial reporting of MPS INFOTECNICS LIMITED as of March 31, 2018 in conjunction with our audit of the Standalone IND AS Financial Statements of the Company for the year ended on that date. Management’s Responsibility for Internal Financial Controls The Company’s management is responsible for establishing and maintaining internal financial controls . These responsibilities include the design, implementation and maintenance of adequate internal financial controls that were operating effectively for ensuring the orderly and efficient conduct of its business, including adherence to company’s policies, the safeguarding of its assets, the prevention and detection of frauds and errors, the accuracy and completeness of the accounting records, and the timely preparation of reliable financial information, as required under the Companies Act, 2013. Our responsibility is to express an opinion on the Company’s internal financial controls over financial reporting based on our audit. We conducted our audit in accordance with the Guidance Note on Audit of Internal Financial Controls Over Financial Reporting (the [Guidance Note) and the Standards on Auditing, issued by ICAI and deemed to be prescribed under section 143(10) of the Companies Act, 2013, to the extent applicable to an audit of internal financial controls, both applicable to an audit of Internal Financial Controls and, both issued by the Institute of Chartered Accountants of India. Those Standards and the Guidance Note require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether adequate internal financial controls over financial reporting was established and maintained and if such controls operated effectively in all material respects. Our audit involves performing procedures to obtain audit evidence about the adequacy of the internal financial controls system over financial reporting and their operating effectiveness. Our audit of internal financial controls over financial reporting included obtaining an understanding of internal financial controls over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. The procedures selected depend on the auditors judgement, including the assessment of the risks of material misstatement of the IND AS Financial Statements, whether due to fraud or error. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion on the Company’s internal financial controls system over financial reporting. Meaning of Internal Financial Controls Over Financial Reporting A company’s internal financial control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of IND AS Financial Statements for external purposes in accordance with generally accepted accounting principles. A company’s internal financial control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of IND AS Financial Statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use, or disposition of the company’s assets that could have a material effect on the IND AS Financial Statements. Inherent Limitations of Internal Financial Controls Over Financial Reporting Because of the inherent limitations of internal financial controls over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of the internal financial controls over financial reporting to future periods are subject to the risk that the internal financial control over financial reporting may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, the Company has, in all material respects, an adequate internal financial controls system over financial reporting and such internal financial controls over financial reporting were operating effectively as at March 31,2018. For M/s. M/s. RMA & Associates LLP Firm Reg. No.: 000978N/N500062 Place: - New Delhi Partner Date : 31st May 2018 M. No. 503109 Visesh Infotechnics Stock Price | Visesh Infotech Stock Quote | Visesh Infotech Results | Visesh Infotech News | View All Related Searches

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professional_accounting

We have audited the accompanying Ind AS financial statements of Madhusudan IndustriesLimited ("the Company") which comprise the balance sheet as at 31stMarch 2018 and the statement of Profit and Loss (including Other Comprehensive Income)the Cash Flow Statement and the Statement of Changes in Equity for the year then endedand a summary of the significant accounting policies and other explanatory information. The Company’s Board of Directors is responsible for the matters stated in Section134(5) of the Companies Act 2013 ("the Act") with respect to the preparation ofthese Ind AS financial statements that give a true and fair view of the state of affairs(financial position) profit or loss (financial performance including other comprehensiveincome) cash flows and changes in equity of the Company in accordance with the accountingprinciples generally accepted in India including the Indian Accounting Standards (Ind AS)prescribed under section 133 of the Act read with the Companies (Indian AccountingStandards) Rules 2015 as amended and other accounting principles generally accepted inIndia. An audit involves performing procedures to obtain audit evidence about the amounts andthe disclosures in the Ind AS financial statements. The procedures selected depend on theauditor’s judgment including the assessment of the risks of material misstatement ofthe Ind AS financial statements whether due to fraud or error. In making those riskassessments the auditor considers internal financial control relevant to theCompany’s preparation of the Ind AS financial statements that give a true and fairview in order to design audit procedures that are appropriate in the circumstances. Anaudit also includes evaluating the appropriateness of the accounting policies used and thereasonableness of the accounting estimates made by the Company’s Directors as wellas evaluating the overall presentation of the Ind AS financial statements. In our opinion and to the best of our information and according to the explanationsgiven to us the aforesaid Ind AS financial statements give the information required bythe Act in the manner so required and give a true and fair view in conformity with theaccounting principles generally accepted in India including the Ind AS of the state ofaffairs (financial position) of the Company as at 31st March 2018 and itsprofit financial performance including other comprehensive income its cash flows and thechanges in equity for the year ended on that date. The comparative financial information of the company for the year ended 31stMarch 2017 and the transition date opening balance sheet as at 1st April 2016prepared in accordance with Ind AS included in these Ind AS financial statements have beenaudited by the predecessor auditor who had audited the financial statements for therelevant periods. The report of the predecessor auditor on the comparative financialinformation and the opening balance sheet dated 25th May 2017 expressed anunmodified opinion. The comparative financial information of the Company for the year ended 31st March 2017and the transition date opening balance sheet as at 1st April 2016 included in these IndAS financial statements are based on the previously issued statutory financial statementsprepared in accordance with the Companies (Accounting Standards) Rules 2006 audited bythe predecessor auditor whose report for the year ended 31st March 2017 and 31stMarch 2016 dated 25th May 2017 and 26th May 2016 respectively expressed anunmodified opinion on those financial statements as adjusted for the differences in theaccounting principles adopted by the Company on transition to the Ind AS which have beenaudited by us. Our opinion on the Ind AS financial statements and our report of Other Legal andRegulatory Requirements below is not modified in respect of these matters. e) On the basis of the written representations received from the directors as on 31stMarch 2018 taken on record by the Board of Directors none of the directors isdisqualified as on 31st March 2018 from being appointed as a director in termsof Section 164(2) of the Act. f) With respect to the adequacy of the internal financial controls over financialreporting of the Company and the operating effectiveness of such controls refer to ourseparate Report in "Annexure B". Our report expresses an unmodified opinion onthe adequacy and operating effectiveness of the Company’s internal financial controlsover financial reporting. Referred to in paragraph 1 under ‘Report on Other Legal and RegulatoryRequirements’ section of our report of even date to the members of MADHUSUDANINDUSTRIES LIMITED on the Ind AS financial statements as of and for the year ended 31stMarch 2018. (b) As explained to us fixed assets have been physically verified by the management atreasonable intervals in a phased periodical manner which in our opinion is reasonablehaving regard to the size of the Company and the nature of its assets. No materialdiscrepancies between the book records and the physical inventory have been noticed inrespect of the assets physically verified. 2. As explained to us the company does not hold any physical inventories during theyear. Thus paragraph 3(ii) of the Order is not applicable to the Company. 3. According to the information and explanations given to us and on the basis of ourexamination of the books of account the Company has not granted any loan secured orunsecured to companies firms Limited Liability Partnerships or other parties covered inthe register maintained under Section 189 of the Companies Act 2013. 4. According to the information and explanations given to us the company has compliedwith the provisions of Section 185 and 186 wherever applicable in respect of loansinvestments guarantees and securities given by the company. 5. In our opinion and according to the information and explanations given to us theCompany has not accepted any deposit from the public in accordance with the provisions ofSection 73 to 76 or any other relevant provisions of the Act and the rules framed thereunder. Accordingly paragraph 3(v) of the Order is not applicable to the Company. 6. In our opinion and according to the information and explanations given to us thecompany is not required to maintain cost records specified by the Central Government undersub-section (1) of section 148 of the Companies Act. 7. (a) According to the records of the company undisputed statutory dues includingProvident Fund Employees’ State Insurance Income-tax Sales-tax Service Tax Dutyof Customs Duty of Excise Value Added Tax Goods and Service Tax Cess and otherstatutory dues have been generally regularly deposited with the appropriate authorities.According to the information and explanations given to us no undisputed amounts payablein respect of the aforesaid dues were outstanding as at 31st of March 2018 fora period of more than six months from the date they became payable. 8. The company does not have any loans or borrowings from any financial institutionbank government or debenture holders during the year. Accordingly paragraph 3(viii) ofthe order is not applicable. 10. To the best of our knowledge and according to the information and explanationsgiven to us no fraud by the Company and no fraud on the Company by its officers oremployees has been noticed or reported during the year. 11. According to the information and explanations given to us the managerialremuneration has been paid or provided in accordance with the requisite approval mandatedby the provisions of section 197 read with schedule V to the Companies Act 2013. 12. The Company is not a Nidhi Company and the Nidhi Rules 2014 are not applicable toit the provisions of clause 3 (xii) of the Order are not applicable to the Company. 13. According to the information and explanations given to us all transactions withthe related parties are in compliance with Section 177 and 188 of the Act whereapplicable and the details have been disclosed in the Financial Statements as required bythe applicable Indian Accounting Standards. 14. According to the information andexplanations given to us and based on our examination of the records of the Company theCompany has not made any preferential allotment or private placement of shares or fully orpartly convertible debentures during the year. Accordingly the provisions of Clause3(xiv) of the Order are not applicable to the Company. 15. According to the information and explanations given to us and based on ourexamination of the records of the Company the Company has not entered into any non-cashtransactions with directors or persons connected with him and hence provisions of section192 of the Companies Act 2013 are not applicable. 16. According to information and explanations given to us the Company is not requiredto be registered under Section 45-IA of the Reserve Bank of India Act 1934. Accordinglythe provisions of Clause 3(xvi) of the Order are not applicable to the Company. Referred to in paragraph 2(f) under ‘Report on Other Legal and RegulatoryRequirements’ Section of our Report of even date to the members of MADHUSUDANINDUSTRIES LIMITED on the financial statements for the year ended 31st March2018. We have audited the internal financial controls over financial reporting of MADHUSUDANINDUSTRIES LIMITED ("the Company") as of March 31 2018 in conjunction with ouraudit of the Ind AS financial statements of the Company for the year ended on that date. The Company’s management is responsible for establishing and maintaining internalfinancial controls based on the internal control over financial reporting criteriaestablished by the Company considering the essential components of internal control statedin the Guidance Note on Audit of Internal Financial Controls Over Financial Reportingissued by the Institute of Chartered Accountants of India (the "Guidance Note").These responsibilities include the design implementation and maintenance of adequateinternal financial controls that were operating effectively for ensuring the orderly andefficient conduct of its business including adherence to company’s policies thesafeguarding of its assets the prevention and detection of frauds and errors theaccuracy and completeness of the accounting records and the timely preparation ofreliable financial information as required under the Companies Act 2013. Our responsibility is to express an opinion on the Company’s internal financialcontrols over financial reporting based on our audit. We conducted our audit in accordancewith the Guidance Note and the Standards on Auditing issued by ICAI and deemed to beprescribed under section 143(10) of the Companies Act 2013 to the extent applicable toan audit of internal financial controls both applicable to and audit of InternalFinancial Controls and both issued by the Institute of Chartered Accountants of India.Those Standards and the Guidance Note require that we comply with ethical requirements andplan and perform the audit to obtain reasonable assurance about whether adequate internalfinancial controls over financial reporting was established and maintained and if suchcontrols operated effectively in all material respects. Our audit involves performing procedures to obtain evidence about the adequacy of theinternal financial controls system over financial reporting and their operatingeffectiveness. Our audit of internal financial controls over financial reportingassessing the risk that a material weakness exists and testing and evaluating the designand operating effectiveness of internal control based on the assessed risk. The proceduresselected depend on the auditor’s judgement including the assessment of the risks ofmaterial misstatement of the financial statements whether due to fraud or error. A Company’s internal financial control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordance withgenerally accepted accounting principles. A company’s internal financial control overfinancial reporting includes those policies and procedures that (1) pertain to themaintenance of records that in reasonable details accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles and that receiptsand expenditures of the company are being made only in accordance with authorities ofmanagement and directors of the company; and (3) provide reasonable assurance regardingprevention or timely detection of unauthorized acquisition use or disposition of thecompany’s assets that could have a material effect on the financial statements. In our opinion the Company has in all material respects an adequate internalfinancial controls system over financial reporting and such internal financial controlsover financial reporting were operating effectively as at March 31 2018 based on theinternal control stated in the Guidance Note on Audit of Internal Financial Controls OverFinancial Reporting issued by the Institute of Chartered Accountants of India.

{'timestamp': '2019-04-19T12:31:40Z', 'url': 'https://www.business-standard.com/company/madhusudan-inds-1435/annual-report/auditors-report', 'language': 'en', 'source': 'c4'}

professional_accounting

In: Business and Management Submitted By nhocyoyo RMIT University Vietnam Corporate Governance and Regulations (BUSM 4158) Individual Social Audit Report on Vedan Vietnam’s Corporate Social Responsibility Prepared by: Nguyen Ngoc Thanh Phuong Student ID: s3480053 Lecturer: Mr. Barry Slutsky Semester 1, 2014 Word count: 1762 Corporate Governance & Regulations -­‐ BUSM 4158 Table of Contents Executive summary ..................................................................................................... 3 Vedan Vietnam and Thi Vai river incident .................................................................... 3 1. Vedan Vietnam – Company in brief: ......................................................................................................... 4 2. Thi Vai river incident ....................................................................................................................................... 4 Vedan’s social and environmental impact ................................................................... 4 1. Environmental impact .................................................................................................................................... 4 2. Social impact ....................................................................................................................................................... 5 2.1 Vedan’s action impacts on local resident’s health: .......................................................................... 5 2.2 Vedan’s action impacts on farmland ..................................................................................................... 5 3. Vedan’s stakeholders reaction .................................................................................................................... 6 3.1 Reaction from Government: ....................................................................................................................... 6 3.2 Reaction from local residents .................................................................................................................... 6 3.3 Financial damages ......................................................................................................................................... 7 Vedan’s Corporate Social Responsibility (CSR) ............................................................. 7 1. Lesson learnt from Thi Vai river incident .............................................................................................. 7 2. Vedan’s current engagement in CSR ......................................................................................................... 8 2.1 Vedan’s CSR activities ....................................................................................................................................... 8 2.2 Vedan’s social reporting .................................................................................................................................. 8 Recommendation ........................................................................................................ 9 References ................................................................................................................. 10 Phuong Nguyen -­‐ S3480053 2 Executive summary Ethics and Corporate Social Responsibility (CSR) have been always brought up to argue the role of profit and this debate may never end. Regardless, CSR has become one important component of business strategy to develop a sustainable success. However, not all company realize the essential role of CSR, Vedan Vienam is a typical example. The purpose of this paper is conducting a social audit on the social and environmental impact of Vedan Vietnam. Annual report, online magazine, company’s website and literature are used to support the auditing. In 2008, Vedan Vietnam was caught in discharging untreated sewage into Thi Vai River, which will be briefly summarized in the first part of this paper. The 12 km long river section of Thi Vai has been heavily polluted as well as surrounded area. Local residents’ health and farmland were badly impacted. The impact of this action on environment and social will be then audited in the second part. Company’s stakeholders are also taken into consideration and what they have reacted upon this incident. Vedan has to be responsible for their action by paying fines to the Government, compensation to local residents and the cost of restoring Thi Vai River. Thirdly, the paper will audit what Vedan has learnt from the mistake and its current engagement in CSR activities and social reporting. Finally, recommendation is provided for Vedan to improve its social and environmental responsibility. Vedan Vietnam and Thi Vai river incident 1. Vedan Vietnam – Company in brief: Vedan Enterprise Corporation was established in 1954 in Taiwan. In order to accelerate market expansion, the company established Vedan Vietnam in 1991 as its major production base (Corporate Profile, 2014). The plant is located on the Southeast of Ho Chi Minh City, in Dong Nai Province. Company’s products include fermentation-­‐based amino acids, food additive products, cassava starch-­‐based industrial products, beverage and specialty chemical products. 2. Thi Vai river incident Vedan’s plant was built next to Thi Vai River and the river happened to change its color in 1995 since Vedan started its operation. Shrimps and fish were killed by the polluted river and the company had to pay a compensation of total VND 15 billions to local farmers (Tuoi Tre Online, 2008). According to Vietnam Environment Administration’s inspection in 2006, the result showed that most samples which taken from Vedan’s sewage all had parameters of organic pollution, nutrients and bacteria exceed standards. After continuous investigation, Vedan finally got caught in the act of discharging untreated sewage into Thi Vai River in September 2008, which not only had a strong impact on the river itself but also the communities around it. Vedan’s social and environmental impact 1. Environmental impact Environmental contamination due to industrial production activities in general and industrial zone in particular has been always an ongoing topic and need to be addressed. What Vedan has done clearly had a bad impact on natural ecosystem. According to Vietnam Environment Administration’s report, the 12 km long river section of Thi vai has been heavily polluted. In this section, aquatic species such as shrip, fish can almost not exist nor grow (VEA, 2006). Discharging untreated sewage into Thi Vai River has a direct negative impact on the environment and also causes significant damage to agriculture production and aquaculture in neighboring areas. The pollution in Thi Vai River has leaded to long-­‐term consequence not only of the river itself but also the surrounded environment. It’s more difficult to abate groundwater pollution than surface’s pollution, as groundwater is able to move further through unseen aquifers. Most water pollutants cannot stay in Thi Vai forever; they are eventually carried from the rivers into the oceans. Therefore, its negative effects are not only as above, they may spread lager and finally unable to compute all damages. 2. Social impact 2.1 Vedan’s action impacts on local resident’s health: Environmental contamination does not only have negative impact on the environment itself, but also increase illness burden, increase the percentage of ill people in that industrial zone and local residential communities who live nearby. One of Vedan’s important stakeholders is local resident of Dong Nai Province. While Thi Vai River is the main domestic water supply source, its pollution had a serious influence on local residents’ health. Indeed, the groundwater’s contamination by Vedan’s sewage leaded to the pollution in soil, water, and air of surrounding areas fore many years. Many wells in the area are foul and unusable due to the contamination of groundwater caused by Vedan’s action. Local residents’ health is directly impacted, causing illness such as skin rashes, respiratory diseases and headaches. These consequences not only last for several years, within a certain group of people but also affect their next generation for many years after. 2.2 Vedan’s action impacts on farmland Thi Vai River was carrying pollutants from Vedan’s sewage while this river is also the main source of water supply for agriculture and aquaculture actives in Dong Nai Province. Thus, the pollution caused huge losses to the farmers who depend on fishing, breeding aquatic creatures and building dams for their livelihood. According to the report of Vietnam Environmental Administration, a total agricultural area of 1438.5 hectares are damaged, most are aquaculture ponds and 29.5 hectares of land is agricultural production (VEA, 2009). Since 2005, due to impact of untreated sewage and emission from Vedan’s factory, Phuong Nguyen -­‐ S3480053 5 production of local farmers declined in both quantity and quality. A farmer from Phuoc Binh Commune said he had lost total of VND 250 millions in the harvest of 2008. The pollution was killing all aquatic creatures and leading farmers to the brink of bankruptcy. According to Mr. Nguyen Van Phung, Deputy Chairman of Ho Chi Minh Farmers’s association, the number of household involved in aquaculture felt drastically from 500 to 170 households, as a result of Vedan’s action. 3. Vedan’s stakeholders reaction Stakeholder is defined as any group or individual who can affect or is affected by the achievement of organizational objectives (Friedman, 2002). Environment, local residents, regulations, governments are Vedan’s major stakeholders in this particular case. The impact of Vedan’s action upon their stakeholders is clearly indicated such as causing environmental contamination, impact on local residents’ health and wealth, which were illustrated above. By the action of discharging untreated sewage into Thi Vai River, Vedan also had to bear for the impact of stakeholders upon the company. 3.1 Reaction from Government: Vedan’s Vietnam has gone against Decree 183 of Vietnam Penal Code 1999 by continuing cause water pollution. According to Tuoi Tre Online, The Government asked the authority of the southern province of Đồng Nai to cooperate with the Ministry of Natural Resources and Environment (MONRE) and the Ministry of Public Security to strictly implement two decisions, namely Decision 1999/QĐ-­‐BTNMT on October 6, 2008 on suspending Vedan’s license to discharge its sewage into water sources and Decision 131/QĐ-­‐XPHC on the same day to impose administrative penalty against Vedan’s law infringement (Tuoi Tre Online, 2008) 3.2 Reaction from local residents Discharging untreated sewage into Thi Vai River directly has the impact on local residents’ health and wealth. For this action, Vedan had to cope with over 10,000 letters demanding legal action. The company is required to send to court by violating environmental protection laws. Besides compensation, local residents also demanded that Vedan’s action must be penalized resolutely and strictly through proper steps to ensure this illegal deed is completely ended. 3.3 Financial damages Vedan has to be responsible for their action by paying fines to the Government, compensation to local residents and the cost of restoring Thi Vai River. According to The Saigon Times, The Ministry of Natural Resources and Environment demanded Vedan to pay the fine of VND 267.5 millions for violating environmental protection plus VND 127 billions fees for environmental protection of industrial sewage. In addition, VND 569 billions were being asked by the HCMC Farmers’ Association as financial support to farmers who were affected by the Thi Vai River’s pollution (The Saigon Times, 2008). On the other hand, Vedan is also requested to construct a sewage treatment system to minimize the environmental contamination. Thi Vai incident badly impacted on Vedan’s reputation and profit. All social organization, newspaper, and the consumers decided to boycott all product of Vedan. With all of the impacts from stakeholders, Vedan recorded a total lost of 50% net profit in 2008 (Vedan Fiscal 2008 Annual Report). Vedan’s Corporate Social Responsibility (CSR) 1. Lesson learnt from Thi Vai river incident From Thi Vai River Incidents, Vedan Vietnam clearly did not fulfill the economic, legal, ethical and philanthropic responsibilities expected of it by its stakeholders. From a firm’s perspective, Vedan’s vision is to be Asia’s leading manufacturer of fermentation (Corporate Profile, 2014). Increasing profit is viewed as the company’s main mission by their illegal and unethical action of cutting down the cost of discharging wastewater process regardless of the consequences. Social and environmental concerns were nowhere considered as parts of Vedan’s mission. Vedan’s General Director Yan Kun Hsiang even initially argued and rejected the accusation until obvious evidence was found. Moreover, Vedan has shown its low social responsibilities and corporate ethics by prolonging the case and gave invalid reasons to bargain the compensation amount. 2. Vedan’s current engagement in CSR Ethics, CSR, have been always brought up to argue the role of profit and this debate may never end. Some firms consider CRS is a marketing tool to build up their positive image while some firms indeed concern CSR is part of company’s vision. Regardless, the role of CRS is more taken into consideration by Vedan after the consequences of Thi Vai River incident. Learning from mistake, Vedan is determined to not only meet the legal requirements on environmental protection in Vietnam, but also excel those requirements and become a green manufacturer. 2.1 Vedan’s CSR activities Aiming at the long-­‐term business in Vietnam, by the end of 2009, Vedan has taken initial step to establish their policy of environmental management system based on the standard of ISO 14001-­‐2004. The purpose of this management system is to orient and train each individual employee the concept of protecting environment and obey all legal regulations. In addition, since September 2009, Vedan Vietnam has strictly conducted the classification of sewage (recoverable and unrecoverable sewages) to each department, unit in the company and obtained good results (Vedan Sustainable Business, 2009). Vedan has realized that protecting environment is the core element contributing to long-­‐term development. After Thi Vai River incident, brand repositioning is probably the most challenging mission that Vedan needs to address. Vedan Vietnam has put together their best effort to gain back accreditation and rebuilt trust from local residents as well as its consumers. Since 2009 until now, Vedan has continuously engaged in CSR activities such as offering houses to poor households in Dong Nai Province, donating over VND 350 millions to Dong Nai’s Children Fund, giving gift to poor families every Lunar New Year, sponsoring scholarship for poor student, etc. (Vedan Sustainable Business). These CSR activities are integrated with Vedan’s main business concern, which is developing long-­‐term business in Vietnam 2.2 Vedan’s social reporting A proper process of communicating the social and environmental effects of Vedan organization however has not been established yet. In another way, Vedan Vietnam is not yet engaging in social report. The company is currently communicating its relevant information regarding CSR’s approach and activities only via the official web page. Phuong Nguyen -­‐ S3480053 8 Information is listed but not documented and presented in a standardized social reporting format. Although understanding that Vedan has tried to put all their CRS activities in action, engaging in social reporting, following international standard will help the company keep track and monitors properly its CSR activities as well as better communicate them to the company’s stakeholders. Recommendation As social responsibility now becomes an integral part of the wealth creation process, which if managed properly should enhance the competitiveness of business and maximize the value of wealth creation to society. Thi Vai River incident left a stain on Vedan’s reputation, which requires company a lot of time to recover. One of the critical tasks that Vedan Vietnam truly needs to work on is improving its social and environmental responsibility. In order to do so, the company must first understand and ensure associating CSR with the company’s strategy. In addition, building and promoting CSR through social media is a great tool in this modern society. It’s also easier for the company to approach its stakeholders and listen to their need. More and more CSR campaigns have gone virally on the Internet and obtained a great result. Social media is now considered as a perfect way of communicating information. Last but not least, Vedan is also required to engage in social reporting based on international standard to ensure its active compliance with the spirit of the law ethical and international norms. References • • Friedman, M. (2002). Capitalism and Freedom. Chicago: University of Chicago Press. Psaros, J. (2009). Australian Corporate Governance: A review and analysis of key issues. 1st ed. Prentice Hall. • Thesaigontimes.vn, (2008). Vedan license suspended, fines VND 127 billions. Viewed Apr 25,20014 < http://www.thesaigontimes.vn/Home/thoisu/doisong/10687/Xu-­‐ly-­‐Vedan-­‐ Tam-­‐dinh-­‐chi-­‐hoat-­‐dong-­‐nop-­‐127-­‐ti-­‐dong.html> • Tuoitre.vn, (2008). Vedan killed Thi Vai River. Viewed Apr 25, 2014 < http://tuoitre.vn/Chinh-­‐tri-­‐Xa-­‐hoi/278294/Vedan-­‐“giet”-­‐song-­‐Thi-­‐Vai.html#ad-­‐image-­‐0> • VEDAN International (Holdings) Limited, (2008). 2008 Interim Report (Full version). Viewed Apr 25, 2014 • Vedan.com.vn, (2014). Sustainable Business | Vedan Website. Viewed Apr 25, 2014 • Vedan.com.vn, (2014). Sustainable Business > Safety – Health – Environment | Vedan Website. Viewed Apr 25, 2014 • Vedaninternational.com, (2006). VEDAN International (Holdings) Limited. Viewed Apr 25, 2014 • Vietnam Environment Administration, (2009). Impact of Industrial Pollution. Viewed Apr 25, 2014 Phuong Nguyen -­‐ S3480053 1 0 ...OFFICE OF THE INSPECTOR GENERAL THE SOCIAL SECURITY ADMINISTRATION’S UNPROCESSED ANNUAL EARNINGS ENFORCEMENT SELECTION August 2012 AUDIT REPORT Introduction This is a report of my audit on Social Security Administration’s Unprocessed Annual Earnings practice. The audit was conducted by Olayinka Olagundoye, of Houston, Texas Audit during August 2012. Objective My audit was to (1) to assess Social Security Administration's (SSA) development in resolving 2.5 million earnings enforcement selections. (2) To determine the amount of improper payments to affected beneficiaries. Background The social security benefits objective is to give earnings to a person or family due to loses from reaching full retirement age. How much social security benefit one can qualify to receive annually and continue to receive monthly depends on the individual’s personal situation as follows: * To receive Social Security (SS) benefits during the year you become full retirement age which is age is 66. If one decides to work and reach full retirement age or older, the beneficiary may keep all benefits, regardless of earnings. * To receive Social Security (SS) benefits before the year one becomes full retirement age, the SSA must withhold $1 from your social security benefit for every $2 you earn over the annual limit. One must add earnings in all the 12 months Jan-Dec regardless of the month entitled to receive SS benefits for each $2 you earn above the limit until the month... A&O Audit Report ...prison on each count except the securities fraud counts, on which they face up to five years in prison. Audit Report A&O Incorporation. Certified Public Accountants Suite A2 Stockton, California Stockton, CA 95207, United States. 303/1350 West Robinhood Drive 209-462-4024 Independent Auditor’s Report To the Stockholders A&O Incorporation We have audited the accompanying balance sheets of A&O Incorporation as of December 31, 2009 and 2010, and the related statements of income, retained earnings, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly,...... Audit Report Modifications ...AUDITOR’S REPORT Board of Directors, Stockholders, Owners, and/or Management of Keystone Computers & Networks, Inc We have audited the accompanying balance sheet of Keystone Computers & Networks, Inc. (the “Company”) as of December 31, 20XX and the related statements of income, retained earnings, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. The major audit issue involved will be determining that the client has properly categorized costs between research and development (those costs involved in establishing technological feasibility) and those costs that should be capitalized. The auditors will have to determine at what point the software product reached the point of technological feasibility. We conducted our audit in accordance with auditing standards generally accepted in (the country where the report is issued). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit...... Modification and Opinions to Audit Reports ...of an audit report. An audit report is a crucial part in the auditing process. It is a guide for users of the financial information. Auditors issue opinions on the financial statements based on certain criteria. The main thing is if the financial statements are presented in accordance to GAAP. Also, modifications can occur after the opinion is issued. Modifications vary depending on the issue at hand. Changes in principles or a report involving other auditors are a few. More will be addressed in the paper. An audit report is different is many ways. Even for one company, the audit report may not be the same every year. Modifications and Opinions in Audit Reports Every publicly traded company gets audited. Pop Iuliana (2012) says, “The purpose of an audit is to improve the degree of trust of the users across the financial situations” (p.454). Companies must present their financial statements in accordance to Generally Accepted Accounting Principles (GAAP). The final stage of an audit is writing an audit report. An audit report “expresses an opinion over the audited financial situations so that any user of this information is able to take decisions based on it” (Iuliana, 2012, p. 453). A standard audit report contains eight parts. The eight parts are report title, audit report address, introductory paragraph, management’s responsibility, auditor’s responsibility, opinion paragraph, name and address of CPA firm, and audit report...... Guidelines for the Strategic Audit Report ...Guidelines for the Strategic Audit Report Revised Sep 2013 Adapted and revised from: Wheelen and Hunger, (2008). Concepts in Strategic Management and Business Policy, 11th Ed., Pearson Education, Inc. Purpose of the strategic audit assignment Your assignment Selecting a company for the strategic audit An effective report Required format for the strategic audit report Required sections of the strategic audit report Executive Summary Current situation Corporate governance External environment: Opportunities and threats Internal environment: Strengths and weaknesses Analysis of strategic factors (SFAS) Strategic alternatives and recommended strategy (TOWS) Implementation of recommended strategy Conclusions Evaluating mission statements Evaluating the Board of Directors Preparing the tables: EFAS, IFAS, SFAS, and TOWS Common-size statements Analyzing financial statements Analyzing financial ratios Writing guidelines Relaxed APA rules Useful resources Purpose of the strategic audit assignment A strategic audit is usually done to help the firm’s management decide how to proceed, or to support a potential investment or loan. The purpose of a strategic audit is essentially to answer the question, “What condition is this firm in?” Because the audit is focused toward answering this question, there must be a conclusion about what the audit shows. Therefore, while this is mostly an objective, informative report, there is a persuasive twist at the end. 1 The point of this...... Audit Report and Control Evaluation ...The Audit Report and Internal Control Evaluation University of Phoenix Michelle Melville Auditing/ACC 546 April 21, 2014 Professor Hillary Edmondson Auditor’s Responsibility for Detecting and Reporting Fraud It is the responsibility of the audit engaged in the audit process to detect material misstatement in management’s assertions. These material misstatements must also be properly reported. Arens et. al (2012) defined fraud as “…any intentional deceit meant to deprive another person or party of their property or rights” p 433. Fraud as it relates to financial reporting is the intentional misstatements of the company’s financial statements and the misappropriations of the company’s assets. In conducting the audit, the audit company needs to be able to identify whether the conditions for fraud, as indicated by Arenet. al (2012) exists. These conditions are; incentives or pressures, opportunities, and attitudes or rationalizations. The existence of certain factors help the auditor to identify whether the conditions for fraud exists. According to SAS 99 auditors are required to enter into the audit engagement with professional skepticism, a questioning mind, and must critically examine and evaluate audit evidence using audit procedures. In using professional skepticism the auditor must never assume the honesty or dishonesty with management reporting. The conditions for rationalization may cause even the most honest person to make allowances for committing...... ...and other similar needs. GNB Networ Power is used for things such as telecommunications, computers, security systems, emergency lighting, and forms of military equipment used in mission critical environments. B.) The company was audited by: KMPG LLP, the Atlanta, Georgia Office C.) The company states that Wal-mart Stores Inc.’s decision to no longer carry their product was a major contributing factor to their need for bankruptcy. They faced $31 million in interest payments in August of 2013 and the maturity of nearly $52 million in convertible notes in September. The company was in debt and one of their major customers choose to no longer carry their product. D.) This is in the email E.) Modified Unqualified F.) The report adequately warns of the bankruptcy in 2013, as the bankruptcy filing is already known. The warning statement “ the Company’s bankruptcy filing and related matters raise substantial doubt about the Company’s ability to continue as a going concern” is provided to users. The causes of bankruptcy were known. G.) Exide Technologies anticipates emerging from Chapter 11 restructing for its U.S. operations by the end of 2014. In an effort to do so on June 11, 2014 the company appointed two new executives to lead the Company’s efforts in upgrading one of it’s recycling facilities. Thomas Strang was named as Vice President of Environment Health, & Safety and Charles Giesige as Vice President of Recyling Operations. Info found: "Exide...... Aicpa Audit Report Format ...Independent Auditor’s Report [Appropriate Address] Report on the Financial Statements We have audited the accompanying consolidated financial statements of ABC Company and its subsidiaries, which comprise the consolidated balance sheet as of December 31, 20x1 and 20x0, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the years then ended, and the related notes to the financial statements. Management’s Responsibility for the Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial stamens in accordance with accounting principles generally accepted in the United States of America; this includes the design, implementation, and maintenance of internal control relevant to the preparation and fair presentation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America,. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated...... ...management is responsible for the financial statements presented, for maintaining effective internal control over financial reporting, and for its assessment of internal control. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements including examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. A company’s internal control over financial...... ...Audit Report Charles Moore ACC 546 Deborah Fitzgerald Thomas To: Deborah Fitzgerald Thomas From: Charles Moore Date: March 19, 2012 Subject: Audit Report Our audit team has completed a review of Apollo Shoes, Inc. operations in conformity with the fiscal year 2006 audit plan. The objective of this review is to contribute to the improvement of risk management and the control systems within the business by identifying and evaluating exposures to risks and the controls designed by management to reduce those risks (Virginia Tech, 2005). Background As stated in the 10-K filings Apollo is a planetary distributor specializing in technology superior athletic podiatric products. The company’s brands are the SIREN, SPOTLIGHT, PHONESHOE, and SPEAKERSHOE. Apollo operates from a large office with operations and warehouse facility in the Shoetown, Maine area. The company’s products are shipped to large and small retail outlets in a six state area. Apollo has more than 100 employees organized in five departments headed by the vice presidents. It should also be noted that the company has recorded investment income in the amount of $945,713.51 from Apollo’s investment in Shock-Proof Socks – a company that has not issued any dividends as of the date of this statement. Scope The sampling methods used were both a non-probabilistic, judgmental, and a probabilistic sample process to determine the sample size. The direct sampling method was based on judgmental criteria...... Beginning the Audit Report ...Audit Engagement Report Casey L. Stewart ACC/546 May 21, 2012 Shawn Cerezo Audit Engagement Report Balestra, Harr & Scherer, CPAs, Inc. Casey L. Stewart Partner 528 South West St Piketon, Ohio 45661 Apollo Shoes, Inc. Mr. Eric Unum VP of Finance 100 Shoe Plaza Shoetown, ME 00001 We are pleased to confirm our understanding of the services we are to provide Apollo Shoes, Inc. for the year ended December 31, 2007. We will audit the financial statements of Apollo Shoes, Inc. as of and for the year ended December 31, 2007. Audit Objective The objective of our audit is the expression of opinions as to whether your basic financial statements are fairly presented, in all material respects, in conformity with generally accepted accounting principles and to report on the fairness of the additional information referred to in the first paragraph when considered in relation to the basic financial statements taken as a whole. Our audit will be conducted in accordance with auditing standards generally accepted in the United States of America and will include tests of the accounting records and other procedures we consider necessary to enable us to express such opinions. If our opinions on the financial statements are other than unqualified, we will fully discuss the reasons with you in advance. If, for any reason, we are unable to complete the audit or are unable to form or have not formed opinions, we may decline to...... Begininning the Audit Report ...Beginning the Audit Report Veronica Hemphill University of Phoenix ACC/546 July 9, 2012 Hemphill Financial Madison, Alabama 35758 July 9, 2012 Mr. Larry Lancaster President, Apollo Shoes 2501 Alabama Lane Phoenix, AZ 35404 Dear Mr. Lancaster: This will confirm our understanding of the arrangements for our audit of the financial statements of Apollo Shoes Inc. for the year ending December 31, 2012. We will audit the company’s financial statements for the year ending December 31, 2012, for the purpose of expressing an opinion on the fairness with which they present, in all material respects, the financial position, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. We will begin the audit process upon reviewing the financial statements, organizational charts, and 2009-2011 federal and state income tax returns. Once the information is carefully reviewed, we will conduct a risk workshop primarily to identify key risks and raise risk awareness, draft an audit plan, and schedule an opening meeting. The opening meeting should include senior management and any administrative staff that may be involved in the audit. During this meeting, the scope of the audit will be discussed. You should feel free to ask the auditors to...... Process of Issuing Audit Report ...INTRODUCTION A financial audit, or more accurately, an audit of financial statements, is the verification of the financial statements of a legal entity, with a view to express an audit opinion. The audit opinion is intended to provide reasonable assurance that the financial statements are presented fairly, in all material respects, and/or give a true and fair view in accordance with the financial reporting framework. The purpose of an audit is to enhance the degree of confidence of intended users in the financial statements. The general definition of an audit is an evaluation of a person, organization, system, process, enterprise, project or product. The term most commonly refers to audits in accounting, but similar concepts also exist in project management, quality management, and energy conservation. Financial audits are typically performed by firms of practising accountants who are experts in financial reporting. The financial audit is one of many assurance functions provided by accounting firms. Many organizations separately employ or hire internal auditors, who do not attest to financial reports but focus mainly on the internal controls of the organization. External auditors may choose to place limited reliance on the work of internal auditors. Internationally, the International Standards on Auditing (ISA) issued by the International Auditing and Assurance Standards Board (IAASB) is considered as the benchmark for audit process. Almost all jurisdictions require...... Hnd Audit Report ...a)The purpose and use of the different accounting records which can be used in MonteHodge: Accounting is a crucial discipline for keeping track of quantifiable factors for a business or individual. Accountants are primarily employed to track the flow of money through an organization. In some cases, they are charged with ensuring legal compliance. In others, they are more specialized in optimizing that cash flow. Accountants also organize and aggregate financial information and produce reports for people less experienced in the discipline. (Source: Purpose of Accounting | eHow.comhttp://www.ehow.com/about_4679149_purpose-accounting_.html#ixzz22YwT2kpu ) The accounting system for your business consists of several types of records. Although there are many types of underlying financial records, such as invoices, journals, and receipts, the major accounting records are types of financial statements that summate the financial status of a business. Each type of accounting record details certain information about your business, and each is used for a different purpose, but each type is also linked to another record in your set of financial statements. Although modern accounting software creates these statements automatically based on transactions you enter, it’s still important to understand how each type of accounting record is used. Income Statement The income statement lists all your business income and expense transactions. It is also known as a profit and loss...... Audit Committee Report ...Audit Committee Report According to the Malaysian Code on Corporate Governance (MCCG) 2007 (Revised), under the Accountability & Audit, as well as the Bursa Malaysia Listing Requirements, The board should establish an audit committee comprising at least three members, a majority of whom are independent. All members of the audit committee should be non-executive directors. The board should provide the audit committee with written terms of reference which deal clearly with its authority and duties. First off, on the matter of the compliance on the size of the board/committee, all the companies that we reviewed comply with that limit. 2 of the 12 companies were actually surpassed that minimum requirement, where they have 4 members in their Audit Committee. Those companies that we wish to highlight are Kamdar Group Berhad & Key Asic Berhad. This is a good example as the more members there are in an Audit Committee, there more reliable and independent the information involving the financial statements and any other relevant information will be, albeit, the independence of each member would be a factor to consider. Moving on, the question of whether those who are in the Audit Committees are independent or not come in to place. According to the MCCG 2007, the board of Audit Committee must have a majority of who are independent. The point here that we should note is that, all of the members of the Audit Committee should comprise fully of non-executive directors. Going...... Counter-Trade Essay First-mover advantage Essay Adolescence Essay Napoleonic Wars Essay First person Essay Education Essay

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Close 197.05 Open Price 199.00 TODAY'S LOW / HIGH Bid PRICE (QTY.) 0.00 (0) Offer PRICE (Qty.) 0.00 (0) 52 WK LOW / HIGH VOLUME : 366559 Company Information Menu Live Quotes Company Profile Board Of Directors Income Statement Balance Sheet Ratios Cash Flow Quaterly Results Halfyearly Results Nine Months Products Raw Material Report Share Holding Pattern Individual Holding Locations MF Holding Peer Comparison Investor Returns Bankers/Auditors Registrar High Low ADR / GDR Board Meetings Book Closure Dividend Details Change Of Name Technical Charting Deliverable Volume Director's Report Notes To Account Market Cap. ( ₹ ) 2782.98 Cr. P/BV Book Value ( ₹ ) 52 Week High/Low ( ₹ ) FV/ML P/E(X) Bookclosure TTM EPS ( ₹ ) Div Yield (%) NOTES TO ACCOUNTS You can view the entire text of Notes to accounts of the company for the latest year Year End :2018-03 Notes:- (i) NIIT Antilles NV, a wholly owned subsidiary of the Company was dissolved and liquidated vide order dated November 23, 2017 issued by Registry Affairs Director of the Curacao Chamber of Commerce and Industry. Consequent to the said liquidation, all assets and liabilities of NIIT Antilles NV, including investments in its three wholly owned subsidiaries (NIIT GC Limited, Mauritius, NIIT Malaysia Sdn Bhd and NIIT West Africa Limited), have been vested/transferred in the Company, subject to applicable regulatory compliances. These wholly owned subsidiaries of NIIT Antilles NV, have become direct wholly owned overseas subsidiaries of the Company. The same has also been reported to Reserve Bank of India (RBI) through authorised dealer, which has been duly noted by RBI. The investment in these subsidiaries has been recorded at fair value which is carried out by an independent valuer. (ii) 900,000 Optionally Convertible Debentures (OCDs) of Rs. 1,000 each fully paid at a coupon rate of 0.5% p.a. for a period of 5 years from the date of allotment. The Company had the right to convert such OCDs into equity shares at the expiry of third year from the date of allotment. These are fair valued as at the yearend through profit and loss. The said OCDs have been converted into equity share for Rs. 500 Million at fair value of Rs. 618.64 Million and Rs. 300 million into loan and balance amount of Rs. 100 million has been repaid during the year. (iii) 22,000,000 Optionally Convertible Debentures (OCDs) of Rs. 10 each fully paid at a coupon rate of 0.5% p.a. for a period of 5 years from the date of allotment wherein the Company had the right to convert such OCDs into equity shares at the expiry of 18 months from the date of allotment. These are fair valued as at the yearend through profit and loss. The said OCDs amounting to Rs. 220 million have been converted into equity at fair value of Rs. 211.10 Million. During the year, the Company has further invested in the equity of NIIT Yuva Jyoti Limited amounting to Rs. 60 million. (iv) During the previous year, the Company had purchased 10% of the equity capital of NIIT Yuva Jyoti Limited (NYJL) from NSDC for a consideration of Rs. 28.51 million. Consequently, NYJL had become a wholly owned subsidiary of the Company. (v) During the year, the Company has performed impairment testing for its investments in subsidiary companies. As a result of this, provision for diminution in value of Investment in equity of NYJL for the amount of Rs. 193.59 million is created. c) Terms/ rights attached to equity shares The company has only one class of equity shares having par value of Rs. 2 per share. Each holder of equity shares is entitled to one vote per share. The company declares and pays dividends in Indian Rupees. The dividend proposed by the Board of Directors is subject to the approval of the shareholders in the ensuing Annual General Meeting. In the event of liquidation of the company, the holders of equity shares will be entitled to receive remaining assets of the company, after distribution of all preferential amounts. The distribution will be in proportion to the number of equity shares held by the shareholders. d) Shares reserved for issue under options Information relating to Employee Stock Option Plan, including details of options issued, granted, exercised and lapsed during the financial year and options outstanding at the end of the reporting period, is set out in Note 35. e) Details of Shareholders holding more than 5% shares in the Company Footnotes : (i) Capital reserve represents the reserve created on amalgamation. (ii) Securities premium reserve is used to record the premium on issue of shares. The reserve is utilised in accordance with the provisions of the Act. (iii) General Reserve represents requirement to transfer specific sums to a General Reserve as per the local laws of the jurisdiction. (iv) The Company uses hedging instruments as part of its management of foreign currency risk associated with its highly probable forecasted transactions, i.e., revenue, as described in Note 24. The Company uses Foreign Currency Forward Contracts which are designated as Cash Flow Hedges for hedging foreign currency risk. To the extent these hedges are effective; the change in fair value of the hedging instrument is recognized in the Cash Flow Hedging Reserve. Amount recognized in the Cash Flow Hedging Reserve is reclassified to profit or loss when the hedged item effects profit and loss, i.e., Revenue. a. Details of Security given against loans (i) The Company availed foreign currency loan of USD 9.05 Million equivalent to Rs. 600 Million which is fully hedged by converting it from the floating rate in Libor with spread of 215 bps into fixed rate Rupee loan through a currency swap at a spot reference (USD INR) exchange rate of USD 1 = INR 66.30, through full maturity of the loan. The said loan is secured by way of whole of the Company's tangible and intangible, moveable fixed assets, both present and future, land and building of the Company at Sector-34, Gurgaon and first exclusive charge on certain immovable properties. The rate of interest on fully neCgeC equivalent loan amount is fixed at 10.25% p.a. for the tenure of the loan. The necessary formalities to create the security has been completed, as per the terms of the agreement. (ii) The Company availed foreign currency loan of USD 16.05 Million equivalent to Rs. 1,000 Million, which is fully hedged by converting it from the floating rate in Libor with spread of 175 bps into fixed rate Rupee loan through a currency swap at a spot reference (USD INR) exchange rate of USD 1 = INR 62.30, through full maturity of the loan. The said loan is secured by way of whole of the Company's tangible and intangible, moveable fixed assets, both present and future, land and building of the Company at Sector-32 and Sector-34, Gurgaon. The rate of interest on fully hedged equivalent loan amount is fixed at 10.25% p.a. for the tenure of the loan. The necessary formalities to create the security has been completed, as per the terms of the agreement. During the year the company has repaid foreign currency term loan amounting to USD 3.21 Million equivalent to Rs. 200 Million (USD 12.84 Million equivalent to Rs. 800 Million is outstanding as at March 31, 2018). Exceptional items as above comprise, items of income/(expenditure), arising from ordinary activities of the Company of such size, nature or incidence that their separate disclosure is considered appropriate to better explain the performance for the year (i) Pursuant to liquidation of NIIT Antilles NV, Rs. 92.72 Million (net of expenses) has been recognised as exceptional income on account of reversal of provision for diminution in value of investment. (ii) During the previous year, the Company had collected Rs. 29.70 Million towards loans, debts and other balances recoverable from its wholly owned subsidiary, Mindchampion Learning Systems Limited for which provision was recognised as an exceptional item in the earlier years was written back. Further the Company had written back provision amounting to Rs. 9.65 Million for doubtful debts and advances recoverable, for which provision was recognised as exceptional items in earlier years. (iii) During the year, the Company has provided for Rs 5.03 Million on account of litigation in Indirect taxes. (iv) During the year, the Company has evaluated the valuation of its investment in NIIT Yuva Jyoti Limited and has accordingly made a provision for diminution in value of investment amounting to Rs. 193.59 Million. (v) During the year, the Company has provided for Rs 19.65 Million on account of deduction from the security in one of the Government projects, which is strongly contested by the Company and is under discussion for resolution. 23 Fair value measurements (i) Fair value hierarchy To provide indication about the reliability of the inputs used in determining fair value, the Company has classified its financial instruments into the three levels prescribed under the accounting standard explained below: Level 1: Level 1 hierarchy includes financial instruments measured using quoted prices. This includes listed equity instruments, traded bonds and mutual funds that have quoted price. The fair value of all equity instruments (including bonds) which are traded in the stock exchanges is valued using the closing price as at the reporting period. The mutual funds are valued using the closing net asset value. Level 2: The fair value of financial instruments that are not traded in an active market (for example foreign exchange forward contracts) is determined using valuation techniques which maximize the use of observable market data and rely as little as possible on entity-specific estimates. If all significant inputs required to fair value an instrument are observable, the instrument is included in level 2. Level 3: If one or more of the significant inputs is not based on observable market data, the instrument is included in level 3. This is the case for unlisted equity securities, contingent consideration and indemnification asset included in level 3. The Company's policy is to recognize transfers into and transfers out of fair value hierarchy levels at the end of reporting period. (ii) Valuation technique used to determine fair value Specific valuation techniques used to value financial instruments include: - The use of quoted market prices for similar instruments. - The fair value of forward foreign exchange contracts is determined using Mark to Market Valuation by the respective bank at the balance sheet date. - The fair value of the remaining financial instruments is determined using discounted cash flow analysis. As of March 31, 2018, March 31, 2017 and April 1, 2016, the fair value of cash and bank balances, trade receivables, other current financial assets and liabilities, borrowings, trade payables approximate their carrying amount largely due to the nature of these instruments. For other financial assets and liabilities that are measured at amortised cost, the carrying amounts approximate the fair value. 24 Financial risk management The Company's principal financial liabilities, other than derivatives, comprise loans and borrowings, trade and other payables. The main purpose of these financial liabilities is to finance the Company's operations and to provide guarantees to support its operations. The Company's principal financial assets include loans, trade and other receivables, and cash and short-term deposits that derive directly from its operations. The Company is exposed to market risk, credit risk and liquidity risk. The Company's senior management oversees the management of these risks. The Company's senior management is supported by a financial risk committee that advises on financial risks and the appropriate financial risk governance framework for the Company. The finance committee provides assurance to the Company's senior management that the Company's financial risk activities are governed by appropriate policies and procedures and that financial risks are identified, measured and managed in accordance with the Company's policies and risk objectives. All derivative activities for risk management purposes are carried out by specialist teams that have the appropriate skills, experience and supervision. It is the Company's policy that no trading in derivatives for speculative purposes may be undertaken. The Board of Directors reviews and agrees policies for managing each of these risks, which are summarised below: (A) Credit risk Credit risk refers to the risk of default on its obligation by the counter parity resulting in a financial loss. The maximum exposure to the credit risk at the reporting date is primarily from trade receivables amounting to Rs. 1,012.73 Million as of March 31, 2018 (March 31, 2017 - Rs. 852.27 Million and April 1, 2016 - Rs 1124.90 Million) and unbilled revenue amounting to Rs. 85.08 Million as of March 31, 2018 (March 31, 2017 - Rs. 83.25 Million and April 1, 2016 - Rs. 72.23 Million). Trade receivables and unbilled revenue are typically unsecured and are derived from revenue earned through individual subsidiaries, government customers and other corporate customers. The Company has used the expected credit loss model to assess the impairment loss or gain on trade receivables and unbilled revenue, and has provided it wherever appropriate. The following table gives the movement in allowance for expected credit loss for the year ended March 31, 2018: (B) Liquidity risk The Company's principal sources of liquidity are cash and cash equivalents and the cash flow that is generated from operations. The Company has outstanding borrowings as term loans and working capital limits from banks. The borrowings are secured by a first charge on the book debts and movable & immovable assets of the Company . However, the Company believes that the working capital is sufficient to meet its current requirements. Accordingly, no liquidity risk is perceived. (i) Maturities of financial liabilities The table below provides details regarding the contractual maturities of significant financial liabilities: (C) Market risk Market risk is the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in market prices. Market risk comprises three types of risk: interest rate risk, currency risk and other price risk, such as equity price risk and commodity risk. Financial instruments afected by market risk include loans and borrowings, deposits, investments measured at FVTPL and derivative financial instruments. (i) Interest rate risk Interest rate risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. The Company's interest rate risk arises primarily from the foreign currency term loan carrying at floating rate of interest. These obligations exposes the Company to cash flow interest rate risk. The Company has mitigated the interest rate risk on foreign currency term loan by converting it from floating rate to fixed rate through currency swap. Hence, there is no significant challenge of interest rate risk. (ii) Foreign currency risk The company operates internationally and is exposed to foreign exchange risk arising from foreign currency transactions, primarily with respect to the USD, GBP EUR. Foreign exchange risk arises from future commercial transactions and recognised assets and liabilities denominated in a currency that is not the company's functional currency. The Company evaluates its exchange rate exposure arising from these transactions and enters into foreign exchange forward contracts to hedge forecasted cash flows denominated in foreign currency and mitigate such exposure. 25 Capital management The primary objective of the management of the Company's capital structure is to maintain an efficient mix of debt and equity in order to achieve a low cost of capital, while taking into account the desirability of retaining financial flexibility to pursue business opportunities and adequate access to liquidity to mitigate the effect of unforeseen events on cash flows. To maximise the shareholder value the management also monitors the return on equity. The Board of directors regularly review the Company's capital structure in light of the economic conditions, business strategies and future commitments. For the purpose of the Company's capital management, capital includes issued share capital, securities premium and all other reserves. Debt includes, foreign currency term loan and other borrowings. During the financial year, no significant changes were made in the objectives, policies or processes relating to the management of the Company's capital structure. 26 Employee Benefits A) Defined Contribution Plans The Company makes contribution towards Provident Fund (other than NIIT Limited and certain other domestic subsidiaries), Superannuation Fund and Pension Scheme to the defined contribution plans for eligible employees. The Company has charged the following costs in Contribution to Provident and Other Funds in the Statement of Profit and Loss:- vii) Investment details of Plan Assets:- The plan assets are maintained with Life Insurance Corporation of India Gratuity Scheme. The details of investment maintained by Life Insurance Corporation are not available with the Company and have not been disclosed. The expected return on plan assets is determined considering several applicable factors mainly the compensation of plan assets held, assessed risk of asset management, historical result of the return on plan assets. The sensitivity of the defined benefit obligation to changes in the weighted principal assumptions is: The above sensitivity analyses are based on a change in an assumption while holding all other assumptions constant. In practice, this is unlikely to occur, and changes in some of the assumptions may be correlated. When calculating the sensitivity of the defined benefit obligation to significant actuarial assumptions the same method (present value of the defined benefit obligation calculated with the projected unit credit method at the end of the reporting period) has been applied as when calculating the defined benefit liability recognised in the balance sheet. Risk exposure Through its defined benefit plans, the group is exposed to a number of risks, the most significant of which are market volatility, changes in inflation, changes in interest rates, rising longevity, changing economic environment, regulatory changes etc. The Company ensures that the investment positions are managed within an asset-liability matching framework that has been developed to achieve investments which are in line with the obligations under the employee benefit plans. Within this framework, the Company's asset-liability matching objective is to match assets to the obligations by investing in securities to match the benefit payments as they fall due. The Company actively monitors how the duration and the expected yield of the investments are matching the expected cash outflows arising from employee benefit obligations. The Company has not changed the processes used to manage its risks from previous periods. Investments are well diversified, such that failure of any single investment should not have a material impact on the overall level of assets. *Pertains to alleged dues towards provident fund payable by vendors of the Company. The Company does not expect any reimbursements in respect of the above. b) The Company had received Show Cause Notices under section 263 of the Income Tax Act, 1961, issued by the Commissioner of Income Tax (CIT) for the Assessment years 1999-00 to 2005-06, who later issued Orders directing the Assessing Officer for re-assessment on certain items. The orders passed by the CIT u/s 263 for AY 1999-00 to AY 2005-06 have been challenged by the Company in the Income Tax Appellate Tribunal ('the Tribunal'). The Tribunal has since passed order for AY 1999-00 wherein the Tribunal has decided the issue of assumption of jurisdiction against the Company. On merits, the Tribunal has allowed some of the issues and dismissed others which were referred back to the assessing officer for fresh examination. The Company has filed an appeal before the Hon'ble High Court of Delhi against the aforesaid order of the Tribunal which is pending for disposal. At this stage there is no ascertained/quantified demands. Based on legal opinion, the Company has fair chances of obtaining adequate relief before the Hon'ble High Court. It is not practical for the Company to estimate the timings of cash outflows, if any, in respect of the above pending resolution of the respective proceedings. Management does not foresee any financial implication based on advice of legal counsel. c) Guarantees i. Guarantees issued by bankers outstanding at the end of the year Rs. 1.10 Million (March 31, 2017 - Rs. 1.10 Million and April 1, 2016 - Rs. 1.12 Million). ii. Corporate Guarantee to National Skill Development Corporation to secure loan of Rs. 85.50 Million (March 31, 2017 - Rs. 90 Million and April 1, 2016 - Rs. 142.64 Million) availed by NIIT Yuva Jyoti Limited, a subsidiary of the Company. iii. Corporate Guarantee to National Skill Development Corporation to secure them in the event of default on the part of NIIT Yuva Jyoti Limited in making payment towards outstanding royalty amount of Rs. 66.27 Million (March 31, 2017 - Rs. 136.49 Million and April 1, 2016 - Nil). iv. Corporate Guarantee issued to banks for availing working capital limits on behalf of Mindchampion Learning Systems Limited Rs. 450 Million (March 31, 2017 - Rs. 450 Million and April 1, 2016 - Nil) [Amount Outstanding at year end Nil (March 31, 2017 - Nil and April 1, 2016 - Nil)]. d) Other Monies for which the Company is contingently liable Standby Letter of Credit is Nil [March 31, 2017 Rs. 486.44 Million (USD 7.5 Million) and April 1, 2016 Rs. 496.31 Million (USD 7.5 Million)] for working capital limits in favour of NIIT (USA) Inc., USA, a subsidiary of the Company, by earmarking working capital facility of NIIT Limited. 28 Capital and Other Commitments (a) Estimated amount of contracts remaining to be executed on capital account (net of advances) not provided for Rs. 209.68 Million (March 31, 2017 - Rs. 287.22 Million and April 1, 2016 - Rs. 508.72 Million). (b) For commitments related to lease arrangements, refer Note 33. (c) The Company has issued a letter of support to provide need based financial support to its subsidiaries Mindchampion Learning Systems Limited, NIIT Yuva Jyoti Limited, NIIT GC Limited and NIIT Learning Solutions (Canada) Limited. 30 Related Party Transactions : A. Related party relationship where control exists: 1 Mindchampion Learning Systems Limited 2 NIIT Institute of Finance Banking and Insurance Training Limited 3 NIIT Yuva Jyoti Limited 4 NIIT Institute of Process Excellence Limited 5 NIIT USA Inc., USA 6 NIIT Limited, UK 7 NIIT Malaysia Sdn. Bhd, Malaysia 8 NIIT West Africa Limited 9 NIIT GC Limited, Mauritius 10 NIIT (Ireland) Limited 11 NIIT Learning Solutions (Canada) Limited 12 Eagle International Institute Inc. USA (w.e.f. January 3, 2018) 13 Eagle Training Spain, S.L.U. (subsidiary of entity at serial no. 12) 14 NIIT Antilles NV, Netherlands Antilles (liquidated w.e.f. November 23, 2017) 15 PT NIIT Indonesia, Indonesia (under liquidation) 16 NIIT China (Shanghai) Limited, Shanghai 1 7 NIIT Wuxi Service Outsourcing Training School, China (Memorandum of Understanding was executed to sell on April 1, 2017) 18 Wuxi NIIT Information Technology Consulting Limited, China (agreement to sell entered on March 31, 2018) 19 Su Zhou NIIT Information Technology Consulting Limited, China (subsidiary of entity at serial no. 18) 20 Changzhou NIIT Information Technology Consulting Limited (subsidiary of entity at serial no. 18) 21 Zhangjiagang NIIT Information Services Limited, China 22 Qingdao NIIT Information Technology Company Limited, China (closed w.e.f. January 31, 2018) 23 Chengmai NIIT Information Technology Company Limited, China 24 Chongqing An Dao Education Consulting Limited, China 25 Chongqing NIIT Education Consulting Limited, China 26 NIIT (NingXia) Education Technology Company Limited, China (incorporated w.e.f. May 19, 2017) 27 Dafeng NIIT information technology Co., Limited, China (closed w.e.f. October 25, 2017) 28 Guizhou NIIT information technology consulting Co., Limited, China 29 NIIT (Guizhou) Education Technology Co., Limited, China B. Other related parties with whom the Company has transacted: a) Associate (Parties in which Company has substantial interest) 1 NIIT Technologies Limited 2 NIIT GIS Limited 3 NIIT Smart Serve Limited b) Key Managerial Personnel 1 Rajendra S Pawar (Chairman) 2 Vijay K Thadani (Vice-Chairman & Managing Director) 3 P Rajendran (Joint Managing Director) 4 Rahul Keshav Patwardhan (Chief Executive Officer upto July 31, 2017) 5 Sapnesh Kumar Lalla (Chief Executive Officer w.e.f. August 1, 2017) 6 Rohit Kumar Gupta (Chief Financial Officer upto February 28, 2017) 7 Amit Roy (Chief Financial Officer w.e.f. March 1, 2017 ) c) Relatives of Key Managerial Personnel 1 Renuka Thadani (Wife of Vijay K Thadani) 2 Veena Oberoi (Sister of Vijay K Thadani) d) Parties in which the Key Managerial P Personnel of the Company are interested 1 NIIT Institute of Information Technology 2 Naya Bazaar Novelties Private Limited 3 NIIT Foundation (formerly known as NIIT Education Society) 4 Pace Industries Private Limited 5 NIIT Network Services Limited 6 NIIT University D. Terms and conditions Transactions relating to dividends, subscriptions for new equity shares were on the same terms and conditions that applied to other shareholders. Transactions with related parties during the year were based on terms that would be available to third parties. All other transactions were made on normal commercial terms and conditions and at market rates. All outstanding balances are unsecured and are repayable in cash. 32 The Board of Directors of the Company has, in its meeting held on March 24, 2017, approved the amalgamation of PIPL Management Consultancy and Investment Private Limited ("PMPL") and Global Consultancy and Investment Private Limited ("GCPL") with NIIT Limited ("the Company or NIIT") by way of and in accordance with a scheme of amalgamation as per the provisions of Sections 230 to 232 and any other applicable provisions of the Companies Act, 2013 (hereinafter referred to as the "Scheme"). PMPL and GCPL hold 15.23% & 15.56% equity shares of NIIT Limited respectively and form part of promoter/ promoter group of NIIT Ltd. From the effective date, pursuant to the Scheme, the entire shareholding of PMPL and GCPL in the Company shall stand cancelled and the equivalent shares of the Company shall be re-issued to the shareholders of PMPL and GCPL as on the record date to be fixed for the purpose. Pursuant to the proposed amalgamation of PMPL and GCPL with the Company, there will be no change in the promoter's shareholding in the Company. All cost and charges arising out of this proposed scheme of amalgamation shall be borne by the promoter/ promoter group. The aforesaid Scheme is subject to various regulatory and other approvals and sanction by National Company Law Tribunal, New Delhi Bench and accordingly, not reflected in these financial statements. 33 Segment Information The Company is engaged in providing Education & Training Services in a single segment. Based on "Management Approach", as defined in Ind AS 108 - Segment Reporting, the Chief Operating Decision Maker (CODM) evaluates the performance and allocates resources based on the analysis of performance of the Company as a whole. Its operations are, therefore, considered to constitute a single segment in the context of Ind AS 108 - Segment Reporting. As per Ind AS 108 - Operating Segments, where the financial report contains both the consolidated financial statements of a parent as well as the parent's separate financial statements, segment information is required only in the consolidated financial statements, Accordingly, no segment information is disclosed in these standalone financial statements of the Company. * Includes payment in respect of premises for office and employee accommodation ** Includes payment in respect of computers, printers and other equipment’s. 35 Share based payments Employee option plan During the year 2005-06, the Company had established NIIT Employee Stock Option Plan 2005 "ESOP 2005" and the same was approved at the General Meeting of the Company held on May 18, 2005. The plan was set up so as to offer and grant, for the benefit of employees (excluding promoters) of the Company, who are eligible under "Securities and Exchange Board of India (SEBI) (Employee Stock Option Scheme and Employee Stock Purchase Scheme) Guidelines, 1999", options of the Company in one or more tranches, and on such terms and conditions as may be fixed or determined by the Board, in accordance with the provisions of law or guidelines issued by the relevant authorities in this regard. As per the plan, each option is exercisable for one equity share of face value of Rs. 2/- each (Rs. 10/- each pre bonus and split) fully paid up on payment to the Company, at a price to be determined in accordance with ESOP 2005. ESOP information is given for the number of shares after sub-division and Bonus issue. The weighted average exercise price per share option at the date of exercise of options exercised during the year ended March 31,2018 was Rs. 53.09 (March 31, 2017 - Rs. 48.20) No options expired during the periods covered in the above tables. 36 Business combinations (a) Summary of acquisition During the previous year, the Company had acquired the business from Perceptron Learning Solutions Private Limited ('Perceptron'). The strategic acquisition is expected to bring complementary technology platforms and capabilities to the Company. The Acquisition was made for an aggregate consideration of Rs. 24.85 Million. Out of the total consideration, an amount of Rs. 14.85 Million was paid upfront during the previous year and Rs. 10 Million is payable based on achievement of performance based milestones. The purchase price nas been allocated between the fair values of assets & liabilities based on an independent valuation report as a result of which a goodwill of Rs. 18.35 Million was recognised. (b) Significant judgements (i) Contingent consideration The Company is confident that the acquisition will achieve the performance based milestones and the entire contingent consideration would be paid to the seller. (ii) Acquired receivables No adjustments have been made to acquire trade receivables. (iii) Assumed payables No adjustments have been made to assume trade payables. 37 First-time adoption of Ind AS Transition to Ind AS These are the Company's first financial statements prepared in accordance with Ind AS. The accounting policies set out in note 2 have been applied in preparing the financial statements for the year ended March 31, 2018, the comparative information presented in these financial statements for the year ended March 31, 2017 and in the preparation of an opening Ind AS balance sheet at April 1, 2016 (The company's date of transition). In preparing its opening Ind AS balance sheet, The company has adjusted the amounts reported previously in financial statements prepared in accordance with the accounting standards notified under Companies (Accounting Standards) Rules, 2006 (as amended) and other relevant provisions of the Act (previous GAAP or Indian GAAP). An explanation of how the transition from previous GAAP to Ind AS has affected the company's financial position, financial performance and cash flows is set out in the following tables and notes. A. Exemptions and exceptions availed Set out below are the applicable Ind AS 101 optional exemptions and mandatory exceptions applied in the transition from previous GAAP to Ind AS. A.1 Ind AS optional exemptions A.1.1 Deemed cost Ind AS 101 permits a first-time adopter to elect to continue with the carrying value for all of its property, plant and equipment as recognised in the financial statements as at the date of transition to Ind AS, measured as per the previous GAAP and use that as its deemed cost as at the date of transition after making necessary adjustments. This exemption has also been used for intangible assets covered by Ind AS 38 Intangible Assets and investment property covered by Ind AS 40 Investment Properties. Accordingly, The company has elected to measure all of its property, plant and equipment, intangible assets and investment property at their previous GAAP carrying value. A. 1.2 Leases Appendix C to Ind AS 17 requires an entity to assess whether a contract or arrangement contains a lease. In accordance with Ind AS 17, this assessment should be carried out at the inception of the contract or arrangement. Ind AS 101 provides an option to make this assessment on the basis of facts and circumstances existing at the date of transition to Ind AS, except where the effect is expected to be not material. The company has elected to apply this exemption for such contracts/arrangements. A 1.3 Investments in subsidiaries, joint ventures and associates As per Ind AS 27, the Company has an option to value its investments in subsidiaries, joint ventures and associates either at Previous GAAP Value or Fair value as deemed cost. The Company has opted for fair value option for one of its subsidiary (with corresponding impact to opening retained earnings as on transition date) and Previous GAAP values for rest of the subsidiaries as per exemptions available on transition. A 1.4 Business Combinations The Company has availed the option to not apply Ind AS 103, retrospectively to business combinations that occurred prior to the transition date. A 1.5 Share based payment transactions The Company has availed the option to apply Ind AS 102 Share-based payment to equity instruments that vested before date of transition to Ind AS. A 1.6 Fair value measurement of financial assets or liabilities at initial recognition Ind AS 109 requires to initially recognize financial assets and liabilities at fair value and if the fair value differs from transaction price, the difference is recognized as gain or loss. The Company has elected to apply these requirements of initial recognition prospectively to transactions entered on or after the date of transition. A.2 Ind AS mandatory exceptions A.2.1 Estimates An entity's estimates in accordance with Ind AS at the date of transition to Ind AS shall be consistent with estimates made for the same date in accordance with previous GAAP (afer adjustments to reflect any difference in accounting policies), unless there is objective evidence that those estimates were in error. Ind AS estimates as at April 1, 2016 are consistent with the estimates as at the same date made in conformity with previous GAAP The company made estimates for following items in accordance with Ind AS at the date of transition as these were not required under previous GAAP: - Impairment of financial assets based on expected credit loss model. A.2.2 Hedge Accounting Hedge accounting can only be applied prospectively from the transition date to transactions that satisfy the hedge accounting criteria in Ind AS 109, at that date. Hedging relationships cannot be designated retrospectively, and the supporting documentation cannot be created retrospectively. AS a result, only hedging relationships that satisfied the hedge accounting criteria as of April 1, 2016 are reflected as hedges in the Company's results under Ind AS. The Company had designated various hedging relationships as cash flow hedges under the previous GAAP On date of transition to Ind AS, the entity had assessed that all the designated hedging relationship qualifies for hedge accounting as per Ind AS 109. Consequently, the Company continues to apply hedge accounting on and after the date of transition to Ind AS. A.2.3 Classification and measurement of financial assets Ind AS 101 requires an entity to assess classification and measurement of financial assets on the basis of the facts and circumstances that exist at the date of transition to Ind AS. C. Notes to first-time adoption: a. Remeasurement of post-employment benefit obligations Under Ind AS, Remeasurement i.e. actuarial gains and losses and the return on plan assets, excluding amounts included in the net interest expense on the net defined benefit liability are recognised in Other Comprehensive Income instead of statement of profit or loss. Under the previous GAAP these Remeasurement were forming part of the statement of profit or loss for the year. As a result of this change, the profit for the year ended March 31, 2017 has been increased by Rs. 8.48 Million and the same has been recognised in Other Comprehensive Income. There is no impact on the other equity as at March 31, 2017. b. Fair valuation of investments Under Previous GAAP investments in equity instruments and OCDs were classified as long-term investments, based on its intended holding period. These long-term investments were carried at cost less provision, other than temporary decline in the value of such investments. Under Ind AS, investments in equity instruments are required to be measured at cost or fair value based on policy choices adopted by the Company. However, investments in OCDs are required to be necessarily measured at fair value. As a result the investment in the equity instrument of one of the subsidiaries, NIIT Yuva Jyoti Limited has reduced by Rs 86.19 Million and Investments in the OCDs in Mindchampion Learning Systems Limited has increased by Rs 120.30 Million as at April 1, 2016. This has resulted in the increase in other equity by Rs 34.11 Million as at April 1, 2016. During the year ended March 31, 2017 Investments in OCDs in Mindchampion Learning Systems Limited has increased by Rs. 14.49 Million and Investments in OCDs in NIIT Yuva Jyoti Limited has reduced by Rs. 26 Million. This has resulted in the reduction in the profit and loss for the year ended March 31, 2017 by Rs. 11.51 Million. c. Recognition of property, plant and equipment Under Ind AS based on principles of substance over form the Company has recognised Land and Building under property, plant and equipment despite the fact that as per the agreement the title of the same would be transferred upon making final payment to the seller. Hence the Company has recognised land and building amounting to Rs. 690.61 Million and Rs 419.61 Million (net of accumulated depreciation) respectively under property, plant and equipment as at April 1, 2016. The Company has also recognised other financial liability (other payables) amounting to Rs 280.02 Million as at March 31, 2017 (April 1, 2016 - Rs. 460.48 Million) and derecognised other non-current asset (capital advances) amounting to Rs 835.66 Million as at March 31, 2017 (April 1, 2016 - Rs 655.19 Million) as a result of this change. This has reduced other equity by Rs 5.46 Million as at April 1, 2016 on account of accumulated depreciation on building till that date. Further the depreciation amounting to Rs 7.32 Million has been charged to the statement of profit and loss during the year ended on March 31, 2017. Further under previous GAAP Investment property was part of property, plant and equipment, however as per Ind AS this requires a separate disclosure. Accordingly amount of Rs 0.56 Million has reclassified from property, plant and equipment to investment property as at April 1, 2016. d. Interest accretion on deferred payment liabilities Under previous GAAP long term liabilities were recognised at transaction value. Under Ind AS, these financial liabilities are required to be recognised initially at their fair value and subsequently at amortised cost. As a result, these financial liabilities have decreased by Rs. 1.64 Million as at March 31, 2017 (April 1, 2016 - Rs. 5.06 Million). The profit for the year ended March 31, 2017 decreased by Rs. 4.84 Million due to interest accretion on deferred payment liabilities. Consequently Goodwill have been initially reduced by Rs 1.42 Million and respective amortization have been reversed by Rs. 2.30 Million during the year ended March 31, 2017. (Net impact on Goodwill is Rs. 0.88 Million). Further other intangible assets have been reduced by Rs. 4.05 Million as at March 31, 2017 (Rs. 7.57 Mn as at April 01, 2016) and the profit has increased by Rs. 3.51 Million during the year ended March 31, 2017 on account of reversal of amortization and other equity has reduced by Rs. 2.52 Million as at April 1, 2016. e. Share based payments Under the previous GAAP the cost of equity settled employee share-based plan was recognized using intrinsic value method. Under Ind AS, the cost of equity settled share-based plan is recognized based on fair value of the options as at grant date. Therefore, the amount recognised in share option outstanding account (under other equity) as on March 31, 2017 increased by Rs. 20.46 Million (April 1, 2016 - Rs. 37.33 Million). Consequently, profit before tax for the year ended March 31, 2017 has decreased by Rs. 10.76 Million. Also, an amount of Rs. 22.63 Million (April 1, 2016 -Rs. 12.92 Million) was recognized as recoverable from subsidiaries on account of Employee stock option expense. f. Provision recognised on trade receivables as per Expected Credit Loss As per Ind AS, the Company is required to apply expected credit loss model for recognising the allowance for doubtful debts. As a result, the allowance for doubtful debts increased by Rs. 45.17 Million as at March 31, 2017 (April 1, 2016 - Rs. 80.95 Million) with consequential decrease in other equity. The profit for the year ended March 31, 2017 increased by Rs. 35.79 Million due to reversal of allowance for doubtful debts under expected credit loss model. g. (i) Deferred Revenue Under previous GAAP, revenue is recognised once the risk and rewards is transferred in a transaction and reliable estimation can be made for its ultimate collectability. However under Ind AS, revenue recognition criteria is applied separately to each components of a single transaction in order to reflect the substance of the transaction considering the perspective of the customer. Accordingly, there has been change in the timing of revenue recognition. Consequent to this change, the amount of deferred revenue increased by Rs. 208.08 Million as at March 31, 2017 (April 1, 2016 Rs. 203.10 Million). The revenue from operations for the year ended March 31, 2017 decreased by Rs. 5.02 Million. As a result of such adjustment in revenue, its corresponding cost has been deferred. Consequently, the amount of prepaid expense increased by Rs. 43.36 Million as at March 31, 2017 (April 1, 2016 Rs. 38.62 Million). The Professional & Technical Outsourcing Expenses for the year ended March 31, 2017 decreased by Rs. 16.30 Million. (ii) Revenue & reimbursement of expenses on net basis Under Previous GAAP the Company recognized the reimbursement of expenses under the head revenue from operations, with the corresponding expenses in the statement of profit and loss. However, under Ind AS, the Company is recognizing the reimbursement of expenses net of corresponding revenue. As a result of this change there is decrease in revenue from operations Rs.11.52 Million for the year ended March 31, 2017. This has alsc resulted in the reclassification of trade receivables to other financial assets amounting to Rs 102.10 Million as at March 31, 2017. (iii) Revenue net of trade discount and rebate Under Previous GAAP the Company recognized the trade discount and rebate under the head other expenses in the statement of profit and loss. However, under Ind AS, the trade discount and rebate is adjusted with the revenue. As the result of this change the revenue and other expense is decreased by Rs. 13.09 Million for the year ended March 31, 2017. h. Deferred tax asset The Company has carried out a review of recoverability of Deferred Tax Asset ('DTA') recognised in the previous GAAP financial statements as on March 31, 2016. Based on above, considering future business plans of the Company and other circumstances which were existing as on that date, the management has determined the DTA would not have been recognised under Ind AS 12 . Accordingly, the opening balance of DTA amounting to Rs. 103.77 Million has been reversed in the other equity as on April 1, 2016. i. Change in fair value of forward contracts designated as cash flow hedges Under Ind AS, changes in the fair value of derivative hedging instruments designated and effective as a cash flow hedge are recognized through other comprehensive income. j. Retained earnings Retained earnings as at March 31, 2017 and April 1, 2016 has been adjusted consequent to the above Ind AS transition adjustments. 38 The comparative financial information of the Company for the year ended March 31, 2017 and the transition date opening balance sheet as at April 01, 2016 included in these Ind AS financial statements, are based on the previously issued financial statements prepared in accordance with accounting principles generally accepted in India and were audited by a firm other than S.R. Batliboi & Associates LLP as adjusted for the differences in the accounting principles adopted by the Company on transition to the Ind AS. Signatures to Notes '1' to '38' above of these Financial Statements. Downloads | Career | Disclaimer | Disclosure | Terms & Conditions | Knowledge Center | Sitemap Existing customers can send in their Grievances to : [email protected] Compliance officer details : Mr. Virendra Pednekar Phone : 022-40350106 [email protected] "KYC is one time exercise while dealing in securities markets - once KYC is done through a SEBI registered intermediary (broker, DP, Mutual Fund etc.), you need not undergo the same process again when you approach another intermediary." | "Prevent Unauthorized Transactions in your Trading & Demat account --> Update your Mobile Number/Email Ids with your Stock Brokers & Depository Participant. Receive information of your transactions directly from Exchange on your mobile/email at the end of the day and also alerts for all debit and other important transactions in your demat account directly from CDSL on the same day......................issued in the interest of investors." | "No need to issue cheques by investors while subscribing to IPO. Just write the bank account number and sign in the application form to authorise your bank to make payment in case of allotment. No worries for refund as the money remains in investor's account." | "The share of the listed stock exchange shall only be dealt by fit and proper persons as per regulation 19 and 20 of SECC Regulations." SEBI Regn. No.: BSE - CASH : INZ000208631; BSE - F&O : INZ000208631; NSE - CASH : INZ000208631; NSE - F&O : INZ000208631; NSE - Currency : INZ000208631;SEBI Regn., MCX Member code:16500 FMC No.: MCX/TCM/CORP/0197 NCDEX Member code:00119 FMC No.: NCDEX/TCM/CORP/0452 NSEL Membership No: 13320; CDSL : IN-DP-230-2016, Research Analyst Regn. No. : INH000004893 Copyright@2015 Latin Manharlal Securities Pvt.Ltd. All rights reserved.

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professional_accounting

NonProfitFacts.com » Michigan » Grand Valley Research Corporation Grand Valley Research Corporation in Allendale, Michigan (MI) Detailed Reports Statements Regarding Other IRS Filings and Tax Compliance Compensation of Officers, Directors, Trustees, Key Employees, Highest Compensated Employees, and Independent Contractors Statement of Functional Expenses Reason for Public Charity Status Support Schedule for Organizations Described in Sections 170(b)(1)(A)(iv) and 170(b)(1)(A)(vi) Organization representatives - add corrected or new information about Grand Valley Research Corporation » Non-representatives - add comments about Grand Valley Research Corporation» Grand Valley Research Corporation Name of Organization Grand Valley Research Corporation In Care of Name James Bachmeier Address 1 Campus Drive - 201 Lmh, Allendale, MI 49401 Foundation Organization which operates for benefit of college or university and is owned or operated by a governmental unit Exempt Organization Status Unconditional Exemption Assets $500,000 to $999,999 Filing Requirement 990 (all other) or 990EZ return Asset Amount $807,287 Amount of Income $650,983 Form 990 Revenue Amount $650,983 National Taxonomy of Exempt Entities (NTEE) Educational Institutions and Related Activities: Single Organization Support Amount of income in 2011: $650,983 (it was $4,558,809 in 2013) Assets in 2011: $807,287 (it was $4,759,681 in 2013) Expenses in 2013: $20,046 Grand Valley Research Corporation: Income to expenses ratio in 2013: 32.5 Grants share in income in 2013: 99.3% Financial snapshot ($) Revenue for 2013 Assets at the end of 2013 Functional expenses for 2013 Is the organization described in section 501(c)(3) or 4947(a)(1) (other than a private foundation)? Yes Is the organization required to complete Schedule B, Schedule of Contributors? Yes Did the organization engage in direct or indirect political campaign activities on behalf of or in opposition to candidates for public office? No Did the organization engage in lobbying activities, or have a section 501(h) election in effect during the tax year? No Is the organization a section 501(c)(4), 501(c)(5), or 501(c)(6) organization that receives membership dues, assessments, or similar amounts as defined in Revenue Procedure 98-19? No Did the organization maintain any donor advised funds or any similar funds or accounts for which donors have the right to provide advice on the distribution or investment of amounts in such funds or accounts? No Did the organization receive or hold a conservation easement, including easements to preserve open space, the environment, historic land areas, or historic structures? No Did the organization maintain collections of works of art, historical treasures, or other similar assets? No Did the organization report an amount for escrow or custodial account liability; serve as a custodian or provide credit counseling, debt management, credit repair, or debt negotiation services? No Did the organization, directly or through a related organization, hold assets in temporarily restricted endowments, permanent endowments, or quasi-endowments? No Did the organization report an amount for land, buildings, and equipment? Yes Did the organization report an amount for investments-other securities that is 5% or more of its total assets? No Did the organization report an amount for investments-program related that is 5% or more of its total assets? Yes Did the organization report an amount for other assets that is 5% or more of its total assets? No Did the organization report an amount for other liabilities? No Did the organization's separate or consolidated financial statements for the tax year include a footnote that addresses the organization's liability for uncertain tax positions under FIN 48 (ASC 740)? Yes Did the organization obtain separate, independent audited financial statements for the tax year? No Was the organization included in consolidated, independent audited financial statements for the tax year? Yes Is the organization a school described in section 170(b)(1)(A)(ii)? No Did the organization maintain an office, employees, or agents outside of the United States? No Did the organization have aggregate revenues or expenses of more than $10,000 from grantmaking, fundraising, business, investment, and program service activities outside the United States, or aggregate foreign investments valued at $100,000 or more? No Did the organization report more than $5,000 of grants or other assistance to or for any foreign organization? No Did the organization report more than $5,000 of aggregate grants or other assistance to or for foreign individuals? No Did the organization report a total of more than $15,000 of expenses for professional fundraising services? No Did the organization report more than $15,000 total of fundraising event gross income and contributions? No Did the organization report more than $15,000 of gross income from gaming activities? No Did the organization operate one or more hospital facilities? No Did the organization attach a copy of its audited financial statements? No Did the organization report more than $5,000 of grants or other assistance to any domestic organization or domestic government? No Did the organization report more than $5,000 of grants or other assistance to or for domestic individuals? No Did the organization answer 'Yes' about compensation of the organization's current and former officers, directors, trustees, key employees, and highest compensated employees? Yes Did the organization have a tax-exempt bond issue with an outstanding principal amount of more than $100,000 as of the last day of the year, that was issued after December 31, 2002? No Did the organization invest any proceeds of tax-exempt bonds beyond a temporary period exception? No Did the organization maintain an escrow account other than a refunding escrow at any time during the year to defease any tax-exempt bonds? No Did the organization act as an 'on behalf of' issuer for bonds outstanding at any time during the year? No Did the organization engage in an excess benefit transaction with a disqualified person during the year? No Is the organization aware that it engaged in an excess benefit transaction with a disqualified person in a prior year, and that the transaction has not been reported on any of the organization's prior Forms 990 or 990-EZ? No Did the organization report any amount for receivables from or payables to any current or former officers, directors, trustees, key employees, highest compensated employees, or disqualified persons? No Did the organization provide a grant or other assistance to an officer, director, trustee, key employee, substantial contributor or employee thereof, a grant selection committee member, or to a 35% controlled entity or family member of any of these persons? No Was the organization a party to a business transaction with one of the following parties A current or former officer, director, trustee, or key employee? No A family member of a current or former officer, director, trustee, or key employee? No An entity of which a current or former officer, director, trustee, or key employee (or a family member thereof) was an officer, director, trustee, or direct or indirect owner? No Did the organization receive more than $25,000 in non-cash contributions? Yes Did the organization receive contributions of art, historical treasures, or other similar assets, or qualified conservation contributions? No Did the organization liquidate, terminate, or dissolve and cease operations? No Did the organization sell, exchange, dispose of, or transfer more than 25% of its net assets? No Did the organization own 100% of an entity disregarded as separate from the organization under Regulations sections 301.7701-2 and 301.7701-3? Yes Was the organization related to any tax-exempt or taxable entity? Yes Did the organization have a controlled entity within the meaning of section 512(b)(13)? Yes Did the organization make any transfers to an exempt non-charitable related organization? No Did the organization conduct more than 5% of its activities through an entity that is not a related organization and that is treated as a partnership for federal income tax purposes? Yes The number reported in Box 3 of Form 1096 0 The number of Forms W-2G 0 Did the organization comply with backup withholding rules for reportable payments to vendors and reportable gaming (gambling) winnings to prize winners? Yes The number of employees reported on Form W-3, Transmittal of Wage and Tax Statements, filed for the calendar year ending with or within the year covered by this return 0 Did the organization file all required federal employment tax returns? No Did the organization have unrelated business gross income of $1,000 or more during the year? No Has it filed a Form 990-T for this year? No No At any time during the calendar year, did the organization have an interest in, or a signature or other authority over, a financial account in a foreign country (such as a bank account, securities account, or other financial account)? No Was the organization a party to a prohibited tax shelter transaction at any time during the tax year? No No Did any taxable party notify the organization that it was or is a party to a prohibited tax shelter transaction? No Did the organization file Form 8886-T? No Does the organization have annual gross receipts that are normally greater than $100,000, and did the organization solicit any contributions that were not tax deductible as charitable contributions? No Did the organization include with every solicitation an express statement that such contributions or gifts were not tax deductible? No Did the organization receive a payment in excess of $75 made partly as a contribution and partly for goods and services provided to the payor? No Did the organization notify the donor of the value of the goods or services provided? No Did the organization sell, exchange, or otherwise dispose of tangible personal property for which it was required to file Form 8282? No Did the organization receive any funds, directly or indirectly, to pay premiums on a personal benefit contract? No Did the organization, during the year, pay premiums, directly or indirectly, on a personal benefit contract? No If the organization received a contribution of qualified intellectual property, did the organization file Form 8899 as required? No If the organization received a contribution of cars, boats, airplanes, or other vehicles, did the organization file a Form 1098-C? No Did a donor advised fund maintained by the sponsoring organization have excess business holdings at any time during the year? No Did the sponsoring organization make any taxable distributions under section 4966? No Did the sponsoring organization make a distribution to a donor, donor advisor, or related person? No Initiation fees and capital contributions $0 Gross receipts for public use of club facilities $0 Gross income from members or shareholders $0 Gross income from other sources $0 Is the organization filing Form 990 in lieu of Form 1041? No The amount of tax-exempt interest received or accrued during the year $0 Is the organization licensed to issue qualified health plans in more than one state? No The amount of reserves the organization is required to maintain by the states in which the organization is licensed to issue qualified health plans $0 The amount of reserves on hand $0 Did the organization receive any payments for indoor tanning services during the tax year? No Has it filed a Form 720 to report these payments? No Officers, Directors, Trustees, Key Employees, and Highest Compensated Employees Total reportable compensation from the organization $0 Total reportable compensation from related organizations $545,487 Total estimated amount of other compensation from the organization and related organizations $130,930 Total number of individuals who received more than $100,000 of reportable compensation from the organization 0 Total number of independent contractors who received more than $100,000 of compensation from the organization 0 Total revenue $4,558,809 Contributions, Gifts, Grants and Other Similar Amounts $4,526,540 Program Service Revenue $32,161 Miscellaneous Financial Investment Activities $952 Lessors of Residential Buildings and Dwellings $31,209 All other program service revenue $0 Other Revenue Investment income (including dividends, interest, and other similar amounts) $108 Income from investment of tax-exempt bond proceeds $0 Royalties $0 Net rental income $0 Net gain/loss from sales of assets other than inventory $0 Net income/loss from fundraising events $0 $0 Net income/loss from gaming activities $0 Net income/loss from sales of inventory $0 Miscellaneous Revenue $0 Total functional expenses $20,046 Grants and other assistance to domestic organizations and domestic governments $0 Grants and other assistance to domestic individuals $0 Grants and other assistance to foreign organizations, foreign governments, and foreign individuals $0 Benefits paid to or for members $0 Compensation of current officers, directors, trustees, and key employees $0 Compensation not included above, to disqualified persons $0 Other salaries and wages $0 Pension plan accruals and contributions $0 Other employee benefits $0 Payroll taxes $0 Fees for services (non-employees) Management $0 Legal $0 Accounting $0 Lobbying $0 Professional fundraising services $0 Investment management fees $0 Other $0 Advertising and promotion $0 Office expenses $0 Information technology $0 Occupancy $0 Travel $0 Payments of travel or entertainment expenses for any federal, state, or local public officials $0 Conferences, conventions, and meetings $0 Interest $0 Payments to affiliates $0 Depreciation, depletion, and amortization $5,825 Other expenses $371 Other expenses $20 Other expenses $13,830 Total assets $206,026 $4,759,681 Cash - non-interest-bearing $102,146 Savings and temporary cash investments $0 Pledges and grants receivable, net $0 Accounts receivable, net $50,987 Loans and other receivables from current and former officers, directors, trustees, key employees, and highest compensated employees $0 Loans and other receivables from other disqualified persons, persons described in section 4958(c)(3)(B), and contributing employers and sponsoring organizations of section 501(c)(9) voluntary employees' beneficiary organizations $0 Notes and loans receivable, net $0 Inventories for sale or use $0 Prepaid expenses and deferred charges $0 Land, buildings, and equipment: cost or other basis $4,336,118 Investments - publicly traded securities $0 Investments - other securities $0 Investments - program-related $270,430 Intangible assets $0 Other assets $0 Total liabilities $0 $18,308 Accounts payable and accrued expenses $4,540 Grants payable $0 Deferred revenue $13,768 Tax-exempt bond liabilities $0 Escrow or custodial account liability $0 Loans and other payables to current and former officers, directors, trustees, key employees, highest compensated employees, and disqualified persons $0 Secured mortgages and notes payable to unrelated third parties $0 Unsecured notes and loans payable to unrelated third parties $0 Other liabilities (including federal income tax, payables to related third parties, and other liabilities) $0 Total net assets or fund balances $4,741,373 Unrestricted net assets $4,741,373 Temporarily restricted net assets $0 Permanently restricted net assets $0 Capital stock or trust principal, or current funds $0 Paid-in or capital surplus, or land, building, or equipment fund $0 Retained earnings, endowment, accumulated income, or other funds $0 Reason for Public Charity Status (for 2013) The organization is not a private foundation because it is: A federal, state, or local government or governmental unit described in section 170(b)(1)(A)(v) Number of organizations supported 0 Sum of amounts of support $0 Support Schedule for Organizations Described in Sections 170(b)(1)(A)(iv) and 170(b)(1)(A)(vi) (for 2009 - 2013) 2009 - 2013 Total Public Support $275,000 Subtotal Support $275,000 Gifts, grants, contributions, and membership fees received $275,000 Tax revenues levied for the organization's benefit and either paid to or expended on its behalf $0 The value of services or facilities furnished by a governmental unit to the organization without charge $0 The portion of total contributions by each person (other than a governmental unit or publicly supported organization) that exceeds 2% of the total support $0 Total Support $303,363 Gross income from interest, dividends, payments received on securities loans, rents, royalties and income from similar sources $28,363 Net income from unrelated business activities, whether or not the business is regularly carried on $0 Other income. Do not include gain or loss from the sale of capital assets $0 Gross receipts from related activities, etc. $31,209 Would you recommend Grand Valley Research Corporation to others? (optional) Add photo of Grand Valley Research Corporation (optional) Life Stream Church in Allendale, MI Blue Water Pregnancy Care Center in Port Huron, MI Knights Of The Road Motorcycle Club in Detroit, MI Oakland County Bible Students Inc in Clawson, MI Mich Volunteer Legionary Corps Of Artillery in Owosso, MI Ludington Recreation Soccer Board, Ludington Soccer Club in Ludington, MI Clinton River Ski Club in Boyne City, MI Rabbit & Small Animal Rescue in Westland, MI Prison Legal Services Of Michigan Inc in Jackson, MI Special Dreams Farm in New Baltimore, MI 1 Ravenwood High School Quarterback Club 1724 Wilson Pike, Brentwood, TN 37027-8105 TN 2007-02 $99,991 2 Slocomb Band Boosters Inc PO BOX 376, Slocomb, AL 36375-0376 AL 2006-12 $54,892 3 Pennies From Heaven Foundation 425 W Western Ave Ste 200, Muskegon, MI 49440-1101 MI 2013-02 $10,113,786 4 Grcs Eagle Impact 2600 Village Dr Se, Grand Rapids, MI 49506 MI 2013-07 $2,901,459 5 Kent School Services Network 1933 East Beltline Ave Ne, Grand Rapids, MI 49525 MI 2014-08 $1,726,279 6 St Marys Preparatory Moms And Dads Club 3535 Commerce Rd, Orchard Lake, MI 48324-1608 MI 2002-08 $1,127,662 7 Mechanical Contractors Apprentice- Ship & Training Reimbursement Fund 14801 W 8 Mile Rd, Detroit, MI 48235-1623 MI 2010-12 $1,088,830 8 Lanse Creuse Athletic Boosters Club 24060 Harrison St, Clinton Twp, MI 48035-3827 MI 2014-05 $1,056,992 9 Detroit Public Schools Foundation 3011 West Grand Blvd 18th Floor, Detroit, MI 48202-3096 MI 2003-04 $880,632 10 Nul Leasehold Holding I Inc 600 Antoinette St, Detroit, MI 48202-3457 MI 2011-03 $689,184 11 Grand Valley Research Corporation 1 Campus Drive - 201 Lmh, Allendale, MI 49401 MI 2007-03 $650,983 12 Lanse Creuse High School-North Band Boosters 23700 21 Mile Rd, Macomb, MI 48042-5106 MI 2011-05 $404,147 13 World Heritage Air Museum 19992 Kelly Rd, Harper Woods, MI 48225-1919 MI 2012-02 $404,145 14 Western Michigan University Research Foundation 1903 W Michigan Ave, Kalamazoo, MI 49008-5200 MI 2004-09 $285,486 15 Mcbain Rural Agricultural School Foundation 107 E Maple St, Mcbain, MI 49657 MI 1999-11 $193,924 16 Stevenson Band Booster Club Inc 39701 Dodge Park Rd, Sterling Hts, MI 48313-5131 MI 2006-11 $168,320 17 Tln Foundation, Tyler Michael President 13331 Reeck Rd, Southgate, MI 48195-3054 MI 2003-11 $163,966 18 Farmington-Farmington Hills Education Foundation 32500 Shiawassee Rd, Farmington, MI 48336-2338 MI 2013-02 $156,001 19 Veritas Christian Educational Foundation, Veritas Christi Educational Foundation 640 Ridgewood Ct, Ann Arbor, MI 48103 MI 2009-09 $110,852 20 Jonesville Athletic Boostersassociation PO BOX 7, Jonesville, MI 49250-0007 MI 2012-02 $102,599 California 1,277 Kentucky 181 Texas 1,212 NonProfitFacts.com is not associated with, endorsed by, or sponsored by Grand Valley Research Corporation and has no official or unofficial affiliation with Grand Valley Research Corporation

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professional_accounting

Use these links to rapidly review the document FOR ANNUAL AND TRANSITION REPORTS ý ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2001 or o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 The Nasdaq Stock Market, Inc. (State or Other Jurisdiction of Incorporation or Organization) 52-1165937 One Liberty Plaza New York, New York Registrant's telephone number, including area code: Common Stock, par value $.01 per share (Title of class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o The aggregate market value of the Nasdaq common stock ("Common Stock") held by non-affiliates of the registrant as of March 18, 2002 was $447,521,854. As of March 18, 2002, 34,424,758 shares of Common Stock were held by non-affiliates of Nasdaq. There is no public trading market for the Common Stock. On March 18, 2002, 78,439,660 shares of the registrant's Common Stock were outstanding (including shares of restricted Common Stock). Portions of the registrant's proxy statement for the annual stockholders' meeting to be held in 2002 are incorporated by reference into Part III. Submission of Matters to a Vote of Security Holders Market for Registrant's Common Equity and Related Stockholder Matters Selected Financial Data Financial Statements and Supplementary Data Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Part III. Directors and Executive Officers of the Registrant Certain Relationships and Related Transactions Part IV. Exhibits, Financial Statement Schedules and Reports on Form 8-K Certain statements in this annual report on Form 10-K contain or may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, The Nasdaq Stock Market, Inc.'s ("Nasdaq") ability to implement its strategic initiatives, economic, political and market conditions and fluctuations, government and industry regulation, interest rate risk, U.S. and global competition, and other factors. Most of these factors are difficult to predict accurately and are generally beyond our control. You should consider the areas of risk described in connection with any forward-looking statements that may be made herein. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of December 31, 2001. Readers should carefully review this annual report in its entirety, including but not limited to Nasdaq's financial statements and the notes thereto and the risks described in "Item 1. Business—Risk Factors." Except for Nasdaq's ongoing obligations to disclose material information under the Federal securities laws, Nasdaq undertakes no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. For any forward-looking statements contained in any document, Nasdaq claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Item 1. Business. Nasdaq Overview Nasdaq operates The Nasdaq Stock Market®, the world's largest electronic, screen-based equity securities market and the largest equity securities market in the world based on share volume. Since its inception in 1971, Nasdaq has been a leader in utilizing technology to democratize and extend the reach of the securities markets, with a current goal of becoming a truly global securities market. Nasdaq provides products and services in the following three principal categories: Transaction services include collecting, processing, and disseminating price quotes of Nasdaq-listed securities, the routing and execution of buy and sell orders for Nasdaq-listed securities, and transaction reporting services. Market participants in The Nasdaq Stock Market, consisting of market makers, electronic communication networks ("ECNs"), and order entry firms, each of which is described below, are the users of Nasdaq's transaction services. For the year ended December 31, 2001, transaction services accounted for revenue of $408.8 million, which represented approximately 47.7% of Nasdaq's total revenue. See "—Products and Services—Transaction Services" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Market information services provide varying levels of quote and trade information to data vendors, who in turn sell the information to the public. For the year ended December 31, 2001, market information services accounted for revenue of $240.5 million, which represented approximately 28.1% of Nasdaq's total revenue. See "—Products and Services—Market Information Services" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Corporate Client Group services (formerly known as issuer services) provide information services and products to Nasdaq-listed companies and are responsible for obtaining new listings on The Nasdaq Stock Market. For the year ended December 31, 2001, Corporate Client Group services accounted for revenue of $156.1 million, which represented approximately 18.2% of Nasdaq's total revenue. See "—Products and Services—Corporate Client Group Services" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations." Nasdaq's market model is one of "open architecture." As a fully electronic market, The Nasdaq Stock Market does not have a central trading floor. Participation in the trading activities on The Nasdaq Stock Market is not limited to any fixed number of market participants. This allows a large number of broker-dealers with widely different business models and trading technologies to participate in the Nasdaq network and compete with one another. The Nasdaq network, called the "Enterprise Wide Network II," is a telecommunications network that Nasdaq uses to deliver transaction and market information services to its market participants. See "—Products and Services—Transaction Services." Market participants can access the Nasdaq network via the Nasdaq Workstation II, Nasdaq's proprietary operating system for the Nasdaq network, or through other customized operating systems. See "—Products and Services—Transaction Services—Access Services." Market makers, also known as dealers, provide liquidity (the ability of a stock to absorb a large amount of buying and selling without substantial movement in price) by standing ready to buy or sell securities at all times at publicly-quoted prices for their own account and by maintaining an inventory of securities for their customers. Market makers in a particular stock are required at all times to post their bid and offer prices (i.e., price at which they will buy and sell) into the Nasdaq network where they can be viewed and accessed by all market participants. Over 300 market makers participate in The Nasdaq Stock Market. On average, securities listed on The Nasdaq Stock Market have 14 market makers. The minimum number of market makers for any Nasdaq-listed stock is two and some securities have over 80 market makers. In addition to traditional market makers, the Nasdaq network also includes other broker-dealers operating as ECNs. ECNs provide electronic facilities for investors to trade directly with one another without going through a market maker. ECNs operate as order-matching and order-routing mechanisms and do not maintain inventories of securities themselves. Nasdaq also connects to other registered exchanges through SelectNet®, SOES,sm and SuperSoessm (each of which is described below) for Nasdaq-listed securities and through the Intermarket Trading System for exchange-listed securities. The flexibility of the Nasdaq network means that innovators with new trading technologies or strategies have an opportunity to implement them quickly in The Nasdaq Stock Market. An order entry firm is a broker-dealer, but not a market maker or an ECN. An order entry firm can use Nasdaq services to view price quotations and route customer orders for securities to a market maker or ECN posting quotes in The Nasdaq Stock Market for that security so that the orders can be executed. Nasdaq's electronic systems centralize the price quotations from all market participants in a given Nasdaq-listed stock to help them compete and allow them to choose with whom they are going to trade. Nasdaq also gathers the trade and quote information from all of these market participants and passes it on to data vendors who resell this information to the investment community and the general public. Nasdaq's total revenue in 2001 was $857.2 million, a 2.9% increase from $832.7 million in 2000. Nasdaq's net income increased 73.8% in 2001 to $40.5 million from $23.3 million in 2000. Total revenue and net income numbers reflect a change in accounting principle adopted as of January 1, 2000 ("Change in Accounting Principle"). See "Item 6. Selected Consolidated Financial Data," "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Consolidated Financial Statements—Note 4." Nasdaq's growth and operating results are directly affected by the trading volume of Nasdaq-listed securities and the number of companies listed on The Nasdaq Stock Market. The following table illustrates Nasdaq's performance: For the 12 months ended The Nasdaq MarketSM SmallCapSM SmallCap Total share volume (billions) 465.5 5.7 471.2 424.0 18.8 442.8 Percentage of total shares traded in the primary United States markets — — 59.3 % — — 61.6 % Dollar volume of equity securities traded on The Nasdaq Stock Market (billions) $ 10,913.8 $ 20.8 $ 10,934.6 $ 20,273.7 $ 121.7 $ 20,395.4 Percentage of dollar volume of all equity securities traded in the primary United States markets — — 49.2 % — — 62.9 % Average daily share volume (millions) 1,877.2 22.8 1,900.0 1,682.4 74.5 1,756.9 Average daily dollar volume (billions) $ 44.0 $ 0.1 $ 44.1 $ 80.5 $ 0.5 $ 81.0 Number of Nasdaq-listed companies (at year end) 3,351 758 4,109 3,827 907 4,734 Total domestic shares outstanding (billions) (at year end) 150.9 6.2 157.1 156.3 7.9 164.2 Market value of Nasdaq-listed companies (billions) (at year end) $ 2,837.8 $ 62.1 $ 2,899.9 $ 3,579.4 $ 17.7 $ 3,597.1 As of December 31, 2001 there were 4,109 companies listed on The Nasdaq Stock Market, consisting of 3,351 companies listed on The Nasdaq National Market tier and 758 on The Nasdaq SmallCap Market tier. As of December 31, 2001, The Nasdaq Stock Market was home to the highest percentage of publicly-traded technology and service companies in the U.S., including approximately 77% of computer hardware and peripherals companies, 96% of computer networking companies, 85% of computer software and data processing companies, 87% of semiconductor companies, 67% of telecommunications companies, and 82% of biotechnology and health care companies. In addition, as of December 31, 2001, there were 447 foreign companies listed on The Nasdaq Stock Market, consisting of 355 foreign companies listed on The Nasdaq National Market tier and 92 on The Nasdaq SmallCap Market tier. The number of listed companies includes those companies that may have otherwise been subject to delisting if not for a temporary suspension of certain listing standards during the period between September 26, 2001 and January 2, 2002. See "—Products and Services—Corporate Client Group Services." Nasdaq's History and Structure Founded in 1971, Nasdaq was a wholly-owned subsidiary of the National Association of Securities Dealers, Inc. (the "NASD") until June 2000. The NASD, which operates subject to the oversight of the U.S. Securities and Exchange Commission (the "SEC"), is the largest self-regulatory organization ("SRO") in the United States with a membership that includes virtually every broker-dealer that engages in the securities business with the U.S. public. The NASD must retain voting control over Nasdaq until such time as Nasdaq may be approved by the SEC for registration as a national securities exchange ("Exchange Registration"), as discussed below. In 2000, the NASD implemented a separation of Nasdaq from the NASD by restructuring and broadening the ownership in Nasdaq (the "Restructuring") through a two-phase private placement of securities commencing in June 2000. The principal goals of the Restructuring, among others, were to (i) raise proceeds to create a financially stronger Nasdaq better able to invest in new technologies and address competitive challenges and global opportunities, (ii) raise proceeds to support the operations of the NASD, which would remain the principal SRO responsible for the securities markets, and (iii) realign strategically the ownership of Nasdaq by enlisting a broad class of strategic investors interested in Nasdaq's long-term success. In the private placements, (i) the NASD sold (A) an aggregate of 10,806,494 warrants to purchase an aggregate amount of 43,225,976 shares of outstanding Nasdaq Common Stock and (B) 4,543,591 shares of outstanding Nasdaq Common Stock and (ii) Nasdaq sold an aggregate of 28,692,543 newly-issued shares of Common Stock to investors. Securities in the private placements were offered to all NASD members, certain issuers listed on The Nasdaq Stock Market, and certain investment companies. All of the securities sold in the private placements are subject to restrictions on transfer until June 2002, and are subject to certain additional restrictions in the event of an initial public offering ("IPO") of the Common Stock. As a result of the private placements of its Common Stock, Nasdaq became a reporting company pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), on June 29, 2001, and became subject to the reporting requirements under Sections 13, 14 and 16 of the Exchange Act. As a continuation of the Restructuring, Nasdaq repurchased 18,461,538 shares of Common Stock from the NASD on May 3, 2001, for an aggregate purchase price of $240.0 million. On March 8, 2002, Nasdaq completed a two stage repurchase of an additional 33,768,895 shares of Common Stock owned by the NASD, which represented all of the outstanding shares of Common Stock owned by the NASD, except for the 43,225,976 shares of Common Stock underlying the warrants issued by the NASD in the private placements. Nasdaq purchased these shares of Common Stock for $305.2 million in aggregate cash consideration, 1,338,402 shares of Nasdaq's Series A Cumulative Preferred Stock and one share of Nasdaq's Series B Preferred Stock (the "Repurchase"). The NASD owns all of the outstanding shares of the Series A and Series B Preferred Stock. All of the shares of Common Stock repurchased by Nasdaq from the NASD are no longer outstanding. In connection with the Restructuring, Nasdaq has filed an application with the SEC for Exchange Registration. In general, Exchange Registration is a change in legal status for Nasdaq as opposed to a change in the way Nasdaq operates. Nasdaq's application for Exchange Registration was published by the SEC for public comment in 2001. Information relating to Nasdaq's application can be found at the SEC's web site at http://www.sec.gov/rules/other/34-44396.htm. In November 2001, Nasdaq agreed to an indefinite extension of the date by which the SEC must approve Nasdaq's application or begin proceedings to determine whether the application should be denied. In December 2001, Nasdaq filed a written response with the SEC that addresses issues raised in the public comment letters. There is no assurance that Nasdaq's application for Exchange Registration will be granted or as to the exact timing of Exchange Registration. See "—Risk Factors—The SEC may challenge or not approve Nasdaq's plan to become a national securities exchange or it may require changes in the manner Nasdaq conducts its business before granting this approval." In connection with Exchange Registration, the SEC is conducting a review of Nasdaq's current rules and operations. The SEC has stated that its approval of Exchange Registration is linked to the NASD's ability to provide an alternative display facility to NASD members to assist in the quotation and transaction reporting of exchange-listed securities ("Alternative Display Facility"). Specifically, in its Notice of Filing of Application for Registration as a National Securities Exchange dated June 7, 2001, the SEC states, "... Nasdaq's exchange registration has implications for the NASD which, as a national securities association, will continue to be required to collect bids, offers, and quotation sizes for those entities seeking to trade listed securities, including Nasdaq securities, otherwise than on a national securities exchange. The Commission notes that the NASD's quotation and transaction reporting facility must be operational upon Nasdaq's exchange registration." (Footnote omitted). The NASD has retained a third-party vendor to assist it in the establishment of this facility and contemplates that the Alternative Display Facility will not be operational until at least the second quarter of 2002. Until such time as Nasdaq may obtain Exchange Registration, Nasdaq's legal authority to operate as a stock market is delegated to it by the NASD under a plan approved by the SEC (the "Delegation Plan"). Although Nasdaq exercises primary responsibility for market-related functions, including market-related rulemaking, all actions taken by Nasdaq pursuant to its delegated authority are subject to review, ratification or rejection by the NASD. In addition, the Delegation Plan requires that the NASD retain greater than 50% of the voting control over Nasdaq. The share of Series B Preferred Stock issued to the NASD in the Repurchase will ensure that the NASD maintains voting control until Exchange Registration. The voting power of the share of Series B Preferred Stock is recalculated for each matter presented to stockholders as of the record date for the determination of the stockholders entitled to vote on the matter. The NASD, as holder of the share of Series B Preferred Stock, will be entitled to cast the number of votes that, together with all other votes that the NASD is entitled to vote by virtue of ownership, proxies or voting trusts, enables the NASD to cast one vote more than one-half of all votes entitled to be cast by stockholders. In addition, the shares of Common Stock underlying unexercised and unexpired warrants as well as shares of Common Stock purchased through the valid exercise of warrants, will be voted by a trustee at the direction of the NASD until Exchange Registration. Shares of Series A Preferred Stock do not have voting rights, except for the right as a class to elect two new directors to the Board of Directors at any time distributions on the Series A Preferred Stock are in arrears for four consecutive quarters and as otherwise required by Delaware law. If Nasdaq obtains Exchange Registration, the share of Series B Preferred Stock will lose its voting rights and will be redeemed by Nasdaq. Nasdaq may redeem the shares of Series A Preferred Stock at any time after Exchange Registration and is required to use the net proceeds from an IPO, and upon the occurrence of certain other events, to redeem all or a portion of the Series A Preferred Stock. If Nasdaq obtains Exchange Registration it will receive its own SRO status, separate from that of the NASD. Pursuant to the Exchange Act, SROs include any registered national securities exchange, registered securities association (of which the NASD is currently the only one), or registered clearing agency, or, for certain purposes, the Municipal Securities Rulemaking Board. In general, an SRO is responsible for regulating its members through the adoption and enforcement of rules and regulations governing the business conduct of its members. As an SRO, Nasdaq will have its own rules pertaining to its members and listed companies regarding listing, membership, and trading that are distinct and separate from those rules applicable generally to broker-dealers as administered by the NASD. Broker-dealers will be able to choose to become members of Nasdaq, in addition to their other SRO memberships, including membership in the NASD. Whether or not Nasdaq is granted Exchange Registration is not expected to have a financial impact on Nasdaq in the short-term. In the long-term, however, Exchange Registration is expected to improve the competitive position of Nasdaq. As an exchange, Nasdaq will no longer have to share revenue from certain proprietary products with certain other exchanges. An independent Nasdaq will have greater access to the capital markets in order to raise funds for service enhancements and increased flexibility to use its Common Stock in connection with acquisitions or other strategic partnerships. The securities market industry historically has included The Nasdaq Stock Market, the larger traditional stock exchanges, such as the NYSE and Amex, and a number of regional exchanges. Some of these regional exchanges have a few exclusive "local" securities, but most compete in the business of trading the more active NYSE-, Nasdaq-, and Amex-listed securities. The regional exchanges include the Boston, Chicago, Cincinnati, Pacific, and Philadelphia exchanges. Regulatory and technological developments have led to gradual changes in the industry and have resulted in greater competition in the trading of securities. The emergence of alternative trading systems—a term that refers generally to internal trading systems that are designed to match buyers and sellers of securities on an agency basis and includes ECNs—has provided an additional venue for investors to transact certain trades. Nasdaq encourages the use of internal or alternative systems to trade securities and considers these systems an important component of The Nasdaq Stock Market in that they report trades through The Nasdaq Stock Market, display their best bid and offer on the market, and transact on The Nasdaq Stock Market. For the year ended December 31, 2001, trades executed by ECNs amounted to approximately 32.4% of the total share volume on The Nasdaq Stock Market and approximately 37.4% of the total dollar volume on The Nasdaq Stock Market. The following table sets forth information comparing the primary U.S. markets for 2001 and 2000: Total share volume (billions) 471.2 307.5 16.3 442.8 262.5 13.3 Total dollar volume (trillions) $ 10.9 $ 10.5 $ 0.8 $ 20.4 $ 11.1 $ 1.0 Average daily share volume (billions) 1.9 1.2 0.1 1.8 1.0 0.1 Average daily dollar volume (billions) $ 44.1 $ 42.3 $ 3.3 $ 81.0 $ 43.9 $ 3.8 Number of listed companies (at year end) 4,109 2,798 691 4,734 2,862 765 National Market System In the 1970s, Congress passed legislation and the SEC adopted rules to create a national market system to disseminate market information. As a result, participants in U.S. securities markets have access to a consolidated stream of quotation and transaction information from all the exchanges and The Nasdaq Stock Market (acting under the Delegation Plan) for most equity securities. The exchanges and The Nasdaq Stock Market act jointly to collect and disseminate this information under national market system plans approved by the SEC. The price and transaction information collected under these national market system plans is sold for a fee to data vendors, who in turn sell the information to the public. These fees are referred to as "Tape Fees." After costs are deducted, the Tape Fees are distributed among the participants in each of the national market system plans based on their transaction volume. The national market system plans include: The Nasdaq Unlisted Trading Privileges Plan ("UTP Plan"), which collects and disseminates price and transaction information for securities listed on The Nasdaq Stock Market. Members of the plan are the NASD and certain regional exchanges. The Consolidated Quotation Plan, which collects and disseminates quotation information for securities listed on the NYSE and Amex. All of the exchanges and the NASD are members of this plan. The Consolidated Tape Association Plan, which collects and disseminates transaction information for NYSE and Amex securities. All of the exchanges and the NASD are members of this plan. The Intermarket Trading System, which is a communications system that allows orders to be sent to the exchange or market quoting the best price. All of the exchanges and the NASD are members of the Intermarket Trading System Plan. Nasdaq, operating under the Delegation Plan, currently acts on behalf of the NASD in each of these plans and intends to become a member in its own right of each of these plans when and if it becomes an exchange. Nasdaq's products and services fall into three principal categories: Transaction services; Market information services; and Corporate Client Group services. Transaction Services. Transaction services are the core set of products designed to provide market participants with access to The Nasdaq Stock Market, quoting and trading capabilities, and post-trade services such as trade reporting and risk management. In addition, Nasdaq provides transaction services for securities authorized for trading on the OTC Bulletin Board Service® ("OTC Bulletin Board") as well as exchange-listed securities that are traded in the over-the-counter market by NASD members. See "—Other Products and Markets—Nasdaq InterMarket" and "—OTC Bulletin Board." All of Nasdaq's market participants are connected over an Enterprise Wide Network jointly designed and managed by Nasdaq and WorldCom, Inc. ("WorldCom"). Nasdaq entered into a six-year contract with WorldCom in 1997 to design and support the network. WorldCom charges Nasdaq monthly for use of the network. The network is scalable and reliable, supporting trading of up to eight billion shares per day. Each market participant is connected to The Nasdaq Stock Market through multiple connections to greatly reduce the risk of connection failure. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results Operations—Contractual Obligations and Contingent Commitments" and "Consolidated Financial Statements Note 16." Access Services. Nasdaq provides access to its execution and trade reporting systems through four products: Nasdaq Workstation II; the Application Program Interface that allows firms to create their own interface to The Nasdaq Stock Market; a Computer-to-Computer Interface ("CTCI") that provides for automated order entry, trade reporting and routing; and the Nasdaq Workstation WebLink system that provides browser-based access to The Nasdaq Stock Market via the Internet. Nasdaq Workstation II, introduced in 1995, is a software product that is installed on approximately 6,800 computer desktops to provide market participants with access to Nasdaq transaction services. Nasdaq Workstation II is designed to provide a fast, flexible, reliable, and convenient trading environment capable of running on a variety of computers. In addition to the Nasdaq Workstation II, the Application Program Interface allows approximately 2,800 users to access The Nasdaq Stock Market over customized interfaces developed by market participants. Using the Application Program Interface, a firm can connect their internal systems to The Nasdaq Stock Market for order and position management. Access to The Nasdaq Stock Market via the Application Program Interface represents a growing trend among Nasdaq market participants. Application Program Interface usage grew 29% during the year ended December 31, 2001. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from Nasdaq Workstation II and the Application Program Interface was $146.2 million, $121.6 million, and $87.6 million, respectively. Nasdaq Workstation II and Application Program Interface fees accounted for approximately 17.1% of Nasdaq's total revenue for the year ended December 31, 2001. Nasdaq also provides CTCI for users to report trades, enter orders into SuperSoes and receive execution messages through SelectNet. The CTCI links The Nasdaq Stock Market to automated firm systems. CTCI revenue accounted for less than 2% of Nasdaq's total revenue for the year ended December 31, 2001 and less than 1% of Nasdaq's total revenue for the years ended December 31, 2000 and 1999, respectively. In February 2001, Nasdaq introduced an Internet browser-based system, Workstation WebLink, for small order-entry and market making firms. Workstation WebLink provides small firms with a low-cost option for performing basic trade reporting and risk management functions as well as order routing. For the year ending December 31, 2001, Workstation WebLink was utilized by over 400 users and accounted for less than 1% of revenue. Quoting and Trading. As part of its price discovery function, Nasdaq provides collection, processing, and dissemination of price quotations of Nasdaq-listed securities to its market participants. Price quotations are made up of two parts—the bid and the offer. The bid is the displayed price at which the quoting market maker or ECN is prepared to buy the security from any seller in the marketplace. The offer is the displayed price at which the quoting market maker or ECN is prepared to sell the security to any buyer in the marketplace. Since market makers and ECNs may wish to pay differing amounts to buy or sell a particular security, Nasdaq looks at all the price quotations of the market makers and ECNs in that security and independently ranks the bids and offers so that one can easily determine the one who is willing to sell the security for the lowest price and the one who is willing to buy the security at the highest price. This combination of the best bid and the best offer is the "inside market" or "inside quote." Included in the price quotations collected by Nasdaq are the quotes of the exchanges that trade Nasdaq-listed securities under the UTP Plan. As of March 20, 2002, the Chicago Stock Exchange, the Cincinnati Stock Exchange, and the Boston Stock Exchange display quotes on The Nasdaq Stock Market pursuant to the UTP Plan. Amex and the Philadelphia Stock Exchange have announced their intention to begin displaying Nasdaq quotes in the near future. Once price quotations have been entered into the Nasdaq system, Nasdaq processes the price quotations by updating the posted price and size (i.e., number of shares the posting party will buy or sell at that price) in response to messages received from the party posting the price quotation. Only registered market makers, ECNs, and UTP Plan participants have the ability to post and adjust quotations in the Nasdaq system. As of February 1, 2002, Nasdaq began charging market makers and ECNs a fee each time they update a quotation. Nasdaq provides electronic routing of buy and sell orders for Nasdaq-listed securities to and from a market maker or ECN and the execution of those orders through the use of automated systems. Order routing and execution are the terms generally used to describe how orders to buy and sell securities are directed to market participants as well as how these orders are handled once they reach their destination. Order routing refers to the act of transmitting orders to another market participant for action. Order execution is a legally binding step in which orders are executed, or responded to, once received by a market participant. During the last few years Nasdaq has experienced increased usage of its electronic order routing and execution systems. Approximately 31% of Nasdaq's share volume (based on the aggregate number of shares traded) comes from orders routed and executed using a Nasdaq system. The remaining 69% comes from market participants' internal or alternative trading systems. Nasdaq has the following systems that provide for order routing and/or execution: The Nasdaq National Market Execution System (also known as "SuperSoessm") is a new and improved system for the execution of buy and sell orders designed to provide automatic execution capability for market makers, ECNs and all their institutional and retail customers, and streamline Nasdaq's transaction systems. The SuperSoes system is only available for securities listed on The Nasdaq National Market. Securities listed on The Nasdaq SmallCap Market continue to be traded through the Small Order Execution System ("SOESsm") and SelectNet (which are described below). SuperSoes was fully implemented on July 30, 2001. SuperSoes combines features of SelectNet and SOES. Like SOES, SuperSoes permits the automatic execution of trades against the best price quotations of other market participants in The Nasdaq National Market without the need for an agreement to trade from the party providing the price quotation. SuperSoes also relaxes the usage restrictions of SOES, including the share size restriction. This system allows the entry of single orders of up to 999,999 shares as opposed to the SOES limit of 1,000 shares. In addition, the time delay between executions of trades with the same market maker at the same price for a single security is eliminated. The fees for SuperSoes are charged on a per transaction basis and consist of an entry charge per order and an execution charge per share. In certain circumstances Nasdaq rebates a portion of the per share execution charge it receives to market participants whose quotation is accessed through SuperSoes. For the year ended December 31, 2001, Nasdaq's total revenue from SuperSoes was $32.3 million. SuperSoes accounted for approximately 3.8% of Nasdaq's total revenue for the year ended December 31, 2001. During the fourth quarter of 2001, its first full quarter of operation, SuperSoes accounted for total revenue of $26.7 million, approximately 12.4% of Nasdaq's total revenue for the quarter. SelectNet is an automated Nasdaq service that facilitates order execution by linking all market participants that trade Nasdaq-listed securities. Prior to the implementation of SuperSoes, SelectNet was the primary system that market makers used to trade with one another. It is also the primary Nasdaq system used to access ECN price quotations and through which ECNs receive the price quotations of other market makers. SelectNet operates as a messaging system, allowing market participants to direct an order message to a particular counter-party or to broadcast such an order to all market participants offering to buy or sell a security at a particular or market price. SelectNet provides market participants with the capability to independently negotiate the terms of trades. Since the implementation of SuperSoes, SelectNet has become primarily a tool to be used by market makers to negotiate trades. Market makers are now prohibited from sending each other SelectNet messages that obligate the receiving party to a trade. However, market makers that wish to trade with ECNs still have the ability to send SelectNet order messages that may be executed upon the ECNs' agreement to trade. ECNs also have the option to use SuperSoes to elect to receive automatic executions against their price quotations, unlike market makers who are mandated to provide automatic executions against their price quotation. If ECNs so elect, they are protected from receiving SelectNet order messages priced and sized in a manner that would obligate the ECN to a trade in response to the SelectNet order message. SelectNet fees are charged on a per transaction basis and consist of an entry charge per order and a graduated execution charge per trade that decreases as the originating party's total number of monthly executions increases. For the years ended December 31, 2001, 2000, and 1999 Nasdaq's total revenue from SelectNet was $87.1 million, $113.5 million, and $83.1 million, respectively. SelectNet accounted for approximately 10.2% of Nasdaq's total revenue for the year ended December 31, 2001. In the fourth quarter of 2001, the first full quarter during which SuperSoes was operational, Nasdaq's total revenue from SelectNet was $11.3 million, approximately 5.2% of Nasdaq's total revenue. SOES routes small orders of public customers to market makers and, based on their quotes, immediately executes trades without a formal response from the market maker. The SOES system is restricted to orders of no greater than 1,000 shares and cannot be used by market makers for their own trading activity. As of August 1, 2001, SOES is only available to trade securities listed on The Nasdaq SmallCap Market. It is also not available to access ECN price quotations or for ECNs to receive the price quotations of other market participants. SOES fees are charged to the originating party on a per transaction basis, with graduated fees per trade that decrease based on monthly activity. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from SOES was $26.1 million, $32.2 million, and $19.7 million, respectively. SOES accounted for approximately 3.0% of Nasdaq's total revenue for the year ended December 31, 2001. In the fourth quarter of 2001, the first full quarter during which SuperSoes was operational, SOES accounted for less than 1% of Nasdaq's total revenue. SOES revenue is not anticipated to be material in future periods. Advanced Computerized Execution System ("ACES") is an order routing service that is used by market makers to execute order flow from order entry firms. Order entry firms generally route buy and sell orders to the best price quotes displayed in the market or enter into agreements with a particular market maker where the market maker agrees to fill the order entry firm's orders at the best price displayed in the market. Order entry firms can route buy and sell orders directly to specified market makers through Nasdaq Workstation II or their own proprietary systems. These orders are executed within the market makers' internal trading systems and execution reports are routed back to the order entry firms. ACES is often used by market makers to connect with firms whose order volume is too low to justify the fixed costs of establishing a proprietary network linkage. ACES fees are charged to the market maker only, and consist of graduated activity fees per execution that decrease as the market maker's number of executions per month increases. ACES accounted for less than 1% of Nasdaq's total revenue for the year ended December 31, 2001, and approximately 2.1% and 2.2% for the years ended December 31, 2000 and 1999, respectively. Computer Assisted Execution Systemsm ("CAESsm") is the transaction service system for Nasdaq InterMarket, which is an electronic marketplace where NASD members can trade securities listed on the NYSE or Amex. CAES is linked to the Intermarket Trading System. CAES allows users to direct orders in exchange-listed securities to other Nasdaq InterMarket market makers for automated response and execution, and also provides access to the Intermarket Trading System. The Intermarket Trading System is a communications system that allows exchange-designated dealers, exchange floor brokers, and NASD members to send orders for execution to the market quoting the best price. Nasdaq charges Nasdaq InterMarket participants a monthly fee per terminal to access to both systems (CAES/Intermarket Trading System). In addition, a per transaction fee is charged to the originating party (i.e., the sender). CAES and Intermarket Trading System fees accounted for less than 1% of Nasdaq's total revenue for the years ended December 31, 2001, 2000, and 1999. Primex Auction Systemtm ("Primex") provides investors and market makers with a new electronic auction trading platform. Primex allows users to seek price improvement opportunities by electronically exposing orders to market participants who compete for the orders at prices at, and within, the prevailing national best bid or offer. Primex is operated pursuant to an agreement between Nasdaq and Primex Trading N.A., LLC, and began operation on December 17, 2001. During the pilot phase, which is scheduled to be completed on March 31, 2002, 194 securities may be traded on Primex, including the securities that make up the Nasdaq-100 Index®, Dow Jones Industrial Average, and Standard & Poor's 100 Index. Nasdaq imposes a monthly fee to access Primex, which will vary based on the method used to access the system. Nasdaq charges execution fees to parties executing trades on shares available in the system. No execution fees are charged for submitting orders that provide liquidity to the system. Nasdaq has waived all fees associated with linking to, and transacting in, Primex for the duration of the pilot phase. Post-Trade Services—Automated Confirmation Transaction Servicesm ("ACTsm"). U.S. securities laws require that all registered stock exchanges and securities associations establish a transaction reporting plan for the central collection of price and volume information concerning trades executed in those markets. Transactions in Nasdaq-listed securities, exchange-listed securities traded over-the-counter, and other equity securities traded over-the-counter have traditionally been reported to the ACT system, Nasdaq's automated trade reporting and reconciliation service that electronically facilitates the post-execution steps of price and volume reporting, comparison, and clearing of trades. A protocol establishes which of the two parties to the trade is responsible for trade reporting, and NASD rules govern the timeliness of trade submission and the information required on each trade report. ACT provides three primary revenue-generating services: trade reporting, trade comparison, and risk management. The majority of trades reported to Nasdaq are locked-in externally from the ACT system, and are submitted for reporting purposes only. These transaction reports are assessed a nominal reporting fee. Trades that require ACT to match and lock-in the two parties to the trade generally are assessed a higher fee based upon the number of shares traded. A fee for the ACT risk management service is also applied to some of the transactions reported to ACT. This fee is assessed to the firms that clear for each of the parties to the trade, provided that the trading parties are not designated as self-clearing firms. A cap on ACT risk management fees was introduced in April 2000, limiting a clearing firm's monthly payment for each of its trading firms (correspondents) to $10,000. With the cap in place for the entire 2001 fiscal year, risk management revenue declined by approximately 50% from fiscal year 2000. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from ACT was $87.3 million, $100.0 million, and $68.1 million, respectively. ACT fees accounted for approximately 10.2% of Nasdaq's total revenue for the year ended December 31, 2001. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from transaction services was $408.8 million, $395.1 million, and $283.7 million, respectively. Transaction services accounted for approximately 47.7% of Nasdaq's total revenue for the year ended December 31, 2001. Market Information Services. As a market operator, Nasdaq collects and disseminates price quotations and information regarding price and volume of executed trades. Market participants in The Nasdaq Stock Market have real-time access to quote and trade data. Interested parties that are not direct market participants in The Nasdaq Stock Market also can receive real-time information through a number of market information services products. Nasdaq has two primary market information products designed to provide the varying levels of detail desired by different broker-dealers and their customers. The first product is known as Level 1. This product provides subscribers with the current inside quote and most recent price at which the last sale or purchase was transacted for a specific security. Professional subscribers, e.g., broker-dealers and other employees of broker-dealers, to this product pay a monthly fee per terminal for the service, which is typically delivered to the subscriber through a third-party data vendor. A vendor or a broker-dealer can provide non-professional customers, i.e., individual investors, with Level 1 information at a reduced fee calculated on a per query basis or a flat monthly fee per user. Although the growth in on-line investing in recent years increased the usage of these fee structures by on-line brokerage firms and other Internet services, weaker economic and market conditions in 2001 caused a substantial reduction in Level 1 revenue due to a decrease in demand for non-professional per query service. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's revenue from Level 1 fees was $140.8 million, $159.6 million, and $135.0 million, respectively. Nasdaq's Level 1 fees accounted for approximately 16.4% of Nasdaq's total revenue for the year ended December 31, 2001. The second market information product, the Nasdaq Quotation Dissemination Service, provides subscribers with the quotes of each individual market maker and ECN, in addition to the inside quotes and last transaction price. The fee for this service is priced on a per terminal per month basis, with professional subscribers paying a higher monthly per terminal fee than non-professional customers. Professional subscribers can also access historical data via a subscription to Nasdaq Trader, a non-UTP Plan product. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's revenue from Nasdaq Quotation Dissemination Service fees was $61.0 million, $74.8 million, and $32.5 million, respectively. The reduction in Nasdaq's revenue from the Nasdaq Quotation Dissemination Service in 2001 reflects the introduction of a reduced non-professional service fee. Nasdaq Quotation Dissemination Service fees accounted for approximately 7.1% of Nasdaq's total revenue for the year ended December 31, 2001. In addition, Nasdaq serves as a securities information processor ("SIP") for purposes of collecting and disseminating quotation and last sale information for all transactions in securities listed on The Nasdaq Stock Market. In creating the national market system, Congress intended for participants in U.S. securities markets to have access to a consolidated stream of quotation and transaction information for the exchanges and The Nasdaq Stock Market. To accomplish this objective, SIPs consolidate information with respect to quotations and transactions in order to increase information availability and thus create the opportunity for a more transparent and effective market. Nasdaq is the exclusive SIP pursuant to the UTP Plan. Under the UTP Plan, as recently amended, each participant can quote and trade any securities from The Nasdaq Stock Market, and Nasdaq collects quotation and last sale information from competing exchanges (currently the Boston Stock Exchange, the Chicago Stock Exchange, and the Cincinnati Stock Exchange actively compete and Amex and the Philadelphia Stock Exchange have announced plans to compete) and consolidates such information with the information for all the securities listed on The Nasdaq Stock Market. Nasdaq sells this information to vendors in exchange for Tape Fees, and the data vendors in turn sell the last sale and quotation data publicly. Under the revenue sharing provision of the UTP Plan, Nasdaq is permitted to deduct certain costs associated with acting as an exclusive SIP from the total amount of Tape Fees collected. After these costs are deducted from the Tape Fees, Nasdaq distributes to the respective UTP Plan participants their share of Tape Fees based on a combination of their respective trade volume and share volume. Currently, the NASD receives a share of Tape Fees based on trade volume and share volume of transactions effected on or reported to The Nasdaq Stock Market and distributes this share to Nasdaq. In anticipation of Nasdaq's registration as a national securities exchange, UTP Plan participants are currently negotiating an amendment to the UTP Plan that would make Nasdaq a direct participant in the UTP Plan and allow Nasdaq to receive a share of Tape Fees directly from the SIP. While Nasdaq is currently the exclusive SIP for the UTP Plan, it is engaged with the other UTP Plan participants in a Request-for-Proposal process to select a new SIP. This process is the result of the SEC's conditions for extending the UTP Plan beyond its March 2001 termination date. The SEC has required that there be good faith negotiations among the UTP Plan participants on a revised UTP Plan that provides for either (i) a fully viable alternative exclusive SIP for all The Nasdaq National Market securities, or (ii) a fully viable alternative non-exclusive SIP. To avoid conflicts of interest, the SEC cautioned that, in the event the revised UTP Plan provides for an exclusive SIP, a UTP Plan participant—particularly Nasdaq—should not operate as the exclusive SIP unless (i) the SIP is chosen on the basis of bona fide competitive bidding and the participant submits the successful bid, and (ii) any decision to award a contract to a UTP Plan participant, and any ensuing renewal of such contract, is made without that UTP Plan participant's direct or indirect voting participation. The UTP Plan participants unanimously approved the Request-for-Proposal on November 7, 2001. The Request-for-Proposal was mailed to prospective bidders, and seven bidders submitted proposals prior to the submission deadline of January 8, 2002. Nasdaq did not submit a bid proposal. The UTP Plan participants currently are reviewing the proposals and it is likely that the new SIP will be operational in early 2003. Nasdaq does not expect its revenue to be affected if it loses its status as an exclusive SIP and no longer serves as a SIP; however, a different SIP operator could have higher operating costs than Nasdaq, leaving less net revenue available for UTP Plan participants including Nasdaq. See "—Risk Factors—Nasdaq's share of net revenue from Tape Fees may decrease once Nasdaq loses its status as the exclusive SIP under the UTP Plan." For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from market information services was $240.5 million, $258.3 million, and $186.5 million, respectively. Market information services accounted for approximately 28.1% of Nasdaq's total revenue for the year ended December 31, 2001. Corporate Client Group Services. Corporate Client Group services provide information services and products to Nasdaq-listed companies and are responsible for obtaining new listings on The Nasdaq Stock Market. The Nasdaq Stock Market has historically attracted traditional growth companies and, as of December 31, 2001, was home to the highest percentage of publicly-traded technology and service companies in the U.S. On December 31, 2001, 4,109 companies were listed on The Nasdaq Stock Market. For the year ended December 31, 2001, 145 new companies listed on The Nasdaq Stock Market, 116 on The Nasdaq National Market and 29 on The Nasdaq SmallCap Market. For the year ended December 31, 2000, 605 new companies listed on The Nasdaq Stock Market, 511 on The Nasdaq National Market, and 94 on The Nasdaq SmallCap Market. During 2001, 63 IPOs, approximately 62% of all IPOs on primary U.S. markets during this period, listed on The Nasdaq Stock Market. These IPOs raised over $7.8 billion, approximately 18% of the total dollar value raised in U.S. IPOs during this period. Of all U.S. IPOs during the year ended December 31, 2000, 397 companies, approximately 88% of U.S. IPOs during this period, listed on The Nasdaq Stock Market. The reduction in The Nasdaq Stock Market's percentage of U.S. IPOs during 2001 reflects a decline in general market and economic conditions, which has impacted the ability of traditional growth companies to access the public equity markets. In addition, during this period there was an increased number of IPOs of companies being spun-off from public companies that, in general, have not operated in traditional growth industries. Of the 12 spin-offs during 2001, 10 of the spin-offs were subsidiaries of NYSE-listed companies, seven of which also listed on the NYSE. During the year ended December 31, 2001, these 12 spin-offs accounted for approximately 12% of all U.S. IPOs and approximately 39% of the total dollar value raised in U.S. IPOs during this period. In comparison, during the year ended December 31, 2000, the number of IPO spin-offs from public companies accounted for only 5% of all U.S. IPOs and approximately 13% of the total dollar value raised in U.S. IPOs during this period. Fifty-six of the 63 IPOs that listed on The Nasdaq Stock Market during 2001 have listed on The Nasdaq National Market and seven companies have listed on The Nasdaq SmallCap Market. Companies cease being listed on The Nasdaq Stock Market for three primary reasons: (i) the failure to meet The Nasdaq Stock Market's listing standards, (ii) the consolidation of listings due to merger and acquisition activity, and (iii) Nasdaq-listed companies switching their listing to another market, such as the NYSE or Amex. See "—Competition—Corporate Client Group Services." For the year ended December 31, 2001, 537 issuers ceased being listed on The Nasdaq National Market and 233 issuers ceased being listed on The Nasdaq SmallCap Market. By comparison, 486 issuers ceased being listed on The Nasdaq National Market and 164 issuers ceased being listed on The Nasdaq SmallCap Market for the year ended December 31, 2000. For the year ended December 31, 2001, 210 issuers on The Nasdaq National Market and 180 issuers on The Nasdaq SmallCap Market were delisted by Nasdaq for failure to satisfy listing standards; 245 issuers on The Nasdaq National Market and 39 issuers on The Nasdaq SmallCap Market were delisted due to mergers and consolidations; 34 issuers on The Nasdaq National Market and no issuers on The Nasdaq SmallCap Market ceased being listed as a result of switches to a competing market, and 48 issuers on The Nasdaq National Market and 14 issuers on the Nasdaq SmallCap Market were delisted due to other reasons, including moving from one tier of The Nasdaq Stock Market to the other tier. In response to the general economic and market uncertainty after the September 11, 2001 terrorist attacks on the United States, Nasdaq formally suspended two requirements for continued listing on both The Nasdaq National Market and The Nasdaq SmallCap Market from September 26, 2001 until January 2, 2002. The first requirement sets a minimum bid price for an issuer's stock (either $1 or $3 per share, depending on the listing standards applicable to the issuer). The second requirement establishes a minimum market value for an issuer's public float. The term "public float" refers to those shares that are not directly or indirectly held by any officer or director of the issuer or any beneficial owner of more than 10% of the total number of shares outstanding. All issuers that were under review or in the hearings process for either of these requirements were taken out of the deficiency review process with respect to these requirements. The suspension had an immediate impact on 209 issuers—159 on The Nasdaq National Market and 50 on The Nasdaq SmallCap Market. In addition to these 209 issuers, 47 issuers on The Nasdaq National Market and 30 issuers on The Nasdaq SmallCap Market, while deficient in the minimum bid price and/or market value of public float requirements, were also deficient in another requirement. As such, these 77 issuers remained in the deficiency review process. On January 2, 2002, the minimum bid price and market value of public float requirements were reinstated. The time periods for review of non-compliance, which are discussed below, began on January 2, 2002 for all issuers, including those that were not in compliance with the requirements as of September 26, 2001. The rules concerning the delisting of issuers from The Nasdaq Stock Market for failure to satisfy the minimum bid price and market value of public float requirements were amended with SEC approval in January 2002. Issuers are subject to the delisting procedure if securities fall below the minimum bid price or fail to meet the market value of public float requirement for 30 consecutive business days. Issuers listed on The Nasdaq National Market that are not in compliance with either requirement are given a 90-day grace period to regain compliance. Issuers listed on The Nasdaq SmallCap Market receive the same 90-day grace period with respect to the market value of public float requirement. However, under a pilot program that is scheduled to expire on January 1, 2004, issuers listed on The Nasdaq SmallCap Market have a longer grace period within which to comply with the minimum bid requirement. These issuers now have 180 days to regain compliance, which may be extended for an additional 180 days if the issuer complies with certain initial listing requirements for The Nasdaq SmallCap Market. Also during the pilot program, issuers on The Nasdaq National Market who are unable to regain compliance with the minimum bid requirements within the applicable 90 day grace period are permitted to phase down to list on The Nasdaq SmallCap Market and use the additional grace period available to issuers on The Nasdaq SmallCap Market. Previously, issuers listed on The Nasdaq National Market that failed to comply within the 90 day grace period were delisted from The Nasdaq Stock Market. Nasdaq charges issuers an initial listing fee, a listing of additional shares ("LAS") fee, and an annual fee. The initial listing fee for securities listed on The Nasdaq National Market or The Nasdaq SmallCap Market includes a one-time listing application fee and a total shares outstanding fee. The estimated service period for initial listing fees is six years. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's revenue from initial listing fees was $35.7 million, $33.9 million, and $27.4 million, respectively. Revenue figures for 1999 are pro forma, assuming the Change in Accounting Principle is applied retroactively. Nasdaq's initial listing fee revenue accounted for approximately 4.2% of Nasdaq's total revenue for the year ended December 31, 2001. The fee for LAS is based on the total shares outstanding, which Nasdaq reviews quarterly. The estimated service period for LAS fees is four years. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's revenue from LAS fees was $35.9 million, $33.6 million, and $30.0 million, respectively. Revenue figures for 1999 are pro forma, assuming a retroactive application of the Change in Accounting Principle. Nasdaq's LAS fee revenue accounted for approximately 4.2% of Nasdaq's total revenue for the year ended December 31, 2001. Annual fees for securities listed on The Nasdaq National Market are based on total shares outstanding. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's revenue from annual listing fees was $83.1 million, $81.1 million, and $77.3 million, respectively. Nasdaq's annual listing fees accounted for approximately 9.7% of Nasdaq's total revenue for the year ended December 31, 2001. Effective January 1, 2002, Nasdaq instituted a new fee structure that increased initial and annual listing fees for companies on both The Nasdaq National Market and The Nasdaq SmallCap Market. The increases marked the first increase in annual listing fees in four years for issuers listed on The Nasdaq National Market and the first such increase in 10 years for foreign issuers with American Depositary Receipts listed on The Nasdaq Stock Market and all issuers listed on The Nasdaq SmallCap Market. The revenue expected to be generated from the fee increase will be used primarily to fund enhancements to the services offered to Nasdaq-listed companies, including the establishment of a Market Intelligence Centersm. See "—Strategic Initiatives—Attracting, Servicing, and Retaining Listed Companies." Following the initial listing, Nasdaq provides information services, products, and programs to Nasdaq-listed companies. Executives of Nasdaq-listed companies are invited to participate in a variety of programs on a wide range of topics, such as industry sector-specific seminars and investor relation forums. These executives also have access to Nasdaq Onlinesm, a strategic planning tool provided free of charge to Nasdaq-listed companies that was rated number one in a recent survey of the top 10 favorite investor relations web sites by the National Investor Relations Institute. Nasdaq Online presents market data on all U.S. traded companies and real-time quotes for Nasdaq-listed securities, as well as information on institutional ownership, research coverage, and performance ratios. This combination of on-line real time data and analytical information, along with a series of other seminars and programs, is designed to help management of listed companies make better equity management decisions. See "—Strategic Initiatives—Attracting, Servicing, and Retaining Listed Companies." Each listed company is assigned a Corporate Client Group director who oversees the listed company's relationship with Nasdaq. A schedule of calls and visits along with invitations to various industry and market forums are used to enhance customer satisfaction, keep companies informed of new developments at Nasdaq, and discuss the benefits of a listing on The Nasdaq Stock Market. Nasdaq also has created a program to educate investment bankers, capital market dealers, institutional investors, and other constituencies that influence listing decisions. For the years ended December 31, 2001, 2000, and 1999 Nasdaq's total revenue from Corporate Client Group services was $156.1 million, $149.3 million, and $136.4 million, respectively. Corporate Client Group services accounted for approximately 18.2% of Nasdaq's total revenue for the year ended December 31, 2001. Revenue figures for 1999 are pro forma, assuming the retroactive application of the Change in Accounting Principle. Other Products and Markets Nasdaq Financial Products. Nasdaq Financial Products is responsible for introducing products that extend and enhance the Nasdaq brand; creating products that will increase investment in Nasdaq-listed companies; developing Nasdaq branded financial products. Nasdaq Financial Products also is responsible for both listings and transactions of non-Nasdaq branded financial products. A number of Nasdaq branded financial product are based on the Nasdaq-100 Index®, launched in January 1985. The Nasdaq-100 Index generally includes the 100 largest non-financial stocks in Nasdaq. The Nasdaq Financial-100 Index® represents the 100 largest financial stocks. The Nasdaq-100 Index has become the basis for a wide variety of financial products, including: futures contracts, exchange traded funds (QQQ), mutual funds, equity options on QQQ, and a variety of structured products such as index warrants and index equity linked notes and certificates offered primarily in Europe. An exchange traded fund is an investment company organized to track an index and to allow for secondary market trading. A structured product is a specialized security designed to respond to specific investment objectives, such as risk reduction, leverage or diversification of current investments, or tax management. Nasdaq receives a license fee for these products that varies by product based on assets under management or number of contracts issued. The exchange traded fund based on The Nasdaq-100 Index is officially named the Nasdaq-100 Index Tracking Stocksm and began trading in 1999 under the symbol "QQQ." For the year ended December 31, 2001, the average daily share volume of QQQ was 70.6 million and the average daily dollar volume of QQQ was approximately $3.0 billion, making it the second most heavily traded stock in terms of shares and the most heavily traded stock in terms of dollar value in the United States. As of December 31, 2001, the QQQ Trust had issued approximately 555.7 billion shares and the assets under management had reached $21.8 billion. Every major stock market in the U.S. including the NYSE, Amex, Boston Stock Exchange, Chicago Stock Exchange, Cincinnati Stock Exchange, Pacific Stock Exchange, and Philadelphia Stock Exchange has been licensed by Nasdaq to use Nasdaq trademarks in connection with trading QQQ under the UTP Plan. The equity options on QQQ also were among the most heavily traded options in the U.S. in 2001. Every major options market in the U.S. has been licensed by Nasdaq to use Nasdaq trademarks to trade the equity options on QQQ. In addition to license fees from QQQ based on assets under management and license fees from exchanges based on UTP volume, Nasdaq is entitled to reimbursement from the QQQ Trust for marketing activities designed to promote the Trust. For the years ended December 31, 2001, 2000, and 1999 Nasdaq's total revenue from Nasdaq Financial Products was $30.6 million, $11.7 million, and $0.6 million, respectively. Nasdaq Financial Products accounted for approximately 3.6% of Nasdaq's total revenue for the year ended December 31, 2001. Nasdaq InterMarket. Nasdaq InterMarket is an electronic marketplace where NASD members can trade securities listed on the NYSE and Amex. Users can trade on Nasdaq InterMarket among themselves using Nasdaq's CAES order delivery system, or with another participating stock exchange through the Intermarket Trading System. CAES allows users to direct orders in exchange-listed securities to other NASD members for automatic response and automatic execution, and also provides access to the Intermarket Trading System. For the years ended December 31, 2001, 2000, and 1999, Nasdaq's total revenue from Nasdaq InterMarket was $33.6 million, $23.1 million, and $18.0 million, respectively. Nasdaq InterMarket revenue accounted for approximately 3.9% of Nasdaq's total revenue for the year ended December 31, 2001. Approximately 96% of the revenue generated from the Nasdaq InterMarket is derived from the sale of data and is included in market information services revenue, and the remaining revenue is derived from transaction service fees for CAES and Intermarket Trading System transactions and included in transaction services revenue. For the year ended December 31, 2001, Nasdaq InterMarket accounted for approximately 7% of trades in securities listed on the NYSE and approximately 33% of trades in securities listed on Amex. All Nasdaq InterMarket trades are reported and disseminated in real-time to the Consolidated Tape Association, and as such, Nasdaq shares in the revenue generated by the Consolidated Tape Association. Two NASD members that are major market makers and one ECN report the majority of trades. Other ECNs report trades through Nasdaq systems to the Consolidated Tape Association and some are planning to begin quoting in Nasdaq InterMarket. NASD members who trade exchange-listed securities away from the exchanges account for a significant amount of Nasdaq InterMarket trading activity. OTC Bulletin Board. The OTC Bulletin Board is an electronic screen-based market for equity securities that, among other things, are not listed on The Nasdaq Stock Market or any primary U.S. national securities exchange. At present, the OTC Bulletin Board is a quotation service, as companies do not list on the OTC Bulletin Board. NASD members may post quotes only for companies that file periodic reports with the SEC and/or with a banking or insurance regulatory authority. In addition, these companies are required to be current with their periodic filings. Market makers are charged a fee per position and are billed based on their number of positions during a month. A position is defined as any price quotation or indication of interest entered by a market maker in a security quoted on the OTC Bulletin Board. There are no fees charged to companies whose securities are quoted on the OTC Bulletin Board. The OTC Bulletin Board revenue accounted for less than 1% of Nasdaq's total revenue for the years ended December 31, 2001, 2000, and 1999, respectively. Revenue generated from the OTC Bulletin Board is included in transaction services revenue. During 2000, in conjunction with Exchange Registration, the Nasdaq Board of Directors and the NASD Board of Governors (the "NASD Board" and, together with the Nasdaq Board, the "Boards"), approved several rule changes that are designed to enhance the OTC Bulletin Board and permit Nasdaq to continue to operate it after Exchange Registration. First, the Boards approved a program for Nasdaq to enter into a listing agreement with OTC Bulletin Board issuers and impose new listing standards to ensure the quality of these issuers. Second, both Boards approved the creation of an automated order delivery system for the OTC Bulletin Board. Finally, to accompany the new listing standards and order delivery system, the Boards approved enhanced market rules that provide for limit order protection, short interest reporting, and intraday trading halt authority. Nasdaq has submitted to the SEC the appropriate proposed rules and plans to submit exemption requests that would allow Nasdaq to continue to operate the OTC Bulletin Board after Exchange Registration, which would be renamed the "Bulletin Board Exchange," or "BBX." The SEC has not yet approved the rules or the exemption request. Therefore, it is not certain whether Nasdaq will continue to operate the OTC Bulletin Board following Exchange Registration. If the SEC does not approve the exemption request, these securities could continue to trade over the counter through a non-Nasdaq facility. Nasdaq may change the pricing of its products and services in response to competitive pressures or changes in market or general economic conditions. Pursuant to the requirements of the Exchange Act, Nasdaq must file all proposals for a change in its pricing structure with the SEC. Nasdaq provides updated information on the pricing of its products and services on its website at www.nasdaqtrader.com. Nasdaq's Strategic Initiatives Nasdaq's strategic initiatives include enhancing its products and services; attracting, servicing, and retaining listed companies; and pursuing global market expansion. Enhancing Products and Services. In the third quarter of 2002, Nasdaq plans to launch the Nasdaq Order Display Facility ("SuperMontagesm"), an improved user interface on the Nasdaq Workstation II designed to refine how market participants can access, process, display, and integrate orders and quotes in The Nasdaq Stock Market. SuperMontage has several strategic implications. It is intended to attract more orders to The Nasdaq Stock Market by providing a comprehensive display of the interest at the inside market and four price levels away, thus increasing competition and market transparency. SuperMontage will also provide pre-trade anonymity to market participants using a Nasdaq system, i.e., prior to execution no one will know the identity of the firm displaying the order unless such firm chooses to reveal its identity. Anonymous trading can contribute to improved pricing for securities by reducing the potential market impact of large transactions and transactions by certain investors whose trading activity, if known, may be more likely to influence others. By allowing (but not requiring) market participants to give the Nasdaq system multiple orders at single as well as at multiple price levels, SuperMontage will assist market participants with the management of their back book, i.e., orders that are not at the best price in the market maker's book/system. This functionality will also assist market participants with compliance with the SEC's order handling rules, which among other things, require the display of customer limit orders priced better than a Nasdaq market maker's or a designated dealer's quote or that are for a larger number of shares at the same price. Other system enhancements will make it easier for ECNs to accept automatic execution via Nasdaq systems. Nasdaq currently contemplates that it will begin user testing of SuperMontage in the second quarter of 2002. SuperMontage provides Nasdaq market information services with two new data products. DepthViewsm will show the aggregate size available at up to five price levels while TotalViewsm will display, in addition to DepthView data, each quote or order, with attribution when available, that makes up the aggregate depth at up to five price levels. These Nasdaq-proprietary data products will provide new revenue streams that are not expected to materially reduce subscriptions of existing products because they are enhancements rather than substitutes for Level 1 and Nasdaq Quotation Dissemination Service. In March 2002, Nasdaq market information services introduced PostDatasm, a new data product that will enable market participants to advertise their ACT-reported trading volume and other parties, particularly the buy side, to view accurate trading data from the previous day. In July 2002, Nasdaq market information services anticipates introducing Liquidity Trackersm, an order routing system that uses ACT data from market participants that opt into the system to route orders to participants likely to take the other side of a trade. Nasdaq is also developing a single stock futures market. On June 1, 2001, Nasdaq and the London International Financial Futures and Options Exchange ("LIFFE") formed Nasdaq LIFFE, LLC (subsequently renamed Nasdaq LIFFE Markets, LLC ("Nasdaq LIFFE")), a new jointly owned U.S. limited liability company to list and trade contracts on single stock futures, among other products. Nasdaq and LIFFE each owns 50% of Nasdaq LIFFE. On August 21, 2001, the Commodity Futures Trading Commission conditionally approved Nasdaq LIFFE as a futures market and SRO. In addition, the U.K. Treasury has recognized Nasdaq LIFFE as an overseas investment exchange in the United Kingdom, allowing Nasdaq LIFFE to provide direct access to its market to members in the United Kingdom. Nasdaq LIFFE is currently positioning itself to be ready to commence trading in single stock futures sometime in the second quarter of 2002, if necessary regulations are in place for trading. Attracting, Servicing, and Retaining Listed Companies. Nasdaq intends to further The Nasdaq Stock Market's reputation as a premier marketplace through a combination of strategic actions including the creation of the Market Intelligence Centersm. The Market Intelligence Center is expected to augment Corporate Client Group productivity resulting in improved corporate sales, service, and retention. The plan for the Market Intelligence Center was announced in October 2001 and the Center is scheduled to debut its first phase in June 2002 as a customer care location that will be a "one-stop-shop" for information and provide rapid response to corporate client queries from a centralized location. The Market Intelligence Center will use customer relationship management, computer-aided telephony, proprietary and non-proprietary information services to provide services to senior executives and board members of Nasdaq-listed companies. In addition, the Corporate Client Group is planning a series of enhancements to Nasdaq Online, Nasdaq's private Internet site for corporate clients. A product group was established to begin the development and commercialization of new products and services focused on the corporate market, as well as increased financial newsmedia coverage of Nasdaq-listed companies. Pursuing Global Market Expansion. Nasdaq Europe S.A./N.V. Nasdaq is pursuing strategic partnership opportunities with a number of major U.S. and foreign securities exchanges to expand its leadership in technology-driven price discovery systems and to utilize its well-recognized and well-respected brand. In March 2001, Nasdaq acquired an approximate 68% ownership interest in EASDAQ S.A./N.V. ("EASDAQ"), a pan-European stock market for emerging growth companies, headquartered in Brussels. Nasdaq has since diluted its interest through the introduction of other strategic partners as shareholders. In connection with this investment, Nasdaq restructured EASDAQ into Nasdaq Europe S.A./N.V. ("Nasdaq Europe") with the goal to make Nasdaq Europe a globally-linked pan-European market. As of December 31, 2001, Nasdaq owned approximately 60% of Nasdaq Europe. As of December 31, 2001, 48 companies were listed on Nasdaq Europe and 265 companies were admitted for trading. The monthly trading volume in December 2001 was 4.5 million shares. Nasdaq Europe is in its nascent stages and has only operating losses since the acquisition by Nasdaq. Nasdaq Europe's future growth is dependent on such things as firms connecting to Nasdaq Europe's trading platform and using its trading facilities, as well as any continuation of the current weakness in European equity markets. See "—Risk Factors—Nasdaq may not be successful in executing its international strategy." Nasdaq Europe's main competitors for listings and trading include the three primary exchanges in Europe: Deutsche Börse AG, Euronext N.V., and the London Stock Exchange. Nasdaq Europe expects the competition for retail and institutional order flow to be based in large part on the ability of firms to operate within an exchange environment that offers optimum market structures and services within a well-regulated marketplace. Nasdaq Europe believes that its approach to such critical issues as market structure, clearance and settlement, product development, and branding, can offer an exchange platform for market participants to compete successfully in Europe. Nasdaq continues to explore opportunities for expanding its presence in Europe, including possible combinations or other collaborative activities with one or more major European institutions. For instance, on November 14, 2001, Nasdaq Europe announced a strategic partnership with the Berlin Stock Exchange that will create a common trading platform between these two markets. Under this partnership, Nasdaq Europe intends, among other things, to pool liquidity with the Berlin Stock Exchange by enabling German specialists to become market makers on Nasdaq Europe in selected securities. Nasdaq anticipates that discussions with other European institutions will continue, but cannot predict the results of any such discussions. Nasdaq Japan, Inc. In 1999, the NASD and SOFTBANK Corp. of Japan entered into a joint venture, subsequently named Nasdaq Japan, to develop and create an electronic stock market in Japan. The NASD later transferred its interest in Nasdaq Japan to Nasdaq Global Holdings ("Nasdaq Global"), a wholly-owned subsidiary of Nasdaq. Nasdaq Global owns approximately 39% of Nasdaq Japan's outstanding stock. Nasdaq Japan signed a business collaboration agreement with the Osaka Securities Exchange (the "OSE") to establish Nasdaq Japan as a new market section of the OSE. The Nasdaq Japan market began operations on June 19, 2000. In its first phase of operations, prior to its deployment of a SuperMontage-like trading platform technology, Nasdaq Japan has focused on recruiting IPOs of companies for listing and trading these securities on the existing OSE system. In October 2001, Starbucks Coffee Japan, Ltd. had an IPO of its common stock and listed on Nasdaq Japan. Starbucks Corporation, a U.S. based Nasdaq-listed Company, is a major shareholder of Starbucks Coffee Japan, Ltd. In addition, Nasdaq Japan, subject to regulatory approvals, is seeking to introduce trading of U.S.-listed securities and exchange traded funds in Japan, including the Nasdaq-100 QQQ exchange traded fund. As of December 31, 2001, 82 companies were trading on the interim trading platform with an average monthly share volume of 8.8 million shares. As a start up operation, Nasdaq Japan has had only operating losses since its inception. See "—Risk Factors—Nasdaq may not be successful in executing its international strategy." Nasdaq believes that the effective use of technology is the key to the future of financial markets. The Nasdaq Stock Market was the world's first electronic screen-based stock market and its use of state-of-the-art computer networking, telecommunications, and information technologies distinguishes it from other U.S. securities markets. Using technology, Nasdaq eliminates the need for a physical trading floor and enables qualified investors across the country to compete freely with one another in an electronic screen-based environment. The Nasdaq network routinely handles trade volumes of over two billion shares daily and over 4,000 transactions per second and is designed to maximize transaction reliability and network security across each of the most critical system services that comprise The Nasdaq Stock Market, including quotation, order processing, trade reporting, and market data dissemination. Furthermore, Nasdaq's system has substantial reserve capacity to handle far greater levels of activity and will further expand bandwidth to maximize its ability to provide an efficient, rapid, reliable trading environment for its market participants. Continual systems improvements provide cost effective and efficient access to multiple market information data and rapid market response capabilities. Nasdaq also employs technology to maximize its ability to communicate with investors, issuers, traders, the media, and others. The securities markets are intensely competitive and they are expected to remain so. Nasdaq competes globally and on a product and/or specific geographical basis. Nasdaq competes based on a number of factors, including the quality of its technological and regulatory infrastructure, total transaction costs, the depth and breadth of its markets, the quality of its value-added customer services (e.g., services to listed companies), international capabilities, reputation and price. In the U.S., Nasdaq is one of the leaders in each of its principal businesses. Nonetheless, Nasdaq expects that current or new exchanges will compete more aggressively against Nasdaq. Some of Nasdaq's most significant challenges and opportunities will arise outside the United States as globalization is likely to result in a need for a worldwide network for linking global pools of capital and offering investors maximum access to invest in companies anywhere at anytime. In order to take advantage of these opportunities, Nasdaq has formed alliances in key financial centers around the world in order to build on its successes in the U.S. and its strong, worldwide brand name. Nevertheless, most of Nasdaq's competitors overseas are currently larger and have a longer operating history in their markets than does Nasdaq. In light of recent technological and regulatory changes and new product introductions, Nasdaq expects to compete with a number of different entities varying in size, business objectives, and strategy. Transaction Services. Nasdaq's core trading services are designed to provide access to The Nasdaq Stock Market, quote and trade execution services, and post-trade services such as trade reporting. Nasdaq expects to face competition from a number of different sources in providing these services including: Competing regional stock exchanges that have lower regulatory costs and are able to offer larger revenue sharing arrangements to entice market participants to report trades to them rather than Nasdaq, thereby reducing both transaction and market information services revenue; ECNs that obtain registration as exchanges and compete for listing, transaction services and market information services. In October 2001, the SEC approved Pacific/Archipelago's proposal to establish the Archipelago Exchange as an equities trading facility of the Pacific Stock Exchange. Archipelago and RediBook, two of the largest users of ACT for trade reporting, have merged and it is likely that they will shift certain trade reporting to the Pacific Stock Exchange later this year. Another ECN, the Island ECN ("Island"), has applied to the SEC for registration as a national securities exchange. See "—Risk Factors—Nasdaq's revenue would be adversely affected by ECNs that register as exchanges;" Competing stock exchanges or network providers that develop ways to effectively replicate Nasdaq's network and offer quote and execution services at a lower cost and/or a greater speed and persuade a critical mass of market participants to switch to the new network/market; Competing stock exchanges that are able to find ways to effectively link into Nasdaq's network while avoiding the subscription fees paid by member firms. The SEC could require Nasdaq to distribute the quotations of independent exchanges or the NASD through the Nasdaq network without permitting Nasdaq to charge the same quotation fees that Nasdaq may assess on Nasdaq quote providers. If this were to occur, Nasdaq would, in effect, incur added costs potentially without an opportunity to recover such costs from its full user base; ECNs and third-party service bureaus that may join together to form one dominant service provider, thereby diminishing Nasdaq's competitive position; Companies that could provide trading services for products and services, including software companies, information and media companies and other companies that are not currently in the securities business; and The NASD's Alternative Display Facility, which could attract trade reporting volume. See "—Risk Factors—Nasdaq may face competition from the NASD's Alternative Display Facility." To address competitive concerns, Nasdaq has looked to enhance its technology and the services it provides to its market participants and refine its pricing approach by reviewing each component of its transaction services, including access services, execution services and post-trade services. For each component, Nasdaq has attempted to make pricing more attractive in order to retain usage of its services. In addition, Nasdaq has enhanced its quoting and trading services through the implementation of SuperSoes and the ongoing phase-in of Primex and will add to that with the introduction of SuperMontage. Market Information Services. Nasdaq's market information services revenue is under competitive threat from other stock exchanges that trade Nasdaq-listed securities, including the established regional exchanges. Current SEC regulations permit these regional exchanges to trade certain securities that are not listed on a national securities exchange, including securities listed on The Nasdaq Stock Market, pursuant to Nasdaq's UTP Plan. Nasdaq's UTP Plan entitles these exchanges to a share of Nasdaq's data revenue, roughly proportional to such exchange's share of trading as measured by share volume and number of trades. Currently, the Boston Stock Exchange, the Chicago Stock Exchange, and the Cincinnati Stock Exchange trade Nasdaq-listed securities pursuant to the UTP Plan. Amex and the Philadelphia Stock Exchange have indicated their intent to commence trading in Nasdaq-listed securities pursuant to the UTP Plan. Current active participants in the UTP Plan have established payment for order flow arrangements with their members and customers through sharing tape revenue. The net effect of these additional competitors, along with continuing advances in technology and regulatory changes may increase pressure on Nasdaq to share more Tape Fees with participants who report trades through Nasdaq. In February 2002, Island began reporting a portion of its trades to the Cincinnati Stock Exchange, a UTP Plan participant. Published reports indicate that the Cincinnati Stock Exchange gained Island's business by committing to lower trade reporting fees and share with Island a substantial portion of Tape Fees that Cincinnati earns from Island's trades. Nasdaq's revenue would be further affected if other ECNs began reporting trades to other UTP Plan participants. To improve its competitive position, Nasdaq recently reduced certain trade reporting fees and began sharing Tape Fees with participants who report trades through Nasdaq after deducting certain costs of regulating The Nasdaq Stock Market. Nasdaq historically has used Tape Fees to pay market regulation expenses that help ensure the quality and fairness of The Nasdaq Stock Market and compliance with all applicable rules and regulations. As a result of the deduction of market regulation expenses, Nasdaq's current Tape Fee sharing with Nasdaq market participants may not match the portion of Tape Fees offered by the Cincinnati Stock Exchange although Nasdaq's Tape Fee sharing is designed to be competitive with the amount of Tape Fees that ECNs such as Island rebate to their users. Nasdaq's trade reporting fees or Tape Fee sharing may be adjusted in the future to respond to competitive pressures. See "—Risk Factors—Competition by regional exchanges for trade reporting business may reduce Nasdaq's trade reporting and market information revenue" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Future Products and Competitive Trends." ECNs pose an additional potential threat to Nasdaq's market information services business because they may register as securities exchanges. As noted above, the SEC has approved Pacific/Archipelago's proposal to establish the Archipelago Exchange as an equities trading facility of the Pacific Exchange and Island has applied for exchange registration and expressed interest in becoming a UTP Plan participant. In this case, they would be eligible for a share of the UTP Plan Tape Fees generated by the sale of Nasdaq's market information products, and their use of Nasdaq's systems could diminish. See "—Risk Factors—Nasdaq's revenue would be adversely affected by ECNs that register as exchanges." Nasdaq is responding aggressively to competition from existing and potential UTP exchanges. Nasdaq is working to ensure that all exchanges are covered by uniform regulatory standards and bear appropriate regulatory costs. Nasdaq also regularly examines its fee structure to insure that costs are fairly distributed among participants and that fees adequately cover the cost of regulation. Corporate Client Group Services. Nasdaq's strategies for maintaining its current listings in both The Nasdaq National Market and The Nasdaq SmallCap Market and gaining new listings include building global brand identity, developing joint marketing opportunities with listed companies, communicating better with key decision makers, and providing other value-added services to Nasdaq-listed companies. Nasdaq's marketing efforts have centered on creating a valuable brand—an important factor in attracting and retaining large world-class growth companies. In terms of obtaining new listings, Nasdaq will continue to focus its efforts primarily on growth companies. Over the last 18-24 months, general market and economic conditions have made it difficult for many companies to access the public equity markets. Nevertheless, Nasdaq believes that its market model, strong global reputation and value-added services will enable it to compete successfully for listings. Nasdaq employs a variety of initiatives and tools in its marketing efforts, including media advertising, Internet publishing (Nasdaq.com), and international road shows. Nasdaq competes primarily with the NYSE for larger company listings on The Nasdaq National Market. As of December 31, 2001, there were 3,351 companies listed on The Nasdaq National Market with an aggregate domestic market capitalization of $2.8 trillion compared to 2,798 companies listed on the NYSE with an aggregate domestic market capitalization of $11.7 trillion. Rule 500 of the NYSE historically has made it very difficult for companies to voluntarily delist from the NYSE. As currently written, Rule 500 allows a company to delist from the NYSE if it obtains the approval of its board of directors and its audit committee, publishes a press release announcing its proposed delisting and sends a written notice to its largest 35 stockholders of record (U.S. stockholders of record if a non-U.S. issuer) alerting them to the proposed delisting. Because of these affirmative steps imposed on an issuer's board of directors, in particular the notice requirements, Nasdaq believes that Rule 500 is anti-competitive and continues to constitute an impediment to Nasdaq's ability to compete for NYSE listings. During 2001, no companies transferred from the NYSE to The Nasdaq Stock Market, while 32 companies switched to the NYSE from The Nasdaq National Market. Nasdaq competes with Amex primarily, but not exclusively, for listings on The Nasdaq SmallCap Market. During the year ended December 31, 2001, eight companies transferred from Amex to The Nasdaq SmallCap Market. During this period, no companies switched to Amex from The Nasdaq SmallCap Market. Two companies transferred to Amex from The Nasdaq National Market during 2001. Companies also have a choice of not listing on any market. In that case, broker-dealers may still make markets for such securities and post their quotes on the OTC Bulletin Board or the Pink Sheets, owned by Pink Sheets LLC, a private company. Other Markets. The Nasdaq Stock Market competes for trading volume in NYSE and Amex-listed securities by offering customers quality trade executions at a reasonable price and derives revenue from the sale of related data. A significant amount of investor self-directed, on-line trading activity in listed securities is currently executed on Nasdaq InterMarket. These orders forgo the exposure of the auction trading systems of the exchanges in favor of the execution services provided by Nasdaq InterMarket participants. Nasdaq is engaged in a vigorous effort to increase market share in the Nasdaq InterMarket by encouraging additional market makers and ECNs to participate through Nasdaq InterMarket. Nasdaq InterMarket has implemented a program designed to lower costs for Nasdaq InterMarket participants executing trades through Nasdaq facilities. The program allows Nasdaq InterMarket participants to share in the Tape Fees Nasdaq receives as a participant in the Consolidated Tape Association Plan. As of March 1, 2002, Nasdaq had 1,276 employees. None of its employees is subject to collective bargaining agreements or is represented by a union. Nasdaq considers its relations with its employees to be good. Service, Regulatory, and Technology Contractual Relationships with the NASD, NASDR, and Amex Although it is contemplated that the NASD will eventually divest completely its ownership interest in Nasdaq, there may still exist certain contractual relationships between the parties once this happens. For example, prior to the Restructuring, Nasdaq had access to many support functions of the NASD, including certain financial services, real estate, legal, information services and corporate and administrative services. On June 28, 2000, the NASD and Nasdaq entered into an interim Separation and Common Services Agreement, which was extended beyond its original expiration date of December 31, 2001 and is now scheduled to expire April 30, 2002. Nasdaq and the NASD are currently in negotiations for a new Separation and Common Services Agreement, under which the NASD will continue to supply similar support services. Under the existing Separation and Common Services Agreement, Nasdaq pays to the NASD the costs of the services provided, including any incidental expenses associated with such services. Nasdaq has contracted with the NASD to provide such services because of the NASD's expertise and experience in providing such services to Nasdaq, resulting in cost savings and greater efficiency for Nasdaq. Nasdaq's costs for services provided by the NASD in 2001 were approximately $32.1 million. Nasdaq anticipates that the annual costs for services under the new Separation and Common Services Agreement, when implemented, will drop in future years as Nasdaq reviews the provision of these services and continues to internalize more of these services or seeks alternative third party providers. See "—Risk Factors—Nasdaq faces potential conflicts of interest with related parties," "—Risk Factors—The intercompany agreements may not be effected on terms as favorable to Nasdaq as could have been obtained from unaffiliated third parties" and "Item 13. Certain Relationships and Related Transactions." In addition, on June 28, 2000, Nasdaq and NASD Regulation, Inc. ("NASDR"), a wholly-owned subsidiary of the NASD, entered into a Regulatory Services Agreement pursuant to which NASDR or its subsidiaries will provide regulatory services to Nasdaq and its subsidiaries commencing upon the effectiveness of Exchange Registration. The term of the Regulatory Services Agreement is 10 years. The services will be of the same type and scope as are currently provided by NASDR to Nasdaq under the Delegation Plan. Each regulatory service is to be provided for a minimum of five years, after which time the parties may determine to terminate the provision by NASDR of a particular service. The termination of a particular service will generally be based upon a review of pricing and the need for such services. In 2001, Nasdaq paid NASDR approximately $83.8 million for regulatory services. Nasdaq expects the cost of these services provided by the NASDR will be approximately the same in future years (subject to general cost increases associated with inflation) unless an unanticipated event requires additional spending for regulatory services. On February 6, 2002, Nasdaq, the NASD, and Amex entered into a Technology Transition Agreement to provide for the sharing of certain administrative and regulatory technologies between Nasdaq and Amex and the provision of certain technology services by Nasdaq to Amex. This agreement replaces the existing technology arrangements among the parties that resulted from the NASD's acquisition of Amex in 1998. Depending upon the applicable service or technology, the term of the agreement ranges between three months and two years while Amex reconstructs these services and technologies in-house, with an option for Amex to extend the term for certain services for up to one year. Pursuant to this agreement, Amex will pay Nasdaq the direct costs of the services provided by Nasdaq, plus certain administrative costs. In addition, this agreement establishes a fund, administered by the NASD, to pay the costs incurred by Nasdaq and Amex in the implementation of this agreement. Nasdaq and the NASD have each agreed to contribute up to $14.5 million to this fund. The parties also entered into a Master Agreement on February 6, 2002 to govern certain non-technology related matters among the parties and their respective affiliates. This agreement, among other things, sets forth the terms of certain trading rights between Nasdaq and Amex. The parties are in the process of scheduling regulatory review of the Technology Transition Agreement and the Master Agreement. See "—Risk Factors—Nasdaq faces potential conflicts of interest with related parties," "—Risk Factors—The intercompany agreements may not be effected on terms as favorable to Nasdaq as could have been obtained from unaffiliated third parties" and "Item 13. Certain Relationships and Related Transactions." The executive officers of Nasdaq are as follows: Hardwick Simmons 61 Chairman of the Nasdaq Board; Chief Executive Officer Richard G. Ketchum 51 President and Deputy Chairman Alfred R. Berkeley, III 57 Vice Chairman David Weild IV 45 Vice Chairman and Executive Vice President—Corporate Client Group Adena T. Friedman 32 Executive Vice President—Data Products Steven Dean Furbush 43 Executive Vice President—Transaction Services William R. Harts 45 Executive Vice President—Corporate Strategy John L. Hilley 54 Executive Vice President and Chairman and Chief Executive Officer of Nasdaq International Edward S. Knight 51 Executive Vice President and General Counsel Steven J. Randich 39 Executive Vice President Operations & Technology and Chief Information Officer Denise B. Stires 39 Executive Vice President—Worldwide Marketing and Investor Services John T. Wall 60 President, Nasdaq International David P. Warren 48 Executive Vice President—Chief Financial Officer Hardwick Simmons, a member of the Nasdaq Board, became Chairman of the Nasdaq Board in September 2001 and has been CEO of Nasdaq since February 2001. Prior to joining Nasdaq, Mr. Simmons served from May 1991 to December 2000 as President and CEO of Prudential Securities Incorporated, the investment and brokerage firm, and Prudential Securities Group Inc., the firm's holding company. Prior to joining Prudential Securities in 1991, Mr. Simmons was President of the Private Client Group at Shearson Lehman Brothers, Inc. Richard G. Ketchum, a member of the Nasdaq Board, was elected to the Nasdaq Board in September 2001 and has been President of Nasdaq since July 2000 and Deputy Chairman since December 2000. Mr. Ketchum is responsible for all aspects of Nasdaq's operations, including the development and formulation of market, regulatory, and legal policies, as well as international initiatives. Prior to his current position, Mr. Ketchum served as President of the NASD since 1998, COO of the NASD since 1993 and Executive Vice President of the NASD since 1991. Alfred R. Berkeley III has been Vice Chairman of Nasdaq since July 2000 and was President of Nasdaq from June 1996 to July 2000. Mr. Berkeley was a member of the Nasdaq Board from June 1996 to May 2001. Prior to joining Nasdaq, Mr. Berkeley served for five years as Managing Director and Senior Banker of the Corporate Finance Department of Alex. Brown & Sons Incorporated, a financial services firm. David Weild IV became Vice Chairman of Nasdaq in October 2001 and Executive Vice President of the Corporate Client Group of Nasdaq in March 2001. Prior to his current positions, Mr. Weild held various positions with Prudential Securities Incorporated, the investment and brokerage firm, including President of Prudential Securities.Com from 2000 to 2001, Managing Director and Head of High Technology Investment Banking from 1997 to 2000, Managing Director of Investment Banking and Head of Corporate Finance from 1995 to 1997, and Managing Director and Head of the Global Equity Transactions Group from 1990 to 1995. Adena T. Friedman became Executive Vice President of Nasdaq Data Products in January 2002 and oversees Nasdaq's market information services. Prior to her current position, Ms. Friedman was Senior Vice President of Nasdaq Data Products from January 2001 to January 2002, Vice President of OTC Bulletin Board, Mutual Fund Quotation Service and NasdaqTrader.com from January 2000 to January 2001, Director of OTC Bulletin Board and Mutual Fund Quotation Service from August 1997 to January 2000, and Marketing Manager overseeing Nasdaq's marketing efforts to broker-dealers from April 1995 to August 1997. Ms. Friedman joined Nasdaq in 1993. Steven Dean Furbush became an Executive Vice President of Nasdaq Transaction Services in January 2001. Prior to his current position, Mr. Furbush was Senior Vice President of Nasdaq Transaction Services from October 2000 to January 2001, Managing Director of Nasdaq InterMarket from October 1999 to October 2000, and Chief Economist from June 1995 to October 1999. William R. Harts became Executive Vice President of Nasdaq Corporate Strategy in January 2002. Prior to joining Nasdaq, Mr. Harts was a Managing Director at Salomon Smith Barney, a global investment banking firm, from October 1991 to November 2001. As a Managing Director, Mr. Harts served at various times as Head of Strategic Business Development for the Global Equity Division and Head of the Portfolio Trading Department. Mr. Harts served as a Director and Vice Chairman of the Philadelphia Stock Exchange from March 1994 to June 1999. John L. Hilley became an Executive Vice President of Nasdaq and Chairman and CEO of Nasdaq International in July 1999. Mr. Hilley joined the NASD as Executive Vice President for Strategic Development in February 1998. Prior to joining the NASD, Mr. Hilley served in the White House as senior advisor to President Clinton since February 1996. Mr. Hilley has also held a number of senior staff positions in the U.S. Senate. Edward S. Knight became an Executive Vice President and General Counsel in October 2000. Prior to his current position, Mr. Knight served as Executive Vice President and Chief Legal Officer of the NASD since July 1999. Prior to joining the NASD, Mr. Knight served as General Counsel of the U.S. Department of the Treasury from September 1994 to June 1999. Steven J. Randich became Executive Vice President of Operations & Technology and Chief Information Officer of Nasdaq in October 2001. Prior to his current position, Mr. Randich served as Executive Vice President and Chief Technology Officer of Nasdaq since October 2000. Prior to joining Nasdaq, Mr. Randich was Executive Vice President and Chief Information Officer of the Chicago Stock Exchange from November 1996 to October 2000. Denise B. Stires became Executive Vice President of Worldwide Marketing and Investor Services in March 2001. Ms. Stires was Chief Marketing Officer of BuyandHold Inc., an on-line financial services company providing dollar-based brokerage services to individuals and corporations, from 2000 to 2001. Prior to that, Ms. Stires was Senior Vice President, Marketing Director of DLJdirect, the on-line discount brokerage service of CSFB from 1997 to 2000. John T. Wall became an Executive Vice President of Nasdaq in February 1994 and President of Nasdaq International in October 1997. Mr. Wall is responsible for the strategic development and international marketing of Nasdaq's products and services. Mr. Wall is also responsible for non-U.S. company listings, as well as promoting and directing the overall globalization of the marketplace. Mr. Wall established Nasdaq's operations in London and negotiates the sale of Nasdaq's computerized systems to other world markets. Mr. Wall joined the NASD in 1965 and during his tenure has been head of Regulation, Membership, and Qualifications Testing. Mr. Wall previously has served on a number of industry committees and boards, including EASDAQ, the National Securities Clearing Corporation, the Options Clearing Corporation and the Hong Kong International Committee for Listing New Enterprises. David P. Warren became Executive Vice President and Chief Administrative Officer of Nasdaq in January 2001 and Chief Financial Officer ("CFO") in September 2001. Mr. Warren oversees finance, human resources, and all administrative services including real estate, property management and purchasing. Prior to his current position, Mr. Warren was CFO of the Long Island Power Authority from January 1998 to December 2000, Deputy Treasurer of the State of Connecticut from March 1995 to January 1998, and a Vice President at CSFB from 1987 to 1995. This Form 10-K contains forward-looking statements that involve risks and uncertainties. Nasdaq's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including the risks faced by Nasdaq described below and elsewhere in this Form 10-K. The risks and uncertainties described below are not the only ones facing Nasdaq. Additional risks and uncertainties not presently known to Nasdaq or that Nasdaq currently believes to be immaterial may also adversely affect Nasdaq's business. If any of the following risks actually occur, Nasdaq's business, financial condition, or operating results could be materially adversely affected. Nasdaq's operating results could fluctuate significantly in the future. Nasdaq's operating results may fluctuate significantly in the future as a result of a variety of factors, including: (i) a decrease in the trading volume in The Nasdaq Stock Market; (ii) increased competition from regional exchanges, ECNs, or other alternative trading systems that might reduce market share and create pricing pressure; (iii) competition from the NYSE or new competing exchanges for new listings; (iv) a reduction in market information revenue; (v) the rate at which The Nasdaq Stock Market obtains new listings and maintains its current listings; (vi) regulatory changes and compliance costs; (vii) Nasdaq's ability to utilize its capital effectively; (viii) Nasdaq's ability to manage personnel, overhead, and other expenses, in particular technology expenses; and (ix) general market and economic conditions. Nasdaq's business could be harmed by market fluctuations and other risks associated with the securities industry generally. A substantial portion of Nasdaq's revenue is tied to the trading volume of its listed securities. Trading volume is directly affected by economic and political conditions, broad trends in business and finance, and changes in volume and price levels of securities transactions. An adverse change affecting the economy or the securities markets could result in a decline in trading volume. Nasdaq is also particularly affected by declines in trading volume in technology and Internet-related securities because a significant portion of its customers trade in these types of securities and a large number of technology and Internet-related companies are listed on The Nasdaq Stock Market. A decline in trading volume would lower transaction services revenue, and Nasdaq's profitability may be adversely affected if it is unable to reduce costs at the same rate. A downturn in the initial public offering market is also likely to have an adverse effect on Nasdaq's revenue, including, in particular, revenue from listing fees. For example, in the year ended December 31, 2001, 63 IPOs were brought to market on The Nasdaq Stock Market compared to 397 in the year ended December 31, 2000. There also were 770 companies delisted during 2001 compared to 650 during 2000. Further downward trends in general market conditions could adversely affect Nasdaq's revenue and reduce its profitability if Nasdaq cannot reduce its costs at the same rate to offset such trends. Substantial listing competition could reduce Nasdaq's revenue. The Nasdaq Stock Market faces competition for listings from other primary exchanges, especially from the NYSE. In addition to competition for initial listings, The Nasdaq Stock Market also competes with the NYSE to maintain listings. In the past, a number of issuers listed on The Nasdaq Stock Market have left for the NYSE each year. The largest 50 Nasdaq-listed issuers (based on U.S. market value) accounted for approximately 47% of total dollar volume traded on The Nasdaq Stock Market for the year ended December 31, 2001. While the loss of one or more of these issuers would result in a decrease in revenue from Nasdaq's Corporate Client Group services, such a loss would cause an even more significant reduction in revenue from Nasdaq's transaction services and market information services. The reduction in initial listings or the loss of a top issuer could have an adverse effect on Nasdaq's business, financial condition, or operating results. Competition by regional exchanges for trade reporting business may reduce Nasdaq's trade reporting and market information revenue. Nasdaq is currently facing increased competition from regional exchanges for trade reporting business, which affects both transaction services and market information services revenue. In February 2002, Island began reporting a portion of its trades to the Cincinnati Stock Exchange, which reportedly gained Island's business by committing to reduce trade reporting fees and share Tape Fees with Island. In response, Nasdaq reduced certain trade reporting fees and began sharing Tape Fees, although not at the same level as Cincinnati. This action may not be sufficient to regain lost business or prevent other market participants from shifting some of their trade reporting to regional exchanges. Nasdaq may be required to take further action with respect to its sharing of Tape Fees and pricing structure to remain competitive. Further erosion of Nasdaq's trade reporting business may adversely affect its business, financial condition, and operating results. Nasdaq's revenue would be adversely affected by ECNs that register as exchanges. In October 2001, the SEC approved Pacific/Archipelago's proposal to establish the Archipelago Exchange as an equities trading facility of the Pacific Stock Exchange. Archipelago and RediBook, two of the largest users of ACT for trade reporting, have merged and it is likely that they will shift certain trade reporting to the Pacific Stock Exchange later this year. In addition, Island has applied to register as an exchange. Exchanges that are UTP Plan participants are entitled to a share of Tape Fees. A proliferation in the number of exchanges and UTP Plan participants could have an adverse impact on Nasdaq's transaction services and market information services revenue if trade reporting is fragmented across exchanges and marketplaces. In addition, new exchanges could adversely affect Nasdaq's revenue from listings. ECNs, unlike exchanges, historically have not provided listing venues. Pacific/Archipelago has announced that the Archipelago Exchange intends to begin competing for listings. In addition, if more ECNs become exchanges and are successful in attracting listings, there can be no assurances that Nasdaq will be able to maintain or increase its listing revenue. The reduction in initial listings or the loss of a top issuer could have an adverse effect on Nasdaq's business, financial condition, and operating results. See "—Substantial listing competition could reduce Nasdaq's revenue." Substantial competition could reduce The Nasdaq Stock Market's market share and harm Nasdaq's financial performance. It is possible that a competing securities exchange, network provider, or technology company could develop ways to replicate Nasdaq's network more efficiently than Nasdaq and persuade a critical mass of market participants to switch to a new network. If there is an increase in the number of market makers or ECNs that determine they do enough order routing traffic to justify setting up a proprietary network for their traffic, Nasdaq may be forced to alter its pricing structure or risk losing its share of the order routing or execution business. In addition, certain system providers link many market makers in The Nasdaq Stock Market. These systems may be able to increase the number of orders executed through their systems versus the Nasdaq systems. A reduction in Nasdaq's order routing or execution business could have an adverse effect on Nasdaq's business, financial condition, and operating results. The traditional products and services offered by markets are being unbundled. Historically, Nasdaq has provided listings, execution services, information services, and regulatory services to the investing public. Currently, there are many competitors operating in the execution services market. Nasdaq has not historically implemented pricing strategies that isolate its various businesses. Due to competition in the execution services business, as well as Nasdaq's past practice of bundling products and services, it is uncertain whether Nasdaq will be able to compete successfully in this business. Furthermore, Nasdaq faces multiple pricing constraints, including in particular, regulatory constraints that may prevent it from competing effectively in certain markets. Nasdaq may face competition from the NASD's Alternative Display Facility. In the SEC's January 2001 order approving SuperMontage, the SEC noted that in order to address concerns that Nasdaq's position as an exclusive SIP would compel participation in SuperMontage, it would require the NASD to provide NASD members with the ability to opt-out of SuperMontage by providing the Alternative Display Facility as an alternative quotation and trade reporting facility for NASD members. Nasdaq's implementation of SuperMontage is dependent on the Alternative Display Facility being available for Nasdaq-listed securities. In addition, the SEC has also stated that the approval of Exchange Registration is linked to the NASD's ability to provide the Alternative Display Facility for NASD members to report trades and disseminate quotations in all exchange-listed securities. If the Alternative Display Facility becomes a viable alternative to The Nasdaq Stock Market, then Nasdaq faces the risk of reduced market share in transactions and market information services revenue, which could adversely affect Nasdaq's business, financial condition, and operating results. Nasdaq's share of net revenue from Tape Fees may decrease once Nasdaq loses its status as the exclusive SIP under the UTP Plan. Under the revenue sharing provision of the UTP Plan, Nasdaq is permitted to deduct certain costs associated with acting as the exclusive SIP from the total amount collected from vendors, and the remaining Tape Fee revenue is distributed to UTP Plan participants. The SEC has stated that as a condition of extending the UTP Plan, the parties to the UTP Plan must negotiate in good faith to revise the UTP Plan so that it provides for either a fully viable alternative exclusive SIP for all Nasdaq-listed securities or a fully viable alternative non-exclusive SIP. This process may increase SIP costs, reducing the amount of Tape Fee revenue that Nasdaq and other participants earn. Certain Congressional and SEC reviews could result in a reduction in data fees that could reduce Nasdaq's revenue. The SEC is reviewing concerns by industry members that the present levels of data fees do not properly reflect the costs associated with their collection, processing, and distribution. The SEC currently is reviewing a report on the issues from its Advisory Committee on Market Information that was issued in September 2001 and comments on the report. Nasdaq has argued that there is significant value in the quality of data it provides to the investing community. Nasdaq also has argued that there are regulatory, market capacity, and other related costs of operating the market. A fee realignment that does not recognize the full value of the data and/or the market costs of creating and delivering high quality market data could reduce overall data revenue in the future and adversely affect Nasdaq's business, financial condition, and operating results. Congress conducted hearings in 2000 and 2001 and introduced legislation in 2000 pertaining to whether stock exchanges and markets have a property right to quote and trade data. Since securities firms are required to supply the market operator with quote and trade information, some have argued that the operator has no right to be able to validate the data, consolidate the data with other market participant data, and sell the data back to the securities firms. This issue may continue to be debated and the outcome could have a significant impact on the viability of Nasdaq's data revenue and, as a consequence, on its business, financial condition, and operating results. Nasdaq is subject to extensive regulation that may harm its ability to compete with less regulated entities. Under current federal securities laws, changes in Nasdaq's rules and operations, including its pricing structure, must be approved by the SEC. The SEC may approve, disapprove, or recommend changes to proposals submitted by Nasdaq. In addition, the SEC may delay the initiation of the public comment process or the approval process. This delay in approving changes, or the altering of any proposed change, could have an adverse effect on Nasdaq's business, financial condition, and operating results. System limitations or failures or security breaches could harm Nasdaq's business. Nasdaq's business depends on the integrity and performance of the computer and communications systems supporting it. If Nasdaq's systems cannot be expanded to cope with increased demand or otherwise fail to perform, Nasdaq could experience unanticipated disruptions in service, slower response times, and delays in the introduction of new products and services. These consequences could result in lower trading volumes, financial losses, decreased customer service and satisfaction, litigation or customer claims, and regulatory sanctions. Nasdaq has experienced occasional systems failures and delays in the past and it could experience future systems failures and delays. Nasdaq uses internally developed systems to operate its business, including transaction processing systems to accommodate increased capacity. However, if The Nasdaq Stock Market's trading volume increases unexpectedly, Nasdaq will need to expand and upgrade its technology, transaction processing systems, and network infrastructure. Nasdaq does not know whether it will be able to project accurately the rate, timing, or cost of any increases, or expand and upgrade its systems and infrastructure to accommodate any increases in a timely manner. Nasdaq's systems and operations also are vulnerable to damage or interruption from human error, natural disasters, power loss, sabotage or terrorism, computer viruses, intentional acts of vandalism, and similar events. Nasdaq has active and aggressive programs in place to identify and minimize its exposure to these vulnerabilities, and works in collaboration with the technology industry to share corrective measures with Nasdaq's business partners. Nasdaq currently maintains multiple computer facilities that are designed to provide redundancy and back-up to reduce the risk of system disruptions, and has facilities in place that are expected to maintain service during a system disruption. Any system failure that causes an interruption in service or decreases the responsiveness of Nasdaq's service could impair its reputation, damage its brand name, and negatively impact its revenue. Nasdaq also relies on a number of third parties for systems support. Any interruption in these third-party services or deterioration in the performance of these services could also be disruptive to Nasdaq's business and have a material adverse effect on its business, financial condition, and operating results. Nasdaq may not be able to keep up with rapid technological and other competitive changes affecting the structure of the securities markets. The markets in which Nasdaq competes are characterized by rapidly changing technology, evolving industry standards, frequent enhancements to existing services and products, the introduction of new services and products, and changing customer demands. These market characteristics are heightened by the emerging nature of the Internet and the trend for companies from many industries to offer Internet-based products and services. In addition, the widespread adoption of new Internet, networking, or telecommunications technologies or other technological changes could require Nasdaq to incur substantial expenditures to modify or adapt its services or infrastructure. Nasdaq's future success will depend on its ability to respond to changing technologies on a timely and cost-effective basis. Nasdaq's operating results may be adversely affected if it cannot successfully develop, introduce, or market new services and products. In addition, any failure by Nasdaq to anticipate or respond adequately to changes in technology and customer preferences, or any significant delays in other product development efforts, could have a material adverse effect on Nasdaq's business, financial condition, and operating results. Nasdaq may have difficulty managing its growth. Over the last several years, Nasdaq has experienced significant growth in its business and the number of its employees. Nasdaq may not be able to continue to manage its growth successfully. In an attempt to stimulate future growth, Nasdaq has undertaken several initiatives to increase its business, including enhancing existing products, developing new products, and forming strategic relationships. The increased costs associated with Nasdaq's initiatives may not be offset by corresponding increases in its revenue. The growth of Nasdaq's business has required, and will continue to require, Nasdaq to increase its investment in technology, management personnel, market regulatory services, and facilities. No assurance can be made that Nasdaq has made adequate allowances for the costs and risks associated with this expansion, that its systems, procedures, or controls will be adequate to support its operations, or that its management will be able to offer and expand its services successfully. If Nasdaq is unable to manage its growth effectively, its business, financial condition, and operating results could be adversely affected. Nasdaq may need additional funds to support its business plan. Nasdaq depends on the availability of adequate capital to maintain and develop its business. Nasdaq believes that its current capital requirements will be met from internally generated funds and from the funds raised in connection with the Restructuring. However, based upon a variety of factors, including the rate of market acceptance of Nasdaq's new products, the cost of service and technology upgrades, and regulatory costs, Nasdaq's capital requirements may vary from those currently planned. There can be no assurance that additional capital will be available on a timely basis, or on favorable terms or at all. Nasdaq may not be successful in executing its international strategy. In order to take advantage of anticipated opportunities that will arise outside the United States, Nasdaq intends to invest significant resources in developing strategic partnerships with non-U.S. stock markets. Nasdaq has had only very limited experience in developing localized versions of its services and in marketing and operating its services internationally. To date, Nasdaq's international efforts have not yet achieved profitability. There can be no assurance that Nasdaq will be able to succeed in marketing its branded services and developing localized services in international markets. Nasdaq may experience difficulty in managing its international operations because of, among other things, competitive conditions overseas, difficulties in supervising foreign operations, managing currency risk, established domestic markets, language and cultural differences, political and economic instability, sustained weakness in European equities markets, and changes in regulatory requirements or the failure to obtain requested regulatory changes and approvals. Any of the above could have an adverse effect on the success of Nasdaq's international operations and, consequently, on Nasdaq's business, financial condition, and operating results. See "Item 1. Business—Nasdaq's Strategic Initiatives—Pursuing Global Market Expansion." Failure to protect its intellectual property rights could harm Nasdaq's brand-building efforts and ability to compete effectively. To protect its rights to its intellectual property, Nasdaq relies on a combination of trademark laws, copyright laws, patent laws, trade secret protection, confidentiality agreements, and other contractual arrangements with its affiliates, clients, strategic partners, and others. The protective steps Nasdaq has taken may be inadequate to deter misappropriation of its proprietary information. Nasdaq may be unable to detect the unauthorized use of, or take appropriate steps to enforce, its intellectual property rights. Nasdaq has registered, or applied to register, its trademarks in the U.S. and in 40 foreign jurisdictions and has pending U.S. and foreign applications for other trademarks. Effective trademark, copyright, patent, and trade secret protection may not be available in every country in which Nasdaq offers or intends to offer its services. Failure to protect its intellectual property adequately could harm its brand and affect its ability to compete effectively. Further, defending its intellectual property rights could result in the expenditure of significant financial and managerial resources, which could adversely affect Nasdaq's business, financial condition, and operating results. Lack of operating history as a for-profit entity with private ownership interests. While Nasdaq has an established operating history, it has only operated as a for-profit company with private ownership interests since June 28, 2000. Therefore, Nasdaq is subject to the risks and uncertainties associated with any newly independent company. Nasdaq has had access to many support functions of the NASD, including: cash management and other financial services, real estate, legal, surveillance, and other regulatory services, information services, and corporate and administrative services. Nasdaq has entered into, and intends to enter into, various intercompany arrangements with the NASD and its affiliates for the provision of these services on an on-going or transitional basis. See "—Nasdaq faces potential conflicts of interest with related parties" and "—The intercompany agreements may not be effected on terms as favorable to Nasdaq as could have been obtained from unaffiliated third parties," "Item 1. Business—Service and Regulatory Contractual Relationships with the NASD and NASDR" and "Item 13. Certain Relationships and Related Transactions." In addition, Nasdaq's initiatives designed to increase operating efficiencies may not yield the expected benefits or efficiencies and may be subject to delays, unexpected costs, and cost overruns, all of which could have an adverse effect on Nasdaq's business, financial condition, and operating results. Failure to attract and retain key personnel may adversely affect Nasdaq's ability to conduct its business. Nasdaq's future success depends on the continued service and performance of its senior management and certain other key personnel. For example, Nasdaq is dependent on specialized systems personnel to operate, maintain, and upgrade its systems. The inability of Nasdaq to retain key personnel or retain other qualified personnel could adversely affect Nasdaq's business, financial condition, and operating results. Nasdaq is subject to risks relating to litigation and potential securities laws liability. Many aspects of Nasdaq's business potentially involve substantial risks of liability. While Nasdaq enjoys immunity for self-regulatory organization activities, it could be exposed to liability under federal and state securities laws, other federal and state laws and court decisions, as well as rules and regulations promulgated by the SEC and other federal and state agencies. These risks include, among others, potential liability from disputes over the terms of a trade, or claims that a system failure or delay cost a customer money, that Nasdaq entered into an unauthorized transaction or that it provided materially false or misleading statements in connection with a securities transaction. As Nasdaq intends to defend any such litigation actively, significant legal expenses could be incurred. An adverse resolution of any future lawsuit or claim against Nasdaq could have an adverse effect on its business, financial condition, and operating results. Nasdaq faces potential conflicts of interest with related parties. Until Exchange Registration, the NASD will retain voting control over Nasdaq. See "Item 1. Business—Nasdaq's History and Structure" and "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters—Unregistered Offerings." In addition, five of the 18 members of the Nasdaq Board are currently members of the NASD Board. Until Exchange Registration, the NASD will be in a position to continue to control substantially all matters affecting Nasdaq, including any determination with respect to the direction and policies of Nasdaq, acquisition or disposition of assets, future issuances of securities of Nasdaq, Nasdaq's incurrence of debt, and any dividend payable on the Common Stock. Conflicts of interest may arise between Nasdaq and the NASD, or its affiliates, in a number of areas relating to their past and ongoing relationships, including the nature, quality, and pricing of services rendered; shared marketing functions; tax and employee benefit matters; indemnity agreements; sales or distributions by the NASD of all or any portion of its ownership interest in Nasdaq; or the NASD's ability to influence certain affairs of Nasdaq prior to Exchange Registration. There can be no assurance that the NASD and Nasdaq will be able to resolve any potential conflict or that, if resolved, Nasdaq would not receive more favorable resolution if it were dealing with an unaffiliated party. Conflicts may also arise between Nasdaq and Amex by virtue of commitments made by the NASD in connection with the NASD's acquisition of Amex. The intercompany agreements may not be effected on terms as favorable to Nasdaq as could have been obtained from unaffiliated third parties. For purposes of governing their ongoing relationship, Nasdaq and the NASD, or their affiliates, have entered into, or intend to enter into, various agreements involving the provision of services such as market surveillance and other regulatory functions, certain financial services, legal services, facilities sharing, information services, corporate services, and other administrative services. Nasdaq has negotiated a contract with the NASDR pursuant to which NASDR will regulate Nasdaq trading activity commencing upon the effectiveness of Exchange Registration. The NASDR will continue regulating trading activity on Nasdaq under a new long-term contract that establishes the various functions NASDR will perform and the price that Nasdaq will pay for these functions. The functions covered under this contract are substantially of the same type and scope as those NASDR performs under the Delegation Plan. The terms of the other intercompany agreements have not yet been fully negotiated. Although it is the intention of the parties to negotiate agreements that provide for arm's length, fair market value pricing, there can be no assurance that these contemplated agreements, or the transactions provided in them, will be effected on terms as favorable to Nasdaq as could have been obtained from unaffiliated third parties. The cost to Nasdaq for such services could increase at a faster rate than its revenue and could adversely affect Nasdaq's business, financial condition, and operating results. See "Item 13. Certain Relationships and Related Transactions." The SEC may challenge or not approve Nasdaq's plan to become a national securities exchange or it may require changes in the manner Nasdaq conducts its business before granting this approval. The SEC may not approve Nasdaq's application for Exchange Registration or may require changes in the manner Nasdaq conducts its business before granting this approval. Failure to be so registered could adversely effect Nasdaq's competitive position and could have a material adverse effect on Nasdaq's business conditions and business prospects. In connection with Exchange Registration, certain changes must be made to the national market system plans. Certain participants in the plans may object to, or request modifications to, amendments proposed by Nasdaq. Failure to resolve these issues in a timely manner could delay Exchange Registration. In addition, the SEC has also stated that its approval of Exchange Registration is linked to the NASD's ability to provide the Alternative Display Facility to NASD members to assist in the quotation and trade reporting of exchange-listed securities. Any significant delay or failure on the part of the NASD to build the Alternative Display Facility also could delay the SEC's approval of Exchange Registration. There can be no assurance that Exchange Registration will occur or that the registration process will occur in a timely manner. Because of the nature of the regulatory process and the variety of market structure issues that would have to be resolved across all markets, the registration process could be lengthy. In the long-term, the failure to be approved as an exchange by the SEC may have negative implications on the ability of Nasdaq to fund its planned initiatives. In addition, the SEC has not yet agreed and may not agree to Nasdaq's proposal to continue to operate the OTC Bulletin Board after Exchange Registration. Item 2. Properties. The following is a description of Nasdaq's material properties as of December 31, 2001. Size (approximate, in square feet) Type of Possession New York, New York Location of MarketSite 26,000 Leased by Nasdaq New York, New York Nasdaq headquarters 78,000 Subleased from the NASD New York, New York General office space 24,000 Leased by Nasdaq Rockville, Maryland Location of Nasdaq data center 110,000 Owned by Nasdaq Rockville, Maryland General office space 82,634 Leased by Nasdaq Trumbull, Connecticut Location for Nasdaq's technology services, systems engineering and market operations 162,000 Owned by Nasdaq Trumbull, Connecticut General office space 101,000 (two locations) Leased by Nasdaq Washington, D.C. General office space 48,000 (two locations) Occupied pursuant to a shared facilities agreement with the NASD In addition to the above, Nasdaq leases administrative and sales facilities in Chicago, Illinois; Menlo Park, California; London, England; Sao Paulo, Brazil; Montreal, Canada; and Shanghai, China. Nasdaq Europe leases administrative facilities in Brussels, Belgium; London, England; and Paris, France. Nasdaq was forced to vacate its headquarters from One Liberty Plaza as a result of the terrorist attacks on September 11, 2001. Nasdaq subsequently determined that it would permanently relocate from One Liberty Plaza to a location closer to its Time Squares MarketSitesm building. Employees returned to One Liberty on a temporary basis in early 2002, but are expected to relocate by early 2003. See "Management's Discussion and Analysis of Financial Condition and Results of Operations—Business Environment—September 11, 2001 Terrorist Attacks." Item 3. Legal Proceedings. Nasdaq is not currently a party to any litigation that it believes could have a material adverse effect on its business, financial condition, or operating results. However, from time to time, Nasdaq has been threatened with, or named as a defendant, in lawsuits. Item 4. Submission of Matters to a Vote of Security Holders. No matters were submitted to a vote of Nasdaq's stockholders during the fourth quarter of 2001. Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. Market Information. No established public trading market exists for the Common Stock. Holders. As of March 18, 2002, Nasdaq had approximately 2,519 holders of record of its Common Stock. Dividends. Nasdaq does not pay, and does not anticipate paying in the foreseeable future, any cash dividends on its common equity. Unregistered Offerings. On January 18, 2001, Nasdaq completed Phase II of its private placement in connection with the Restructuring by selling an aggregate of 5,028,797 shares of Common Stock for aggregate consideration of $65,374,361 to investors consisting of NASD members, issuers with securities listed on The Nasdaq Stock Market, institutional investment firms and providers of technology services to Nasdaq. In Phase II, the number of shares of Common Stock offered to each category of investor was based upon a variety of factors, including the offeree's contributions to Nasdaq's growth. The shares of Common Stock sold by Nasdaq in Phase II were issued to "accredited investors" in private transactions exempt under Regulation D of the Securities Act of 1933, as amended (the "Securities Act"). On May 3, 2001, Nasdaq sold $240.0 million in aggregate principal amount of its convertible Subordinated Notes (the "Subordinated Notes") to Hellman & Friedman Capital Partners IV, L.P and certain of its affiliated limited partnerships (collectively, "Hellman & Friedman"). The Subordinated Notes are convertible at any time into an aggregate of 12.0 million shares of Common Stock, reflecting a conversion price of $20.00 per share, subject to adjustment. Nasdaq has granted Hellman & Friedman certain registration rights with respect to the shares of Common Stock underlying the Subordinated Notes. The Subordinated Notes were sold in a private transaction pursuant to Section 4(2) of the Securities Act, which exempts sales of securities that do not involve a public offering. No underwriter was used in this transaction. For the offering period ended June 29, 2001, Nasdaq sold 209,120.675 shares of Common Stock pursuant to its Employee Stock Purchase Plan for an aggregate offering price of $2,221,907. During the offering period ended December 31, 2001, 117,459.195 shares of Common Stock were sold pursuant to the Employee Stock Purchase Plan for an aggregate sale price of $1,248,004. The foregoing sales of shares of Common Stock were made pursuant to Rule 701 under the Securities Act, which exempts issuances of securities under certain written compensatory employee benefit plans. On November 12, 2001, Nasdaq sold an aggregate amount of 535,000 shares of Common Stock to five members of the Nasdaq Board of Directors and 500,000 shares of Common Stock to Hellman & Friedman for an aggregate offering price of $10,608,750. All of the foregoing shares were sold in a private transaction at the current fair market value pursuant to Section 4(2) of the Securities Act. No underwriter was used in these transactions. On December 21, 2001, Nasdaq issued a warrant to SOFTBANK that allows the warrant holder to buy an aggregate of 479,648 shares of Common Stock, exercisable in four equal annual tranches beginning on June 28, 2002. The exercise price of the warrant is $13 per share of Common Stock for the first tranche, and increases by $1 per share in each subsequent tranche up to a maximum of $16 per share for the final tranche. The warrant was issued to SOFTBANK as part of a transaction in which Nasdaq repurchased SOFTBANK's 22.2% interest in Nasdaq Europe Planning Company, Inc., a subsidiary of Nasdaq, for consideration totaling 7,211 Class A shares of Nasdaq Europe owned by Nasdaq, the warrant for shares of Nasdaq Common Stock and Japanese Yen 937,500,000 in cash (approximately $7,360,000 based on the Yen-Dollar exchange rate on December 21, 2001). As part of the transaction, SOFTBANK agreed that the entire cash consideration be paid to Nasdaq Japan, thereby increasing SOFTBANK's investment in Nasdaq Japan. The warrant was issued in a private transaction exempt under Section 4(2) of the Securities Act. No underwriter was used in this transaction. Item 6. Selected Consolidated Financial Data. The following sets forth selected consolidated financial information on a historical basis for Nasdaq. The following information should be read in conjunction with the consolidated financial statements and notes thereto of Nasdaq included elsewhere in this Form 10-K. ($ in thousands, except per share amounts) Year Ended December 31, Statements of Income Data: Transaction services $ 408,770 $ 395,123 $ 283,652 $ 160,506 $ 174,741 Market information services 240,524 258,251 186,543 152,665 126,436 Corporate Client Group services 156,124 149,297 163,425 137,344 113,019 Other 51,814 30,040 628 308 2,530 Total revenues 857,232 832,711 634,248 450,823 416,726 Compensation and benefits 183,369 137,284 98,129 78,565 64,324 Marketing and advertising 28,017 45,908 62,790 42,483 53,817 Depreciation and amortization 93,400 65,645 43,696 34,984 31,336 Professional and contract services 76,049 61,483 35,282 35,127 22,259 Computer operations and data communications 174,939 138,228 100,493 72,111 61,438 Travel, meetings, and training 14,593 12,113 10,230 7,750 7,310 Occupancy 27,183 14,766 6,591 5,354 4,883 Provision for bad debts 15,459 5,554 2,978 3,757 5,078 Publications, supplies, and postage 11,998 7,181 4,670 5,208 5,223 Disaster related 23,208 — — — — Technology transition cost 9,200 — — — — Other 37,883 20,007 19,688 10,985 8,685 Total direct expenses 695,298 508,169 384,547 296,324 264,353 Support cost from related parties, net 101,799 128,522 115,189 100,841 85,880 Total expenses 797,097 636,691 499,736 397,165 350,233 Net operating income 60,135 196,020 134,512 53,658 66,493 Interest income 22,603 20,111 12,201 9,269 7,522 Interest expense (9,647 ) (2,130 ) (2,143 ) (1,962 ) (797 ) Minority interests 5,704 872 — — — Provision for income taxes (38,332 ) (90,477 ) (58,421 ) (26,010 ) (33,187 ) Income before cumulative effect of change in accounting principle 40,463 124,396 86,149 34,955 40,031 Cumulative effect of change in accounting principle — (101,090 ) — — — Net income $ 40,463 $ 23,306 $ 86,149 $ 34,955 $ 40,031 Weighted average common shares outstanding(1) 116,458,902 112,090,493 100,000,000 100,000,000 100,000,000 Basic earnings per share: Before cumulative effect of change in accounting principle $ 0.35 $ 1.11 $ 0.86 $ 0.35 $ 0.40 Cumulative effect of change in accounting principle — (0.90 ) — — — Net income $ 0.35 $ 0.21 $ 0.86 $ 0.35 $ 0.40 Diluted earnings per share: Pro forma amounts assuming the change in accounting principle is applied retroactively: Total revenues $ 832,711 $ 607,203 $ 444,764 $ 401,774 Net income 124,396 69,944 31,332 31,090 Basic and diluted earnings per share $ 1.11 $ 0.70 $ 0.31 $ 0.31 EBITDA(2) $ 153,535 $ 261,665 $ 178,208 $ 88,642 $ 97,829 Capital expenditures 73,277 119,040 94,193 33,605 79,887 Net cash provided by operating activities 65,030 255,554 135,125 56,723 76,755 Net cash used in investing activities (109,196 ) (292,243 ) (131,157 ) (58,150 ) (123,064 ) Net cash provided by financing activities 75,640 288,348 3,876 156 29,766 Number of listed companies (at year end) 4,109 4,734 4,829 5,068 5,487 Shares traded (in thousands) 471,200,000 442,800,000 272,600,000 202,000,000 163,900,000 As of December 31, Balance Sheet Data:(3)(4) Cash and cash equivalents $ 293,731 $ 262,257 $ 10,598 $ 2,754 $ 4,025 Working capital(5) 521,620 440,260 154,372 120,831 84,668 Total assets 1,326,251 1,164,399 578,254 403,745 353,134 Total long term obligations 508,934 221,464 78,965 41,248 41,362 Total stockholders' equity 518,388 645,159 352,012 266,255 229,166 Gives effect to the June 28, 2000, 49,999-for-one stock dividend of the shares of Common Stock for years ended 1997-2000. EBITDA represents income before cumulative change in accounting principle, net interest, income taxes, minority interest and depreciation and amortization expense. EBITDA is not a measure of performance under generally accepted accounting principles and should not be considered as an alternative to net income as a measure of operating results or cash flows as a measure of liquidity. Nasdaq believes that investors find EBITDA a good measure of Nasdaq's cash flow and ability to incur and service indebtedness. EBITDA as defined may not be comparable to similarly titled measures reported by other companies. Balance sheet data for 1997-1999 has not been restated for the Change in Accounting Principle, which was adopted as of January 1, 2000. Certain amounts in the prior years have been reclassified to conform with the 2001 presentation. Working capital is calculated as current assets (reduced for held-to-maturity investments classified as current assets) less current liabilities. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of the financial condition and results of operations of Nasdaq should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Form 10-K. This discussion contains forward-looking statements that involve risks and uncertainties. Nasdaq's actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including, but not limited to, those set forth under "Item 1. Business—Risk Factors" and elsewhere in this Form 10-K. Nasdaq operates The Nasdaq Stock Market, the world's largest, electronic, screen-based equity securities market and the largest equity securities market in the world based on share volume. Nasdaq operates in one segment as defined in the Statement of Financial Accounting Standards No. 131 "Disclosures About Segments of an Enterprise and Related Information" ("SFAS 131"). Nasdaq's principal business products are price discovery and trading services, the sale of related data and information, and listing of issues. The majority of this business is transacted with listed companies, market data vendors, and firms in the broker-dealer industry within the United States. Transaction services include collecting, processing, and disseminating price quotes of Nasdaq-listed securities, the routing and execution of buy and sell orders for Nasdaq-listed securities, and post-trade reporting services; Market information services provide varying levels of quote and trade information to data vendors, who in turn sell the information to the public; and Corporate Client Group services provide information services and products to Nasdaq-listed companies and are responsible for obtaining new listings on The Nasdaq Stock Market. As of December 31, 2001, the NASD beneficially owned approximately 25% of Nasdaq on a fully diluted basis that assumes the full exercise of all warrants purchased in the two phases ("Phases I and II") of the Restructuring (approximately 69% on a non-diluted basis). On March 8, 2002, Nasdaq completed the Repurchase, a two stage repurchase of an additional 33,768,895 shares of Common Stock owned by the NASD, which represented all of the outstanding shares of Common Stock owned by the NASD, except for the 43,225,976 shares of Common Stock underlying the warrants issued by the NASD in the Restructuring. Nasdaq purchased the Common Stock for approximately $305.2 million in aggregate cash consideration, 1,338,402 shares of Nasdaq's Series A Cumulative Preferred Stock, and one share of Nasdaq's Series B Preferred Stock. The Repurchase furthered Nasdaq's goal of separating itself from the NASD. As a result of the Repurchase, the NASD owns approximately 55% of the outstanding Common Stock on a non-diluted basis and no Common Stock on a fully-diluted basis (assuming the full exercise of all warrants purchased in Phase I and II of the Restructuring and conversion of all potentially dilutive securities). In addition, the NASD owns all of the outstanding shares of Series A and Series B Preferred Stock. The Series B Preferred Stock is structured to ensure that the NASD will retain voting control over Nasdaq until Exchange Registration is achieved. The economic conditions in the United States worsened during 2001 as corporate profits, growth in productivity, and business investment declined. These economic difficulties were reflected in the November 2001 announcement by the National Bureau of Economic Research that the U.S. economy had been in a recession since March 2001. In addition, the securities industry and capital markets were severely affected by the September 11, 2001 terrorist attacks on the United States that caused a four-day suspension of trading on U.S. equities markets. The economic reversal from the expansion of prior years and resulting investor uncertainty had a negative effect on the performance of U.S. equity markets, as evidenced by declines in the major stock indices. During 2001, the Nasdaq Composite Index fell approximately 21%, the S&P 500 fell approximately 13%, the Dow Jones Industrial Average fell approximately 7% and the Wilshire 5000 fell approximately 12%. Market declines adversely affected both investors and the securities industry by reducing interest in the equities market from the levels reached in 1999 and 2000. A significant decline in on-line trading during 2001 contributed to an abrupt end to the expansion of the securities industry and resulted in staff reductions throughout the industry. Decreased market activity led to reduced demand or slower growth for a variety of Nasdaq market services related to trading, system access, market information, and data products. While average daily share volume in 2001 was up approximately 8% compared to share volume in 2000 (primarily from volume growth in the first half of the year), substantially lower stock prices resulted in a more than 45% decline in average daily dollar volume. Weak economic conditions and lower stock prices also limited the ability of companies to raise money in the equity markets. New issues on all U.S. markets were well off the pace of previous years. Particularly affected were companies in the technology and growth fields, a high percentage of which historically have listed on The Nasdaq Stock Market. In 2001, there were only 63 IPOs on The Nasdaq Stock Market compared to 397 in 2000. This reduction in IPOs limited Nasdaq's opportunities to expand listing revenue and had a spill-over effect on transaction and market information services revenue. The market declines also produced an unprecedented number of delistings, as 770 companies left The Nasdaq Stock Market for a variety of reasons. Approximately 88% of the delistings were related to the failure to satisfy applicable listing requirements and merger and acquisition activity. September 11, 2001 Terrorist Attacks. The unprecedented terrorist attacks on the United States on September 11th had a significant impact on general economic conditions in the United States and the operations of The Nasdaq Stock Market and the other U.S. securities marketplaces. After the attacks, Nasdaq's systems were operative; however, The Nasdaq Stock Market closed for four days as a result of the effect the events had on market participants and to assure that they would be in a position to respond to customer needs once the markets reopened. Nasdaq's operating results for the third quarter of 2001 were affected by the closure of the market and the disruption in business operations of market participants. As a result of the attacks, Nasdaq's executive offices in New York City were closed for the remainder of 2001 and its New York-based employees were relocated. Also, as a result of the attacks, Nasdaq decided to relocate its headquarters from One Liberty Plaza, which is adjacent to the site where the World Trade Center Towers stood, to a location closer to its Times Square Nasdaq MarketSite building. Employees returned to One Liberty Plaza on a temporary basis in the first quarter of 2002, but are expected to relocate by early 2003. Due to its decision to relocate its headquarters from One Liberty Plaza, Nasdaq has estimated a $21.5 million loss on the sublease for this property which is included in disaster related expenses on the Consolidated Statement of Income for the year ended December 31, 2001. In addition, it has been necessary for Nasdaq to make certain non-budgeted expenditures relating to September 11th including, but not limited to, costs related to the efforts to restore services to market participants; the testing of trading systems; and required reconfiguring of technology, telecommunications and alternative office facilities due to the temporary relocation of employees. These other third and fourth quarter expenses of $1.7 million are also shown in disaster related expenses on the Consolidated Statement of Income for the year ended December 31, 2001. Nasdaq is in the process of determining the total loss of revenue and additional expenses incurred as well as any applicable insurance recoveries related to the attacks. Additional expenses and recoveries will be recorded in future periods. In response to the general economic and market uncertainty after the terrorist attacks, Nasdaq formally suspended minimum bid price and market value of public float requirements for continued listing on both The Nasdaq National Market and The Nasdaq SmallCap Market from September 26, 2001 until January 2, 2002. The implementation of the moratorium did not have a material positive effect on Nasdaq's operating results in 2001. See "Item 1. Business—Products and Services—Corporate Client Group Services." Overview of First Half of 2001. Trading activity was generally strong in the first six months of 2001 versus the comparable period of 2000. Average daily share volume in the first quarter of 2001 averaged 2.14 billion shares compared to 1.82 billion shares in the first quarter of 2000, a gain of approximately 18%. Average daily share volume in the second quarter of 2001 averaged 1.95 billion shares compared to 1.60 billion in the second quarter of 2000, a gain of approximately 22%. Increases in share and trade volume led to increases in transaction services revenue. Market information services revenue was adversely impacted by the overall market decline and a drop in on-line retail trading, as demand for non-professional market information services declined. The slowing economy also led to an increase in delistings and decreases in the number of IPOs and the number of listed companies issuing additional shares. While reported revenue associated with Corporate Client Group activities increased during the first half of 2001 due to the Change in Accounting Principle (see "Change in Accounting Principle" below), actual initial listing and LAS fees charged to issuers decreased during the period. Total new issues of companies listed on The Nasdaq Stock Market, including IPOs, were 69 in the first half of 2001 compared to 342 during the same period of 2000. Overview of Third Quarter of 2001. Although average daily share and trading volumes historically have been weakest in the third quarter, share and trading volumes in the third quarter of 2001 were even lower than seasonal trends. Prior to the September 11th terrorist attacks, share volume slowed to an average of 1.51 billion shares a day, an approximately 23% decline from the second quarter of 2001. Nasdaq posted particularly weak volume numbers in August, with the month accounting for eight of the 10 lowest share volume days (and 16 of the 18 days with the lowest number of trades) during the period from January through August 2001. Average daily share volume for the remainder of the quarter (post September 11th) was 2.14 billion shares per day, while the average daily share volume for the entire third quarter (excluding the four day trading suspension discussed above) was 1.63 billion shares per day compared to 1.95 billion shares per day in the second quarter of 2001, and 1.59 billion shares per day for the third quarter of 2000. All of Nasdaq's primary revenue streams were negatively affected by the continued market slow-down. Lower share and trading volumes resulted in reduced transaction services revenue. Market information services revenue experienced a similar decline as the demand for both professional and non-professional market information softened. While reported revenue from Corporate Client Group services were flat due to the Change in Accounting Principle, actual Corporate Client Group activities were down significantly in the third quarter of 2001, reflecting in part the fact that there were no IPOs in the U.S. equity markets in September for the first time in 25 years. Total new issues of companies listed on The Nasdaq Stock Market, including IPOs, were 32 in the third quarter of 2001, compared to 163 in the third quarter of 2000. Overview of Fourth Quarter of 2001. Building on post-September 11th momentum, trading activity on U.S. equity markets rebounded in the fourth quarter of 2001. Daily share volume grew to an average of 1.86 billion shares from 1.63 billion shares in the third quarter. This approximately 14% increase represented the only volume rise from one quarter to the next in 2001. Increases in share and trade volumes resulted in a slight increase in transaction services revenue in the fourth quarter. While demand for professional and non-professional information remained weak, there was a modest increase in market information services revenue that resulted from trading of exchange listed securities through Nasdaq InterMarket. Total new issues of companies listed on The Nasdaq Stock Market, including IPOs, were 44 in the fourth quarter compared to 100 in the fourth quarter of 2000. There were 24 IPOs in the fourth quarter of 2001, nearly twice as many as in any other quarter of 2001. 2002 Outlook. Nasdaq continues to face economic and competitive challenges. In January and February 2002, trading volume was flat versus December 2001 and daily share volume in January and February averaged 1.89 billion and 1.81 billion shares, respectively. The flattening of trading activity resulted from a combination of factors including a change toward agency and riskless principal trading and trade reporting by some institutional market participants. Under agency and riskless principle trading, these institutional market participants no longer report to Nasdaq certain transactions with their customers. Trading activity also has been affected by continued uncertainty among investors about the economy and markets. There is also a threat of some competitive attrition of Nasdaq's market share. Some ECNs, which have traditionally relied on Nasdaq's execution and reporting systems, have allied themselves with regional exchanges or are seeking to establish themselves as national securities exchanges and will compete with Nasdaq for trade reporting, Tape Fees, and possibly even listings business. It is difficult at this time to determine whether the economy and market conditions have begun a sustained improvement. A rise in investor confidence could result in a corresponding increase in demand for transactions services and data products. In addition, the full impact of last year's move to decimal pricing on investing behavior and market making has not been realized. Trading activity could see an additional boost as investors returning to the market benefit from substantially lower spreads. Any sustained rebound in equity markets should provide Nasdaq with greater opportunities for new listings and secondary offerings. However, if weak domestic and international economic conditions continue or worsen, Nasdaq's business, financial condition, and results of operations may be materially adversely affected. Change in Accounting Principle On August 17, 2001, Nasdaq concluded discussions with the SEC with respect to the implementation in its financial statements of Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which became effective for SEC reporting companies in the fourth quarter of 2000. Nasdaq became a SEC public reporting company on June 29, 2001, the effective date of its Registration Statement on Form 10. As a result of the discussions with the SEC, Nasdaq changed its method of accounting for revenue recognition for certain components of its Corporate Client Group services revenue (the "Change in Accounting Principle"). Although SAB 101 was adopted effective the fourth quarter of 2000, the Change in Accounting Principle has been applied as of January 1, 2000. In accordance with applicable accounting guidance prior to SAB 101, Nasdaq recognized revenue for issuer initial listing fees and LAS fees in the month the listing occurred or in the period additional shares were issued, respectively. Nasdaq now recognizes revenue related to initial listing fees and LAS fees on a straight line basis over estimated service periods, which are six and four years, respectively. As a result of the Change in Accounting Principle, pro forma net income for the year ended December 31, 2000, excluding the cumulative effect of the Change in Accounting Principle on prior years' results, decreased $20.8 million ($0.19 per share). In addition, Nasdaq recognized a one-time cumulative effect of the Change in Accounting Principle in the first quarter of 2000. This cumulative effect of the Change in Accounting Principle decreased net income in 2000 by $101.1 million ($0.90 per share), resulting in net income of $23.3 million ($0.21 per share). The adjustment to first quarter 2000 net income for the cumulative change to prior years' results consists of the following: ($ in millions) Deferred initial listing fees $ 108.5 Deferred LAS fees 60.6 Total deferred fees 169.1 Deferred income tax benefit (68.0 ) Cumulative effect of change in accounting principle $ 101.1 For the years ended December 31, 2001 and 2000, Nasdaq recognized $44.9 million and $55.7 million in revenue, respectively, that was included in the cumulative effect adjustment as of January 1, 2000. This revenue contributed $27.3 million (after income taxes of $17.6 million) and $33.3 million (after income taxes of $22.4 million) to net income for the years ended December 31, 2001 and 2000, respectively. The following table compares net income under the former accounting method to net income under the new accounting method: Net income, before implementation of SAB 101 $ 30.0 $ 145.2 Increase due to recognition of prior period fees, included in the cumulative effect adjustment as of 1/1/00, net of taxes 27.3 33.3 Increase due to recognition of prior period deferred fees, subsequent to the cumulative effect adjustment, net of taxes 12.9 — Decrease due to deferral of current period fees, net of taxes (29.7 ) (54.1 ) Cumulative effect of change in accounting principle, net of taxes — (101.1 ) Net income $ 40.5 $ 23.3 Revenue deferred in accordance with SAB 101 as of December 31, 2001 and 2000 is discussed in Note 4 to the Consolidated Financial Statements. Financial Overview. Nasdaq's financial position can vary due to a number of factors discussed throughout this "Management's Discussion and Analysis of Financial Conditions and Results of Operation" and in "Item 1. Business—Risk Factors." The following table sets forth an overview of Nasdaq's financial results: ($ in millions, except per share amounts) Total revenue $ 857.2 $ 832.7 $ 634.2 Pre-tax income 78.8 214.9 144.6 Cumulative effect of change in accounting principle — (101.1 ) — Net income 40.5 23.3 86.1 Basic and diluted earnings per share before change in accounting principle 0.35 1.11 0.86 Earnings per share 0.35 0.21 0.86 Return on average equity 7.0 % 4.7 % 27.9 % For the Years Ended December 31, 2001 and 2000. Total revenue in 2001 increased $24.5 million, or 2.9%, from 2000. For the Years Ended December 31, 2000 and 1999. Total revenue in 2000 increased $198.5 million, or 31.3%, from 1999. Pursuant to the Change in Accounting Principle for Corporate Client Group services revenue adopted as of January 1, 2000, pro forma total revenues for 1999 would have been $607.2 million and the increase for 2000 would have been $225.5 million, or 37.1%. For the Years Ended December 31, 2001 and 2000. Net income in 2001 increased $17.2 million, or 73.8%, from 2000. Compared to pro forma net income for the year ended December 31, 2000 of $124.4 million, which excludes the cumulative effect of the Change in Accounting Principle, net income decreased by $83.9 million, or 67.4%. For the Years Ended December 31, 2000 and 1999. Net income in 2000 decreased $62.8 million, or 72.9% from 1999. Compared to pro forma net income for the year ended December 31, 2000, which excludes the cumulative effect of the Change in Accounting Principle, net income increased by $54.5 million, or 78.0%, from pro forma net income of $69.9 million for the year ended December 31, 1999. The following table sets forth the revenue from transaction services: Workstation II and Application Programming Interfaces $ 146.2 $ 121.6 $ 87.6 ACT 87.3 100.0 68.1 SelectNet 87.1 113.5 83.1 SuperSoes 32.3 — — SOES 26.1 32.2 19.7 CTCI 15.5 3.2 2.3 Other transaction services revenue 14.3 24.6 22.9 Total transaction services revenue $ 408.8 $ 395.1 $ 283.7 For the Years Ended December 31, 2001 and 2000. For the year ended December 31, 2001, transaction services revenue of $408.8 million increased $13.7 million from $395.1 million for the year ended December 31, 2000, an increase of 3.5%. The Nasdaq Workstation II is the trader's direct connection to Nasdaq's quote and trade execution facilities, providing quotation services, automated trade executions, real-time reporting, trade negotiations and clearing. This trading device, along with Application Programming Interfaces, provided revenue of $146.2 million, an increase of $24.6 million, or 20.2%, for the year ended December 31, 2001 from $121.6 million for the year ended December 31, 2000. This increase was primarily due to higher fees used to expand network capacity. Nasdaq Workstation II fees are charged monthly based upon the number of authorized logon identifications and servers. ACT, an automated service that provides the post-execution steps of reporting price, volume comparison and clearing of pre-negotiated trades as well as risk management services, provided revenue of $87.3 million, a decrease of $12.7 million, or 12.7%, for the year ended December 31, 2001 from $100.0 million for the year ended December 31, 2000 primarily due to various fee changes enacted subsequent to March 31, 2000. These changes include a cap in risk management fees, fee reductions on certain existing services, and a rule change that eliminated charges for certain transactions. ACT fees are generally charged on a per transaction basis. SelectNet, a messaging system for order execution, provided revenue of $87.1 million, a decrease of $26.4 million, or 23.3%, for the year ended December 31, 2001 from $113.5 million for the year ended December 31, 2000, primarily due to a decrease in trade volume related to the introduction of SuperSoes on July 30, 2001, which reduced the number of trades directed to SelectNet. Revenues from SelectNet also decreased as a result of the introduction of a new fee schedule for SelectNet in the third quarter of 2001. While Nasdaq revised the SelectNet fee schedule on October 1, 2001 to mitigate the negative effect of the prior fee schedule, the migration of trading to SuperSoes caused revenue from SelectNet to continue to decline in the fourth quarter. With the implementation of SuperSoes, SelectNet becomes primarily a tool to be used by market makers to negotiate trades. SelectNet fees are charged on a per transaction basis. On July 30, 2001, Nasdaq fully implemented SuperSoes. SuperSoes is designed to provide capability for automatic execution of buy and sell orders for market makers, ECNs and institutional and retail customers, and streamline Nasdaq's transaction systems. SuperSoes combines features of SelectNet and SOES execution systems and is only available for securities listed on The Nasdaq National Market tier of The Nasdaq Stock Market. Securities listed on The Nasdaq SmallCap Market will continue to be traded through SOES and SelectNet. SuperSoes has resulted in the migration of significant transaction volume, and its corresponding revenue, from SelectNet and SOES to SuperSoes. The introduction of the SuperSoes fee schedule at the time of implementation of SuperSoes had a negative effect on revenue in the third quarter. Revised fee structure implemented October 1, 2001 for SuperSoes mitigated this negative effect in the fourth quarter of 2001. SuperSoes fees are charged on a per transaction basis and consist of an entry charge per order and an execution charge per share. In certain circumstances Nasdaq rebates a portion of the per share execution charge it receives to market participants whose quotation is accessed through SuperSoes. The fees for order entry and executions were coupled with the fee rebate as part of the overall pricing strategy for the new fee structure introduced in October. SuperSoes provided revenue of $32.3 million for the year ended December 31, 2001. SOES, a system providing for the automatic execution of small orders, provided revenue of $26.1 million, a decrease of $6.1 million, or 18.9%, for the year ended December 31, 2001 from $32.2 million for the year ended December 31, 2000, due to the migration of SOES trading activity into the new SuperSoes system for securities listed on The Nasdaq National Market. SOES will continue to operate as an execution system solely for securities listed on The Nasdaq SmallCap Market. Due to the implementation of SuperSoes, SOES revenue is not expected to be material in future periods. SOES fees are charged on a per transaction basis. Nasdaq provides CTCI for users to report trades, enter orders into SuperSoes and receive execution messages. The CTCI links market participants' automated systems to Nasdaq. This interface has recently been upgraded to a new protocol and increased line speeds. CTCI revenue for the year ended December 31, 2001 are $15.5 million, up $12.3 million from $3.2 million for the year ended December 31, 2000. The increase in revenue was driven primarily by increased Nasdaq fees associated with an upgraded interface. Previously, the majority of fees for CTCI services was charged by Worldcom the system provider, rather than Nasdaq. Users are charged a monthly fee based upon the size of the line used by the customer. For the Years Ended December 31, 2000 and 1999. For the year ended December 31, 2000 transaction services revenue of $395.1 million increased $111.4 million, or 39.3%, from $283.7 million for the year ended December 31, 1999. The Nasdaq Workstation II, along with Application Programming Interfaces, provided revenue of $121.6 million, an increase of $34.0 million, or 38.8%, for the year ended December 31, 2000 from $87.6 million for the year ended December 31, 1999, primarily due to a larger customer base. ACT provided revenue of $100.0 million, an increase of $31.9 million, or 46.8%, for the year ended December 31, 2000 from $68.1 million for the year ended December 31, 1999, primarily due to an increase in trade volume. SelectNet provided revenue of $113.5 million, an increase of $30.4 million, or 36.6%, for the year ended December 31, 2000 from $83.1 million for the year ended December 31, 1999, primarily due to an increase in trade volume. SOES provided revenue of $32.2 million, an increase of $12.5 million, or 63.5%, for the year ended December 31, 2000 from $19.7 million for the year ended December 31, 1999, primarily due to an increase in volume of SOES executions. Market Information Services The following table sets forth the revenue from market information services: Level 1 Service $ 140.8 $ 159.6 $ 135.0 Nasdaq Quotation Dissemination Service 61.0 74.8 32.5 Nasdaq InterMarket Tape Fees 32.5 21.9 17.2 Other market information services revenue 6.2 2.0 1.8 Total market information services revenue $ 240.5 $ 258.3 $ 186.5 For the Years Ended December 31, 2001 and 2000. For the year ended December 31, 2001, market information services revenue of $240.5 million decreased $17.8 million, or 6.9%, from $258.3 million for the year ended December 31, 2000. Nasdaq's Level 1 service provides subscribers with current inside quote and most recent price at which the last sale or purchase was transacted for a specific security. Fees for professional users are based on monthly subscriptions to terminals or access lines. Non-professional users have the option to access this information through either a flat monthly rate or a per query usage charge. The growth in on-line investing in recent years increased the usage of these fee structures by on-line brokerage firms and other Internet services. However, the weaker economic and market conditions in 2001 caused a substantial reduction in Level 1 revenue due to a decrease in demand for both professional and non-professional per query service. Level 1 provided revenue of $140.8 million, a decrease of $18.8 million, or 11.8%, for the year ended December 31, 2001 from $159.6 million for the year ended December 31, 2000. Nasdaq Quotation Dissemination Service provides subscribers with the quotes of each individual market maker and ECN, in addition to the inside quotes and last transaction prices. Nasdaq Quotation Dissemination Service provided revenue of $61.0 million, a decrease of $13.8 million, or 18.4%, for the year ended December 31, 2001 from $74.8 million for the year ended December 31, 2000. This reduction reflects the introduction of the new reduced non-professional service fee. Although the number of Nasdaq Quotation Dissemination Service subscribers increased in total, revenue decreased due to the number of subscribers eligible for the new reduced non-professional fee. Nasdaq Quotation Dissemination Service revenue is derived from monthly subscriptions. Nasdaq InterMarket Tape Fee revenue is derived from data revenue generated by the Consolidated Quotation Plan and the Consolidated Tape Association Plan. The information collected under the Consolidated Quotation Plan and the Consolidated Tape Association Plan is sold to data vendors, who in turn sell it to the public. Nasdaq's InterMarket revenue is directly related to the percentage of trades in exchange listed securities that are executed in a Nasdaq facility and reported through the Consolidated Quotation Plan and the Consolidated Tape Association Plan. Nasdaq InterMarket tape provided revenue of $32.5 million, an increase of $10.6 million, or 48.4%, for the year ended December 31, 2001, from $21.9 million for the year ended December 31, 2000. This increase is primarily driven by increased trading through Nasdaq in Amex- listed exchange traded funds, specifically the Nasdaq-100 QQQ exchange traded fund. For the Years Ended December 31, 2000 and 1999. For the year ended December 31, 2000, market information revenue of $258.3 million increased $71.8 million, or 38.5%, from $186.5 million for the year ended December 31, 1999. Level 1 provided revenue of $159.6 million, an increase of $24.6 million, or 18.2%, for the year ended December 31, 2000 from $135.0 million for the year ended December 31, 1999, primarily due to an increase in demand for non-professional services including both per month and per query usage. Nasdaq Quotation Dissemination Service provided revenue of $74.8 million, an increase of $42.3 million, or 130.2%, for the year ended December 31, 2000 from $32.5 million for the year ended December 31, 1999. This increase was primarily due to growth in the number of subscribers. Nasdaq InterMarket tape provided revenue of $21.9 million, and increase of $4.7 million, or 27.3%, for the year ended December 31, 2000, from $17.2 million for the year ended December 31, 1999. Corporate Client Group Services The following table sets forth the revenue from Corporate Client Group services: Annual fee revenue $ 83.1 $ 81.1 $ 77.3 LAS fee revenue 35.9 33.6 30.0 * Initial listing fee revenue 35.7 33.9 27.4 * Other Corporate Client Group services revenue 1.4 0.7 1.7 Total Corporate Client Group services revenue $ 156.1 $ 149.3 $ 136.4 * Pro forma assuming retroactive application of the Change in Accounting Principle, which was adopted as of January 1, 2000. Corporate Client Group services revenue is derived from initial listings, LAS, and annual fees for companies listed on The Nasdaq Stock Market. Fees are generally calculated based upon total shares outstanding for the issuing company. These fees are initially deferred and amortized over the estimated service periods for which the services are provided. Revenue from initial listings and LAS fees are amortized over six and four years, respectively, and annual fees are amortized on a pro-rata basis over the calendar year. For the Years Ended December 31, 2001 and 2000. Corporate Client Group services revenue increased to $156.1 million for the year ended December 31, 2001 from $149.3 million for the year ended December 31, 2000, an increase of $6.8 million, or 4.6%. Annual fee revenue increased by $2.0 million, or 2.5%, to $83.1 million for the year ended December 31, 2001 from $81.1 million for the year ended December 31, 2000. LAS revenue increased $2.3 million, or 6.8%, from $33.6 million for the year ended December 31, 2000 to $35.9 million for the year ended December 31, 2001. Initial listing revenue increased $1.8 million, or 5.3%, from $33.9 million in the year ended December 31, 2000 to $35.7 million for the year ended December 31, 2001. Actual initial listing and LAS fees charged during the year ended December 31, 2001 decreased due to significantly reduced IPO activity and capital raising activity by current issuers. Initial listings on The Nasdaq Stock Market, including IPOs, declined from 605 during the year ended December 31, 2000 to 145 during the year ended December 31, 2001. Initial listing fees charged decreased $40.5 million, or 76.3%, from $53.1 million for the year ended December 31, 2000 to $12.6 million for the year ended December 31, 2001. LAS fees charged decreased $8.0 million, or 16.1%, from $49.6 million for the year ended December 31, 2000 to $41.6 million for the year ended December 31, 2001. For the Years Ended December 31, 2000 and 1999. Corporate Client Group services revenue decreased from $163.4 million for the year ended December 31, 1999 to $149.3 million for the year ended December 31, 2000, a decrease of $14.1 million, or 8.6%. Annual fee revenue increased from $77.3 million to $81.1 million, an increase of $3.8 million, or 4.9%. Revenue related to LAS increased from $29.6 million to $33.6 million, an increase of $4.0 million, or 13.5%, driven by an increase in the number of secondary offerings by current issuers offset by the Change in Accounting Principle, adopted as of January 1, 2000. Initial listing revenue decreased from $54.9 million to $33.9 million, a decrease of $21.0 million or 38.3%, due to the effect of the Change in Accounting Principle. Pro forma Corporate Client Group services revenue increased from $136.4 million for the year ended December 31, 1999, to $149.3 million for the year ended December 31, 2000, an increase of $12.9 million, or 9.5%. Actual initial listing and LAS fees charged during 2000 increased due to higher IPO activity and capital raising activity by current issuers. Initial listing revenue increased from $27.4 million to $33.9 million, an increase of $6.5 million, or 23.7%. Revenue related to LAS increased from $30.0 million to $33.6 million, an increase of $3.6 million, or 12.0%. Pro forma amounts assume the Change in Accounting Principle, adopted as of January 1, 2000, is applied retroactively. Other Revenue For the Years Ended December 31, 2001 and 2000. Other revenue for the year ended December 31, 2001 totaled $51.8 million, up from $30.0 million for the year ended December 31, 2000, an increase of $21.8 million, or 72.7%. This growth was primarily due to increased trademark and licensing revenue related to the Nasdaq-100 Trust and related products. Other revenue also includes revenue associated with Nasdaq Tools, Nasdaq.com as well as advertising revenue from the Nasdaq MarketSite. For the Years Ended December 31, 2000 and 1999. Other revenue for the year ended December 31, 2000 totaled $30.0 million, up significantly from $0.6 million for the year ended December 31, 1999. This growth is attributable to increased trademark and licensing revenue, new banner advertising revenue for Nasdaq.com, revenue generated by the newly opened Nasdaq MarketSite, and revenue related to Nasdaq Tools, which was acquired in 2000. Nasdaq Tools develops a set of software utilities that can be loaded on a Nasdaq Workstation II terminal. Future Products and Competitive Trends Products. In the third quarter of 2002, Nasdaq plans to implement SuperMontage, an improved user interface on the Nasdaq Workstation II designed to refine how market participants can access, process, display, and integrate orders and quotes in The Nasdaq Stock Market. SuperMontage is intended to attract more orders to The Nasdaq Stock Market, thereby increasing competition and market transparency. SuperMontage will replace SuperSoes as the transaction system for automatic execution of buy and sell orders. Nasdaq currently contemplates that it will begin user testing of SuperMontage in the second quarter of 2002. Assuming the testing and phase-in of SuperMontage proceeds according to this schedule, it is not anticipated that SuperMontage will generate revenue until at least the third quarter of 2002. In conjunction with the implementation of SuperMontage, Nasdaq market information services will have two new data products. DepthView will show the aggregate size available at up to five price levels while TotalView will display, in addition to DepthView data, each quote or order, with attribution when available, that makes up the aggregate depth at up to five price levels. These Nasdaq-proprietary data products will provide new revenue streams that are not expected to materially reduce subscriptions of existing products because they are enhancements rather than substitutes for Level 1 and Nasdaq Quotation Dissemination Service. Nasdaq is currently developing pricing structures for these products. In addition, Nasdaq reviews the pricing of its existing products and services in response to competitive pressures or changes in market or general economic conditions. Pursuant to the requirements of the Exchange Act, Nasdaq must file all proposals for a change in its pricing structure with the SEC. See "Item 1. Business—Fee Changes." Primex, which is operated pursuant to an agreement between Nasdaq and Primex Trading N.A., LLC, provides investors and market makers with a new electronic auction trading platform. Primex was launched in December 2001 and is currently in its pilot phase, which is scheduled to be completed on March 31, 2002. Nasdaq has waived all fees associated with linking to, and transacting in, Primex for the duration of the pilot phase. Assuming successful completion of the pilot phase, Primex is not expected to generate revenue until the third quarter of 2002. Competitive Trends. Nasdaq faces increasing competition from regional exchanges for the trade reporting business of ECNs and market makers. In February 2002, Island began reporting a portion of its trades to the Cincinnati Stock Exchange, a UTP Plan participant. Published reports indicate that the Cincinnati Stock Exchange gained Island's business by committing to lower trade reporting fees and share with Island a substantial portion of Tape Fees that Cincinnati earns from Island's trades. Nasdaq's market share under the UTP Plan dropped from approximately 97.6% of trade volume and 98.2% of share volume for the month of January 2002 to 77.3% of trade volume and 88.5% of share volume for the first ten trading days in March 2002. The reduction in trade reporting to Nasdaq was consistent with Nasdaq's estimates and projections for trade reporting in 2002. Nasdaq's revenue would be further affected if other ECNs began reporting trades to other UTP Plan participants. To improve its competitive position, Nasdaq recently reduced certain trade reporting fees and began sharing Tape Fees with participants who report trades through Nasdaq. Nasdaq shares 80% of its Tape Fees after deducting certain costs of regulating The Nasdaq Stock Market. Nasdaq historically has used Tape Fees to pay market regulation expenses that help ensure the quality and fairness of The Nasdaq Stock Market and compliance with all applicable rules and regulations. As a result of the deduction of market regulation expenses, Nasdaq's current Tape Fee sharing with Nasdaq market participants may not match the portion of Tape Fees offered by the Cincinnati Stock Exchange although Nasdaq's Tape Fee sharing is designed to be competitive with the amount of Tape Fees that ECNs such as Island rebate to their users. Nasdaq's trade reporting fees or Tape Fee sharing may be adjusted in the future to respond to competitive pressures. See "Item 1. Business—Competition," and "Item 1. Business—Risk Factors—Competition by regional exchanges for trade reporting business may reduce Nasdaq's trade reporting and market information revenue." In addition, Nasdaq's business is materially affected by a number of general competitive concerns and financial market and economic conditions that are discussed elsewhere in this Form 10-K. See "Item 1. Business—Competition," and "Item 1. Business—Risk Factors." Direct Expenses Compensation and benefits $ 183.4 $ 137.3 $ 98.1 Marketing and advertising 28.0 45.9 62.8 Depreciation and amortization 93.4 65.6 43.7 Professional and contract services 76.0 61.5 35.3 Computer operations and data communications 174.9 138.2 100.5 Provision for bad debts 15.5 5.6 3.0 Occupancy 27.2 14.8 6.6 Technology transition costs 9.2 — — Disaster related 23.2 — — Other 64.5 39.3 34.5 Total direct expenses $ 695.3 $ 508.2 $ 384.5 Number of employees 1,259 1,214 1,043 For the Years Ended December 31, 2001 and 2000. Direct expenses increased 36.8% to $695.3 million for the year ended December 31, 2001 from $508.2 million for the year ended December 31, 2000. Compensation and benefits expense increased to $183.4 million for the year ended December 31, 2001 from $137.3 million for the year ended December 31, 2000, an increase of $46.1 million, or 33.6%. This increase is due to a number of factors, including an increase of approximately $23.2 million due to the transfer of positions from the NASD associated with Nasdaq's restructuring as an independent company. The number of employees increased by a net 45, or 3.7%, to 1,259 employees as of December 31, 2001, from 1,214 employees as of December 31, 2000. In addition to the above, Nasdaq recorded a $7.4 million charge associated with severance and outplacement costs. This was in response to the departure of certain senior managers and to softening market conditions, which caused Nasdaq to implement a staff reduction plan in June 2001 that eliminated 137 positions, or approximately 10% of the workforce at that time. In addition, direct expenses include $4.0 million of compensation and benefits related to employees of Nasdaq Europe from the date of acquisition by Nasdaq. Marketing and advertising expense decreased to $28.0 million for the year ended December 31, 2001 from $45.9 million for the year ended December 31, 2000, a decrease of $17.9 million, or 39.0%, due to reduced spring and fall advertising campaigns. Depreciation and amortization expense increased $27.8 million, or 42.4%, to $93.4 million for the year ended December 31, 2001 from $65.6 million for the year ended December 31, 2000 due to a higher overall asset base to support current initiatives, such as SuperMontage and Primex, and the implementation of decimal quoting and trading. Also contributing to the increase was $9.2 million in depreciation and amortization expense of Nasdaq Europe from the date of acquisition by Nasdaq. Professional and contract services expense increased to $76.0 million for the year ended December 31, 2001 from $61.5 million for the year ended December 31, 2000, an increase of $14.5 million, or 23.6%, in support of SuperMontage and Primex development, and future technology design planning, and costs associated with the Restructuring. Computer operations and data communications expense increased $36.7 million, or 26.6%, to $174.9 million for the year ended December 31, 2001 from $138.2 million for the year ended December 31, 2000. The computer operations component of the costs increased $4.5 million from the year ended December 31, 2000 to the year ended December 31, 2001 due to increases in maintenance and software licenses to support a higher asset base. Data communications costs increased $32.2 million due to increased charges for the upgraded bandwidth and processing speed and additional users that are commensurate with the increase in Nasdaq Workstation II revenue as discussed above. Also contributing to the increase is $8.1 million of system operating costs of Nasdaq Europe from the date of acquisition by Nasdaq. Provision for bad debts increased to $15.5 million for the year ended December 31, 2001 from $5.6 million for the year ended December 31, 2000 reflecting an $8.4 million receivable write-off relating to the bankruptcy filing by Bridge Information Systems, a vendor of Nasdaq's market information. The remaining increase in provision for bad debts was commensurate with the growth in Nasdaq's accounts receivable. Occupancy expense increased $12.4 million, or 83.8%, to $27.2 million for the year ended December 31, 2001 from $14.8 million for the year ended December 31, 2000. This increase was primarily due to Nasdaq's new corporate offices, located at One Liberty Plaza, New York, New York, new office space in Trumbull, Connecticut and the amortization of leasehold improvements to the Rockville, Maryland data center. These increased costs were slightly offset by a rent abatement granted Nasdaq due to the closure of One Liberty Plaza following the September 11th attacks. Disaster related expenses of $23.2 million are related to the terrorists attacks of September 11, 2001. As a result of the attacks, Nasdaq was required to make certain non-budgeted expenditures related to the efforts to restore services to market participants; the testing of trading systems; and required reconfiguring of technology, telecommunications and alternative office facilities due to the temporary relocation of employees which amounted to $1.7 million. In addition, Nasdaq has made a decision to vacate its leased space at One Liberty Plaza and relocate its headquarters to mid-town New York City, and recorded a charge of $21.5 million to reflect the estimated loss on the sublease for this property. Technology transition costs of $9.2 million have been accrued under a commitment by Nasdaq to Amex to fund technology development costs associated with the separation of Amex from Nasdaq. See "—Related Party Transactions" and Note 16 to the Consolidated Financial Statements for a further explanation of Nasdaq's commitment under the agreement. The remaining direct expenses increased $25.2 million, or 64.1%, to $64.5 million for the year ended December 31, 2001, from $39.3 million for the year ended December 31, 2000, related to increases in various expense categories including losses from strategic equity investments, telephone expense, and training and travel expenses. Interest expense increased $7.5 million to $9.6 million for the year ended December 31, 2001 from $2.1 million for the year ended December 31, 2000 due to interest on the Subordinated Notes issued to Hellman & Friedman in May 2001. For the Years Ended December 31, 2000 and 1999. Direct expenses increased $123.7 million, or 32.2%, to $508.2 million for the year ended December 31, 2000 from $384.5 million for the year ended December 31, 1999. Compensation and benefits costs increased $39.2 million, or 40.0%, to $137.3 million for the year ended December 31, 2000 from $98.1 million for the year ended December 31, 1999. This increase was primarily due to growth in the number of employees required to support business and operational demands created by the rapid expansion of the market during 2000. The number of employees increased by 171, or 16.4%, to 1,214 employees as of December 31, 2000, from 1,043 employees as of December 31, 1999. As a result, salaries for the period increased $20.8 million. Also contributing were increases in incentive compensation and retirement and savings plan expenses. Approximately 30% of the overall increase in compensation and benefits costs related to the transfer of directors and executive officers from the NASD to Nasdaq as well as new executive officer hires and existing directors and executive officers. Marketing and advertising costs decreased $16.9 million, or 26.9%, to $45.9 million for the year ended December 31, 2000 from $62.8 million for the year ended December 31, 1999, primarily due to a decrease in scale of the media advertising campaign in the fall of 2000 as compared to the fall campaign in 1999. During 1999, additional media events were scheduled to establish the Nasdaq and Amex brand following the NASD's 1998 acquisition of Amex. Depreciation and amortization expense increased $21.9 million, or 50.1%, to $65.6 million for the year ended December 31, 2000 from $43.7 million for the year ended December 31, 1999, primarily due to purchases of computer hardware necessary to handle the growth in trading volumes. Also contributing to this increase was the opening of the MarketSite and broadcast facility located in Times Square, New York City. Professional and contract services costs increased $26.2 million, or 74.2%, to $61.5 million for the year ended December 31, 2000 from $35.3 million for the year ended December 31, 1999. The main projects driving this increase included Nasdaq Global and related international initiatives, design costs related to Nasdaq.com and Nasdaq online, vendor services for the new MarketSite and broadcast facility located in Times Square, New York, and helpdesk and desktop support costs provided by Electronic Data Systems Corporation. Computer operations and data communications costs increased $37.7 million, or 37.5%, to $138.2 million for the year ended December 31, 2000 from $100.5 million for the year ended December 31, 1999. This overall increase was required to support additional capacity. The Nasdaq Stock Market's total share volume for the year ended December 31, 2000 increased approximately 64.5% compared to the year ended December 31, 1999. The computer operations and data communications complex was upgraded to provide the capability for processing four billion shares on a peak day. The computer operations component of the costs increased $14.4 million between 1999 and 2000 to support this capacity. This increase resulted from help desk and network license increases of $2.3 million, hardware maintenance increases of $5.4 million, Tandem lease increases of $1.3 million, software leases and maintenance increases of $3.9 million, and computer supplies and cabling increases of $1.5 million. Data communications costs increased $23.3 million due to the increased Enterprise Wide Network II charges from WorldCom for T-1 communications lines for new customers and upgraded bandwidth and processing speed. The remaining direct expenses increased $15.6 million, or 35.4%, to $59.7 million for the year ended December 31, 2000 from $44.1 million for the year ended December 31, 1999. This was primarily due to an increase in occupancy costs as a result of the MarketSite and broadcast facility in Times Square, New York, new office space in Trumbull, Connecticut, increased travel to support international initiatives, and losses in strategic foreign equity investments. Support Costs Due to its historical relationship with the NASD, Nasdaq currently receives services from the NASD and NASDR, and provides services to the NASD and Amex. As such, these services are considered related party transactions. Specifically, in 2001 the NASD has provided certain administrative, corporate and infrastructure services, including certain financial services, real estate, legal and human resource services. NASDR provides surveillance and other regulatory services for Nasdaq. These charges are composed primarily of the costs relating to technological investments for market surveillance as well as direct costs for enforcement and other regulation services. Nasdaq provides systems and technology support to Amex in the form of market data storage and dissemination, web development and hosting and customer relationship management application support. Nasdaq also provides security services to the NASD. It is expected that as Nasdaq continues moving towards self-sufficiency, with the exception of surveillance and regulatory services, these related party transactions will diminish. Support costs with related parties have been transacted at the cost of providing the service. See "Item 1. Business—Service, Regulatory, and Technology Contractual Relationship with the NASD, NASDR and Amex." For the Years Ended December 31, 2001 and 2000. Support costs from related parties decreased by $26.7 million, or 20.8%, to $101.8 million for the year ended December 31, 2001 from $128.5 million for the year ended December 31, 2000. Surveillance and other regulatory charges from NASDR increased by $3.9 million to $83.8 million for the year ended December 31, 2001 from $79.9 million for the year ended December 31, 2000. Support costs from the NASD decreased $21.5 million to $32.1 million for the year ended December 31, 2001 from $53.6 million for the year ended December 31, 2000. In addition, contributing to the decrease was an increase in the amount of Nasdaq costs charged to the Amex of $9.2 million to $14.1 million for the year ended December 31, 2001 from $4.9 million for the year ended December 31, 2000. For the Years Ended December 31, 2000 and 1999. Support costs from related parties increased by $13.3 million, or 11.5%, to $128.5 million for the year ended December 31, 2000 from $115.2 million for the year ended December 31, 1999. Specifically, Nasdaq incurred increased surveillance and other regulatory charges from NASDR. Surveillance and other regulatory charges from NASDR increased by $14.8 million, or 22.7%, to $79.9 million for the year ended December 31, 2000 from $65.1 million for the year ended December 31, 1999. Additionally, contributing to the increase is a decline in the amount of Nasdaq costs charged to Amex of $9.1 million, or 65.0%, to $4.9 million for the year ended December 31, 2000 from $14.0 million for the year ended December 31, 1999. The support cost increases are partially offset by a decrease in support costs from the NASD of $10.5 million, or 16.4%, to $53.6 million for the year ended December 31, 2000 from $64.1 million for the year ended December 31, 1999. The decrease in support costs primarily reflects the outsourcing of Nasdaq's computer desktop operations to Electronic Data Systems effective June 1, 1999. Prior to June 1, 1999, the NASD provided these services to Nasdaq. For the Years Ended December 31, 2001 and 2000. Nasdaq's income tax provision was $38.3 million for the year ended December 31, 2001 compared to $90.5 million for the year ended December 31, 2000. The effective tax rate was 48.6% for the year ended December 31, 2001 compared to 42.1% for the year ended December 31, 2000. The increase in Nasdaq's effective tax rate was primarily due to its foreign losses for which no tax benefit is taken, offset by the recognition of permanent items for tax preferred investments such as tax-exempt interest and dividends received deductions. For the Years Ended December 31, 2000 and 1999. Nasdaq's income tax provision was $90.5 million for 2000 compared to $58.4 million for 1999. The effective tax rate was 42.1% for 2000 compared to 40.4% for 1999. The increase in Nasdaq's effective tax rate was primarily due to an increase in its foreign losses for which no tax benefit is taken. For the Years Ended December 31, 2001 and 2000. Cash and cash equivalents and available-for-sale securities totaled $521.8 million at December 31, 2001, an increase of $27.5 million from $494.3 million at December 31, 2000. Working capital increased $81.3 million to $521.6 million as of December 31, 2001, from $440.3 million as of December 31, 2000. Cash and cash equivalents increased $31.4 million from $262.3 million on December 31, 2000 to $293.7 million as of December 31, 2001, primarily due to cash provided by operating activities of $65.0 million and cash provided by financing activities of $75.6 million, partially offset by cash used in investing activities of $109.2 million. Operating activities provided net cash inflows of $65.0 million for the year ended December 31, 2001, primarily due to cash received from customers of $821.9 million less cash paid to suppliers, employees, and related parties of $730.1 million and income taxes paid of $26.8 million. Net cash used in investing activities was $109.2 million for the year ended December 31, 2001, primarily due to capital expenditures related to SuperMontage, Primex, global initiatives and general capacity increases. The remaining cash used in investing activities is attributable to purchases of investments with the proceeds from the sale of Common Stock in Phase II of the Restructuring that closed in January 2001 and receipts from the sales and maturities of investments. Cash provided by financing activities was approximately $75.6 million for the year ended December 31, 2001. On May 3, 2001, Nasdaq sold Subordinated Notes to Hellman & Friedman, yielding gross proceeds of approximately $240.0 million. Nasdaq used the proceeds to repurchase 18,461,538 shares of Common Stock from the NASD for $13.00 per share for an aggregate purchase price of approximately $240.0 million. During this period, Nasdaq also received net proceeds from Phase II of the Restructuring that equaled approximately $63.7 million and repaid approximately $28.6 million to the venture partners who participated in Nasdaq Europe Planning Company Limited. Nasdaq used a portion of the proceeds to repurchase additional shares from the NASD in 2002 and will use the remaining proceeds from its financing activities to invest in new technology, implement and form strategic alliances, implement competitive pricing of its services, and build its brand through marketing programs. Approximately $305.2 million of Nasdaq's cash and cash equivalents were used in the first quarter of 2002 to fund the Repurchase, as discussed in Note 20 to the Consolidated Financial Statements. Nasdaq believes that the liquidity provided by existing cash and cash equivalents, investments, and cash generated from operations will provide sufficient capital to meet current and future operating requirements. Nasdaq is exploring alternative sources of financing that may increase liquidity in the future. Nasdaq has generated positive cash flows annually in each of the five years since 1996 and believes that it will continue to do so in the future to meet both short and long term operating requirements. For the Years Ended December 31, 2000 and 1999. Cash and cash equivalents and available-for-sale securities totaled $494.3 million as of December 31, 2000, an increase of $330.1 million from $164.2 million as of December 31, 1999. Working capital increased $285.9 million to $440.3 million as of December 31, 2000, from $154.4 million as of December 31, 1999. Cash and cash equivalents increased $251.7 million to $262.3 million as of December 31, 2000, primarily due to cash provided by financing activities as a result of the net proceeds received from Phase I of the Restructuring that equalled $253.3 million. For the year ended December 31, 2000, operating activities provided net cash inflows of $255.6 million, primarily due to cash received from customers of $713.4 million less cash paid to suppliers, employees, and related parties of $403.8 million and income taxes paid of $101.2 million. Net cash used in investing activities was $292.2 million for the twelve months ended December 31, 2000, due in part to capital expenditures to complete construction of the MarketSite and broadcast facility in Times Square and the acquisition of Financial Systemware, Inc. (now known as Nasdaq Tools). In addition, Nasdaq continued to make capital investments in technology to continue to support Nasdaq's system capacity needs. The remaining cash used in investing activities is attributable to purchases of investments with the proceeds of the Phase I of the Restructuring that exceeded the sales and maturities of investments. Cash provided by financing activities was $288.3 million as of December 31, 2000, primarily due to the net proceeds received from Phase I that equalled approximately $253.3 million. Nasdaq used the proceeds to invest in new technology, implement and form strategic alliances and build its brand identity through marketing programs. Also contributing to cash provided from financing activities was $30.0 million in capital contributions to Nasdaq Europe Planning Company Limited from the minority shareholders. Liquidity and Capital Adequacy Nasdaq's Treasury Department manages Nasdaq's capital structure, funding, liquidity, collateral, and relationships with bankers, investment advisors and creditors on a global basis. The Treasury Department works jointly with subsidiaries to manage internal and external borrowings. The Board of Directors approved a revised investment policy for Nasdaq and its subsidiaries for internally and externally managed portfolios. The goal of the policy is to maintain adequate liquidity at all times and to fund current budgeted operating and capital requirements and to maximize return. All securities must meet credit ratings as established by the policy, and will be denominated in subsidiary specific currencies, with maturities up to 24 months, and an average life of not greater than 12 months. The policy prohibits debt interest in any contractor company where Nasdaq has a material contribution to the business of such company and debt interest in an entity that derives more that 25% of its gross revenue from the combined broker/dealer and/or investment advisory of all of its subsidiaries and affiliates. This policy will be reviewed annually, and regular reviews of investments and investment managers will also be made. Nasdaq has pledged certain investments as collateral for a $25.0 million loan to a financial institution. Collateral is limited to U.S. Government and Agency securities with a margined value of approximately $28.6 million, and is invested in accordance with the note agreement. The majority of liquidity for Nasdaq and its subsidiaries is raised by Nasdaq. Nasdaq lends necessary funds from time to time to its equity and consolidated subsidiaries to meet their working capital requirements. Contractual Obligations and Contingent Commitments Nasdaq has contractual obligations to make future payments under long-term debt and long-term noncancelable lease agreements and has contingent commitments under a variety of arrangements as discussed in the Notes to the Consolidated Financial Statements. The following table sets forth these contractual obligations as of December 31, 2001: ($ in thousands) 2007 and Long-term borrowings by contract maturity $ 12,837 $ 48,604 $ 253,305 $ 30,765 $ 345,511 Minimum rental commitments under noncancelable operating leases 14,913 30,489 30,054 127,676 203,132 Minimum rental commitments under capitalized leases 6,129 10,258 2,952 — 19,339 In May 1997, Nasdaq entered into a $25.0 million note payable with a financial institution. Principal payments are scheduled to begin in 2007 and continue in equal monthly installments until maturity in 2012. On March 27, 2001, Nasdaq acquired 68.2% of Nasdaq Europe and has accounted for this acquisition under the purchase method of accounting. Nasdaq Europe has $23.5 million of notes payable outstanding as of December 31, 2001. Principal payments are scheduled in 2003 and 2004. On May 3, 2001, Nasdaq issued and sold $240 million in aggregate principal amount of 4.0% convertible Subordinated Notes due 2006 to Hellman & Friedman. See Note 9 to the Consolidated Financial Statements for further information regarding long-term borrowings. Nasdaq leases certain office space and equipment in connection with its operations. The majority of these leases contain escalation clauses based on increases in property taxes and building operating costs. Minimum lease payments at December 31, 2001 were $203.1 million. As of December 31, 2001, Nasdaq had future minimum lease payments under noncancellable capital leases of $19.3 million. The Board of Directors of Nasdaq has approved a capital contribution of up to $13.0 million in Nasdaq Japan. This contribution is expected to take place during 2002. Additionally, Nasdaq has committed to lend up to $5.0 million to Nasdaq Japan. As of December 31, 2001 $2.8 million has been loaned to Nasdaq Japan with the remainder expected to be loaned in 2002. The Board of Directors of Nasdaq has approved a capital contribution of up to $25.0 million to Nasdaq LIFFE joint venture. Nasdaq made contributions of $2.0 million in 2001. Additional contributions under this agreement are expected to be made during 2002. Nasdaq entered into a six-year $600 million contract with WorldCom in 1997 to design and support the network. The contract with WorldCom will automatically renew for successive renewal periods unless it is previously terminated by one of the parties. As part of that contract, Nasdaq provided a guaranteed revenue commitment to WorldCom of $300 million. Nasdaq is permitted to renegotiate the contract once the minimum guarantee is satisfied. Nasdaq expects to meet this commitment by May 2002. Market risk represents the risks of changes in the value of a financial instrument, derivative or non-derivative, caused by fluctuations in interest rates, foreign exchange rates, and equity prices. As of December 31, 2001, Nasdaq's investment portfolio consists primarily of floating rate securities, obligations of U.S. Government sponsored enterprises, municipal bonds, and commercial paper. Nasdaq's primary market risk is associated with fluctuations in interest rates and the effects that such fluctuations may have on its investment portfolio and outstanding debt. The weighted average maturity of the fixed income portion of the portfolio is four years as of December 31, 2001. Nasdaq's outstanding debt obligations generally specify fixed interest rates until May 2007 and a floating interest rate based on the lender's cost of funds until maturity in 2012. The investment portfolio is held primarily in short-term investments with maturities averaging approximately one year. Therefore, management does not believe that a 100 basis point fluctuation in market interest rates will have a material effect on the carrying value of Nasdaq's investment portfolio or on Nasdaq earnings or cash flows. Nasdaq's exposure to these risks has not materially changed since December 31, 2000. Nasdaq has exposure to foreign currency translation gains and losses due to its subsidiaries and equity method investments. Nasdaq has not hedged its accounting translation exposure to foreign currency fluctuations relative to these investments. However, Nasdaq expects to periodically re-evaluate its foreign currency hedging policies and may choose in the future to enter into such transactions. Nasdaq's consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States, which requires the use of estimates and assumptions (see Note 3 to the consolidated financial statements). Nasdaq believes the following critical accounting policies, among others, affect the more significant judgments and estimates used in the preparation of the statements: Revenue Recognition. Market information services revenues (28.1% of total revenues in 2001) are based on the number of presentation devices in service and quotes delivered through those devices. These revenues are recorded net of amounts due under revenue sharing arrangements with market participants. Market information services revenues are recognized in the month that information is provided. Transaction services revenues (47.7% of total revenues in 2001) are variable based on service volumes and are recognized as transactions occur. Corporate Client Group services revenues (18.2% of total revenues in 2001) are recognized in a number of ways. Annual fee revenue are recognized ratably over the following 12-month period. Effective January 1, 2000, initial listing and LAS fees are recognized in accordance with Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), on a straight line basis over estimated service periods, which are six and four years, respectively. These estimated service periods are based on historical average listing lives of issuers. Prior to 2000, initial listing fees were recognized in the month listing occurred and LAS fees were recognized in the period the incremental shares were issued. The change in accounting for these fees is more fully described in Note 4 to the Consolidated Financial Statements. Software Costs. Significant purchased application software, and operational software that is an integral part of computer hardware, are capitalized and amortized on the straight-line method over their estimated useful lives, generally two to seven years. All other purchased software is charged to expense as incurred. Nasdaq adopted Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), effective January 1, 1999. SOP 98-1 requires that certain costs incurred in connection with developing or obtaining internal use software be capitalized. Under the provisions of this SOP, Nasdaq capitalizes internal and third party costs incurred in connection with the development of internal use software. Related Party Transactions. Related party receivables and payables are the result of various transactions between Nasdaq and its affiliates. Payables to related parties are comprised primarily of the regulation charge from NASDR, a wholly-owned subsidiary of the NASD. NASDR charges Nasdaq for costs incurred related to Nasdaq market regulation and enforcement. Support charges from the NASD to Nasdaq represent another significant component of payables to related parties. The support charge includes an allocation of a portion of the NASD's administrative expenses as well as its costs incurred to develop and maintain technology on behalf of Nasdaq. The remaining component of payables to related parties is cash disbursements funded by the NASD on behalf of Nasdaq. All related party transactions are currently charged at cost. Receivables from related parties are primarily attributable to costs incurred by Amex and funded by Nasdaq related to various Amex technology projects. The remaining portion of the receivable from related parties balance is related to cash disbursements funded by Nasdaq on behalf of its affiliates. Until Exchange Registration, the NASD will retain voting control over Nasdaq. See "Item 1. Business—Nasdaq's History and Structure" and "Item 5. Market for Registrant's Common Equity and Related Stockholder Matters—Unregistered Offerings." In addition, five of the 18 members of the Nasdaq Board are currently members of the NASD Board. Until Exchange Registration, the NASD will be in a position to continue to control substantially all matters affecting Nasdaq, including any determination with respect to the direction and policies of Nasdaq, acquisition or disposition of assets, future issuances of securities of Nasdaq, Nasdaq's incurrence of debt, and any dividend payable on the Common Stock. Conflicts of interest may arise between Nasdaq and the NASD, or its affiliates, in a number of areas relating to their past and ongoing relationships, including the nature, quality, and pricing of services rendered; shared marketing functions; tax and employee benefit matters; indemnity agreements; sales or distributions by the NASD of all or any portion of its ownership interest in Nasdaq; or the NASD's ability to influence certain affairs of Nasdaq prior to Exchange Registration. Nasdaq has agreed to fund a portion of the necessary expenses related to the separation of software, hardware, and data under a plan to transition technology applications and support from Nasdaq to Amex. The NASD originally integrated Nasdaq and Amex technology subsequent to the 1998 acquisition of Amex by the NASD. The total estimated cost of the separation has been established at a maximum of $29.0 million, and is to be shared evenly between Nasdaq and the NASD. Nasdaq has accrued $9.2 million of its $14.5 million commitment as of December 31, 2001. Provision for Bad Debts. Nasdaq evaluates the collectibility of accounts receivable based on a combination of factors. In circumstances where a specific customer's inability to meet its financial obligations is known (bankruptcy filings, substantial downgrading of credit scores), Nasdaq records a specific provision for bad debts against amounts due to reduce the receivable to the amount it reasonably believes will be collected. For all other customers, provisions for bad debts are made based on the length of time the receivable is past due and historical experience. For receivables past due for over 60, 90, and 120 days, 10%, 50%, and 100%, respectively, of the outstanding balances are reserved for. If circumstances change (i.e., higher than expected defaults or an unexpected material adverse change in a major customer's ability to pay), our estimates of recoverability could be reduced by a material amount. In June 2001, the FASB issued SFAS No. 141, "Business Combinations," and SFAS No. 142, "Goodwill and Other Intangible Assets," ("SFAS 142") effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. Other intangible assets will continue to be amortized over their useful lives. Nasdaq will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of 2002. Application of the nonamortization provisions of SFAS 142 is not expected to have a material impact to Nasdaq's financial position or results of operations. During 2002, Nasdaq will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of January 1, 2002. Nasdaq does not expect the effect of these tests to have a material impact on its earnings and financial position. Quarterly Results from Operations (Unaudited, in thousands, except earnings per share information) 1st Qtr 2nd Qtr 3rd Qtr 4th Qtr Total revenues $ 207,015 $ 211,504 $ 202,720 $ 211,472 $ 832,711 Net operating income 75,791 71,751 40,877 7,601 196,020 Interest income 2,200 3,205 5,519 9,187 20,111 Interest expense (483 ) (476 ) (718 ) (453 ) (2,130 ) Minority interests — — — 872 872 Provision for income taxes (31,158 ) (29,181 ) (23,649 ) (6,489 ) (90,477 ) Income before cumulative effect of change in accounting principle 46,350 45,299 22,029 10,718 124,396 Cumulative effect of change in accounting principle (101,090 ) — — — (101,090 ) Net (loss) income $ (54,740 ) $ 45,299 $ 22,029 $ 10,718 $ 23,306 Basic and diluted earnings per share: Cumulative effect of change in accounting principle (1.01 ) — — — (0.90 ) Net (loss) income $ (0.55 ) $ 0.45 $ 0.18 $ 0.09 $ 0.21 Pro forma amounts assuming the accounting change is applied retroactively: Total revenues $ 207,015 $ 832,711 Net income $ 46,350 $ 124,396 Basic and diluted earnings per share $ 0.46 $ 1.11 Net operating income 42,094 32,733 6,754 (21,446 ) 60,135 Interest expense (480 ) (1,970 ) (2,997 ) (4,200 ) (9,647 ) Minority interests 217 1,765 3,252 470 5,704 Provision for income taxes (21,808 ) (16,753 ) (5,736 ) 5,965 (38,332 ) Net income (loss) $ 26,193 $ 19,582 $ 7,945 $ (13,257 ) $ 40,463 Basic earnings per share $ 0.21 $ 0.17 $ 0.07 $ (0.12 ) $ 0.35 Diluted earnings per share $ 0.21 $ 0.16 $ 0.07 $ (0.12 ) $ 0.35 Item 7A. Quantitative and Qualitative Disclosure About Market Risk. Information about quantitative and qualitative disclosures about market risk is incorporated herein by reference from "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Quantitative and Qualitative Disclosure About Market Risk." Item 8. Financial Statements and Supplementary Data. Nasdaq's consolidated financial statements, including consolidated balance sheets as of December 31, 2001 and 2000, consolidated statements of income for the years ended December 31, 2001, 2000 and 1999, consolidated statements of changes in stockholders' equity for the years ended December 31, 2001, 2000 and 1999, consolidated statements cash flows for the years ended December 31, 2001, 2000, and 1999, and notes to our consolidated financial statements, together with a report thereon of Ernst & Young LLP, dated March 6, 2002, are attached hereto as pages F-1 through F-29. Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. Item 10. Directors and Executive Officers of the Registrant. Information about Nasdaq's directors is incorporated by reference from the discussion under Proposal 1 in Nasdaq's Proxy Statement for the 2002 Annual Meeting of Stockholders. The balance of the response to this item is contained in the discussion entitled "Executive Officers" under Item 1 of Part I of this report. Item 11. Executive Compensation. Information about executive compensation is incorporated by reference from the discussion under the heading "Executive Compensation" in Nasdaq's Proxy Statement for the 2002 Annual Meeting of Stockholders. Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. Information about security ownership of certain beneficial owners and management is incorporated by reference from the discussion under the heading "Security Ownership of Certain Beneficial Owners and Management" in Nasdaq's Proxy Statement for the 2002 Annual Meeting of Stockholders. Item 13. Certain Relationships and Related Transactions. Information about certain relationships and transactions with related parties is incorporated herein by reference from the discussion under the heading "Certain Relationships and Related Transactions" in Nasdaq's Proxy Statement for the 2002 Annual Meeting of Stockholders. Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K. (a)(1) Financial Statements See "Index to Consolidated Financial Statements." (a)(2) Financial Statement Schedules All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted. (a)(3) Exhibits: 3.1 Restated Certificate of Incorporation of The Nasdaq Stock Market, Inc.(+) 3.2 By-Laws of The Nasdaq Stock Market, Inc.(#) 3.3 Certificate of Designations of The Nasdaq Stock Market, Inc.'s Series A Cumulative Preferred Stock. 3.4 Certificate of Designations of The Nasdaq Stock Market, Inc.'s Series B Preferred Stock. 4.1 Form of Common Stock certificate.(+) 9.1 Voting Trust Agreement dated June 28, 2000, among The Nasdaq Stock Market, Inc., the National Association of Securities Dealers, Inc. and The Bank of New York.(+) 9.2 First Amendment to the Voting Trust Agreement, dated as of January 18, 2001, among The Nasdaq Stock Market, Inc., the National Association of Securities Dealers, Inc. and The Bank of New York.(+) 10.1 Network Service Agreement, dated November 19, 1997, between MCI Telecommunications Corporation and The Nasdaq Stock Market, Inc.*(+) 10.2 Consolidated Agreement, between Unisys Corporation and The Nasdaq Stock Market, Inc.*(+) 10.3 Network User License Agreement, dated November 30, 1993, between Oracle Corporation and The Nasdaq Stock Market, Inc.*(+) 10.4 Software License and Services Agreement, dated November 30, 1993, between Oracle Corporation and The Nasdaq Stock Market, Inc.*(+) 10.5 Regulatory Services Agreement, dated June 28, 2000, between NASD Regulation, Inc. and The Nasdaq Stock Market, Inc.*(+) 10.6 Separation and Common Services Agreement, dated as of June 28, 2000, between the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(+) 10.7 The Nasdaq Stock Market, Inc. 2000 Employee Stock Purchase Plan.(+) 10.8 The Nasdaq Stock Market, Inc. Equity Incentive Plan.(+) 10.9 Securities Purchase Agreement, dated as of March 23, 2001, among The Nasdaq Stock Market, Inc., Hellman & Friedman Capital Partners IV, L.P. and the other purchasers listed in the signature pages thereto.(+) 10.9.1 Securityholders Agreement, dated as of May 3, 2001, among The Nasdaq Stock Market, Inc., Hellman & Friedman Capital Partners IV, L.P., and the other securityholders listed on the signature pages thereto.(^) 10.10 Purchase and Sale Agreement, dated March 23, 2001, by and between the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(+) 10.11 Employment Agreement between the National Association of Securities Dealers, Inc. and Frank G. Zarb effective on February 24, 1997.(+) 10.12 Instrument of Amendment, dated March 18, 1998, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997.(+) 10.13 Instrument of Amendment, dated as of August 20, 1999, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998.(+) 10.14 Instrument of Amendment, dated March 30, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended on August 20, 1999.(+) 10.15 Instrument of Amendment, effective as of July 27, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended in August, 1999, and subsequently amended on March 30, 2000.(+) 10.16 Instrument of Amendment, effective as of November 1, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended in August, 1999, and subsequently amended on March 30, 2000, and as of July 27, 2000.(+) 10.17 Instrument of Amendment, effective as of April 25, 2001, to Employment Agreement between National Association of Securities Dealers, Inc., The Nasdaq Stock Market, Inc., and Frank G. Zarb, effective on February 24, 1997, as subsequently amended effective March 18, 1998, August 20, 1999, March 30, 2000, July 27, 2000 and November 1, 2000.(+) 10.18 Letter Agreement, dated July 22, 2001, among Frank G. Zarb, the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(—) 10.19 Employment Agreement by and between The Nasdaq Stock Market, Inc. and John L. Hilley, effective as of December 29, 2000.(+) 10.19.1 Amendment One to the Employment Agreement by and between The Nasdaq Stock Market, Inc. and John L. Hilley, effective as of February 1, 2002. 10.20 Employment Agreement by and between The Nasdaq Stock Market, Inc. and Richard G. Ketchum, effective as of December 29, 2000.(+) 10.20.1 Amendment One to the Employment Agreement by and between The Nasdaq Stock Market, Inc. and Richard G. Ketchum, effective as of February 1, 2002. 10.21 Employment Agreement by and between The Nasdaq Stock Market, Inc. and Hardwick Simmons, dated December 7, 2000, effective as of February 1, 2001.(+) 10.21.1 Amendment Number One to the Employment Agreement by and between the The Nasdaq Stock Market, Inc., and Hardwick Simmons, effective as of February 1, 2001. (+) 10.21.2 Amendment Number Two to the Employment Agreement by and between the The Nasdaq Stock Market, Inc., and Hardwick Simmons, effective as of February 1, 2002. 10.22 Employment Letter, dated May 31, 1996, from the National Association of Securities Dealers, Inc. to Alfred R. Berkeley, III.(#) 10.23 Employment Letter from The Nasdaq Stock Market, Inc. to David Weild IV, dated March 8, 2001 as amended and restated March 21, 2002. 10.24 Purchase and Sale Agreement, dated as of February 20, 2002, by and between The Nasdaq Stock Market, Inc., and the National Association of Securities Dealers, Inc. 10.24.1 Investor Rights Agreement, dated as of February 20, 2002, between The Nasdaq Stock Market, Inc., and the National Association of Securities Dealers, Inc. (~) 10.25 Separation Agreement, dated as of December 12, 2001, by and between The Nasdaq Stock Market, Inc. and J. Patrick Campbell. 10.25.1 Employment Agreement by and between The Nasdaq Stock Market, Inc. and J. Patrick Campbell, effective as of December 29, 2000. (+) 10.26 Loan Agreement, dated December 28, 2001, by and between The Nasdaq Stock Market, Inc. and David P. Warren. 10.27 Loan Agreement, dated December 30, 2001, by and between The Nasdaq Stock Market, Inc. and Steven Dean Furbush. 11 Statement regarding computation of per share earnings (incorporated herein by reference to "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K" of this Form 10-K). 21.1 List of all subsidiaries. 23.1 Consent of Independent Auditors. 24.1 Powers of Attorney. Confidential treatment has been requested from the U.S. Securities and Exchange Commission for certain portions of this exhibit. Previously filed with The Nasdaq Stock Market, Inc.'s Registration Statement on Form 10 (file number 000-32651) filed on April 30, 2001. (^) Previously filed with The Nasdaq Stock Market, Inc.'s Amendment No. 1 to Registration Statement on Form 10 (file number 000-32651) filed on May 14, 2001. Previously filed with The Nasdaq Stock Market, Inc.'s Amendment No. 4 to Registration Statement on Form 10 (file number 000-32651) filed on August 31, 2001. Previously filed with The Nasdaq Stock Market, Inc.'s Amendment No. 5 to Registration Statement on Form 10 (file number 000-32651) filed on November 16, 2001. (~) Previously filed with The Nasdaq Stock Market, Inc.'s Current Report on Form 8-K filed on February 22, 2002. Reports on Form 8-K: Exhibits: See Item 14(a)(3) above. Financial Statement Schedules: Pursuant to the requirements of Section 13 of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on March 27, 2002. /s/ HARDWICK SIMMONS Name: Hardwick Simmons Title: Chairman of the Board and Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant in the capacities indicated as of March 27, 2002. Hardwick Simmons /s/ DAVID P. WARREN David P. Warren (Principal Financial and Accounting Officer) Dr. Josef Ackermann H. Furlong Baldwin Frank E. Baxter Michael Casey Michael W. Clark William S. Cohen F. Warren Hellman /s/ RICHARD G. KETCHUM Richard G. Ketchum President and Director John D. Markese E. Stanley O'Neal Vikram S. Pandit Kenneth D. Pasternak David S. Pottruck Arthur Rock Richard C. Romano Arvind Sodhani Sir Martin Sorrell Pursuant to Power of Attorney By: /s/ EDWARD S. KNIGHT Edward S. Knight Attorney-in-Fact INDEX TO CONSOLIDATED FINANCIAL STATEMENTS The following consolidated financial statements of The Nasdaq Stock Market, Inc. and its subsidiaries are presented herein on the page indicated: Report of Independent Auditors F-2 Consolidated Balance Sheets F-3 Consolidated Statements of Income F-4 Consolidated Statements of Changes in Stockholders' Equity F-5 Consolidated Statements of Cash Flows F-6 Notes to Consolidated Financial Statements F-7 REPORT OF INDEPENDENT AUDITORS We have audited the accompanying consolidated balance sheets of The Nasdaq Stock Market, Inc. ("Nasdaq") as of December 31, 2001 and 2000, and the related consolidated statements of income, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2001. These consolidated financial statements are the responsibility of Nasdaq's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Nasdaq at December 31, 2001 and 2000, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States. As discussed in Note 4 to the consolidated financial statements, effective January 1, 2000, Nasdaq changed its method of accounting for certain Corporate Client Group services revenue. Ernst & Young LLP (in thousands, except share and par value amounts) Investments: Available-for-sale, at fair value 228,029 232,090 Held-to-maturity, at amortized cost — 21,967 Receivables, net 194,040 172,660 Receivables from related parties 34,953 8,250 Deferred tax asset 51,170 32,367 Held-to-maturity, at amortized cost 28,569 6,612 Property and equipment: Land, buildings and improvements 88,861 80,727 Data processing equipment and software 441,928 363,332 Furniture, equipment and leasehold improvements 184,572 134,638 Less accumulated depreciation and amortization (336,528 ) (252,380 ) Total property and equipment, net 378,833 326,317 Non-current deferred tax asset 74,987 61,257 Other assets 28,690 25,753 Accounts payable and accrued expenses $ 111,676 $ 111,133 Accrued personnel costs 43,744 36,514 Other accrued liabilities 47,296 29,879 Current obligation under capital lease 4,454 5,495 Due to banks 11,460 13,876 Payables to related parties 9,556 19,158 Total current liabilities 293,552 282,233 Senior notes 48,548 25,000 Subordinated notes 240,000 — Non-current obligation under capital lease 12,125 9,107 Accrued pension costs 24,064 10,390 Non-current deferred tax liability 41,981 32,116 Deferred revenue non-current 121,687 138,166 Other liabilities 20,529 6,685 Total long-term liabilities 508,934 221,464 Minority interests 5,377 15,543 Common stock, $.01 par value, 300,000,000 authorized, shares issued: 130,161,823 in 2001 and 123,663,746 in 2000; shares outstanding: 111,700,285 in 2001 and 123,663,746 in 2000 1,302 1,237 Common stock in treasury, at cost: 18,461,538 shares in 2001 and 0 shares in 2000 (240,000 ) — Accumulated other comprehensive income (6,976 ) (1,892 ) Deferred stock compensation (3,350 ) — Common stock issuable 6,065 — Total stockholders' equity 518,388 645,159 Total liabilities, minority interest and stockholders' equity $ 1,326,251 $ 1,164,399 See accompanying notes to consolidated financial statements. Consolidated Statements of Income Years ended December 31, Transaction services $ 408,770 $ 395,123 $ 283,652 Market information services 240,524 258,251 186,543 Corporate Client Group services 156,124 149,297 163,425 Other 51,814 30,040 628 Total revenue 857,232 832,711 634,248 Compensation and benefits 183,369 137,284 98,129 Marketing and advertising 28,017 45,908 62,790 Depreciation and amortization 93,400 65,645 43,696 Professional and contract services 76,049 61,483 35,282 Computer operations and data communications 174,939 138,228 100,493 Provision for bad debts 15,459 5,554 2,978 Travel, meetings and training 14,593 12,113 10,230 Occupancy 27,183 14,766 6,591 Publications, supplies and postage 11,998 7,181 4,670 Disaster related 23,208 — — Technology transition costs 9,200 — — Other 37,883 20,007 19,688 Total direct expenses 695,298 508,169 384,547 Support cost from related parties, net 101,799 128,522 115,189 Total expenses 797,097 636,691 499,736 Net operating income 60,135 196,020 134,512 Interest income 22,603 20,111 12,201 Interest expense (9,647 ) (2,130 ) (2,143 ) Minority interests 5,704 872 — Net income before taxes 78,795 214,873 144,570 Provision for income taxes (38,332 ) (90,477 ) (58,421 ) Income before cumulative effect of change in accounting principle 40,463 124,396 86,149 Cumulative effect of change in accounting principle, net of taxes of $67,956 (Note 4) — (101,090 ) — Net income $ 40,463 $ 23,306 $ 86,149 Before cumulative effect of change in accounting principle $ 0.35 $ 1.11 $ 0.86 Cumulative effect of change in accounting principle — (0.90 ) — Net income $ 0.35 $ 0.21 $ 0.86 Total revenue $ 832,711 $ 607,203 Net income $ 124,396 $ 69,944 (in thousands, except share amounts) Outstanding (1) Paid in Capita1 (1) Income (Loss) Issuable Balance, January 1, 1999 100,000,000 $ 1,000 $ 149 $ — $ 262,972 $ 2,020 $ — $ — $ 266,141 Net income — — — — 86,149 — — — 86,149 Change in unrealized losses on available-for-sale investments, net of tax of $(149) — — — — — (278 ) — — (278 ) Comprehensive income for the year ended December 31, 1999 — — — — — — — — 85,871 Balance, December 31, 1999 100,000,000 $ 1,000 $ 149 $ — $ 349,121 $ 1,742 $ — $ — $ 352,012 Change in unrealized losses on available-for-sale investments, net of tax of $765 — — — — — (1,421 ) — — (1,421 ) Foreign currency translation net of minority interests of $(1,185) — — — — — (2,213 ) — — (2,213 ) Comprehensive income for the year ended December 31, 2000 — — — — — — 19,672 Capital contribution — — 30,000 — — — — — 30,000 Minority interest resulting from original share of equity in Nasdaq Europe Planning Company Limited — — (17,600 ) — — — — — (17,600 ) Adjustment to carrying amount of investment in Nasdaq Japan due to its private placement — — 7,784 — — — — — 7,784 Net proceeds from Phase I offering 23,663,746 237 253,054 — — — — — 253,291 Balance, December 31, 2000 123,663,746 $ 1,237 $ 273,387 $ — $ 372,427 $ (1,892 ) $ — $ — $ 645,159 Change in unrealized losses on available-for-sale investments, net of tax of $(1,030) — — — — — 918 — — 918 Foreign currency translation, net of minority interests of $340 and net of tax of $(380) — — — — — (4,607 ) — — (4,607 ) Minimum pension liability, net of tax of $900 — — — — — (1,395 ) — — (1,395 ) Net proceeds from Phase II offering 5,028,797 50 63,638 — — — — — 63,688 Sale of subsidiary stock — — 6,930 — — — — — 6,930 Purchase of minority interests in Nasdaq Europe Planning Company Limited — — (12,400 ) — — — — — (12,400 ) Sale of warrants to purchase common stock — — 1,438 — — — — — 1,438 Purchase of common stock for treasury (18,461,538 ) — — (240,000 ) — — — — (240,000 ) Restricted stock awards, net of forfeitures — — — — — — (7,465 ) 7,465 — Amortization and vesting of restricted stock 107,700 1 1,399 — — — 4,115 (1,400 ) 4,115 Other purchases of common stock by related parties or affiliated entities 1,361,580 14 14,065 — — — — — 14,079 Balance, December 31, 2001 111,700,285 $ 1,302 $ 348,457 $ (240,000 ) $ 412,890 $ (6,976 ) $ (3,350 ) $ 6,065 $ 518,388 Gives effect to the June 28, 2000 49,999-for-one common stock dividend for the year ended December 31, 1999. Reconciliation of net income to cash provided by operating activities Non-cash items included in net income: Cumulative effect of change in accounting principle, net of taxes — 101,090 — Amortization of restricted stock awards and other stock-based compensation 6,883 3,788 — Minority interest (5,704 ) (872 ) — Loss from equity-method affiliates 17,224 2,160 — Deferred taxes (23,178 ) (67,063 ) 340 Other non-cash items included in net income 3,550 3,131 1,114 Net change in: Receivables, net (33,309 ) (65,439 ) (42,875 ) Receivables from related parties (33,457 ) (1,082 ) 2,497 Other current assets 2,112 (2,168 ) (6,521 ) Other assets (22,297 ) (8,850 ) 4,866 Accounts payable and accrued expenses (11,608 ) 55,490 19,315 Accrued personnel costs 6,804 6,460 9,303 Deferred revenue (17,484 ) 103,254 1,413 Other accrued liabilities 16,846 12,742 2,580 Obligation under capital lease 1,977 (14,237 ) (397 ) Payables to related parties (11,555 ) 7,416 7,931 Accrued pension costs 10,329 3,317 2,507 Other liabilities 8,575 21,912 229 Cash provided by operating activities 65,030 255,554 135,125 Proceeds from redemptions of available-for-sale investments 369,573 154,931 107,328 Purchases of available-for-sale investments (366,438 ) (237,241 ) (131,291 ) Proceeds from maturities of held-to-maturity investments 25,465 10,811 30,743 Purchases of held-to-maturity investments (25,455 ) (10,973 ) (30,990 ) Acquisition, net of cash acquired 4,990 (16,979 ) — Purchases of property and equipment (122,555 ) (195,900 ) (110,989 ) Proceeds from sales of property and equipment 5,224 3,108 4,042 Cash used in investing activities (109,196 ) (292,243 ) (131,157 ) (Decrease) increase in due to banks (2,416 ) 5,057 3,876 Proceeds from Phase I and Phase II private placement offering 63,688 253,291 — Payments for treasury stock purchases (240,000 ) — — Increase in long-term debt 251,592 — — Purchase of minority interests in Nasdaq Europe Planning Company Limited (27,361 ) — — Issuances of common stock 14,079 — — Issuance of shares by subsidiary 16,058 — — Contributions from minority shareholders — 30,000 — Cash provided by financing activities 75,640 288,348 3,876 Increase in cash and cash equivalents 31,474 251,659 7,844 Cash and cash equivalents at beginning of year 262,257 10,598 2,754 Cash and cash equivalents at end of year $ 293,731 $ 262,257 $ 10,598 1. Organization and Nature of Operations The Nasdaq Stock Market, Inc. ("Nasdaq"), operates the world's largest electronic, screen-based equity securities market and the world's largest equity securities market based on share volume. Nasdaq is the parent company of Nasdaq Global Holdings ("Nasdaq Global"); Quadsan Enterprises, Inc. ("Quadsan"); Nasdaq Tools, Inc. ("Nasdaq Tools"); Nasdaq Financial Products Services, Inc. ("Nasdaq Financial Products"), formerly Nasdaq Investment Product Services, Inc.; Nasdaq International Market Initiatives, Inc. ("NIMI"); Nasdaq Canada, Inc. ("Nasdaq Canada"); and Nasdaq European Planning Company, Limited ("Nasdaq Europe Planning"); collectively referred to as "Nasdaq". These entities are wholly-owned by Nasdaq. At December 31, 2001, Nasdaq also owns an approximate 60% majority interest in Nasdaq Europe S.A./N.V. ("Nasdaq Europe"), and a 50% interest in Nasdaq LIFFE Markets, LLC. Nasdaq Global, which is incorporated in Switzerland, is the holding company for Nasdaq's investments in IndigoMarketssm Ltd. ("IndigoMarkets") and Nasdaq Japan, Inc. ("Nasdaq Japan"), in which it had 55.0% and 39.7% interests, respectively, as of December 31, 2001. Quadsan is a Delaware investment holding company that provides investment management services for Nasdaq. Nasdaq Tools provides software products and services related to the broker-dealer industry to be used in conjunction with Nasdaq Workstation II software. Nasdaq Financial Products is the sponsor of the Nasdaq-100 Trust. NIMI offers a variety of consulting services to assist emerging and established securities markets around the world with both technology applications and regulation. Nasdaq Canada was created to develop a new securities market within Canada under a cooperative agreement with the Provincial Government of Quebec. Nasdaq Europe Planning was formed to expand Nasdaq into the European community; however, it has been inactive due to the purchase of Nasdaq Europe. Nasdaq Europe is a pan-European market headquartered in Brussels. Nasdaq is a majority owned subsidiary of the National Association of Securities Dealers, Inc. (the "NASD"). At a special meeting of the NASD members held on April 14, 2000, a majority of NASD members approved a plan to broaden the ownership in Nasdaq through a two-phase private placement to all NASD members, Nasdaq issuers and institutional investor firms. The two phases consisted of (1) newly-issued shares of Nasdaq common stock, $.01 par value per share (the "Common Stock") and (2) additional shares of Common Stock and warrants to purchase shares of outstanding common stock owned by the NASD (the transactions collectively, the "Restructuring"). The Restructuring was intended, among other things, to strategically realign the ownership of Nasdaq, minimize potential conflicts of interest between Nasdaq and NASD Regulation, Inc. ("NASDR") and allow Nasdaq to respond to current and future competitive challenges caused by technological advances and the increasing globalization of financial markets. In connection with the first phase of the Restructuring ("Phase I"); (1) the NASD separated the American Stock Exchange LLC ("Amex") from The Nasdaq-Amex Market Group, Inc. ("Market Group"), a holding company that was a subsidiary of the NASD; (2) Market Group was merged with and into Nasdaq; (3) Nasdaq effected a 49,999-for-one stock dividend creating 100 million shares of Common Stock outstanding (all of which were initially owned by the NASD); and (4) Nasdaq authorized the issuance of an additional 30.9 million new shares to be offered for sale by Nasdaq. All share and per share amounts have been retroactively adjusted to reflect the stock dividend. Phase I closed on June 28, 2000 with Nasdaq selling 23.7 million of its newly issued shares, yielding net proceeds of approximately $253.3 million. As of December 31, 2000, the NASD owned approximately 81% of Nasdaq on a non-diluted basis. The second phase of the Restructuring ("Phase II") closed on January 18, 2001, with Nasdaq selling approximately 5.0 million shares, yielding net proceeds of approximately $63.7 million. At December 31, 2001, the NASD owned approximately 69% of Nasdaq on a non-diluted basis and 25% on a fully-diluted basis. This reflects the sale by the NASD of 4.5 million shares of Common Stock and warrants to purchase 43.2 million shares of Common Stock in Phases I and II of the Restructuring, the repurchase by Nasdaq of 18.5 million shares of Common Stock from the NASD in May 2001 and the assumed conversion of all potentially dilutive securities. Nasdaq operates in one segment as defined in the Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures About Segments of an Enterprise and Related Information." Nasdaq uses a multiple market maker system to operate its electronic, screen-based equity market. Nasdaq's principal business products are price discovery and trading services, the sale of related market data and information, and the listing of securities. The majority of this business is transacted with Nasdaq listed companies, market data vendors and firms in the broker-dealer industry within the United States. 2. Significant Transactions Hellman and Friedman Capital Partners, IV On May 3, 2001, Nasdaq issued and sold $240.0 million in aggregate principal amount of 4.0% convertible subordinated notes due 2006 (the "Subordinated Notes") to Hellman & Friedman Capital Partners IV, L.P. and certain of its affiliated limited partnerships (collectively, "Hellman & Friedman"). Nasdaq used the proceeds from the sale of the Subordinated Notes to purchase 18,461,538 shares of Common Stock from the NASD for $13.00 per share. On November 12, 2001, Nasdaq sold an aggregate amount of 500,000 shares of Common Stock to Hellman & Friedman for an aggregate offering price of $5,125,000 which was the fair value at that date. See Note 10 for more information on the Subordinated Notes. See Note 18 for more information on the purchase of Common Stock. Nasdaq Europe S.A./N.V. On March 27, 2001, Nasdaq acquired a 68.2% ownership interest in the European Association of Securities Dealers Automated Quotation S.A./N.V., ("EASDAQ"), a pan-European market headquartered in Brussels for approximately $12.5 million. Nasdaq has renamed the company Nasdaq Europe S.A./N.V. ("Nasdaq Europe") and is in the process of restructuring it into a globally linked, pan-European market. Nasdaq's acquisition of Nasdaq Europe has been accounted for under the purchase method of accounting, and, accordingly, assets acquired and liabilities assumed have been recorded at estimated fair value at the date of acquisition, resulting in the initial recording of goodwill of approximately $4.7 million. The results of operations of Nasdaq Europe have been included in the Consolidated Statements of Income from its date of acquisition. During 2001, Nasdaq purchased an additional 2% ownership of Nasdaq Europe for approximately $6.0 million, and sold 1.2% of its ownership to a third party. Nasdaq Europe sold additional shares representing a 9.0% ownership interest for approximately $13.9 million to third party investors, thereby reducing Nasdaq's ownership interest from 68.2% to approximately 60% at December 31, 2001. As a result of Nasdaq Europe's sale of additional shares to third party investors, Nasdaq recorded an increase of $7.7 million, to stockholders' equity, to reflect its adjusted share of the book value of Nasdaq Europe. Nasdaq Europe Planning Company Limited In February 2000, the NASD formed a joint venture, Nasdaq Europe Planning, with SOFTBANK Corp. of Japan ("Softbank"), and two other partners, whereby each partner contributed $10.0 million in cash. The NASD contributed $10.0 million, licensing of its brand and provided technology expertise and management leadership in exchange for a 56% interest in this venture. As part of the Restructuring, the NASD's ownership interest in Nasdaq Europe Planning was transferred to Nasdaq Global. Nasdaq Europe Planning's proposed joint venture did not occur due to a strategic decision to pursue a strategy for European expansion through the acquisition in March 2001 of a controlling interest of Nasdaq Europe rather than through Nasdaq Europe Planning. As a result, Nasdaq agreed to repurchase the ownership interests of the three other shareholders in Nasdaq Europe Planning for $10.0 million each, thereby unwinding the joint venture. Repurchases from two of the shareholders, for a total of $20.0 million, were completed in the first quarter of 2001. The repurchase from the third shareholder was completed in the fourth quarter of 2001 for aggregate consideration estimated at $10.0 million, comprised of cash of $7.4 million, a warrant to purchase up to 479,648 shares of Common Stock, and 7,211 shares of Nasdaq Europe. As of December 31, 2001, Nasdaq owned 100% of Nasdaq Europe Planning. Nasdaq Tools, Inc. On March 7, 2000, Nasdaq acquired Financial Systemware, Inc. ("Financial Systemware", now known as Nasdaq Tools), a company that develops and markets a set of software utilities that can be loaded on a Nasdaq Workstation II terminal to enhance the features and functionalities of Nasdaq Workstation II software. This acquisition was accounted for using the purchase method of accounting. Upon consummation of the transaction, Nasdaq acquired 100% of Nasdaq Tools' issued and outstanding stock for $7.3 million. The goodwill of $6.5 million recorded as a result of the acquisition is being amortized on a straight-line basis over five years. The Nasdaq Tools' principals, ("the sellers"), were paid $10.0 million upon closing, which is being recognized as expense on a straight-line basis over five years. In addition, the sellers were entitled to additional cash payments to be paid over the five years following closing, contingent upon their continued employment and development efforts on behalf of Nasdaq Tools. During 2001, $3.0 million was paid to the principals pursuant to this transaction. The unamortized goodwill and other intangible assets related to the acquisition of Nasdaq Tools are $4.1 million and $6.3 million, and $5.4 million and $8.3 million as of December 31, 2001 and 2000, respectively, and are included in other assets in the Consolidated Balance Sheets. Nasdaq LIFFE Markets, LLC. On June 1, 2001, Nasdaq and the London International Financial Futures and Options Exchange ("LIFFE") formed Nasdaq LIFFE Markets, LLC (formerly Nasdaq LIFFE, LLC, "Nasdaq LIFFE"), a new U.S. joint venture company to list and trade single stock futures. See Note 7 for additional information. IndigoMarkets Ltd. In May 2000, IndigoMarkets was established for the purpose of creating market systems for Nasdaq Global markets, including Nasdaq Japan. Nasdaq Global transferred an approximate 45.0% interest in IndigoMarkets to SSI Ltd., an India based software developer, in return for intellectual property rights in certain software applications. 3. Summary of Significant Accounting Policies Principles of Consolidation The consolidated financial statements include the accounts of Nasdaq and its majority and wholly-owned subsidiaries. All non-majority owned investments are accounted for under the equity method of accounting. All significant intercompany accounts and transactions have been eliminated in consolidation. The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Cash and cash equivalents include cash in banks and all non-restricted highly liquid investments purchased with a remaining maturity of three months or less at the time of purchase. Such investments included in cash and cash equivalents in the Consolidated Balance Sheets were $243.4 million and $218.5 million at December 31, 2001 and 2000, respectively. Cash equivalents are carried at cost plus accrued interest which approximates fair value. Under SFAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," management determines the appropriate classification of investments at the time of purchase. Investments for which Nasdaq does not have the intent or ability to hold to maturity are classified as "available-for-sale" and are carried at fair market value, with the unrealized gains and losses, net of tax, reported as a separate component of stockholders' equity. Investments for which Nasdaq has the intent and ability to hold to maturity are classified as "held-to-maturity" and are carried at amortized cost. The amortized cost of debt securities classified as held-to-maturity or available-for-sale is adjusted for amortization of premiums and accretion of discounts, which are included in interest income. Realized gains and losses on sales of securities are included in earnings using the specific identification method. A decline in the market value of any available-for-sale or held-to-maturity security below cost, that is deemed to be other than temporary, results in a reduction in carrying amount to fair value. The impairment is charged to earnings and a new cost basis for the security is established. Nasdaq's receivables are concentrated with NASD member firms, market data vendors and Nasdaq listed companies. Receivables are shown net of reserves for uncollectable accounts. Reserves are calculated based on the age and source of the underlying receivable and are tied to past collections experience. Total reserves netted against receivables in the Consolidated Balance Sheets were $7.4 million and $5.4 million at December 31, 2001 and 2000, respectively. Property and Equipment Property and equipment are recorded at cost less accumulated depreciation. Equipment acquired under capital leases is recorded at the lower of fair market value or the present value of future lease payments. Depreciation is provided on the straight-line method. Estimated useful lives generally range from 10 to 40 years for buildings and improvements, two to seven years for data processing equipment and software, and five to 10 years for furniture and equipment. Leasehold improvements are amortized using the straight-line method over the lesser of the useful life of the improvement or the term of the applicable lease. Depreciation expense was $82.4 million, $60.2 million and $43.2 million for the years ended December 31, 2001, 2000 and 1999, respectively. Property and equipment includes capital leases of $26.9 million and $17.3 million, and accumulated amortization of $10.5 million and $2.9 million for the years ending December 31, 2001 and 2000, respectively. Goodwill and other intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from five to 10 years. Nasdaq periodically evaluates the recoverability of intangible assets and takes into account events or circumstances that warrant revised estimates of useful lives or that indicate that an impairment exists. As of December 31, 2001 and 2000, goodwill and other intangibles were $18.4 million and $16.2 million, respectively. Goodwill amortization expense was $4.0 million and $3.1 million for the years ended December 31, 2001 and 2000, respectively. There was no goodwill in 1999. In June 2001, the Financial Accounting Standards Board issued SFAS No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"). SFAS 141 requires business combinations initiated after June 30, 2001 to be accounted for using the purchase method of accounting. It also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill. SFAS 142 requires that goodwill and certain intangibles no longer be amortized, but instead tested for impairment at least annually. SFAS 142 is required to be applied starting with fiscal years beginning after December 15, 2001. Nasdaq does not expect the adoption of SFAS 142 in fiscal 2002 to have a material impact on its consolidated financial statements. Impairment of Long-Lived Assets In the event that facts and circumstances indicate that long-lived assets or other assets may be impaired, an evaluation of recoverability would be performed. If an evaluation were required, the estimated future undiscounted cash flows associated with the asset would be compared to the asset's carrying amount to determine if a write-down is required. If a write-down were required, Nasdaq would prepare a discounted cash flow analysis to determine the amount of the write-down. Market information services revenue is based on the number of presentation devices in service and market data information quotes delivered through those devices. This revenue is recorded net of amounts due under revenue sharing arrangements with market participants. Market information services revenue is recognized in the month that information is provided. Transaction services revenue is variable, and is based on service volumes, and is recognized as transactions occur. Corporate Client Group services revenue includes annual fees, initial listing fees and listing of additional shares ("LAS") fees. Annual fees are recognized ratably over the following 12-month period. Effective January 1, 2000, initial listing and LAS fees are recognized on a straight-line basis over estimated service periods, which are six and four years, respectively. Prior to 2000, initial listing fees were recognized in the month listing occurred and LAS fees were recognized in the period the additional shares were issued. The change in accounting for these fees is more fully described in Note 4. Nasdaq accounts for stock option grants in accordance with Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," ("APB 25"). Nasdaq grants stock options with an exercise price equal to the fair market value of the stock at the date of the grant, and accordingly, recognizes no compensation expense related to such grants. Deferred revenue represents cash received and billed receivables for Corporate Client Group services, which are unearned until services are provided. Advertising Costs Nasdaq expenses advertising costs, which include media advertising and production costs, in the periods in which the costs are incurred. Media advertising and production costs included as marketing and advertising in the Consolidated Statements of Income totaled $13.8 million, $35.3 million and $45.3 million for 2001, 2000 and 1999, respectively. Significant purchased application software and operational software that is an integral part of computer hardware are capitalized and amortized on the straight-line method over their estimated useful lives, generally two to seven years. All other purchased software is charged to expense as incurred. Nasdaq adopted Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"), effective January 1, 1999. The provisions of SOP 98-1 require certain costs incurred in connection with developing or obtaining internal use software to be capitalized. Unamortized capitalized software development costs of $65.2 million and $32.9 million as of December 31, 2001 and 2000, respectively, are carried in data processing equipment and software in the consolidated balance sheets. Amortization of costs capitalized under SOP 98-1 totaled $7.0 million, $2.3 million and $0.5 million for 2001, 2000 and 1999, respectively, and are included in depreciation and amortization in the consolidated statements of income. Additions to capitalized software were $39.3 million and $34.4 million in 2001 and 2000, respectively. Nasdaq and its eligible subsidiaries file a consolidated U.S. federal income tax return and all applicable state and local returns. Nasdaq uses the asset and liability method required by SFAS No. 109, "Accounting for Income Taxes", to provide income taxes on all transactions recorded in the consolidated financial statements. Deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax basis of existing assets and liabilities (i.e., temporary differences) and are measured at the enacted rates that will be in effect when these differences are realized. If necessary, a valuation allowance is established to reduce deferred tax assets to the amount that is more likely than not to be realized. Assets and liabilities of non-U.S. subsidiaries that operate in a local currency environment are translated to U.S. dollars at exchange rates in effect at the balance sheet date. Revenue and expenses are translated at average exchange rates during the year. Translation adjustments resulting from this process are charged or credited to other comprehensive income. Foreign currency translation also includes the translation of gains and losses for non-U.S. equity method investments. Minority interests in the consolidated balance sheets represent the minority owners' share of equity as of the balance sheet date. Minority interests in the consolidated statements of income represent the minority owners' share of the income or loss of certain consolidated subsidiaries, principally Nasdaq Europe and IndigoMarkets at December 31, 2001 and Nasdaq Europe Planning at December 31, 2000. Certain amounts for the prior years have been reclassified to conform with the 2001 presentation. Nasdaq has also changed its presentation of the Consolidated Statement of Cash Flows from the direct method to the indirect method for the three years ending December 31, 2001. 4. Change in Accounting Principle On August 17, 2001, Nasdaq concluded discussions with the U.S. Securities and Exchange Commission (the "SEC"), with respect to the implementation in its financial statements of Staff Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB 101"), which became effective for SEC public reporting companies in the fourth quarter of 2000. Nasdaq became a SEC public reporting company on June 29, 2001, the effective date of its Registration Statement on Form 10, and as a result of discussions with the SEC, changed its method of accounting for revenue recognition for certain components of its Corporate Client Group services revenue. SAB 101 was adopted effective the fourth quarter of 2000, the change in accounting principle has been applied as of January 1, 2000. In accordance with applicable accounting guidance prior to SAB 101, Nasdaq recognized revenue for issuer initial listing fees and LAS fees in the month the listing occurred or in the period additional shares were issued, respectively. Nasdaq now recognizes revenue related to initial listing fees and LAS fees on a straight-line basis over estimated service periods, which are six and four years, respectively. As a result of the adoption of SAB 101, Nasdaq recognized a one-time cumulative effect of a change in accounting principle in the first quarter of 2000. This cumulative effect of a change in accounting principle decreased net income for the year ended December 31, 2000 by $101.1 million ($.90 per share) resulting in net income of $23.3 million ($.21 per share). The adjustment to December 31, 2000 net income for the cumulative change to prior years' results consists of the following: Deferred initial listing fees $ 108,476 Deferred LAS fees 60,570 Total deferred fees 169,046 Deferred income tax benefit (67,956 ) Cumulative effect of change in accounting principle $ 101,090 As a result of the change in accounting principle, for the year ended December 31, 2000, revenue decreased $35.5 million and pro forma net income, excluding the cumulative change in accounting principle, decreased $20.8 million ($.19 per share). For the years ended December 31, 2001 and 2000, Nasdaq recognized $44.9 million and $55.7 million in revenue, respectively, that was included in the cumulative effect adjustment as of January 1, 2000. This revenue contributed $27.3 million (after income taxes of $17.6 million), and $33.3 million (after income taxes of $22.4 million) to net income for the years ended December 31, 2001 and 2000, respectively. Nasdaq's deferred revenue as of December 31, 2001 relating to Corporate Client Group services revenues will be recognized in the following years: and Other 2002 $ 31,839 $ 33,527 $ — $ 65,366 2003 27,199 26,629 — 53,828 2005 16,168 6,191 — 22,359 2006 and thereafter 6,950 — — 6,950 $ 104,629 $ 82,424 $ — $ 187,053 Nasdaq's deferred revenue for the year ended December 31, 2001 and 2000 is reflected in the following tables. The additions reflect Corporate Client Group services revenue charged during the year while the amortization reflects Corporate Client Group services revenue recognized during the year based on SAB 101. Balance at January 1, 2001 $ 127,693 $ 76,651 $ — $ 204,344 Additions 12,602 41,637 84,594 138,833 Amortization (35,666 ) (35,864 ) (84,594 ) (156,124 ) Balance at December 31, 2001 $ 104,629 $ 82,424 $ — $ 187,053 5. Disaster Related Expenses As a result of the attacks on September 11, 2001, Nasdaq's executive offices in New York City were closed for the remainder of 2001 and its New York-based employees were relocated. Also, as a result of the attacks, Nasdaq decided to relocate its New York City headquarters from One Liberty Plaza, which was adjacent to the site where the World Trade Center Towers stood, to a location closer to its Times Square MarketSite building. Employees returned to One Liberty Plaza on a temporary basis in the first quarter of 2002, and are expected to relocate to midtown New York City by early 2003. As of December 31, 2001, Nasdaq is obligated under the terms of its One Liberty Plaza lease to pay $106.9 million over the remaining life of the lease. As of December 31, 2001, Nasdaq has recorded an estimated loss on the sublease of One Liberty Plaza for $21.5 million which is included in disaster related expenses on the Consolidated Statement of Income. The estimated loss was calculated assuming relocation as of January 2003. Additionally, the loss was calculated using an 8% net discount rate and an estimated 21 year sublease term commencing June 2003 at estimated market rates. In addition, it has been necessary for Nasdaq to make certain non-budgeted expenditures relating to September 11th, including, but not limited to, costs related to the efforts to restore services to market participants, the testing of trading systems, and required reconfiguring of technology, telecommunications and alternative office facilities due to the temporary relocation of employees. These other third and fourth quarter expenses of $1.7 million are also included in disaster related expenses on the Consolidated Statement of Income. Additional expenses and recoveries will be recorded in future periods. 6. Investments Investments consist of U.S. Treasury securities, obligations of U.S. Government sponsored enterprises, municipal bonds, equity securities, and other financial instruments. Following is a summary of investments classified as available-for-sale that are carried at fair value as of December 31, 2001: Available-for-Sale Securities Gross Unrealized Gains Gross Unrealized Losses Estimated Fair Value U.S. Treasury securities and obligations of U.S. government agencies $ 156,197 $ 1,749 $ 207 $ 157,739 Obligations of states and political subdivisions 45,670 817 61 46,426 Asset-backed securities 1,042 33 — 1,075 U.S. corporate securities 5,537 92 90 5,539 Other debt securities — — — — Total debt securities 208,446 2,691 358 210,779 Equity securities 17,373 1,595 1,718 17,250 Total $ 225,819 $ 4,286 $ 2,076 $ 228,029 At December 31, 2001, all held-to-maturity investments were U.S. Treasury securities and obligations of U.S. government agencies. The cost of the securities were $28.6 million and had gross unrealized capital gains and losses of $570 thousand and $31 thousand, respectively and a total estimated fair value of $29.1 million at December 31, 2001. Following is a summary of investments classified as available-for-sale which are carried at fair value as of December 31, 2000: U.S. Treasury securities and obligations of U.S. government agencies $ 109,350 $ 542 $ 59 $ 109,833 Obligations of states and political subdivisions 43,664 55 954 42,765 Asset-backed securities 52,846 202 513 52,535 Other debt securities 649 9 — 658 Total debt securities 212,527 869 1,616 211,780 At December 31, 2000, all held-to-maturity investments were U.S. Treasury securities and obligations of U.S. government agencies. The cost of the securities were $28.6 million and had gross unrealized capital gains and losses of $45 thousand and $32 thousand, respectively, and a total estimated fair value of $28.6 million at December 31, 2000. The cost and estimated fair value of debt and marketable equity securities classified as available-for-sale that are carried at fair value at December 31, 2001, by contractual maturity, are shown below. Gross Unrealized Due in one year or less $ 99,626 $ 657 $ 110 $ 100,173 Due after one through five years 60,682 1,200 2 61,880 Due after five through 10 years 28,629 420 133 28,916 Due after 10 years 19,509 414 113 19,810 $ 225,819 $ 4,286 $ 2,076 $ 228,029 All investments classified as held-to-maturity are carried at amortized cost as of December 31, 2001, and mature between 2003 and 2007. During the years ended December 31, 2001 and 2000, debt and marketable equity available-for-sale securities with a fair value at the date of sale of $369.6 million and $72.7 million, respectively, were sold. The gross realized gains on such sales totaled $1.8 million and $2.8 million, respectively, and the gross realized losses totaled $4.2 million and $1.0 million, respectively. The net adjustment to unrealized holding gains (losses) on available-for-sale securities included as a separate component of stockholders' equity totaled ($1.2) million and ($0.2) million, for 2001 and 2000, respectively. The net adjustment to unrealized gains (losses) on available-for-sale securities included as a separate component of stockholders' equity due to the sale of securities totaled $2.1 million and ($1.2) million, for 2001 and 2000, respectively. At December 31, 2001 and 2000, investments with a carrying value of approximately $28.6 million and $28.0 million were pledged as collateral for Nasdaq's $25.0 million note payable. See Note 9 for further information. In connection with the OptiMark, Inc. ("OptiMark") partnership, OptiMark issued warrants to Nasdaq to purchase up to an aggregate of 11.25 million shares of its common stock, $.01 par value per share, which expire in 2004. The warrants are exercisable in several tranches upon the achievement of certain milestones, which are based primarily upon the average daily share volume of Nasdaq-listed securities traded through the OptiMark Trading System. In September 2000, OptiMark announced a strategic change in its business that will allow it to focus on providing technology solutions to electronic marketplaces. As part of the change, OptiMark decided to suspend trading operations on the OptiMark Trading System. As a result, Nasdaq management concluded that its investment in warrants in OptiMark as well as the realization of the deferred revenue related to these warrants was impaired and reduced its investment in warrants and related deferred revenue to zero. As of December 31, 2001, Nasdaq still considered the investment in warrants and the related deferred revenue impaired. 7. Joint Ventures and Equity Method Investments Nasdaq LIFFE Markets, LLC On June 1, 2001, Nasdaq and LIFFE formed Nasdaq LIFFE, a new U.S. joint venture company to list and trade single stock futures. The products of this joint venture are expected to be traded through a modified version of the LIFFE CONNECT™ electronic system. Nasdaq has committed up to $25.0 million plus the rights to use certain of its trademarks in this venture. Nasdaq contributed $2.0 million during 2001. On August 21, 2001, the Commodity Futures Trading Commission approved Nasdaq LIFFE as a futures market and self-regulatory organization. Nasdaq accounts for its investment in Nasdaq LIFFE under the equity method of accounting. In 2001, Nasdaq recorded losses of approximately $6.0 million representing its share of the losses incurred by Nasdaq LIFFE. Nasdaq Japan In 1999, the NASD contributed approximately $2.6 million for its initial 50.0% interest in Nasdaq Japan. After granting a restricted stock award of 4.0% of its shares, the NASD transferred its remaining 46.0% interest to Nasdaq Global. In October 2000, Nasdaq Japan sold an approximate 15.0% stake for approximately $48.0 million to a group of 13 major Japanese, U.S. and European brokerages, thereby reducing Nasdaq Global's interest from 46.0% to approximately 39.2%. As a result of the private placement, Nasdaq increased the carrying value of its investment by approximately $7.8 million, recorded through stockholders' equity, to reflect its adjusted share of the book value of Nasdaq Japan. In 2001, Nasdaq invested an additional $7.4 million in Nasdaq Japan, increasing its ownership to 39.7%. Nasdaq accounts for its investment in Nasdaq Japan under the equity method of accounting, and recorded losses of $11.3 million representing its share of the losses incurred by Nasdaq Japan in 2001. Nasdaq has committed up to $13.0 million in Nasdaq Japan. A condensed summary of combined assets and liabilities and results of operations for Nasdaq LIFFE and Nasdaq Japan for 2001 and Nasdaq Japan for 2000 follows: Condensed income statement information: Revenue $ 1,971 $ 1,144 Expenses 48,464 32,441 Loss from operations (46,493 ) (31,297 ) Net loss (47,300 ) (31,962 ) Condensed balance sheet information: Current assets $ 20,155 $ 29,095 Non-current assets 20,025 7,922 Current liabilities 14,312 9,518 Non-current liabilities 16,352 2,692 8. Fair Value of Financial Instruments Nasdaq considers cash and cash equivalents, receivables, receivables from related parties, investments, accounts payable and accrued expenses, accrued personnel costs, due to banks, and senior notes and subordinated notes to be its financial instruments. The carrying amounts reported in the consolidated balance sheets for cash and cash equivalents, receivables, receivables from related parties, investments, accounts payable and accrued expenses, accrued personnel costs, and due to banks closely approximates their fair values due to the short-term nature of these assets and liabilities. The approximate fair value of Nasdaq's senior notes, subordinated notes and obligations under capital leases was estimated using discounted cash flow analysis based on Nasdaq's assumed incremental borrowing rates for similar types of borrowing arrangements. This analysis indicates that the fair value of these obligations at December 31, 2001 and 2000 approximates their carrying amounts. 9. Senior Notes In May 1997, Nasdaq entered into a $25.0 million note payable with a financial institution (the "Lender"). Principal payments are scheduled to begin in 2007 and continue in equal monthly installments until maturity in 2012. The note requires monthly interest payments through May 2007 at an annual rate of 7.41%. After May 2007, Nasdaq will incur interest equal to the Lender's cost of funds rate, as defined in the agreement, plus 0.5%. Interest expensed and paid under the agreement totaled approximately $1.9 million for each of the years ended December 31, 2001, 2000 and 1999. Nasdaq Europe has $23.5 million of notes payable outstanding as of December 31, 2001. These notes are denominated in Euros, and mature in 2003, 2004 and within five days of default of any loan covenant. Nasdaq Europe incurs interest expense at a rate of 6% on approximately $3.7 million of the notes, and London Inter-Bank Offered Rate plus 1% on the remaining $19.8 million of the notes. Interest expensed and accrued totaled approximately $0.8 million for the year ended December 31, 2001. 10. Subordinated Notes On May 3, 2001, Nasdaq sold the Subordinated Notes to Hellman & Friedman. Until Nasdaq becomes registered with the SEC as a national securities exchange ("Exchange Registration"), Hellman & Friedman may only exercise its conversion rights for a number of shares of Common Stock such that immediately following such conversion, the NASD will continue to control greater than 50% of the combined voting power of Nasdaq. Nasdaq used the proceeds from the sale of the Subordinated Notes to purchase 18,461,538 shares of Common Stock from the NASD for $13.00 per share. The annual 4.0% coupon will be payable in arrears and the Subordinated Notes are convertible at any time into an aggregate of 12.0 million shares of Common Stock at $20.00 per share, subject to adjustment, in general, for any stock split, dividend, combination, recapitalization or other similar event. Holders of the Subordinated Notes currently have no voting rights. However, Nasdaq has agreed to use its best efforts to seek stockholder approval of an amendment to Nasdaq's Restated Certificate of Incorporation (the "Certificate of Incorporation") that would provide for voting debt in order to permit the holders of the Subordinated Notes to vote on an as-converted basis on all matters on which holders of common stock have the right to vote, subject to the current 5.0% voting limitation in the Certificate of Incorporation. In addition, the SEC has approved this proposed charter amendment. Nasdaq has granted Hellman & Friedman certain registration rights with respect to the shares of Common Stock underlying the Subordinated Notes. On an as-converted basis, Hellman & Friedman owned an approximate 9.7% equity interest as a result of these Subordinated Notes in Nasdaq as of December 31, 2001. Hellman & Friedman is permitted to designate one person reasonably acceptable to Nasdaq for nomination as a director of Nasdaq for so long as Hellman & Friedman owns Subordinated Notes and/or shares of Common Stock issued upon conversion thereof representing at least 50.0% of the shares of Common Stock issuable upon conversion of the Subordinated Notes initially purchased. F. Warren Hellman, chairman of Hellman & Friedman, was elected as a director of Nasdaq pursuant to this agreement. The income tax provision includes the following amounts: Current income taxes: Federal $ 50,625 $ 75,446 $ 46,482 State 10,885 14,138 11,599 Total current income taxes 61,510 89,584 58,081 Deferred income taxes: Federal (22,078 ) (53,717 ) 273 State (1,100 ) (13,346 ) 67 Total deferred income taxes (23,178 ) (67,063 ) 340 Less deferred tax benefit attributable to cumulative effect of change in accounting principle Total provision for income taxes $ 38,332 $ 90,477 $ 58,421 Income taxes paid during the year $ 26,844 $ 101,171 $ 49,992 Reconciliation of the statutory U.S. federal income tax rates to the effective tax rates are as follows: Federal 35.0 % 35.0 % 35.0 % State 6.2 3.6 5.2 Foreign losses without U.S. benefit 15.9 2.9 — Tax preferred investments (6.9 ) — — Tax credit (2.3 ) — — State temporary differences at a lower rate 1.9 — — Other (1.2 ) 0.6 0.2 Effective rate 48.6 % 42.1 % 40.4 % Components of Nasdaq's deferred tax assets and liabilities consisted of the following: Deferred tax assets: Deferred fees $ 78,328 $ 82,600 Foreign net operating losses 31,318 5,043 Technology costs 11,765 1,499 Expense accruals 8,242 — Lease reserve 7,691 — Deferred capital loss carryforward 6,078 6,078 Bad debts 5,903 5,139 Compensation and benefits 5,133 1,592 Joint ventures 4,754 — Other 4,341 2,794 Gross deferred tax assets $ 163,553 $ 104,745 Deferred tax liabilities: Software development costs $ (29,025 ) $ (19,624 ) Other (2,308 ) — Gross deferred tax liabilities $ (41,981 ) $ (32,116 ) Valuation allowance $ (37,396 ) $ (11,121 ) Net deferred tax asset $ 84,176 $ 61,508 Nasdaq has a deferred tax asset related to a deferred capital loss carryforward of $6.1 million at December 31, 2001 and 2000. Since it is uncertain whether such loss will be realized, a valuation allowance for the full amount of this deferred tax asset has been recorded. Nasdaq has foreign deferred tax assets of $31.3 million and $5.0 million, as of December 31, 2001 and 2000, respectively. The foreign deferred tax assets are composed of net operating losses, of which $3.6 million expire in 2007, $4.1 million expire in 2008 and $23.6 million have no expiration date. The foreign deferred tax assets have been fully reserved by an offsetting valuation allowance as it is not "more likely than not" that these deferred tax assets will be realized. The following represents the domestic and foreign components of income (loss) before income tax expense: Domestic $ 114,640 $ 233,647 $ 144,527 Foreign (35,845 ) (18,774 ) 43 Income before income tax expense $ 78,795 $ 214,873 $ 144,570 12. Employee Benefits Nasdaq is a participating employer in a noncontributory, defined-benefit pension plan that the NASD sponsors for the benefit of its eligible employees and the eligible employees of its subsidiaries. The benefits are primarily based on years of service and the employees' average salary during the highest 60 consecutive months of employment. The plan assets consist primarily of fixed income and equity securities. In addition, Nasdaq participates in a Supplemental Executive Retirement Plan ("SERP") that is maintained by the NASD for certain highly compensated employees. The following table sets forth the combined plans' funded status and amounts recognized as of December 31: Change in benefit obligation Benefit obligation at beginning of year $ 53,667 $ 39,773 Net employee transfers into plan 147 — Service cost 7,032 4,543 Interest cost 4,519 3,246 Actuarial losses 5,384 5,488 Benefits paid (4,860 ) (1,988 ) Plan amendments 1,127 — Curtailments (1,301 ) — Special benefits 760 — Loss due to change in discount rate 1,907 2,605 Benefit obligation at end of year 68,382 53,667 Change in plan assets Fair value of plan assets at beginning of year 31,464 28,312 Net employee transfers into plan 8,419 — Actual return on plan assets 848 2,058 Company contributions 3,321 3,082 Fair value of plan assets at end of year 39,192 31,464 Underfunded status of the plan (29,190 ) (22,203 ) Unrecognized net actuarial gain 7,305 8,393 Unrecognized prior service cost 1,585 906 Unrecognized transition asset (337 ) (390 ) Accrued benefit cost $ (20,637 ) $ (13,294 ) Weighted-average assumptions as of December 31: Discount rate 7.3 % 7.5 % Expected return on plan assets 9.0 9.0 Rate of compensation increase 5.5 5.2 Components of net periodic benefit cost Service cost $ 7,032 $ 4,543 $ 3,304 Interest cost 4,519 3,246 2,448 Expected return on plan assets (3,311 ) (2,533 ) (2,261 ) Amortization of unrecognized transition asset (58 ) (57 ) (57 ) Recognized net actuarial loss 160 145 101 Prior service cost recognized 465 131 133 Special benefits 760 — — Curtailment/settlement loss recognized — 1,296 — Benefit cost $ 9,567 $ 6,771 $ 3,668 As of December 31, 2001 and 2000, $4.3 million and $2.4 million, respectively, of the accrued pension liability is carried as current in the accounts payable and accrued expenses line of the Consolidated Balance Sheets. During 2001, there was a curtailment gain recognized of $1.3 million in the pension plan to reflect the reduction in force on June 26, 2001. Pursuant to the provisions of SFAS No. 87 "Employer's Accounting for Pensions," related to the SERP, an intangible asset of $1.0 million and an adjustment to stockholders' equity of $1.4 million (net of tax of $0.9 million), were recorded as of December 31, 2001 to recognize the minimum pension liability. Nasdaq also participates in a voluntary savings plan for eligible employees of the NASD and its subsidiaries. Employees are immediately eligible to make contributions to the plan and are also eligible for an employer contribution match at an amount equal to 100% of the first 4% of eligible employee contributions. Eligible plan participants may also receive an additional discretionary match from Nasdaq. Savings plan expense for the years ended December 31, 2001, 2000 and 1999, was $5.9 million, $3.7 million and $2.9 million, respectively. The expense includes a discretionary match authorized by the Nasdaq Board of Directors totaling $0.75 million for the year ended December 31, 2001, $1.3 million for the year ended December 31, 2000, and $1.9 million for the year ended December 31, 1999. 13. Stock Compensation and Stock Awards Effective December 5, 2000, as amended on February 14, 2001, Nasdaq adopted The Nasdaq Stock Market, Inc. Equity Incentive Plan (the "Plan"), under which nonqualified and qualified incentive stock options, restricted stock, restricted stock units, or other stock based awards may be granted to employees, directors, officers and consultants. A total of 20,000,000 shares are authorized under the Plan. At December 31, 2001, 9,779,863 were available for future grants under the Plan. In 2001, Nasdaq granted 10,795,223 stock options and 630,550 shares of restricted stock to employees and officers pursuant to the Plan. During 2001, 1,169,636 stock options and 36,000 shares of restricted stock awards were forfeited. Restricted stock awards are awarded in the name of the employee or officer at fair value on the date of the grant. The awards contain restrictions on sales and transfers, are subject to a five-year vesting period, and are expensed over the vesting period. Nasdaq recognized $4.1 million in amortization expense related to restricted stock during the year ended December 31, 2001. Stock options are granted with an exercise price equal to the estimated fair market value of the stock on the date of the grant. Nasdaq accounts for stock option grants in accordance with APB 25, and, accordingly, recognizes no compensation expense related to such grants. Options granted generally vest over three years and expire 10 years from the date of grant. All options to date have been granted at fair market value on the date of grant. At December 31, 2001, options for 3,597,430 shares were vested, and exercisable with a weighted-average exercise price of $12.73. Stock option activity during the year ended December 31, 2001 is set forth below: Price per Share Balance, January 1, 2001 — — — Granted 10,795,223 $ 10.25 - $13.00 $ 12.73 Exercised — — — Forfeited 1,169,636 $ 10.25 - $13.00 $ 12.98 Balance, December 31, 2001 9,625,587 $ 10.25 - $13.00 $ 12.70 Pro forma information regarding net income and earnings per share is required under SFAS No. 123, "Accounting for Stock-Based Compensation" and has been determined as if Nasdaq had accounted for all stock option grants based on the fair value method. The fair value of each stock option grant was estimated at the date of grant using the Black-Scholes valuation model assuming a weighted-average expected life of five years, weighted-average expected volatility of 30% and a weighted-average risk free interest rate of 4.68%. The weighted-average fair value of options granted in 2001 was $4.55. For purposes of the pro forma information, the fair value of stock option grants are amortized over the vesting period. The pro forma information for the year ended December 31, 2001 is as follows: Net income $ 40,463 $ 25,476 Nasdaq has an employee stock purchase plan for all eligible employees. Under the plan, shares of Common Stock may be purchased at six-month intervals (each, an "Offering Period") at 85% of the lower of the fair market value on the first or the last day of each Offering Period. Employees may purchase shares having a value not exceeding 10% of their annual compensation, subject to applicable annual Internal Revenue Service limitations. During 2001, employees purchased an aggregate of 326,580 shares at an average price of $10.63 per share. In May and July 2000, restricted Common Stock and options on Common Stock of Nasdaq Japan were awarded to certain Nasdaq officers and key employees who devote substantial time to the operations of Nasdaq Japan. These awards contain restrictions and are subject to vesting provisions, generally three years. The options were granted at an exercise price of $125 per share, the estimated fair market value of the common stock at the time of the award. The options are exercisable for a period of seven years. As of December 31, 2001 there were 784 stock options outstanding to purchase shares of Nasdaq Japan held by Nasdaq Global, 261 of them exercisable with an approximate value of $6,175 per share. The restricted common stock award was for 1,900 shares at the estimated fair value of $125 per share. Approximately one-third of the shares vested immediately while the remaining two-thirds vest over a two-year period. As of December 31, 2001, the restricted common stock had an approximate value of $6,250 per share. All share and dollar amounts reflect a four-for-one stock split of Nasdaq Japan shares in April 2001. The options and restricted common stock awards are marked to market, and the fair value is being expensed over the vesting periods. Nasdaq recorded approximately $2.8 million and $3.8 million in compensation expense related to these awards in 2001 and 2000, respectively. 14. Leases Nasdaq leases certain office space and equipment in connection with its operations. The majority of these leases contain escalation clauses based on increases in property taxes and building operating costs. Certain of these leases also contain renewal options. Rent expense for operating leases was $11.0 million, $9.9 million and $4.0 million for the years ended December 31, 2001, 2000 and 1999, respectively. See Note 5 for additional information. Future minimum lease payments under noncancelable operating leases with initial or remaining terms of one year or more, (including the sublease obligation at One Liberty Plaza of $106.9 million, see Note 5) consisted of the following at December 31, 2001: Year ending December 31: 2002 $ 14,913 Remaining years 127,676 Total minimum lease payments $ 203,132 Future minimum lease payments under noncancelable capital leases with initial or remaining terms of one year or more consisted of the following at December 31, 2001: 2002 $ 6,129 Total minimum lease payments $ 19,339 Imputed interest (2,760 ) Present value of net minimum payments $ 16,579 15. Accumulated Other Comprehensive Income Comprehensive income is composed of net income and other comprehensive income, which includes the after-tax change in unrealized gains and losses on available-for-sale securities, foreign currency translation adjustments, and a minimum pension liability adjustment. The following table outlines the components of other comprehensive income: Unrealized Gains (Losses)(a) Adjustments(b) Minimum Pension Liability(c) Balance, January 1, 1999 $ 2,020 $ — $ — $ 2,020 Net change (278 ) — — (278 ) Balance, December 31, 1999 1,742 — — 1,742 Net change (1,421 ) (2,213 ) — (3,634 ) Balance, December 31, 2000 321 (2,213 ) — (1,892 ) Net change 918 (4,607 ) (1,395 ) (5,084 ) Balance, December 31, 2001 $ 1,239 $ (6,820 ) $ (1,395 ) $ (6,976 ) Primarily represents the after-tax difference between the fair value and cost of the available-for-sale securities portfolio. Includes after-tax gains and losses on foreign currency translation from operations for which the functional currency is other than the U.S. dollar. Represents the after-tax adjustment to record the minimum pension liability for the SERP. 16. Commitments and Contingencies In November 1997, Nasdaq entered into a $600.0 million six-year agreement with WorldCom to replace the existing data network that connects the Nasdaq market facilities to market participants. As part of the agreement, Nasdaq gave an $8.0 million deposit to WorldCom in order to guarantee certain usage levels. Nasdaq guaranteed WorldCom that the market participants would generate a minimum of $300.0 million in usage under the contract. Under the contract, the deposit is refundable if certain higher service usage is achieved. Nasdaq expects to generate the minimum guaranteed level of service usage under the contract. However, Nasdaq is renegotiating the contract with WorldCom, and as part of that negotiation, believes that it is unlikely that the deposit will be returned. As of December 31, 2001, the deposit of $8.0 million has been fully reserved. In October 2000, Nasdaq entered into a contract with OptiMark under which OptiMark was engaged to provide software development services in connection with the development of the SuperMontage system. Nasdaq agreed to pay OptiMark for the services over a period not to exceed 12 months. In addition, OptiMark was entitled to receive incentive payments if it met certain delivery milestones agreed to in the contract. Nasdaq paid OptiMark $12.3 million under this contract, which expired in December 2001. Nasdaq has agreed to fund a portion of the necessary expenses related to the separation of software, hardware and data under a plan to transition technology applications and support from Nasdaq to Amex. The NASD originally integrated certain Nasdaq and Amex technology subsequent to the 1998 acquisition of Amex by the NASD. The total estimated cost of the separation has been established at a maximum of $29.0 million, and is to be shared evenly between Nasdaq and the NASD. In 2001, Nasdaq accrued $9.2 million under this commitment and expects to fund this commitment up to $14.5 million in the future. Nasdaq has a loan commitment to Nasdaq Japan for $5.0 million, of which $2.8 million was loaned in 2001, and the remainder is expected to be loaned in 2002. Nasdaq has made $2.0 million of capital contributions to Nasdaq LIFFE Joint venture in 2001. Other contributions are expected in 2002, up to the approved $25.0 million. In March 2000, Nasdaq entered into an agreement with Primex Trading N.A., LLC ("Primex") in which the Primex Auction System™ would be operated as a facility of The Nasdaq Stock Market® for the trading of Nasdaq and exchange-listed securities. Under the agreement, Nasdaq is required to pay Primex a monthly licensing fee as well as a transaction fee for each trade executed in the Primex Auction System™ which will commence in 2002. Nasdaq may be subject to claims arising out of the conduct of its business. Currently, there are certain legal proceedings pending against Nasdaq. Management believes, based upon the opinion of counsel, that any liabilities or settlements arising from these proceedings will not have a material adverse effect on the financial position or results of operations of Nasdaq. Management is not aware of any unasserted claims or assessments that would have a material adverse effect on the financial position and the results of operations of Nasdaq. 17. Related Party Transactions Related party receivables and payables are the result of various transactions between Nasdaq and its affiliates. Payables to related parties are comprised primarily of the regulation charge from NASDR, a wholly-owned subsidiary of the NASD. NASDR charges Nasdaq for costs incurred related to Nasdaq market regulation and enforcement. Support charges from the NASD to Nasdaq represent another significant component of payables to related parties. The support charges include an allocation of a portion of the NASD's administrative expenses as well as its costs incurred to develop and maintain technology on behalf of Nasdaq. The remaining component of payables to related parties is cash disbursements funded by the NASD on behalf of Nasdaq. Receivables from related parties are primarily attributable to costs incurred by Amex and funded by Nasdaq related to various Amex technology projects. The remaining portion of the receivable from related parties balance is related to cash disbursements funded by Nasdaq on behalf of its affiliates. Disbursements made by Nasdaq on behalf of affiliates relate mainly to office supply and utility charges where Nasdaq represents the largest portion. Surveillance Charge from NASDR NASDR incurs costs associated with surveillance monitoring, legal and enforcement activities related to the regulation of The Nasdaq Stock Market. These costs are charged to Nasdaq based upon the NASD management's estimated percentage of costs incurred by each NASDR department that are attributable directly to The Nasdaq Stock Market surveillance. The following table represents Nasdaq management's estimate of the composition of costs charged by NASDR to Nasdaq: Compensation $ 32,912 $ 32,018 $ 32,529 Occupancy 651 399 1,687 Publications, supplies and postage 2,857 2,924 1,661 Computer operations and data communication 4,755 5,010 3,430 Depreciation 10,868 8,435 3,831 Travel, meetings and training 2,811 2,848 1,841 Other 810 1,106 150 Total $ 83,822 $ 79,850 $ 65,129 On June 28, 2000, Nasdaq entered into a Regulatory Services Agreement with NASDR (the "Regulatory Services Agreement"). Under the terms of this agreement, NASDR or its subsidiaries will provide Nasdaq and its subsidaries regulatory services and related administrative functions necessary for NASDR's performance of such services commencing upon effectiveness of Exchange Registration. The services will be of the same type and scope as are currently provided by NASDR to Nasdaq under the Delegation Plan. Prior to the effectiveness of Exchange Registration, NASDR's fees charged to Nasdaq are on a cost basis. Once Exchange Registration is effective, fees will be determined on a "cost-plus" basis for each service. Support Charge from the NASD The NASD provides various administrative services to Nasdaq including legal assistance, accounting and managerial services. It is the NASD's policy to charge these expenses and other operating costs to Nasdaq based upon usage percentages determined by management of the NASD and Nasdaq. Additionally, the NASD incurs certain costs related to the development and maintenance of technology for Nasdaq. Technology development costs are allocated directly to Nasdaq based upon specific projects requested by Nasdaq. Technology maintenance costs are allocated based upon Nasdaq's share of computer usage. The following table represents Nasdaq management's estimate of the composition of costs charged by the NASD to Nasdaq: Professional and contract services 4,585 9,986 16,671 Occupancy 4,992 9,576 4,637 Computer operations and data communications 191 1,500 5,243 Depreciation 2,483 2,894 6,514 Travel, meetings and training 573 1,504 2,020 Other 1,528 701 759 On June 28, 2000, Nasdaq entered into an interim Separation and Common Services Agreement with the NASD. Under the terms of this agreement, the NASD provides Nasdaq the same administrative, corporate and infrastructure services it has historically provided. The rates and methodology to be used in determining the cost of such services are consistent with past practices. Nasdaq and the NASD are in the process of negotiating a new Separation and Common Services Agreement, which will provide for the NASD's continued support in the same areas. Nasdaq intends to develop its internal capabilities in the future in order to reduce its reliance on the NASD for such services. Nasdaq Charge to Amex Nasdaq incurs technology costs on behalf of Amex related to development of new Amex systems and enhancement of existing Amex systems. Amounts are charged based upon specific projects requested by Amex. Amounts charged from Nasdaq to Amex are included in support costs from related parties and are summarized as follows: Compensation $ 605 $ 345 $ 600 Professional and contract services 13,195 4,389 13,090 Publications, supplies and postage 19 11 19 Other 329 187 326 Total $ 14,148 $ 4,932 $ 14,035 Nasdaq has agreed to fund a portion of the necessary expenses related to the separation of software, hardware and data under a plan to transition technology applications and support from Nasdaq to Amex. The NASD originally integrated Nasdaq and Amex technology subsequent to the 1998 acquisition of Amex by the NASD. In the opinion of management, all methods of cost allocation described above are reasonable for the services rendered. See Note 16 for further information. 18. Capital Stock At December 31, 2001, 300,000,000 shares of Nasdaq's Common Stock were authorized, 130,161,823 shares were issued, and 111,700,285 shares were outstanding. Each share of Common Stock has one vote, except that any person, other than the NASD or any other person as may be approved for such exemption by the Nasdaq Board of Directors prior to the time such person owns more than 5% of the then-outstanding shares of Common Stock, who would otherwise be entitled to exercise voting rights in respect of more than 5% of the then-outstanding shares of Common Stock will be unable to exercise voting rights for any shares in excess of 5% of the then-outstanding shares of Common Stock. In connection with the Restructuring, the NASD sold approximately 10,806,494 warrants to purchase up to an aggregate of 43,225,976 outstanding shares of Common Stock owned by the NASD. The voting rights associated with the shares of Common Stock underlying the warrants, as well as the shares of Common Stock purchased through the valid exercise of warrants, are governed by the voting trust agreement (the "Voting Trust Agreement") entered into by the NASD, Nasdaq and The Bank of New York, as voting trustee (the "Voting Trustee"). Initially, the holders of the warrants (each, a "Warrant Holder" and, collectively, the "Warrant Holders") will not have any voting rights with respect to the shares of Common Stock underlying such warrants. Until Exchange Registration the shares of Common Stock underlying unexercised and unexpired warrant tranches, as well as the shares of Common Stock purchased through the exercise of warrants, will be voted by the Voting Trustee at the direction of the NASD. The voting rights associated with the shares of Common Stock underlying unexercised and expired warrant tranches will revert to the NASD. However, the NASD has determined, commencing upon Exchange Registration, to vote any shares of Common Stock that it owns (other than shares underlying then outstanding warrants) in the same proportion as the other stockholders of Nasdaq. Upon Exchange Registration, the Warrant Holders will have the right to direct the Voting Trustee as to the voting of the shares of Common Stock underlying unexercised and unexpired warrant tranches until the earlier of the exercise or the expiration of such warrant tranches. The shares of Common Stock purchased upon a valid exercise of a warrant tranche prior to Exchange Registration will be released from the Voting Trust Agreement upon Exchange Registration. The shares of Common Stock purchased upon a valid exercise of a warrant tranche after Exchange Registration will not be subject to the Voting Trust Agreement. In connection with the repurchase of ownership interest of a shareholder in Nasdaq Europe Planning, Nasdaq issued a warrant to purchase up to an aggregate of 479,648 shares of Common Stock. The warrant is exercisable in four annual tranches ranging from $13.00 to $16.00 per share. The issuance of the warrants has been recorded at fair value in stockholders' equity. On November 12, 2001, Nasdaq sold an aggregate amount of 535,000 shares of Common Stock to five members of the Nasdaq Board of Directors and 500,000 shares of Common Stock to Hellman & Friedman for an aggregate offering price of $10,608,750. The shares were sold in a private transaction at the current fair market value, pursuant to section 4(2) of the Securities Act. As of December 31, 2001, there were 30,000,000 shares of preferred stock authorized, and none issued and outstanding. On March 8, 2002, Nasdaq issued 1,338,402 shares of Nasdaq's Series A Cumulative Preferred Stock and one share of Nasdaq's Series B Preferred Stock. See Note 20 for additional information. In December 2001, the Board adopted a revised Non-Employee Directors Compensation Policy whereby beginning in 2002 all non-employee directors will be awarded 5,000 stock options per year with an exercise price at fair market value, which may be exercised for up to 10 years while serving on the Board of Directors (in general, three years from termination of service on the Board of Directors). Earnings per common share is computed in accordance with SFAS No. 128, "Earnings Per Share" ("SFAS 128"). Basic earnings per share excludes the dilutive effects of options and convertible securities, and is calculated by dividing net income available to common stock holders by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects all potentially dilutive securities. The following table sets forth the computation of basic earnings per share. ($ in thousands, except share amounts) Numerator Net income applicable to common shares for basic and diluted earnings per share $ 40,463 $ 23,306 $ 86,149 Weighted-average common shares for basic earnings per share 116,458,902 112,090,493 100,000,000 Weighted-average effect of dilutive securities: Employee stock options and awards 280,789 — — Convertible Subordinated Notes — — — Weighted-average common and common equivalent shares for diluted earnings per share 116,739,691 112,090,493 100,000,000 Options to purchase 8,569,258 shares of Common Stock, 12,000,000 shares underlying Subordinated Notes and 479,648 shares underlying warrants were outstanding during 2001, but were not included in the computation of earnings per share as their inclusion would be antidilutive. During 2000 and 1999, there were no potentialy dilutive common shares outstanding. 20. Subsequent Events On March 8, 2002, Nasdaq completed a two-stage repurchase of 33,768,895 shares of Common Stock owned by the NASD, which represented all of the remaining outstanding shares of Common Stock owned by the NASD, except for the 43,225,976 shares of Common Stock underlying the warrants issued by the NASD in Phase I and II. Nasdaq purchased the Common Stock for $305,155,435 in aggregate cash consideration, 1,338,402 shares of Nasdaq's Series A Cumulative Preferred Stock (face and liquidation value of $100 per share, plus any accumulated unpaid dividends), and one share of Nasdaq's Series B Preferred Stock, (face and liquidation value of $1.00 per share). The NASD owns all of the outstanding shares of Series A and Series B Preferred Stock. All of the shares of Common Stock repurchased by Nasdaq from the NASD are no longer outstanding. The Series A Preferred Stock carries a 7.6% dividend rate payable at the discretion of Nasdaq's Board of Directors. Dividends do not begin accruing until March 2003. Shares of Series A Preferred Stock do not have voting rights, except for the right as a class to elect two new directors to the Board of Directors anytime distributions on the Series A Preferred Stock are in arrears for four consecutive quarter and as otherwise required by Delaware law. The Series B Preferred Stock does not pay dividends. Series B Preferred Stock will be entitled to cast the number of votes that, together with all other votes that the NASD is entitled to vote by virtue of ownership, proxies or voting trusts, enables the NASD to cast one vote more than one-half of all votes entitled to be cast by stockholders. If Nasdaq obtains Exchange Registration, the share of Series B Preferred Stock will lose its voting rights and will be redeemed by Nasdaq. Nasdaq may redeem the shares of Series A Preferred Stock at any time after Exchange Registration and is required to use the net proceeds from an IPO, and upon the occurrence of certain other events, to redeem all or a portion of the Series A Preferred Stock. By-Laws of The Nasdaq Stock Market, Inc.(#) Certificate of Designations of The Nasdaq Stock Market, Inc.'s Series A Cumulative Preferred Stock. Certificate of Designations of The Nasdaq Stock Market, Inc.'s Series B Preferred Stock. Form of Common Stock certificate.(+) Voting Trust Agreement dated June 28, 2000, among The Nasdaq Stock Market, Inc., the National Association of Securities Dealers, Inc. and The Bank of New York.(+) First Amendment to the Voting Trust Agreement, dated as of January 18, 2001, among The Nasdaq Stock Market, Inc., the National Association of Securities Dealers, Inc. and The Bank of New York.(+) Network Service Agreement, dated November 19, 1997, between MCI Telecommunications Corporation and The Nasdaq Stock Market, Inc.*(+) Consolidated Agreement, between Unisys Corporation and The Nasdaq Stock Market, Inc.*(+) Network User License Agreement, dated November 30, 1993, between Oracle Corporation and The Nasdaq Stock Market, Inc.*(+) Software License and Services Agreement, dated November 31, 1993, between Oracle Corporation and The Nasdaq Stock Market, Inc.*(+) Regulatory Services Agreement, dated June 28, 2000, between NASD Regulation, Inc. and The Nasdaq Stock Market, Inc.*(+) Separation and Common Services Agreement, dated as of June 28, 2000, between the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(+) The Nasdaq Stock Market, Inc. 2000 Employee Stock Purchase Plan.(+) The Nasdaq Stock Market, Inc. Equity Incentive Plan.(+) Securities Purchase Agreement, dated as of March 23, 2001, among The Nasdaq Stock Market, Inc., Hellman & Friedman Capital Partners IV, L.P. and the other purchasers listed in the signature pages thereto.(+) Securityholders Agreement, dated as of May 3, 2001, among The Nasdaq Stock Market, Inc., Hellman & Friedman Capital Partners IV, L.P., and the other securityholders listed on the signature pages thereto.(^) Purchase and Sale Agreement, dated March 23, 2001, by and between the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(+) Employment Agreement between the National Association of Securities Dealers, Inc. and Frank G. Zarb effective on February 24, 1997.(+) Instrument of Amendment, dated March 18, 1998, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997.(+) Instrument of Amendment, dated as of August 20, 1999, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998.(+) Instrument of Amendment, dated March 30, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended on August 20, 1999.(+) Instrument of Amendment, effective as of July 27, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended in August, 1999, and subsequently amended as of March 30, 2000.(+) Instrument of Amendment, effective as of November 1, 2000, to Employment Agreement between National Association of Securities Dealers, Inc. and Frank G. Zarb, effective on February 24, 1997, as amended effective March 18, 1998, and subsequently amended as of August, 1999, and subsequently amended on March 30, 2000, and as of July 27, 2000.(+) Instrument of Amendment, effective as of April 25, 2001, to Employment Agreement between National Association of Securities Dealers, Inc., The Nasdaq Stock Market, Inc., and Frank G. Zarb, effective on February 24, 1997, as subsequently amended effective March 18, 1998, August 20, 1999, March 30, 2000, July 27, 2000 and November 1, 2000.(+) Letter Agreement, dated July 22, 2001, among Frank G. Zarb, the National Association of Securities Dealers, Inc. and The Nasdaq Stock Market, Inc.(—) Employment Agreement by and between The Nasdaq Stock Market, Inc. and John L. Hilley, effective as of December 29, 2000.(+) Amendment One to the Employment Agreement by and between The Nasdaq Stock Market, Inc. and John L. Hilley, effective as of February 1, 2002. Employment Agreement by and between The Nasdaq Stock Market, Inc. and Richard G. Ketchum, effective as of December 29, 2000.(+) Amendment One to the Employment Agreement by and between The Nasdaq Stock Market, Inc. and Richard G. Ketchum, effective as of February 1, 2002. Employment Agreement by and between The Nasdaq Stock Market, Inc. and Hardwick Simmons, dated December 7, 2000, effective as of February 1, 2001.(+) Amendment Number One to the Employment Agreement by and between the The Nasdaq Stock Market, Inc., and Hardwick Simmons, effective as of February 1, 2001.(+) Amendment Number Two to the Employment Agreement by and between The Nasdaq Stock Market, Inc., and Hardwick Simmons, effective as of February 1, 2002. Employment Letter, dated May 31, 1996, from the National Association of Securities Dealers, Inc. to Alfred R. Berkeley, III.(#) Employment Letter from The Nasdaq Stock Market, Inc. to David Weild IV, dated March 8, 2001 as amended and restated March 21, 2002. Purchase and Sale Agreement, dated as of February 20, 2002, by and between The Nasdaq Stock Market, Inc., and the National Association of Securities Dealers, Inc. Investor Rights Agreement, dated as of February 20, 2002, between The Nasdaq Stock Market, Inc., and the National Association of Securities Dealers, Inc. (~) Separation Agreement, dated as of December 12, 2001, by and between The Nasdaq Stock Market, Inc. and J. Patrick Campbell. Employment Agreement by and between The Nasdaq Stock Market, Inc. and J. Patrick Campbell, effective as of December 29, 2000.(+) Loan Agreement, dated December 28, 2001, by and between The Nasdaq Stock Market, Inc. and David P. Warren. Loan Agreement, dated December 30, 2001, by and between The Nasdaq Stock Market, Inc. and Steven Dean Furbush. Statement regarding computation of per share earnings (incorporated herein by reference to "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K" of this Form 10-K). List of all subsidiaries. Ernst & Young LLP consent. Powers of Attorney. CERTIFICATE OF DESIGNATIONS, PREFERENCES AND RIGHTS SERIES A CUMULATIVE PREFERRED STOCK Pursuant to Section 151 of the Delaware General Corporation Law The Nasdaq Stock Market, Inc., a Delaware corporation (the "Corporation"), certifies that pursuant to the authority contained in its Restated Certificate of Incorporation (the "Certificate of Incorporation") and in accordance with the provisions of Section 151 of the General Corporation Law of the State of Delaware, the Board of Directors of the Corporation (the "Board of Directors"), acting by unanimous written consent, adopted the following resolution, which resolution remains in full force and effect as of the date hereof: DOES HEREBY CERTIFY THAT: RESOLVED, that there is hereby established a series of authorized preferred stock consisting of 1,338,402 shares, which series shall have the following powers, designations, preferences and relative, participating, optional or other rights, and the following qualifications, limitations and restrictions (in addition to any powers, designations, preferences and relative, participating, optional or other rights, and any qualifications, limitations and restrictions, set forth in the Certificate of Incorporation): SECTION 1. DESIGNATION AND AMOUNT. The series of preferred stock created hereby shall be designated "Series A Cumulative Preferred Stock," par value $.01 per share (hereinafter called the "Series A Preferred Stock") and the number of shares constituting such series shall be 1,338,402. SECTION 2. DIVIDENDS; RANKING. (a) The holders of the Series A Preferred Stock shall be entitled to receive when, as and if declared by the Board of Directors out of the funds legally available therefor, (i) during the period commencing the date which is the first anniversary (the "7.60% Dividend Date") of the date of the original issuance of the Series A Preferred Stock (the "Issue Date") and ending the date that is the second anniversary of the Issue Date (the "Second Anniversary Date") cash dividends, at the annual rate of 7.60% of the Series A Preferred Stock Liquidation Preference (as defined below) per annum per share, and no more, which shall be fully cumulative and shall accrue without interest from the 7.60% Dividend Date, and (ii) during the period commencing the date which is the day immediately following the Second Anniversary Date (the "10.60% Dividend Date"), cash dividends, at the annual rate of 10.60% of the Series A Preferred Stock Liquidation Preference per annum per share, and no more, which shall be fully cumulative and shall accrue without interest from the 10.60% Dividend Date. No dividends shall accrue in respect of the period commencing on the Issue Date and ending on the date that is the day immediately prior to the 7.60% Dividend Date. Dividends shall be paid quarterly in arrears in equal amounts (prorated for any partial dividend period) on March 31, June 30, September 30 and December 31 of each year (unless such day is not a Business Day (as defined below), in which event such dividends shall be payable on the next succeeding Business Day) (each such date being referred to herein as a "Dividend Payment Date"), commencing with March 31, 2003 (and in the case of any accrued but unpaid dividends, at such additional times and for such interim periods, if any, as determined by the Board of Directors) to the holders of record as they appear on the stock books of the transfer agent for the Corporation (the "Transfer Agent") on the immediately preceding March 15, June 15, September 15 and December 15, respectively, (and in the case of accrued and unpaid dividends to be paid at such additional times and for such interim periods, if any, on such record dates, which shall be not more than 30 days nor less than 10 days preceding the Dividend Payment Dates, as fixed by the Board of Directors) (each such date being referred to herein as a "Series A Record Date"), PROVIDED that holders of shares of Series A Preferred Stock called for redemption on a redemption date falling between any Series A Record Date and the corresponding Dividend Payment Date shall, in lieu of receiving such dividend payment on the Dividend Payment Date fixed therefor, receive such dividend payment together with all other accrued and unpaid dividends on the date fixed for redemption. The amount of dividends payable per share of Series A Preferred Stock for each quarterly dividend period shall be computed, which computation shall be made within five Business Days of the Dividend Payment Date, by dividing the annual dividend amount per share by four and adding to such amount the amount of all accrued and unpaid dividends. The amount of dividends payable for the initial dividend period and dividends payable for any other period that is shorter or longer than a full quarterly dividend period shall be computed on the basis of a 360-day year consisting of twelve 30-day months. Holders of shares of Series A Preferred Stock shall not be entitled to receive any dividends, whether payable in cash, property or stock, which are in excess of the cumulative dividends provided for herein. "Business Day" shall mean any day other than a Saturday, Sunday or a day on which state or federally chartered banking institutions in New York, New York are not required to be open. (b) The Series A Preferred Stock shall rank, both as to the payment of dividends and as to the distribution of assets upon Liquidation (as defined below), senior to any existing and future classes or series of equity securities of the Corporation, including, without limitation, the Corporation's Common Stock, par value $.01 per share (the "Common Stock"), and the Corporation's Series B Preferred Stock, par value $.01 ("Series B Preferred Stock"). (c) So long as any shares of the Series A Preferred Stock are outstanding, no dividends (other than dividends or distributions paid in shares of, or options, warrants or rights to subscribe for or purchase, or to effectuate a stock split, on shares of Junior Securities (as defined below)) shall be declared or paid or set apart for payment on Junior Securities, for any period, nor, except for the Series B Preferred Stock, shall any Junior Securities be redeemed, purchased or otherwise acquired (other than a redemption, purchase or other acquisition of shares of Common Stock made for the purposes of incentive or benefit plans or arrangements of the Corporation or any subsidiary thereof) for any consideration (or any moneys be paid to or made available for a sinking fund for the redemption of any such Junior Securities) by the Corporation (except for conversion into or exchange into other Junior Securities) unless, in each case, prior to or currently with such declaration, payment or setting apart for payment all accrued and unpaid dividends on all outstanding shares of the Series A Preferred Stock shall have been paid or set apart for payment and any such dividend on shares of Junior Securities or consideration for any such redemption, purchase or other acquisition of Junior Securities shall consist only of cash or Common Stock or options, warrants or rights to subscribe for or purchase Common Stock. (d) As used in this Certificate of Designations, the term "Junior Securities" means any class or series of stock or equity securities of the Corporation that by its terms is junior to the Series A Preferred Stock, either as to the payment of dividends or as to the distribution of assets upon Liquidation, or both, including the Common Stock and the Series B Preferred Stock. (e) For purposes of the Series A Preferred Stock, the amount of dividends "accrued" on any share of stock of any class or series as of any date shall be deemed to be the amount of any unpaid dividends accumulated thereon to and including the date of such determination. SECTION 3. PREFERENCE ON LIQUIDATION. (a) In the event of the Liquidation of the Corporation, the holders of the Series A Preferred Stock shall be entitled to have paid to them out of the assets of the Corporation available for distribution to stockholders before any distribution is made to or set apart for the holders of shares of Common Stock, Series B Preferred Stock or other Junior Securities, an amount in cash equal to $100.00 per share plus all accrued and unpaid dividends thereon, whether or not declared, to the date of Liquidation (the "Series A Preferred Stock Liquidation Preference"); PROVIDED, HOWEVER, upon a Liquidation in which upon distribution of assets some or all of the consideration shall be paid other than in cash, then the Series A Preferred Stock Liquidation Preference shall be payable in such form of consideration as shall be payable generally to stockholders upon such Liquidation, and if there shall be more than one type of consideration payable upon such Liquidation, then the Series A Preferred Stock Liquidation Preference shall be comprised of cash, to the full extent available, and such other type of consideration, it being understood that no holders of Junior Securities shall be entitled to receive any cash consideration unless and until the aggregate Series A Preferred Stock Liquidation Preference shall have been paid in full. (b) If, upon any Liquidation, the assets of the Corporation or proceeds thereof distributable among the holders of shares of the Series A Preferred Stock shall be insufficient to permit the payment in full of the Series A Preferred Stock Liquidation Preference for each share of the Series A Preferred Stock then outstanding, then such assets or proceeds thereof shall be distributed among such holders of Series A Preferred Stock ratably in accordance with the respective amounts that would be payable on such shares if all amounts payable thereon were paid in full. (c) In the event of a Liquidation, the Corporation shall give, by certified mail, return receipt requested, postage prepaid, addressed to each holder of any shares of Series A Preferred Stock at the address of such holder as shown on the books of the Corporation, at least 20 days' prior written notice of the date on which the books of the Corporation shall close or a record shall be taken for determining rights to vote in respect of any such Liquidation and of the date when the same shall take place. (d) As used in this Certificate of Designations, the term "Liquidation" shall be deemed to include (i) any liquidation, dissolution or winding up of the Corporation, whether voluntary or involuntary, (ii) the sale, lease, abandonment, transfer or other disposition (each, a "Transfer") by the Corporation of all or substantially all its assets for cash where (A) the Board of Directors is required, pursuant to the law of the state of incorporation of the Corporation, to approve such Transfer and (B) at the time of such Transfer no holder of Series A Preferred Stock, directly or indirectly, in the aggregate, has affirmative voting control of the Corporation either through ownership of capital stock or other equity securities or through representation on the Board of Directors (any Transfer satisfying the foregoing clauses (A) and (B), being referred to herein as a "Qualifying Asset Sale"), and (iii) any merger or consolidation of the Corporation into or with any other person or persons where (x) the Corporation is not the surviving person, (y) the Board of Directors is required, pursuant to the law of the state of incorporation of the Corporation, to approve such merger or consolidation and (z) at the time of such merger or consolidation, no holder of Series A Preferred Stock, directly or indirectly, in the aggregate, has affirmative voting control of the Corporation either through ownership of capital stock or other equity securities or through representation on the Board of Directors (any merger or consolidation satisfying the foregoing clauses (x), (y) and (z), being referred to herein as a "Qualifying Merger"). For the avoidance of doubt, "Liquidation" shall not be deemed to include (i) a consolidation or merger of the Corporation into or with any other entity or entities other than a Qualifying Merger, (ii) other than in connection with a Qualifying Merger, a transaction or series of related transactions that results in the transfer of more than 50% of the voting power of the Corporation and (iii) the Transfer by the Corporation of all or substantially all its assets other than in connection with a Qualifying Asset Sale or in connection with a plan of liquidation, dissolution or winding up of the Corporation. Notwithstanding the foregoing, if at any time after the Issue Date, the Board of Directors determines in good faith, based upon a review of relevant information, including a written opinion of its independent auditors, that as a result of any change in U.S. generally accepted accounting principles or any applicable U.S. accounting authority, treating a Qualifying Merger or a Qualifying Asset Sale as a Liquidation would no longer permit the Series A Preferred Stock to be accounted for as stockholders' equity of the Corporation, a "Liquidation" will no longer be deemed to include a Qualifying Merger or a Qualifying Asset Sale, as the case may be; PROVIDED, HOWEVER, that the Corporation shall provide prompt notice of such determination by the Board of Directors, together with a copy of the written opinion of the Corporation's independent auditors referred to above, to each holder of the Series A Preferred Stock. For purposes of this Section 3(d) and Section 6, "person" means any natural person, corporation, general or limited partnership, limited liability company, joint venture, trust, association or entity of any kind. SECTION 4. VOTING. (a) Except as herein provided or as otherwise required by applicable law, holders of Series A Preferred Stock shall have no voting rights. (b) If and whenever four consecutive quarterly dividends payable on the Series A Preferred Stock have not been paid in full, the number of directors then constituting the Board of Directors shall be increased by two and the holders of the Series A Preferred Stock, voting as a single class, shall be entitled, in accordance with the Certificate of Incorporation and subject to the requirements of applicable laws, rules and regulations, to elect the two additional directors to serve on the Board of Directors at any annual meeting of stockholders or special meeting held in place thereof, or at a special meeting of the holders of the Series A Preferred Stock called as hereinafter provided. Whenever all arrears in dividends on the Series A Preferred Stock then outstanding shall have been paid or the Corporation shall have repurchased and redeemed all then-outstanding shares of Series A Preferred Stock, as the case may be, then the right of the holders of the Series A Preferred Stock to elect such additional two directors shall cease (but subject always to the same provisions for the vesting of such voting rights in the case of any similar future arrearages in four consecutive quarterly dividends), and the terms of office of all persons elected as directors by the holders of the Series A Preferred Stock shall forthwith terminate and the number of the Board of Directors shall be reduced accordingly. At any time after such voting power shall have been so vested in the holders of shares of the Series A Preferred Stock, the secretary of the Corporation may, and upon the written request of holders of at least 25% of the outstanding shares of Series A Preferred Stock (addressed to the secretary at the principal office of the Corporation) shall, call a special meeting of the holders of the Series A Preferred Stock for the election of the two directors, who shall satisfy all requirements of the Corporation's By-Laws, Certificate of Incorporation, applicable laws, rules and regulations for service as members of the Board of Directors, to be elected by them as herein provided, such call to be made by notice similar to that provided in the By-Laws of the Corporation for a special meeting of the stockholders or as required by law. If any such special meeting required to be called as above provided shall not be called by the secretary within 20 days after receipt of any such request, then any holder of shares of Series A Preferred Stock may call such meeting, upon the notice above provided, and for that purpose shall have access to the stock books of the Corporation. The directors elected at any such special meeting shall hold office until the next annual meeting of the stockholders or special meeting held in lieu thereof if such office shall not have previously terminated as above provided. If any vacancy shall occur among the directors elected by the holders of the Series A Preferred Stock, a successor shall be appointed by the then-remaining director elected by the holders of the Series A Preferred Stock or the successor of such remaining director of a person who satisfies all requirements of the Corporation's By-Laws, Certificate of Incorporation, applicable laws, rules and regulations for service as a member of the Board of Directors, to serve until the next annual meeting of the stockholders or special meeting held in place thereof if such office shall not have previously terminated as provided herein. If at any time both director positions elected by the holders of the Series A Preferred Stock are vacant at the same time, the Board of Directors shall appoint such persons as designated by a majority of the holders of the Series A Preferred Stock who satisfy all requirements of the regulations for service as a member of the Board of Directors, to serve until the next annual meeting of the stockholders or special meeting held in place thereof if such office shall not have previously terminated as provided herein. Directors elected or appointed in accordance with this Section 4(b) may only be removed with the written consent of at least 66 2/3% in Series A Preferred Stock Liquidation Preference of the outstanding shares of Series A Preferred Stock or the vote of holders of at least 66 2/3% in Series A Preferred Stock Liquidation Preference of the outstanding shares of Series A Preferred Stock at a meeting of the holders of Series A Preferred Stock called for such purpose. (c) Without the written consent of the holders of at least 66 2/3% in Series A Preferred Stock Liquidation Preference of the outstanding shares of Series A Preferred Stock or the vote of holders of at least 66 2/3% in Series A Preferred Stock Liquidation Preference of the outstanding shares of Series A Preferred Stock at a meeting of the holders of Series A Preferred Stock called for such purpose, the Corporation will not amend, alter or repeal any provision of the Certificate of Incorporation (by merger or otherwise) so as to adversely affect the preferences, rights or powers of the Series A Preferred Stock; PROVIDED that any such amendment that changes the dividend payable on or the liquidation preference of the Series A Preferred Stock shall require the affirmative vote at a meeting of holders of Series A Preferred Stock called for such purpose or written consent of the holder of each share of Series A Preferred Stock. (d) In exercising the voting rights set forth in this Section 4, each share of Series A Preferred Stock shall have one vote per share, except that when any other series of preferred stock shall have the right to vote with the Series A Preferred Stock as a single class on any matter, then the Series A Preferred Stock and such other series shall have with respect to such matters one vote per $100 of stated liquidation preference, disregarding any provision for accrued and unpaid dividends. Except as otherwise required by applicable law or as set forth herein, the shares of Series A Preferred Stock shall not have any relative, participating, optional or other special voting rights and powers and the consent of the holders thereof shall not be required for the taking of any corporate action. SECTION 5. REDEMPTION. (a) OPTIONAL REDEMPTION. Subject to the provisions of this Section 5, to the extent the Corporation shall have funds legally available for such payment, the Corporation shall have the right, exercisable from time to time, to redeem, at its option, in part or in whole, then-outstanding shares of Series A Preferred Stock at a redemption price per share in cash equal to $100.00 plus any accrued and unpaid dividends in arrears to, but excluding, the applicable redemption date (the "Redemption Price"); PROVIDED, HOWEVER, that no holder of Series A Preferred Stock, directly or indirectly, in the aggregate, capital stock or other equity securities, or through representation on the Board of Directors, at the time the Corporation determines to exercise its redemption right pursuant to this Section 5(a). (b) MANDATORY REDEMPTION UPON AN IPO. In the event of a sale by the Corporation of shares of Common Stock in the first underwritten public offering (the "IPO") of Common Stock pursuant to a registration statement under the Securities Act of 1933, as amended (the "Securities Act"), the Corporation shall, within 10 business days from the consummation of the IPO, use the net proceeds to the Corporation from the IPO (the "IPO Net Proceeds") to redeem, in part or in whole, the maximum number, rounded downward to the nearest share, of outstanding shares of Series A Preferred Stock that may be redeemed at the Redemption Price per share through application of the IPO Net Proceeds. (c) MANDATORY REDEMPTION UPON A NON-IPO SALE OF CAPITAL STOCK. In the event of a sale by the Corporation or any of its Restricted Subsidiaries (as defined below) of shares of their capital stock or other equity securities for cash proceeds from time to time, other than in the IPO, the Corporation shall, within 60 days from the consummation of such sale, use the net proceeds to the Corporation or any of its Restricted Subsidiaries from any such sale (the "Stock Sale Net Proceeds") to redeem, in whole or in part, the maximum number, rounded downward to the nearest whole share, of outstanding shares of Series A Preferred Stock that may be redeemed at the Redemption Price per share through application of the Stock Sale Net Proceeds. The obligations of this Section 5(c) shall not (i) if the aggregate net proceeds in any transaction or series of transactions with respect to sales of capital stock by the Corporation or any Restricted Subsidiary does not exceed $10,000,000; (ii) to sales of capital stock in connection with a joint venture, strategic alliance or other similar arrangement, in any such case the primary purpose of which is other than the raising of capital for the Corporation and the consideration involved in such transaction is not predominantly comprised of cash, in each case as determined in good faith by the Board of Directors; PROVIDED, HOWEVER, that for the purposes of this Section 5(c)(ii) any transaction or series of transactions that involves cross-shareholdings obtained through substantially similar cash investments shall not be deemed to have a primary purpose of raising capital or to involve predominantly cash consideration; or (iii) to any issuance of shares of equity securities, or securities convertible into equity, by the Corporation or a Restricted Subsidiary, as the case may be, pursuant to benefit plans or arrangements for employees, officers, directors or consultants, or pursuant to warrants or convertible subordinated debentures outstanding on the Issue Date. (d) If the Corporation shall redeem shares of Series A Preferred Stock pursuant to this Section 5, notice of such redemption shall be given by certified mail, return receipt requested, postage prepaid, mailed not less than two days nor more than 45 days prior to the redemption date, to each holder of record of the shares to be redeemed at such holder's address as the same appears on the stock books of the Transfer Agent. Any notice that was mailed in the manner herein provided shall be conclusively presumed to have been duly given on the date mailed whether or not the holder receives the notice. Each such notice shall state: (i) the redemption date; (ii) the number of shares of Series A Preferred Stock to be redeemed and, if fewer than all the shares held by such holder are to be redeemed, the number of shares to be redeemed from such holder; (iii) the amount payable; (iv) the place or places where certificates for such shares are to be surrendered for payment of the Redemption Price; and (v) that dividends on the shares to be redeemed will cease to accrue on such redemption date, except as otherwise provided herein. (e) Upon surrender in accordance with notice given pursuant to this Section 5 of the certificates for any shares of Series A Preferred Stock (properly endorsed or assigned for transfer, if the Board of Directors of the Corporation shall so require and the notice shall so state), such shares shall be redeemed by the Corporation at the Redemption Price. If fewer than all the outstanding shares of Series A Preferred Stock are to be redeemed, the number of shares to be redeemed shall be determined by the Board of Directors in accordance with this Certificate of Designations and the shares to be redeemed shall be selected pro rata (with any fractional shares being rounded down to the nearest whole share). In case fewer than all the shares of Series A Preferred Stock represented by any such certificate are redeemed, a new certificate shall be issued representing the unredeemed shares without cost to the holder thereof. (f) If notice has been mailed as aforesaid, from and after the redemption date (unless default shall be made by the Corporation in providing for the payment of the Redemption Price of the shares called for redemption), (i) except as otherwise provided herein, dividends on the shares of Series A Preferred Stock so called for redemption shall cease to accrue, (ii) said shares shall no longer be deemed to be outstanding, and (iii) all rights of the holders thereof as holders of the Series A Preferred Stock shall cease (except the right to receive from the Corporation the Redemption Price without interest thereon, upon surrender and endorsement of their certificates so required). (g) As used in this Certificate of Designations, the term "Restricted Subsidiary" shall be deemed to mean any direct or indirect subsidiary of the Corporation other than (i) any subsidiary set forth on Schedule A hereto and (ii) any subsidiary that is formed in connection with a joint venture, strategic alliance or other similar arrangement and the primary purpose of which is other than the raising of capital, as determined in good .faith by the Board of Directors. SECTION 6. MERGER OR CONSOLIDATION. In the event of a merger or consolidation of the Corporation with or into any person pursuant to which the Corporation shall not be the continuing person and that does not constitute a Liquidation within the meaning of Section 3(d), the Series A Preferred Stock shall be converted into or exchanged for and shall become preferred shares of such successor or resulting company or, at the Corporation's sole discretion, the parent of such successor or resulting company, having in respect of such successor or resulting company or parent of such successor or resulting company, substantially the same powers, preferences and relative participating, optional or other special rights, and the qualifications, limitations or restrictions thereon, that the Series A Preferred Stock had immediately prior to such transaction, and with any additional preferences, rights or powers as may be determined by the Corporation that would not adversely affect the preferences, rights or powers of the Series A Preferred Stock. SECTION 7. LIMITATION AND RIGHTS UPON INSOLVENCY. Notwithstanding any other provision of this Certificate of Designations, the Corporation shall not be required to pay any dividend on, or to pay any amount in respect to any redemption of, the Series A Preferred Stock at a time when immediately after making such payment the Corporation is or would be rendered insolvent (as defined by applicable law), PROVIDED, that the obligation of the Corporation to make any such payment shall not be extinguished in the event the foregoing limitation applies. SECTION 8. SHARES TO BE RETIRED. Any share of Series A Preferred Stock redeemed, exchanged or otherwise acquired by the Corporation shall be retired and canceled and shall upon cancellation be restored to the status of authorized but unissued shares of preferred stock, subject to reissuance by the Board of Directors as Series A Preferred Stock or as shares of preferred stock of one or more other series. SECTION 9. RECORD HOLDERS. The Corporation and the Transfer Agent, if any, may deem and treat the record holder of any shares of Series A Preferred Stock as the true and lawful owner thereof for all purposes, and neither the Corporation nor the Transfer Agent, if any, shall be affected by any notice to the contrary. SECTION 10. TRANSFER RESTRICTIONS. Prior to the one-year anniversary date of the Issue Date, a holder of Series A Preferred Stock may not effect any offer, sale, pledge, transfer or other disposition or distribution (or enter into any agreement with respect to any of the foregoing) of Series A Preferred Stock without the prior written consent of the Corporation. SECTION 11. LEGENDS. (a) Prior to the one-year anniversary date of the Issue Date, any certificate representing shares of Series A Preferred Stock shall bear the following legend: THE SHARES OF SERIES A PREFERRED STOCK, PAR VALUE $.01 PER SHARE, OF THE NASDAQ STOCK MARKET, INC. REPRESENTED BY THIS CERTIFICATE MAY NOT BE OFFERED, SOLD OR TRANSFERRED BY THE HOLDER HEREOF PRIOR TO MARCH 8, 2003 WITHOUT THE PRIOR WRITTEN CONSENT OF THE NASDAQ STOCK MARKET, Subsequent to the one-year anniversary date of the Issue Date, the Corporation agrees, from time to time and at the request of a holder, to issue replacement certificates representing such holder's shares of Series A Preferred Stock that do not bear the legend contained in Section 11(a). (b) Until no longer required by applicable law, any certificate representing shares of Series A Preferred Stock shall bear the following legend: THE NASDAQ STOCK MARKET, INC. REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933, AS AMENDED, OR UNDER THE SECURITIES LAWS OF ANY STATE OR FOREIGN JURISDICTION AND MAY NOT BE OFFERED, SOLD OR TRANSFERRED WITHOUT COMPLIANCE WITH APPLICABLE FEDERAL, STATE OR FOREIGN SECURITIES LAWS. Subsequent to registration of the Series A Preferred Stock pursuant to the Securities Act, the Corporation agrees, from time to time and upon request of a holder, to issue replacement certificates representing such holder's shares of Series A Preferred Stock that do not bear the legend contained in Section 11(b). SECTION 12. NOTICES. Except as may otherwise be provided for herein, all notices referred to herein shall be in writing, and all notices hereunder shall be deemed to have been given upon the earlier of (a) receipt of such notice, (b) three Business Days after the mailing of such notice if sent by registered mail (unless first-class mail shall be specifically permitted for such notice under the terms hereof) or (c) the Business Day following the date such notice was sent by overnight courier, in any case with postage or delivery charges prepaid, addressed: if to the Corporation, to its offices at One Liberty Plaza, New York, New York 10006, Attention: General Counsel, or to an agent of the Corporation designated as permitted by the Certificate of Incorporation, or, if to any holder of the Series A Preferred Stock, to such holder at the address of such holder of the Series A Preferred Stock as listed in the stock record books of the Corporation, or as the holder shall have designated by written notice similarly given by the holder and received by the Corporation. SECTION 13. OTHER RIGHTS. Other than as may be prescribed by law, the holders of the Series A Preferred Stock shall not have any other voting rights, conversion rights, preferences or special rights. IN WITNESS WHEREOF, the undersigned has caused this Certificate of Designations to be executed this 8th day of March, 2002. By: /s/ David P. Warren Name: David P. Warren Title: Executive Vice President and 1. Nasdaq Tools, Inc. 2. Nasdaq Global Holdings 3. Nasdaq Global Technology, Ltd. 4. Nasdaq International Ltd. 5. Nasdaq Ltda 6. Nasdaq Europe Planning Company Ltd. 7. Nasdaq Japan, Inc. 8. Nasdaq Europe S.A./N.V. 9. IndigoMarkets Ltd. 10. IndigoMarkets India Private Ltd. 11. Nasdaq Financial Products Services, Inc. 12. Nasdaq International Market Initiatives, Inc. 13. Nasdaq Canada, Inc. 14. Nasdaq Educational Foundation Inc. 15. Nasdaq-BIOS R&D Joint Venture SERIES B PREFERRED STOCK preferred stock consisting of one share, which series shall have the following powers, designations, preferences and relative, participating, optional or other rights, and the following qualifications, limitations and restrictions (in addition to any powers, designations, preferences and relative, participating, optional or other rights, and any qualifications, limitations and restrictions, set forth in the Certificate of Incorporation): created hereby shall be designated "Series B Preferred Stock," par value $.01 per share (hereinafter called the "Series B Preferred Stock") and the number of shares constituting such series shall be one. SECTION 2. DIVIDENDS. The holder of the Series B Preferred Stock shall not be entitled to receive dividends. SECTION 3. PREFERENCE ON LIQUIDATION. (a) In the event of the Liquidation (as defined below) of the Corporation, the holder of the Series B Preferred Stock shall be entitled to have paid to it out of the assets of the Corporation available for distribution to stockholders before any distribution is made to or set apart for the holders of shares of the Corporation's Common Stock, par value $.01 per share (the "Common Stock"), or other Junior Securities (as defined below), an amount in cash equal to $1.00 per share (the "Series B Preferred Stock Liquidation Preference"). (b) In the event of a Liquidation, the Corporation shall give, by certified mail, return receipt requested, postage prepaid, addressed to the holder of the share of Series B Preferred Stock at the address of such holder as shown on the books of the Corporation, at least 20 days prior written notice of the date on which the books of the Corporation shall close or a record shall be taken for determining rights to vote in respect of any such Liquidation and of the date when the same shall take place. (c) As used in this Certificate of Designations, the term "Junior Securities" means any class or series of stock or equity securities of the Corporation that by its terms is junior to the Series B Preferred Stock as to the distribution of assets upon Liquidation. (d) As used in this Certificate of Designations, the term "Liquidation" shall be deemed to include any liquidation, dissolution or winding up of the Corporation, whether voluntary or involuntary. For the avoidance of doubt, "Liquidation" shall not be deemed to include (i) a entities, (ii) a transaction or series of related transactions that results (iii) unless in connection with a plan of liquidation, dissolution or winding up of the Corporation, the sale, lease, abandonment, transfer or other disposition by the Corporation of all or substantially all its SECTION 4. VOTING. The holder of the share of Series B Preferred Stock shall have the following voting rights: (a) The holder of the share of Series B Preferred Stock shall be entitled to vote on all matters submitted to a vote of the stockholders of the Corporation, voting together with the holders of the Common Stock (and of any other shares of capital stock of the Corporation entitled to vote at a meeting of stockholders) as one class, except in cases where a separate or additional vote or consent of the holders of any class or series of capital stock or other equity securities of the Corporation shall be required by the Certificate of Incorporation, including, without limitation, Section 4(c) hereof, or by applicable law, in which case the requirement for any such separate or additional vote or consent shall apply in addition to the single class vote or consent otherwise required by this paragraph. (b) As of each record date for the determination of the Corporation's stockholders entitled to vote on any matter (a "Record Date"), the share of Series B Preferred Stock shall have voting rights and powers equal to the number of votes that, together with all other votes entitled to be cast by the holder of the share of Series B Preferred Stock on such Record Date, whether by virtue of beneficial ownership of capital stock of the Corporation, proxies, voting trusts or otherwise, entitle the holder of the share of Series B Preferred Stock to exercise one vote more than one-half of all votes entitled to be cast as of such Record Date by all holders of capital stock of the Corporation. (c) Without the written consent of the holder of the share of Series B Preferred Stock at a meeting of the holder of the Series B Preferred Stock called for such purpose, the Corporation will not amend, alter or repeal any provision of the Certificate of Incorporation (by merger or otherwise) so as to adversely affect the preferences, rights or powers of the Series B Preferred Stock. (d) Upon the Corporation becoming registered with the U.S. Securities and Exchange Commission as a national securities exchange ("Exchange Registration"), the rights of the holder of the Series B Preferred Stock pursuant to this Section 4 shall immediately terminate and the holder of the Series B Preferred Stock shall thereafter have no voting rights, except as otherwise required by applicable law. SECTION 5. REDEMPTION. (a) Upon Exchange Registration, to the extent the Corporation shall have funds legally available for such payment, the Corporation shall promptly redeem the share of Series B Preferred Stock at a redemption price per share in cash equal to the Series B Preferred Stock Liquidation Preference (the "Redemption Price"). (b) If the Corporation shall redeem the share of Series B Preferred Stock pursuant to this Section 5, notice of such redemption shall be given by certified mail, return receipt requested, postage prepaid, mailed not less than two days nor more than 45 days prior to the redemption date, to the holder of record of the share to be redeemed at such holder's address as the same appears on the stock books of the transfer agent for the Corporation (the "Transfer Agent"). Any notice that was mailed in the manner herein provided shall be conclusively presumed to have been duly given on the date mailed whether or not the holder receives the notice. Each such notice shall state: (i) the redemption date; and (ii) the place or places where the certificate for such share is to be surrendered for payment of the Redemption Price. (c) Upon surrender in accordance with notice given pursuant to this Section 5 of the certificate for the share of Series B Preferred Stock (properly endorsed or assigned for transfer, if the Board of Directors of the Corporation shall so require and the notice shall so state), such share shall be redeemed by the Corporation at the Redemption Price. (d) If notice has been mailed as aforesaid, from and after the redemption date (unless default shall be made by the Corporation in providing for the payment of the Redemption Price of the shares called for redemption), (i) said share shall no longer be deemed to be outstanding, and (iii) all rights of the holder thereof as holder of the Series B Preferred Stock shall cease (except the right to receive from the Corporation the Redemption Price without interest thereon, upon surrender and endorsement of its certificates if so required). SECTION 6. MERGER OR CONSOLIDATION. In the event of a merger or consolidation of the Corporation with or into any person pursuant to which the corporation shall not be the continuing person, the Series B Preferred Stock shall be converted into or exchanged for and shall become a preferred share of such successor or resulting company or, at the Corporation's sole discretion, the parent of such successor or resulting company, having in respect of such successor or resulting company or parent of such successor or resulting company, substantially the same powers, preferences and relative participating, optional or other special rights, and the qualifications, limitations or restrictions thereon, that the Series B Preferred Stock had immediately prior to such transaction and with any additional preferences, rights or powers as may be determined by the Corporation that would not adversely affect the preferences, rights or powers of the Series B Preferred Stock. For purposes of this Section 6, "person" means any natural person, corporation, general or limited partnership, limited liability company, joint venture, trust, association or entity of any kind. SECTION 7. LIMITATION AND RIGHTS UPON INSOLVENCY. Notwithstanding any other provision of this Certificate of Designations, the Corporation shall not be required to pay any amount in respect to any redemption of the Series B Preferred Stock at a time when immediately after making such payment the Corporation is or would be rendered insolvent (as defined by applicable law), provided that the obligation of the Corporation to make any such payment shall not be extinguished in the event the foregoing SECTION 8. SHARE TO BE RETIRED. When the share of Series B Preferred Stock is redeemed, exchanged or otherwise acquired by the Corporation, it shall be retired and canceled and shall upon cancellation be restored to the status of authorized but unissued shares of preferred stock, subject to reissuance by the Board of Directors as Series B Preferred Stock or as shares of preferred stock of one or more other series. SECTION 9. RECORD HOLDERS. The Corporation and the Transfer Agent, if any, may deem and treat the record holder of the share of Series B Preferred Stock as the true and lawful owner thereof for all purposes, and neither the Corporation nor the Transfer Agent, if any, shall be affected by any notice to the contrary. SECTION 10. TRANSFER RESTRICTIONS. The holder of Series B Preferred Stock may not effect any offer, sale, pledge, transfer or other disposition or distribution (or enter into any agreement with respect to any of the foregoing) of the share of Series B Preferred Stock. SECTION 11. LEGENDS. The certificate representing the share of Series B Preferred Stock shall bear the following legend: THE SHARE OF SERIES B PREFERRED STOCK, PAR VALUE $.01 PER SHARE, OF BE OFFERED, SOLD OR TRANSFERRED BY THE HOLDER HEREOF. all notices referred to herein shall be in writing, and all notices hereunder shall be deemed to have been given upon the earlier of (a) receipt of such notice, (b) three Business Days (as defined below) after the mailing of such notice if sent by registered mail (unless first-class mail shall be specifically permitted for such notice under the terms hereof) or (c) the Business Day following the date such notice was sent by overnight courier, in any case with postage or delivery charges prepaid, addressed: if to the Corporation, to its offices at One Liberty Plaza, New York, New York 10006, Attention: General Counsel, or to an agent of the Corporation designated as permitted by the Certificate of Incorporation, or, if to the holder of the Series B Preferred Stock, to such holder at the address of such holder of the Series B Preferred Stock as listed in the stock record books of the Corporation, or as the holder shall have designated by written notice similarly given by the holder and received by the Corporation. "Business Day" shall mean any day other than a Saturday, Sunday or a day on which state or federally chartered banking institutions in New York, New York are not required to be holders of the Series B Preferred Stock shall not have any other voting rights, conversion rights, preferences or special rights. IN WITNESS WHEREOF, the undersigned has caused this Certificate of Designations to be executed this 8th day of March, 2002. By: /s/ David P. Warren Name: David P. Warren Title: Executive Vice President and EXECUTION COPY AMENDMENT ONE TO THE This Amendment is hereby entered into effective as of February 1, 2002, by and between The Nasdaq Stock Market, Inc. (the "Company") and John Hilley (the "Executive"). WHEREAS, the Company and the Executive entered into on December 29, 2000, an Employment Agreement (the "Employment Agreement"), providing for the Executive's continued employment with the Company; and WHEREAS, the Company and the Executive desire to amend the Employment NOW THEREFORE, in consideration of the premises and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto hereby agree as follows: 1. Section 3 of the Employment Agreement is hereby amended in its entirety to contain two subsections (a) and (b) each of which shall read in their entirety as follows: (a) ANNUAL SALARY. During the Employment Term, the Company shall pay the Executive salary (the "Annual Salary") at the annual rate of not less than $500,000. Annual Salary shall be payable in regular installments in accordance with the Company's usual payroll practices. The Management Compensation Committee of the Board (the "Compensation Committee") shall review Annual Salary for the purpose of increasing it in accordance with its normal review procedures. (b) INCENTIVE COMPENSATION/BONUS. With respect to each calendar year during the Employment Term, the Company shall award the Executive such incentive compensation (hereinafter "Incentive Compensation") as the Compensation Committee may determine in its discretion; provided that in no event may the sum of Incentive Compensation to be awarded and the Executive's Annual Salary be less than $1.2 million. Incentive Compensation for each calendar year shall be paid at the same time as the Company pays Incentive Compensation awards to other executives, but in no event later than the March 1st following the calendar year with respect to which such Incentive Compensation relates. Notwithstanding the foregoing, twenty percent (20%) of the Incentive Compensation awarded and otherwise due and payable with respect to each calendar year (the "Retained Amount"), shall be retained by the Company in accordance with the terms of the Company's Retention Component of the Incentive Compensation Program, as adopted by the Compensation Committee on January 23, 2002 (the "Retention Policy"). The Retained Amount shall be credited with interest at the rate set forth in the Retention Policy and shall be due and payable pursuant to the terms of the Retention Policy, and to the extent applicable, as modified by this Section 3(b). In the event the Executive's employment is terminated on or after December 31, 2003, other than pursuant to Section 8(a) of the Employment Agreement (for Cause), the Company shall pay the Executive the Retained Amount plus interest at the rate set forth in the Retention Policy. 2. Section 4(b)(ii) of the Employment Agreement is hereby amended such that it reflects that the cross-referenced sections for the definitions of (x) Disability and (y) Cause and Good Reason shall be to Sections 8(b) and 8(c) respectively. 3. The first sentence of Section 7 of the Employment Agreement is hereby amended to read as follows: Subject to the Executive's employment with the Company on August 9, 2002 (the "Stay Pay Date"), the Company shall pay the Executive an additional bonus equal to not less than $2.4 million (the "Stay Pay Bonus"); PROVIDED, HOWEVER, that the Executive's earlier death or Disability (as defined in Section 8(b) hereof) while employed or termination pursuant to Section 8(c) hereof shall also be a Stay Pay 4. The second paragraph of Section 8(b) of the Employment Agreement is hereby amended such that the phrase "and Incentive Compensation" appears immediately following the phrase "all unpaid Annual Salary" in clause (ii) of such paragraph. 5. The second paragraph of Section 8(c) of the Employment Agreement is hereby amended to read in its entirety as follows: If the Executive's employment is terminated by the Company without Cause (other than by reason of his Disability or death) or the Executive terminates this Agreement for Good Reason, the Executive shall be entitled to receive: (i) any accrued but unpaid Annual Salary through the date of such termination, (ii) the Stay Pay Bonus provided by Section 7 hereof if not already paid and (iii) all other current cash obligations of the Company to the Executive (e.g. unused vacation). In addition, the Executive shall be entitled to receive: (x) his Annual Salary through the later of (i) the balance of the Term or (ii) twenty-four months from the date of such termination (the "Severance Period") and (y) any Incentive Compensation (including any Retained Amount pursuant to Section 3(b) hereof) and assuming the awarding of the minimum guaranteed amount of such Incentive Compensation as set forth in Section 3(b)) hereof, that would have been paid or earned by the Executive through the Severance Period. Such severance shall be paid in a lump sum within thirty (30) days following the termination date. The Company shall provide continued health coverage at its expense for the Severance Period. All other benefits, if any, due the Executive following termination pursuant to this Section 8(c) shall be determined in accordance with the plans, policies and practices of the Company; PROVIDED, HOWEVER, that the Executive shall not participate in any severance plan, policy or program of the Company. 6. This Amendment shall in no way reduce or otherwise negatively impact the calculation of the SERP benefits due the Executive pursuant to Section 4(b) of the Employment Agreement and accordingly, subsection (vi) of Section 4(b) is For purposes of determining the Executive's Final Average Compensation, the Executive's "Compensation" shall be deemed to be the sum of (x) one-half of the sum of his Annual Salary and Incentive Compensation and (y) one-third of one-half of the sum of his Annual Salary and Incentive Compensation. Except as specifically set forth herein, all other provisions of the Employment Agreement shall remain unchanged and in full force effect. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed March 1, 2002. By: /s/ John Hilley John Hilley By: /s/ H. Furlong Baldwin H. Furlong Baldwin, Chairman of Management Compensation Committee Exhibit 10.20.1 This Amendment is hereby entered into effective as of February 1, 2002, by and between The Nasdaq Stock Market, Inc. (the "Company") and Richard G. Ketchum (the "Executive"). WHEREAS, the Company and the Executive entered into on December 29, 2000, an Employment Agreement (the "Employment Agreement"), providing for the NOW THEREFORE, in consideration of the premises and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto hereby agree as follows: 1. Section 4 of the Employment Agreement is hereby amended by adding the following two new sentences at the end thereof: Notwithstanding the foregoing, twenty percent (20%) of the Incentive Compensation, otherwise due and payable with respect to each calendar year (the "Retained Amount"), shall be retained by the Company in accordance with the terms of the Company's Retention Component of the Incentive Compensation Program, as adopted by the Compensation Committee on January 23, 2002 (the "Retention Policy"), as such policy may be amended from time to time. The Retained Amount shall be credited with interest at the rate set forth in the Retention Policy and shall be due and payable pursuant to the terms of the Retention Policy. 2. For the avoidance of doubt, this Amendment shall in no way reduce or otherwise negatively impact: (i) the calculation of the SERP benefits due the Executive pursuant to Section 5(b) of the Employment Agreement, or (ii) the amount of severance otherwise due and payable to the Executive in accordance with applicable subsection of Section 9 of the Employment Agreement. 3. Except as specially set forth above, all other provisions of the Employment Agreement shall remain unchanged and in full force effect. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed February 17, 2002. By: /s/ Richard G. Ketchum AMENDMENT TWO TO This Amendment is hereby entered into by and between The Nasdaq Stock Market, Inc. ("Nasdaq") and Hardwick Simmons ("Simmons") effective as of February 1, 2002. WHEREAS, Nasdaq and Simmons have entered into on December 7, 2000 a certain employment agreement, to be effective as of February 1, 2001 (the "Employment Agreement"), providing for Simmons' employment with Nasdaq; and WHEREAS, Nasdaq and Simmons desire to amend the Employment Agreement. 1. Paragraph 3(a) of the Employment Agreement is hereby amended to add the following new sentence at the end thereof: Notwithstanding anything to the contrary contained in the Agreement, twenty percent (20%) of the Incentive Compensation, otherwise due and payable pursuant to this Paragraph 3(a) shall be retained by Nasdaq in accordance with the terms of the Nasdaq Retention Component of the Incentive Compensation Program, as adopted by the Management Compensation Committee of the Nasdaq Board of Directors on January 23, 2002, and as such policy may be amended from time to 2. For the avoidance of doubt, this Amendment shall in no way reduce or otherwise negatively impact the calculation or amount of any pension or retirement benefit due the Simmons pursuant to the Employment Agreement or any employee benefit plan of Nasdaq. 3. Except as specially set forth above, all other provisions of the Employment Agreement shall remain unchanged and in full force and effect. IN WITNESS WHEREOF, the parties hereto have caused this Amendment to be executed February 8, 2002. By: /s/ Hardwick Simmons By: /s/ H.Furlong Baldwin H. Furlong Baldwin, Chairman of The Nasdaq Stock Market, Inc. Management Compensation Committee [NASDAQ LOGO] February 8, 2001 (as amended March 21, 2002) Mr. David Weild IV Dear David: This letter agreement (the "Letter Agreement"), serves as an amendment and restatement of the offer letter presented to you on March 8, 2001. This Letter Agreement contains the entire understanding between you and The Nasdaq Stock Market, Inc. (the "Company") with respect to your employment with the Company and any and all agreements including, without limitation, the March 8, 2001 offer letter (other than your Option Agreements and Restricted Stock Agreement described in Paragraph 4 of this Letter Agreement) previously entered into shall be null and void. This Letter Agreement may not be altered, modified, or amended except by written instrument signed by the parties hereto. 1. Your position with the Company is Vice Chairman and Executive Vice President, Corporate Client Group and in this role you report directly to the Chairman and Chief Executive Officer. 2. Your annual base salary is $400,000 beginning with your start date of March 12, 2001. Your base salary will be reviewed periodically for purposes of increasing it based upon your performance. 3. You are entitled to receive a guaranteed minimum annual bonus of $700,000 for each of calendar year 2001 and 2002, payable with respect to each such calendar year at the same time as the Company pays bonus awards to other senior executives, but in no event later than March 1st following the calendar year with respect to which the bonus relates contingent upon your not having (a) been terminated for "Cause" or (b) voluntarily resigned without "Good Reason." Notwithstanding the foregoing, under the terms of our incentive compensation program, as adopted by the Management Compensation Committee of our Board of Directors (the "Board"), 20% of your annual bonus (the "Retained Amount") will be retained for 24 months following the date bonuses are paid in accordance with the terms of that program. For purposes of this Letter Agreement the terms "Cause", "Good Reason" and "Change in Control" shall have the following meanings: (a) Cause means (i) you engaging in willful misconduct that is injurious to the Company or its affiliates, (ii) your embezzlement or misappropriation of funds or property of the Company or its affiliates, or your conviction of a felony or your entrance of a plea of guilty or nolo contendere to a felony, (iii) your willful failure or refusal to substantially perform your duties or responsibilities that continues after being brought to your attention (other than any such failure resulting from your incapacity due to disability), or (iv) your violation any restrictive covenants entered into between you and the Company or the Company's Guidelines for Appropriate Conduct as described in the Company's Employee Handbook, or the Company's Code of Conduct. (b) Good Reason means a material diminishment of your responsibilities and compensation, relocation without your consent, or a Change in Control. (c) Change in Control means the first to occur of any one of the events set forth in the following paragraphs: (i) any "Person," as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934 (the "Exchange Act") (other than (A) the Company, (B) any trustee or other fiduciary holding securities under an employee benefit plan of the Company, (C) any entity owned, directly or indirectly, by the stockholders of the Company in substantially the same proportions as their ownership of the Common Stock of the Company ("Shares"), and (D) the National Association of Securities Dealers, Inc.), is or becomes the "beneficial owner" (as defined in Rule 13d-3 under the Exchange Act), directly or indirectly (not including any securities acquired directly (or through an underwriter) from the Company or its affiliates), of 25% or more of the Shares; (ii) the following individuals cease for any reason to constitute a majority of the number of directors then serving on the Company's Board of Directors (the "Board"): individuals who, on March 12, 2001, were members of the Board and any new director (other than a director whose initial assumption of office is in connection with an actual or threatened election contest, including but not limited to a consent solicitation, relating to the election of directors of the Company) whose appointment or election by the Board or nomination for election by the Company's stockholders was approved or recommended by a vote of at least two-thirds (2/3) of the directors then still in office who either were directors on March 12, 2001 or whose appointment, election or nomination for election was previously so approved or recommended; (iii) there is consummated a merger or consolidation of the Company with any other corporation or the Company issues Shares in connection with a merger or consolidation of any direct or indirect subsidiary of the Company with any other corporation, other than (A) a merger or consolidation that would result in the Shares of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving or parent entity) more than 50% of the Company's then outstanding Shares or 50% of the combined voting power of such surviving or parent entity outstanding immediately after such merger or consolidation or (B) a merger or consolidation effected to implement a recapitalization of the Company (or similar transaction) in which no Person, directly or indirectly, acquired 25% or more of the Company's then outstanding Shares (not including any securities acquired directly (or through an underwriter) from the Company or its affiliates); or (iv) the stockholders of the Company approve a plan of complete liquidation of the Company or there is consummated an agreement for the sale or disposition by the Company of all or substantially all of the Company's assets (or any transaction having a similar effect), other than a sale or disposition by the Company of all or substantially all of the Company's assets to an entity, at least 50% of the combined voting power of the voting securities of which are owned directly or indirectly by as their ownership of the Company immediately prior to such sale. 4. You were granted pursuant to the terms of the Company's Equity Incentive Plan (the "Equity Plan"), 14,000 incentive stock options, 250,000 non-qualified stock options and 15,900 shares of restricted stock. The terms and conditions of these awards are governed by the Equity Plan and the Stock Option and Restricted Stock Award Agreements entered into by and between you and the Company. 5. You will also be eligible for future equity grants/awards commensurate with the Company policy or practice in effect at the time of issuance. Any such awards will require current and continued employment with the Company and continued satisfactory performance. 6. You are entitled to four (4) weeks paid vacation per year. 7. The Company shall pay or reimburse you for your reasonable legal fees and expenses incurred in connection with the negotiation and execution of this Letter Agreement upon presentation by you of written invoices or receipts setting forth in reasonable detail the basis for such legal fees and expenses. 8. During your employment with the Company you shall be provided with benefits on the same basis as benefits are generally made available to other senior executives of the Company, including without limitation, medical, dental, vision, disability, life insurance and pension benefits. David, we look forward to your continued employment with the Company. Agreed and Accepted: /s/ David Weild, IV 3/21/02 - ------------------------------ ------------------------------ David Weild, IV Date /s/ Hardwick Simmons 3/22/02 Hardwick Simmons, CEO of Date NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. Dated as of February 20, 2002 PURCHASE AND SALE AGREEMENT dated as of February 20, 2002 (this "AGREEMENT"), between the National Association of Securities Dealers, Inc., a Delaware nonprofit corporation (the "NASD"), and The Nasdaq Stock Market, Inc., a Delaware corporation ("NASDAQ"). WHEREAS, the NASD is the beneficial owner of 76,994,871 shares of the common stock, par value $.01 per share, of Nasdaq (the "COMMON STOCK"); and WHEREAS, in furtherance of enabling Nasdaq and the NASD to meet a principal goal of the restructuring and recapitalization of Nasdaq (the "RESTRUCTURING")--the reduction of the NASD's ownership of Nasdaq--as well as to assist the NASD in fulfilling its commitment to attempt to eliminate its ownership interest in Nasdaq by June 2002, the NASD desires to sell and Nasdaq desires to purchase on the terms and subject to the conditions provided for herein, 33,768,895 shares of Common Stock (the "SHARES"), which, together with the shares of Common Stock underlying outstanding and unexpired warrants issued by the NASD in connection with the Restructuring (such shares, the "WARRANT SHARES"), constitute all of the shares of Common Stock beneficially owned by the NASD as of the date hereof; and WHEREAS, in connection with the foregoing purchase and sale, the parties desire to provide for certain other agreements. NOW, THEREFORE, in consideration of the provisions contained herein, the parties hereto agree as follows: 1. PURCHASE AND SALE OF THE SHARES. 1.01 SALE OF THE SHARES. On the terms and subject to the conditions contained herein, the NASD agrees to sell to Nasdaq and Nasdaq agrees to buy from the NASD the Shares. 1.02 DELIVERY OF THE SHARES. As set forth in SECTION 2, the NASD shall deliver to Nasdaq validly issued certificates representing the Shares duly endorsed in blank or accompanied by stock powers duly executed in blank, with all necessary stock transfer stamps affixed thereto. 1.03 PURCHASE PRICE. The aggregate purchase price (the "PURCHASE PRICE") for the Shares shall consist of (i) $305,155,435 in cash (the "CASH PURCHASE PRICE"), (ii) 1,338,402 shares of Nasdaq's Series A preferred stock, the terms of which are substantially as set forth in the form of Series A Certificate of Designations attached as EXHIBIT I hereto (the "SERIES A PREFERRED STOCK"), and (iii) one share of Nasdaq's Series B preferred stock, the terms of which are substantially as set forth in the form of Series B Certificate of Designations attached as EXHIBIT II hereto (the "SERIES B PREFERRED STOCK" and together with the Series A Preferred Stock, the "PREFERRED 2. THE CLOSING. 2.01 CLOSING. The closing of the purchase and sale of the Shares provided for in this Agreement (the "CLOSING") shall take place in two stages. In the first stage of the Closing (the "STAGE ONE CLOSING"), the NASD shall sell, and Nasdaq shall purchase, 13,461,538 of the Shares (the "STAGE ONE SHARES") in exchange for $174,999,994 of the Cash Purchase Price (the "STAGE ONE CASH CONSIDERATION"). In the second stage of the Closing (the "STAGE TWO CLOSING"), the NASD shall sell, and Nasdaq shall purchase, 20,307,357 of the Shares (the "STAGE TWO SHARES") in exchange for (i) $130,155,441 of the Cash Purchase Price (the "STAGE TWO CASH CONSIDERATION") and (ii) the Preferred 2.02 CLOSING DATES. The Stage One Closing shall take place on February 21, 2002, or such other date as the parties may mutually agree (the date of such closing being referred to herein as the "STAGE ONE CLOSING DATE"). The Stage Two Closing shall take place on March 1, 2002, or such other date as the parties may mutually agree (the date of such closing being referred to herein as the "STAGE TWO CLOSING DATE"). In the event that all the conditions provided for in SECTIONS 6 and 7 have not been satisfied or waived by March 1, 2002, or such other mutually agreed upon date, the Stage Two Closing shall take place on the second business day following the date that all such conditions have been satisfied or waived, other than those that by their nature are to be satisfied on the Stage Two Closing Date, but subject to the satisfaction or waiver of those conditions. Each of the Stage One Closing and the Stage Two Closing shall take place at the offices of Skadden, Arps, Slate, Meagher & Flom LLP, Four Times Square, New York, New York 10036, at 10 a.m., or at such other place and time as the parties hereto may mutually agree. 2.03 CLOSING DELIVERIES. 2.3.1 STAGE ONE CLOSING DELIVERIES. (a) On the Stage One Closing Date, Nasdaq shall pay to the NASD the Stage One Cash Consideration by wire transfer of immediately available funds to an account specified by the NASD for such purpose. (b) On the Stage One Closing Date, the NASD shall deliver to Nasdaq validly issued certificates representing the Stage One Shares duly endorsed in blank or accompanied by stock powers duly executed in blank, with all necessary stock transfer stamps affixed thereto. 2.3.2 STAGE TWO CLOSING DELIVERIES. (a) On the Stage Two Closing Date, Nasdaq shall (i) pay to the NASD the Stage Two Cash Consideration by wire transfer of immediately available funds to an account specified by the NASD for such purpose and (ii) deliver to the NASD validly issued certificates representing the Preferred Stock in the name of the NASD. (b) On the Stage Two Closing Date, the NASD shall deliver to Nasdaq validly issued certificates representing the Stage Two Shares duly endorsed in 3. COVENANTS. 3.01 FURTHER ACTIONS. The parties hereto agree to use their reasonable best efforts to have the Closing occur as soon as practicable consistent with the provisions of this Agreement. 3.02 INVESTOR RIGHTS AGREEMENT. The parties hereto agree to take all action reasonably necessary to finalize, execute and deliver an investor rights agreement (the "INVESTOR RIGHTS AGREEMENT"), as of the Stage One Closing Date. 3.03 VOTING. Commencing upon Nasdaq becoming registered with the U.S. Securities and Exchange Commission (the "SEC") as a national securities exchange ("EXCHANGE REGISTRATION"), at any meeting at which holders of Common Stock are entitled to vote or in connection with any written consent by holders of Common Stock, the NASD shall cause to be counted as present thereat for the purpose of establishing a quorum and shall vote (or grant its consent in respect of) all shares of Common Stock beneficially owned by the NASD that are not then subject to the Voting Trust Agreement (as defined below) on each matter presented in the same proportion as all other holders of Common Stock have voted (or granted consent) on such matter (for such purposes, only votes in favor, in opposition or abstention shall be counted as voting, shares that are not voted shall not be counted). In connection with the foregoing, the NASD shall so instruct the inspector of election or party seeking consent to cause such shares of Common Stock to be counted as provided above. The NASD acknowledges that the voting of the Warrant Shares shall be governed by the Voting Trust Agreement, dated June 28, 2000, as amended from time to time (the "VOTING TRUST AGREEMENT"), by and among Nasdaq, the NASD and The Bank of New York, as voting trustee. 3.04 SEC APPROVALS. (a) Prior to, and following, the Stage Two Closing Date, (i) the NASD shall use all reasonable efforts to secure SEC approval of the rules previously filed by the NASD with the SEC, in connection with the NASD's alternative display facility. (b) Nasdaq agrees to use its reasonable best efforts to secure SEC approval of each of the Series A Certificate of Designations and the Series B Certificate of Designations as soon as practicable consistent with the provisions of this Agreement. 3.05 CERTAIN ACTIONS OF NASDAQ PRIOR TO REDEMPTION OF THE SERIES A PREFERRED STOCK. During the period commencing on the Stage Two Closing Date and terminating on the date of the redemption or purchase in full of all of the then-outstanding shares of Series A Preferred Stock by Nasdaq, Nasdaq shall not, and shall not permit any of its Restricted Subsidiaries to, without the prior written consent of the NASD, which consent shall not be unreasonably withheld, conditioned or delayed (it being understood that conditioning such consent on Nasdaq's agreement to use the net proceeds of such transaction to redeem Series A Preferred Stock shall be deemed to be not unreasonable): (a) incur or assume any new long-term debt (a, "LONG-TERM DEBT INCURRENCE"); PROVIDED, HOWEVER, that this clause (a) shall not restrict in any manner any Long-Term Debt Incurrences whereby the amount of net proceeds to, plus the amount of long-term debt assumed by, Nasdaq and its Restricted Subsidiaries, collectively, from Long-Term Debt Incurrences together with net proceeds to Nasdaq and its Restricted Subsidiaries, collectively, from Extraordinary Asset Sales (as defined below), do not exceed at any time an aggregate outstanding amount equal to $200,000,000 (or its equivalent in other currencies) (which amount shall include, but not be limited to, the amount of net proceeds to Nasdaq and its Restricted Subsidiaries, collectively, from Long-Term Debt Incurrences to refinance the Cash Purchase Price). For purposes of this Agreement, "LONG-TERM DEBT INCURRENCES" shall NOT include the incurrence of any new long-term debt (i) the purpose of which is to refinance debt of Nasdaq or any Restricted Subsidiary, collectively, outstanding on the Stage One Closing Date or (ii) pursuant to or under lines of credit to Nasdaq or any Restricted Subsidiary existing on the Stage One Closing Date. (b) sell, transfer or otherwise dispose of assets of Nasdaq held directly or indirectly through any Restricted Subsidiary for cash outside of the ordinary course of Nasdaq's business (an "EXTRAORDINARY ASSET SALE"); PROVIDED, HOWEVER, that this clause (b) shall not restrict in any manner any sale, transfer or other disposition of assets resulting in net proceeds to Nasdaq and its Restricted Subsidiaries, collectively, that together with the amount of net proceeds to, plus the amount of long-term debt assumed by, Nasdaq and its Restricted Subsidiaries, collectively, from Long-Term Debt Incurrences at any time outstanding, do not exceed at any time an aggregate amount equal to $200,000,000 (or its equivalent in other currencies). For purposes of this Agreement, "EXTRAORDINARY ASSET SALES" shall NOT include (i) any sale, transfer or disposition of assets of Nasdaq to a Restricted Subsidiary, if such Restricted Subsidiary agrees in writing for the benefit of the NASD to be bound by the provisions of this SECTION 3.05(b) with respect to such assets, (ii) any sale, transfer or disposition of assets of Nasdaq in connection with a joint venture, strategic alliance or other similar arrangement, in any such case, the primary purpose of which is other than the raising of capital for Nasdaq and the consideration involved in such transaction is not predominantly comprised of cash, in each case as determined in good faith by the board of directors of Nasdaq (the "BOARD OF DIRECTORS") and (iii) any sale of any interest in the capital stock of Nasdaq or any sale by a subsidiary, other than a Restricted Subsidiary, of any interest in its capital stock. For purposes of this Agreement, the term "RESTRICTED SUBSIDIARY" means any direct or indirect subsidiary of Nasdaq other than (i) any subsidiary set forth on Schedule A hereto; PROVIDED, HOWEVER, that Quadsan Enterprises Inc. ("QUADSAN") shall not be permitted to issue any long-term debt, issue any interests in its capital stock, or sell, transfer or otherwise dispose of its assets for cash outside the ordinary course of its business and; PROVIDED, FURTHER, that any purchase, sale or transfer of any marketable securities in the ordinary course of business by Quadsan shall not be deemed to be subject to SECTION 3.5 and (ii) any subsidiary that is formed in connection with a joint venture, strategic alliance or other similar arrangement and the primary purpose of which is other than the raising of capital, as determined in good faith by the Board of Directors. 4. REPRESENTATIONS AND WARRANTIES OF THE NASD. The NASD represents and warrants to Nasdaq as follows: 4.01 ORGANIZATION AND STANDING. The NASD is a non-profit corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware. 4.02 BINDING AGREEMENT. This Agreement will be duly and validly executed and delivered on behalf of the NASD and, assuming due authorization, execution and delivery by Nasdaq, will constitute the legal and binding obligation of the NASD enforceable against the NASD in accordance with its terms, subject to the effects of bankruptcy, insolvency, fraudulent conveyance, reorganization, moratorium and other similar laws relating to or affecting creditors' rights generally and to general equity principles (whether considered in a proceeding in equity or at law). 4.03 TITLE TO SHARES. The NASD has good and valid title to the Shares, free and clear of all liens, charges, claims, security interests, restrictions, options, proxies, voting trusts or other encumbrances (each an "ENCUMBRANCE"), other than Encumbrances created by this Agreement and the Investor Rights Agreement. Assuming Nasdaq has the requisite power and authority to be lawful owner of the Shares, upon delivery to Nasdaq at the Stage One Closing and the Stage Two Closing, as applicable, of certificates representing the Stage One Shares and Stage Two Shares, as applicable, and upon the NASD's receipt of the applicable Purchase Price for the Shares, Nasdaq will acquire all of the NASD's right, title and interest in and to the Shares being sold to it and will receive good and valid title to the Shares, free and clear of any and all Encumbrances. 4.04 ACQUISITION OF THE PREFERRED STOCK. The NASD is acquiring the shares of Preferred Stock not with a view toward, or for the sale in connection with, any distribution in violation of the Securities Act of 1933, as amended (the "SECURITIES ACT"). The NASD acknowledges and agrees that (i) for the period of one year following the original issuance of the Series A Preferred Stock (the "NO TRANSFER PERIOD"), the Series A Preferred Stock may not be sold, transferred, offered for sale, pledged, hypothecated or otherwise disposed of (each, a "TRANSFER") without the prior written consent of Nasdaq, (ii) following the No Transfer Period, the Series A Preferred Stock may not be Transferred without registration under the Securities Act and any applicable state securities laws or regulations, except pursuant to an exemption from such registration under the Securities Act and any applicable state securities laws or regulations, (iii) certain contractual restrictions may restrict its ability to Transfer the shares of Series A Preferred Stock and (iv) the Series B Preferred Stock may not be Transferred. 4.05 LEGENDS. (a) The NASD acknowledges and agrees that prior to the one-year anniversary date of the Stage Two Closing Date, any certificate evidencing the shares of Series A Preferred Stock shall bear a legend substantially as follows: BE OFFERED, SOLD OR TRANSFERRED BY THE HOLDER HEREOF PRIOR TO THE ONE-YEAR ANNIVERSARY DATE OF ITS ORIGINAL ISSUANCE WITHOUT THE PRIOR WRITTEN CONSENT OF THE NASDAQ STOCK MARKET, INC. (b) The NASD acknowledges and agrees that, upon its request, until no longer required by applicable law, following the No Transfer Period, the certificates evidencing the shares of Series A Preferred Stock may be replaced with certificates bearing a legend substantially as follows: (c) The NASD acknowledges and agrees that, until no longer required by applicable law, the certificates evidencing the share of Series B Preferred Stock shall bear a legend substantially as follows: 4.06 REQUIRED APPROVALS, NOTICES AND CONSENTS. Except as set forth herein, no material consent or approval of, other action by, or any notice to, any governmental body or agency, domestic or foreign, or any third party is required in connection with the execution and delivery by the NASD of this Agreement or the consummation by the NASD of the transaction contemplated hereby. 5. REPRESENTATIONS AND WARRANTIES OF NASDAQ. Nasdaq represents and warrants to the NASD as follows: 5.01 ORGANIZATION AND STANDING. Nasdaq is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Delaware. 5.02 PREFERRED STOCK. At the Stage One Closing Date, the shares of Preferred Stock will have been duly authorized and, when transferred to the NASD in accordance with this Agreement on the Stage One Closing Date, will be validly issued, fully paid and nonassessable and the issuance of such shares will not be subject to any preemptive or similar rights. 5.03 BINDING AGREEMENT. This Agreement will have been duly and validly authorized, executed and delivered by Nasdaq and, assuming due authorization, execution and delivery by the NASD, will constitute the legal and binding obligation of Nasdaq enforceable against Nasdaq in accordance with its terms, subject to the effects of bankruptcy, insolvency, fraudulent conveyance, reorganization, moratorium and other laws relating to or affecting creditors' rights generally and to general equity principles (whether considered in a proceeding in equity or at law). required in connection with the execution and delivery by Nasdaq of this Agreement or the consummation by Nasdaq of the transaction contemplated hereby. 6. CONDITIONS TO OBLIGATIONS OF THE NASD. The obligations of the NASD are subject to the fulfillment on or prior to the Stage Two Closing as follows, except, to the extent permitted by applicable law, as may be waived by the NASD pursuant to SECTION 9.06 hereof: 6.01 STATUTES, RULES AND REGULATIONS. No statute, rule, regulation or order of any court or administrative agency shall be in effect which prohibits the consummation of the transactions contemplated hereby. 7. CONDITIONS TO OBLIGATIONS OF NASDAQ. The obligations of Nasdaq are subject to the fulfillment on or prior to the Stage Two Closing as follows, except, to the extent permitted by applicable law, as may be waived by Nasdaq 7.02 SEC OBJECTION. The SEC shall have not objected, disapproved or otherwise expressed disfavor to Nasdaq, whether in writing or orally, with respect to the Series A Certificate of Designations or the Series B Certificate of Designations. 8.01 TERMINATION. This Agreement may be terminated at any time prior to the Stage Two Closing: (a) by the mutual written consent of the parties; and (b) by either party in the event the Stage Two Closing has not occurred on or before May 20, 2002, unless the failure of such consummation shall be due to a breach of this Agreement by the party seeking to terminate 8.02 EFFECT OF TERMINATION. In the event of the termination of this Agreement pursuant to SECTION 8.01, this Agreement shall forthwith become void, and there shall be no liability on the part of any party hereto (or any stockholder, director, officer, partner, employee, agent, consultant or representative of such party) except that (a) nothing herein shall relieve any party from liability for, or eliminate the rights of any party relating to, any willful breach of this Agreement and (b) this SECTION 8.02 and SECTIONS 9.01, 9.02, 9.03 and 9.09 shall survive termination of this Agreement. 9.01 ENTIRE AGREEMENT. This Agreement, the Investor Rights Agreement and all schedules, attachments and exhibits embody the entire agreement and understanding of the parties with respect to the subject matter hereof and supersede any and all prior agreements, arrangements and undertakings, whether written or oral, relating to matters provided for herein and therein (including those set forth in the term sheet dated as of January 15, 2002 between the parties). There are no provisions, undertakings, representations or warranties relative to the subject matter of this Agreement not expressly set forth herein and therein. 9.02 EXPENSES. Except as otherwise specifically provided in this Agreement, all costs and expenses, including, without limitation, fees and disbursements of counsel, financial advisors and accountants, incurred in connection with this Agreement and the transaction contemplated hereby shall be paid by the party incurring such expense. 9.03 NOTICES. Any notice, demand, claim, notice of claim, request or communication required or permitted to be given under the provisions of this Agreement shall be in writing and shall be deemed to have been duly given if delivered personally by facsimile transmission or sent by first class or certified mail, postage prepaid to the following addresses, If to the NASD: 1735 K Street, N.W. with a copy to: Shearman & Sterling Attention: Robert Mundheim, Esq. and James B. Bucher, Esq. If to Nasdaq: One Liberty Plaza Four Times Square Attention: Matthew J. Mallow, Esq. and Eric J. Friedman, Esq. or to such other address as any party may request by notifying in writing all of the other parties to this Agreement in accordance with this SECTION 9.03. Any such notice shall be deemed to have been received on the date of personal delivery, the date set forth on the Postal Service return receipt, the date of delivery shown on the records of the overnight courier or the date shown on the facsimile confirmation, as applicable. 9.04 SURVIVAL OF REPRESENTATIONS AND WARRANTIES. Each of the representations and warranties made by the parties in this Agreement shall terminate 12 months after the Stage Two Closing. 9.05 BENEFIT AND ASSIGNMENT. This Agreement will be binding upon and inure to the benefit of the parties hereto and their respective successors and permitted assigns. There shall be no assignment of any interest under this Agreement by any party. Nothing herein, express or implied, is intended to or shall confer upon any other person any legal or equitable right, benefit or remedy of any nature whatsoever under or by reason of this Agreement. 9.06 WAIVER. Any waiver of any provision of this Agreement shall be valid only if set forth in an instrument in writing signed by the party to be bound thereby. Any waiver of any term or condition shall not be construed as a waiver of any subsequent breach or a subsequent waiver of the same term or condition, or a waiver of any other term or condition, of this Agreement. The failure of any party to assert any of its rights hereunder shall not constitute a waiver of any such rights. 9.07 AMENDMENT. This Agreement may not be amended or modified except by an instrument in writing signed by, or on behalf of, the NASD and Nasdaq. 9.08 CONSTRUCTION OF THIS AGREEMENT; COUNTERPARTS. The language used in this Agreement shall be deemed to be the language chosen by the parties hereto to express their mutual agreement, and this Agreement shall not be deemed to have been prepared by any single party hereto. The headings of the sections and subsections of this Agreement are inserted as a matter of convenience and for reference purposes only and in no respect define, limit or describe the scope of this Agreement or the intent of any section or subsection. This Agreement may be executed in one or more counterparts and by the different parties hereto in separate counterparts, each of which when executed shall be deemed to be an original but all of which taken together shall constitute one and the same agreement. 9.09 GOVERNING LAW. This Agreement shall be governed by, and construed and enforced in accordance with, the internal laws of the State of New York applicable to contracts executed and to be performed in the State of New York. 9.10 PUBLIC ANNOUNCEMENTS. No party hereto shall make any public announcement concerning the transactions contemplated by this Agreement without the prior approval of the other party hereto, except as such announcement may be required by the applicable laws, rules and regulations. The parties hereto acknowledge that promptly after the execution of this Agreement and each of the Stage One Closing and the Stage Two Closing, the parties will make public disclosure, to be mutually agreed upon, of the transactions contemplated by this 9.11 SPECIFIC PERFORMANCE. The parties recognize and agree that if for any reason any of the provisions of this Agreement are not performed in accordance with their specific terms or are otherwise breached, immediate and irreparable harm or injury would be caused for which money damages would not be an adequate remedy. Accordingly, each party agrees that, in addition to any other available remedies, each other party shall be entitled to an injunction restraining any violation or threatened violation of the provisions of this Agreement without the necessity of posting a bond or other form of security. In the event that any action should be brought in equity to enforce the provisions of the Agreement, no party will allege, and each party hereby waives the defense, that there is an adequate remedy at law. 9.12 FURTHER ASSURANCES. The NASD hereby agrees that it shall from time to time, at the request of Nasdaq, execute and deliver to Nasdaq any and all instruments or documents as Nasdaq may reasonably request for the purpose of vesting in Nasdaq the full right, title and interest of the NASD in and to the Shares. [Signature page follows] IN WITNESS WHEREOF, this Agreement has been duly executed by the parties hereto as of the date first above written. NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. By: /s/ Douglas Shulman Name: Douglas Shulman Title: Executive Vice President By: /s/ Edward S. Knight Name: Edward S. Knight Exhibit I FORM OF SERIES A CERTIFICATE OF DESIGNATIONS [Previously Filed] Exhibit II FORM OF SERIES B CERTIFICATE OF DESIGNATIONS LIST OF NON-RESTRICTED SUBSIDIARIES 1. Nasdaq Tools, Inc. 2. Quadsan Enterprises Inc. 3. Nasdaq Global Holdings 4. Nasdaq Global Technology, Ltd. 5. Nasdaq International Ltd. 6. Nasdaq Ltda 7. Nasdaq Europe Planning Company Ltd. 8. Nasdaq Japan, Inc. 9. Nasdaq Europe S.A./N.V. 10. IndigoMarkets Ltd. 11. IndigoMarkets India Private Ltd. 12. Nasdaq Financial Products Services, Inc. 13. Nasdaq International Market Initiatives, Inc. 14. Nasdaq Canada, Inc. 15. Nasdaq Educational Foundation Inc. 16. Nasdaq-BIOS R&D Joint Venture [LETTERHEAD OF NASDAQ] Mr. J. Patrick Campbell 8900 Bel Air Place Re: RESIGNATION AND RELEASE OF CLAIMS Dear Pat: This letter (including Attachment A hereto) sets forth the agreement (the "Agreement and Release") by and among you and The Nasdaq Stock Market, Inc. (the "Company"). This Agreement and Release confirms our understanding and agreement with respect to your resignation of employment with the Company as follows: 1. RESIGNATION. You confirm the resignation of your employment as President, Nasdaq U.S. Markets, and the resignation of any other positions held by you with the Company or the Releasees (as defined below) effective December 31, 2001 (hereinafter, the "Resignation Date"). You agree that thereafter, you will not represent yourself to be associated in any capacity with the Company or the Releasees. You further agree to cooperate and execute administrative documents necessary to effectuate such resignation(s). By this Agreement and Release, the Employment Agreement between you and the Company effective December 29, 2000 (and any predecessor agreement) is terminated and superseded by this Agreement and Release, except as specifically provided in Paragraph 8 below (a copy of your December 29, 2000 Employment Agreement is attached hereto for reference). You will continue to receive payments at the current rate of your base compensation ($436,000 per year) through December 31, 2001, payable in accordance with the Company's payroll practices. 2. COMPENSATION. You will be entitled to the following payments and benefits, subject to applicable deductions and tax withholding and (i) the execution and delivery of this Agreement and Release in accordance with the provisions of Paragraph 19 below, and non-revocation of the same; (ii) on December 31, 2001, the execution and delivery of Attachment A hereto pursuant to its terms and non-revocation of the same, (iii) the terms and conditions of this Agreement and Release, and (iv) with respect to Paragraph 2(d) below, approval of the Nasdaq Stock Market, Inc. Equity Plan Committee: a. You will be paid $436,000 (100% of your annual base compensation), which you agree represents your Incentive Compensation for 2001, payable in a lump sum upon the expiration of your right to revoke Attachment A hereto; b. You will be paid $470,000, which you agree represents your deferred compensation for 1999 and 2000, payable on June 30, 2002; c. You will be paid $1,000,000, which you agree represents an additional separation payment, payable in equal installments over the twelve month period beginning January 1, 2002 and ending December 31, 2002, in accordance with the Company's payroll practices in effect at the time; d. Subject to your continued employment through December 31, 2001, on January 1, 2002, your restricted stock award of 30,000 shares will become fully vested, your incentive stock option (ISO) award and your nonqualified stock option (NSO) award will vest as to 4667 shares and 35,233 shares respectively, and your ISO and NSO awards, to the extent so vested, will remain exercisable until, and will terminate upon, the eighteen month anniversary of the Resignation Date. You acknowledge and agree that (i) the tax withholding obligation that arises by reason of the vesting of your restricted stock award will be satisfied from the cash payments payable pursuant to the other clauses of this Paragraph 2, (ii) the ISO, to the extent exercised more than 3 months after the Resignation Date, will be treated as a nonqualified option for tax purposes as required by applicable law, (iii) the vested awards remain subject to the terms and conditions of the Company's Equity Incentive Plan (including those contained in Section 9 thereof, which references transfer restrictions, as well as the Company's right to repurchase the shares, which you agree remains outstanding for 6 months from the Resignation Date, or, in the case of options, the date you acquire the shares), and (iv) all other stock or equity-based awards that are not vested as provided above are cancelled as of the Resignation Date; e. Under the NASD Supplemental Executive Retirement Plan (the "SERP"), upon your attainment of age 55, you will be treated as having satisfied the age and service requirements solely for purposes of Sections 4.1 and 4.3 of the SERP, and not for any other purpose, including the calculation of your "Retirement Benefit" under Section 4.2 of the SERP ("SERP Calculation"). The SERP Calculation will be based upon your actual period of completed service and actual compensation paid during your employment as such service and compensation are determined under the SERP and, except as provided herein, will be consistent with the policies and practices of the SERP applicable to similarly eligible Company executives. The Company will cooperate with your reasonable request to explain the actuarial bases and methodology of the SERP Calculation; f. Following the Resignation Date, you and your family will continue to receive health coverage on the same basis that such coverage is provided to active employees. This coverage will terminate on the earlier of December 31, 2003 or the date you become eligible for coverage under another group health plan (whether or not as an employee), and you agree to notify the Company in writing immediately upon becoming so eligible. You acknowledge that the period of coverage provided under this Paragraph 2(f) will be counted as continuation health coverage under "COBRA"; g. Upon the Resignation Date, you will cease to actively participate in all other benefit plans and programs, including, but not limited to, the Company's pension plan, 401(k) plan, employee stock purchase plan and flexible spending plan, and any entitlements thereunder will be governed by the terms of such plans and programs. You agree that any amounts payable under this Paragraph 2 will not be taken into account in determining any such entitlements; h. You will be paid your accrued and unused vacation time in a lump sum on January 2, 2002; and i. You will be reimbursed for approved and authorized out-of-pocket travel and business expenses incurred through December 31, 2001, as soon as practicable thereafter. 3. NO OTHER COMPENSATION. Other than as set forth herein, you will not receive compensation, payments or benefits of any kind from the Company or Releasees (as that term is defined below) relating to or arising out of your employment, compensation or benefits with the Company, or the resignation thereof, or any services rendered by you during the period of such employment. You understand and agree that the compensation, payments and benefits provided for in this Agreement and Release are in excess of those to which you may be entitled from the Company or Releasees, and you expressly acknowledge and agree that you are not entitled to any additional compensation, payment or benefit from the Company, including, but not limited to, any compensation, payment or benefit under any Company severance plan or policy. 4. WAIVER AND RELEASE BY YOU. In exchange for the compensation, payments, benefits and other consideration provided to you pursuant to this Agreement and Release, you agree to execute Attachment A pursuant to its terms, and you further agree as follows: a. You agree to accept the compensation, payments, benefits and other consideration provided for in this Agreement and Release in full resolution and satisfaction of, and hereby IRREVOCABLY AND UNCONDITIONALLY RELEASE, WAIVE AND FOREVER DISCHARGE the Company and Releasees from, any and all agreements, promises, liabilities, claims, demands, rights and entitlements of any kind whatsoever, in law or equity, whether known or unknown, asserted or unasserted, fixed or contingent, apparent or concealed, which you, your heirs, executors, administrators, successors or assigns ever had, now have or hereafter can, shall or may have for, upon, or by reason of any matter, cause or thing whatsoever existing, arising or occurring at any time on or prior to the date you execute this Agreement and Release, including, without limitation, any and all claims arising out of or relating to your employment, compensation and benefits with the Company and/or the resignation thereof, and any and all contract claims, benefit claims, tort claims, fraud claims, claims under your December 29, 2000 Employment Agreement (and any predecessor agreement), commissions, defamation, disparagement, or other personal injury claims, claims related to any bonus compensation, claims for accrued vacation pay, claims under any federal, state or municipal wage payment, discrimination or fair employment practices law, statute or regulation, and claims for costs, expenses and attorneys' fees with respect thereto, except that the Company's obligations under this Agreement and Release shall continue in full force and effect in accordance with their terms. THIS RELEASE AND WAIVER INCLUDES, WITHOUT LIMITATION, ANY AND ALL RIGHTS AND CLAIMS UNDER TITLE VII OF THE CIVIL RIGHTS ACT OF 1964, AS AMENDED, THE CIVIL RIGHTS ACT OF 1991, THE CIVIL RIGHTS ACT OF 1866 (42 U.S.C. 1981), THE EMPLOYEE RETIREMENT INCOME SECURITY ACT, AS AMENDED, THE AMERICANS WITH DISABILITIES ACT, THE FAIR LABOR STANDARDS ACT, THE FAMILY AND MEDICAL LEAVE ACT, THE AGE DISCRIMINATION IN EMPLOYMENT ACT, THE DISTRICT OF COLUMBIA HUMAN RIGHTS ACT, THE DISTRICT OF COLUMBIA FAMILY AND MEDICAL LEAVE ACT OF 1990, THE NEW YORK STATE EXECUTIVE LAW, THE NEW YORK CITY ADMINISTRATIVE CODE and all other federal, state or local fair employment practices statutes, ordinances, regulations or constitutional provisions; PROVIDED, HOWEVER, that this waiver and release shall not prohibit you from testifying truthfully under oath pursuant to subpoena, order or otherwise, or cooperating in an official government investigation as may be required by law, or from enforcing against the Company or Releasees your rights under this Agreement and Release. You further represent and affirm (i) that you have not filed any claim or demand for relief against the Company or Releasees and (ii) that to the best of your knowledge and belief, there are no outstanding claims or demands for relief within the meaning of this Paragraph 4(a); b. For the purpose of implementing a full and complete release and discharge of claims, you expressly acknowledge that this Agreement and Release is intended to include in its effect, without limitation, all the claims described in the preceding Paragraph 4(a), whether known or unknown, apparent or concealed, and that this Agreement and Release contemplates the extinction of all such claims, including claims for attorney's fees. You expressly waive any right to assert after the execution of this Agreement and Release that any such claim, demand, obligation or cause of action has, through ignorance or oversight, been omitted from the scope of this Agreement and Release; and c. For purposes of this Agreement and Release, the term "the Company and Releasees" includes The Nasdaq Stock Market, Inc., and any past, present and future direct and indirect parents, subsidiaries, affiliates, divisions, predecessors, successors, and assigns, and their past, present and future officers, directors, shareholders, representatives, employees, agents and attorneys, in their official and individual capacities, and all other related individuals and entities, jointly and individually, and this Agreement and Release shall inure to the benefit of and be enforceable by all such entities and individuals and their successors and assigns. 5. WAIVER AND RELEASE BY THE COMPANY. By signing this Agreement and by acceptance of the mutual consideration and covenants contained herein, the Company WAIVES, RELEASES AND FOREVER DISCHARGES you with respect to any and all unasserted, fixed or contingent, apparent or concealed, which the Company ever had, now has or hereafter can, shall or may have for, upon, or by reason of any matter, cause or thing whatsoever existing, arising or occurring at any time on or prior to the date the Company executes this Agreement, including, without limitation, any and all claims arising out of or relating to your employment, compensation and benefits with the Company, and your resignation thereof; provided, however, that this waiver and release shall not prohibit the Company and Releasees from enforcing against you their rights under 6. ADMISSIONS. Nothing contained in this Agreement and Release shall be deemed to constitute an admission or evidence of any wrongdoing or liability on your part or the part of the Company or Releasees. 7. RETURN OF DOCUMENTS AND PROPERTY. On or before the Resignation Date, you will return to the Company all known equipment, data, material, books, records, documents (whether stored electronically or on computer hard drives or disks), computer disks, credit cards, Company keys, I.D. cards and other property, including, without limitation, stand alone computer, fax machine, printers, telephones, and Blackberry(TM) in your possession, custody, or control which are or were owned and/or leased by the Company in connection with the conduct of the business of the Company (collectively referred to as "Company Property"). You further warrant that you have not retained, or delivered to any person or entity, copies of Company Property or permitted any copies of Company Property to be made by any other person or entity. 8. NON-COMPETITION/CONFIDENTIAL INFORMATION/NON-SOLICITATION/MUTUAL NON- DISPARAGEMENT. a. You and the Company acknowledge and agree that you possess knowledge and skills unique to the Company and the Company's industry. You acknowledge and agree that the provisions and restrictions regarding, among other things, non-competition, confidentiality and non-solicitation, as set forth in Paragraph 10, subparagraphs (a)-(d), inclusive, of your December 29, 2000 Employment Agreement, survive the termination of that Employment Agreement, are incorporated herein by reference and shall remain in full force and effect pursuant to their terms. NOTWITHSTANDING THE FOREGOING, you may accept employment with, consult for and/or provide services to (i) alternative trading systems that are not Electronic Communication Networks ("ECNs") and (ii) non-U.S. registered exchanges, as each of those terms are defined in the Securities Exchange Act of 1934, as amended, and the rules and regulations promulgated thereunder, without breach of your non-competition restrictions and obligations under this Paragraph 8. Further, during the "Restricted Period" (as that term is defined in Paragraph 10 of your December 29, 2000 Employment Agreement), you may, in writing, request permission from the Company to accept employment with, consult for and/or provide services to a specific person or entity engaged in a "Competitive Business" (as that term is defined in Paragraph 10 of your December 29, 2000 Employment Agreement) and the Company agrees to consider any such reasonable request in good faith, and, in its sole discretion, determine whether or not to grant or deny such request. In no event shall any partial waiver by the Company of your non-competition restrictions and obligations as described in this Paragraph 8(a) relieve you of your restrictions and obligations regarding confidentiality and non-solicitation as set forth in Paragraph 10 of your December 29, 2000 Employment Agreement, which you agree shall remain b

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Nexstar Media Group Inc, Warner Bros Discovery Inc, Paramount Global, Paramount Global Nexstar Media Group Reports Record Third Quarter Net Revenue of $1.27 Billion Net Revenue Drives Record Q3 Operating Income of $355.3 Million, Net Income of $287.5 Million, Adjusted EBITDA of $488.8 Million and Free Cash Flow of $293.6 Million All-Time High Third Quarter and Nine Month Return of Capital to Shareholders of $250.1 Million and $729.6 Million, Respectively IRVING, Texas--(BUSINESS WIRE)--Nov. 8, 2022-- Nexstar Media Group, Inc. (NASDAQ: NXST) (“Nexstar” or “the Company”) today reported financial results for the third quarter ended September 30, 2022 as summarized below: Summary 2022 Third Quarter Highlights ($ in millions) Core Advertising Revenue (7.6 Political Advertising Revenue +942.7 Total Television Advertising Revenue Distribution Revenue Digital Revenue Net Revenue Income from Operations Adjusted EBITDA Before Transaction and Other One-Time Expenses (1) Adjusted EBITDA (1) Adjusted EBITDA Margin (2) Free Cash Flow Before Transaction and Other One-Time Expenses (1) Free Cash Flow (1) The contribution from Nexstar’s 31.3% ownership stake in TV Food Network and other investments is included in the Condensed Consolidated Statements of Operations under caption “Income from equity method investments, net”. (1) Definitions and disclosures regarding non-GAAP financial information including reconciliations are included at the end of the press release. (2) Adjusted EBITDA margin is Adjusted EBITDA as a percentage of net revenue. Perry Sook, Nexstar’s Chairman and Chief Executive Officer, commented, “Nexstar delivered another quarter of record financial results as third quarter net revenue rose 9.7%, led by strong growth in political advertising, distribution, and digital revenue. Adjusted EBITDA and free cash flow were also third quarter records and we returned 85.2% of our free cash flow to shareholders through a combination of dividends and share repurchases. Our focus on generating strong free cash flow and enhancing shareholder value are highlighted by our 2022 year-to-date return of $729.6 million to shareholders. “Nexstar’s results continue to benefit from our diverse, scaled, efficient and low leverage business model. Over 50% of revenue is contractual and from non-advertising sources and approximately 70% of our core advertising is from local advertisers which are historically more consistent in their spend throughout economic cycles. Nexstar has built an unparalleled local moat with more than 1,500 local sellers and 40,000 advertiser relationships in the 116 local markets we serve across America. In addition, we are extremely well positioned to continue to benefit from record levels of political advertising spending which is not dependent on the economy. “We expect the fourth quarter to benefit from a continuation of strong political advertising trends while 2023 will see distribution revenue upside from renewals of agreements representing more than half of our subscribers. Looking forward, we expect 2024 to benefit from another record year for political advertising due to the presidential election combined with the benefit of another wave of distribution agreement renewals for approximately 40% our subscribers. “Longer-term, we believe implementing our plans for The CW Network, growing NewsNation and progressing towards the monetization of our spectrum through the deployment of ATSC 3.0 technology will complement our other growth initiatives to support the further enhancement of shareholder value.” Third Quarter 2022 Business Highlights Consistent with the Company’s commitment to enhancing shareholder value, Nexstar’s Board of Directors took the following actions: Extended the employment agreement of Chief Executive Officer, Perry A. Sook, through March 31, 2026. Approved a new share repurchase program authorizing the Company to repurchase up to $1.5 billion of its common stock. Voted to recommend that shareholders approve an amendment to its corporate charter to declassify the Board of Directors. The proposed charter amendment is subject to shareholder approval at the Company’s next Annual Meeting of Shareholders, which will be held in 2023. On September 30th, Nexstar closed its previously announced acquisition of a 75% ownership interest in The CW Network, LLC (“The CW”) from co-owners Warner Bros. Discovery (Nasdaq: WBD) and Paramount Global (Nasdaq: PARA, PARAA), who each retained a 12.5% ownership interest in The CW. The transaction is expected to solidify the Company’s programming and revenue opportunities as the largest CW affiliate group, diversify its content outside of news, and establish it as a scaled participant in advertising video-on-demand (AVOD) services via The CW App. Dennis Miller, a seasoned television executive with a long-term record of success and value creation in the industry, has been named President of The CW. Mr. Miller is focused on creating value for The CW and Nexstar shareholders by improving The CW ratings, revenue, and profitability. Mr. Miller previously served as a member of Nexstar’s Board of Directors since 2014 and stepped down from the Board in connection with his appointment. The Board of Directors has initiated a search for his replacement. NewsNation, the fastest growing national cable news network, announced key journalist and editorial additions and production facility expansions in New York City and Washington, D.C. Nexstar Digital launched The Hill TV FAST channel, building upon The Hill’s success as an essential, agenda-setting read for lawmakers, policymakers and influential digital consumers from Capitol Hill to Main Street. Nexstar-owned KTLA 5, Los Angeles’ #1 TV station, entered into a new broadcast television partnership with the Los Angeles Clippers to exclusively air fifteen games, which will also be carried by several other Nexstar local television stations across California. Nexstar-owned and partner stations and NewsNation delivered unprecedented mid-term election coverage, hosting 50 local and statewide candidate debates and forums from the primaries through Election Day, including the only televised debates for key U.S. Senate races in Ohio, Georgia and Pennsylvania and the Governor’s races in Texas and Illinois. Nexstar Media Inc. stations earned a Sigma Delta Chi Award from the Society of Professional Journalists and four National Edward R. Murrow Awards from the Radio Television Digital News Association (RTDNA), including recognition for “Excellence in Innovation,” “Breaking News Coverage,” “Digital” and “Podcast.” Third Quarter 2022 Financial Highlights Record third quarter net revenue of $1.27 billion increased 9.7% from the prior year quarter. Revenue growth was driven by strong political advertising revenue and healthy year-over-year increases in distribution, digital and other revenue, partially offset by a decline in core advertising, including the allocation of inventory to political advertising. 58.3% of Nexstar’s third quarter net revenue was generated by distribution, digital and other revenue sources. Third quarter core television advertising revenue of $399.7 million decreased 7.6% year-over-year, reflecting a weaker national advertising market, the absence of the Olympics and political inventory displacement. Offsetting the rate of decline was a more stable local advertising market, which constitutes approximately 70% of Nexstar’s core advertising revenue, aided by new local television advertising incentive program revenue of $36.1 million which increased 4% year-over-year. Third quarter political advertising revenue of $129.3 million increased 942.7% year-over-year and 84.3% over the third quarter of 2018, and was just $3.1 million behind third quarter 2020 levels. The increase reflects strong mid-term election spending, led by strong spending in California, Nevada, Missouri, Michigan and Pennsylvania, among others. Record third quarter distribution revenue rose 3.7% year-over-year to approximately $641.7 million. The increase reflects the renewal of distribution agreements in 2021 on improved terms and annual rate escalators, partially offset by MVPD subscriber attrition. Record third quarter digital revenue increased 5.7% year-over-year to approximately $85.7 million. Revenue growth was driven by year-over-year increases in Nexstar’s core digital advertising revenue and agency services business, combined with contributions from The Hill, which was acquired in the third quarter of 2021. Record third quarter adjusted EBITDA increased 19.1% to $488.8 million, representing a 38.5% margin, and record third quarter free cash flow increased 16.6% to $293.6 million, representing 60.1% of Adjusted EBITDA. Growth in Adjusted EBITDA was primarily attributable to increased revenue net of related variable expenses and continued operational focus on controlling fixed expense growth. In the third quarter of 2022, the Company used cash flow from operations to: Reduce debt by approximately $59.6 million, and Return $250.1 million to shareholders through the repurchase of 1,197,138 shares of Nexstar’s common stock at an average price of approximately $179.77 per share for a total cost of $215.2 million, and quarterly cash dividend payments of $34.9 million. As of September 30, 2022, Nexstar had 38.3 million shares of common stock outstanding. As of September 30, 2022, Nexstar has approximately $1.5 billion available under its share repurchase authorization. Debt and Leverage Review The consolidated debt of Nexstar and Mission Broadcasting, Inc., an independently owned variable interest entity, at September 30, 2022 was $7,177.2 million, including senior secured debt of $4,423.5 million. The Company’s unrestricted cash balance includes cash at the Company’s consolidated, 75%-owned subsidiary, The CW Network LLC, but this cash is excluded from its leverage ratios in accordance with the terms of its credit agreements. The Company calculates its leverage ratios in accordance with the terms of its credit agreements. The Company’s first lien net leverage ratio at September 30, 2022 was 1.92x compared to a covenant of 4.25x. The Company’s total net leverage ratio at September 30, 2022 was 3.18x. The table below summarizes the Company’s debt obligations (net of financing costs, discounts and/or premiums). First Lien Term Loans 5.625% Senior Unsecured Notes due 2027 4.75% Senior Unsecured Notes due 2028 Total Outstanding Debt Unrestricted Cash Third Quarter Conference Call Nexstar will host a conference call at 10:00 a.m. ET today. Senior management will discuss the financial results and host a question-and-answer session. The dial in number for the audio conference call is +1 929-477-0402, conference ID 6574015 (domestic and international callers). Participants can also listen to a live webcast of the call through the “Events and Presentations” section under “Investor Relations” on Nexstar’s website at nexstar.tv. A webcast replay will be available for 90 days following the live event at nexstar.tv. Definitions and Disclosures Regarding non-GAAP Financial Information Adjusted EBITDA is calculated as net income, plus interest expense (net), loss on extinguishment of debt, income tax expense (benefit), depreciation of property and equipment, amortization of intangible assets and broadcast rights, (gain) loss on asset disposal, impairment charges, (income) loss from equity method investments, distributions from equity method investments and other expense (income), minus reimbursement from the FCC related to station repack and broadcast rights payments. We consider Adjusted EBITDA to be an indicator of our assets’ operating performance and a measure of our ability to service debt. It is also used by management to identify the cash available for strategic acquisitions and investments, maintain capital assets and fund ongoing operations and working capital needs. We also believe that Adjusted EBITDA is useful to investors and lenders as a measure of valuation and ability to service debt. Free cash flow is calculated as net income, plus interest expense (net), loss on extinguishment of debt, income tax expense (benefit), depreciation of property and equipment, amortization of intangible assets and broadcast rights, (gain) loss on asset disposal, stock-based compensation expense, impairment charges, (income) loss from equity method investments, distributions from equity method investments and other expense (income), minus payments for broadcast rights, cash interest expense, capital expenditures, proceeds from disposals of property and equipment, and operating cash income tax payments. We consider Free Cash Flow to be an indicator of our assets’ operating performance. In addition, this measure is useful to investors because it is frequently used by industry analysts, investors and lenders as a measure of valuation for broadcast companies, although their definitions of Free Cash Flow may differ from our definition. For a reconciliation of these non-GAAP financial measurements to the GAAP financial results cited in this news announcement, please see the supplemental tables at the end of this release. With respect to our forward-looking guidance, no reconciliation between a non-GAAP measure to the closest corresponding GAAP measure is included in this release because we are unable to quantify certain amounts that would be required to be included in the GAAP measure without unreasonable efforts. We believe such reconciliations would imply a degree of precision that would be confusing or misleading to investors. In particular, a reconciliation of forward-looking Free Cash Flow to the closest corresponding GAAP measure is not available without unreasonable efforts on a forward-looking basis due to the high variability, complexity and low visibility with respect to the charges excluded from these non-GAAP measures. For example, the definition of Free Cash Flow excludes stock-based compensation expenses specific to equity compensation awards that are directly impacted by unpredictable fluctuations in our stock price. In addition, the definition of Free Cash Flow excludes the impact of non-recurring or unusual items such as impairment charges, transaction-related costs and gains or losses on sales of assets which are unpredictable. We expect the variability of these items to have a significant, and potentially unpredictable, impact on our future GAAP financial results. About Nexstar Media Group, Inc. Nexstar Media Group, Inc. (NASDAQ: NXST) is a leading diversified media company that produces and distributes engaging local and national news, sports and entertainment content across television, streaming and digital platforms, including nearly 300,000 hours of original video content each year. Nexstar owns America’s largest local broadcasting group comprised of top network affiliates, with 200 owned or partner stations in 116 U.S. markets reaching 212 million people. Nexstar’s national television properties include The CW, America’s fifth major broadcast network, NewsNation, America’s fastest-growing national news and entertainment cable network reaching 70 million television homes, popular entertainment multicast networks Antenna TV and Rewind TV, and a 31.3% ownership stake in TV Food Network. The Company’s portfolio of digital assets, including The Hill and BestReviews, are collectively a Top 10 U.S. digital news and information property. In addition to delivering exceptional content and service to our communities, Nexstar provides premium multiplatform and video-on-demand advertising opportunities at scale for businesses and brands seeking to leverage the strong consumer engagement of our compelling content offering. For more information, please visit nexstar.tv. This communication includes forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Forward-looking statements include information preceded by, followed by, or that includes the words "guidance," "believes," "expects," "anticipates," "could," or similar expressions. For these statements, Nexstar claims the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. The forward-looking statements contained in this communication, concerning, among other things, future financial performance, including changes in net revenue, cash flow and operating expenses, involve risks and uncertainties, and are subject to change based on various important factors, including the impact of changes in national and regional economies, the ability to service and refinance our outstanding debt, successful integration of business acquisitions (including achievement of synergies and cost reductions), pricing fluctuations in local and national advertising, future regulatory actions and conditions in the television stations' operating areas, competition from others in the broadcast television markets, volatility in programming costs, the effects of governmental regulation of broadcasting, industry consolidation, technological developments and major world news events. Nexstar undertakes no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. In light of these risks, uncertainties and assumptions, the forward-looking events discussed in this communication might not occur. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this release. For more details on factors that could affect these expectations, please see Nexstar’s other filings with the Securities and Exchange Commission. -tables follow- (in millions, except for share and per share amounts, unaudited) Operating expenses (income): Direct operating expenses Selling, general and administrative expenses, excluding corporate Amortization of broadcast rights Amortization of intangible assets Depreciation of property and equipment Reimbursement from the FCC related to station repack (17.9 Gain on bargain purchase Income from equity method investments, net (233.2 Pension and other postretirement plans credit, net Other income (expenses), net Net loss attributable to noncontrolling interests Net income attributable to Nexstar Media Group, Inc. Net income per common share attributable to Nexstar Media Group, Inc.: Weighted average number of common shares outstanding: Basic (in thousands) Diluted (in thousands) Reconciliation of Adjusted EBITDA (Non-GAAP Measure) ($ in millions, unaudited) Adjusted EBITDA: Add (Less): Stock-based compensation expense Amortization of right-of-use assets attributable to favorable leases Loss (gain) on asset disposal and operating lease terminations, net Transaction and other one-time expenses Distributions from equity method investments Other (income) expenses, net Gain on disposal of a business unit, net Payments for broadcast rights Adjusted EBITDA before transaction, one-time and other non-cash items Margin % Less: Transaction and other one-time expenses Adjusted EBITDA before other non-cash items Adjusted EBITDA before transaction and other one-time expenses Reconciliation of Free Cash Flow (Non-GAAP Measure) Free Cash Flow: Cash interest expense Capital expenditures, excluding station repack and CVR spectrum Capital expenditures related to station repack Proceeds from disposal of assets(1) Operating cash income tax payments, net(2) Free cash flow before transaction, one-time and other non-cash items Free cash flow before other non-cash items Add: Pension and other postretirement plans credit, net Free cash flow before transaction and other one-time expenses Excludes proceeds from the sale of certain real estate property of $40.4 million during Q2 2022 ($45.3 million in total including deposits received in Q1 2022 and Q4 2021). Excludes Q3 2022 tax payments related to the sale of certain real property of $4.6 million. Thomas E. Carter President and Chief Operating Officer Lee Ann Gliha Joseph Jaffoni or Jennifer Neuman 212/835-8500 or [email protected] Gary Weitman EVP and Chief Communications Officer 972/373-8800 or [email protected] Source: Nexstar Media Group, Inc.

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professional_accounting

FLEX REPORTS THIRD QUARTER FISCAL 2023 RESULTS SAN JOSE, Calif., Jan. 25, 2023 /PRNewswire/ -- Flex (NASDAQ: FLEX) today announced results for its third quarter ended December 31, 2022. Third Quarter Fiscal Year 2023 Highlights: Net Sales: $7.8 billion GAAP Operating Income: $321 million Adjusted Operating Income: $372 million GAAP Net Income Attributable to Flex Ltd.: $230 million Adjusted Net Income: $285 million GAAP Earnings Per Share: $0.50 Adjusted Earnings Per Share: $0.62 An explanation and reconciliation of non-GAAP financial measures to GAAP financial measures is presented in Schedules II and V attached to this press release. "We achieved another strong quarter through the focused efforts of the team, and strong execution against healthy demand," said Revathi Advaithi, CEO of Flex. "I remain confident about the resiliency of our portfolio and our ability to deliver growth and value to our stakeholders." Fourth Quarter Fiscal 2023 Guidance Revenue: $7.0 billion to $7.4 billion GAAP Operating Income: $268 million to $298 million Adjusted Operating Income: $315 million to $345 million GAAP EPS: $0.37 to $0.43 Adjusted EPS: $0.48 to $0.54 which excludes $0.06 for stock-based compensation expense, $0.04 for net intangible amortization, and $0.01 for Nextracker LLC series A redeemable preferred units dividends payable in kind. Fiscal Year 2023 Guidance Updated Revenue: $29.9 billion to $30.3 billion Adjusted EPS: $2.27 to $2.33 which excludes $0.23 for stock-based compensation expense, $0.15 for net intangible amortization, $0.06 for other charges, and $0.05 for Nextracker LLC series A redeemable preferred units dividends payable in kind. Webcast and Conference Call The Flex management team will host a conference call today at 1:30 PM (PT) / 4:30 PM (ET), to review third quarter fiscal 2023 results. A live webcast of the event and slides will be available on the Flex Investor Relations website at http://investors.flex.com. An audio replay and transcript will also be available after the event on the Flex Investor Relations website. About Flex Flex (Reg. No. 199002645H) is the diversified manufacturing partner of choice that helps market-leading brands design, build and deliver innovative products that improve the world. Through the collective strength of a global workforce across approximately 30 countries with responsible, sustainable operations, Flex delivers advanced manufacturing solutions and operates one of the most trusted global supply chains, supporting the entire product lifecycle with fulfillment, after-market and circular economy solutions for diverse industries. David Rubin Vice President, Investor Relations [email protected] Mark Plungy Director, Corporate Integrated Communications [email protected] This press release contains forward-looking statements within the meaning of U.S. securities laws, including: statements related to future expected revenues and earnings per share. These forward-looking statements involve risks and uncertainties that could cause the actual results to differ materially from those anticipated by these forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements. These risks include: that we may not achieve our expected future operating results, including margins; the effects that the current and future macroeconomic environment, including inflation, rising interest rates, and currency exchange rate fluctuations, could have on our business and demand for our products; the impact of component shortages, fluctuations in the pricing or availability of raw materials, labor and energy, and logistical constraints, including their impact on our revenues and margins; uncertainties and risks relating to our ability to successfully complete a transaction for our Nextracker business, including the proposed initial public offering of our Nextracker business, including the possibility that we may not be able to consummate the transaction on the expected timeline or at all, or that we will achieve the anticipated benefits of the transaction; the possibility that we may not fully realize the projected benefits of the Anord Mardix acquisition, including our expectation that the acquisition will be accretive to our fiscal year 2023 adjusted earnings per share; geopolitical risk, including the termination and renegotiation of international trade agreements and trade policies, including the impact of tariffs and related regulatory actions; the war in Ukraine and escalating geopolitical tensions as a result of Russia's invasion of Ukraine, including the imposition of economic sanctions on Russia which could lead to disruption, instability, and volatility in global markets and negatively impact our operations and financial performance; the scope and duration of the COVID-19 pandemic and its effects on our business, results of operations and financial condition; the effects that current and future credit and market conditions could have on the liquidity and financial condition of our customers and suppliers, including any impact on their ability to meet their contractual obligations to us and our ability to pass through costs to our customers; the challenges of effectively managing our operations, including our ability to control costs and manage changes in our operations; retaining key personnel; litigation and regulatory investigations and proceedings; our compliance with legal and regulatory requirements; changes in laws, regulations, or policies that may impact our business, including those related to climate change; the possibility that benefits of the Company's restructuring actions may not materialize as expected; that the expected revenue and margins from recently launched programs may not be realized; our dependence on industries that continually produce technologically advanced products with short product life cycles; the short-term nature of our customers' commitments and rapid changes in demand may cause supply chain issues, excess and obsolete inventory, and other issues which adversely affect our operating results; our dependence on a small number of customers; our industry is extremely competitive; we may be exposed to financially troubled customers or suppliers; the success of certain of our activities depends on our ability to protect our intellectual property rights and we may be exposed to claims of infringement or breach of license agreements; a breach of our IT or physical security systems, or violation of data privacy laws, may cause us to incur significant legal and financial exposure and disrupt our operations; physical and operational risks from natural disasters, severe weather events, or climate change; our ability to achieve sustainability goals; we may be exposed to product liability and product warranty liability; and that recently proposed changes or future changes in tax laws in certain jurisdictions where we operate could materially impact our tax expense. In addition, the COVID-19 pandemic increases the likelihood and potential severity of many of the foregoing risks. Additional information concerning these, and other risks is described under "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our annual report on Form 10-K for the fiscal year ended March 31, 2022 and in subsequent quarterly reports on Form 10-Q. The forward-looking statements in this press release are based on current expectations and Flex assumes no obligation to update these forward-looking statements. Our share repurchase program does not obligate the Company to repurchase a specific number of shares and may be suspended or terminated at any time without prior notice. This press release does not constitute an offer to sell or the solicitation of an offer to buy any securities. Any securities to be offered in any offering may not be sold nor may offers to buy be accepted prior to the time a registration statement becomes effective. SCHEDULE I UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (2) Three-Month Periods Ended GAAP: Restructuring charges Intangible amortization Interest and other, net Provision for income taxes Net income attributable to redeemable noncontrolling interest Net income attributable to Flex Ltd. Diluted earnings per share attributable to the shareholders of Flex Ltd: Non-GAAP Diluted shares used in computing per share amounts See Schedule II for the reconciliation of GAAP to non-GAAP financial measures. See the accompanying notes on Schedule V attached to this press release. Nine-Month Periods Ended SCHEDULE II RECONCILIATION OF GAAP TO NON-GAAP FINANCIAL MEASURES (1)(2) (In millions, except per share amounts) * GAAP operating income Stock-based compensation expense Legal and other Non-GAAP operating income GAAP provision for income taxes Intangible amortization benefit Other tax related adjustments Non-GAAP provision for income taxes GAAP net income attributable to Flex Ltd. Payable-in-kind dividend for subsidiary's redeemable preferred units Adjustments for taxes Non-GAAP net income See the accompanying notes on Schedule V attached to this press release. *Amounts may not sum due to rounding SCHEDULE III As of December 31, 2022 Accounts receivable, net of allowance for doubtful accounts Contract assets Operating lease right-of-use assets, net Other intangible assets, net LIABILITIES, REDEEMABLE NONCONTROLLING INTEREST AND SHAREHOLDERS' EQUITY Bank borrowings and current portion of long-term debt Accrued payroll Deferred revenue and customer working capital advances Long-term debt, net of current portion Operating lease liabilities, non-current Other liabilities Redeemable noncontrolling interest Total shareholders' equity Total liabilities, redeemable noncontrolling interests, and shareholders' equity SCHEDULE IV Depreciation, amortization and other impairment charges Changes in working capital and other, net Purchases of property and equipment Proceeds from the disposition of property and equipment Acquisition of businesses, net of cash acquired Other investing activities, net Proceeds from bank borrowings and long-term debt Repayments of bank borrowings and long-term debt Payments for repurchases of ordinary shares Other financing activities, net Net cash provided by (used in) financing activities Effect of exchange rates on cash and cash equivalents Net decrease in cash and cash equivalents Cash and cash equivalents, beginning of period FLEX AND SUBSIDIARIES NOTES TO SCHEDULES I, II, and III (1) To supplement Flex's unaudited selected financial data presented consistent with U.S. Generally Accepted Accounting Principles ("GAAP"), the Company discloses certain non-GAAP financial measures that exclude certain charges and gains, including non-GAAP operating income, non-GAAP net income and non-GAAP net income per diluted share. These supplemental measures exclude certain legal and other charges, stock-based compensation expense, intangible amortization, other discrete events as applicable and the related tax effects. These non-GAAP measures are not in accordance with or an alternative for GAAP and may be different from non-GAAP measures used by other companies. We believe that these non-GAAP measures have limitations in that they do not reflect all of the amounts associated with Flex's results of operations as determined in accordance with GAAP and that these measures should only be used to evaluate Flex's results of operations in conjunction with the corresponding GAAP measures. The presentation of this additional information is not meant to be considered in isolation or as a substitute for the most directly comparable GAAP measures. We compensate for the limitations of non-GAAP financial measures by relying upon GAAP results to gain a complete picture of the Company's performance. In calculating non-GAAP financial measures, we exclude certain items to facilitate a review of the comparability of the Company's operating performance on a period-to-period basis because such items are not, in our view, related to the Company's ongoing operational performance. We use non-GAAP measures to evaluate the operating performance of our business, for comparison with forecasts and strategic plans, for calculating return on investment, and for benchmarking performance externally against competitors. In addition, management's incentive compensation is determined using certain non-GAAP measures. Also, when evaluating potential acquisitions, we exclude certain of the items described below from consideration of the target's performance and valuation. Since we find these measures to be useful, we believe that investors benefit from seeing results "through the eyes" of management in addition to seeing GAAP results. We believe that these non-GAAP measures, when read in conjunction with the Company's GAAP financials, provide useful information to investors by offering: the ability to make more meaningful period-to-period comparisons of the Company's ongoing operating results; the ability to better identify trends in the Company's underlying business and perform related trend analyses; a better understanding of how management plans and measures the Company's underlying business; and an easier way to compare the Company's operating results against analyst financial models and operating results of competitors that supplement their GAAP results with non-GAAP financial measures. The following are explanations of each of the adjustments that we incorporate into non-GAAP measures, as well as the reasons for excluding each of these individual items in the reconciliations of these non-GAAP financial measures: Stock-based compensation expense consists of non-cash charges for the estimated fair value of unvested restricted share unit awards granted to employees and assumed in business acquisitions. The Company believes that the exclusion of these charges provides for more accurate comparisons of its operating results to peer companies due to the varying available valuation methodologies, subjective assumptions and the variety of award types. In addition, the Company believes it is useful to investors to understand the specific impact stock-based compensation expense has on its operating results. Intangible amortization consists primarily of non-cash charges that can be impacted by, among other things, the timing and magnitude of acquisitions. The Company considers its operating results without these charges when evaluating its ongoing performance and forecasting its earnings trends, and therefore excludes such charges when presenting non-GAAP financial measures. The Company believes that the assessment of its operations excluding these costs is relevant to its assessment of internal operations and comparisons to the performance of its competitors. Restructuring charges include severance for rationalization at existing sites and corporate SG&A functions as well as asset impairment, and other charges related to the closures and consolidations of certain operating sites and targeted activities to restructure the business. These costs may vary in size based on the Company's initiatives and are not directly related to ongoing or core business results, and do not reflect expected future operating expenses. These costs are excluded by the Company's management in assessing current operating performance and forecasting its earnings trends and are therefore excluded by the Company from its non-GAAP measures. Legal and other consist primarily of costs not directly related to core business results and may include matters relating to commercial disputes, government regulatory and compliance, intellectual property, antitrust, tax, employment or shareholder issues, product liability claims and other issues on a global basis as well as acquisition related costs and customer related asset impairments (recoveries). During the first half of fiscal year 2023, the Company accrued for certain loss contingencies where losses were considered probable and estimable, and during the third quarter of fiscal year 2022, the Company incurred $4.8 million in acquisition-related costs related to the acquisition of Anord Mardix. These costs and recoveries are excluded by the Company's management in assessing current operating performance and forecasting its earnings trends and are therefore excluded by the Company from its non-GAAP measures. Interest and other, net consists of various other types of items that are not directly related to ongoing or core business results, such as the gain or losses related to certain divestitures, currency translation reserve write-offs upon liquidation of certain legal entities, debt extinguishment costs and impairment charges or gains associated with certain non-core investments. The Company excludes these items because they are not related to the Company's ongoing operating performance or do not affect core operations. Excluding these amounts provides investors with a basis to compare Company performance against the performance of other companies without this variability. In September 2021, the Company received approval from the relevant tax authorities in Brazil of the Credit Habilitation request related to certain federal operational tax credits and the Company recorded a total gain of 809.6 million Brazilian reals (approximately USD $149.3 million based on the exchange rate as of October 1, 2021) under other charges (income), net in the condensed statements of operations. The total gain recorded included credits from February 2003 to September 2021, net of additional taxes, as the Credit Habilitation received covering the period from February 2003 to December 2019 resolved any uncertainty regarding the Company's ability to claim such credits. This gain is non-cash and can only be used to offset certain current and future tax obligations. Payable-in-kind dividend for subsidiary's redeemable preferred units relates to a non-cash payable-in-kind dividend on the Series A preferred units of Nextracker LLC sold to TPG Rise Flash, L.P. ("TPG Rise"). The Series A preferred units have a dividend rate of 5% per annum, payable semi-annually, up to 100% of which may be paid by the issuance of additional series A preferred units ("payable-in-kind") during the first two years following the closing of the sale to TPG Rise, and 50% of which may be payable in kind thereafter. The paid-in-kind dividend is excluded by the Company's management in assessing current operating performance and forecasting its earnings trends and is therefore excluded by the Company from its non-GAAP measures. Adjustment for taxes relates to the tax effects of the various adjustments that we incorporate into non-GAAP measures in order to provide a more meaningful measure on non-GAAP net income and certain adjustments related to non-recurring settlements of tax contingencies or other non-recurring tax charges, when applicable. (2) Beginning in the second quarter of fiscal year 2022, the Company elected to include operating income as a subtotal in the condensed consolidated statements of operations. As such, non-GAAP operating income is now reconciled to the nearest GAAP measure which is GAAP operating income. Historical periods are recast to conform with the current period presentation. View original content to download multimedia:https://www.prnewswire.com/news-releases/flex-reports-third-quarter-fiscal-2023-results-301730653.html SOURCE Flex

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professional_accounting

MANAGEMENT’S DISCUSSION & ANALYSIS Certain Factors Affecting Results of Operations Geographic Diversification Liquidity, Funding and Capital Resources Summary of Contractual Obligations Off-Balance-Sheet Arrangements Critical Accounting Policies New Accounting Developments REPORT OF INDEPENDENT AUDITORS NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SELECTED FINANCIAL DATA OTHER STOCKHOLDER INFORMATION [Note: Page numbers correspond to pages in the printed 2002 Annual Report.] Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company” or “Lehman Brothers”) is a leading financial services firm that provides investment banking and capital markets facilitation to a global client base. The Company’s business activities are divided into three segments: Investment Banking, Capital Markets and Client Services. The investment banking industry is influenced by several factors inherent in the global financial markets and economic conditions worldwide. As a result, revenues and earnings may vary from quarter to quarter and from year to year. Some of the statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations, including those relating to the Company’s strategy and other statements that are predictive in nature, that depend upon or refer to future events or conditions or that include words such as “expects,” “anticipates,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. These statements are not historical facts but instead represent only the Company’s expectations, estimates and projections regarding future events. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict, which may include, but are not limited to, the factors listed below. The Company’s actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements. The Company undertakes no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise. The Company’s results of operations may be affected by uncertain or unfavorable economic, market, legal and other conditions. These conditions include: Market Fluctuations and Volatility Changes in interest and foreign exchange rates, securities and commodities valuations and increases in volatility can increase risk and may also impact customer flow related revenues in the Capital Markets and Client Services businesses, as well as impact the volume of debt and equity underwritings and merger and acquisition transactions. Industry Competition and Changes in Competitive Environment Increased competition from both banking institutions and non-traditional financial services providers and industry consolidation could impact fees earned from the Company’s investment banking and capital markets businesses. Investor Sentiment This past year has seen a record number of accounting and corporate governance scandals which have had a significant impact on investor confidence in the market place. In addition, geopolitical concerns about possible military action and terrorist activities can have an effect on the global financial markets. Liquidity risk management is of critical importance to the Company. Liquidity could be impacted by the inability to access the long-term or short-term debt markets or the repurchase and securities lending markets. However, the Company’s liquidity and funding policies have been designed with the goal of providing sufficient liquidity resources to continually fund its balance sheet and to meet its obligations in all market environments. The Company’s access to the unsecured funding markets is dependent upon the Company’s credit ratings. A reduction in the Company’s credit ratings could adversely affect the Company’s access to liquidity alternatives and its competitive position, and could increase the cost of funding or trigger additional collateral requirements. Credit Exposure Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Although the Company actively manages daily credit risk exposure as part of its risk management framework, counterparty default risk may arise from unforeseen events or circumstances. Legal and regulatory changes in the U.S. and other jurisdictions could have unfavorable impacts on the Company’s businesses and results. The principal business activities of the Company are investment banking and capital markets facilitation. Through the Company’s investment banking, trading, research, structuring and distribution capabilities in equity and fixed income products, the Company continues to build on its client/customer business model. This model focuses on “customer flow” activities. The “customer flow” model is based upon the Company’s principal focus of facilitating customer transactions in all major global capital markets products and services. The Company generates customer flow revenues from institutional and high-net-worth clients/customers by (i) advising on and structuring transactions specifically suited to meet client needs, (ii) serving as a market maker and/or intermediary in the global marketplace, including having securities and other financial instrument products available to allow clients to rebalance their portfolios and diversify risks across different market cycles and (iii) acting as an underwriter to clients. Marketplace uncertainties experienced throughout 2001 continued into 2002, with a further deterioration in global market conditions. The market downturn was fueled by a number of negative influences: a heightened degree of geopolitical risks, simultaneously weak levels of economic activity globally and reduced investor confidence levels, particularly in the U.S., resulting from certain corporate accounting practices and governance issues. These negative factors served to increase both the risk premium and volatility in the global equity markets, which resulted in lower returns in all major equity markets during 2002. The Dow Jones Industrial Average (“DJIA”) finished the year at 8,896, down 10% from fiscal year-end 2001. The NASDAQ composite and the S&P 500 decreased 23% and 18%, respectively, from the fiscal year-end of 2001. The FTSE 100 decreased 20% during the fiscal year while the DAX decreased 33%. In Asia, the Nikkei closed the year down 14%, reaching its lowest level in the past two decades, as Japan continued to be mired in a decade long recession. In November 2002, the Federal Reserve lowered the Federal Funds rate by 50 basis points to 1.25% in an attempt to stimulate growth after having left the Federal Funds rate unchanged for most of the fiscal year. The Bank of England kept rates unchanged at 4% throughout 2002 while the European Central Bank lowered rates in December of 2002 in hopes of spurring confidence and growth in the marketplace. Declining market valuations had a significant impact on global equity origination activity. Fiscal 2002 global equity origination activity was at a five-year low, with volume slightly down from the already depressed levels of 2001. Fixed income markets continued to benefit from low interest rates in 2002 with global debt origination relatively flat to the robust levels experienced in 2001. However, accounting and corporate governance scandals coupled with historically unprecedented numbers of debt downgrades and high profile defaults caused investors to move away from certain credit products and towards more defensive assets such as government and mortgage-backed securities. This resulted in a widening of credit spreads and negatively impacted investment grade and high yield debt originations, which declined by 13% and 22%, respectively, from prior year levels. Asset- and mortgage-backed debt issuances benefited from the shift into more defensive asset classes and saw increases of 15% and 44%, respectively, during fiscal year 2002. (Statistics provided by Thomson Financial Securities Data Corp (“TFSD”).) Mergers and acquisitions (“M&A”) advisory activity, which slowed in 2001, experienced even further declines in 2002 to its lowest level since 1995. Market conditions for acquisitions continued to be extremely difficult, as corporations concentrated on corporate governance matters and focused less on strategic transactions. Worldwide completed M&A activity for 2002 decreased 45% from the prior year, according to TFSD, and announced M&A activity for fiscal 2002 decreased 29% from the prior year’s levels. The Company reported net income of $975 million or $3.47 per share (diluted) in 2002 down from net income of $1,255 million and earnings per share (diluted) of $4.38 in 2001. Net revenues were $6,155 million and $6,736 million in 2002 and 2001, respectively. Although 2002 results decreased from the prior year’s levels, the Company believes that these results in an extremely challenging market environment, coupled with market share increases in many products, demonstrate the strength, diversity and resiliency of the Company’s franchise. The Company has improved its market position in a number of key areas including: M&A advisory and debt and common stock underwriting. The Company also continued to maintain a strict discipline with regard to its core competencies during the year, specifically managing expenses, risk management and capital deployment. The Company’s results in 2002 include the impact of three special items: a pre-tax net gain of $108 million associated with September 11th related costs and insurance settlement proceeds, a $128 million pre-tax charge associated with decisions to reconfigure certain other global real estate holdings and an $80 million pre-tax charge related to the Company’s participation in the proposed settlement regarding allegations of research analyst conflicts of interest. The net pre-tax effect of these three items is a charge of $100 million ($78 million after-tax), which resulted in a decrease to earnings per share (diluted) of $0.30. (Additional information about these amounts can be found in Notes 2, 3 and 4 to the Consolidated Financial Statements.) The Company’s 2001 results include the impact of a $127 million pre-tax charge ($71 million after-tax) stemming from the events of September 11th, which resulted in the displacement and relocation of substantially all of the Company’s New York based employees. The effect of the charge was a decrease to earnings per share (diluted) of $0.26. (Additional information about this charge can be found in Note 2 to the Consolidated Financial Statements.) In 2000, the Company reported record net income of $1,775 million or $6.38 per share (diluted) and net revenues of $7,707 million, reflecting a much more favorable global market environment. The Company recorded net revenues of $6,155 million, $6,736 million and $7,707 million for fiscal years 2002, 2001 and 2000, respectively. The decrease in net revenues over this three- year period principally resulted from the deterioration of global market conditions from the more favorable environment in 2000 in which the Company recorded record net revenues. The 9% decrease in net revenues in 2002 was principally the result of lower M&A, equity origination and equity capital markets revenue levels, partially offset by an increase in fixed income capital markets revenues. Client Service revenues and debt origination revenue levels remained relatively unchanged from fiscal 2001. (See page 38 for a detailed discussion of revenues by segment.) Global equity markets declined significantly throughout this period, as evidenced by an average decline in global equity indices of 20% and 17% in fiscal 2002 and fiscal 2001, respectively. The declines in equity market valuations negatively impacted both the volume of global M&A transactions, as completed transactions were approximately 65% lower in 2002 than 2000, and the level of global equity underwriting, as volumes were 45% lower in fiscal 2002 than fiscal 2000. Global fixed income markets have benefited as a result of the historically low interest rate environment over the past two years. Global fixed income underwriting volumes reached record levels in 2002 from robust activity levels in 2001, fueled by lower interest rates globally, particularly in the U.S., which saw decreases in the Federal Funds rate of 75 basis points in fiscal 2002 and 450 basis points in fiscal 2001. Benefiting from the low interest rate environment as well as expanding market share, the Company increased its volume of global debt originations by 12% in fiscal 2002 and 51% in fiscal 2001. Revenues from fixed income products were also bolstered by strong levels of institutional customer flow activity as investors sought more defensive asset classes in 2002 and 2001. However, record levels of accounting and corporate governance scandals as well as significantly higher levels of issuer defaults, resulted in a significant widening of credit spreads, and extreme volatility, which had a negative impact on valuations and customer flow trading volumes for certain credit sensitive products in 2002. Principal Transactions, Commissions and Net Interest Revenues The Company evaluates the performance of its Capital Markets and Client Services revenues in the aggregate, including Principal transactions, Commissions and net interest. Decisions relating to these activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction, including any associated commissions, and the interest revenue or expense associated with financing or hedging the Company’s positions. Therefore, the Company views net revenues from Principal transactions, Commissions and Interest revenue, offset by Interest expense, in the aggregate. Caution should be used when analyzing these revenue categories individually, as they are not always indicative of the performance of the Company’s overall Capital Markets and Client Services activities. Principal transactions, Commissions and Net interest revenues totaled $4,339 million in 2002 as compared to $4,684 million in 2001 and $5,357 million in 2000. The 7% decrease in 2002 from 2001 principally reflects the negative conditions within the global equity markets. These negative conditions resulted in a decline in equity capital markets revenues, most notable in equity derivatives, as investor concerns regarding corporate governance and geopolitical risks resulted in reduced demand for these products. Equity capital markets revenues were also reduced by losses on the Company’s private equity investments in 2002. Despite these negative conditions, the Company improved its market share in both listed and NASDAQ trading volumes. Partially offsetting these revenue declines was an increase in fixed income revenues, particularly in mortgage products, which benefited from their less credit sensitive nature and low interest rate levels. Principal transactions, Commissions and net interest revenues decreased by $673 million or 13% in 2001 from 2000 as robust revenues from fixed income products, fueled by declining interest rates and increased customer flow activity as investors sought more defensive asset classes, were more than offset by lower revenues from equity products. Within the above amounts, Principal transactions revenues were $1,951 million in 2002 as compared to $2,779 million in 2001 and $3,713 million in 2000. Commissions revenues were $1,286 million in 2002 as compared to $1,091 million in 2001 and $944 million in 2000. Interest and dividend revenues were $11,728 million in 2002 as compared to $16,470 million in 2001 and $19,440 million in 2000. Interest expense was $10,626 million in 2002 as compared to $15,656 million in 2001 and $18,740 million in 2000. The decrease in Principal transactions revenues in 2002 and 2001 principally reflects reduced equity product revenues resulting from poor global market conditions. In addition, Principal transactions revenues decreased in 2002 as a result of the transition to a commission-based revenue structure on NASDAQ trades, whereby these revenues are classified as Commissions in 2002. In prior years, the Company’s NASDAQ trades for substantially all of its institutional customers were transacted on a spread basis, with related revenues classified within Principal transactions. Commissions revenues increased in 2002 as compared to the prior year’s levels due to the migration to institutional commission-based pricing in the NASDAQ market, growth in market trading volumes and an increase in the Company’s market share of listed and NASDAQ trading volumes. Commission revenues increased in 2001 as a result of growth in market trading volumes and an increase in the Company’s market share of listed and NASDAQ trading volumes. Interest and dividends revenues and Interest expense are a function of the level and mix of total assets and liabilities, principally financial instruments owned and secured financing activities, the prevailing level of interest rates, as well as the term structure of the Company’s financings. Interest and dividends revenues and Interest expense are integral components of the Company’s overall customer flow activities. The decline in interest revenues and interest expense in 2002 and 2001 is principally due to the substantial declines in interest rates during those periods. The increase in net interest revenue to $1,102 million in 2002 from $814 million in 2001 was due in part to a change in inventory mix to higher levels of interest-bearing assets in response to shifts in customer asset preferences. The increase in net interest revenue to $814 million in 2001 from $700 million in 2000 was primarily due to a decline in the cost of financing and a change in inventory mix to higher levels of interest bearing assets. Investment Banking revenues were $1,771 million for 2002 as compared to $2,000 million for 2001 and $2,216 million in 2000. Investment banking revenues result mainly from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, and advising clients on M&A activities and other services. In 2002, Investment banking revenues decreased 11% from 2001, reflecting the significant market weakness in equity underwriting and M&A advisory activities, partially offset by improvements in the Company’s market share for completed M&A transactions and underwriting of fixed income and certain equity products. In 2001, Investment banking revenues decreased by 10% driven by industry wide decreases in M&A and equity origination activities. (See page 40 for a detailed discussion of the Company’s Investment Banking segment.) Non-Interest Expenses Twelve months ended November 30 Nonpersonnel September 11th related (recoveries)/expenses, net Other real estate reconfiguration charge Regulatory settlement Total non-interest expenses Compensation and benefits/Net revenues Non-interest expenses were $4,756 million for fiscal 2002, down 5% from $4,988 million in fiscal 2001 and down 3% in fiscal 2001 from $5,128 million in fiscal 2000. Total non-interest expenses in fiscal 2002 included a net gain of $108 million associated with September 11th related costs and insurance settlement proceeds, a charge of $128 million for certain other real estate reconfiguration costs and a charge of $80 million resulting from the Company’s regulatory settlement associated with allegations of research analyst conflicts of interest. Fiscal 2001 total non-interest expenses included a charge of $127 million related to September 11th insurance recoveries and expenses, net. (Additional information about these charges can be found in Notes 2, 3 and 4 to the Consolidated Financial Statements.) Nonpersonnel expenses were $1,517 million in 2002 compared to $1,424 million in 2001. The increase in nonpersonnel expenses is principally attributable to increases in occupancy, technology and communication, and brokerage and clearance expenses, partially offset by decreases in discretionary spending items. Occupancy expenses increased to $287 million in 2002 from $198 million in 2001, principally attributable to additional space to accommodate the growth in headcount resulting from the Company’s expansion during the past several years as well as the increased cost of our new corporate headquarters. Technology and communication expenses were $552 million in 2002 compared to $501 million in 2001. This increase reflects additional spending to enhance the Company’s capital markets trading platforms and technology infrastructure. Brokerage and clearance expenses increased by 7% due to higher volumes in certain fixed income structured products. Business development and professional fees decreased by 20% and 15%, respectively, from 2001, due to lower discretionary spending in response to the current market environment. Nonpersonnel expenses increased 19% in 2001 from 2000 mainly attributable to increases in investments in technology and communications, occupancy expenses to accommodate headcount growth and increased brokerage and clearance expenses. Compensation and benefits expenses were $3,139 million in 2002, $3,437 million in 2001 and $3,931 million in 2000. Compensation and benefits expense as a percentage of net revenues in 2002 remained at 51%, consistent with fiscal 2001 and 2000. Compensation and benefits expense includes the cost of salaries, incentive compensation and employee benefit plans as well as the amortization of deferred stock compensation awards. Lower levels of revenues in 2002 resulted in lower variable compensation expenses, which decreased by 21% from 2001. Fixed compensation, consisting primarily of salaries and benefits, increased 6% in 2002 from 2001, due to an increase in pension expense, related to lower asset values and projected returns, as well as higher severance costs related to headcount reductions made during the fourth quarter of 2002. Compensation and benefits expenses decreased 13% in 2001 from 2000 consistent with the decrease in the Company’s revenues. Net pension expense/(income) was $26 million, $(32) million and $(34) million in 2002, 2001 and 2000, respectively. The Company views its pension cost as a component of compensation expense and, in keeping with its expense management discipline, has maintained total compensation at 51% of net revenues over the past several years. Nonpersonnel and compensation expenses combined were $4,656 million, $4,861 million and $5,128 million in 2002, 2001 and 2000, respectively. The overall decrease year-over-year is principally associated with the decrease in net revenues coupled with the Company’s continued disciplined approach to expense management. The Company recorded an income tax provision of $368 million, $437 million, and $748 million for 2002, 2001, and 2000, respectively. These provisions resulted in effective tax rates of 26.3%, 25.0%, and 29.0%, respectively. The increase in the effective tax rate in 2002 from 2001 was principally due to a less favorable mix of geographic earnings, partially offset by a greater impact of permanent differences, including tax-exempt income. The decrease in the effective tax rate in 2001 from 2000 was primarily due to a greater impact of permanent differences, resulting from a decrease in the level of pre-tax income, an increase in tax-exempt income, and a higher level of income from foreign operations. Additional information about the Company’s income taxes can be found in Note 14 to the Consolidated Financial Statements. The Company is segregated into three business segments (each of which is described below): Investment Banking, Capital Markets and Client Services. Each segment represents a group of activities and products with similar characteristics. These business activities result in revenues from both institutional and high-net-worth retail clients, which are recognized across all revenue categories contained in the Company’s Consolidated Statement of Income. (Net revenues also contain certain internal allocations, including funding costs, which are centrally managed.) Segment Results Twelve months ended November 30, 2002 Principal Transactions Total Revenues Non-Interest Expenses(1) Earnings Before Taxes(1) Earnings Before Taxes (1) Excludes the impact of the real estate reconfiguration charge of $128 million, September 11th related (recoveries)/expenses, net gain of ($108) million and regulatory settlement charge of $80 million. (2) Excludes the impact of September 11th related expenses, net of $127 million. The following discussion provides an analysis of the Company’s results by segment for the above periods. Lehman Brothers provides a full array of capital markets products and advisory services worldwide. Through the Company’s banking, trading, research, structuring and distribution capabilities in equity and fixed income products, the Company continues to effectively build its client/customer business model. This model focuses on “customer flow” activities, which represent a majority of the Company’s revenues. In addition to its customer flow activities, the Company also takes proprietary positions, the success of which is dependent upon its ability to anticipate economic and market trends. The Company believes its customer flow orientation helps to mitigate its overall revenue volatility. The Company, through its subsidiaries, is a market-maker in all major equity and fixed income products in both the U.S. and international markets. In order to facilitate its market-making activities, the Company is a member of all principal securities and commodities exchanges in the U.S. and holds memberships or associate memberships on several principal international securities and commodities exchanges, including the London, Tokyo, Hong Kong, Frankfurt, Milan and Paris stock exchanges. As part of its customer flow activities, the Company maintains inventory positions of varying amounts across a broad range of financial instruments, which are marked-to-market on a daily basis and, along with any proprietary trading positions, give rise to Principal transactions revenues. Net revenues from the Company’s customer flow activities are recorded as either Principal transactions, Commissions or net interest revenues in the Consolidated Statement of Income, depending upon the method of execution, financing and/or hedging related to specific inventory positions. In assessing the performance of Capital Markets and Client Services, the Company evaluates Principal transactions, Commissions and net interest revenues in the aggregate. Decisions relating to Capital Markets and Client Services activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction including any associated commissions, and the interest revenue or expense associated with financing or hedging the Company’s positions. Therefore, the Company views net revenues from Principal transactions, Commissions and Interest revenue, offset by related Interest expense, in the aggregate, because the revenue classifications, when analyzed individually, are not always indicative of the performance of the Company’s Capital Markets and Client Services activities. This segment’s net revenues result from fees earned by the Company for underwriting public and private offerings of fixed income and equity securities, and advising clients on merger and acquisition activities and other services. The division is structured into global industry groups—Communications & Media, Consumer/Retailing, Financial Institutions, Financial Sponsors, Healthcare, Industrial, Natural Resources, Power, Real Estate and Technology—where bankers deliver industry knowledge and the resources to meet clients’ objectives. Specialized product groups within Mergers and Acquisitions, Equity Capital Markets, Debt Capital Markets, Leveraged Finance and Private Placements are partnered with global relationship managers in the industry groups to provide comprehensive solutions for clients. The Company’s specialists in new product development and derivatives also are utilized to tailor specific structures for clients. Investment Banking net revenues decreased 10% in 2002 to $1,731 million from $1,925 million in 2001, primarily due to a decline in M&A advisory revenues. Investment Banking net revenues decreased 12% in 2001 to $1,925 million from $2,179 million in 2000 as record fixed income underwriting activity in 2001 was more than offset by decreases in equity origination and M&A activity. Investment Banking Net Revenues Debt Underwriting Equity Underwriting Merger and Acquisition Advisory • Named “Bank of the Year” in 2002 by International Financing Review Magazine • Increase in market share across most major product categories • Decline in Investment Banking net revenues reflects difficult global market conditions Debt underwriting revenues of $886 million in 2002 remained relatively flat compared to the record results of $893 million in 2001 as issuers continued to take advantage of historically low interest rates. The Company also continued to improve its competitive position resulting in an increase in global market share for debt origination, which grew to 7.2% in calendar year 2002 from 6.9% in calendar year 2001, according to TFSD. In addition, the Company’s market share for high yield debt issuance increased to 7.9% from 6.3% and market share for leveraged loan transactions increased to 3.6% from 1.8%. In 2001, debt underwriting revenues increased 53% to a record $893 million from $585 million in 2000 as issuers took advantage of lower interest rates to raise long-term debt and replace short-term financing. In calendar year 2001, the Company’s market share increased to 6.9% from 5.9% in calendar year 2000. Equity origination revenues of $420 million in 2002 were down 5% as compared to a year ago. Global equity markets remained challenging in 2002 as market-wide new issuance volumes declined for the second consecutive year. Despite the difficult market conditions, the Company increased its share of common stock new issuances to 4.2% in 2002 from 3.6% in the prior year, but saw a reduced share of activity in the convertibles market. Equity origination revenues decreased 46% in 2001 from $817 million in 2000 as industry-wide equity underwriting declined significantly during 2001, partially offset by an increase in the Company’s global equity underwriting market share in 2001. M&A advisory fees decreased 28% to $425 million in 2002 from 2001. This decrease reflects extremely difficult global market conditions and weakened demand for strategic transactions as corporations remained conservative amid an uncertain business climate. Market volume in 2002 for M&A advisory was at a six-year low. Despite the low volume of activity in the advisory markets, the Company improved its market share for completed transactions in calendar year 2002 to 10.7% vs. 7.4% for calendar year 2001, and its market share for announced transactions increased to 10.7% for calendar year 2002 from 6.5% for calendar year 2001, according to TFSD. M&A advisory fees decreased 24% in 2001 to $592 million from 2000 record results as a result of depressed market conditions in 2001. Investment Banking pre-tax earnings of $410 million in 2002 increased 10% from 2001, as the 10% decrease in net revenues was more than offset by lower expenses. The decrease in expenses reflects reduced compensation expenses associated with lower revenue and headcount levels and reduced nonpersonnel related expenses, particularly business development and professional fees, as the Company focused on minimizing discretionary spending in light of reduced revenue levels. In 2001, Investment Banking pre-tax earnings of $373 million decreased 25% from 2000, as a result of the 12% decrease in net revenues coupled with higher compensation and benefits expenses as a result of an increase in headcount. This segment’s earnings reflect institutional customer flow activities and secondary trading and financing activities related to fixed income and equity products. These products include a wide range of cash, derivative, secured financing and structured instruments. Capital Markets Net Revenues • Record fixed income net revenues for second consecutive year • U.S. fixed income research team ranked #1 and fixed income trading ranked #2 by Institutional Investor • U.S. equity research ranked #2 by Institutional Investor in 2002, up from #5 in 2001 • Gains in fixed income net revenues were more than offset by a 44% decline in equities net revenues in 2002 • Market share increases in both listed and NASDAQ equity trading volumes in 2002 Capital Markets net revenues were $3,620 million for 2002, down 10% from 2001 as record fixed income revenues were more than offset by a 44% decline in equities net revenue. The decrease of $665 million in Capital Markets net revenues in 2001 was principally due to lower equities revenues as a result of declining global equity market valuations. In fixed income, the Company remains a leading global market-maker in numerous products, including U.S., European and Asian government securities, money market products, corporate high grade and high yield securities, mortgage- and asset-backed securities, preferred stock, municipal securities, bank loans, foreign exchange, financing and derivative products. Net revenues from the fixed income component of capital markets increased 18% to a record $2,619 million from $2,227 million in the prior year. The increase was principally driven by a strong level of institutional customer flow activity, particularly in mortgage-related products, as secondary flow was aided by near record levels of origination activity as investors continued to minimize risk by moving toward more diversified and defensive asset categories. The Federal Funds rate remained at historically low levels throughout the fiscal year, with a 50 basis point decrease in the rate occurring in November 2002. The low interest rate environment throughout 2002 contributed to strong results in the Company’s mortgage businesses, principally from increases in securitization transactions and the distribution of various mortgage loan products, which were bolstered by the active refinancing environment. Additionally, the Company had strong results in structured credit related products, particularly in collateralized debt obligations (“CDOs”), as clients migrated to products offering diversification and hedging capabilities. In 2001, fixed income net revenues increased 8% to a then record level of $2,227 million from $2,060 million in 2000, principally driven by a strong level of institutional customer flow activity as investors sought more defensive asset classes. Areas that benefited the most from the strength in institutional customer flow included mortgages, high grade debt and municipals. In equities, the Company is one of the largest investment banks for U.S. and pan-European listed trading volume, and the Company maintains a major presence in over-the-counter U.S. stocks, major Asian large capitalization stocks, warrants, convertible debentures and preferred issues. In addition, the Company makes certain investments in private equity positions and/or partnerships for which the Company acts as general partner. Net revenues from the equities component of Capital Markets decreased 44% to $1,001 million in 2002 from $1,797 million in 2001, driven by negative market conditions which resulted in revenue declines across most equity products, including equity derivatives, equity financing and private equity. Equity derivative revenues declined primarily as a result of reduced client demand for structured equity derivative products given market weaknesses. The decrease in equity finance revenues was primarily attributed to a decline in customer balances in the prime brokerage business, while private equity investments suffered losses on both private and public investments. These declines in revenues were partially offset by improvements in the Company’s market share in both listed and NASDAQ securities, which increased to 7.2% and 3.6%, respectively, in 2002 from 5.7% and 3.2% in 2001. Net revenues from the equities component of Capital Markets decreased 32% to $1,797 million in 2001 from $2,629 million in 2000 primarily as a result of declining global equity markets. Capital Markets pre-tax earnings of $898 million in 2002 decreased 32% from pre-tax earnings of $1,322 million in 2001, driven by a 10% decrease in net revenues. Capital Markets non-interest expenses remained relatively flat in 2002 when compared to the previous year as a decrease in compensation and benefits was offset by an increase in nonpersonnel expenses, including increased occupancy costs associated with increased headcount levels and higher technology spending in order to enhance the Company’s trading platforms and technology infrastructure. Capital markets pre-tax earnings of $1,322 million in 2001 decreased by 27% from $1,801 in 2000 as a result of a 14% decrease in net revenues, partially offset by a 6% decrease in non-interest expenses. The Company evaluates the performance of its Capital Markets business revenues in the aggregate, including Principal transactions, Commissions and net interest. Substantially all of the Company’s net interest is allocated to its Capital Markets segment. Decisions relating to these activities are based on an overall review of aggregate revenues, which includes an assessment of the potential gain or loss associated with a transaction, including any associated commissions, and the interest revenue or expense associated with financing or hedging the Company’s positions; therefore, caution should be utilized when analyzing revenue categories individually. Interest and dividend revenues for Capital Markets businesses decreased 29% in 2002 from 2001, whereas interest expense decreased 32% over this same period, reflecting the decline in interest rates over the year. Net interest revenue increased 37% in 2002 over the prior year, reflecting benefits from the steepening yield curve environment and higher interest earning asset levels in 2002 as compared to 2001. Interest and dividend revenue for Capital Markets businesses decreased 15% in 2001 from 2000, whereas interest expense decreased 16% over this same period, reflecting the decline in interest rates during 2001. Net interest revenue increased 18% in 2001 over the prior year, primarily due to a decrease in the cost of funding coupled with a change in inventory mix. Client Services Net Revenues • Private Client net revenues increased 7% over prior year on strong fixed income activity among high-net-worth clients • Private Equity assets under management decreased 20% in 2002 to $4.5 billion from $5.6 billion in 2001 Client Services net revenues reflect earnings from the Company’s Private Client and Private Equity businesses. Private Client net revenues reflect the Company’s high-net-worth retail customer flow activities as well as asset management fees, where the Company strives to add value to its client base of high-net-worth individuals and mid-sized institutional investors through innovative financial solutions, global access to capital, research, global product depth and personal service and advice. Private Equity net revenues include the management and incentive fees earned in the Company’s role as general partner for thirty-three private equity partnerships. Private Equity currently operates in five major asset classes: Merchant Banking, Real Estate, Venture Capital, Fixed Income-related and Third Party Funds. As of the fiscal year ended 2002, Private Equity had $4.5 billion of assets under management. Client Services net revenues were $804 million in 2002 as compared to $787 million in 2001 and $839 million in 2000. Despite the weak equity markets, Private Client net revenues increased to $762 million in 2002 from $711 million in 2001 due to record fixed income activity which more than offset decreased performance in equities as the Company’s high-net-worth clients continued to reposition their portfolios to more defensive asset classes. Client Services net revenues were $787 million in 2001 compared to $839 million for 2000. Excluding a special performance-based asset management fee of $73 million in 2000 and a $20 million merchant banking incentive fee in 2001, Client Services results remained relatively flat in 2001, as the Company’s high-net-worth sales force continued to produce strong results despite the weak equity market environment. Private Equity net revenues decreased $34 million in 2002 from 2001, principally as a result of lower incentive fees earned in 2002. Private Equity net revenues increased $32 million in 2001 from 2000, primarily due to a $15 million increase in management fees from new funds sponsored by the Company and the recognition of a $20 million incentive fee from a single merchant banking investment. Client Services pre-tax earnings of $191 million in 2002 increased 6% from 2001 as a result of higher net revenues. Non-interest expenses of $613 million remained relatively flat in 2002 as compared to 2001. Client Services pre-tax earnings of $180 million in 2001 decreased 35% from $279 million in 2000 as a result of a 6% decrease in net revenues, coupled with an 8% increase in non-interest expenses, mainly attributable to the increase in headcount during 2001. The Company’s European and Asia Pacific regions continued to be affected by the global economic slowdown in 2002. Despite the dampened economic environment, the Company was able to improve certain rankings and market share in Europe and Asia, most prominently in M&A transactions, where market share in European completed transactions improved to 14.9% from 6.1% and market share in European announced transactions increased to 13.2% from 6.0% in calendar year 2002 from calendar year 2001 (according to TFSD). International net revenues were $2,286 million in 2002, $2,495 million in 2001 and $3,215 million in 2000, representing approximately 37% of total net revenues in 2002 and 2001, and 42% in 2000. International net revenues as a percentage of total net revenues remained flat from 2001 to 2002 as a higher proportion of revenues earned from international Capital Markets businesses was offset by a decrease in international Investment Banking businesses. International net revenues, consistent with U.S. revenues, saw declines in revenues from equity products as such results were adversely impacted by declining equity indices. Partially offsetting this decrease were increased revenues from fixed income products in both Europe and Asia. Net Revenues from the Company’s European region decreased 14% to $1,674 million in 2002 from $1,955 million in 2001. Europe’s fixed income capital markets business experienced a record year driven by continued growth in structured transactions, including CDO’s, as well as strong performance in interest rate and real estate mortgage related products. This was offset by a significant decline in equity capital markets and investment banking net revenues due to a lack of corporate demand for equity derivative products and a continued decline in the European equity origination markets. Net revenues from the Company’s European region decreased 18% in 2001 versus 2000 as the region encountered the same weak market conditions experienced in the U.S. during 2001. Net Revenues from the Company’s Asia Pacific region of $612 million in 2002 increased 13% from $540 million in 2001. Asia’s fixed income capital markets business experienced their second highest year ever, driven by strength in derivatives, high yield and mortgage-related products as a result of strong customer flow activities and new transactions, particularly in the distressed assets securitization business. This performance was partially offset by a decline in equity capital markets and investment banking net revenues due to a lack of corporate demand for equity derivatives, depressed equity markets and poor market conditions in the investment banking environment. Net revenues from the Company’s Asia Pacific region decreased 35% in 2001 from 2000 as a result of the difficult market conditions experienced during 2001. Net Revenue Diversity by Geographic Region [Graphic Omitted—pie chart showing:] • International net revenues represented approximately 37% of total net revenues in 2002, compared with only 28% in 1997. Liquidity Risk Management Liquidity and liquidity management are of paramount importance to the Company, providing a framework which seeks to ensure that the Company maintains sufficient liquid financial resources to continually fund its balance sheet and meet all of its funding obligations in all market environments. Our liquidity management philosophy incorporates the following principles: • Liquidity providers are credit and market sensitive and quick to react to any perceived market or firm specific risks. Consequently, firms must be in a state of constant liquidity readiness. The Company maintains a large cash position at Holdings to help absorb the impact of a severe liquidity event. • During a liquidity event, certain secured lenders will require higher quality collateral, resulting in a lower availability of secured funding for “harder to fund” asset classes. Firms must therefore not overestimate the availability of secured financing, and must fully integrate their secured and unsecured funding strategies. The Company has established “Reliable Secured Funding” levels by asset category and by counterparty and ensures that any secured funding above those levels is longer term. • Firms should not rely on asset sales to generate cash or believe that they can increase unsecured borrowings or funding efficiencies in a liquidity crisis. The Company does not rely on reducing its balance sheet for liquidity reasons in a liquidity event (although it may do so for risk reasons). • A firm’s legal entity structure may constrain liquidity. Regulatory requirements can restrict the flow of funds between regulated and unregulated group entities and this should be explicitly accounted for in liquidity planning. The Company seeks to ensure that each regulated entity and Holdings has sufficient stand-alone liquidity and that there is no “cross subsidization” of liquidity from the regulated entities to Holdings. The Company’s Funding Framework incorporates the above principles and seeks to mitigate liquidity risk by helping to ensure that the Company maintains sufficient funding resources to withstand a severe liquidity event, including: • Sufficient cash capital (i.e., liabilities with remaining maturities of over one year) to fund: Secured funding “haircuts,” (i.e., the difference between the market value of the available inventory and the estimated value of cash that would be advanced to the Company by counterparties against that inventory in a stress environment). Less liquid assets, including fixed assets, goodwill, deferred taxes and prepaid assets. Operational cash at banks and unpledged assets regardless of collateral quality. Anticipated draws of unfunded commitments. To ensure that the Company is operating “within its means,” the businesses operate within strict cash capital limits. This limit culture has been institutionalized and engages the entire Company in managing liquidity. • Sufficient “Reliable Secured Funding” capacity to fund the Company’s liquid inventory on a secured basis. This capacity represents an assessment of the reliable secured funding capacity, by asset class, that the Company would anticipate in a liquidity event. The Company pays careful attention to validating this capacity through a periodic counterparty-by-counterparty, product-by-product review, which draws upon the Company’s understanding of the financing franchise and the funding experience with the counterparties. In cases where a business has inventory at a level above its “Reliable Secured Funding” capacity, the Company requires the excess to be funded on a term basis. The Company has increased the capacity for funding certain asset classes through the growth of Lehman Brothers Bank (a FDIC-insured thrift) and Lehman Brothers Bankhaus (a GDPF-insured bank). These entities operate in a deposit-protected environment and are able to source low cost unsecured funds that are generally insulated from a company- or market-specific event, thereby providing more reliable funding for mortgage products and select loan assets. • Sufficient liquidity to withstand a liquidity event characterized by: The Company’s inability to issue any unsecured short-term and long-term debt for one year. Haircut widening for secured funding; Funding requirements resulting from a credit rating downgrade (e.g., the increased collateral requirements for over-the-counter derivative transactions). To provide liquidity to Holdings during periods of adverse market conditions, the Company maintains a portfolio of cash and unencumbered liquid assets, comprised primarily of U.S. Government and agency obligations, investment grade securities and listed equities, which can be sold or pledged to provide liquidity to Holdings where most of the unsecured debt is issued. As of November 30, 2002, the estimated pledge value of this portfolio, along with the undrawn portion of Holdings’ committed credit facility (see “Credit Facilities” below) amounted to approximately $15.8 billion. Cash and unencumbered liquid assets that are presumed to be “trapped” in a regulated entity or required for operational purposes, and are therefore not seen as a completely reliable source of cash to repay maturing unsecured debt in a liquidity stress event, are not included in this portfolio. The Company has developed and regularly updates its Contingency Funding Plan — which represents a detailed action plan to manage a stress liquidity event — including a communication plan for creditors, investors and customers during a funding crisis. Short-Term Debt to Total Assets Less Matched Book [Graphic Omitted—bar graph showing: ] Short-Term Debt to Total Debt • Lehman Brothers has lowered its Short-Term Debt to Total Assets Less Matched Book and its Short-Term Debt to Total Debt ratios over the past five years to lessen the impact of short-term dislocations in the unsecured funding markets. The Company issues debt in a variety of maturities and currencies. The Company’s funding strategy emphasizes long-term debt over short-term debt. As a result, the Company has reduced its reliance on short-term debt, including commercial paper, as a source of funding. As of November 30, 2002, the Company had $2.4 billion of short-term unsecured debt outstanding as compared to $7.8 billion five years ago. In order to manage the refinancing risk of long-term debt the Company sets limits for the amount maturing over any three, six and twelve month horizon. The Company also manages the maturity refinancing risk of its term secured borrowings. Additionally, in order to limit its reliance on any given borrower, the Company also diversifies its lender base. Managing Liquidity, Funding And Capital Resources The Company’s Finance Committee is responsible for developing, implementing and enforcing the liquidity, funding and capital policies. These policies include recommendations for capital and balance sheet size, as well as the allocation of capital and balance sheet to the business units. Through the establishment and enforcement of capital and funding limits, the Company’s Finance Committee ensures compliance throughout the organization so that the Company is not exposed to undue risk. Subordinated Indebtedness Preferred Securities Subject to Mandatory Redemption Preferred Equity Common Equity The Company’s Total Capital (defined as long-term debt, preferred securities subject to mandatory redemption and stockholders’ equity) increased 2% to $48.3 billion at November 30, 2002, compared to $47.5 billion at November 30, 2001. The increase in Total Capital principally resulted from increased equity from the retention of earnings as well as a net increase in long-term debt. Long-term debt increased to $38.7 billion at November 30, 2002 from $38.3 billion at November 30, 2001 with a weighted-average maturity of 4.0 years at November 30, 2002 and 3.8 years at November 30, 2001. The Company operates in many regulated businesses that require various minimum levels of capital. These businesses are also subject to regulatory requirements that may restrict the free flow of funds to affiliates. Regulatory approval is generally required for paying dividends in excess of certain established levels and making advancements to affiliated companies. Additional information about the Company’s capital requirements can be found in Note 12 to the Consolidated Financial Statements. 43.9 billion Holdings maintains a Revolving Credit Agreement (the “Credit Agreement”) with a syndicate of banks. Under the Credit Agreement, the banks have committed to provide up to $1 billion through April 2005. The Credit Agreement contains covenants that require, among other things, that the Company maintain a specified level of tangible net worth. The Company views the Credit Agreement as one of its many sources of liquidity available through its funding framework, and as such the Company utilizes this liquidity for general business purposes from time to time. The Company also maintains a backstop $750 million Committed Securities Repurchase Facility (the “Facility”) for Lehman Brothers International (Europe) (“LBIE”), the Company’s major operating entity in Europe. The Facility provides secured multi-currency financing for a broad range of collateral types. Under the terms of the Facility, the bank group has agreed to provide funding for up to one year on a secured basis. Any loans outstanding on the commitment termination date may be extended for up to an additional year at the option of LBIE. The Facility contains covenants which require, among other things, that LBIE maintain specified levels of tangible net worth. This commitment expires at the end of October 2003. There were no borrowings outstanding under either the Credit Agreement or the Facility at November 30, 2002. The Company has maintained compliance with the applicable covenants for both the Credit Agreement and the Facility at all times. Balance Sheet And Financial Leverage The Company’s balance sheet consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The majority of these assets are funded on a secured basis through collateralized short-term financing agreements. The Company’s total assets increased to $260 billion at November 30, 2002 from $248 billion at November 30, 2001. The Company’s net balance sheet, defined as total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase, remained relatively constant at $166 billion at November 30, 2002 compared to $165 billion at November 30, 2001. The Company believes that net balance sheet is a more effective measure of evaluating balance sheet usage when comparing companies in the securities industry. The Company utilizes its net balance sheet primarily to carry inventory necessary to facilitate customer flow trading activities. As such, the Company’s mix of net assets is subject to change depending principally upon customer demand. In addition, due to the nature of the Company’s customer flow activities and based upon the Company’s business outlook, the overall size of the Company’s balance sheet fluctuates from time to time and, at specific points in time, may be higher than the fiscal year-end or quarter-end amounts. The increase in the Company’s total assets at November 30, 2002 was primarily driven by an increase in the Company’s matched book secured financing activities. The Company’s net balance sheet size at November 30, 2002 remained consistent with the prior year; however, 2002 saw a decrease in the level of equity inventory, consistent with reduced customer demand for equity products in light of the market weaknesses, with a corresponding increase in high quality fixed income inventory levels reflecting increased customer flow activities in these products. Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. Leverage ratios are commonly calculated using either total assets or net balance sheet. The Company believes that net leverage (i.e., net balance sheet divided by total stockholders’ equity and preferred securities subject to mandatory redemption) is a more effective measure of financial risk when comparing companies in the securities industry. The Company’s net leverage ratios were 17.2x and 17.9x as of November 30, 2002 and 2001, respectively. Consistent with maintaining a single A credit rating, the Company targets a net leverage ratio of under 20.0x. The Company continues to operate below this level. The Company, like other companies in the securities industry, relies on external sources to finance a significant portion of its day-to-day operations. The cost and availability of unsecured financing generally are dependent on the Company’s short-term and long-term credit ratings. Factors that may be significant to the determination of the Company’s credit ratings or otherwise affect the ability of the Company to raise short-term and long-term financing include its profit margin, its earnings trend and volatility, its cash liquidity and liquidity management, its capital structure, its risk level and risk management, its geographic and business diversification, and its relative positions in the markets in which it operates. A deterioration in any of the previously mentioned factors or combination of these factors may lead rating agencies to downgrade the credit ratings of the Company, thereby increasing the cost to the Company of, or possibly limiting the access of the Company to, certain types of unsecured financings. In addition, the Company’s debt ratings can impact certain capital markets revenues, particularly in those businesses where longer-term counterparty performance is critical, such as over-the-counter derivative transactions, including credit derivatives and interest rate swaps. As of November 30, 2002, the short- and long-term debt ratings of Holdings and LBI were as follows: Short- Long- term** Fitch IBCA, Inc. A+/A Moody’s(1) A1*/A2 Standard & Poor’s Corp.(2) A+*/A *Provisional ratings on shelf registration **Senior/subordinated (1) On October 8, 2002, Moody’s revised its outlook to positive from stable for all long-term debt ratings of Holdings. The short-term rating was affirmed. (2) On August 15, 2002, Standard & Poor’s revised its outlook on Holdings to negative from stable. The ‘A’ long-term and ‘A-1’ short-term ratings were affirmed. High Yield Securities The Company underwrites, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt instruments are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities, due to the issuer’s creditworthiness and the liquidity of the market for such securities. In addition, these issuers generally have relatively higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt instruments are carried at fair value, with unrealized gains or losses recognized in the Company’s Consolidated Statement of Income. Such instruments at November 30, 2002 and November 30, 2001 included long positions with an aggregate market value of approximately $4.0 billion and $3.5 billion, respectively, and short positions with an aggregate market value of approximately $1.1 billion and $1.0 billion, respectively. The Company mitigates its aggregate and single-issuer net exposure through the use of derivatives, non-recourse securitization financing and other financial instruments. The Company has investments in thirty-three private equity-related partnerships, for which the Company acts as general partner, as well as related direct investments. At November 30, 2002 and 2001, the Company’s private equity related investments totaled $965 million and $826 million, respectively. The Company’s policy is to carry its investments, including the appreciation of its general partnership interests, at fair value based upon the Company’s assessment of the underlying investments. Additional information about the Company’s private equity activities, including related commitments, can be found in Note 20 to the Consolidated Financial Statements. In the normal course of business, the Company enters into various commitments and guarantees, including lending commitments to high grade and high yield borrowers, liquidity commitments and other guarantees. In all instances, the Company marks-to-market these commitments and guarantees, with changes in fair value recognized in Principal transactions revenues. As of November 30, 2002 and 2001, the Company was contingently liable for $0.8 billion and $1.1 billion, respectively, of letters of credit, primarily used to provide collateral for securities and commodities borrowed and to satisfy margin deposits at option and commodity exchanges. In connection with its financing activities, the Company had outstanding commitments under certain lending arrangements of approximately $1.5 billion and $2.1 billion, at November 30, 2002 and 2001, respectively. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under the above lending arrangements are typically at variable interest rates and generally provide for over-collateralization based upon the borrowers’ creditworthiness. At November 30, 2002, the Company had commitments to enter into forward starting reverse repurchase and repurchase agreements, principally secured by government and government agency collateral, of $89.9 billion and $50.3 billion, respectively, as compared to $52.3 billion and $26.5 billion, respectively, at November 30, 2001. The Company, through its high grade and high yield sales, trading and underwriting activities, makes commitments to extend credit in loan syndication transactions. The Company utilizes various hedging and funding strategies to actively manage its market, credit and liquidity exposures on these commitments. In addition, total commitments are not indicative of actual risk or funding requirements, as the commitments may not be drawn or fully utilized. These commitments and any related draw downs of these facilities typically have fixed maturity dates and are contingent upon certain representations, warranties and contractual conditions applicable to the borrower. The Company had credit risk associated with lending commitments to investment grade borrowers (after consideration of hedges) of $3.2 billion and $4.1 billion at November 30, 2002 and November 30, 2001, respectively. In addition, the Company had credit risk associated with lending commitments to non-investment grade borrowers (after consideration of hedges) of $1.7 billion and $1.4 billion at November 30, 2002 and November 30, 2001, respectively. Before consideration of hedges, the Company had commitments to investment and non-investment grade borrowers of $7.1 billion and $1.8 billion as compared to $5.9 billion and $1.4 billion at November 30, 2002 and November 30, 2001, respectively. The Company had available undrawn borrowing facilities with third parties of approximately $5.2 billion and $4.9 billion at November 30, 2002 and November 30, 2001, respectively, which can be drawn upon to provide funding for these commitments. These funding facilities contain limits for certain concentrations of counterparty, industry or credit ratings of the underlying loans. In addition, the Company provided high yield contingent commitments related to acquisition financing of approximately $2.8 billion and $0.6 billion at November 30, 2002 and 2001, respectively. The Company’s intent is, and its past practice has been, to sell down significantly all the credit risk associated with these loans, if closed, through loan syndications consistent with the Company’s credit facilitation framework. These commitments are not indicative of the Company’s actual risk, as the borrower’s ability to draw is subject to there being no material adverse change in either market conditions or the borrower’s financial condition, among other factors. In addition, these commitments contain certain flexible pricing features in order to adjust for changing market conditions prior to closing. At November 30, 2002, the Company had liquidity commitments of approximately $4.4 billion related to trust certificates backed by investment grade municipal securities, as compared to $3.6 billion at November 30, 2001. The Company’s obligation under such liquidity commitments is generally less than one year and is further limited by the fact that the Company’s obligation ceases if the underlying assets are downgraded below investment grade or default. In addition, the Company had certain other commitments and guarantees associated with special purpose entities of approximately $5.0 billion and $0.7 billion, at November 30, 2002 and 2001, respectively. These commitments consist of liquidity facilities and other default protection to investors, which are principally overcollateralized with investment grade collateral. As of November 30, 2002 and 2001, the Company had commitments to invest up to $672 million and $555 million, respectively, directly and through partnerships in private equity related investments. These commitments will be funded as required through the end of the respective investment periods, principally expiring in 2004. Aggregate contractual obligations and other commitments as of November 30, 2002 by maturity are as follows: Amount of Commitment Expiration Per Period Lending commitments: Contingent acquisition facilities Secured lending transactions, including forward starting resale and repurchase agreements Municipal securities related liquidity commitments Other commitments and guarantees associated with other special purpose entities Private equity investments Operating lease obligations Capital lease obligations Long-term debt maturities *The Company views its net credit exposure for high grade commitments, after consideration of hedges, to be $3.2 billion. ** The Company views its net credit exposure for high yield commitments, after consideration of hedges to be $1.7 billion. For additional information on contractual obligations see Note 20 to the Consolidated Financial Statements. Overview Derivatives are financial instruments, examples of which include swaps, options, futures, forwards and warrants, whose value is based upon an underlying asset (e.g., treasury bond), index (e.g., S&P 500) or reference rate (e.g., LIBOR). Derivatives are often referred to as “off-balance-sheet instruments,” as a derivative’s notional amount is not recorded on-balance-sheet. Notional amounts are generally not exchanged, but rather represent the basis for exchanging cash flows during the duration of the contract. Notional amounts are generally not indicative of the Company’s at risk amount. A derivative contract may be traded on an exchange or negotiated in the over-the-counter markets. Exchange-traded derivatives are standardized and include futures, warrants and certain option contracts listed on an exchange. Over-the-counter (“OTC”) derivative contracts are individually negotiated between contracting parties and include forwards, swaps and certain options, including caps, collars and floors. The use of derivative financial instruments has expanded significantly over the past decade. A primary reason for this expansion is that derivatives provide a cost-effective alternative for managing market risk. Additionally, derivatives provide users with access to market risk management tools that are often unavailable in traditional cash instruments, as derivatives can be tailored to meet client needs. Derivatives can also be used to take proprietary trading positions. Derivatives are subject to various risks similar to non-derivative financial instruments including market, credit and operational risk. Market risk is the potential for a financial loss due to changes in the value of derivative financial instruments due to market changes, including changes in interest rates, foreign exchange rates and equity and commodity prices. Credit risk results from the possibility that a counterparty to a derivative transaction may fail to perform according to the terms of the contract. Therefore, the Company’s exposure to credit risk is represented by its net receivable from derivative counterparties, after consideration of collateral. Operational risk is the possibility of financial loss resulting from a deficiency in the Company’s systems for executing derivative transactions. In addition to these risks, counterparties to derivative financial instruments may also be exposed to legal risks related to derivative activities, including the possibility that a transaction may be unenforceable under applicable law. The risks of derivatives should not be viewed in isolation but rather should be considered on an aggregate basis along with the Company’s other trading-related activities. As derivative products have continued to expand in volume, so has market participation and competition. As a result, additional liquidity has been added into the markets for conventional derivative products, such as interest rate swaps. Competition has also contributed to the development of more complex products structured for specific clients. It is this rapid growth and complexity of certain derivative products which has led to the perception, by some, that derivative products are unduly risky to users and the financial markets. In order to remove the public perception that derivatives may be unduly risky and to ensure ongoing liquidity of derivatives in the marketplace, the Company supports the efforts of the regulators in striving for enhanced risk management disclosures which consider the effects of both derivative products and cash instruments. In addition, the Company supports the activities of regulators that are designed to ensure that users of derivatives are fully aware of the nature of risks inherent within derivative transactions. As evidence of this support, the Company has been actively involved with the various regulatory and accounting authorities in the development of additional enhanced reporting requirements related to derivatives. The Company strongly believes that derivatives provide significant value to the financial markets and is committed to providing its clients with innovative products to meet their financial needs. Lehman Brothers’ Use Of Derivative Instruments In the normal course of business, the Company enters into derivative transactions both in a trading capacity and as an end-user. As an end-user, the Company utilizes derivative products to adjust the interest rate nature of its funding sources from fixed to floating interest rates, and to change the index upon which floating interest rates are based (e.g., Prime to LIBOR) (collectively, “End-User Derivative Activities”). For a further discussion of the Company’s End-User Derivative Activities, see Note 15 to the Consolidated Financial Statements. The Company utilizes derivative products in a trading capacity as a dealer to satisfy the financial needs of its clients, and in each of its trading businesses (collectively, “Trading-Related Derivative Activities”). In this capacity the Company transacts extensively in derivatives including interest rate, credit (both single name and portfolio), foreign exchange and equity derivatives. The Company’s use of derivative products in its trading businesses is combined with transactions in cash instruments to allow for the execution of various trading strategies. The Company conducts its derivative activities through a number of wholly-owned subsidiaries. The Company’s fixed income derivative products business is conducted through its subsidiary, Lehman Brothers Special Financing Inc., and separately capitalized “AAA” rated subsidiaries, Lehman Brothers Financial Products Inc. and Lehman Brothers Derivative Products Inc. The Company’s equity derivative product business is conducted through Lehman Brothers Finance S.A. In addition, as a global investment bank, the Company is also a market-maker in a number of foreign currencies and actively trades in the global commodity markets. Counterparties to the Company’s derivative product transactions are primarily financial intermediaries (U.S. and foreign banks), securities firms, corporations, governments and their agencies, finance companies, insurance companies, investment companies and pension funds. The Company manages the risks associated with derivatives on an aggregate basis, along with the risks associated with its non-derivative trading and market-making activities in cash instruments, as part of its firmwide risk management policies. The Company utilizes industry standard derivative contracts whenever appropriate. These contracts may contain provisions requiring the posting of additional collateral by the Company in certain events, including a downgrade in the Company’s credit rating (as of November 30, 2002, the Company would be required to post additional collateral pursuant to derivative contracts of approximately $400 million in the event that the Company were to experience a downgrade of its senior debt). The Company believes that its funding framework incorporates all reasonably likely collateral requirements related to these provisions. For a further discussion of the Company’s risk management policies, refer to the discussion which follows. For a discussion of the Company’s liquidity management policies see page 44. See the Notes to the Consolidated Financial Statements for a description of the Company’s accounting policies and further discussion of the Company’s Trading-Related Derivative Activities. Other Off-Balance-Sheet Arrangements Special purpose entities (“SPEs”) are corporations, trusts or partnerships which are established for a limited purpose. SPEs by their nature generally do not provide equity owners with significant voting powers, as the SPE documents govern all material decisions. The Company’s primary involvement with SPEs relates to securitization transactions in which transferred assets, including mortgages, loans, receivables and other assets, are sold to an SPE and repackaged into securities (i.e. securitized). SPEs may also be utilized by the Company to create securities with a unique risk profile desired by investors, and as a means of intermediating financial risk. In summary, in the normal course of business, the Company may establish SPEs; sell assets to SPEs; underwrite, distribute, and make a market in securities issued by SPEs; transact derivatives with SPEs; own securities or residual interests in SPEs; and provide liquidity or other guarantees for SPEs. The Company accounts for the transfers of financial assets, including transfers to SPEs, in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities–a replacement of SFAS No. 125” (“SFAS 140”). In accordance with this guidance, the Company recognizes transfers of financial assets as sales provided that control has been relinquished. Control is deemed to be relinquished only when all of the following conditions have been met: (i) the assets have been isolated from the transferor, even in bankruptcy or other receivership (true sale opinions are required); (ii) the transferee has the right to pledge or exchange the assets received and (iii) the transferor has not maintained effective control over the transferred assets (e.g. a unilateral ability to repurchase a unique or specific asset). Therefore, in accordance with this guidance, the Company derecognizes financial assets transferred in securitizations provided that the Company has relinquished control over such assets. The Company is also required to follow the accounting guidance under SFAS 140 and Emerging Issues Task Force (“EITF”) Topic D-14, “Transactions Involving Special-Purpose Entities,” to determine whether or not an SPE is required to be consolidated. The majority of the Company’s involvement with SPEs relates to securitization transactions meeting the SFAS 140 definition of a qualifying special purpose entity (“QSPE”). A QSPE can generally be described as an entity with significantly limited powers which are intended to limit it to passively holding financial assets and distributing cash flows based upon pre-set terms. Based upon the guidance in SFAS 140, the Company is not required to and does not consolidate such QSPEs. Rather, the Company accounts for its involvement with QSPEs under a financial components approach in which the Company recognizes only its retained involvement with the QSPE. The Company accounts for such retained interests at fair value with changes in fair value reported in earnings. The Company is a market leader in mortgage (both residential and commercial), municipal and other asset-backed securitizations which are principally transacted through QSPEs. The Company securitized approximately $155 billion of financial assets during fiscal 2002 including $108 billion of residential, $15 billion of commercial and $32 billion of municipal and other financial assets. As of November 30, 2002, the Company had approximately $1.1 billion of non-investment grade retained interests from its securitization activities. Retained interests are recorded in Securities and Other Financial Instruments Owned within the Company’s Consolidated Statement of Financial Condition and primarily represent junior interests in commercial and residential securitization transactions. The Company records its trading assets, including retained interests on a mark-to-market basis, with related gains or losses recognized in Principal transactions in the Consolidated Statement of Income. (See Note 16 to the Consolidated Financial Statements.) Certain special purpose entities do not meet the QSPE criteria due to their permitted activities not being sufficiently limited, or because the assets are not deemed qualifying financial instruments (e.g. real estate). In instances in which the Company is either the sponsor of or transferor to a non-qualifying SPE, the Company follows the accounting guidance provided by EITF Topic D-14 to determine whether consolidation is required. Under this guidance, the Company would not be required to, and does not consolidate such SPE if a third party investor made a substantive equity investment in the SPE (minimum of 3%), was subject to first dollar risk of loss of such SPE, and had a controlling financial interest. Examples of the Company’s involvement with such SPEs include: CDOs, where the Company’s role is principally limited to acting as structuring and placement agent, warehouse provider and underwriter for CDO transactions; and Synthetic Credit Transactions, where the Company’s role is primarily that of underwriter and buyer of credit risk protection from SPEs. On January 17, 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities – an interpretation of ARB No. 51,” (“Interpretation No. 46”). This interpretation provides new consolidation accounting guidance for entities involved with special purpose entities and will replace guidance provided by EITF Topic D-14. This guidance does not impact the accounting for securitizations transacted through QSPEs. This interpretation will require a primary beneficiary, defined as an entity which participates in either a majority of the risks or rewards of such SPE, to consolidate the SPE. An SPE would not be subject to this interpretation if such entity has sufficient voting equity capital (presumed to require a minimum of 10%), such that the entity is able to finance its activities without additional subordinated financial support from other parties. While the Company has not yet completed its analysis of the impact of the new interpretation, the Company does not anticipate that the adoption of this interpretation will have a material impact to the Company’s financial condition or its results of operations. In addition to the above consolidation policies related to SPEs, the Company follows SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries,” for its dealings with operating entities. The Company consolidates operating entities when the Company has a controlling financial interest over the business activities of such entities. Non-controlled operating entities are accounted for under the equity method when the Company is able to exercise significant influence over the business activities of such entities. The cost method is applied when the ability to exercise significant influence is not present. As a leading global investment banking company, risk is an inherent part of the Company’s businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks to Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk Management is considered to be of paramount importance in the Company’s day-to-day operations. Consequently, the Company devotes significant resources (including investments in personnel and technology) across all of its worldwide trading operations to the measurement, management and analysis of risk. The Company seeks to reduce risk through the diversification of its businesses, counterparties and activities in geographic regions. The Company accomplishes this objective by allocating the usage of capital to each of its businesses, establishing trading limits and setting credit limits for individual counterparties, including regional concentrations. The Company seeks to achieve adequate returns from each of its businesses commensurate with the risks that they assume. Nonetheless, the effectiveness of the Company’s policies and procedures for managing risk exposure can never be completely or accurately predicted or fully assured. For example, unexpectedly large or rapid movements or disruptions in one or more markets or other unforeseen developments can have an adverse effect on the Company’s results of operations and financial condition. The consequences of these developments can include losses due to adverse changes in inventory values, decreases in the liquidity of trading positions, higher volatility in the Company’s earnings, increases in the Company’s credit exposure to customers and counterparties and increases in general systemic risk. Overall risk management policy is established at the Office of the Chairman level and begins with The Capital Markets Committee which consists of the Chief Executive Officer, other members of the Company’s Executive Committee, the Global Head of Risk, the Chief Economist and Strategist as well as various other business heads. The Capital Markets Committee serves to frame the Company’s risk opinion in the context of the global market environment. The Company’s Risk Committee, which consists of the Chief Executive Officer, members of the Executive Committee and the Global Head of Risk, meets weekly and reviews all risk exposures, position concentrations and risk taking activities. The Global Risk Management Group (the “Group”) is independent of the trading areas and reports directly into the Office of the Chairman. The Group includes credit risk management, market risk management and operational risk management. Combining these disciplines facilitates the analysis of risk exposures, while leveraging personnel and information technology resources in a cost-efficient manner. The Group maintains staff in each of the Company’s regional trading centers and has daily contact with trading staff and senior management at all levels within the Company. These discussions include a review of trading positions and risk exposures. Credit risk represents the possibility that a counterparty will be unable to honor its contractual obligations to the Company. Credit risk management is therefore an integral component of the Company’s overall risk management framework. The Credit Risk Management Department (“CRM Department”) has global responsibility for implementing the Company’s overall credit risk management framework. The CRM Department manages the credit exposure related to trading activities by giving initial credit approval for counterparties, establishing credit limits by counterparty, country and industry group and by requiring collateral in appropriate circumstances. In addition, the CRM Department strives to ensure that master netting agreements are obtained whenever possible. The CRM Department also considers the duration of transactions in making its credit decisions, along with the potential credit exposure for complex derivative transactions. The CRM Department is responsible for the continuous monitoring and review of counterparty credit exposure and creditworthiness and recommending valuation adjustments, where appropriate. Credit limits are reviewed periodically to ensure that they remain appropriate in light of market events or the counterparty’s financial condition. Market risk represents the potential change in value of a portfolio of financial instruments due to changes in market rates, prices and volatilities. Market risk management also is an essential component of the Company’s overall risk management framework. The Market Risk Management Department (“MRM Department”) has global responsibility for implementing the Company’s overall market risk management framework. It is responsible for the preparation and dissemination of risk reports, developing and implementing the firmwide Risk Management Guidelines, and evaluating adherence to these guidelines. These guidelines provide a clear framework for risk management decision making. To that end, the MRM Department identifies and quantifies risk exposures, develops limits and reports and monitors these risks with respect to the approved limits. The identification of material market risks inherent in positions includes, but is not limited to, interest rate, equity and foreign exchange risk exposures. In addition to these risks, the MRM Department also evaluates liquidity risks, credit and sovereign concentrations. The MRM Department utilizes qualitative as well as quantitative information in managing trading risk, believing that a combination of the two approaches results in a more robust and complete approach to the management of trading risk. Quantitative information is developed from a variety of risk methodologies based upon established statistical principles. To ensure high standards of qualitative analysis, the MRM Department has retained seasoned risk managers with the requisite experience and academic and professional credentials. Market risk is present in cash products, derivatives and contingent claim structures that exhibit linear as well as non-linear profit and loss sensitivity. The Company’s exposure to market risk varies in accordance with the volume of client-driven market-making transactions, the size of the Company’s proprietary positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments. The Company participates globally in interest rate, equity and foreign exchange markets. The Company’s Fixed Income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset-backed securities, municipal bonds and interest rate derivatives. The Company’s Equities division facilitates domestic and foreign trading in equity instruments, indices and related derivatives. The Company’s foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts. The Company incurs short-term interest rate risk when facilitating the orderly flow of customer transactions through the maintenance of government and high grade corporate bond inventories. Market-making in high yield instruments exposes the Company to additional risk due to potential variations in credit spreads. Trading in international markets exposes the Company to spread risk between the term structure of interest rates in different countries. Mortgages and mortgage-related securities are subject to prepayment risk and changes in the level of interest rates. Trading in derivatives and structured products exposes the Company to changes in the level and volatility of interest rates. The Company actively manages interest rate risk through the use of interest rate futures, options, swaps, forwards and offsetting cash market instruments. Inventory holdings, concentrations and agings are monitored closely and used by management to selectively hedge or liquidate undesirable exposures. The Company is a significant intermediary in the global equity markets through its market-making in U.S. and non-U.S. equity securities, including common stock, convertible debt, exchange-traded and OTC equity options, equity swaps and warrants. These activities expose the Company to market risk as a result of price and volatility changes in its equity inventory. Inventory holdings are also subject to market risk resulting from concentrations and changes in liquidity conditions that may adversely impact market valuation. Equity market risk is actively managed through the use of index futures, exchange-traded and OTC options, swaps and cash instruments. The Company enters into foreign exchange transactions in order to facilitate the purchase and sale of non-dollar instruments, including equity and interest rate securities. The Company is exposed to foreign exchange risk on its holdings of non-dollar assets and liabilities. The Company is active in many foreign exchange markets and has exposure to the Euro, Japanese yen, British pound, Swiss franc and Canadian dollar, as well as a variety of developed and emerging market currencies. The Company hedges its risk exposures primarily through the use of currency forwards, swaps, futures and options. If any of the strategies utilized to hedge or otherwise mitigate exposures to the various types of risks described above are not effective, the Company could incur losses. Operational Risk is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems, or from external events. Operational Risk Management (ORM) is responsible for implementing and maintaining the Company’s overall global operational risk management framework, which seeks to minimize these risks through assessing, reporting, monitoring and tracking operational risks. Value-At-Risk For purposes of Securities and Exchange Commission (“SEC”) risk disclosure requirements, the Company discloses an entity-wide value-at-risk for virtually all of its trading activities. In general, the Company’s value-at-risk measures potential loss of trading revenues at a given confidence level over a specified time horizon. Value-at-risk over a one-day holding period measured at a 95% confidence level implies that the potential loss of daily trading revenue will be at least as large as the value-at-risk amount on one out of every 20 trading days. The Company’s methodology estimates a reporting day value-at-risk using actual daily trading revenues over the previous 250 trading days. This estimate is measured as the loss, relative to the median daily trading revenue. The Company also estimates an average value-at-risk measure over 250 rolling reporting days, thus looking back a total of 500 trading days. Year Ended November 30, 2002 Equity price risk Foreign exchange risk Diversification benefit (5.2 Total Company • The average, high and low value-at-risk for the year ended November 30, 2001 were $23.8 million, $25.1 million and $22.4 million, respectively. The above table sets forth the daily value-at-risk for each component of market risk as well as total value-at-risk. Value-at-risk is one measurement of potential loss in trading revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. As with all measures of value-at-risk, the Company’s estimate has substantial limitations due to its reliance on historical performance, which is not necessarily a predictor of the future. Consequently, this value-at-risk estimate is only one of a number of tools the Company utilizes in its daily risk management activities. The increase in interest rate risk as of November 30, 2002 from November 30, 2001 reflects higher volatility in fixed income securities, while the decrease in equity risk is primarily related to lower equity positions held for customer flow purposes. Distribution Of Trading Revenues Substantially all of the Company’s inventory positions are marked-to-market on a daily basis as part of the Company’s Capital Markets business segment with changes recorded in net revenues. The following chart sets forth the frequency distribution for weekly net revenues for the Company’s Capital Markets and Client Services segments (excluding asset management fees) for the years-ended November 30, 2002 and 2001. As discussed throughout Management’s Discussion and Analysis, the Company seeks to reduce risk through the diversification of its businesses and a focus on customer flow activities. This diversification and focus, combined with the Company’s risk management controls and processes, helps mitigate the net revenue volatility inherent in the Company’s trading activities. Although historical performance is not necessarily indicative of future performance, the Company believes its focus on business diversification and customer flow activities should continue to reduce the volatility of future net trading revenues. Trading Net Revenues Distribution for 2002 and 2001 In weeks Less than $0 $0-50 million $50-100 million $100-150 million $200+ million • Average weekly trading net revenues for 2002 and 2001 were approximately $89 million and $90 million, respectively. In May 2002, the Securities and Exchange Commission proposed rules to require disclosures associated with critical accounting polices which are most important in gaining an understanding of an entity’s financial statements. The following is a summary of the Company’s critical accounting policies. For a full description of these and other accounting policies, see Note 1 to the Consolidated Financial Statements. The Company’s financial statements are prepared in conformity with generally accepted accounting principles, many of which require the use of estimates and assumptions. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates particularly in light of the industry in which the Company operates. The determination of fair value is a critical accounting policy which is fundamental to the Company’s financial condition and results of operations. The Company records its inventory positions including Securities and other financial instruments owned and Securities sold but not yet purchased at market or fair value with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. In all instances, the Company believes that it has established rigorous internal control processes to ensure that the Company utilizes reasonable and prudent measurements of fair value. When evaluating the extent to which management estimates may be required to be utilized in preparing the Company’s financial statements, the Company believes it is useful to analyze the balance sheet as follows: Assets: Securities and other financial instruments owned Secured financings Receivables and other assets Liabilities & Equity Securities and other financial instruments sold but not yet purchased Payables and other liabilities A significant majority of the Company’s assets and liabilities are recorded at amounts for which significant management estimates are not utilized. The following balance sheet categories comprising 54% of total assets and 74% of liabilities and equity are valued at either historical cost or at contract value (including accrued interest) which by their nature, do not require the use of significant estimates: Secured financings, Receivables/Payables and Other assets/liabilities and Total capital. The remaining balance sheet categories, comprised of Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased (long and short inventory positions, respectively), are recorded at market or fair value, the components of which may require, to varying degrees, the use of estimates in determining fair value. The majority of the Company’s long and short inventory is recorded at market value based upon listed market prices or utilizing third party broker quotes and therefore do not incorporate significant estimates. Examples of inventory valued in this manner include government securities, agency mortgage-backed securities, listed equities, money markets, municipal securities, corporate bonds and listed futures. If listed market prices or broker quotes are not available, fair value is determined based on pricing models or other valuation techniques, including use of implied pricing from similar instruments. Pricing models are typically utilized to derive fair value based upon the net present value of estimated future cash flows including adjustments, where appropriate, for liquidity, credit and/or other factors. For the vast majority of instruments valued through pricing models, significant estimates are not required, as the market inputs into such models are readily observable and liquid trading markets provide clear evidence to support the valuations derived from such pricing models. Examples of inventory valued utilizing pricing models or other valuation techniques include: OTC derivatives, private equity investments, certain high-yield positions, certain mortgage loans and direct real estate investments and non-investment grade retained interests. Fair Value of OTC Derivative Contracts by Maturity At November 30, 2002 Greater than 10 years Interest rate, currency and credit default swaps and options Foreign exchange forward contracts and options Other fixed income securities contracts Equity contracts (including swaps, warrants and options) The fair value of the Company’s OTC derivative assets and liabilities at November 30, 2002 were $12.8 billion and $9.5 billion, respectively. OTC derivative assets represent the Company’s unrealized gains, net of unrealized losses for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. The vast majority of the Company’s OTC derivatives are transacted in liquid trading markets for which fair value is determined utilizing pricing models with readily observable market inputs. Examples of such derivatives include: interest rate swaps contracts, TBA’s (classified in the above table as other fixed income securities contracts), foreign exchange forward and option contracts in G-7 currencies and equity swap and option contracts on listed securities. However, the determination of fair value for certain less liquid derivatives requires the use of significant estimates and include: certain credit derivatives, equity option contracts greater than 5 years, and certain other complex derivatives utilized by the Company in providing clients with hedging alternatives to unique exposures. The Company strives to limit the use of significant judgment by using consistent pricing assumptions between reporting periods and utilizing observed market data for model inputs whenever possible. As the market for complex products develops, the Company refines its pricing models based upon market experience in order to utilize the most current indicators of fair value. The Company’s private equity investments of $965 million at November 30, 2002 include both public and private equity positions. The determination of fair value for these investments may require the use of estimates and assumptions as these investments are generally less liquid and often contain trading restrictions. The determination of fair value for private equity investments is based on estimates incorporating valuations which take into account expected cash flows, earnings multiples and/or comparison to similar market transactions. Valuation adjustments are an integral part of pricing these instruments, reflecting consideration of credit quality, concentration risk, sale restrictions and other liquidity factors. At November 30, 2002, the Company had high yield long and short positions of $4.0 billion and $1.1 billion, respectively. The majority of these positions are valued utilizing broker quotes or listed market prices. In certain instances, when broker quotes or listed prices are not available the Company utilizes prudent judgment in determining fair value which may involve the utilization of analysis of credit spreads associated with pricing of similar instruments, or other valuation techniques. Mortgage Loans and Real Estate The Company is a market leader in mortgage-backed securities trading and mortgage securitizations (both residential and commercial). The Company’s inventory of mortgage loans principally represents loans held prior to securitization. In this activity, the Company purchases mortgage loans from loan originators or in the secondary markets and then aggregates pools of mortgages for securitization. The Company records mortgage loans and direct real estate investments at fair value, with related mark-to-market gains and losses recognized in Principal transactions revenues. As the Company’s inventory of residential loans turns over through sale to securitization trusts rather frequently, such loans are generally valued without the use of significant estimates. The Company is also a market leader in the commercial lending and securitization markets. Commercial real estate loans are generally valued based upon an analysis of the loans’ carrying value relative to the value of the underlying real estate, known as loan-to-value ratios. As the loan-to-value ratio increases, the fair value of such loan is influenced to a greater extent by a combination of cash flow projections and underlying property values. Approximately $5.6 billion of the Company’s commercial real estate loans and direct real estate investments are valued using both cash flow projections as well as underlying property values. The Company utilizes independent appraisals to support management’s assessment of the property in determining fair value for these positions. In addition, the Company held approximately $1.1 billion of non-investment grade retained interests at November 30, 2002, down from $1.6 billion at November 30, 2001. As these interests primarily represent the junior interests in commercial and residential mortgage securitizations, for which there are not active trading markets, estimates are generally required to be utilized in determining fair value. The Company values these instruments using prudent estimates of expected cash flows, and considers the valuation of similar transactions in the market. (See Note 16 to the Consolidated Financial Statements for additional information on the impact of adverse changes in assumptions on the fair value of these interests.) In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). Under SFAS 142, intangible assets with indefinite lives and goodwill will no longer be amortized. Instead, these assets are required to be tested annually for impairment. The Company adopted the provisions of SFAS 142 as of the beginning of fiscal 2002, and such adoption did not have a material effect on the Company’s financial condition or results of operations. In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 provides accounting guidance for the impairment or disposal of long-lived assets, such as property, plant and equipment. In addition, SFAS 144 amends Accounting Research Bulletin No. 51, “Consolidated Financial Statements” to eliminate the exception to consolidation for a subsidiary for which control is likely to be temporary. The Company will adopt this standard in the first quarter of fiscal 2003. The Company does not expect that the adoption will have a material impact to the Company’s financial condition or results of operations. In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS 146”). This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” The Company will adopt the provisions of SFAS 146 at the beginning of fiscal 2003 and does not expect the adoption to have a material impact to the Company’s financial condition or results of operations. In October 2002, the EITF reached a consensus on Issue No. 02-03, “Issues Involved in Accounting for Derivative Contracts Held for Trading Purposes and Contracts Involved in Energy Trading and Risk Management Activities.” This issue clarifies the FASB staff view that profits should not be recognized at the inception of a derivative contract if the contract does not have observable pricing. In such instances, the transaction price is viewed by the FASB to be the best indicator of fair value. The Company does not expect the application of this guidance to have a material impact on the Company’s financial condition or results of operations. On January 17, 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities — an interpretation of ARB No. 51,” (“Interpretation 46”). This interpretation provides new consolidation accounting guidance for entities involved with special purpose entities. This guidance does not impact the accounting for securitizations transacted through QSPEs. This interpretation will require a primary beneficiary, defined as an entity which participates in either a majority of the risks or rewards of such SPE, to consolidate the SPE. An SPE would not be subject to this interpretation if such entity had sufficient voting equity capital, such that the entity is able to finance its activities without the additional subordinated financial support from other parties. Interpretation 46 also requires additional disclosures related to involvement with SPEs. The accounting provisions of this interpretation are effective for new transactions executed after January 31, 2003. The interpretation will be effective for all existing transactions with SPEs beginning in the Company’s fourth quarter of 2003. While the Company has not yet completed its analysis of the impact of the new interpretation, the Company does not anticipate that the adoption of this interpretation will have a material impact to the Company’s financial condition or results of operations. Because the Company’s assets are, to a large extent, liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects the Company’s expenses, such as employee compensation, office space leasing costs and communications charges, which may not be readily recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it may adversely affect the Company’s financial position and results of operations in certain businesses. The Board of Directors and Stockholders of Lehman Brothers Holdings Inc. We have audited the accompanying consolidated statement of financial condition of Lehman Brothers Holdings Inc. and Subsidiaries (the “Company”) as of November 30, 2002 and 2001, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended November 30, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Lehman Brothers Holdings Inc. and Subsidiaries at November 30, 2002 and 2001, and the consolidated results of its operations and its cash flows for each of the three years in the period ended November 30, 2002, in conformity with accounting principles generally accepted in the United States. Ernst & Young LLP In millions, except per share data Brokerage and clearance Professional fees Income before taxes and dividends on trust preferred securities Provision for income taxes Dividends on trust preferred securities Net income applicable to common stock See Notes to Consolidated Financial Statements. Consolidated Statement of Financial Condition Cash and securities segregated and on deposit for regulatory and other purposes Securities and other financial instruments owned: (includes $22,211 in 2002 and $28,517 in 2001 pledged as collateral) Collateralized short-term agreements: Securities purchased under agreements to resell Securities borrowed Receivables: Brokers, dealers and clearing organizations Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $590 in 2002 and $424 in 2001) Excess of cost over fair value of net assets acquired (net of accumulated amortization of $155 in 2002 and $151 in 2001) Consolidated Statement of Financial Condition continued Commercial paper and short-term debt Collateralized short-term financing: Securities sold under agreements to repurchase Securities loaned Other secured borrowings Payables: Accrued liabilities and other payables Long-term debt: Common stock, $0.10 par value; Shares authorized: 600,000,000 in 2002 and 2001; Shares issued: 258,791,416 in 2002 and 256,178,907 in 2001; Shares outstanding: 231,131,043 in 2002 and 237,534,091 in 2001 Accumulated other comprehensive income (net of tax) Other stockholders’ equity, net Common stock in treasury, at cost: 27,660,373 shares in 2002 and 18,644,816 shares in 2001 Consolidated Statement of Changes in Stockholders’ Equity 5% Cumulative Convertible Voting, Series A and B: Shares subject to redemption Shares repurchased 5.94% Cumulative, Series C: Beginning and ending balance 5.67% Cumulative, Series D: 7.115% Fixed/Adjustable Rate Cumulative, Series E: Shares issued Redeemable Voting: Total Preferred Stock, ending balance Common Stock(1) Additional Paid-In Capital(1) RSUs exchanged for Common Stock Employee stock-based awards Shares issued to RSU Trust Tax benefits from the issuance of stock-based awards Other, net (1) Amounts have been retroactively adjusted to give effect for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective on October 20, 2000. Consolidated Statement of Changes in Stockholders’ Equity continued Translation adjustment, net(2) Dividends declared: 5% Cumulative Convertible Voting Series A and B Preferred Stock 5.94% Cumulative, Series C Preferred Stock 5.67% Cumulative, Series D Preferred Stock 7.115% Fixed/Adjustable Rate Cumulative, Series E Preferred Stock Redeemable Voting Preferred Stock Common Stock Issuable Deferred stock awards granted Common Stock Held in RSU Trust Deferred Stock Compensation Amortization of deferred compensation, net Common Stock In Treasury, at Cost Treasury stock purchased Shares issued for preferred stock conversion (2) Net of income taxes of $(1) in 2002, $(1) in 2001 and $(8) in 2000. Adjustments to reconcile net income to net cash provided by (used in) operating activities: Deferred tax provision (benefit) Tax benefit from issuance of stock-based awards Amortization of deferred stock compensation September 11th (recoveries) expenses Other adjustments Cash and securities segregated and on deposit Other secured financing Receivables from brokers, dealers and clearing organizations Receivables from customers Payables to brokers, dealers and clearing organizations Payables to customers Other operating assets and liabilities, net Net cash provided by (used in) operating activities Proceeds from issuance of senior notes Principal payments of senior notes Principal payments of subordinated indebtedness Net proceeds from (payments for) commercial paper and short-term debt Resale agreements net of repurchase agreements Payments for repurchases of preferred stock Payments for treasury stock purchases, net Dividends paid Issuances of common stock Issuance of preferred stock, net of issuance costs Purchases of property, equipment and leasehold improvements, net Proceeds from the sale of 3 World Financial Center, net Acquisition, net of cash acquired Net cash used in investing activities Net change in cash and cash equivalents Cash and cash equivalents, beginning of period Cash and cash equivalents, end of period SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions): Interest paid totaled $10,686 in 2002, $15,588 in 2001 and $18,500 in 2000. Income taxes paid totaled $436 in 2002, $654 in 2001 and $473 in 2000. C O N T E N T S Summary of Significant Accounting Policies Short-Term Financings Incentive Plans Capital Requirements Derivative Financial Instruments Securitizations Fair Value of Financial Instruments Securities Pledged as Collateral Other Commitments and Contingencies Quarterly Information (unaudited) Note 1 Summary of Significant Accounting Policies The consolidated financial statements include the accounts of Lehman Brothers Holdings Inc. (“Holdings”) and subsidiaries (collectively, the “Company” or “Lehman Brothers”). Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high-net-worth individual clients and customers. The Company’s worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by offices in additional locations in North America, Europe, the Middle East, Latin America and the Asia Pacific region. The Company is engaged primarily in providing financial services. The principal U.S. subsidiary of Holdings is Lehman Brothers Inc. (“LBI”), a registered broker-dealer. All material intercompany accounts and transactions have been eliminated in consolidation. The consolidated financial statements are prepared in conformity with generally accepted accounting principles which require management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Management estimates are required to be utilized in determining the valuation of trading inventory particularly in the area of OTC derivatives, certain high yield positions, private equity securities and mortgage loan positions. Additionally, management estimates are required in assessing the realizability of deferred tax assets, the outcome of litigation and determining the components of the September 11th related (recoveries)/expenses, net and the other real estate reconfiguration charge. Management believes that the estimates utilized in preparing its financial statements are reasonable and prudent. Actual results could differ from these estimates. The Company uses the trade date basis of accounting. Certain prior period amounts reflect reclassifications to conform to the current year’s presentation. Securities And Other Financial Instruments Securities and other financial instruments owned and Securities and other financial instruments sold but not yet purchased are valued at market or fair value, as appropriate, with unrealized gains and losses reflected in Principal transactions in the Consolidated Statement of Income. Market value is generally based on listed market prices. If listed market prices are not available, or if liquidating the Company’s position is reasonably expected to affect market prices, fair value is determined based on broker quotes, internal valuation models which take into account time value and volatility factors underlying the financial instruments or management’s estimate of the amounts that could be realized under current market conditions, assuming an orderly liquidation over a reasonable period of time. As of November 30, 2002 and 2001, all firm-owned securities pledged to counterparties where the counterparty has the right, by contract or custom, to sell or repledge the securities are classified as Securities owned (pledged as collateral) as required by Statement of Financial Accounting Standards (“SFAS”) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of SFAS No.125” (“SFAS 140”). A derivative is typically defined as an instrument whose value is “derived” from an underlying instrument, index or rate, such as a future, forward, swap, or option contract, or other financial instrument with similar characteristics. A derivative contract generally represents future commitments to exchange interest payment streams or currencies based on the contract or notional amount or to purchase or sell other financial instruments at specified terms on a specified date. Derivatives are recorded at market or fair value in the Consolidated Statement of Financial Condition on a net by counterparty basis where a legal right of set-off exists and are netted across products when such provisions are stated in the master netting agreement. Derivatives are often referred to as off-balance-sheet instruments since neither their notional amounts nor the underlying instruments are reflected as assets or liabilities of the Company. Instead, the market or fair value related to the derivative transactions is reported in the Consolidated Statement of Financial Condition as an asset or liability in Derivatives and other contractual agreements, as applicable. Margin on futures contracts is included in receivables and payables from/to brokers, dealers and clearing organizations, as applicable. Changes in fair values of derivatives are recorded as Principal transactions revenues in the current period. Market or fair value is generally determined by either quoted market prices (for exchange-traded futures and options) or pricing models (for swaps, forwards and options). Pricing models utilize a series of market inputs to determine the present value of future cash flows, with adjustments, as required for credit risk and liquidity risk. Further valuation adjustments may be recorded, as deemed appropriate for new or complex products or for positions with significant concentrations. These adjustments are integral components of the mark-to-market process. Credit-related valuation adjustments incorporate business and economic conditions, historical experience, concentrations, estimates of expected losses and the character, quality and performance of credit sensitive financial instruments. As an end-user, the Company primarily utilizes derivatives to modify the interest rate characteristics of its long-term debt and secured financing activities. The Company also utilizes equity derivatives to hedge its exposure to equity price risk embedded in certain of its debt obligations and foreign exchange forwards to manage the currency exposure related to its net monetary investment in non-U.S. dollar functional currency operations (collectively, “end-user derivative activities”). Effective December 1, 2000, the Company adopted SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities” (collectively, “SFAS 133”), which requires that all derivative instruments be reported on the Consolidated Statement of Financial Condition at fair value. Under SFAS 133, the accounting for end-user derivative activities is dependent upon the nature of the hedging relationship. In certain hedging relationships, both the derivative and the hedged item will be marked-to-market through earnings for changes in fair value (“fair value hedge”). In many instances, the hedge relationship is fully effective so that the mark-to-market on the derivative and the hedged item will offset. In other hedging relationships, the derivative will be marked-to-market with the offsetting gains or losses recorded in Accumulated other comprehensive income, a component of Stockholder’s Equity, until the related hedged item is realized in earnings (“cash flow hedge”). SFAS 133 also requires certain derivatives embedded in long-term debt to be bifurcated and marked-to-market through earnings. SFAS 133 changed the accounting treatment for the hedged item in a fair value hedge (e.g., long-term debt or secured financing activities) from what was an accrual basis to a modified mark-to-market value. The hedged item’s carrying value may differ from a full mark-to-market value since SFAS 133 requires that the hedged item be adjusted only for changes in fair value associated with the designated risks being hedged during the hedge period. The Company principally utilizes fair value hedges to convert a substantial portion of the Company’s fixed rate debt and certain long-term secured financing activities to floating interest rates. Any hedge ineffectiveness in these relationships is recorded as a component of Interest expense on the Company’s Consolidated Statement of Income. Gains or losses from revaluing foreign exchange contracts associated with hedging the Company’s net investments in foreign affiliates are reported within Accumulated other comprehensive income in Stockholder’s Equity. Unrealized receivables/payables resulting from the mark-to-market on end-user derivatives are included in Securities and other financial instruments owned or sold but not yet purchased. The adoption of SFAS 133, as of December 1, 2000, did not have a material effect on the Company’s Consolidated Statement of Financial Condition or the results of operations, as most of the Company’s derivative transactions are entered into for trading-related activities for which the adoption of SFAS 133 had no impact. Prior year amounts have not been restated to conform with the current SFAS 133 accounting treatment. Therefore, end-user derivative activities for all periods prior to December 1, 2000 are recorded on an accrual basis provided that the derivative was designated and deemed to be a highly effective hedge. For periods prior to fiscal 2001, realized gains or losses on early terminations of derivatives that were designated as hedges were deferred and amortized to interest income or interest expense over the remaining life of the instrument being hedged. Secured Financing Activities Repurchase and Resale Agreements Securities purchased under agreements to resell and Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized primarily by government and government agency securities and are carried net by counterparty, when permitted, at the amounts at which the securities will be subsequently resold or repurchased plus accrued interest. It is the policy of the Company to take possession of securities purchased under agreements to resell. The Company monitors the market value of the underlying positions on a daily basis as compared to the related receivable or payable balances, including accrued interest. The Company requires counterparties to deposit additional collateral or return collateral pledged as necessary, to ensure that the market value of the underlying collateral remains sufficient. Securities and other financial instruments owned that are financed under repurchase agreements are carried at market value with changes in market value reflected in the Consolidated Statement of Income. The Company utilizes interest rate swaps as an end-user to modify the interest rate exposure associated with certain fixed rate resale and repurchase agreements. In accordance with SFAS No. 133, the Company adjusted the carrying value of these secured financing transactions that have been designated as the hedged item. Securities Borrowed and Loaned Securities borrowed and securities loaned are carried at the amount of cash collateral advanced or received plus accrued interest. It is the Company’s policy to value the securities borrowed and loaned on a daily basis, and to obtain additional cash as necessary to ensure such transactions are adequately collateralized. Other Secured Borrowings Other secured borrowings are recorded at contractual amounts plus accrued interest. The Company carries its private equity investments, including its partnership interests, at fair value based upon the Company’s assessment of each underlying investment. The Company accounts for income taxes under the provisions of SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”). The Company recognizes the current and deferred tax consequences of all transactions that have been recognized in the financial statements using the provisions of the enacted tax laws. In this regard, deferred tax assets are recognized for temporary differences that will result in deductible amounts in future years and for tax loss carry-forwards, if in the opinion of management, it is more likely than not that the deferred tax asset will be realized. SFAS 109 requires companies to set up a valuation allowance for that component of net deferred tax assets which does not meet the “more likely than not” criterion for realization. Deferred tax liabilities are recognized for temporary differences that will result in taxable income in future years. Translation Of Foreign Currencies Assets and liabilities of foreign subsidiaries having non-U.S. dollar functional currencies are translated at exchange rates at the statement of financial condition date. Revenues and expenses are translated at average exchange rates during the period. The gains or losses resulting from translating foreign currency financial statements into U.S. dollars, net of hedging gains or losses and taxes, are included in Accumulated other comprehensive income, a separate component of Stockholders’ Equity. Gains or losses resulting from foreign currency transactions are included in the Company’s Consolidated Statement of Income. Property, Equipment And Leasehold Improvements Property, equipment and leasehold improvements are recorded at historical cost, net of accumulated depreciation and amortization. Depreciation is recognized on a straight-line basis over the estimated useful lives. Buildings are depreciated up to a maximum of 40 years. Leasehold improvements are amortized over the lesser of their economic useful lives or the terms of the underlying leases, ranging up to 30 years. Equipment, furniture and fixtures are depreciated over periods of up to 15 years. Internal use of software which qualifies for capitalization under American Institute of Certified Public Accountants (“AICPA”) Statement of position 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” is capitalized and subsequently amortized over the estimated useful life of the software, generally 3 years, with a maximum of 7 years. Long-Lived Assets In accordance with SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of” the Company reviews assets, such as property, equipment and leasehold improvements for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. If the total of the expected future undiscounted cash flows is less than the carrying amount of the asset, then an impairment loss would be recognized to the extent that the carrying value of such asset exceeded its fair value. As of December 1, 2001, the Company adopted SFAS No. 141, “Business Combinations” (“SFAS 141”), and SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). SFAS 141 requires all business combinations initiated after June 30, 2001 to be accounted for using the purchase method. Under SFAS 142, intangible assets with indefinite lives and goodwill are no longer required to be amortized. Instead, these assets are evaluated annually for impairment. The Company adopted the provisions of SFAS 142 at the beginning of fiscal year 2002 and the change did not have a material impact to the Company’s financial position or its results of operations. Prior to December 1, 2001, the Company amortized goodwill using the straight-line method over periods not exceeding 35 years. Goodwill is reduced upon the recognition of certain acquired net operating loss carryforward benefits. Stock-Based Awards SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), established financial accounting and reporting standards for stock-based employee compensation plans. SFAS 123 permits companies either to continue accounting for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 (“APB 25”) or using the fair value method prescribed by SFAS 123. The Company continues to follow APB 25 and its related interpretations in accounting for its stock-based compensation plans. Accordingly, no compensation expense has been recognized for stock option awards because the exercise price was at or above the fair market value of the Company’s common stock on the grant date. For purposes of the Consolidated Statement of Cash Flows, the Company defines cash equivalents as highly liquid investments with original maturities of three months or less, other than those held for sale in the ordinary course of business. The Company computes earnings per common share in accordance with SFAS No. 128, “Earnings per Share” (“EPS”). Basic earnings per share is computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the assumed conversion of all dilutive securities. All share and per share amounts have been restated for the two-for-one common stock split, effected in the form of a 100% stock dividend, which became effective October 20, 2000. See Notes 9 and 11 of Notes to Consolidated Financial Statements for more information. Consolidation Accounting Policies Operating Companies The Company follows SFAS No. 94, “Consolidation of All Majority-Owned Subsidiaries” and consolidates operating entities when the Company has a controlling financial interest over the business activities of such entities. Non-controlled operating entities are accounted for under the equity method when the Company is able to exercise significant influence over the business activities of such entities. The cost method is applied when the ability to exercise significant influence is not present. Special Purpose Entities For those entities which do not meet the definition of conducting a business, often referred to as special purpose entities (“SPEs”), the Company follows the accounting guidance under SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities — a replacement of FASB No. 125,” and Emerging Issues Task Force (“EITF”) Topic D-14, “Transactions Involving Special-Purpose Entities,” to determine whe

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professional_accounting

Home > Galleries > Auditing the Auditors: Creatin... > A Political Hotbed: Crafting t... Auditing the Auditors: Creating the Public Company Accounting Oversight Board Race to Restore Confidence: Passing the Sarbanes-Oxley Act A Rocky Start: Naming the First PCAOB Chairman From the Ground Up: Establishing the PCAOB A Political Hotbed: Crafting the Internal Control Over Financial Reporting Standard An Existential Threat: Free Enterprise Fund vs. PCAOB Expanding the Mandate: The Dodd-Frank Wall Street Reform and JOBS Acts The March Forward: Access to China and Other Challenges In Recognition “You need a good standard, but it’s worthless if the implementation is not appropriate.” ~Douglas R. Carmichael, PCAOB Chief Auditor and Director of Professional Standards “I found out that when you go to Washington and you want to get something done, you almost immediately meet the people who don't want you to do it.” ~Thomas Ray, PCAOB Deputy and Chief Auditor “I completely underestimated the attention, politicization, and polarization that would happen around the implementation of 404.” ~Laura J. Phillips, PCAOB Deputy Chief Auditor “I thought going into standard setting meant doing research all day in a think-tank environment. Instead I landed in the middle of a political hotbed.” ~Sharon Virag, PCAOB Project Lead A Challenging Process The implementation of SOX Section 404, the internal control over financial reporting provision, inaugurated a nearly four-year saga during which the PCAOB introduced a detailed prescriptive standard and then, in the face of massive corporate criticism, struggled to modulate the standard without losing its core requirements. At odds were issuers confronting deferred maintenance on their internal controls and sharply increasing audit costs, auditors doing substantially more work to comply with the new PCAOB audit standard, and a new SEC chairman promoting a deregulatory agenda. In 2006, Deputy Chief Auditor Thomas Ray succeeded Douglas R. Carmichael to become Chief Auditor. Ray served until 2009. “It was a very challenging process,” said then-Deputy Chief Auditor Thomas Ray. (He would later succeed Douglas Carmichael as PCAOB Chief Auditor and Director of Professional Standards.) “We got a lot of pressure from all sides, to both make the standard more efficient but not lose the essence of it.” For more than 20 years, observers of the auditing profession had put forth proposals to require internal control reporting to be part of issuers’ financial reporting. The 1978 Cohen Commission report, 1987 Treadway Commission study, and a 1993 special report by the Public Oversight Board all recommended it. However, these recommendations were always shelved over concerns that the cost of documentation, testing, assessment, and public reporting were too high. One of the primary champions for including internal control provisions in SOX was Charles A. Bowsher, former GAO Comptroller General who had served on the 1999 Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees. Bowsher led the GAO in addressing the savings and loan crisis and helped convince Congress to include a provision in the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) requiring auditors of large financial institutions to examine the effectiveness of, and attest to management’s assessment of, internal control over financial reporting. SOX Section 404 was patterned after this requirement and contained two subsections. Under Section 404(a) management discloses its responsibility for and assessment of the company’s internal control structure over financial reporting. Section 404(b) requires the company’s independent auditor to attest to management’s assessment. Auditing Standard No. 2 (AS 2), the PCAOB’s first audit standard that set forth procedural requirements, was developed to meet the SEC’s deadline for large accelerated filers to file the audit reports required under Section 404(a) and (b) with their audited financial statements for fiscal years ending on or after November 15, 2004. Standards staff culled advice and ideas from numerous sources including a public roundtable, meetings with federal bank regulators to review FDICIA compliance, and an Auditing Standards Board internal control exposure draft. Several factors impeded its smooth implementation. Accustomed to having a more hands-on role in the development of standards under the AICPA’s Auditing Standards Board, the audit firms felt they were missing a nuanced understanding of the first consequential standard written by the PCAOB. “Our rigorous standard-setting procedure was not meant to put the firms at a disadvantage, but it left out a lot of debate that would have been happening at the Auditing Standards Board of ‘What does that really mean?’” said Laura J. Phillips, PCAOB Deputy Chief Auditor. Immediately, implementation questions came pouring in. The Office of the Chief Auditor (OCA) set up two working groups to handle the inquiries (one for auditors, one for issuers) and produced four sets of Staff Questions and Answers within the first six months. At the same time, OCA staff juggled hectic speaking schedules to publicize the new standard with constant meetings to hear from stakeholders. “We were working six or seven days a week, very long hours,” said Tom Ray. People were very dedicated and committed a lot of themselves to these projects.” Deferred Maintenance and Manpower Challenges Companies faced a major backlog in bringing their internal control over financial reporting - including documentation and testing - up to date. Although public companies had been required to maintain a system of internal accounting controls since the 1977 passage of the Foreign Corrupt Practices Act, many needed to make dramatic improvements to be ready for AS 2 audits. (1) Most issuers assessed their internal control using the principles-based framework introduced by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. However auditors, under the requirements of AS 2, were seeking more documentation and testing procedures. Many companies were also facing a multitude of deferred maintenance issues, including a lack of integration between new and legacy technology systems, flawed electronic security, and jury-rigged Y2K patches. Issuers in general balked at the effort and cost to document, test, and assess internal control over financial reporting and remediate deficiencies. (2) In addition, management teams and boards found it disconcerting to publicly report on material weaknesses in internal control. PCAOB Founding Board Members. Left to right: Bill Gradison, William J. McDonough, Kayla J. Gillan, Charles D. Niemeier, Daniel L. Goelzer “Prior to the enactment of 404 and despite the existence of the Foreign Corrupt Practices Act, internal control over financial reporting (ICFR) was not a high priority of either companies or their auditors,” said Board Member Kayla Gillan in a 2006 speech. “As a result, much of the first year costs, over and above the ‘learning curve’ costs, were the direct result of documenting ICFR systems and correcting ICFR flaws that had long existed – the so-called ‘deferred maintenance’ costs.” Audit firms faced massive training, manpower, and time challenges to get their auditors up to speed to take on the additional, substantial work to assess internal control in public companies within the 2004 reporting period. (3) “As I recall, that first year of AS 2, we used heat maps of our public companies to track the teams’ progress and see who was struggling and who needed resources,” said Sam Ranzilla, KPMG’s former National Managing Partner for Audit Quality and Professional Practice. “If an audit team encountered a particular issue, they had to come to the national office to get one of our black belts to help guide them along.” Given the increased workload, large audit firms actively hired new personnel, but shortages persisted. In some cases, Big Four firms had to “discontinue” serving some of their smaller public company clients, which created resource pressure for the next tier of audit firms who were suddenly trying to accommodate new, smaller issuer clients. “It was a major staffing issue because the whole profession was going absolutely nuts with the demands that were being placed on us, to get all this done,” said James S. Turley, then Chairman and CEO of Ernst & Young. “I can remember in some places we literally were resigning from a number of accounts because the practice just didn’t have enough bodies to do quality work.” To make sure they were satisfying the PCAOB standard, some audit teams tried to identify and test as many controls as possible. With the increased work, audit fees escalated and restatements shot up. Issuers up in arms at hefty audit bills and reports of material weaknesses complained loudly to the SEC and their congressional representatives. “A lot of detailed work was being done that wouldn’t have been required to identify material weaknesses,” said Douglas R. Carmichael, the PCAOB’s Chief Auditor. “We were hearing horror stories about the things auditors were requiring issuers to do.” First-Year Feedback On April 13, 2005, the SEC and PCAOB hosted a joint roundtable to get feedback about first-year experiences under AS 2. The SEC was roundly chided for not having released guidance for issuers, who felt their auditors and the PCAOB auditing standard were driving their companies’ efforts. Less than a week later, the Wall Street Journal printed a blistering editorial criticizing Section 404 as a costly, antibusiness measure that disproportionately affected smaller businesses. It also claimed that auditors, who had been blamed for causing the accounting scandals, were now the main beneficiaries of Section 404. (4) In response to the cascade of concerns presented, the PCAOB and the SEC released additional guidance (PCAOB Board Policy Statement, SEC Staff Views) a month later to encourage auditors to work more efficiently. The PCAOB also dedicated its June Standing Advisory Group meeting to internal control. Then in November, the PCAOB released its first Board public report, known as a 4010 report after the PCAOB rule authorizing it, that described inspections results of the first year of AS 2 implementation. “The 4010 report was a big milestone in terms of realizing the PCAOB's potential of having standard setting, inspections, and enforcement all under one roof and being able to provide fast feedback to the firms on the application of AS 2,” said Laura Phillips. The 4010 report revealed that in too many cases the audits were “bottom up” looking carefully at low-level controls instead of “top down” and first focusing on significant overarching controls at the top. (5) The report also cited a shortage of trained staff, the limited timeframe in year one, and the backlog of deferred issuer maintenance for the high audit costs. The report predicted that auditors would get more effective and efficient as their learning curve flattened. In December 2005, retiring PCAOB Chairman William J. McDonough told reporters he was optimistic that the second-year implementation of AS 2 was going much better and that there was no need to amend the standard, but that adjustments could be made through additional guidance. (6) A Divided Issue A noisy backlash continued to flow from corporate boardrooms. At one public meeting an executive from a pharmaceutical company developing childhood vaccines accused AS 2 of “killing babies,” because the company’s scarce resources were being directed away from research to pay auditing costs. “The voices of opposition just got louder and louder over time,” said Sharon Virag, a PCAOB project lead. Critics blamed the costs of Section 404 for causing American companies to delist and go private and for discouraging foreign companies from listing their securities in the United States. Proponents maintained that the cost of raising capital decreases when companies maintain adequate internal controls. President George W. Bush announces Rep. Christopher Cox, (R-Ca) as his choice for Chairman of the Securities and Exchange Commission, June 2, 2005. The SEC, under new Chairman Christopher Cox, who had been appointed in August 2005, actively began to seek a reduction in the effort and cost of compliance with the SOX 404 requirements and AS 2. The SEC also delayed the deadline for compliance with Section 404 for foreign companies and smaller U.S. companies with under $75 million market capitalization. The SEC pressed the PCAOB to consider changes to the standard. In a press release announcing another joint PCAOB/SEC roundtable, Acting PCAOB Chairman Bill Gradison indicated that he was “very much open to suggestions to make the internal control assessment process more efficient, including modification of the PCAOB’s auditing standard.” (7) Willis (Bill) Gradison. Founding PCAOB Board Member. “It was very much a divided issue—not all the voices were on one side,” said PCAOB Board Member Daniel L. Goelzer. “But it became clear to us, with some help from the SEC, that we had to make some kind of a change.” Believing that firms’ bottom-up methods were both inefficient and ineffective, the PCAOB developed guidance laying out a top-down, risk-based approach that would address both problems. On May 1, 2006, the PCAOB set forth a new framework for second-year inspections, stating that it would assess how well the firms followed the new top-down guidance. Behind the scenes, a fierce lobbying battle was being waged, pitting investor advocates and the largest accounting firms who didn’t want regulations watered down against a coalition of business advocates, public companies, and trade associations who sought relief from Section 404. While admittedly generating higher audit fees from the increased work required by the implementation of Section 404, the major audit firms could see benefits beginning to emerge. By then they and their clients had already made major investments in documenting and creating procedures to test controls. The firms could see the advantages of improved documentation, increased audit committee involvement, standardizing practices, and the benefits that were accruing to many of their clients. As well, they believed the heightened audit costs and fees would reduce over time. Meanwhile, smart chief financial officers at many companies were leveraging their Section 404 compliance work to enhance their overall business processes. “We didn't want the PCAOB to throw out the baby with the bathwater,” said Robert J. Kueppers, Deputy Chief Executive Officer at Deloitte. “Fortunately, the PCAOB stood its ground and passed a very workable standard.” Political Pressure to Fix 404 The formal plan to revise AS 2 was made public at the May 17, 2006, joint roundtable between the SEC and PCAOB. They announced a four-point plan to improve implementation of internal control reporting, which would include changing AS 2 and providing SEC guidance to companies. Drawing on two reports on smaller public companies released in April 2006, the SEC again postponed Section 404 compliance for smaller public companies. In an SEC press release issued that day, the SEC said it would “work closely with the PCAOB to ensure that the proposed revisions to AS 2 are in the public interest and consistent with the protection of investors.” Yet behind closed doors, the majority of the SEC Commissioners seemed more intent on rolling back the regulation. The PCAOB OCA staff members charged with rewriting the standard were invited to multiple briefings with SEC Commissioners, White House officials, and congressional staff, many of who were interested in making Section 404 less expensive for small and midsize companies. At the same time, investor advocates and a few vocal former government officials complained that regulators were favoring business at the expense of average investors. “I had never seen or felt the kind of political pressure that we were under at that time,” said Sharon Virag. Zoe-Vonna Palmrose, accounting professor and SEC Deputy Chief Accountant, understood that President Bush told Chairman Cox to make fixing Section 404 the SEC’s highest priority. “It’s pretty rare that you get an accounting and auditing topic elevated to the Oval Office,” said Palmrose. She heard concerns that Section 404 was contributing to a general questioning of the costs versus benefits of SOX and was putting U.S. businesses at a competitive disadvantage. (8) PCAOB Chairman Mark W. Olson, 2006. Mark W. Olson, a former banker and Federal Reserve Governor, who was appointed PCAOB Chairman in June 2006, embraced the effort to amend AS 2. “The Board encouraged the staff to re-challenge every provision within the current standard and retain the necessary principles of the audit of internal control,” he said at an Open Board Meeting. (Chairman Olson passed away on September 12, 2018, before the SEC Historical Society could conduct interviews with him.) Laura Phillips and Sharon Virag undertook the rewriting of the standard with help from Tom Ray. Board Member Kayla Gillan and her Special Advisor Joanne O’Rourke Hindman offered creative advice that helped the team streamline several provisions, while the entire Board was intensely focused on the project’s success. In the end, the 180-page AS 2 was rewritten into just 65 pages, and introduced as a brand new standard, Auditing Standard No. 5 (AS 5). “In terms of the magnitude of change that we were looking to drive, it became very clear that the right thing to do was a new standard with a new number, a new title, and completely new branding,” said Phillips. Core Principles Retained AS 5 was initially proposed Dec. 19, 2006, and, after additional negotiations with the SEC to ensure alignment between management guidance and the audit standard, the final standard was adopted May 24, 2007. PCAOB Board Members, 2006. Left to right: Bill Gradison, Mark W. Olson, Kayla J. Gillan, Daniel L. Goelzer, Charles D. Niemeier. The Board also developed an implementation plan to support the new standard. Sharon Virag became the AS 5 point person, training PCAOB inspectors on how to inspect against it. Her fellow PCAOB Inspection trainers William J. Powers and Gregory S. Wilson printed up “I heart AS 5” buttons to pass out after the training. Virag also met with the largest audit firms to make sure they updated both their guidance and their instructions for their staff. “The PCAOB was under extreme pressure to get fees down, but it was a bit ironic that for the first three years they were telling us we weren’t doing enough work, then when we went to AS 5, they were telling us we were doing too much work. Eventually, we got to where we needed to be,” said Sam Ranzilla of KPMG. Section 404 proved to be one of the earliest and most controversial skirmishes of the Board’s standard setting, provoking a swift and ferocious reaction from companies and critics. Despite having made significant changes to the standard, all the Board members maintain the foundation of Section 404 remained unscathed. PCAOB buttons made for AS-5 training sessions As Board Member Charley Niemeier put it: “It was a distinction without a difference. The marketing changed, but, fundamentally, we did not change the standard as the core principles essential to an effective internal control audit were retained.” Although the Board undertook the revision largely to address concerns about cost, many Board members believed the resounding benefits of internal control reporting outweighed the associated costs. Those benefits include the reduced cost of capital, the important warnings that some companies’ internal control might not detect or prevent material misstatement, and the unprecedented numbers of companies that identified and fixed problems in their internal control and actual reporting. AS 2 had given ammunition to detractors complaining about onerous and anticompetitive regulation. The dispute over the scope of Section 404 had become a clarion call for a resurgent deregulation campaign by industry groups who had temporarily lost their voice after the fraud at Enron and WorldCom. Yet, even while AS 5 was being drafted, some critics launched an even bigger strike against the fledging regulator, when two anti-tax, pro-business groups mounted a constitutional challenge against the PCAOB. (1) Report on the Initial Implementation of Auditing Standard No. 2, PCAOB Release No, 2005, Nov 30, 2005, page 5. (2) Harvard Business Review, “The Unexpected Benefits of Sarbanes-Oxley,” by Stephen Wagner and Lee Dittmar, April 2006. (3) Report on the Initial Implementation of Auditing Standard No. 2, PCAOB Release No. 2005, Nov. 30, 2005, page 1. (4) Wall Street Journal, “SOX and Stocks” April 19, 2005. (5) New York Times, “Top Regulator Says Sarbanes-Oxley Act Audits are Too Costly and Inefficient,” by Floyd Norris, Dec. 1, 2005. (6) Ibid. (7) SEC Press Release, “Commission and PCAOB Announce Roundtable on Internal Control Reporting Requirements,” 2006-22, Feb. 16, 2006. (8) Accounting Horizons, “Balancing the Costs and Benefits of Auditing and Financial Reporting Regulation Post-Sox, Part I: Perspectives from the Nexus at the SEC,” Commentary by Zoe-Vonna Palmrose, p. 314. Related Museum Resources SEC Release - Internal Control Reporting (SOX Section 404) Roundtable. image pdf PCAOB Statement regarding Auditing Standard No. 2 (AS-2) implementation SEC statement on Implementation of Internal Control Reporting Requirements Report on the Initial Implementation of Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction With an Audit of Financial Statements PCAOB Statement on Inspections of Internal Control Audits SEC and PCAOB transcript of Joint Roundtable on Internal Control SEC Commission Paul Atkins, Cynthia Glassman, William Donaldson, Harvey Goldschmid and Roel Campos (Courtesy of Andrew Glickman ) SEC Commission with Senior Staff (seated) Roel Campos, Cynthia Glassman, Christopher Cox, Paul Atkins and Annette Nazareth Christopher Cox Zoe-Vonna Palmrose Laura Phillips Laura Phillips served as the Deputy Chief Auditor of the Public Company Accounting Oversight Board (PCAOB) from 2003 – 2007 during which time she was instrumental in developing the PCAOB’s standards that implement the internal control audit requirement established by the Sarbanes-Oxley Act of 2002. She began her career in 1991 as an auditor with Ernst and Young LLP in Cleveland. After her stint at the PCAOB, she joined General Motors Company as its Assistant Corporate Controller, then Brown-Forman Corporation as its Corporate Controller. She completed her undergraduate work at Miami University majoring in accounting and finance. Fireside Chat - Sarbanes-Oxley Section 404 Moderator: Theresa Gabaldon Presenter(s): Kurt Schacht, Herbert Wander

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professional_accounting

Franco-Nevada Reports Record Q1 Results Franco-Nevada Corporation (in U.S. dollars unless otherwise noted) Dividend Increased for 12th Consecutive Year Ongoing Board and Succession Planning TORONTO, May 8, 2019 /CNW/ - "Franco-Nevada's diversified portfolio performed very well in the first quarter delivering record revenue and net income," stated David Harquail, CEO. "We expect even stronger numbers in the second half as Cobre Panama begins its initial deliveries, Candelaria returns to normal operations and our U.S. energy royalties continue to grow. It is a testament to both the portfolio and our business model that today Franco-Nevada has increased its dividend for the 12th consecutive year adding to the over $1 billion of dividends already paid." Pierre Lassonde, Chair, added: "I would like to welcome Jennifer Maki who was elected today at our AGM as the newest member of the Franco-Nevada board. Jennifer is the former CEO of Vale Canada and Executive Director of Vale Base Metals and is a Chartered Professional Accountant. She brings a depth of mining and financial experience to our board. On a separate note, today at the AGM, I announced my intention to step down as Chair at the next annual meeting in May 2020. At that point, I will have served as chair for over 12 years. Both announcements are part of an orderly and long-term succession planning process being led by the board." Q1/2019 Financial Highlights 122,049 GEOs sold $179.8 million in revenue – a new record $65.2 million of Net Income (a new record), or $0.35 per share $31.0 million in Cash Costs, or $254 per GEO $140.9 million of Adjusted EBITDA, or $0.75 per share Quarterly dividend increased to $0.25 from $0.24 per share – increased for 12th consecutive year Revenue and GEOs by Asset Categories Q1/2019 (in millions) Other Mining Assets For Q1/2019, revenue was sourced 88.4% from gold and gold equivalents (63.4% gold, 11.1% silver, 10.6% PGM and 3.3% other mining assets) and 11.6% from energy (oil, gas and NGLs). The portfolio is actively managed to maintain a focus on precious metals (gold, silver and PGM) with a target of no more than 20% from energy. Geographically, revenue was sourced 81.6% from the Americas (41.7% Latin America, 18.3% U.S. and 21.6% Canada). Corporate Updates Board of Directors: Franco-Nevada's board is leading an orderly and long-term succession process. At today's AGM, Jennifer Maki was elected to the board. She has served as Chief Executive Officer of Vale Canada and Executive Director of Vale Base Metals (2014 to 2017) and previously held several other positions with Vale Base Metals and is a Chartered Professional Accountant. Pierre Lassonde has served as Chair of Franco-Nevada since 2007 and has announced his intention to step down as Chair at the next annual meeting in May 2020. These two announcements are unrelated. Salares Norte: On January 31, 2019, Franco-Nevada, through a wholly-owned Chilean subsidiary, acquired an existing 2% NSR on Gold Fields' Salares Norte gold project in the Atacama region of northern Chile for $32.0 million, comprised of $27.0 million of Franco-Nevada common shares (366,499 common shares) and $5.0 million in cash. Gold Fields has an option to buy back 1% of the NSR for $6.0 million within 24 months of commercial production. Valentine Lake: On February 21, 2019, Franco-Nevada acquired a 2% NSR on Marathon Gold Corporation's ("Marathon") Valentine Lake Gold Camp in central Newfoundland for C$18.0 million. Marathon has an option to buy back 0.5% of the NSR for $7.0 million until December 31, 2022. Q1/2019 Portfolio Updates Mining — Latin America: GEOs from Latin American mining assets were stable year-over-year, with 57,546 GEOs earned compared to 57,854 GEOs in Q1/2018. While deliveries from Candelaria increased significantly year-over-year, the impact was mostly offset by lower production from Antapaccay and Antamina. Cobre Panama (gold and silver stream) – The operator, First Quantum, reports that ore milling has begun and 25 tonnes of copper concentrate were produced. First Quantum reiterated its production guidance of 140,000 to 175,000 tonnes of copper for Cobre Panama for 2019. It expects the operation to be milling at an annualized rate of 72 mtpy by year end. First Quantum also released a technical report in March that projects the operation reaching a milling throughput of 100 mtpy in 2023. Franco-Nevada's precious metals streams are tied to copper produced. Candelaria (gold and silver stream) – GEOs earned from Candelaria in the quarter were higher due to the processing of higher grade ore. The operation is expected to benefit substantially in the second half from over $1 billion in fleet purchases, stripping and development. Antapaccay (gold and silver stream) – GEOs earned from Antapaccay were lower as expected with the life of mine plan. Antamina (22.5% silver stream) – GEOs earned from Antamina were lower as expected in the life of mine plan. Cerro Moro (2% royalty) – Cerro Moro began production in 2018. Franco-Nevada will benefit from the first full year of production in 2019. An aggressive drill program is planned to delineate near-mine targets. Guadalupe-Palmarejo (50% gold stream) – GEOs sold in Q1/2019 were down year-over-year as less mining occurred on Franco-Nevada stream lands. Development at the La Nación deposit, located between the Independencia and Guadalupe mines and predominantly on stream lands, remains on-schedule with production expected in the second half of 2019. Mining — U.S.: GEOs from U.S. mining assets decreased by 5.0% in Q1/2019 compared with Q1/2018 mainly due to lower payments from Fire Creek/Midas and South Arturo, partly offset by strong production from Stillwater. GEOs received from the U.S. mining assets were 17,558 GEOs. Goldstrike (2-4% royalty & 2.4-6% NPI); Gold Quarry (7.29% royalty) – Barrick and Newmont's joint venture in Nevada is expected to realize synergies. This could positively impact the NPI royalty at Goldstrike. Rosemont (1.5% royalty) – Hudbay announced in March 2019 the receipt of the final key federal permit outstanding allowing the company to advance Rosemont towards construction. Hudbay subsequently announced that it has reached an agreement to purchase United Copper & Moly LLC's 7.95% interest in the project and terminate the earn-in and off-take rights. Franco-Nevada's royalty is on all metals produced. South Arturo (4-9% royalty) – Joint venture operators Barrick and Premier Gold continue to advance the construction of the El Nino underground and Phase 1 open pit. A small amount of production is expected in 2019 with more meaningful production expected in 2020. Stillwater (5% royalty) – Sibanye-Stillwater is forecasting PGM production between 645,000-675,000 ounces for 2019 as the Blitz project continues to ramp-up. Blitz is anticipated to increase total PGM production from Stillwater by more than 50% to approximately 850,000 ounces per year by late 2021 or early 2022. Fire Creek/Midas (2.5% royalty) – The fixed delivery requirement for Fire Creek/Midas was met in 2018. The new operator, Hecla, has placed the Midas mine on care and maintenance with more focus being placed on increasing production from Fire Creek. Mining — Canada: GEOs from Canadian mining assets increased 53.6% in Q1/2019 to 21,581 GEOs compared with Q1/2018 mainly due to the resumption of mining at Sudbury's McCreedy mine. Sudbury (50% precious metals stream) – KGHM announced that it has resumed mining the PM zone at the McCreedy mine which contains higher grade precious metal ore. As part of the revised arrangements with KGHM, Franco-Nevada has agreed to increase its ongoing cost to $800 per GEO delivered from McCreedy until December 31, 2021. The increase in deliveries from McCreedy will be partially offset going forward by plans to put the Levack mine on care and maintenance at the end of March 2019. Brucejack (1.2% royalty) – Pretium provided an updated mine plan for the Brucejack operation in April 2019. The updated plan assumes average annual production of over 525,000 ounces of gold over the first 10 years and over 440,000 ounces of gold over the 14-year mine life. The mine passed the 503,386 gold ounce production threshold in December 2018 which triggered the start of royalty payments to Franco-Nevada. Hardrock (3% royalty) – The Hardrock project received provincial government approval in March 2019 which follows receipt of the federal approval in December 2018. The joint venture partners will continue to advance permitting including construction permit applications and additional drilling for the balance of 2019. Kirkland Lake (1.5-5.5% royalty & 20% NPI) – The Macassa mine produced a record 72,776 ounces during the quarter, an increase of 35% from Q1/2018. Kirkland Lake continues to advance the construction of the #4 Shaft at the Macassa mine. Kirkland Lake has the goal of increasing production at Macassa to over 400,000 ounces per year over the next five to seven years. Musselwhite (5% NPI) – An underground fire at the end of March 2019 caused the operation to be suspended. Newmont, the new operator, is expected to give an update on the integration of the Goldcorp assets during the second quarter of 2019 with potentially more information regarding the re-opening of Musselwhite. Golden Highway (0.25–10% royalty) – Franco-Nevada and Kirkland Lake amended the royalty agreement on the Holloway property to a fixed 3% NSR royalty versus the previous sliding scale royalty. Kirkland Lake is now targeting approximately 20,000 ounces of production in 2019, growing to approximately 50,000 ounces by 2021. Previously, the Holloway mine was on care and maintenance. Mining — Rest of World: GEOs from Rest of World mining assets were 25,364 GEOs during the quarter, remaining stable compared to Q1/2018. Subika (2% royalty) – Newmont declared commercial production at the Subika Underground in Q4/2018. The second major project, the Ahafo Mill expansion, is expected to have first production and declare commercial production in the second half of 2019. Duketon (2% royalty) – Regis Resources commenced underground development below the current Rosemont open pit and delineated a maiden mineral reserve of 123,000 ounces. Ity (1–1.5% royalty) – Franco-Nevada has a 1.5% royalty on the project until 35 tonnes of gold are produced. With Endeavour's increased production forecast for 2019, this threshold may be met by the end of the year. Agi Dagi (2% royalty) – Alamos received its operating permit for Kirazli (not subject to our royalty) and expects to start earthworks at the project. When Kirazli is constructed, the development focus is expected to shift to Agi Dagi. Tasiast (2% royalty) – The Phase One (12,000 tpd) expansion is complete. Phase Two activities are paused as Kinross continues to analyze expansion options and engages in discussions with the Government of Mauritania. Energy: Revenue from the energy assets increased to $20.8 million in Q1/2019 compared to $19.0 million in Q1/2018, reflecting the additional contributions from new investments in the SCOOP/STACK and positive year-over-year production from the Permian interests. This was partially offset by lower revenue from our Canadian assets. SCOOP/STACK (Continental) (various royalty rates) –The Royalty Acquisition Venture is having good success at acquiring additional royalties. In Q1/2019, Franco-Nevada recorded contributions of $51.4 million to the Royalty Acquisition Venture and its remaining commitment over the next three years is $206.8 million. Revenue in Q1/2019 totalled $2.8 million. SCOOP/STACK (Other) (various royalty rates) – These assets generated $2.7 million in revenue in Q1/2019 versus $2.2 million in Q1/2018, due to an increase in volumes from new wells on royalty lands. Encana is now a significant operator over our STACK royalty lands. Permian (various royalty rates) – Franco-Nevada's interests in the Permian Basin earned revenue of $4.5 million in Q1/2019 versus $3.7 million in Q1/2018, reflecting the addition of the Delaware royalties, an increase in volumes from new wells and proceeds received from prior periods. Weyburn (NRI, ORR, WI) – Weyburn contributed $7.3 million in revenue in Q1/2019 versus $10.1 million in Q1/2018. Revenues in the quarter were affected by lower realized prices and increased capital spending at the operation. Through 2019, realized prices are expected to improve as a result of a more balanced market in western Canada and capital spending at Weyburn is expected to be lower. Orion (4% GORR) – Orion generated $1.7 million in revenue in Q1/2019 versus $0.8 million in Q1/2018. While production volume was significantly higher, revenue was negatively impacted by price differentials and government mandated volume curtailments. These issues are expected to improve over the balance of 2019. Franco-Nevada is pleased to announce that its board of directors has declared a quarterly dividend of $0.25 per share. The dividend is a 4.2% increase from the previous $0.24 per share quarterly dividend and marks the 12th consecutive annual dividend increase for Franco-Nevada shareholders. Canadian investors in Franco-Nevada's IPO in December 2007 are now receiving an effective 8.9% yield on their cost base. The dividend will be paid on June 27, 2019 to shareholders of record on June 13, 2019 (the "Record Date"). The Canadian dollar equivalent is to be determined based on the daily average rate posted by the Bank of Canada on the Record Date. Under Canadian tax legislation, Canadian resident individuals who receive "eligible dividends" are entitled to an enhanced gross-up and dividend tax credit on such dividends. The Company has a Dividend Reinvestment Plan (the "DRIP"). Participation in the DRIP is optional. The Company will issue additional common shares through treasury at a 3% discount to the Average Market Price, as defined in the DRIP. However, the Company may, from time to time, in its discretion, change or eliminate the discount applicable to treasury acquisitions or direct that such common shares be purchased in market acquisitions at the prevailing market price, any of which would be publicly announced. The DRIP and enrollment forms are available on the Company's website at www.franco-nevada.com. Canadian and U.S. registered shareholders may also enroll in the DRIP online through the plan agent's self-service web portal at www.investorcentre.com/franco-nevada. Canadian and U.S. beneficial shareholders should contact their financial intermediary to arrange enrollment. During Q2/2018, the Company amended and restated the DRIP to allow for certain non-Canadian and non-U.S. shareholders to participate in the DRIP, subject to the satisfaction of certain conditions. Non-Canadian and non-U.S. shareholders should contact the Company to determine whether they satisfy the necessary conditions to participate in the DRIP. This press release is not an offer to sell or a solicitation of an offer of securities. A registration statement relating to the DRIP has been filed with the U.S. Securities and Exchange Commission and may be obtained under the Company's profile on the U.S. Securities and Exchange Commission's website at www.sec.gov. The complete Consolidated Interim Financial Statements and Management's Discussion and Analysis can be found today on Franco‑Nevada's website at www.franco-nevada.com, on SEDAR at www.sedar.com and on EDGAR at www.sec.gov. Management will host a conference call tomorrow, Thursday, May 9, 2019 at 8:30 a.m. Eastern Time to review Franco‑Nevada's Q1/2019 results. Interested investors are invited to participate as follows: Via Conference Call: Toll-Free: (888) 390-0546; International: (416) 764-8688 Conference Call Replay until May 16: Toll-Free (888) 390-0541; International (416) 764-8677; Code 770553# Webcast: A live audio webcast will be accessible at www.franco-nevada.com Corporate Summary Franco-Nevada Corporation is the leading gold-focused royalty and stream company with the largest and most diversified portfolio of cash-flow producing assets. Its business model provides investors with gold price and exploration optionality while limiting exposure to many of the risks of operating companies. Franco-Nevada has a strong balance sheet and uses its free cash flow to expand its portfolio and pay dividends. It trades under the symbol FNV on both the Toronto and New York stock exchanges. Franco-Nevada is the gold investment that works. This press release contains "forward looking information" and "forward looking statements" within the meaning of applicable Canadian securities laws and the United States Private Securities Litigation Reform Act of 1995, respectively, which may include, but are not limited to, statements with respect to future events or future performance, management's expectations regarding Franco-Nevada's growth, results of operations, estimated future revenues, carrying value of assets, future dividends and requirements for additional capital, mineral reserve and mineral resource estimates, production estimates, production costs and revenue, future demand for and prices of commodities, expected mining sequences, business prospects and opportunities, audits being conducted by the Canada Revenue Agency and available remedies, and the remedies relating to and consequences of the ruling of the Supreme Court of Panama in relation to the Cobre Panama project. In addition, statements (including data in tables) relating to reserves and resources and gold equivalent ounces ("GEOs") are forward looking statements, as they involve implied assessment, based on certain estimates and assumptions, and no assurance can be given that the estimates and assumptions are accurate and that such reserves and resources and GEOs will be realized. Such forward looking statements reflect management's current beliefs and are based on information currently available to management. Often, but not always, forward looking statements can be identified by the use of words such as "plans", "expects", "is expected", "budgets", "scheduled", "estimates", "forecasts", "predicts", "projects", "intends", "targets", "aims", "anticipates" or "believes" or variations (including negative variations) of such words and phrases or may be identified by statements to the effect that certain actions "may", "could", "should", "would", "might" or "will" be taken, occur or be achieved. Forward looking statements involve known and unknown risks, uncertainties and other factors, which may cause the actual results, performance or achievements of Franco-Nevada to be materially different from any future results, performance or achievements expressed or implied by the forward looking statements. A number of factors could cause actual events or results to differ materially from any forward looking statement, including, without limitation: fluctuations in the prices of the primary commodities that drive royalty and stream revenue (gold, platinum group metals, copper, nickel, uranium, silver, iron-ore and oil and gas); fluctuations in the value of the Canadian and Australian dollar, Mexican peso, and any other currency in which revenue is generated, relative to the U.S. dollar; changes in national and local government legislation, including permitting and licensing regimes and taxation policies and the enforcement thereof; regulatory, political or economic developments in any of the countries where properties in which Franco-Nevada holds a royalty, stream or other interest are located or through which they are held; risks related to the operators of the properties in which Franco-Nevada holds a royalty, stream or other interest, including changes in the ownership and control of such operators; influence of macroeconomic developments; business opportunities that become available to, or are pursued by Franco-Nevada; reduced access to debt and equity capital; litigation; title, permit or license disputes related to interests on any of the properties in which Franco-Nevada holds a royalty, stream or other interest; whether or not the Corporation is determined to have "passive foreign investment company" ("PFIC") status as defined in Section 1297 of the United States Internal Revenue Code of 1986, as amended; potential changes in Canadian tax treatment of offshore streams; excessive cost escalation as well as development, permitting, infrastructure, operating or technical difficulties on any of the properties in which Franco-Nevada holds a royalty, stream or other interest; access to sufficient pipeline capacity; actual mineral content may differ from the reserves and resources contained in technical reports; rate and timing of production differences from resource estimates, other technical reports and mine plans; risks and hazards associated with the business of development and mining on any of the properties in which Franco-Nevada holds a royalty, stream or other interest, including, but not limited to unusual or unexpected geological and metallurgical conditions, slope failures or cave-ins, flooding and other natural disasters, terrorism, civil unrest or an outbreak of contagious diseases; and the integration of acquired assets. The forward looking statements contained in this press release are based upon assumptions management believes to be reasonable, including, without limitation: the ongoing operation of the properties in which Franco-Nevada holds a royalty, stream or other interest by the owners or operators of such properties in a manner consistent with past practice; the accuracy of public statements and disclosures made by the owners or operators of such underlying properties; no material adverse change in the market price of the commodities that underlie the asset portfolio; the Corporation's ongoing income and assets relating to determination of its PFIC status; no material changes to existing tax treatment; no adverse development in respect of any significant property in which Franco-Nevada holds a royalty, stream or other interest; the accuracy of publicly disclosed expectations for the development of underlying properties that are not yet in production; integration of acquired assets; the expected application of tax laws and regulations by taxation authorities; the expected assessment and outcome of any audit by any taxation authority; and the absence of any other factors that could cause actions, events or results to differ from those anticipated, estimated or intended. However, there can be no assurance that forward looking statements will prove to be accurate, as actual results and future events could differ materially from those anticipated in such statements. Investors are cautioned that forward looking statements are not guarantees of future performance. Franco-Nevada cannot assure investors that actual results will be consistent with these forward looking statements and investors should not place undue reliance on forward looking statements due to the inherent uncertainty therein. For additional information with respect to risks, uncertainties and assumptions, please refer to the "Risk Factors" section of Franco-Nevada's most recent Annual Information Form filed with the Canadian securities regulatory authorities on www.sedar.com and Franco-Nevada's most recent Annual Report filed on Form 40-F filed with the SEC on www.sec.gov. The forward looking statements herein are made as of the date of this press release only and Franco-Nevada does not assume any obligation to update or revise them to reflect new information, estimates or opinions, future events or results or otherwise, except as required by applicable law. NON-IFRS MEASURES: Cash Costs, Adjusted EBITDA, and Adjusted Net Income are intended to provide additional information only and do not have any standardized meaning prescribed under IFRS and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with IFRS. These measures are not necessarily indicative of operating profit or cash flow from operations as determined under IFRS. Other companies may calculate these measures differently. For a reconciliation of these measures to various IFRS measures, please see below or the Company's current MD&A disclosure found on the Company's website, on SEDAR and on EDGAR. Comparative information has been recalculated to conform to current presentation. GEOs include our gold, silver, platinum, palladium and other mining assets. GEOs are estimated on a gross basis for NSR royalties and, in the case of stream ounces, before the payment of the per ounce contractual price paid by the Company. For NPI royalties, GEOs are calculated taking into account the NPI economics. Platinum, palladium, silver and other minerals are converted to GEOs by dividing associated revenue, which includes settlement adjustments, by the relevant gold price. The gold price used in the computation of GEOs earned from a particular asset varies depending on the royalty or stream agreement, which may make reference to the market price realized by the operator, or the average for the month, quarter, or year in which the mineral was produced or sold. For Q1/2019, the average commodity prices were as follows: $1,304 gold (2018 - $1,329), $15.57 silver (2018 - $16.77), $823 platinum (2018 - $978) and $1,435 palladium (2018 - $1,035). Cash Costs attributable to GEO production and Cash Costs per GEO are non-IFRS financial measures. Cash Costs attributable to GEO production is calculated by starting with total costs of sale and excluding depletion and depreciation, costs not attributable to GEO production such as our Energy operating costs, and other non-cash costs of sales such as costs related to our prepaid gold purchase agreement. Cash Costs is then divided by GEOs sold, excluding prepaid ounces, to arrive at Cash Costs per GEO. Adjusted EBITDA and Adjusted EBITDA per share are non-IFRS financial measures, which exclude the following from net income and earnings per share ("EPS"): income tax expense/recovery; finance expenses; finance income; depletion and depreciation; non-cash costs of sales; impairment charges related to royalty, stream and working interests and investments; gains/losses on sale of royalty interests; gains/losses on investments; and foreign exchange gains/losses and other income/expenses. Adjusted Net Income and Adjusted Net Income per share are non-IFRS financial measures, which exclude the following from net income and EPS: foreign exchange gains/losses and other income/expenses; impairment charges related to royalty, stream and working interests and investments; gains/losses on sale of royalty interests; gains/losses on investments; unusual non-recurring items; and the impact of income taxes on these items. Reconciliation to IFRS measures: For the three months ended (expressed in millions, except per GEO amounts) Total costs of sales Depletion and depletion Energy operating costs Non-cash costs of sales Cash Costs attributable to GEO production GEOs, excluding prepaid ounces Cash Costs per GEO (expressed in millions, except per share amounts) Finance expenses Finance income Depletion and depreciation Foreign exchange (gains)/losses and other (income)/expenses Basic weighted average shares outstanding Adjusted EBITDA per share Tax effect of adjustments Adjusted Net Income per share CONSOLIDATED STATEMENTS OF FINANCIAL POSITION (unaudited, in millions of U.S. dollars) At March 31, At December 31, Cash and cash equivalents (Note 4) Prepaid expenses and other (Note 6) Royalty, stream and working interests, net (Note 7) Investments (Note 5) Deferred income tax assets Other assets (Note 8) Accounts payable and accrued liabilities Current income tax liabilities Lease liabilities Debt (Note 9) Deferred income tax liabilities SHAREHOLDERS' EQUITY(Note 15) Contributed surplus Accumulated other comprehensive loss Total liabilities and shareholders' equity Contingencies(Note 19) Subsequent events(Note 20) The accompanying notes are an integral part of these consolidated financial statements and can be found in our Q1/2019 Report available on our website CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME (unaudited, in millions of U.S. dollars, except per share amounts) Revenue (Note 10) Costs of sales (Note 11) Other operating expenses (income) General and administrative expenses Gain on sale of gold bullion Total other operating expenses (income) Operating income Foreign exchange gain and other income (expenses) Income before finance items and income taxes Finance items (Note 13) Net income before income taxes Income tax expense (Note 14) Earnings per share (Note 16) Weighted average number of shares outstanding (Note 16) Other comprehensive income (loss) Items that may be reclassified subsequently to profit and loss: Currency translation adjustment Items that will not be reclassified subsequently to profit and loss: Changes in the fair value of equity investments at fair value through other comprehensive income ("FVTOCI"), net of income tax (Note 5) Comprehensive income CONSOLIDATED STATEMENTS OF CASH FLOWS Adjustments to reconcile net income to net cash provided by operating activities: Share-based payments Unrealized foreign exchange gain Deferred income tax expense Other non-cash items Acquisition of gold bullion Proceeds from sale of gold bullion Operating cash flows before changes in non-cash working capital Changes in non-cash working capital: Decrease in receivables Increase in prepaid expenses and other Increase in current liabilities Net cash provided by operating activities Acquisition of royalty, stream and working interests Acquisition of energy well equipment Proceeds from sale of investments Net cash used in investing activities Repayment of credit facilities Credit facility amendment costs Payment of dividends Proceeds from exercise of stock options Net cash used in financing activities Effect of exchange rate changes on cash and cash equivalents Net change in cash and cash equivalents Cash and cash equivalents at beginning of period Cash and cash equivalents at end of period Supplemental cash flow information: Cash paid for interest expense and loan standby fees Income taxes paid SOURCE Franco-Nevada Corporation For further information: please go to our website at www.franco-nevada.com or contact: Stefan Axell, Director, Corporate Affairs, (416) 306-6328, [email protected]; Sandip Rana, Chief Financial Officer, (416) 306-6303 www.franco-nevada.com Franco-Nevada Corporation is the leading gold-focused royalty and streaming company with the largest and most diversified portfolio of cash-flow producing assets. Its business model provides investors with gold price and exploration optionality while limiting exposure to... Franco-Nevada Reports Strong Q3 Results... Franco-Nevada To Release Third Quarter 2021 Results... Franco-Nevada Reports Record Q2 and H1 Results...

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professional_accounting

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF 1600 Smith Street, Dept. HQSEO Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No _____ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No _____ As of July 14, 2003, 65,735,778 shares of Class B common stock were outstanding. Financial Statements - Consolidated Balance Sheets - Management's Discussion and Analysis of Financial Condition and Results of Operations Changes in Securities and Use of Proceeds Submission of Matters to a Vote of Security Holders Exhibits and Reports on Form 8-K Index to Exhibits PART I - FINANCIAL INFORMATION Item 1. Financial Statements. Security fee reimbursement Fleet impairment losses and other special charges Income (Loss) before Income Taxes and Minority Interest Income Tax (Provision) Benefit Distributions on Preferred Securities of Trust, net of applicable income taxes of $1, $1, $3 and $3, respectively Earnings (Loss) per Share: Shares Used for Computation: Cash and cash equivalents, including restricted cash of $129, $62, and $28 Spare parts and supplies, net Airport operating rights, net Intangible pension asset Investment in unconsolidated subsidiaries LIABILITIES AND Current maturities of long-term debt and Accrued payroll Accrued Pension Liability Mandatorily Redeemable Preferred Securities of Subsidiary Trust Holding Solely Convertible Subordinated Debentures of Continental Redeemable Preferred Stock of Subsidiary Preferred Stock - $.01 par, 10,000,000 shares authorized; one share of Series B issued and outstanding, stated at par value authorized; 91,202,972, 91,203,321 and 89,782,876 shares issued Treasury stock - 25,467,194, 25,442,529 and 25,442,529 shares, at cost Net cash provided by (used in) operations Purchase deposits paid in connection with future aircraft deliveries Purchase deposits refunded in connection with aircraft delivered Purchase of short-term investments Proceeds from sale of ExpressJet stock, net Payments on long-term debt and capital lease Proceeds from issuance of Class B common stock Payments to collateralize letters of credit Net cash provided by financing activities Cash and Cash Equivalents - Beginning of Period (1) Cash and Cash Equivalents - End of Period (1) Excludes restricted cash. In our opinion, the unaudited consolidated financial statements included herein contain all adjustments necessary to present fairly our financial position, results of operations and cash flows for the periods indicated. Such adjustments are of a normal, recurring nature, except for the security fee reimbursement and fleet impairment losses and other special charges. The accompanying consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto contained in our Annual Report on Form 10-K/A-1 for the year ended December 31, 2002 (the "2002 10-K"). As used in these Notes to Consolidated Financial Statements, the terms "Continental", "we", "us", "our" and similar terms refer to Continental Airlines, Inc. and, unless the context indicates otherwise, our subsidiaries. "Holdings" refers to our 53.1%-owned subsidiary, ExpressJet Holdings, Inc., and "ExpressJet" refers to ExpressJet Airlines, Inc., Holdings' wholly owned subsidiary whic h operates as Continental Express. Certain reclassifications have been made in the prior period's financial statements to conform to the current year presentation. The following table sets forth the computation of basic and diluted earnings per share (in millions): Ended June 30, 2003 Numerator for basic earnings per share - net income 4.5% Convertible Notes Numerator for diluted earnings per share - net income after assumed Denominator for basic earnings per share - weighted average shares Denominator for diluted earnings per share - adjusted weighted-average and assumed conversions Weighted average options to purchase approximately 7 million, 1 million, 7 million and 1 million shares of our Class B common stock were not included in the computation of diluted loss per share for the three months ended June 30, 2003 and 2002 and the six months ended June 30, 2003 and 2002, respectively, because the options' exercise prices were greater than the average market price of the common shares and, therefore, the effect would have been antidilutive. The shares issuable upon conversion of the 5% Convertible Notes due 2023 were not included in the computation of diluted earnings per share since the conditions for conversion have not been met (see Note 7). Because of losses during the three months ended June 30, 2002 and six months ended June 30, 2003 and 2002, the Mandatorily Redeemable Preferred Securities of Subsidiary Trust and 4.5% Convertible Notes were also antidilutive. As a result, there was no difference between basic and diluted loss per share for the three months ended June 30, 200 2 and the six months ended June 30, 2003 and 2002. We account for our stock-based compensation plans under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees". No stock-based employee compensation cost for our stock option plans is reflected in our consolidated statement of operations since all options granted under our plans have an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the pro forma effect on net income (loss) and earnings (loss) per share if we had applied the fair value recognition provisions of Statement of Financial Accounting Standards ("SFAS") 123, "Accounting for Stock-based Compensation" (in millions except per share amounts): Net income (loss), as reported Deduct total stock-based employee compensation expense determined under SFAS 123, net of tax Net income (loss), pro forma Basic, as reported Basic, pro forma Diluted, as reported Diluted, pro forma NOTE 3 - COMPREHENSIVE INCOME (LOSS) We include in other comprehensive income (loss) changes in minimum pension liabilities and changes in the fair value of derivative financial instruments which qualify for hedge accounting. For the second quarter of 2003 and 2002, total comprehensive income (loss) amounted to $85 million and $(154) million, respectively. For the six months ended June 30, 2003 and 2002, total comprehensive loss amounted to $(138) million and $(310) million, respectively. The difference between the net income (loss) and total comprehensive income (loss) for each period was primarily attributable to changes in the fair value of derivative financial instruments. NOTE 4 - NEW ACCOUNTING PRONOUNCEMENTS Effective January 1, 2003, we adopted SFAS 146, "Accounting for Costs Associated with Disposal or Exit Activities", which requires liabilities for costs associated with exit or disposal activities to be recognized when the liabilities are incurred, rather than when an entity commits to an exit plan. The new rule changes the timing of liability and expense recognition related to exit or disposal activities, but not the ultimate amount of such expenses. We also adopted Financial Accounting Standards Board ("FASB") Interpretation 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others". Interpretation 45 requires a guarantor to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. This interpretation applies to guarantees issued or modified after December 31, 2002 and has had no impact on our consolidated results of operations or consolidated balance sheet. Effective July 1, 2003, we will adopt SFAS 150, "Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity". Upon adoption, we will reclassify the $5 million redeemable preferred stock of subsidiary to a liability. This standard will not have a material impact on our consolidated financial statements. The FASB issued Interpretation 46, "Consolidation of Variable Interest Entities" ("FIN 46"), in January 2003. FIN 46 requires the consolidation of certain types of entities in which a company absorbs a majority of another entity's expected losses, receives a majority of the other entity's expected residual returns, or both, as a result of ownership, contractual or other financial interests in the other entity. These entities are called "variable interest entities". The principal characteristics of variable interest entities are (1) an insufficient amount of equity to absorb the entity's expected losses, (2) equity owners as a group are not able to make decisions about the entity's activities, or (3) equity that does not absorb the entity's losses or receive the entity's residual returns. "Variable interests" are contractual, ownership or other monetary interests in an entity that change with fluctuations in the entity's net asset value. As a result, variable interest entities can arise from items such as lease agreements, loan arrangements, guarantees or service contracts. If an entity is determined to be a "variable interest entity", the entity must be consolidated by the "primary beneficiary". The primary beneficiary is the holder of the variable interests that absorbs a majority of the variable interest entity's expected losses or receives a majority of the entity's residual returns in the event no holder has a majority of the expected losses. There is no primary beneficiary in cases where no single holder absorbs the majority of the expected losses or receives a majority of the residual returns. The determination of the primary beneficiary is based on projected cash flows at the inception of the variable interests. FIN 46 initially applied to variable interest entities created after January 31, 2003 and to variable interest entities in which a company obtained an interest after that date. However, beginning in the third quarter of 2003, we must also apply FIN 46 to all interests in variable interest entities existing prior to January 31, 2003. We have identified several types of transactions that may be impacted by this interpretation. While we are continuing to evaluate the impact of this complex interpretation, our initial conclusions about the application of FIN 46 are as follows: We are the lessee in a series of operating leases covering the majority of our leased aircraft where we do not currently consolidate the entity serving as lessor. The lessors are trusts established specifically to purchase, finance and lease aircraft to us. These leasing entities meet the criteria for variable interest entities. We are generally not the primary beneficiary of the leasing entities if the lease terms are consistent with market terms at the inception of the lease and do not include a residual value guarantee, fixed-price purchase option or similar feature that obligates us to absorb decreases in value or entitles us to participate in increases in the value of the aircraft. This is the case for most of our operating leases; however, leases of approximately 75 aircraft contain a fixed-price purchase option that allow us to purchase the aircraft at predetermined prices on specified dates during the lease term. We currently believe that we will not be required to consolidate the lessors up on application of FIN 46 because, even taking into consideration these purchase options, we are still not the primary beneficiary based on our cash flow analysis. We are the lessee of real property under long-term operating leases at a number of airports where we are also the guarantor of the underlying debt, as discussed in Note 11. The leases are typically with municipalities or other governmental entities. We believe that FIN 46 is not applicable to arrangements with governmental entities. To the extent our lease and related guarantee are with a separate legal entity other than a governmental entity, we believe we are not the primary beneficiary because the lease terms are consistent with market terms at the inception of the lease and the lease does not include a residual value guarantee, fixed price purchase option or similar feature as discussed above. We have a consolidated subsidiary trust that has Mandatorily Redeemable Preferred Securities outstanding with a liquidation value of $248 million ($241 million net of issuance costs). These securities are reported on our balance sheet as Mandatorily Redeemable Preferred Securities of Subsidiary Trust. The trust is a variable interest entity under FIN 46 because we only have a limited ability to make decisions about its activities. We currently believe that we are not the primary beneficiary of the trust. Therefore, the trust and the Mandatorily Redeemable Preferred Securities issued by the trust will no longer be reported on our balance sheet. Instead, we will report as a liability our subordinated convertible notes payable to the trust. These notes have previously been eliminated in our consolidated financial statements. Distributions on the Mandatorily Redeemable Preferred Securities will no longer be reported on our statements of operations, but interest on the notes will be recorded as interes t expense. These changes on our balance sheet and statements of operations are essentially reclassifications. We are evaluating whether we will make these reclassifications and other FIN 46 changes, if any, effective July 1, 2003 or will make the change retroactive to prior periods. We currently consolidate Holdings and ExpressJet due to our majority ownership interest. Holdings and ExpressJet each meet the criteria for a variable interest entity due to the terms of our capacity purchase agreement with them, including provisions where we, rather than Holdings' common stockholders as a group, could be required to absorb some of the entities' losses, or could receive some of the entities' residual returns. We are currently evaluating whether we would be the primary beneficiary under the agreement and would therefore continue to consolidate Holdings and ExpressJet if our ownership interest falls below 50%. We will continue to evaluate the impact of FIN 46 during the third quarter of 2003. NOTE 5 - FLEET INFORMATION As shown in the following table, our operating aircraft fleet consisted of 358 mainline jets and 212 regional jets at June 30, 2003, excluding aircraft out of service. Our purchase commitments (firm orders) for aircraft, as well as options to purchase additional aircraft as of June 30, 2003 are also shown below. As of June 30, 2003, we had the following aircraft out of service: Total Aircraft DC 10-30 The 20 owned out-of-service aircraft are being carried at an aggregate fair market value of $32 million. In the first half of 2003, we sold eight owned ATR-42-320s, two MD-80s and two 747-200s. Also in the first half of 2003, we returned 11 leased out-of-service aircraft to their lessors, including one DC10-30, five MD-80s and five 737-300s. We currently sublease three of the DC10-30 aircraft to third parties and continue to explore sublease or sale opportunities for the remaining out-of-service aircraft that do not have near-term lease expirations. The timing of the disposition of these aircraft will depend on the economic environment in the airline industry as well as our ability to find purchasers or sublessees for the aircraft. We cannot predict if purchasers or sublessees can be found, and it is possible that our assets (including aircraft currently in service) could suffer additional impairment. We removed eight mainline jet aircraft from service in the first half of 2003, including two 737-500s, two 737-300s and four MD-80 aircraft. Four of these removals occurred in the second quarter and four occurred in the first quarter, primarily in conjunction with the expiration of their lease terms. In the second half of 2003, 10 mainline jet aircraft (mainly leased 737-300 aircraft) have leases that expire, some of which are expected to be returned to their lessors. As of June 30, 2003, we had firm purchase commitments for 67 Boeing aircraft with an estimated cost of approximately $2.7 billion and options to purchase an additional 87 Boeing aircraft. During the second quarter of 2003, we agreed to defer firm deliveries of 36 Boeing 737 aircraft that were originally scheduled for delivery in 2005, 2006 and 2007. These aircraft will now be delivered in 2008 and beyond. In connection with the deferrals, we have recorded a charge of $14 million. Additionally, we are in discussions with Boeing regarding the terms of delivery of the 11 remaining 757-300 aircraft that we have on order. We are currently in negotiations with Boeing for backstop financing for approximately 12 firm aircraft. We do not have backstop financing or any other financing currently in place for the remainder of the firm aircraft. In addition, at June 30, 2003, we had firm commitments to purchase 8 spare engines related to the new Boeing aircraft for approximately $53 million. We have financing in place for the first three of these spare engines, which are scheduled for delivery between September and December 2003. We do not have financing currently in place for the remaining five spare engines, which are scheduled to be delivered in 2004 and the first quarter of 2005. Further financing will be needed to satisfy our capital commitments for our firm aircraft. There can be no assurance that sufficient financing will be available for the aircraft on order or the other related capital expenditures. During the first half of 2003, ExpressJet took delivery of 24 ERJ-145XR aircraft, of which 12 were delivered in the second quarter. As of June 30, 2003, ExpressJet had firm commitments for an additional 62 Embraer regional jets with an estimated aggregate cost of $1.2 billion and options to purchase an additional 100 Embraer regional jets exercisable through 2008. Effective February 2003, ExpressJet and Embraer amended the purchase agreement to slow the pace of regional jet deliveries. ExpressJet will take delivery of 12 regional jets during the remainder of 2003 (for a total of 36 in 2003), down from its original plan for 48 deliveries, and will take 21 aircraft deliveries in 2004, down from 36. As a result, ExpressJet will increase its aircraft deliveries to 21 and eight for 2005 and 2006, up from two and zero for these years, respectively. Neither we nor ExpressJet has any obligation to take any of these firm aircraft that are not financed by a third party and leased either to them or us. In addition, ExpressJet expects to purchase 12 spare engines related to the 62 remaining aircraft on firm order for approximately $33 million through 2006. Neither we nor ExpressJet has any financing currently in place for these spare engines. ExpressJet would have no obligation to acquire the spare engines if the firm order aircraft were not delivered for any reason. Substantially all of the aircraft and engines we own are subject to mortgages. A significant portion of our spare parts inventory is also encumbered. NOTE 6 - FLEET IMPAIRMENT LOSSES AND OTHER SPECIAL CHARGES We recorded fleet impairment losses and other special charges in the first quarter of 2003 and the first two quarters of 2002, each of which was partially the result of the September 11, 2001 terrorist attacks and their aftermath. The special charge in the second quarter of 2003 relates to the deferral of aircraft deliveries (see Note 5). In the first quarter of 2003, we recorded fleet impairment losses and other special charges of $65 million ($41 million after income taxes). This charge consisted of a $44 million additional impairment of our fleet of owned MD-80s, which was initially determined to be impaired and written down to fair value in 2002. The remainder of the charge consisted primarily of the write-down to market value of spare parts inventory for permanently grounded fleets. The first quarter 2003 charge reflects the impact of the war in Iraq and the resulting deterioration of the already weak revenue environment for the U.S. airline industry. These write-downs were necessary because the fair market values of the MD-80 fleet and spare parts inventory had declined as a result of the difficult financial environment and further reductions in capacity by U.S. airlines. In the first quarter of 2002, we recorded a fleet charge of $90 million ($57 million after taxes) primarily in connection with the permanent grounding and retirement of our leased DC10-30 fleet. In the second quarter of 2002, we recorded a fleet charge of $59 million ($37 million after taxes) primarily related to the permanent grounding and retirement of ExpressJet's leased turboprop aircraft and certain leased MD-80 aircraft. The majority of these charges related to future commitments under noncancelable lease agreements past the dates the aircraft were permanently removed from service. The remainder of these charges related to costs expected to be incurred related to the storage and return of these aircraft. Additionally, in the second quarter of 2002, we performed an impairment assessment of our owned aircraft and concluded that the carrying value of our owned turboprop and MD-80 fleets was not recoverable. As a result, we recorded an impairment charge of $93 million ($59 million after taxes) to reduce the carrying value of these aircraft to their estimated fair value. In the second quarter of 2002, we filed our final application for a grant under the Air Transportation Safety and System Stabilization Act. We recorded a charge of $12 million ($8 million after taxes) to write down our receivable from the U.S. government based on this final application. Activity related to the accruals for future lease payments, return condition and storage costs and closure/under-utilization of facilities for the six months ending June 30, 2003 is as follows (in millions): Allowance for future lease payments, return Condition and storage costs Closure/under-utilization of facilities Maturities of long-term debt due before December 31, 2003 and for the next four years are as follows (in millions): July 1, 2003 through December 31, 2003 In May 2003, we issued $100 million of floating rate secured subordinated notes due December 2007. The notes are secured by a portion of our spare parts inventory. The notes bear interest at the three-month LIBOR rate plus 7.5%, for an initial all-in rate of 8.78%. In May 2003, we incurred $96 million of floating rate indebtedness under a term loan agreement that matures in May 2011. This indebtedness is secured by certain of our spare engines and initially bears interest at the three-month LIBOR rate plus 3.5%, for an initial all-in rate of 4.78%. In June 2003, we issued $175 million of 5% Convertible Notes due 2023. The notes are convertible into our Class B common stock at an initial conversion price of $20 per share, subject to certain conditions on conversion. The notes are redeemable for cash at our option on or after June 18, 2010 at par plus accrued and unpaid interest, if any. Holders may require us to repurchase the notes on June 15 of 2010, 2013 or 2018 or in the event of certain changes in control at par plus accrued and unpaid interest, if any. We may at our option choose to pay this repurchase price in cash or in shares of common stock or any combination thereof, except in certain circumstances involving a change in control, in which case we will be required to pay cash. In addition, in May 2003, ExpressJet incurred $11 million of floating rate indebtedness under a term loan agreement that matures in May 2011, which is secured by a flight simulator for Embraer aircraft. ExpressJet used the proceeds to repay a portion of its indebtedness to us. We used the proceeds from these borrowings for working capital and general corporate purposes. NOTE 8 - SECURITY FEE REIMBURSEMENT In May 2003, we received and recognized in earnings $176 million in cash from the United States government pursuant to a supplemental appropriations bill enacted in April 2003. This amount is reimbursement for our proportional share of passenger security and air carrier security fees paid or collected by U.S. air carriers as of the date of enactment of the legislation, together with other items. Highlights of the provisions of the legislation are as follows: $2.3 billion for reimbursement of airline security fees - both the passenger and the air carrier security fees - that had been paid or collected by the carriers as of date of enactment, was reimbursed to the carriers. Additionally, the passenger security fees will not be imposed during the period beginning June 1, 2003 and ending September 30, 2003. Carriers will be compensated $100 million for the direct costs associated with installing strengthened flight deck doors and locks. Aviation war risk insurance provided by the government was extended for one year to August 2004. Our two most highly compensated executives' total compensation will be limited, during the period between April 1, 2003 and April 1, 2004, to the annual salary paid to those officers during fiscal year 2002 (and any violation of this limitation will require us to repay the government the amount of its reimbursement described above). We have entered into agreements with our two most highly compensated executives permitting us to reduce their total compensation to comply with the restrictions of the supplemental appropriations bill. However, there are limited situations, such as a change in control of the company, the termination of such executives' employment or the retirement or voluntary resignation of the executive, that could result in our being unable to comply with those restrictions and thus being required to repay to the government the amount of our reimbursement. We believe that the likelihood of these situations occurring is remote. NOTE 9 - CAPACITY PURCHASE AGREEMENT Our capacity purchase agreement with Holdings and ExpressJet provides that we purchase in advance all of ExpressJet's available seat miles for a negotiated price, and we are at risk for reselling the available seat miles at market prices. Our payments to ExpressJet under the capacity purchase agreement for the three months ended June 30, 2003 and June 30, 2002 and the six months ended June 30, 2003 and June 30, 2002, respectively, totaled $320 million, $270 million, $627 million and $535 million. These payments are eliminated in our consolidated financial statements. In March 2003, in connection with ExpressJet's agreement to slow the delivery of regional jets from Embraer (see discussion in Note 5), we extended by one year, to December 31, 2006, our agreement that ExpressJet will be our sole provider of regional jet service in our hubs and agreed that the first date on which we could exercise our right to terminate the capacity purchase agreement without cause would be extended by one year to January 1, 2007. Beginning July 1, 2004, we have the right to reduce the number of aircraft covered by the contract. Under the agreement, we are entitled to remove capacity under an agreed upon methodology provided that we have given 12 months notice before such action. Set forth below are estimates of our future minimum noncancelable commitments under the capacity purchase agreement, as amended, excluding the underlying obligations for aircraft and facility rent (in millions): 2007 and thereafter It is important to note that in making the assumptions used to develop these estimates, we are attempting to estimate our minimum noncancelable commitments and not the amounts that we currently expect to pay to ExpressJet (which are expected to be higher since we do not currently expect to reduce capacity under the agreement to the extent assumed above or terminate the agreement at the earliest possible date). In addition, our actual minimum noncancelable commitments to ExpressJet could differ materially from the estimates discussed above, because actual events could differ materially from the assumptions used to develop these estimates. We have two reportable segments: (1) mainline jet and (2) regional jet and turboprop (turboprops were removed entirely from our fleet in December 2002). We evaluate segment performance based on several factors, of which the primary financial measure is operating income (loss). Since assets can be readily moved between the two segments and are often shared, we do not report information about total assets or capital expenditures between the segments. Financial information for the three and six months ended June 30 by business segment is set forth below (in millions): Mainline Jet Regional Jet and Turboprop Total Consolidated Operating Income (Loss): Net Income (Loss): The amounts presented above for the regional jet and turboprop segment are not the same as the amounts reported in stand-alone financial statements of Holdings. The amounts presented above are presented on the basis of how our management reviews segment results. Under this basis, the regional jet and turboprop segment's revenue includes a pro-rated share of our ticket revenue for segments flown by Holdings, and expenses include all activity related to the regional jet and turboprop operations, regardless of whether the costs were paid by us or by Holdings. Net income for the regional jet and turboprop segment for the three months ended June 30, 2003 and June 30, 2002 and the six months ended June 30, 2003 and June 30, 2002, respectively, reflects a $13 million, $8 million, $25 million and $8 million after-tax reduction in earnings attributable to the minority interest that is reflected in our consolidated statement of operations. Holdings' stand-alone financial statements are based on its results of operations, which are driven almost exclusively by the capacity purchase agreement. Under this agreement, we pay Holdings for each scheduled block hour based on an agreed formula. On this basis, selected results of operations for Holdings were as follows (in millions): The minority interest in Holdings' operations reported in our consolidated statement of operations is based on these net income amounts. Financings and Guarantees. We are the guarantor of approximately $1.6 billion aggregate principal amount of tax-exempt special facilities revenue bonds and interest thereon (excludes certain City of Houston bonds and includes a US Airways contingent liability, both discussed below). Excluding the US Airways contingent liability, these bonds, issued by various airport municipalities, are payable solely from our rentals paid under long-term agreements with the respective governing bodies. In August 2001, the City of Houston completed the offering of $324 million aggregate principal amount of tax-exempt special facilities revenue bonds to finance the construction of Terminal E at Bush Intercontinental Airport. In the aggregate, this project will add 20 gates to our Houston hub. We began using seven gates for domestic operations in June 2003, and expect the entire terminal to be substantially completed by December 2003. The final phase of the Terminal E project, the international ticketing hall facility, is projected to be substantially completed by the City of Houston in the spring of 2005, at which time the City of Houston is also expected to complete a new federal customs and immigration facility, enabling both domestic and international use of the entire Terminal E concourse. In connection therewith, we entered into a long-term lease with the City of Houston requiring that upon completion of construction, with limited exceptions, we will make rental payments sufficient to service the related tax-exempt bonds through their maturity in 2029. Approximately $174 million of the bond proceeds had been expended as of June 30, 2003 and this project is proceeding within budget. During the construction period, we retain the risks related to our own actions or inactions while managing portions of the construction. Potential obligations associated with these risks are generally limited based upon the percentages of construction costs incurred to date. We have also entered into a binding corporate guaranty with the bond trustee for the repayment of the principal and interest on the bonds that becomes effective upon the completion of construction, our failure to comply with the lease (which is within our control), or our termination of the lease. Further, we have not assumed any c ondemnation risk, casualty event risk (unless caused by us), or risk related to certain overruns (and in the case of cost overruns, our liability for the project would be limited to 89.9% of the capitalized costs) during the construction period. Accordingly, we are not considered the owner of the project and, therefore, have not capitalized the construction costs or recorded the debt obligation in our consolidated financial statements. However, our potential obligation under the guarantee is for payment of the principal of $324 million and related interest charges, at an average rate of 6.78%. We remain contingently liable until December 1, 2015, for US Airways' obligations under a lease agreement between US Airways and the Port Authority of New York and New Jersey related to the East End Terminal at LaGuardia airport. These obligations include the payment of ground rentals to the Port Authority and the payment of principal and interest on $182 million par value special facilities revenue bonds issued by the Port Authority. Upon its emergence from bankruptcy on March 31, 2003, US Airways assumed the lease. If US Airways defaulted on these obligations, we would be required to cure the default, and we would have the right to occupy the terminal. We also have letters of credit and performance bonds at June 30, 2003 in the amount of $144 million with expiration dates through June 2008. General Guarantees and Indemnifications. We are the lessee under many real estate leases. It is common in such commercial lease transactions for us to agree to indemnify the lessor and other related third parties for tort liabilities that arise out of or relate to our use or occupancy of the leased premises. In some cases, this indemnity extends to related liabilities arising from the negligence of the indemnified parties, but usually excludes any liabilities caused by their gross negligence or willful misconduct. Additionally, we typically indemnify such parties for any environmental liability that arises out of or relates to our use of the leased premises. In our aircraft financing agreements, we typically indemnify the financing parties, trustees acting on their behalf and other related parties against liabilities that arise from the manufacture, design, ownership, financing, use, operation and maintenance of the aircraft and for tort liability, whether or not these liabilities arise out of or relate to the negligence of these indemnified parties, except for their gross negligence or willful misconduct. We expect that we would be covered by insurance (subject to deductibles) for most tort liabilities and related indemnities described above with respect to real estate we lease and aircraft we operate. In our financing transactions that include loans from banks in which the interest rate is based on LIBOR, we typically agree to reimburse the lenders for certain increased costs that they incur in carrying these loans as a result of any change in law and for any reduced returns with respect to these loans due to any change in capital requirements. We had $1.5 billion of floating rate debt at June 30, 2003. In several financing transactions, with an aggregate carrying value of $930 million and involving loans from non-U.S. banks, export-import banks and other lenders secured by aircraft, we bear the risk of any change in tax laws that would subject loan payments thereunder to non-U.S. lenders to withholding taxes. In addition, in cross-border aircraft lease agreements for two 757 aircraft, we bear the risk of any change in U.S. tax laws that would subject lease payments made by us to a resident of Japan to U.S. taxes. Our lease obligations for these two aircraft totaled $73 million at June 30, 2003 . We cannot estimate the potential amount of future payments under the foregoing indemnities and agreements. Virgin Atlantic Codeshare Agreement. Effective April 1, 2003, we made adjustments to our codeshare agreement with Virgin Atlantic Airways eliminating our fixed commitment to purchase seats. We continue to codeshare on each other's flights between New York/Newark and London, and we continue to place our code on seven other routes flown by Virgin Atlantic between the United States and the United Kingdom. Employees. Collective bargaining agreements between both us and ExpressJet and our respective pilots became amendable in October 2002. After being deferred due to the economic uncertainty following the September 11, 2001 terrorist attacks, negotiations recommenced with the Air Line Pilots Association in September 2002 and are continuing. We continue to believe that mutually acceptable agreements can be reached with our pilots, although the ultimate outcome of the negotiations is unknown at this time. Environmental Matters. We could be responsible for environmental remediation costs primarily related to jet fuel and solvent contamination surrounding our aircraft maintenance hangar in Los Angeles. In 2001, the California Regional Water Quality Control Board mandated a field study of the site, which was completed in September 2001. We have established a reserve for estimated losses from environmental remediation at Los Angeles and elsewhere in our system, based primarily on third-party environmental remediation costs. We expect our total losses from environmental matters, net of insurance recoveries, to be $37 million for which we were 100% accrued at June 30, 2003. Although we believe, based on currently available information, that our reserves for potential environmental remediation costs are adequate, reserves could be adjusted as further information develops or circumstances change. However, we do not expect these items to materially impact our financial condition, liquidity or results of operations. Internal Revenue Service Examination. The Internal Revenue Service is in the process of examining our income tax returns for years through 1999 and has indicated that it may disallow certain deductions we claimed. We believe the ultimate resolution of this audit will not have a material adverse effect on our financial condition or results of operations. Legal Proceedings. Sarah Futch Hall d/b/a/ Travel Specialists v. United Air Lines, et al. (U.S.D.C. Eastern District of North Carolina). This class action was filed in federal court on June 21, 2000 by a travel agent, on behalf of herself and other similarly situated U.S. travel agents, challenging the reduction and ultimate elimination of travel agent base commissions by certain air carriers, including Continental and other domestic and international air carriers. The amended complaint alleges an unlawful agreement among the airline defendants to reduce, cap or eliminate commissions in violation of federal antitrust laws during the years 1997 to 2002. The plaintiffs seek compensatory and treble damages, injunctive relief and their attorneys' fees. The class was certified on September 18, 2002. Discovery has been completed. Summary judgment and other motions are pending. Recently, the Court set a new trial date of February 2, 2004. We believe the plaintiffs' claims are without mer it and are vigorously defending this lawsuit. A final adverse court decision awarding substantial money damages, however, would have a material adverse impact on our financial condition, liquidity or results of operations. We and/or certain of our subsidiaries are defendants in various other lawsuits, including suits relating to certain environmental claims, and proceedings arising in the normal course of business. While the outcome of these lawsuits and proceedings cannot be predicted with certainty and could have a material adverse effect on our financial position, results of operations and cash flows, it is our opinion, after consulting with counsel, that the ultimate disposition of such suits will not have a material adverse effect on our financial position, results of operations or cash flows. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion contains forward-looking statements that are not limited to historical facts, but reflect our current beliefs, expectations or intentions regarding future events. In connection therewith, please see the risk factors set forth in our 2002 10-K, which identify important factors such as the war in Iraq, terrorist attacks and the resulting regulatory developments and costs, our recent operating losses and special charges, our high leverage and significant financing needs, our historical operating results, the significant cost of aircraft fuel, labor costs, certain tax matters, the Japanese economy and currency risk, competition and industry conditions, regulatory matters and the seasonal nature of the airline business, that could cause actual results to differ materially from those in the forward-looking statements. In addition to the foregoing risks, there can be no assurance that we will be able to achieve the pre-tax contributions from the revenue-generating and cost-reducing initiatives discussed below, some of which will depend, among other matters, on customer acceptance and competitor actions. We undertake no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date of this report. General information about us can be found at www.continental.com/About Continental/Investor Relations. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments to those reports, are available free of charge through our website as soon as reasonably practicable after we file them with, or furnish them to, the SEC. Despite recent improvements, the current U.S. domestic airline environment continues to be one of the worst in airline history, and could deteriorate further. Please see the "Overview" section of Management's Discussion and Analysis of Financial Condition and Results of Operations in our 2002 10-K for a detailed discussion of the financial and operational challenges we face. Subsequent to the filing of our 2002 10-K, several significant developments adversely affected our results. First, the United States and certain of its allies commenced military actions in Iraq. The hostilities and post-war unrest in Iraq significantly reduced our bookings and lowered passenger traffic. Second, the spread of Severe Acute Respiratory Syndrome, or "SARS", in China, Hong Kong, Canada and elsewhere caused a further decline in passenger traffic, particularly to Hong Kong and some of the other Asian cities we serve. Both of these events disproportionately affected our international passenger traffic. We responded to the reduced actual and anticipated demand by reducing capacity on certain trans-Atlantic and trans-Pacific routes (including the suspension of our flights between Hong Kong and Newark from April 2003 until August 2003) and by reducing our summer schedule. In March 2003, we announced plans to implement measures designed to improve our current 2004 pre-tax outlook by $500 million, although we have not yet identified all of the measures to achieve that goal, nor have we been able to implement all identified savings opportunities. We currently believe that we will realize more than $150 million in pre-tax benefits in 2003 as these initiatives are implemented. During the second quarter of 2003, we agreed to defer firm deliveries of 36 Boeing 737 aircraft that were originally scheduled for delivery in 2005, 2006 and 2007. These aircraft will now be delivered in 2008 and beyond. In connection with the deferrals, we have recorded a charge of $14 million in fleet impairment losses and other special charges. Additionally, we are in discussions with Boeing regarding the terms of delivery of the 11 remaining 757-300 aircraft that we have on order. With current planned deliveries of new Boeing aircraft in 2003 and 2004 and retirements of older MD-80s and 737-300s, we currently expect our mainline fleet to decline slightly through 2007. With the exit of the MD-80s by January 2005, we will operate just three common-rated mainline jet fleet types, consisting of the Boeing 737, 757/767 and 777 aircraft. In spite of these measures, increased hostilities in the Middle East, continued soft demand or yields, or cost increases outside our control (such as fuel, security and insurance) could lead to further reductions in service, including service to small and medium-sized communities, and further job eliminations. The following discussion provides an analysis of our results of operations and reasons for material changes therein for the three and six months ended June 30, 2003 as compared to the corresponding periods ended June 30, 2002. Comparison of Three Months Ended June 30, 2003 to Three Months Ended June 30, 2002 We recorded consolidated net income of $79 million for the second quarter of 2003 as compared to consolidated net loss of $139 million for the three months ended June 30, 2002. The primary reasons for the change were a $176 million security fee reimbursement received from the federal government under the supplemental appropriations bill enacted in April 2003 and a fleet impairment loss and other special charges of $164 million in 2002. The following discussion provides an analysis of our results of operations and other reasons for material changes therein for the three months ended June 30, 2003 as compared to the corresponding period in 2002. Total passenger revenue decreased 1.7%, $36 million, during the quarter ended June 30, 2003 as compared to the same period in 2002, which was principally due to traffic and capacity declines. These traffic and capacity declines were largely due to a reduction in certain international flights in response to decreased demand during the war in Iraq and related to SARS. Yield was 1.2% lower in the second quarter of 2003 than in the second quarter 2002 primarily as a result of continued weakness in the number of business travelers. Comparisons of passenger revenue, revenue per available seat mile (RASM) and available seat miles (ASMs) by geographic region for our mainline jet and regional jet and turboprop (turboprops were removed entirely from our fleet in 2002) operations are shown below: Increase (Decrease) for Second Quarter 2003 vs. Second Quarter 2002 Passenger Revenue RASM ASMs Trans-Atlantic (31.3)% Total Mainline Jet Operations Cargo, mail and other revenue increased 46.2%, $60 million, during the quarter ended June 30, 2003 as compared to the same period in 2002 primarily due to military charter flights, higher mail volumes and revenue-generating initiatives. Wages, salaries and related costs increased 2.1%, $16 million, during the quarter ended June 30, 2003 as compared to the same period in 2002, primarily due to higher wage rates and pension costs, partially offset by a 3.4% reduction in the average number of employees. Aircraft fuel expense increased 18.9%, $48 million, in the three months ended June 30, 2003 as compared to the same period in the prior year. The average jet fuel price per gallon increased 22.9% from 68.27 cents in the second quarter of 2002 to 83.90 cents in the second quarter of 2003. Fuel consumption was down 7.2% as a result of reduced flights and more fuel-efficient aircraft. Landing fees and other rentals decreased 5.0%, $8 million, primarily due to lower rent at certain airports as a result of the reduced number of flights. Maintenance, materials and repairs increased 5.9%, $7 million, in the second quarter of 2003 compared to the second quarter of 2002 primarily due to increases in the engine cost per hour contract rates. Commission expense decreased 36.8%, $21 million, during 2003 as compared to 2002 primarily due to the elimination of domestic base commissions in 2002. Other operating expense decreased 12.8%, $37 million, in the three months ended June 30, 2003 as compared to the same period in the prior year, primarily as a result of lower insurance costs and cost saving measures. Other nonoperating income (expense) in the three months ended June 30, 2003 included foreign currency gains of $4 million and equity in earnings of unconsolidated subsidiaries of $4 million. Our effective tax rates differ from the federal statutory rate of 35% primarily due to expenses that are not deductible for federal income tax purposes, state income taxes and the accrual in 2003 of income tax expense on our share of Holdings' net income. Minority interest represents the portion of Holdings' net income attributable to the 46.9% of Holdings that we do not own. Comparison of Six Months Ended June 30, 2003 to Six Months Ended June 30, 2002 We recorded consolidated net loss of $142 million for the first half of 2003 as compared to consolidated net loss of $305 million for the six months ended June 30, 2002. The primary reasons for the change were a $176 million security fee reimbursement received from the federal government under the supplemental appropriations bill enacted in April 2003 and $175 million higher fleet impairment losses and other special charges in 2002 than in 2003. The following discussion provides an analysis of our results of operations and other reasons for material changes therein for the six months ended June 30, 2003 as compared to the corresponding period in 2002. Total passenger revenue decreased 0.9%, $36 million, during the six months ended June 30, 2003 as compared to the same period in 2002, which was principally due to traffic and capacity declines. These traffic and capacity declines were largely due to a reduction in certain international flights in response to decreased demand during the war in Iraq and related to SARS. These declines were offset in part by slightly higher yield. Increase (Decrease) for June 30, 2003 YTD vs. June 30, 2002 YTD Cargo, mail and other revenue increased 42.9%, $108 million, during the six months ended June 30, 2003 as compared to the same period in 2002 primarily due to military charter flights, higher mail volumes and revenue-generating initiatives. Wages, salaries and related costs increased 4.3%, $63 million, during the six months ended June 30, 2003 as compared to the same period in 2002, primarily due to higher wage rates and pension costs, partially offset by a 1.7% reduction in the average number of employees. Aircraft fuel expense increased 40.5%, $187 million, in the six months ended June 30, 2003 as compared to the same period in the prior year. The average jet fuel price per gallon increased 41.6% to 91.17 cents in the first six months of 2003 from 64.37 cents in the first six months of 2002. Fuel consumption was down 4.2% as a result of reduced flights and more fuel-efficient aircraft. Landing fees and other rentals decreased 5.3%, $17 million, primarily due to lower rent at certain airports. Maintenance, materials and repairs increased 12.1%, $28 million, in the first half of 2003 compared to the first half of 2002 primarily due to increases in the engine cost per hour contract rates. Other operating expense decreased 12.7%, $74 million, in the six months ended June 30, 2003 as compared to the same period in the prior year, primarily as a result of lower insurance costs and cost saving measures. Other nonoperating income (expense) in the six months ended June 30, 2003 included foreign currency gains of $5 million and equity in earnings of unconsolidated subsidiaries of $6 million, offset by the write-off of our $6 million investment in Cordiem LLC, an internet-based procurement service. Certain Statistical Information An analysis of statistical information for our operations for the periods indicated is as follows: Increase/ (Decrease) Mainline Jet Statistics: Cargo ton miles (millions) 1.2 pts. Operating cost per available seat mile including security fee reimbursement and fleet impairment losses and special charges (cents) Security fee reimbursement and fleet impairment losses and special charges per available seat mile (cents) Average yield per revenue passenger mile (cents) (4) Average price per gallon of fuel, excluding fuel taxes (cents) Average price per gallon of fuel, including Average daily utilization of each aircraft (hours) (5) Actual aircraft in fleet at end of period (6) Regional Jet and Turboprop Statistics: Consolidated Statistics: Consolidated passenger load factor (3) Consolidated breakeven passenger load factor (7) (15.6) pts. (1.6) pts. The number of seats available for passengers multiplied by the number of scheduled miles that those seats are flown. Excludes aircraft that are either temporarily or permanently removed from service. The percentage of seats that must be occupied by revenue passengers for us to break even on a net income basis. Security fee reimbursement and fleet impairment losses and other special charges in the three months ended June 30, 2003 and 2002 and the six months ended June 30, 2003 and 2002 included in the consolidated breakeven passenger load factor account for a decrease of 7.4, an increase of 8.3, a decrease of 2.3 and an increase of 6.6 percentage points, respectively. LIQUIDITY AND CAPITAL COMMITMENTS As of June 30, 2003, we had $1.6 billion in cash, cash equivalents and short-term investments, which is $285 million higher than at December 31, 2002. Cash and cash equivalents at June 30, 2003 included $129 million of restricted cash held by us and $118 million of cash held by Holdings (to which we do not have access). The restricted cash is primarily collateral for letters of credit and interest rate swap agreements. Our cash balance at June 30, 2003 was positively impacted by the May 2003 receipt of $176 million from the United States government pursuant to a supplemental appropriations bill enacted in April 2003 and the financings discussed below. Operating Activities. Cash flows provided by operations for the six months ended June 30, 2003 were $225 million compared to cash flows used in operations of $24 million in the comparable period of 2002. The 2003 period was impacted by the security fee reimbursement and the 2002 period was impacted by our January 2002 payment of $168 million in transportation taxes, the payment of which had been deferred pursuant to the Air Transportation Safety and System Stabilization Act. We expect to incur a significant loss for the full year 2003. Absent adverse factors outside our control such as those described herein or in our 2002 10-K, we believe that our liquidity and access to cash will be sufficient to fund our current operations through 2004 (and beyond if we are successful in implementing our previously announced revenue-generating and cost cutting measures). These measures, which are designed to permit us to operate profitably in a prolonged low-fare environment, are as follows: In August 2002, we announced plans to implement a number of revenue generating and cost saving measures intended to achieve a pre-tax contribution in excess of $350 million. Included in the more than 100 planned changes were the assessment of fees for paper tickets, the elimination of discounts on certain fares, the enforcement of all fare rules with a policy against exceptions, the optimization of our flight schedule to best match demand and capacity, and the modification of certain employee programs. We currently believe that these measures will result in savings of approximately $400 million in 2003. In March 2003, we announced plans to implement measures designed to improve our current 2004 pre-tax outlook by $500 million, although we have not yet identified or been able to implement all of the measures to achieve that goal. We currently believe that we will realize more than $150 million in pre-tax benefits in 2003 as these initiatives are implemented. Cost-saving measures to be implemented include a significant reduction in distribution expenses through increased utilization of our website, continental.com, the reduction of airport facility costs and landing fees, the elimination of paper tickets worldwide by June 30, 2004, the closing of select city ticket offices and the renegotiation of contracts with key suppliers. In addition, we have reduced our workforce by approximately 500 positions since March 2003, and expect to reduce it by an additional 700 positions by December 31, 2003. Investing Activities. Cash flows used in investing activities, primarily capital expenditures, were $85 million for the six months ended June 30, 2003 and $428 million for the six months ended June 30, 2002, reflecting fewer aircraft deliveries in 2003. We have substantial commitments for capital expenditures, including for the acquisition of new aircraft. See Note 5. Capital expenditures for the full year 2003 are expected to be $260 million, or $210 million when reduced by purchase deposits to be refunded, net of purchase deposits paid, in 2003. Through June 30, 2003, our capital expenditures totaled $107 million and net purchase deposits refunded totaled $20 million. Projected capital expenditures consist of $90 million of fleet expenditures, $100 million of non-fleet expenditures and $70 million for rotable parts and capitalized interest. Financing Activities. Cash flows provided by financing activities, primarily the issuance of long-term debt, were $53 million for the six months ended June 30, 2003, compared to cash flows provided by financing activities of $499 million in the six months ended June 30, 2002. The 2002 amount includes $447 million received in the initial public offering of Holdings. In May 2003, we incurred $96 million of floating rate indebtedness under a term loan agreement that matures in May 2011. This indebtedness is secured by a portion of our spare engines and initially bears interest at the three-month LIBOR rate plus 3.5%, for an initial all-in rate of 4.78%. On several occasions subsequent to September 11, 2001, each of Moody's Investors Service, Standard and Poor's and Fitch, IBCA, Duff & Phelps downgraded the credit ratings of a number of major airlines, including our credit ratings. Additional downgrades were made in March and April 2003 and further downgrades are possible. As of June 30, 2003, our senior unsecured debt was rated Caa2 by Moody's, CCC+ by Standard and Poor's and CCC+ by Fitch, IBCA, Duff & Phelps. Reductions in our credit ratings have increased the interest we pay on new issuances of debt and may increase the cost and reduce the availability of financing to us in the future. We do not have any debt obligations that would be accelerated as a result of a credit rating downgrade. Under the most restrictive provisions of a credit facility agreement with an outstanding balance of $71 million at June 30, 2003, we are required to maintain a minimum unrestricted cash balance of $600 million. Also, under a separate agreement with an outstanding balance of $43 million at June 30, 2003, we are required to maintain a minimum 1:1 ratio of EBITDAR (earnings before interest, income taxes, depreciation and aircraft rentals) to fixed charges, which consist of interest expense, aircraft rental expense, cash income taxes and cash dividends, for the previous four quarters. We met both of these covenants at June 30, 2003 and believe that we will be able to meet them for the remainder of 2003. We do not currently have any undrawn lines of credit and substantially all of our otherwise readily financeable assets are encumbered. We have utilized proceeds from the issuance of pass-through certificates to finance the acquisition of 257 leased and owned mainline jet aircraft. Typically, these pass-through certificates, as well as a separate financing secured by aircraft spare parts, contain liquidity facilities whereby a third party agrees to make payments sufficient to pay at least 18 months of interest on the applicable certificates if a payment default occurs. The liquidity providers for these certificates include the following: Landesbank Hessen-Thuringen Girozentrale, Morgan Stanley Capital Services, Westdentsche Landesbank Girozentrale, AIG Matched Funding Corp., ABN AMRO Bank N.V., Credit Suisse First Boston, Caisse des Depots et Consignations, Bayerische Landesbank Girozentrale, ING Bank N.V. and De Nationale Investeringsbank N.V. We currently utilize policy providers to provide credit support on three separate financings with an outstanding principal balance of $585 million at June 30, 2003. The policy providers have unconditionally guaranteed the payment of interest on the notes when due and the payment of principal on the notes no later than 24 months after the final scheduled payment date. Policy providers on these notes are MBIA Insurance Corporation (a subsidiary of MBIA, Inc.), Ambac Assurance Corporation (a subsidiary of Ambac Financial Group, Inc.) and Financial Security Assurance, Inc. (a subsidiary of Financial Security Assurance Holdings Ltd.). Financial information for the parent companies of these policy providers is available over the internet at the SEC's website at http//www.sec.gov or at the SEC's public reference room in Washington, D.C. Income Taxes. As of December 31, 2002, we had a net deferred tax liability of $355 million including gross deferred tax assets aggregating $1,801 million, $704 million related to net operating losses ("NOLs"), and a valuation allowance of $603 million. Section 382 of the Internal Revenue Code ("Section 382") imposes limitations on a corporation's ability to utilize NOLs if it experiences an "ownership change." In general terms, an ownership change may result from transactions increasing the ownership of certain stockholders in the stock of a corporation by more than 50 percentage points over a three-year period. In the event of an ownership change, utilization of our NOLs would be subject to an annual limitation under Section 382 determined by multiplying the value of our stock at the time of the ownership change by the applicable federal long-term tax-exempt rate (which was 4.45% for June 2003). Any unused annual limitation may be carried over to later years. The amount of the limitation may be increased under certain circumstances by the built-in gains in assets held by us at the time of the change that are recognized in the five-year period after the change. Under current conditions, if an ownership change were to occur, our annual NOL util ization would be limited to approximately $43 million per year other than through the recognition of future built-in gain transactions. The Internal Revenue Service is in the process of examining our income tax returns for years through 1999 and has indicated that it may disallow certain deductions we claimed. We believe the ultimate resolution of this audit will not have a material adverse effect on our financial condition or results of operations. Pension Plans. We have a noncontributory defined benefit plan covering substantially all our employees. As of December 31, 2002, this plan was underfunded by approximately $1.2 billion as measured by SFAS 87, "Employers Accounting for Pensions". We contributed $42 million to our plan on June 30, 2003 and expect to make additional contributions of at least $47 million by December 31, 2003. Based on current information and trends (including currently anticipated unit revenue and costs), we expect to incur a significant loss for the fourth quarter and full year 2003. We expect our mainline passenger load factor to be flat or slightly higher for the full year compared to 2002, although against reduced capacity. We may make further reductions in capacity in response to market conditions. The reduced capacity, coupled with the fact that many of our costs are fixed in the intermediate to long term, will continue to drive higher unit costs. We currently expect our net cash flows for the third quarter of 2003 to be breakeven, including required debt payments and capital expenditures. We also have significant future funding requirements for our pension plan beyond 2003. Absent any changes to the plan (which in most cases are subject to collective bargaining agreements with our unions), changes in governing legislation or a waiver by the Internal Revenue Service of required payments, the minimum funding requirement in 2004 related to the 2002 plan year is approximately $240 million. We expect that minimum funding requirements in 2004 relating to the 2003 plan year will also be significant. Investment returns on plan assets, changes to the discount rate used to value the pension liability and the possibility that we will make higher than required contributions in 2003 will also impact the required contributions in 2004. We believe that our costs are likely to be affected in the future by a number of factors, which are discussed in Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Overview" of our 2002 10-K. In March 2003, the Department of Transportation completed its review of our marketing agreement with Delta Air Lines and Northwest Airlines, which we have now begun to implement. When fully implemented, this alliance will involve codesharing, reciprocal frequent flyer benefits and reciprocal airport lounge privileges. Effective April 1, 2003, we made adjustments to our codeshare agreement with Virgin Atlantic Airways eliminating our fixed commitment to purchase seats. We continue to codeshare on each other's flights between New York/Newark and London, and Continental places its code on other routes flown by Virgin Atlantic between the United States and the United Kingdom. Item 3. Quantitative and Qualitative Disclosures about Market Risk. There have been no material changes in market risk from the information provided in Item 7A. "Quantitative and Qualitative Disclosures About Market Risk" in our 2002 10-K except as follows: Our results of operations are significantly impacted by changes in the price of aircraft fuel. From time to time, we enter into petroleum call options and petroleum swap agreements to provide short-term protection (generally three to nine months) against a sharp increase in jet fuel prices. As of June 30, 2003, we had hedged approximately 25% of our remaining 2003 projected fuel requirements using petroleum call options. We estimate that a 10% increase in the price per gallon of aircraft fuel would increase the fair value of petroleum call options existing at June 30, 2003 by approximately $13 million. Also, as of June 30, 2003, we entered into option and forward contracts to hedge approximately 58% of our projected yen-denominated net cash flows for the remainder of 2003. We estimate that at June 30, 2003, a 10% strengthening in the value of the U.S. dollar relative to the yen would have increased the fair value of the existing option and forward contracts by $5 million, offset by a corresponding loss on the underlying 2003 Japanese yen exposure of $7 million, resulting in a net loss of $2 million. Item 4. Controls and Procedures. On July 15, 2003, our Chief Executive Officer and Chief Financial Officer performed an evaluation of our disclosure controls and procedures, which have been designed to permit us to effectively identify and timely disclose important information. They concluded that the controls and procedures were effective. We have made no significant changes in our internal controls or in other factors that could significantly affect our internal controls since July 15, 2003. PART II - OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds. Item 3. Defaults Upon Senior Securities. The Company's Annual Meeting of Stockholders was held on May 14, 2003. The following individuals were elected to the Company's Board of Directors to hold office for the ensuing year: VOTES FOR VOTES WITHHELD Gordon M. Bethune Kirbyjon H. Caldwell Douglas H. McCorkindale A proposal to ratify the appointment of Ernst & Young LLP as the Company's independent auditors for the fiscal year ending December 31, 2003 was voted on by the stockholders as follows: Votes Against Votes Abstaining Broker Non-Votes A proposal that stockholders request that the Company annually submit to a stockholder vote any poison pill adopted since the previous annual meeting and/or currently in place was voted on by the stockholders as follows: Item 5. Other Information. Item 6. Exhibits and Reports on Form 8-K. Agreement between the Company and the United States of America, acting through the Transportation Security Administration, dated May 7, 2003. Agreement between the Company and Gordon M. Bethune, dated May 19, 2003. Agreement between the Company and Lawrence W. Kellner, dated May 19, 2003. Supplemental Agreement No. 19 to Agreement of Lease between the Company and the Port Authority of New York and New Jersey regarding Terminal C at Newark Liberty International Airport. Certifications of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Report dated March 28, 2003, reporting Item 5. "Other Events". No financial statements were filed with this report, which reported the downgrading of our corporate credit rating and included a press release reporting our March 2003 performance and our estimated consolidated breakeven load factor for April 2003. Report dated April 15, 2003, reporting Item 5. "Other Events". No financial statements were filed with this report, which included a press release reporting our first quarter 2003 results of operations and a letter to investors and analysts related to our financial and operational outlook for the second quarter and full year 2003. Report dated May 1, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a press release reporting our April 2003 performance and our estimated consolidated breakeven load factor for May 2003. Report dated May 9, 2003, reporting Item 5. "Other Events". No financial statements were filed with this report, which included a press release announcing the closing of an offering of $100 million of Floating Rate Secured Subordinated Notes due December 2007. Report dated May 14, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a press release announcing the election by our Board of Directors of Ronald B. Woodard to fill a vacancy on the Board. Report dated June 2, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a press release reporting our May 2003 performance and our estimated consolidated breakeven load factor for June 2003. Report dated June 4, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a press release announcing a proposed offering of $150 million of 5% Convertible Notes due 2023 pursuant to Rule 144A. Report dated June 5, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a letter to investors and analysts related to our financial and operational outlook for the second quarter of and for the full year 2003. Report dated June 10, 2003, reporting Item 9. "Regulation FD Disclosure". No financial statements were filed with this report, which included exhibits related to data being presented by certain of our officers at a conference. Report dated June 10, 2003, reporting Item 5. "Other Events". No financial statements were filed with the report, which included a press release announcing the completion of our sale of $175 million principal amount of our 5% Convertible Notes due 2023. Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. /s/ Jeffrey J. Misner /s/ Chris Kenny Chris Kenny Staff Vice President and Controller (Principal Accounting Officer) I, Gordon M. Bethune, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Continental Airlines, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. /s/ Gordon M. Bethune Chairman of the Board and I, Jeffrey J. Misner, certify that: 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): February 20, 202 AGREEMENT BETWEEN THIS Agreement ("Agreement") is made and entered into on this 7th day of May, 2003 ("Effective Date") by and between Continental Airlines, Inc. ("Air Carrier") and the United States of America, acting through the Transportation Security Administration ("TSA"). 1.0 AUTHORITY TSA enters into this Agreement under the authority of the Title IV, Public Law No. 108-11 (hereinafter P.L. 108-11), the Emergency Wartime Supplemental Appropriations Act, 2003, (hereinafter Act), which requires the execution and delivery of this Agreement as a condition to the remittance of the funds provided for in the second proviso of Title IV, P.L. 108-11, except for any air carrier that operates aircraft exclusively with 85 seats or less, any Hawaii-based carrier or any carrier that does not operate trans-Pacific or trans-Atlantic flights. Air Carriers that would be exempted from the requirement to execute and deliver this Agreement but for the operation of private charter flights, including flights provided to the United States under the Civil Reserve Air Fleet (CRAF), for which no fees were incurred pursuant to 49 U.S.C. Section 44940(a) for these flights, shall not be required to execute and deliver this Agreement solely because of those flights for which no fees were incurred. This Agreement describes the terms and conditions to which the Air Carrier must agree to be eligible for remittance of the funds provided for in the second proviso of Title IV, P.L. 108-11. 3.1 "Excluded Compensation" means award of stock, stock options, preexisting contracts governing retirement, health benefits, life insurance benefits, and reimbursement of reasonable expenses to an executive officer. Awards of stock and stock options shall include related granting, vesting, issuance, exercise and sale events. 3.2 "Executive Officer" means the two most highly compensated named executive officers (as that term is used in section 402(a)(3) of Regulation S-K promulgated by the Securities and Exchange Commission under the Securities and Exchange Act of 1934 (17 C.F.R. Section 229.402(a)(3)). For the purposes of applying this Agreement to an executive officer- (A) who was employed by Air Carrier for less than 12 months during Air Carrier's fiscal year 2002, or whose employment began after the last day of the last fiscal year of such Air Carrier ending before the date of enactment of P.L. 108-11, (i) the salary paid to that executive officer in Air Carrier's fiscal year 2002, or in the next fiscal year of Air Carrier (if such next fiscal year began before the date of enactment of P.L. 108-11), respectively, shall be determined as an annual rate of pay; (ii) that annual rate of pay shall be treated as if it were the annual salary paid to that executive officer during Air Carrier's fiscal year 2002; and (iii) that executive officer shall be deemed to have been employed during that fiscal year; and (B) whose employment begins after the date of enactment of P.L. 108-11- (i) the annual salary at which that executive officer is first employed by Air Carrier may not exceed the maximum salary paid to any executive officer by Air Carrier during Air Carrier's fiscal year 2002 with the same or similar responsibilities; (ii) that salary shall be treated as if it were the annual salary paid to the executive officer during Air Carrier's fiscal year 2002; and (iii) the executive officer shall be deemed to have been employed by Air Carrier during Air Carrier's fiscal year 2002. For purposes of (A) above, an employee promoted to a position during the Air Carrier's fiscal year 2002 shall be treated as first employed by the Air Carrier on the date of such promotion. 3.3 "Operates" means currently operating or did operate between February 1, 2002 and April 16, 2003. 3.4 "Salary" means the base salary of an individual, excluding any bonuses, awards of stock or other financial benefits provided by an air carrier to the individual. 3.5 "Total Cash Compensation" has the meaning given the term "total compensation" by section 104(b) of the Air Transportation Safety and System Stabilization Act, Public Law No. 107-42 (49 U.S.C. Section 40101 note), but does not include awards of stock or stock options or preexisting contracts governing retirement. More specifically, "Total Cash Compensation" for purposes of this Agreement shall mean any compensation, other than Excluded Compensation as defined above, provided (including any amounts paid in cash during the 12-month period beginning April 1, 2003 that were earned in prior periods and any amounts which would have been paid but which were deferred) by the Air Carrier, including all of its holding companies, subsidiaries, and affiliated entities, as follows: (a) Salary; (b) Bonus; (c) Employer contributions under any retirement plan (excluding preexisting plans or contracts related to retirement); (d) Perquisites, including personal automobile allowances, positive space travel benefits and any associated tax gross-ups, valued in a manner consistent with the valuation of such perquisites for purposes of reporting such perquisites in Air Carrier's proxy statement for its annual meeting of stockholders (except that the reporting threshold of $50,000 or 10% of the annual salary and bonus described in 17 C.F.R. Paragraph 229.402(b)(1)(C)(1) shall not apply to the Agreement); (e) Any other compensation required to be disclosed in the Air Carrier's proxy statement for its annual meeting of stockholders that is paid (including amounts paid during the 12-month period beginning April 1, 2003 that were earned in prior periods) during the 12 month period beginning April 1, 2003, including but not limited to any cash long-term incentive plan payouts; and (f) Other financial benefits, reasonably valued by the good faith determination of the Compensation Committee of the Board of Directors of Air Carrier, excluding Excluded Compensation. 3.6 "Total compensation" as defined by section 104(b) of the Air Transportation Safety and System Stabilization Act, includes salary, bonuses, awards of stock, and other financial benefits provided by an air carrier to an officer or employee of the Air Carrier. 3.7 "Trans-Atlantic" means from one side of the Atlantic Ocean to the other side, with or without intermediate stops. It does not include flights that solely travel between the United States and the Caribbean or between North America and South America. "Trans-Pacific" means from one side of the Pacific Ocean to the other side, with or without intermediate stops. 4.0 RESTRICTIONS ON COMPENSATION 4.1 The Air Carrier, including all of its holding companies, subsidiaries, and affiliated entities, agrees that it will not provide Total Cash Compensation during the 12-month period beginning April 1, 2003, to an executive officer in an amount equal to more than the annual Salary paid to that officer with respect to the Air Carrier's fiscal year 2002; and 4.2 If the Air Carrier violates the agreement under paragraph 4.1, Air Carrier will pay to the Secretary of the Treasury, within 60 days after the date on which the violation occurs, an amount, determined by the Administrator of the Transportation Security Administration, equal to the total amount of assistance received by Air Carrier pursuant to the second proviso of Title IV, P.L. 108-11. 4.3 Nothing in this Agreement shall be construed to prohibit or limit an air carrier in providing health benefits, life insurance benefits, or reimbursement of reasonable expenses to an executive officer as provided in P.L. 108-11. 5.0 COMPTROLLER GENERAL AUDIT AND EXAMINATION The Air Carrier agrees that the Comptroller General of the United States, or any of the Comptroller General's duly authorized representatives, shall have access for the purpose of audit and examination to any books, accounts, documents, papers, and records of the Air Carrier, including all of its holding companies, subsidiaries, and affiliated entities, that relate to the information required to implement the provisions of this Executive Compensation Agreement. 6.0 REPRESENTATIONS 6.1 That the Air Carrier is duly incorporated, validly existing and in good standing under the laws of the State of Delaware. 6.2 The execution, delivery, and performance by the Air Carrier of this Agreement has been duly authorized by all necessary corporate action; this Agreement has been duly executed and delivered by the Air Carrier; and when executed and delivered by a duly authorized representative of TSA, will constitute a valid and binding obligation of the Air Carrier, enforceable against it in accordance with its terms. 6.3 No authorization, approval, consent or order of any court or governmental authority or agency or any other person or entity is required in connection with the execution and delivery by the Air Carrier of this Agreement or its performance hereunder. 7.0 NOTICES The Air Carrier shall have the obligation to notify TSA no later than ten (10) working days, following the occurrence of any event that constitutes a breach of this Agreement. All notices required or permitted hereunder shall be in writing and shall be deemed effectively given: (1) upon personal delivery to the party to be identified below, (2) when sent by confirmed electronic mail or facsimile if sent during normal business hours of the recipient; if not, then on the next business day, (3) five days after having been sent by registered or certified mail, return receipt requested, postage prepaid, or (4) one day after deposit with a nationally recognized overnight courier, specifying next day delivery, with written verification of receipt. All communications shall be sent to the party to be notified at the address as set forth below or at such other address as such party may designate by ten days advance written notice to the other parties hereto. If to AIR CARRIER: If to TSA: 1600 Smith, Dept. HQSLG _Howard_Kass _Director, Economic and Regulatory Policy 701 12th Street South, 11th Floor North, TSA-9 (571) 227-2627/[email protected] < A NAME="_Toc533238940"> 8.0 GOVERNING LAW This Agreement is governed by and shall be construed in accordance with Federal law. 9.0 SUCCESSORS AND ASSIGNS BOUND BY COVENANTS This Agreement shall bind, and inure to the benefit of the parties and their respective heirs, executors, administrators, successors, and assigns. In the event any term, covenant, condition or provision of this Agreement is held to be invalid by any court or tribunal of competent jurisdiction, the invalidity of any such covenant, condition or provision shall in no way affect any other covenant, condition or provision herein contained. 11.0 AMENDMENT This Agreement may not be amended, discharged or terminated without the written consent of the parties hereto, and no provision hereof may be waived without the written consent of the Administrator of the Transportation Security Administration. 12.0 INTEGRATED AGREEMENT This Agreement, upon execution, contains the entire agreement of the parties, and no prior written or oral agreement, express or implied, shall be admissible to contradict the provisions of this Agreement. There may exist other agreements between the Parties as to other matters, which are not affected by this Agreement and are not included within this integration clause. 13.0 WAIVER No failure by either party to insist upon the strict performance of any provision of this Agreement or to exercise any right or remedy consequent upon a breach thereof, and no acceptance of full or partial assistance payments (if applicable) or other performance by either party during the continuance of any such breach shall constitute a waiver of any such breach of such provision. 14.0 COUNTERPARTS This Agreement may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. IN WITNESS WHEREOF, the parties have entered into this Agreement by their duly authorized officers the day and year first above written. AIR CARRIER Name: Jeffery A. Smisek Position: Executive Vice President Name: ______________________________ Position: _________________________________ COMPENSATION CAP AGREEMENT This Compensation Cap Agreement (this "Agreement") is entered into as of May 19, 2003 between Gordon M. Bethune ("Executive") and Continental Airlines, Inc., a Delaware corporation ("Company"). Company and Executive are parties to that certain Employment Agreement, dated as of July 25, 2000, as amended by letter agreement dated as of September 26, 2001 and by letter agreement dated as of April 9, 2002 (as so amended, the "Employment Agreement"); and Company has applied for the funds provided for in Title IV, Public Law No. 108-11 (the "Act") under the second proviso thereof; Executive is one of the two most highly compensated named executive officers (as such term is defined in the Act) of Company; One of the conditions of Company being eligible for such funds is that Company must execute a contract with the Secretary of Homeland Security agreeing to limit the compensation of Executive in the manner and during the period specified in the Act, and the Act further provides that if Company violates such contract, it must pay to the Secretary of the Treasury the amount of such funds remitted to Company under the second proviso of Title IV of the Act; The Secretary of Homeland Security has delegated responsibility for such contract to the Administrator of the Transportation Security Administration, and Company has entered into such contract, dated as of May 7, 2003, with the United States of America, acting through the Transportation Security Administration (the "Limitation Agreement"); Company has provided Executive with a copy of the Limitation Agreement; and In connection therewith, Company desires to enter into this Agreement with Executive, and Executive has consented to entering into this Agreement, in order to facilitate receipt and retention by Company of such funds, to the benefit of Company and Executive. NOW THEREFORE, in consideration of the foregoing, Company and Executive agree as follows: Executive agrees that Company (including all of its holding companies, subsidiaries and affiliated entities) shall not provide to him Total Cash Compensation (as such term is defined in the Limitation Agreement) during the 12-month period beginning April 1, 2003 (the "Restricted Period") in an amount equal to more than the annual Salary (as such term is defined in the Limitation Agreement) paid to Executive with respect to Company's fiscal year 2002. Such annual Salary is $1,042,500. 2. In order to assure compliance by Company with the Limitation Agreement, Executive agrees that Company may reduce Executive's annual Salary (and any payment thereof) during the Restricted Period as follows: (i) initially, beginning with the semi-monthly pay period ending May 31, Executive's annual Salary shall be reduced by $11,250 per semi-monthly pay period, and (ii) thereafter, Executive's annual Salary may be reduced by such additional amount (but not to exceed, in the aggregate, the remaining amount of Executive's annual Salary) as Company and Executive reasonably agree as necessary to assure compliance by Company with the Limitation Agreement. Upon the conclusion of the Restricted Period and the audit and examination of Company's books, accounts, documents, papers and records by the Comptroller General or its duly authorized representatives, as provided by the Limitation Agreement and the Act (and in any event no later than April 1, 2005), to the extent that Company has reduced Executive's an nual Salary by an amount in excess of that necessary to have permitted Company to comply with its Limitation Agreement, the amount of such excess shall be promptly paid to Executive. 3. Executive agrees that any amount of Total Cash Compensation (as such term is defined in the Limitation Agreement) provided by Company (including all of its holding companies, subsidiaries and affiliated entities) to Executive during the Restricted Period shall be held by Executive in trust for the benefit of Company until Company and Executive reasonably agree that the provision thereof shall not cause Company to violate its Limitation Agreement, and if Company and Executive reasonably agree that the provision thereof would cause Company to violate its Limitation Agreement, Executive shall promptly return to Company such amount of such Total Cash Compensation as Company and Executive reasonably agree shall be necessary to prevent Company from violating the Limitation Agreement; it being the intent of the parties hereto that Executive shall not be provided Total Cash Compensation (as such term is defined in the Limitation Agreement) at any time during the Restricted Period that would cause Company to violate the Limitation Agreement. In no event shall Executive's obligations under this paragraph 3 extend beyond April 1, 2005. 4. Executive agrees that the vesting of such number of PARs as otherwise would vest during the Restricted Period shall be suspended, and such number of PARs shall instead vest on April 2, 2004. Executive further agrees not to redeem or otherwise dispose of vested PARs, in each case during the Restricted Period. Executive further agrees that Executive's restricted stock that is scheduled to vest on July 25, 2003 shall not vest, and that the vesting thereof shall be suspended, and that the number of shares that would have so vested shall instead vest on April 2, 2004. 5. Executive agrees to surrender without value his performance awards with respect to Company's Executive Bonus Performance Award Program and Company's special bonus program for key management, each with respect to 2003, and his performance award with respect to the performance period ending December 31, 2003 under Company's Long-Term Incentive Performance Award Program (and, if reasonably determined by Company and Executive to be necessary to permit Company to comply with the Limitation Agreement, all of Executive's other performance awards currently outstanding under Company's Long-Term Incentive Performance Award Program), and agrees that Executive shall receive no awards under any such programs or under Company's Officer Retention and Incentive Award Program during the Restricted Period. 6. Executive agrees that Company may take (and upon request of Company, Executive shall take) such other action with respect to his Total Cash Compensation (as such term is defined in the Limitation Agreement) provided to him by Company during the Restricted Period (including restricting, suspending or eliminating perquisites or other financial benefits), as Company and Executive reasonably agree to be necessary in order to permit Company to comply with its Limitation Agreement. 7. Notwithstanding the foregoing and notwithstanding anything to the contrary in this Agreement, Executive expressly does not waive any rights he has upon a termination of employment (whether by Company or by Executive) for any reason (including, without limitation, his right to receive his Existing Severance (as such term is defined in Executive's Employment Agreement) upon any termination of his employment with Company), or upon his retirement, or upon a Change in Control of Company (as defined in Company's Incentive Plan 2000, as amended), which rights arise under his Employment Agreement or any other agreement governing Executive's compensation or other benefits or otherwise, and Company expressly agrees that such rights shall not be affected by this Agreement, even if the enforcement of such rights by Executive would cause Company to violate the Limitation Agreement. 8. Executive agrees that no action taken by Company in compliance with this Agreement shall give rise to a breach of Executive's Employment Agreement or any other agreement governing Executive's compensation or other benefits, and that such Employment Agreement and each other such agreement shall be deemed amended by this Agreement, and Company agrees that such Employment Agreement and each other such agreement, as amended hereby, shall remain in full force and effect in accordance with their respective terms and are hereby expressly ratified and confirmed. 9. The parties agree that this Agreement constitutes the entire agreement between the parties with respect to the subject matter hereof, and supersedes any other prior agreement, written or oral, between the parties with respect thereto. This Agreement is governed by the laws of the State of Texas, may not be amended or waived except in a writing signed by both parties hereto, and shall be binding on the parties' respective successors, assigns, heirs, executors or administrators. IN WITNESS WHEREOF, the parties, thereunto duly authorized, have executed this Agreement as of the date first above mentioned. By:__________________________ This Compensation Cap Agreement (this "Agreement") is entered into as of May 19, 2003 between Lawrence W. Kellner ("Executive") and Continental Airlines, Inc., a Delaware corporation ("Company"). Executive agrees that Company (including all of its holding companies, subsidiaries and affiliated entities) shall not provide to him Total Cash Compensation (as such term is defined in the Limitation Agreement) during the 12-month period beginning April 1, 2003 (the "Restricted Period") in an amount equal to more than the annual Salary (as such term is defined in the Limitation Agreement) paid to Executive with respect to Company's fiscal year 2002. Such annual Salary is $730,000. 7. Notwithstanding the foregoing and notwithstanding anything to the contrary in this Agreement, Executive expressly does not waive any rights he has upon a termination of employment (whether by Company or by Executive) for any reason, or upon his retirement, or upon a Change in Control of Company (as defined in Company's Incentive Plan 2000, as amended), which rights arise under his Employment Agreement or any other agreement governing Executive's compensation or other benefits or otherwise, and Company expressly agrees that such rights shall not be affected by this Agreement, even if the enforcement of such rights by Executive would cause Company to violate the Limitation Agreement. THIS SUPPLEMENTAL AGREEMENT SHALL NOT BE BINDING UPON THE PORT AUTHORITY UNTIL DULY EXECUTED BY AN EXECUTIVE OFFICER THEREOF AND DELIVERED TO THE LESSEE BY AN AUTHORIZED REPRESENTATIVE OF THE PORT AUTHORITY Newark International Airport Port Authority Lease No. ANA-170 Supplement No. 19 SUPPLEMENTAL AGREEMENT THIS SUPPLEMENTAL AGREEMENT (hereinafter sometimes referred to as "Supplement No. 19" or the "Supplemental Agreement") made as of the 1st day of June, 2003, by and between THE PORT AUTHORITY OF NEW YORK AND NEW JERSEY (hereinafter called the "Port Authority") and CONTINENTAL AIRLINES, INC. (hereinafter called the "Lessee"); WITNESSETH, That: WHEREAS, the Port Authority and People Express Airlines, Inc. as of January 11, 1985 entered into an agreement of lease covering certain premises, rights and privileges at and in respect to Newark International Airport (hereinafter called the "Airport") as therein set forth (said agreement of lease as heretofore supplemented and amended is hereinafter called the "Lease"); and WHEREAS, the Lease was thereafter assigned by said People Express Airlines, Inc. to the Lessee pursuant to an Assignment of Lease with Assumption and Consent Agreement entered into among the Port Authority, the Lessee and said People Express Airlines, Inc. and dated August 15, 1987; and WHEREAS, a certain Stipulation between the parties hereto was submitted for approval of the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court") covering the Lessee's assumption of the Lease as part of the confirmation of its reorganization plan in its Chapter 11 bankruptcy proceedings and as debtor in possession pursuant to the applicable provisions of the United States Bankruptcy Code as set forth in and subject to the terms and conditions of said Stipulation (said Stipulation being hereinafter referred to as the "Stipulation"); and WHEREAS, the Stipulation and the Lessee's assumption of the Lease was approved by the Bankruptcy Court by an Order thereof dated the 1st day of October, 1993; and WHEREAS the Port Authority and the Lessee desire to further amend the Lease in certain respects as hereinafter set forth; NOW, THEREFORE, for and in consideration of the covenants and mutual agreements herein contained, the Port Authority and the Lessee hereby agree, effective as of the date set forth above, as follows: 1. For purposes of this Supplement No. 19, the capitalized words and phrases in this Paragraph, shall have the meanings given to those terms herein and capitalized terms and phrases not defined in this Paragraph shall have the meanings ascribed to them in Section 96 of Supplement No. 17 of the Lease. "Bond Resolution" shall mean the resolutions adopted by the NJEDA on December 8, 1998, July 13, 1999 and August 13, 2002 as the same may be modified or amended, authorizing the issuance and sale of the initial series of Bonds and additional Bonds, Series 2003. "Financing Documents" shall mean all the agreements and documents which are related to or are part of the Financing Transaction including but not limited to the NJEDA Sublease Agreement, the Indenture, the Bonds, the Bond Resolution, the Lessee Guaranty, the Leasehold Mortgage, and the other documents as described in paragraph 1(j) of the Port Authority Consent to NJEDA Subleases as amended by the First Amendment To Consent To Subleases and Leasehold Mortgage Agreement (but such term shall not include the Basic Lease, the Supplement No. 17, this Supplement No. 19, the Port Authority Consent to NJEDA Sublease, as amended, or the Other Lease). "Indenture" shall mean that certain Indenture of Trust dated as of September 1, 1999, as amended by the First Supplement to Trust Indenture dated as of February 1, 2002 and the Second Supplement to Trust Indenture dated as of June 1, 2003, and each entered into between the NJEDA and the Trustee with respect to the Bonds. "Lessee Guaranty" shall mean that certain agreement of guaranty dated as of September 1, 1999 entered into between the Lessee and the Trustee, as amended, pursuant to which the Lessee guarantees the payment of the principal of, redemption premium, if any, and interest on the Bonds. "NJEDA Sublease Agreement" shall mean that certain agreement dated as of September 1, 1999, as amended by the First Amendment to NJEDA Sublease Agreement dated as of June 1, 2003, and each entered into between the Lessee and the NJEDA whereby (i) the Lessee subleases the Mortgaged Premises to the NJEDA and (ii) the NJEDA sub-sub-subleases the Mortgaged Properties back to the Lessee subject to the Port Authority Consent to NJEDA Sublease Agreement, as amended by the First Amendment to Consent to Subleases and Leasehold Mortgage Agreement dated as of June 1, 2003 ((i) and (ii) collectively, "NJEDA Subleases"). 2. Except as hereby amended, all of the terms, covenants, provisions, conditions and agreements of the Lease shall be and remain in full force and effect. 3. Each party represents and warrants that no broker has been concerned in the negotiation of this Supplemental Agreement and that there is no broker who is or may be entitled to be paid a commission in connection therewith. Each party shall indemnify and save harmless the other party of and from all claims for commission or brokerage made by any and all persons, firms or corporations whatsoever for services provided to or on behalf of the indemnifying party in connection with the negotiation and execution of this Supplemental Agreement or the extension hereunder. 4. No Commissioner, director, officer, agent or employee of either party to this Supplemental Agreement, shall be charged personally or held contractually liable by or to the other party under any term or provision of this Supplemental Agreement, or because of its or their execution or attempted execution or because of any breach or attempted or alleged breach thereof. The Lessee agrees that no representations or warranties with respect to this Supplemental Agreement shall be binding upon the Port Authority unless expressed in writing herein. 5. This Supplemental Agreement, together with the Lease which it amends constitutes the entire agreement between the Port Authority and the Lessee on the subject matter, and may not be changed, modified, discharged or extended except by instrument in writing duly executed on behalf of both the Port Authority and the Lessee. The Lessee agrees that no representations or warranties shall be binding upon the Port Authority unless expressed in writing in the Lease or this Supplemental Agreement. IN WITNESS WHEREOF, the Port Authority and the Lessee have executed these presents as of the date first above written. ATTEST: THE PORT AUTHORITY OF NEW YORK AND NEW JERSEY ______________________ By:____________________________ (Title)__________________________ (Seal) ATTEST: CONTINENTAL AIRLINES, INC. ______________________ By (Title) President (Corporate Seal) For The Port Authority of NY & NJ STATE OF NEW YORK ) ) ss. COUNTY OF NEW YORK ) On the 10th day of June in the year 2003, before me, the undersigned, a Notary Public in and for said state, personally appeared Francis A. Dimola, personally known to me or proved to me on the basis of satisfactory evidence to be the individual(s) whose name(s) is (are) subscribed to the within instrument and acknowledged to me that he/she/they executed the same in his/her/their capacity(ies), and that by his/her/their signature(s) on the instrument, the individual(s), or the person upon behalf of which the individual(s) acted, executed the instrument. (Notarial seal and stamp) For Continental Airlines, Inc. STATE OF ) COUNTY OF ) On this 6th day of June, 2003, before me, the subscriber, a notary public of , personally appeared Holden Shannon the Vice President of Corporate Real Estate and Environmental Affairs signed the within instrument; and I having first made known to him the contents thereof, he did acknowledge that he signed, sealed with the corporate seal and delivered the same as such officer aforesaid and that the within instrument is the voluntary act and deed of such corporation, made by virtue of the authority of the Board of Directors. Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (Subsections (a) and (b) of Section 1350, Chapter 63 of Title 18, United States Code) Pursuant to section 906 of The Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350, chapter 63 of title 18, United States Code), each of the undersigned officers of Continental Airlines, Inc., a Delaware corporation (the "Company"), does hereby certify, to such officer's knowledge, that: The Quarterly Report on Form 10-Q for the quarter ended June 30, 2003 (the "Form 10-Q") of the Company fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 and information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of the Company.

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professional_accounting

current yield Main Page: money, business, investment, credit, payroll, inventory, stock trading, finance, Definition of current yield Annual coupon payments divided by bond price. For bonds or notes, the coupon rate divided by the market price of the bond. The percentage return on a financial asset based on the current price of the asset, without reference to any expected change in the price of the asset. This contrasts with yield-to-maturity, for which the calculation includes expected price changes. See also yield. The interest rate that makes the present value of a stream of future payments associated with an asset equal to the current price of that asset. Also called yield to maturity. See also current yield. Annual percentage yield (APY) The effective, or true, annual rate of return. The APY is the rate actually earned or paid in one year, taking into account the affect of compounding. The APY is calculated by taking one plus the periodic rate and raising it to the number of periods in a year. For example, a 1% per month rate has an APY of 12.68% (1.01^12). Bond equivalent yield Bond yield calculated on an annual percentage rate method. Differs from annual effective yield. Bond-equivalent yield The annualized yield to maturity computed by doubling the semiannual yield. Bond yield calculated on an annual percentage rate method Capital gains yield The price change portion of a stock's return. concurrent engineering see simultaneous engineering Convenience yield The extra advantage that firms derive from holding the commodity rather than the future. Coupon equivalent yield True interest cost expressed on the basis of a 365-day year. Net flow of goods, services, and unilateral transactions (gifts) between countries. That part of the balance of payments accounts that records demands for and supplies of a currency arising from activities that affect current income, namely imports, exports, investment income payments such as interest and dividends, and transfers such as gifts, pensions, and foreign aid. Current asset Typically the cash, accounts receivable, and inventory accounts on the balance sheet, or any other assets that are expected to be liquidated within a short time interval. Value of cash, accounts receivable, inventories, marketable securities and other assets that could be converted to cash in less than 1 year. Cash, things that will be converted into cash within a year (such as accounts receivable), and inventory. Amounts receivable by the business within a period of 12 months, including bank, debtors, inventory and prepayments. current refers to cash and those assets that will be turned into cash in the short run. Five types of assets are classified as current: cash, short-term marketable investments, accounts receivable, inventories, and prepaid expenses—and they are generally listed in this order in the balance sheet. Cash and other company assets that can be readily turned into cash within one year. Current cost Under target costing concepts, this is the cost that would be applied to a new product design if no additional steps were taken to reduce costs, such as through value engineering or kaizen costing. Under traditional costing concepts, this is the cost of manufacturing a product with work methods, materials, and specifications currently in use. A bond selling at or close to par, that is, a bond with a coupon close to the yields currently offered on new bonds of a similar maturity and credit risk. Current-coupon issues Related: Benchmark issues A variable like GDP is measured in current dollars if each year's value is measured in prices prevailing during that year. In contrast, when measured in real or constant dollars, each year's value is measured in a base year's prices. In Treasury securities, the most recently auctioned issue. Trading is more active in current issues than in off-the-run issues. Amount owed for salaries, interest, accounts payable and other debts due within 1 year. Bills a company must pay within the next twelve months. Amounts due and payable by the business within a period of 12 months, e.g. bank overdraft, creditors and accruals. current means that these liabilities require payment in the near term. Generally, these include accounts payable, accrued expenses payable, income tax payable, short-term notes payable, and the portion of long-term debt that will come due during the coming year. Keep in mind that a business may roll over its debt; the old, maturing debt may be replaced in part or in whole by new borrowing. Debts or other obligations coming due within a year. Current liability This is typically the accounts payable, short-term notes payable, and accrued expense accounts on the balance sheet, or any other liabilities that are expected to be liquidated within a short time interval. Current maturity current time to maturity on an outstanding debt instrument. current / noncurrent method Under this currency translation method, all of a foreign subsidiary's current assets and liabilities are translated into home currency at the current exchange rate while noncurrent assets and liabilities are translated at the historical exchange rate, that is, the rate in effect at the time the asset was acquired or the liability incurred. Current rate method Under this currency translation method, all foreign currency balance-sheet and income statement items are translated at the current exchange rate. Indicator of short-term debt paying ability. Determined by dividing current assets by current liabilities. The higher the ratio, the more liquid the company. A ratio that shows how many times a company could pay its current debts if it used its current assets to pay them. The formula: (current assets) / (current liabilities) Calculated to assess the short-term solvency, or debt-paying ability of a business, it equals total current assets divided by total current liabilities. Some businesses remain solvent with a relatively low current ratio; others could be in trouble with an apparently good current ratio. The general rule is that the current ratio should be 2:1 or higher, but please take this with a grain of salt, because current ratios vary widely from industry to industry. A measure of the ability of a company to use its current assets to pay its current liabilities. It is calculated by dividing the total current assets by the total current liabilities. current assets divided by current liabilities. This ratio indicates the extent to which the claims of short-term creditors are covered by assets expected to be converted to cash in the near future. Dividend yield (Funds) Indicated yield represents return on a share of a mutual fund held over the past 12 months. Assumes fund was purchased 1 year ago. Reflects effect of sales charges (at current rates), but not redemption charges. Cash dividends paid by a business over the most recent 12 months (called the trailing 12 months) divided by the current market price per share of the stock. This ratio is reported in the daily stock trading tables in the Wall Street Journal and other major newspapers. Dividend yield (Stocks) Indicated yield represents annual dividends divided by current stock price. Earnings yield The ratio of earnings per share after allowing for tax and interest payments on fixed interest debt, to the current share price. The inverse of the price/earnings ratio. It's the Total Twelve Months earnings divided by number of outstanding shares, divided by the recent price, multiplied by 100. The end result is shown in percentage. Effective annual yield Annualized interest rate on a security computed using compound interest techniques. Annualized rate of return on a security computed using compound interest techniques Equivalent bond yield Annual yield on a short-term, non-interest bearing security calculated so as to be comparable to yields quoted on coupon securities. Flattening of the yield curve A change in the yield curve where the spread between the yield on a long-term and short-term Treasury has decreased. Compare steepening of the yield curve and butterfly shift. High-yield bond See:junk bond. Indicated yield The yield, based on the most recent quarterly rate times four. To determine the yield, divide the annual dividend by the price of the stock. The resulting number is represented as a percentage. See: dividend yield. labor yield variance (standard mix X actual hours X standard rate) - (standard mix X standard hours X standard rate); it shows the monetary impact of using more or fewer total hours than the standard allowed Liquid yield option note (LYON) Zero-coupon, callable, putable, convertible bond invented by Merrill Zero-coupon, callable, putable, convertible bond invented by Merrill Lynch & Co. material yield variance (standard mix X actual quantity X standard price) - (standard mix X standard quantity X standard price); it computes the difference between the actual total quantity of input and the standard total quantity allowed based on output and uses standard mix and standard prices to determine variance Non-parallel shift in the yield curve A shift in the yield curve in which yields do not change by the same number of basis points for every maturity. Related: Parallel shift in the yield curve. Value of non-cash assets, including prepaid expenses and accounts receivable, due within 1 year. Par yield curve The yield curve of bonds selling at par, or face, value. Parallel shift in the yield curve A shift in the yield curve in which the change in the yield on all maturities is the same number of basis points. In other words, if the 3 month T-bill increases 100 basis points (one percent), then the 6 month, 1 year, 5 year, 10 year, 20 year, and 30 year rates increase by 100 basis points as Related: Non-parallel shift in the yield curve. process quality yield the proportion of good units that resulted from the activities expended Production yield variance The difference between the actual and budgeted proportions of product resulting from a production process, multiplied by the standard unit cost. Pure yield pickup swap Moving to higher yield bonds. Realized compound yield yield assuming that coupon payments are invested at the going market interest rate at the time of their receipt and rolled over until the bond matures. Relative yield spread The ratio of the yield spread to the yield level. Reoffering yield In a purchase and sale, the yield to maturity at which the underwriter offers to sell the bonds to investors. Required yield Generally referring to bonds, the yield required by the marketplace to match available returns for financial instruments with comparable risk. Riding the yield curve Buying long-term bonds in anticipation of capital gains as yields fall with the declining maturity of the bonds. Spot curve, spot yield curve See Zero curve. Steepening of the yield curve and short-term Treasury has increased. Compare flattening of the yield curve and butterfly shift. Weighted average portfolio yield The weighted average of the yield of all the bonds in a portfolio. The percentage rate of return paid on a stock in the form of dividends, or the effective rate of interest paid on a bond or note. the quantity of output that results from a specified input a. Measure of return on an investment, stated as a percentage of price. yield can be computed by dividing return by purchase price, current market value, or other measure of value. b. Income from a bond expressed as an annualized percentage rate. c. The nominal annual interest rate that gives a future value of the purchase price equal to the redemption value of the security. Any coupon payments determine part of that yield. The graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities. Related: Term structure of interest rates. Harvey (1991) finds that the inversions of the yield curve (short-term rates greater than long term rates) have preceded the last five U.S. recessions. The yield curve can accurately forecast the turning points of the business cycle. A graphical representation of the level of interest rates for securities of differing maturities at a specific point of time Graph of yields (vertical axis) of a particular type of security versus the time to maturity (horizontal axis). This curve usually slopes upward, indicating that investors usually expect to receive a premium for securities that have a longer time to maturity. The benchmark yield curve is for U.S. Treasury securities with maturities ranging from three months to 30 years. See Term structure. Graph of the relationship between time to maturity and yield to maturity. A graph showing how the yield on bonds varies with time to maturity. Yield curve option-pricing models Models that can incorporate different volatility assumptions along the yield curve, such as the Black-Derman-Toy model. Also called arbitrage-free option-pricing models. Yield curve strategies Positioning a portfolio to capitalize on expected changes in the shape of the Treasury yield curve. Yield ratio The quotient of two bond yields. the expected or actual relationship between input and output Yield spread strategies Strategies that involve positioning a portfolio to capitalize on expected changes in yield spreads between sectors of the bond market. The percentage rate of a bond or note, if you were to buy and hold the security until the call date. This yield is valid only if the security is called prior to maturity. Generally bonds are callable over several years and normally are called at a slight premium. The calculation of yield to call is based on the coupon rate, length of time to the call and the market price. The percentage rate of return paid on a bond, note or other fixed income security if you buy and hold it to its maturity date. The calculation for YTM is based on the coupon rate, length of time to maturity and market price. It assumes that coupon interest paid over the life of the bond will be reinvested at the same rate. The measure of the average rate of return that will be earned on a debt security held until it matures A measure of the average rate of return that will be earned on a bond if held to maturity. Interest rate for which the present value of the bond’s payments equals the price. Yield to worst The bond yield computed by using the lower of either the yield to maturity or the yield to call on every possible call date. Zero curve, zero-coupon yield curve A yield curve for zero-coupon bonds; zero rates versus maturity dates. Since the maturity and duration (Macaulay duration) are identical for zeros, the zero curve is a pure depiction of supply/ demand conditions for loanable funds across a continuum of durations and maturities. Also known as spot curve or spot yield curve. 1) When bond yields and prices fall, the market is said to back-up. 2) When an investor swaps out of one security into another of shorter current maturity he is said to back up.

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professional_accounting

Jack in the Box Inc. Reports First Quarter FY 2013 Earnings; Updates Guidance for FY 2013 Release9dc3c497-e62e-4bf9-a7d2-7f01118fc505_1787082.pdf 138.1 KB SAN DIEGO--(BUSINESS WIRE)--Feb. 20, 2013-- Jack in the Box Inc. (NASDAQ: JACK) today reported earnings from continuing operations of $23.9 million, or $0.54 per diluted share, for the first quarter ended January 20, 2013, compared with earnings from continuing operations of $12.0 million, or $0.27 per diluted share, for the first quarter of fiscal 2012. Operating earnings per share, a non-GAAP measure which the company defines as diluted earnings per share from continuing operations on a GAAP basis excluding restructuring charges and gains from refranchising, were $0.54 per share in the first quarter of fiscal 2013 compared with $0.25 per share in the prior year quarter. Gains from refranchising contributed approximately $0.01 per diluted share for the quarter as compared with approximately $0.02 per diluted share in the prior year quarter. A reconciliation of non-GAAP measurements to GAAP results is provided below with additional information included in the attachment to this release. Figures may not add due to rounding. 16 Weeks Ended 2013 January 22, Diluted earnings per share from continuing operations – GAAP $ 0.54 $ 0.27 Plus: Restructuring charges 0.01 − Less: Gains from refranchising (0.01 ) (0.02 ) Operating earnings per share – Non-GAAP $ 0.54 $ 0.25 During the first quarter of 2013, the company continued to review and refine its organization to create a structure that more efficiently supports its business model. As a result, restructuring charges of $0.8 million, or approximately $0.01 per diluted share, were recorded during the first quarter of 2013. These charges are included in “impairment and other charges, net” in the accompanying consolidated statements of earnings. As previously announced, during the fourth quarter of 2012, the company began outsourcing its distribution business, and the transition was completed in the first quarter of fiscal 2013. As a result of the outsourcing, the company recorded an after-tax charge totaling $3.3 million in the first quarter of fiscal 2013, which reduced diluted net earnings per share by approximately $0.07. This charge and the results of operations for the distribution business are included in discontinued operations in the accompanying consolidated statements of earnings for all periods presented. Increase in same-store sales: Jack in the Box®: Company 2.1 % 5.3 % Franchise 1.8 % 2.8 % System 1.9 % 3.6 % Qdoba®: Linda A. Lang, chairman and chief executive officer, said, “Jack in the Box company same-store sales increased 2.1 percent and system same-store sales increased 1.9 percent in the first quarter. Jack in the Box system same-store sales growth for the quarter exceeded that of the QSR sandwich segment for the comparable period, according to The NPD Group’s SalesTrack Weekly for the 16-week time period ended January 20, 2013. Included in this segment are the top 15 sandwich and QSR burger chain competitors. “Qdoba same-store sales in the first quarter increased 1.5 percent for company restaurants, driven by transaction and catering growth. One of our key priorities for 2013 is to drive traffic at Qdoba, and we believe our promotional efforts aimed at differentiating the brand resulted in the improvement in traffic and sales trends. “Numerous companies in both the restaurant and retail space have reported some weakening in sales in the last part of January and first half of February which has been attributed to higher payroll taxes, delayed tax refunds and the rapid increase in gas prices over the last month. Our sales guidance for the second quarter reflects the softness we’ve seen thus far in the quarter and the uncertainty surrounding consumer spending,” Lang said. Consolidated restaurant operating margin improved by 220 basis points to 15.7 percent of sales in the first quarter of 2013, compared with 13.5 percent of sales in the year-ago quarter. Restaurant operating margin increased 320 basis points to 17.1% of sales for Jack in the Box and decreased 40 basis points to 11.6% of sales for Qdoba. Food and packaging costs in the quarter were 130 basis points lower than prior year. The decrease resulted from the benefit of price increases, favorable product mix at Jack in the Box, and a greater proportion of Qdoba company restaurants which combined to more than offset slight commodity inflation and the impact of promotional activity at Qdoba. Overall commodity costs were up less than 1 percent in the quarter. Payroll and employee benefits costs were 40 basis points lower than the year-ago quarter, reflecting leverage from same-store sales increases, the favorable impact of recent acquisitions of Qdoba franchised restaurants, and a modest benefit from refranchising Jack in the Box restaurants. Occupancy and other costs decreased 50 basis points in the first quarter due primarily to leverage from same-store sales increases and the favorable impact of recent acquisitions of Qdoba franchised restaurants. SG&A expense for the first quarter increased by $1.6 million and was 14.5 percent of revenues as compared to 14.4 percent in the prior year quarter. Mark-to-market adjustments on investments supporting the company’s non-qualified retirement plans positively impacted SG&A by $1.3 million in the first quarter as compared to a positive impact of $3.2 million in last year’s first quarter, resulting in a year-over-year increase in SG&A of $1.9 million. The increase in SG&A was also due to higher incentive compensation, increased G&A related to Qdoba growth, and higher pension costs which were partially offset by the benefit of the company’s restructuring activities as well as lower advertising and overhead costs resulting from the Jack in the Box refranchising strategy. Impairment and other charges decreased $1.1 million in the quarter compared to a year ago primarily due to income of $2.1 million recognized in 2013 in connection with the resolution of two eminent domain matters involving Jack in the Box restaurants. Gains on the sale of company-operated Jack in the Box restaurants were $0.7 million in the 2013 quarter, or approximately $0.01 per diluted share, which primarily represented additional proceeds received as a result of the extension of underlying franchise and lease agreements for previously sold restaurants. This compares to gains of $1.1 million, or approximately $0.02 per diluted share, in the year-ago quarter. The tax rate for the first quarter of 2013 was 30.2 percent versus 34.3 percent for the first quarter of 2012. The lower tax rate in the first quarter of fiscal 2013 was due primarily to legislation that retroactively reinstated Work Opportunity Tax Credits, as well as the market performance of insurance investment products used to fund certain non-qualified retirement plans. Changes in the cash value of the insurance products are not deductible or taxable. The company now expects its full year tax rate to be approximately 35 to 36 percent as a result of the reinstated tax credits. The company repurchased approximately 985,000 shares of its common stock in the first quarter at an average price of $27.26 per share for an aggregate cost of $26.9 million, leaving $50 million remaining under a $100 million stock-buyback program authorized by the company’s board of directors that expires in November 2013, and $100 million remaining under an authorization that expires in November 2014. Nine new Jack in the Box restaurants opened in the first quarter of fiscal 2013, including six franchised locations, compared with 16 new restaurants opened system-wide during the same quarter last year, of which 11 were franchised. In the first quarter, 17 Qdoba restaurants opened, including 14 franchised locations, versus 15 new restaurants in the year-ago quarter, of which 9 were franchised. The company also acquired 6 Qdoba restaurants from franchisees in the quarter. At January 20, 2013, the company’s system total comprised 2,255 Jack in the Box restaurants, including 1,704 franchised locations, and 636 Qdoba restaurants, including 311 franchised locations. The following guidance and underlying assumptions reflect the company’s current expectations for the second quarter ending April 14, 2013, and the fiscal year ending September 29, 2013. Fiscal 2013 is a 52-week year, with 16 weeks in the first quarter, and 12 weeks in each of the second, third and fourth quarters. Second quarter fiscal year 2013 guidance Same-store sales are expected to be approximately flat at Jack in the Box company restaurants versus a 5.6 percent increase in the year-ago quarter. Same-store sales are expected to be flat to down 2 percent at Qdoba company restaurants versus a 3.8 percent increase in the year-ago quarter. Fiscal year 2013 guidance Same-store sales are expected to increase approximately 1.5 to 2.5 percent at Jack in the Box company restaurants. Same-store sales are expected to increase approximately 1.0 to 2.0 percent at Qdoba company restaurants. Overall commodity costs are expected to increase by approximately 2 to 3 percent for the full year. Restaurant operating margin for the full year is expected to range from approximately 15.5 to 16.0 percent, depending on same-store sales and commodity inflation. SG&A as a percentage of revenue is expected to be in the mid-14 percent range as compared to 14.7% in fiscal 2012. G&A as a percentage of system-wide sales is expected to decline to approximately 4.3% in fiscal 2013 from 4.6% in fiscal 2012. Impairment and other charges as a percentage of revenue are expected to be approximately 50 to 70 basis points, excluding restructuring charges. The company no longer provides guidance with respect to refranchising gains or proceeds. 20 to 25 new Jack in the Box restaurants are expected to open, including approximately 10 company locations. 70 to 85 new Qdoba restaurants are expected to open, of which approximately 40 to 45 are expected to be company locations. Capital expenditures are expected to be $95 to $105 million. The tax rate is expected to be approximately 35 to 36 percent. Operating earnings per share, which the company defines as diluted earnings per share from continuing operations on a GAAP basis excluding restructuring charges and gains from refranchising, are now expected to range from $1.48 to $1.63 in fiscal 2013 as compared to operating earnings per share of $1.20 in fiscal 2012. Diluted earnings per share includes approximately $0.04 of incentive payments to Jack in the Box franchisees in fiscal 2013 to complete the installation of new signage as compared to $0.11 in fiscal 2012 to complete the re-image program. The company will host a conference call for financial analysts and investors on Thursday, February 21, 2013, beginning at 8:30 a.m. PT (11:30 a.m. ET). The conference call will be broadcast live over the Internet via the Jack in the Box website. To access the live call through the Internet, log onto the Investors section of the Jack in the Box Inc. website at http://investors.jackinthebox.com at least 15 minutes prior to the event in order to download and install any necessary audio software. A replay of the call will be available through the Jack in the Box Inc. corporate website for 21 days, beginning at approximately 11:30 a.m. PT on February 21. Jack in the Box Inc. (NASDAQ: JACK), based in San Diego, is a restaurant company that operates and franchises Jack in the Box® restaurants, one of the nation’s largest hamburger chains, with more than 2,200 restaurants in 21 states. Additionally, through a wholly owned subsidiary, the company operates and franchises Qdoba Mexican Grill®, a leader in fast-casual dining, with more than 600 restaurants in 44 states, the District of Columbia and Canada. For more information on Jack in the Box and Qdoba, including franchising opportunities, visit www.jackinthebox.com or www.qdoba.com. This press release contains forward-looking statements within the meaning of the federal securities laws. Such statements are subject to substantial risks and uncertainties. A variety of factors could cause the company’s actual results to differ materially from those expressed in the forward-looking statements, including the following: the success of new products and marketing initiatives; the impact of competition, unemployment, trends in consumer spending patterns and commodity costs; the company’s ability to achieve and manage its planned expansion, such as the availability of a sufficient number of suitable new restaurant sites, the performance of new restaurants, and risks relating to expansion into new markets; and stock market volatility. These and other factors are discussed in the company’s annual report on Form 10-K and its periodic reports on Form 10-Q filed with the Securities and Exchange Commission which are available online at http://investors.jackinthebox.com or in hard copy upon request. The company undertakes no obligation to update or revise any forward-looking statement, whether as the result of new information or otherwise. JACK IN THE BOX INC. AND SUBSIDIARIES RECONCILIATION OF NON-GAAP MEASUREMENTS TO GAAP RESULTS Operating earnings per share, a non-GAAP measure, is defined by the company as diluted earnings per share from continuing operations on a GAAP basis excluding restructuring charges and gains from refranchising. Management believes this non-GAAP financial measure provides important supplemental information to assist investors in analyzing the performance of the company’s core business. In addition, the company uses operating earnings per share in establishing performance goals for purposes of executive compensation. The company encourages investors to rely upon its GAAP numbers but includes this non-GAAP financial measure as a supplemental metric to assist investors. This non-GAAP financial measure should not be considered as a substitute for, or superior to, financial measures calculated in accordance with GAAP. In addition, this non-GAAP financial measure used by the company may be calculated differently from, and therefore may not be comparable to, similarly titled measures used by other companies. Below is a reconciliation of non-GAAP operating earnings per share to the most directly comparable GAAP measure, diluted earnings per share from continuing operations. Figures may not add due to rounding. CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS Sixteen Weeks Ended Company restaurant sales $ 360,094 $ 364,102 Franchise revenues 105,429 93,819 Operating costs and expenses, net: Company restaurant costs: Food and packaging 116,101 122,107 Payroll and employee benefits 104,064 106,811 Occupancy and other 83,354 85,943 Total company restaurant costs 303,519 314,861 Franchise costs 52,488 49,859 Selling, general and administrative expenses 67,336 65,717 Impairment and other charges, net 3,263 4,351 Gains on the sale of company-operated restaurants (748 ) (1,122 ) Earnings from operations 39,665 24,255 Interest expense, net 5,365 6,057 Earnings from continuing operations and before income taxes 34,300 18,198 Income taxes 10,356 6,248 Earnings from continuing operations 23,944 11,950 Losses from discontinued operations, net of income tax benefit (3,255 ) Net earnings $ 20,689 $ 11,950 Net earnings per share - basic: Earnings from continuing operations $ 0.56 $ 0.27 Losses from discontinued operations (0.08 ) — Net earnings per share $ 0.48 $ 0.27 Net earnings per share - diluted: Weighted-average shares outstanding: Basic 42,997 43,863 Diluted 44,356 44,659 (Dollars in thousands, except share data) Cash and cash equivalents $ 9,542 $ 8,469 Accounts and other receivables, net 40,489 78,798 Inventories 8,235 7,752 Prepaid expenses 20,543 32,821 Deferred income taxes 26,931 26,932 Assets held for sale and leaseback 44,847 45,443 Assets of discontinued operations held for sale — 30,591 Other current assets 671 375 Total current assets 151,258 231,181 Property and equipment, at cost 1,528,889 1,529,650 Less accumulated depreciation and amortization (729,755 ) (708,858 ) Property and equipment, net 799,134 820,792 Goodwill 147,283 140,622 Other assets, net 279,614 271,130 $ 1,377,289 $ 1,463,725 Current maturities of long-term debt $ 20,976 $ 15,952 Accounts payable 38,231 94,713 Accrued liabilities 150,579 164,637 Total current liabilities 209,786 275,302 Long-term debt, net of current maturities 374,947 405,276 Other long-term liabilities 367,387 371,202 Preferred stock $0.01 par value, 15,000,000 shares authorized, none issued — — Common stock $0.01 par value, 175,000,000 shares authorized, 76,427,051 and 75,827,894 issued, respectively Capital in excess of par value 236,672 221,100 Retained earnings 1,141,360 1,120,671 Accumulated other comprehensive loss (132,168 ) (136,013 ) Treasury stock, at cost, 32,941,042 and 31,955,606 shares, respectively (821,459 ) (794,571 ) Total stockholders’ equity 425,169 411,945 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 30,016 29,534 Deferred finance cost amortization 729 788 Deferred income taxes (1,370 ) (1,203 ) Share-based compensation expense 4,062 2,022 Pension and postretirement expense 9,584 8,212 Gains on cash surrender value of company-owned life insurance (2,836 ) (6,742 ) (Gains) losses on the disposition of property and equipment (832 ) 1,083 Impairment charges and other 4,458 1,199 Loss on early retirement of debt 939 — Changes in assets and liabilities, excluding acquisitions and dispositions: Accounts and other receivables 38,766 8,630 Inventories 26,361 (6,462 ) Prepaid expenses and other current assets 11,980 (1,412 ) Accounts payable (33,966 ) 2,222 Accrued liabilities (9,141 ) (21,849 ) Pension and postretirement contributions (5,525 ) (996 ) Other (3,201 ) 1,938 Cash flows provided by operating activities 89,965 27,792 Purchases of property and equipment (21,394 ) (26,945 ) Purchases of assets intended for sale and leaseback (13,357 ) (11,046 ) Proceeds from sale and leaseback of assets 13,513 3,143 Proceeds from the sale of company-operated restaurants 833 1,249 Collections on notes receivable 1,848 3,539 Disbursements for loans to franchisees — (2,604 ) Acquisitions of franchise-operated restaurants (7,800 ) (6,195 ) Other 2,042 14 Cash flows used in investing activities (24,315 ) (38,845 ) Borrowings on revolving credit facilities 385,148 222,020 Repayments of borrowings on revolving credit facilities (445,148 ) (191,295 ) Proceeds from issuance of debt 200,000 — Principal repayments on debt (165,305 ) (5,380 ) Debt issuance costs (4,386 ) — Proceeds from issuance of common stock 10,733 785 Repurchases of common stock (26,888 ) (6,901 ) Excess tax benefits from share-based compensation arrangements 675 191 Change in book overdraft (19,406 ) (6,147 ) Cash flows provided by (used in) financing activities (64,577 ) 13,273 Net increase in cash and cash equivalents 1,073 2,220 Cash and cash equivalents at beginning of period 8,469 11,424 Cash and cash equivalents at end of period $ 9,542 $ 13,644 The following table presents certain income and expense items included in our consolidated statements of earnings as a percentage of total revenues, unless otherwise indicated. Percentages may not add due to rounding. CONSOLIDATED STATEMENTS OF EARNINGS DATA Company restaurant sales Franchise revenues Food and packaging(1) Payroll and employee benefits(1) Occupancy and other(1) Total company restaurant costs(1) Franchise costs(1) Impairment and other charges, net Gains on the sale of company-operated restaurants (0.2 )% (0.2 )% Earnings from operations Income tax rate(2) As a percentage of the related sales and/or revenues. As a percentage of earnings from continuing operations and before income taxes. The following table presents Jack in the Box and Qdoba company restaurant sales, costs and costs as a percentage of the related sales. Percentages may not add due to rounding. SUPPLEMENTAL COMPANY-OPERATED RESTAURANTS STATEMENTS OF EARNINGS DATA Jack in the Box: Food and packaging 87,798 Payroll and employee benefits 77,002 Occupancy and other 56,588 Total company restaurant costs $ 221,388 Qdoba: Company restaurant sales $ 92,918 $ 69,749 Total company restaurant costs $ 82,131 The following table summarizes the changes in the number and mix of Jack in the Box and Qdoba company and franchise restaurants in each fiscal year: Company Franchise Total Company Franchise Total Beginning of year 547 1,703 2,250 629 1,592 2,221 New 3 6 9 5 11 16 Acquired from franchisees 1 (1 ) — — — — Closed — (4 ) (4 ) — (1 ) (1 ) End of period 551 1,704 2,255 634 1,602 2,236 % of Jack in the Box system 24 % 76 % 100 % 28 % 72 % 100 % % of consolidated system 63 % 85 % 78 % 71 % 83 % 79 % Beginning of year 316 311 627 245 338 583 New 3 14 17 6 9 15 Acquired from franchisees 6 (6 ) — 11 (11 ) — End of period 325 311 636 262 335 597 % of Qdoba system 51 % 49 % 100 % 44 % 56 % 100 % Consolidated: Total system 876 2,015 2,891 896 1,937 2,833 % of consolidated system 30 % 70 % 100 % 32 % 68 % 100 %

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Internal Revenue Bulletin: 2008-14 Highlights of This Issue EMPLOYEE PLANS The IRS Mission Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986 T.D. 9381 Rev. Rul. 2008-20 Part III. Administrative, Procedural, and Miscellaneous Notice 2008-40 Part IV. Items of General Interest REG-153589-06 Announcement 2008-23 Definition of Terms and Abbreviations Numerical Finding List Effect of Current Actions on Previously Published Items Finding List of Current Actions on Previously Published Items How to get the Internal Revenue Bulletin INTERNAL REVENUE BULLETIN CUMULATIVE BULLETINS ACCESS THE INTERNAL REVENUE BULLETIN ON THE INTERNET INTERNAL REVENUE BULLETINS ON CD-ROM We Welcome Comments About the Internal Revenue Bulletin These synopses are intended only as aids to the reader in identifying the subject matter covered. They may not be relied upon as authoritative interpretations. Rev. Rul. 2008-20 Rev. Rul. 2008-20 Federal rates; adjusted federal rates; adjusted federal long-term rate and the long-term exempt rate. For purposes of sections 382, 642, 1274, 1288, and other sections of the Code, tables set forth the rates for April 2008. T.D. 9378 T.D. 9378 Final regulations under section 6325 of the Code outline specific procedures for obtaining a release of a federal tax lien or a discharge of a federal tax lien from property to which it has attached. The regulations incorporate changes to the Code that were made by the IRS Restructuring and Reform Act of 1998, which afford a means for a person whose property is encumbered by a federal tax lien, but who does not owe the tax giving rise to the lien, to have his property discharged from the lien. Temporary and proposed regulations under section 1221 of the Code provide the time and manner for making an election to treat the sale or exchange of musical compositions or copyrights in musical works created by the taxpayer as the sale or exchange of a capital asset. REG-153589-06 REG-153589-06 Final regulations under section 199 of the Code concern the amendments made by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) to section 199, which provides a deduction for income attributable to domestic production activities. Notice 2008-40 Notice 2008-40 Amplification of Notice 2006-52; Deduction for Energy Efficient Commercial Buildings. This notice sets forth additional guidance relating to the deduction for energy efficient commercial buildings under section 179D of the Code and is intended to be used with Notice 2006-52. Several aspects of the deduction for energy efficient commercial buildings were not addressed in Notice 2006-52. This notice addresses some of these items including the allocation of the section 179D deduction to designers of government owned buildings, certification requirements for the interim lighting rule, and the application of the interim lighting rule to unconditioned garage space. Notice 2006-52 clarified and amplified. Announcement 2008-25 Announcement 2008-25 This document withdraws a portion of proposed regulations (REG-107592-00, 2007-44 I.R.B. 908) under the consolidated return regulations. The withdrawn portion relates to the treatment of transactions involving the provision of insurance between members of a consolidated group. Pre-approved defined contribution master and prototype and volume submitter plans; issuance of EGTRRA opinion and advisory letters. This announcement states that the Service will soon issue opinion and advisory letters for pre-approved, i.e., master and prototype and volume submitter defined contribution plans that were timely filed with the Service to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and other changes in plan qualification requirements listed in Notice 2004-84, 2004-2 C.B. 1030. A list is provided of organizations now classified as private foundations. Final regulations under section 6020 of the Code relate to returns prepared or signed by the Commissioner or other Internal Revenue Officers or employees. The regulations provide guidance for preparing a substitute for return under section 6020(b). Absent the existence of a return under section 6020(b), the addition to tax under section 6651(a)(2) does not apply to a nonfiler. The regulations affect any person who fails to file a required return. Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conventions, legislation, court decisions, and other items of general interest. It is published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bulletin contents are compiled semiannually into Cumulative Bulletins, which are sold on a single-copy basis. It is the policy of the Service to publish in the Bulletin all substantive rulings necessary to promote a uniform application of the tax laws, including all rulings that supersede, revoke, modify, or amend any of those previously published in the Bulletin. All published rulings apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management are not published; however, statements of internal practices and procedures that affect the rights and duties of taxpayers are published. Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts stated in the revenue ruling. In those based on positions taken in rulings to taxpayers or technical advice to Service field offices, identifying details and information of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory requirements. Rulings and procedures reported in the Bulletin do not have the force and effect of Treasury Department Regulations, but they may be used as precedents. Unpublished rulings will not be relied on, used, or cited as precedents by Service personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances are substantially the same. The Bulletin is divided into four parts as follows: Part I.—1986 Code. This part includes rulings and decisions based on provisions of the Internal Revenue Code of 1986. Part II.—Treaties and Tax Legislation. This part is divided into two subparts as follows: Subpart A, Tax Conventions and Other Related Items, and Subpart B, Legislation and Related Committee Reports. Part III.—Administrative, Procedural, and Miscellaneous. To the extent practicable, pertinent cross references to these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rulings. Bank Secrecy Act Administrative Rulings are issued by the Department of the Treasury’s Office of the Assistant Secretary (Enforcement). Part IV.—Items of General Interest. This part includes notices of proposed rulemakings, disbarment and suspension lists, and announcements. The last Bulletin for each month includes a cumulative index for the matters published during the preceding months. These monthly indexes are cumulated on a semiannual basis, and are published in the last Bulletin of each semiannual period. Part I. Rulings and Decisions Under the Internal Revenue Code of 1986 TIPRA Amendments to Section 199 26 CFR Part 1 Internal Revenue Service (IRS), Treasury. Final regulations. This document contains final regulations concerning the amendments made by the Tax Increase Prevention and Reconciliation Act of 2005 to section 199 of the Internal Revenue Code. The final regulations also contain a rule concerning the use of losses incurred by members of an expanded affiliated group. Section 199 provides a deduction for income attributable to domestic production activities. The final regulations affect taxpayers engaged in certain domestic production activities. Effective Date: These regulations are effective on February 15, 2008. Applicability Date: For dates of applicability, see §1.199-8(i)(5) and (6). Concerning §§1.199-2(e)(2) and 1.199-8(i)(5), Paul Handleman or David McDonnell, (202) 622-3040; concerning §§1.199-3(i)(7) and (8), and 1.199-5, William Kostak, (202) 622-3060; and concerning §§1.199-7(b)(4) and 1.199-8(i)(6), Ken Cohen, (202) 622-7790 (not toll-free numbers). This document provides rules relating to the deduction for income attributable to domestic production activities under section 199 of the Internal Revenue Code (Code). Section 199 was added to the Code by section 102 of the American Jobs Creation Act of 2004 (Public Law 108-357, 118 Stat. 1418), and amended by section 403(a) of the Gulf Opportunity Zone Act of 2005 (Public Law 109-135, 119 Stat. 25), section 514 of the Tax Increase Prevention and Reconciliation Act of 2005 (Public Law 109-222, 120 Stat. 345) (TIPRA), and section 401 of the Tax Relief and Health Care Act of 2006 (Public Law 109-432, 120 Stat. 2922). On June 1, 2006, the IRS and Treasury Department published final regulations under section 199 (T.D. 9263, 2006-1 C.B. 1063 [71 FR 31268]). On October 19, 2006, the IRS and Treasury Department published final and temporary regulations on the TIPRA amendments to section 199 (T.D. 9293, 2006-2 C.B. 957 [71 FR 61662]) and cross-referencing proposed regulations (REG-127819-06, 2006-2 C.B. 1013 [71 FR 61692]). No public hearing was requested or held on the proposed regulations. One comment responding to the proposed regulations was received. After consideration of the comment, the proposed regulations are adopted as amended by this Treasury decision and the corresponding temporary regulations are removed. Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)). Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. For this purpose, section 199(b)(2)(A) defines the term W-2 wages to mean, with respect to any person for any taxable year of such person, the sum of the amounts described in section 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. Section 514(a) of TIPRA added new section 199(b)(2)(B), which provides that the term W-2 wages does not include any amount which is not properly allocable to domestic production gross receipts (DPGR) for purposes of section 199(c)(1). Section 199(b)(2)(C) provides that the term W-2 wages does not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return. Pass-thru Entities Section 199(d)(1)(A) provides that, in the case of a partnership or S corporation, (i) section 199 shall be applied at the partner or shareholder level, (ii) each partner or shareholder shall take into account such person’s allocable share of each item described in section 199(c)(1)(A) or (B) (determined without regard to whether the items described in section 199(c)(1)(A) exceed the items described in section 199(c)(1)(B)), and (iii) each partner or shareholder shall be treated for purposes of section 199(b) as having W-2 wages for the taxable year in an amount equal to such person’s allocable share of the W-2 wages of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary). Section 199(d)(1)(B) provides that, in the case of a trust or estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as determined therein) and the W-2 wages of the trust or estate for the taxable year shall be apportioned between the beneficiaries and the fiduciary (and among the beneficiaries) under regulations prescribed by the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the trust or estate shall be determined as provided in section 67(e) with the adjustments described in such section. Section 199(d)(1)(C) provides that the Secretary may prescribe rules requiring or restricting the allocation of items and wages under section 199(d)(1) and may prescribe such reporting requirements as the Secretary determines appropriate. Expanded Affiliated Groups Section 199(d)(4)(A) provides that all members of an expanded affiliated group (EAG) are treated as a single corporation for purposes of section 199. Section 199(d)(4)(B) provides that an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4). Authority to Prescribe Regulations Section 199(d)(9) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199, including regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any activity described in section 199(c)(4)(A)(i). Summary of Comments For taxable years beginning after May 17, 2006, §1.199-2T(e)(2)(i) provides that the term W-2 wages includes only amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) that are properly allocable to DPGR (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances. Section 1.199-2T(e)(2)(ii) and (iii) provide safe harbors for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under the wage expense safe harbor in §1.199-2T(e)(2)(ii)(A) for taxpayers using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e), a taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR by multiplying the amount of paragraph (e)(1) wages by the ratio of the taxpayer’s wage expense included in calculating QPAI for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or AGI, if applicable) for the taxable year. For purposes of determining the amount of wage expense included in cost of goods sold (CGS) for this safe harbor, §1.199-2T(e)(2)(ii)(B) provides that a taxpayer may determine its wage expense included in CGS using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances. Under the wage expense safe harbor in §1.199-2T(e)(2)(ii)(A), a taxpayer uses its wage expense, not W-2 wages, to determine the amount of W-2 wages that are properly allocable to DPGR. Section 1.199-2T(e)(2)(ii)(A) defines the term wage expense as wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting. The commentator suggested that, in certain circumstances, it should not be necessary for W-2 wages to be paid by a taxpayer in order for those wages to be properly allocable to DPGR. Specifically, the commentator suggested that W-2 wages should be treated as properly allocable to DPGR if the wages are paid to employees that are performing services in connection with an activity attributable to DPGR. Thus, in the case of partnership-shared services, if the employees of one partnership perform services that give rise to DPGR for another partnership and both partnerships have common ownership, then some or all of the W-2 wages should be treated as properly allocable to DPGR. The commentator further suggested that W-2 wages should be properly allocable to DPGR as long as the owner of the pass-thru entity includes in its taxable income DPGR (as a distributive share of another pass-thru entity’s DPGR) and deducts from its taxable income wages paid to employees (those employed by the pass-thru entity) whose services created that DPGR. As an alternative, the commentator suggested that owners of certain pass-thru entities be permitted to treat non-DPGR as DPGR for purposes of determining whether W-2 wages are properly allocable to DPGR. The commentator suggested that the activity attribution rules for qualifying in-kind partnerships in §1.199-3T(i)(7)(i), EAG partnerships in §1.199-3T(i)(8)(ii), and EAGs in §1.199-7(a)(3) be extended to pass-thru entities with respect to gross receipts attributable to services performed by employees of a pass-thru entity if such gross receipts are taken into account as an item of income on a tax return in which the DPGR attributable to those services also is reported. The commentator believes the result of such a rule would be to recharacterize non-DPGR as DPGR if the activities giving rise to the employee wages contribute to generating DPGR that is reported on the same tax return as the wage deduction. Therefore, the pass-thru entity with the employees would be treated as engaged in a qualifying production activity to the extent of the W-2 wages and the W-2 wages would be treated as properly allocable to DPGR. The interplay between the TIPRA amendment to section 199(b)(2) and the rules for qualifying in-kind partnerships under §1.199-3T(i)(7), EAG partnerships under §1.199-3T(i)(8), and EAGs under §1.199-7 may reduce or eliminate the section 199 deduction for EAGs and partners in qualifying in-kind partnerships if one entity uses employees of another entity to perform activities giving rise to DPGR. In addition, even though §1.199-3(f) provides rules for contract manufacturing and certain government contracts, the TIPRA amendment to section 199(b)(2) may reduce or eliminate the section 199 deduction for taxpayers entering into such contracts because the contract manufacturer’s W-2 wages are not attributed to the taxpayer. The commentator’s suggestions would treat pass-thru entities more favorably than non-consolidated EAGs. In general, §1.199-7(a) and (b) provides that each member of an EAG calculates its own taxable income or loss, QPAI, and W-2 wages, which are then aggregated in determining the EAG’s section 199 deduction. After the TIPRA amendment to section 199(b)(2), to qualify as W-2 wages within the meaning of §1.199-2T(e)(2), paragraph (e)(1) wages must be properly allocable to DPGR. Because each member of an EAG separately calculates its own items before they are aggregated by the EAG, the member having the paragraph (e)(1) wages must itself have DPGR to which the wages are properly allocable in order to qualify those wages as W-2 wages. Paragraph (e)(1) wages that are not properly allocable to DPGR of the member having the paragraph (e)(1) wages do not qualify as W-2 wages, even if the paragraph (e)(1) wages were paid in connection with another member’s DPGR activities. Example 5 in §1.199-2T(e)(2)(iv) illustrates this point. Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) regarding a partner’s or shareholder’s share of W-2 wages from a partnership or S corporation for taxable years beginning after May 17, 2006. After TIPRA, the section 199(d)(1)(A)(iii) rule for determining a partner’s or shareholder’s share of W-2 wages from a pass-thru entity no longer includes the second prong of the former two-prong standard, by which a partner’s or shareholder’s share of W-2 wages from the partnership or S corporation was limited to the lesser of that person’s allocable share of W-2 wages from the entity or a specified percentage of the person’s QPAI, computed by taking into account only the items of the entity allocated to that person for the taxable year of the entity. Before TIPRA, if the employees of a partnership performed services that gave rise to DPGR for another entity, but the partnership had no DPGR, then under the section 199(d)(1)(A)(iii) wage limitation, a partner could not take into account any W-2 wages from the partnership. After TIPRA, if the partner uses the section 861 method of cost allocation under §1.199-4(d), the partner cannot take into account any W-2 wages from the partnership because the W-2 wages do not generate DPGR in the partnership. Thus, in the case of partnership-shared services where the partner uses the section 861 method, the TIPRA amendment to section 199(b)(2) retains the result that the partner cannot take into account any W-2 wages from the partnership in applying the wage limitation under section 199(b)(1). Moreover, the TIPRA amendment modified the W-2 wage limitation to narrow the availability of the section 199 deduction. The commentator’s suggestions would allow more taxpayers to claim the section 199 deduction and increase the amount of the deduction for some taxpayers, which conflicts with the changes made by TIPRA. Accordingly, the final regulations do not adopt the commentator’s suggestions. In finalizing §1.199-5, certain clarifying changes have been made and conforming clarifications have been made to §1.199-9. As described in the preamble to the final and temporary regulations on the TIPRA amendments to section 199, published on October 19, 2006 (T.D. 9293, 71 FR 61662), the combination of the aggregation rules for determining the taxable income of an EAG in §1.199-7(b)(1) of the June 1, 2006 final regulations (T.D. 9263, 71 FR 31268) and the rules of section 172 for net operating loss deductions could cause the unintended result of the same loss being used twice in determining the taxable income limitation under section 199(a)(1)(B). To eliminate this unintended result, §1.199-7T(b)(4) was promulgated to prevent a loss that was used in the year it was sustained in determining any EAG’s taxable income for purposes of the taxable income limitation under section 199(a)(1)(B) from being used again as either a carryover or carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). No comments were received on the provisions of §1.199-7T(b)(4) and those provisions are finalized without change. Effective/Applicability Dates Section 199 applies to taxable years beginning after December 31, 2004. Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are applicable for taxable years beginning on or after October 19, 2006 (the effective date of the temporary regulations). A taxpayer may apply §§1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 to taxable years beginning after May 17, 2006, and before October 19, 2006, regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2)(ii)(b)), the provisions of REG-105847-05, 2005-2 C.B. 987, or §§1.199-1 through 1.199-8. Section 1.199-7(b)(4) is applicable for taxable years beginning on or after February 15, 2008. It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.199-0 is amended by adding new entries for §§1.199-2(e)(2), 1.199-3(i)(7), 1.199-3(i)(8), 1.199-5, and 1.199-7(b)(4) to read as follows: §1.199-0 Table of contents. §1.199-2 Wage limitation. (e) * * * (2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (i) In general. (ii) Wage expense safe harbor. (A) In general. (B) Wage expense included in cost of goods sold. (iii) Small business simplified overall method safe harbor. (iv) Examples. §1.199-3 Domestic production gross receipts. (i) * * * (7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (ii) Definition of qualifying in-kind partnership. (iii) Other rules. (iv) Example. (8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (ii) Attribution of activities. (B) Attribution between EAG partnerships. (C) Exceptions to attribution. §1.199-5 Application of section 199 to pass-thru entities for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005. (b) Partnerships. (i) Determination at partner level. (ii) Determination at entity level. (2) Disallowed losses or deductions. (3) Partner’s share of paragraph (e)(1) wages. (4) Transition rule for definition of W-2 wages and for W-2 wage limitation. (5) Partnerships electing out of subchapter K. (6) Examples. (c) S corporations. (i) Determination at shareholder level. (2) Disallowed losses and deductions. (3) Shareholder’s share of paragraph (e)(1) wages. (d) Grantor trusts. (e) Non-grantor trusts and estates. (1) Allocation of costs. (2) Allocation among trust or estate and beneficiaries. (ii) Treatment of items from a trust or estate reporting qualified production activities income. (4) Example. (f) Gain or loss from the disposition of an interest in a pass-thru entity. (g) No attribution of qualified activities. §1.199-7 Expanded affiliated groups. (b) * * * (4) Losses used to reduce taxable income of expanded affiliated group. (ii) Examples. §1.199-8 Other rules. (5) Tax Increase Prevention and Reconciliation Act of 2005. §1.199-1 [Amended] Par. 3. Section 1.199-1 is amended by removing the language “§1.199-9(d)” in paragraphs (d)(3)(i) and (ii) and adding the language “§1.199-5(d) or §1.199-9(d)” in its place. Par. 4. Section 1.199-2 is amended by revising paragraph (e)(2) to read as follows: (2) Limitation on W-2 wages for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. The term W-2 wages includes only amounts described in paragraph (e)(1) of this section (paragraph (e)(1) wages) that are properly allocable to domestic production gross receipts (DPGR) (as defined in §1.199-3) for purposes of section 199(c)(1). A taxpayer may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances. (ii) Wage expense safe harbor—(A) In general. A taxpayer using either the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) may determine the amount of paragraph (e)(1) wages that is properly allocable to DPGR for a taxable year by multiplying the amount of paragraph (e)(1) wages for the taxable year by the ratio of the taxpayer’s wage expense included in calculating qualified production activities income (QPAI) (as defined in §1.199-1(c)) for the taxable year to the taxpayer’s total wage expense used in calculating the taxpayer’s taxable income (or adjusted gross income, if applicable) for the taxable year, without regard to any wage expense disallowed by section 465, 469, 704(d), or 1366(d). A taxpayer that uses the section 861 method of cost allocation under §1.199-4(d) or the simplified deduction method under §1.199-4(e) to determine QPAI must use the same expense allocation and apportionment methods that it uses to determine QPAI to allocate and apportion wage expense for purposes of this safe harbor. For purposes of this paragraph (e)(2)(ii), the term wage expense means wages (that is, compensation paid by the employer in the active conduct of a trade or business to its employees) that are properly taken into account under the taxpayer’s method of accounting. (B) Wage expense included in cost of goods sold. For purposes of paragraph (e)(2)(ii)(A) of this section, a taxpayer may determine its wage expense included in cost of goods sold (CGS) using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, such as using the amount of direct labor included in CGS or using section 263A labor costs (as defined in §1.263A-1(h)(4)(ii)) included in CGS. (iii) Small business simplified overall method safe harbor. A taxpayer that uses the small business simplified overall method under §1.199-4(f) may use the small business simplified overall method safe harbor for determining the amount of paragraph (e)(1) wages that is properly allocable to DPGR. Under this safe harbor, the amount of paragraph (e)(1) wages that is properly allocable to DPGR is equal to the same proportion of paragraph (e)(1) wages that the amount of DPGR bears to the taxpayer’s total gross receipts. (iv) Examples. The following examples illustrate the application of this paragraph (e)(2). See §1.199-5(e)(4) for an example of the application of paragraph (e)(2)(ii) of this section to a trust or estate. The examples read as follows: Example 1. Section 861 method and no EAG. (i) Facts. X, a United States corporation that is not a member of an expanded affiliated group (EAG) (as defined in §1.199-7) or an affiliated group as defined in the regulations under section 861, engages in activities that generate both DPGR and non-DPGR. X’s taxable year ends on April 30, 2011. For X’s taxable year ending April 30, 2011, X has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. All of X’s production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of X’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). X is able to specifically identify CGS allocable to DPGR and to non-DPGR. X incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none of the R&E is included in CGS. X incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of X’s gross income. For X’s taxable year ending April 30, 2011, the adjusted basis of X’s assets is $50,000, $40,000 of which generate gross income attributable to DPGR and $10,000 of which generate gross income attributable to non-DPGR. For X’s taxable year ending April 30, 2011, the total square footage of X’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. For its taxable year ending April 30, 2011, X’s taxable income is $1,380 based on the following Federal income tax items: DPGR (all from sales of products within SIC AAA) $3,000 Non-DPGR (all from sales of products within SIC BBB) 3,000 CGS allocable to DPGR (includes $200 of wage expense) (600) CGS allocable to non-DPGR (includes $600 of wage expense) (1,800) Section 162 selling expenses (includes $600 of wage expense) (840) Section 174 R&E-SIC AAA (includes $100 of wage expense) (300) Section 174 R&E-SIC BBB (includes $200 of wage expense) (600) Interest expense (not included in CGS) (300) Headquarters overhead expense (includes $100 of wage expense) (180) X’s taxable income 1,380 (ii) X’s QPAI. X allocates and apportions its deductions to gross income attributable to DPGR under the section 861 method in §1.199-4(d). In this case, the section 162 selling expenses and overhead expense are definitely related to all of X’s gross income. Based on the facts and circumstances of this specific case, apportionment of the section 162 selling expenses between DPGR and non-DPGR on the basis of X’s gross receipts is appropriate. In addition, based on the facts and circumstances of this specific case, apportionment of the headquarters overhead expense between DPGR and non-DPGR on the basis of the square footage of X’s headquarters is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). X elects to apportion interest expense under the tax book value method of §1.861-9T(g). X has $2,400 of gross income attributable to DPGR (DPGR of $3,000 - CGS of $600 allocated based on X’s books and records). X’s QPAI for its taxable year ending April 30, 2011, is $1,395, as shown in the following table: CGS allocable to DPGR (600) Section 162 selling expenses ($840 x ($3,000 DPGR/$6,000 total gross receipts)) (420) Section 174 R&E-SIC AAA (300) Interest expense (not included in CGS) ($300 x ($40,000 (X’s DPGR assets)/$50,000 (X’s total assets))) (240) Headquarters overhead expense ($180 x (2,000 square feet attributable to DPGR activity/total 8,000 square feet)) (45) X’s QPAI 1,395 (iii) W-2 wages. X chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps: (A) Step one. X determines that $625 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 1, as shown in the following table: CGS wage expense $200 Section 162 selling expenses wage expense ($600 x ($3,000 DPGR/$6,000 total gross receipts)) 300 Section 174 R&E-SIC AAA wage expense 100 Headquarters overhead wage expense ($100 x (2,000 square feet attributable to DPGR activity/8,000 total square feet)) 25 Total wage expense taken into account 625 (B) Step two. X determines that $1,042 of the $3,000 in paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation: Step one wage expense x X’s paragraph (e)(1) wages X’s total wage expense for taxable year ending April 30, 2011 $625 x $3,000 = $1,042 (iv) Section 199 deduction determination. X’s tentative deduction under §1.199-1(a) (section 199 deduction) is $124 (.09 x (lesser of QPAI of $1,395 or taxable income of $1,380)) subject to the wage limitation under section 199(b)(1) (W-2 wage limitation) of $521 (50% x $1,042). Accordingly, X’s section 199 deduction for its taxable year ending April 30, 2011, is $124. Example 2. Section 861 method and EAG. (i) Facts. The facts are the same as in Example 1 except that X owns stock in Y, a United States corporation, equal to 75% of the total voting power of the stock of Y and 80% of the total value of the stock of Y. X and Y are not members of an affiliated group as defined in section 1504(a). Accordingly, the rules of §1.861-14T do not apply to X’s and Y’s selling expenses, R&E, and charitable contributions. X and Y are, however, members of an affiliated group for purposes of allocating and apportioning interest expense (see §1.861-11T(d)(6)) and are also members of an EAG. Y’s taxable year ends April 30, 2011. For Y’s taxable year ending April 30, 2011, Y has $2,000 of paragraph (e)(1) wages reported on 2010 Forms W-2. For Y’s taxable year ending April 30, 2011, the adjusted basis of Y’s assets is $50,000, $20,000 of which generate gross income attributable to DPGR and $30,000 of which generate gross income attributable to non-DPGR. All of Y’s activities that generate DPGR are within SIC Industry Group AAA (SIC AAA). All of Y’s activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). None of X’s and Y’s sales are to each other. Y is not able to specifically identify CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of Y’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For Y’s taxable year ending April 30, 2011, the total square footage of Y’s headquarters is 8,000 square feet, of which 2,000 square feet is set aside for domestic production activities. Y incurs section 162 selling expenses that are not includible in CGS and are definitely related to all of Y’s gross income. For Y’s taxable year ending April 30, 2011, Y’s taxable income is $1,710 based on the following Federal income tax items: CGS allocated to DPGR (includes $300 of wage expense) (1,200) CGS allocated to non-DPGR (includes $300 of wage expense) (1,200) Section 174 R&E-SIC AAA (includes $20 of wage expense) (100) Section 174 R&E-SIC BBB (includes $60 of wage expense) (200) Interest expense (not included in CGS and not subject to §1.861-10T) (500) Charitable contributions (50) Headquarters overhead expense (includes $40 of wage expense) (200) Y’s taxable income 1,710 (ii) QPAI. (A) X’s QPAI. Determination of X’s QPAI is the same as in Example 1 except that interest is apportioned to gross income attributable to DPGR based on the combined adjusted bases of X’s and Y’s assets. See §1.861-11T(c). Accordingly, X’s QPAI for its taxable year ending April 30, 2011, is $1,455, as shown in the following table: CGS allocated to DPGR (600) Interest expense (not included in CGS and not subject to §1.861-10T) ($300 x ($60,000 (tax book value of X’s and Y’s DPGR assets)/$100,000 (tax book value of X’s and Y’s total assets))) (180) Headquarters overhead expense ($180 x (2,000 square feet attributable to DPGR activity/total 8,000 square feet)) (45) (B) Y’s QPAI. Y makes the same elections under the section 861 method as does X. Y has $1,800 of gross income attributable to DPGR (DPGR of $3,000 - CGS of $1,200 allocated based on Y’s gross receipts). Y’s QPAI for its taxable year ending April 30, 2011, is $905, as shown in the following table: CGS allocated to DPGR (1,200) Charitable contributions (not included in CGS) ($50 x ($1,800 gross income attributable to DPGR/$3,600 total gross income)) (25) Y’s QPAI 905 (iii) W-2 wages. (A) X’s W-2 wages. X’s W-2 wages are $1,042, the same as in Example 1. (B) Y’s W-2 wages. Y chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps: (1) Step one. Y determines that $480 of wage expense were taken into account in determining its QPAI in paragraph (ii)(B) of this Example 2, as shown in the following table: Section 174 R&E-SIC AAA wage expense 20 Headquarters overhead wage expense ($40 x (2,000 square feet attributable to DPGR activity/ 8,000 total square feet)) 10 (2) Step two. Y determines that $941 of the $2,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation: Step one wage expense x Y’s paragraph (e)(1) wages Y’s total wage expense for taxable year ending April 30, 2011 $480 x $2,000 = $941 (iv) Section 199 deduction determination. The section 199 deduction of the X and Y EAG is determined by aggregating the separately determined taxable income, QPAI, and W-2 wages of X and Y. See §1.199-7(b). Accordingly, the X and Y EAG’s tentative section 199 deduction is $212 (.09 x (lesser of combined QPAI of X and Y of $2,360 (X’s QPAI of $1,455 plus Y’s QPAI of $905) or combined taxable incomes of X and Y of $3,090 (X’s taxable income of $1,380 plus Y’s taxable income of $1,710)) subject to the combined W-2 wage limitation of X and Y of $992 (50% x ($1,042 (X’s W-2 wages) + $941 (Y’s W-2 wages)))). Accordingly, the X and Y EAG’s section 199 deduction is $212. The $212 is allocated to X and Y in proportion to their QPAI. See §1.199-7(c). Example 3. Simplified deduction method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z is able to specifically identify CGS allocable to DPGR and to non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items: DPGR $3,000 Non-DPGR 3,000 Expenses, losses, or deductions (deductions) (includes $1,000 of wage expense) (2,220) Z’s taxable income 1,380 (ii) Z’s QPAI. Z uses the simplified deduction method under §1.199-4(e) to apportion deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $1,290, as shown in the following table: Deductions apportioned to DPGR ($2,220 x ($3,000 DPGR/$6,000 total gross receipts)) (1,110) Z’s QPAI 1,290 (iii) W-2 wages. Z chooses to use the wage expense safe harbor under paragraph (e)(2)(ii) of this section to determine its W-2 wages, as shown in the following steps: (A) Step one. Z determines that $700 of wage expense were taken into account in determining its QPAI in paragraph (ii) of this Example 3, as shown in the following table: Wage expense included in CGS allocable to DPGR $200 Wage expense included in deductions ($1,000 in wage expense x ($3,000 DPGR/$6,000 total gross receipts)) 500 Wage expense allocable to DPGR 700 (B) Step two. Z determines that $1,167 of the $3,000 paragraph (e)(1) wages are properly allocable to DPGR, and are therefore W-2 wages, as shown in the following calculation: Step one wage expense x Z’s paragraph (e)(1) wages Z’s total wage expense for taxable year ending April 30, 2011 (iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $116 (.09 x (lesser of QPAI of $1,290 or taxable income of $1,380)) subject to the W-2 wage limitation of $584 (50% x $1,167). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $116. Example 4. Small business simplified overall method. (i) Facts. Z, a corporation that is not a member of an EAG, engages in activities that generate both DPGR and non-DPGR. Z’s taxable year ends on April 30, 2011. For Z’s taxable year ending April 30, 2011, Z has $3,000 of paragraph (e)(1) wages reported on 2010 Forms W-2, and Z’s taxable income is $1,380 based on the following Federal income tax items: CGS and deductions (4,620) (ii) Z’s QPAI. Z uses the small business simplified overall method under §1.199-4(f) to apportion CGS and deductions between DPGR and non-DPGR. Z’s QPAI for its taxable year ending April 30, 2011, is $690, as shown in the following table: CGS and deductions apportioned to DPGR ($4,620 x ($3,000 DPGR/$6,000 total gross receipts)) (2,310) Z’s QPAI 690 (iii) W-2 wages. Z’s W-2 wages under paragraph (e)(2)(iii) of this section are $1,500, as shown in the following calculation: $3,000 in paragraph (e)(1) wages x ($3,000 DPGR/$6,000 total gross receipts) $1,500 (iv) Section 199 deduction determination. Z’s tentative section 199 deduction is $62 (.09 x (lesser of QPAI of $690 or taxable income of $1,380)) subject to the W-2 wage limitation of $750 (50% x $1,500). Accordingly, Z’s section 199 deduction for its taxable year ending April 30, 2011, is $62. Example 5. Corporation uses employees of non-consolidated EAG member. (i) Facts. Corporations S and B are the only members of a single EAG but are not members of a consolidated group. S and B are both calendar year taxpayers. All the activities described in this Example 5 take place during the same taxable year and they are the only activities of S and B. S and B each use the section 861 method described in §1.199-4(d) for allocating and apportioning their deductions. B is a manufacturer but has only three employees of its own. S employs the remainder of the personnel who perform the manufacturing activities for B. S’s only receipts are from supplying employees to B. In 2010, B manufactures qualifying production property (QPP) (as defined in §1.199-3(j)(1)), using its three employees and S’s employees, and sells the QPP for $10,000,000. B’s total CGS and other deductions are $6,000,000, including $1,000,000 paid to S for the use of S’s employees and $100,000 paid to its own employees. B reports the $100,000 paid to its employees on the 2010 Forms W-2 issued to its employees. S pays its employees $800,000 that is reported on the 2010 Forms W-2 issued to the employees. (ii) B’s W-2 wages. In determining its W-2 wages, B utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. The entire $100,000 paid by B to its employees is included in B’s wage expense included in calculating its QPAI and is the only wage expense used in calculating B’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, B’s W-2 wages are $100,000 ($100,000 (paragraph (e)(1) wages) x ($100,000 (wage expense used in calculating B’s QPAI)/$100,000 (wage expense used in calculating B’s taxable income))). (iii) S’s W-2 wages. In determining its W-2 wages, S utilizes the wage expense safe harbor described in paragraph (e)(2)(ii) of this section. Because S’s $1,000,000 in receipts from B do not qualify as DPGR and are S’s only gross receipts, none of the $800,000 paid by S to its employees is included in S’s wage expense included in calculating its QPAI. However, the entire $800,000 is included in calculating S’s taxable income. Thus, under the wage expense safe harbor described in paragraph (e)(2)(ii)(A) of this section, S’s W-2 wages are $0 ($800,000 (paragraph (e)(1) wages) x ($0 (wage expense used in calculating S’s QPAI)/$800,000 (wage expense used in calculating S’s taxable income))). (iv) Determination of EAG’s section 199 deduction. The section 199 deduction of the S and B EAG is determined by aggregating the separately determined taxable income or loss, QPAI, and W-2 wages of S and B. See §1.199-7(b). B’s taxable income and QPAI are each $4,000,000 ($10,000,000 DPGR - $6,000,000 CGS and other deductions). S’s taxable income is $200,000 ($1,000,000 gross receipts - $800,000 total deductions). S’s QPAI is $0 ($0 DPGR - $0 CGS and other deductions). B’s W-2 wages (as calculated in paragraph (ii) of this Example 5) are $100,000 and S’s W-2 wages (as calculated in paragraph (iii) of this Example 5) are $0. The EAG’s tentative section 199 deduction is $360,000 (.09 x (lesser of combined QPAI of $4,000,000 (B’s QPAI of $4,000,000 + S’s QPAI of $0) or combined taxable income of $4,200,000 (B’s taxable income of $4,000,000 + S’s taxable income of $200,000))) subject to the W-2 wage limitation of $50,000 (50% x ($100,000 (B’s W-2 wages) + $0 (S’s W-2 wages))). Accordingly, the S and B EAG’s section 199 deduction for 2010 is $50,000. The $50,000 is allocated to S and B in proportion to their QPAI. See §1.199-7(c). Because S has no QPAI, the entire $50,000 is allocated to B. Example 6. Corporation using employees of consolidated EAG member. The facts are the same as in Example 5 except that B and S are members of the same consolidated group. Ordinarily, as demonstrated in Example 5, S’s $1,000,000 of receipts would not be DPGR and its $800,000 paid to its employees would not be W-2 wages (because the $800,000 would not be properly allocable to DPGR). However, because S and B are members of the same consolidated group, §1.1502-13(c)(1)(i) provides that the separate entity attributes of S’s intercompany items or B’s corresponding items, or both, may be redetermined in order to produce the same effect as if S and B were divisions of a single corporation. If S and B were divisions of a single corporation, S and B would have QPAI and taxable income of $4,200,000 ($10,000,000 DPGR received from the sale of the QPP - $5,800,000 CGS and other deductions) and, under the wage expense safe harbor described in paragraph (e)(2)(ii) of this section, would have $900,000 of W-2 wages ($900,000 (combined paragraph (e)(1) wages of S and B) x ($900,000 (wage expense used in calculating QPAI)/$900,000 (wage expense used in calculating taxable income))). The single corporation would have a tentative section 199 deduction equal to 9% of $4,200,000, or $378,000, subject to the W-2 wage limitation of 50% of $900,000, or $450,000. Thus, the single corporation would have a section 199 deduction of $378,000. To obtain this same result for the consolidated group, S’s $1,000,000 of receipts from the intercompany transaction are redetermined as DPGR. Thus, S’s $800,000 paid to its employees are costs properly allocable to DPGR and S’s W-2 wages are $800,000. Accordingly, the consolidated group has QPAI and taxable income of $4,200,000 ($11,000,000 DPGR (from the sale of the QPP and the redetermined intercompany transaction) - $6,800,000 CGS and other deductions) and W-2 wages of $900,000. The consolidated group’s section 199 deduction is $378,000, the same as the single corporation. However, for purposes of allocating the section 199 deduction between S and B, the redetermination of S’s income as DPGR under §1.1502-13(c)(1)(i) is not taken into account. See §1.199-7(d)(5). Accordingly, the consolidated group’s entire section 199 deduction of $378,000 is allocated to B. §1.199-2T [Removed] Par. 5. Section 1.199-2T is removed. Par. 6. Section 1.199-3 is amended by: 1. Revising the first sentence of paragraph (f)(1). 2. Adding the language “paragraph (i)(8) of this section and” before the language “§1.199-9(j)” in paragraph (g)(4)(ii)(B). 3. Adding the language “paragraph (i)(7) of this section and” before the language “§1.199-9(i)” in paragraph (g)(4)(ii)(D). 4. Revising paragraphs (i)(7) and (8). 5. Removing the language “§1.199-9(e)” in the last sentence of paragraph (m)(6)(iv)(B) and adding the language “§§1.199-5(e) and 1.199-9(e)” in its place. 6. Revising the second and third sentences in paragraph (p). The revisions read as follows: (f) * * * (1) In general. With the exception of the rules applicable to an expanded affiliated group (EAG) under §1.199-7, qualifying in-kind partnerships under paragraph (i)(7) of this section and §1.199-9(i), EAG partnerships under paragraph (i)(8) of this section and §1.199-9(j), and government contracts under paragraph (f)(2) of this section, only one taxpayer may claim the deduction under §1.199-1(a) with respect to any qualifying activity under paragraphs (e)(1), (k)(1), and (l)(1) of this section performed in connection with the same QPP, or the production of a qualified film or utilities. * * * (7) Qualifying in-kind partnership for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. If a partnership is a qualifying in-kind partnership described in paragraph (i)(7)(ii) of this section, then each partner is treated as having MPGE or produced the property MPGE or produced by the partnership that is distributed to that partner. If a partner of a qualifying in-kind partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of the property that was MPGE or produced by the qualifying in-kind partnership and distributed to that partner, then, provided such partner is a partner of the qualifying in-kind partnership at the time the partner disposes of the property, the partner is treated as conducting the MPGE or production activities previously conducted by the qualifying in-kind partnership with respect to that property. With respect to a lease, rental, or license, the partner is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the partner is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. (ii) Definition of qualifying in-kind partnership. For purposes of this paragraph (i)(7), a qualifying in-kind partnership is a partnership engaged solely in— (A) The extraction, refining, or processing of oil, natural gas (as described in paragraph (l)(2) of this section), petrochemicals, or products derived from oil, natural gas, or petrochemicals in whole or in significant part within the United States; (B) The production or generation of electricity in the United States; or (C) An activity or industry designated by the Secretary by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter). (iii) Other rules. Except as provided in this paragraph (i)(7), a qualifying in-kind partnership is treated the same as other partnerships for purposes of section 199. Accordingly, a qualifying in-kind partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including application of the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages) from the partnership under §1.199-5(b)(3). In determining whether a qualifying in-kind partnership or its partners MPGE QPP in whole or in significant part within the United States, see paragraphs (g)(2) and (3) of this section. (iv) Example. The following example illustrates the application of this paragraph (i)(7). Assume that PRS and X are calendar year taxpayers. The example reads as follows: Example. X, Y, and Z are partners in PRS, a qualifying in-kind partnership described in paragraph (i)(7)(ii) of this section. X, Y, and Z are corporations. In 2007, PRS distributes oil to X that PRS derived from its oil extraction. PRS incurred $600 of CGS extracting the oil distributed to X, and X’s adjusted basis in the distributed oil is $600. X incurs $200 of CGS in refining the oil within the United States. In 2007, X, while it is a partner in PRS, sells the oil to a customer for $1,500. X is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes. Under paragraph (i)(7)(i) of this section, X is treated as having extracted the oil. The extraction and refining of the oil each qualify as an MPGE activity under paragraph (e)(1) of this section. Therefore, X’s $1,500 of gross receipts qualify as DPGR. X subtracts from the $1,500 of DPGR the $600 of CGS incurred by PRS and the $200 of refining costs it incurred. Thus, X’s QPAI is $700 for 2007. (8) Partnerships owned by members of a single expanded affiliated group for taxable years beginning after May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2005—(i) In general. For purposes of this section, if all of the interests in the capital and profits of a partnership are owned by members of a single EAG at all times during the taxable year of the partnership (EAG partnership), then the EAG partnership and all members of that EAG are treated as a single taxpayer for purposes of section 199(c)(4) during that taxable year. (ii) Attribution of activities—(A) In general. If a member of an EAG (disposing member) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by an EAG partnership, all the partners of which are members of the same EAG to which the disposing member belongs at the time that the disposing member disposes of such property, then the disposing member is treated as conducting the MPGE or production activities previously conducted by the EAG partnership with respect to that property. The previous sentence applies only for those taxable years in which the disposing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the disposing member is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing member is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. Likewise, if an EAG partnership derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by a member (or members) of the same EAG (the producing member) to which all the partners of the EAG partnership belong at the time that the EAG partnership disposes of such property, then the EAG partnership is treated as conducting the MPGE or production activities previously conducted by the producing member with respect to that property. The previous sentence applies only for those taxable years in which the producing member is a member of the EAG of which all the partners of the EAG partnership are members for the entire taxable year of the EAG partnership. With respect to a lease, rental, or license, the EAG partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts derived from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the EAG partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. See paragraph (i)(8)(iv) Example 3 of this section. (B) Attribution between EAG partnerships. If an EAG partnership (disposing partnership) derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of property that was MPGE or produced by another EAG partnership (producing partnership), then the disposing partnership is treated as conducting the MPGE or production activities previously conducted by the producing partnership with respect to that property, provided that each of these partnerships (the producing partnership and the disposing partnership) is owned for its entire taxable year in which the disposing partnership disposes of such property by members of the same EAG. With respect to a lease, rental, or license, the disposing partnership is treated as having disposed of the property on the date or dates on which it takes into account its gross receipts from the lease, rental, or license under its method of accounting. With respect to a sale, exchange, or other disposition, the disposing partnership is treated as having disposed of the property on the date it ceases to own the property for Federal income tax purposes, even if no gain or loss is taken into account. (C) Exceptions to attribution. Attribution of activities does not apply for purposes of the construction of real property under paragraph (m)(1) of this section and the performance of engineering and architectural services under paragraphs (n)(2) and (3) of this section, respectively. (iii) Other rules. Except as provided in this paragraph (i)(8), an EAG partnership is treated the same as other partnerships for purposes of section 199. Accordingly, an EAG partnership is subject to the rules of this section regarding the application of section 199 to pass-thru entities, including the section 199(d)(1)(A)(iii) rule under §1.199-5(b)(3). In determining whether a member of an EAG or an EAG partnership MPGE QPP in whole or in significant part within the United States or produced a qualified film or produced utilities within the United States, see paragraphs (g)(2) and (3) of this section and Example 5 of paragraph (i)(8)(iv) of this section. (iv) Examples. The following examples illustrate the rules of this paragraph (i)(8). Assume that PRS, X, Y, and Z all are calendar year taxpayers. The examples read as follows: Example 1. Contribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, X MPGE QPP within the United States and contributes the QPP to PRS. In 2007, PRS sells the QPP for $1,000. Under this paragraph (i)(8), PRS is treated as having MPGE the QPP within the United States, and PRS’s $1,000 gross receipts constitute DPGR. PRS, X, and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the paragraph (e)(1) wages from the partnership under §1.199-5(b)(3). Example 2. Sale. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X sells the QPP to customers for $10,000, incurring selling expenses of $2,000. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $10,000 of gross receipts qualify as DPGR. PRS, X and Y must apply the rules of this section regarding the application of section 199 to pass-thru entities with respect to the activity of PRS, including application of the section 199(d)(1)(A)(iii) rule for determining a partner’s share of the paragraph (e)(1) wages from the partnership under §1.199-5(b)(3). The results would be the same if PRS sold the QPP to Z rather than to X. However, if PRS did sell the QPP to Z, and Z was not a member of the EAG for PRS’s entire taxable year, the activities previously conducted by PRS with respect to the QPP would not be attributed to Z, and none of Z’s $10,000 of gross receipts would qualify as DPGR. Example 3. Lease. X, Y, and Z are the only members of a single EAG for the entire 2007 year. X and Y each own 50% of the capital and profits interests in PRS, a partnership, for PRS’s entire 2007 taxable year. In 2007, PRS MPGE QPP within the United States and then sells the QPP to X for $6,000, its fair market value at the time of the sale. PRS’s gross receipts of $6,000 qualify as DPGR. In 2007, X rents the QPP it acquired from PRS to customers unrelated to X. X takes the gross receipts attributable to the rental of the QPP into account under its method of accounting in 2007 and 2008. On July 1, 2008, X ceases to be a member of the same EAG to which Y, the other partner in PRS, belongs. For 2007, X is treated as having MPGE the QPP within the United States under paragraph (i)(8)(ii)(A) of this section, and its gross receipts derived from the rental of the QPP qualify as DPGR. For 2008, however, because X and Y, partners in PRS, are no longer members of the same EAG for the entire year, the gross rental receipts X takes into account in 2008 do not qualify as DPGR. Example 4. Distribution. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both members of a single EAG for the entire 2007 year. In 2007, PRS MPGE QPP within the United States, incurring $600 of CGS, and then distributes the QPP to X. X’s adjusted basis in the QPP is $600. X incurs $200 of CGS to further MPGE the QPP within the United States. In 2007, X sells the QPP for $1,500 to an unrelated customer. X is treated as having disposed of the QPP on the date it ceases to own the QPP for Federal income tax purposes. Under paragraph (i)(8)(ii)(A) of this section, X is treated as having MPGE the QPP within the United States, and X’s $1,500 of gross receipts qualify as DPGR. Example 5. Multiple sales. (i) Facts. X and Y are the only partners in PRS, a partnership, for PRS’s entire 2007 taxable year. X and Y are both non-consolidated members of a single EAG for the entire 2007 year. PRS produces in bulk form in the United States the active ingredient for a drug. Assume that PRS’s own MPGE activity with respect to the active ingredient is not substantial in nature, taking into account all of the facts and circumstances, and PRS’s direct labor and overhead to MPGE the active ingredient within the United States are $15 and account for 15% of PRS’s $100 CGS of the active ingredient. In 2007, PRS sells the active ingredient in bulk form to X. X uses the active ingredient to produce the finished dosage form drug. Assume that X’s own MPGE activity with respect to the finished dosage form drug is not substantial in nature, taking into account all of the facts and circumstances, and X’s direct labor and overhead to MPGE the finished dosage form drug within the United States are $12 and account for 10% of X’s $120 CGS of the drug. In 2007, X sells the finished dosage form drug to Y and Y sells the finished dosage form drug to customers. Assume that Y’s own MPGE activity with respect to the finished dosage form drug is not substantial in nature, taking into account all of the facts and circumstances, and Y incurs $2 of direct labor and overhead and Y’s CGS in selling the finished dosage form drug to customers is $130. (ii) Analysis. PRS’s gross receipts from the sale of the active ingredient to X are non-DPGR because PRS’s MPGE activity is not substantial in nature and PRS does not satisfy the safe harbor described in paragraph (g)(3) of this section because PRS’s direct labor and overhead account for less than 20% of PRS’s CGS of the active ingredient. X’s gross receipts from the sale of the finished dosage form drug to Y are DPGR because X is considered to have MPGE the finished dosage form drug in significant part in the United States pursuant to the safe harbor described in paragraph (g)(3) of this section because the $27 ($15 + $12) of direct labor and overhead incurred by PRS and X equals or exceeds 20% of X’s total CGS ($120) of the finished dosage form drug at the time X disposes of the finished dosage form drug to Y. Similarly, Y’s gross receipts from the sale of the finished dosage form drug to customers are DPGR because Y is considered to have MPGE the finished dosage form drug in significant part in the United States pursuant to the safe harbor described in paragraph (g)(3) of this section because the $29 ($15 + $12 + $2) of direct labor and overhead incurred by PRS, X, and Y equals or exceeds 20% of Y’s total CGS ($130) of the finished dosage form drug at the time Y disposes of the finished dosage form drug to Y’s customers. (p) * * * Thus, partners, including partners in partnerships described in paragraphs (i)(7) and (8) of this section and §1.199-9(i) and (j), may not treat guaranteed payments as DPGR. See §§1.199-5(b)(6) Example 5 and 1.199-9(b)(6) Example 5. 1. Revising paragraph (d)(5). 2. Removing the language “§1.199-9(d)” in paragraph (e)(1) and adding the language “§1.199-5(d) or §1.199-9(d)” in its place. 3. Revising paragraph (f)(5). §1.199-4 Costs allocable to domestic production gross receipts. (d) * * * (5) Treatment of items from a pass-thru entity reporting qualified production activities income. If, pursuant to §1.199-5(e)(2) or §1.199-9(e)(2), or to the authority granted in §1.199-5(b)(1)(ii) or (c)(1)(ii), or §1.199-9(b)(1)(ii) or (c)(1)(ii), a taxpayer must combine QPAI and W-2 wages from a partnership, S corporation, trust (to the extent not described in §1.199-5(d) or §1.199-9(d)) or estate with the taxpayer’s total QPAI and W-2 wages from other sources, then for purposes of apportioning the taxpayer’s interest expense under this paragraph (d), the taxpayer’s interest in such partnership (and, where relevant in apportioning the taxpayer’s interest expense, the partnership’s assets), the taxpayer’s shares in such S corporation, or the taxpayer’s interest in such trust shall be disregarded. (f) * * * (5) Trusts and estates. Trusts and estates under §§1.199-5(e) and 1.199-9(e) may not use the small business simplified overall method. Par. 9. Section 1.199-5 is added to read as follows: (a) In general. The provisions of this section apply solely for purposes of section 199 of the Internal Revenue Code (Code). (b) Partnerships—(1) In general—(i) Determination at partner level. The deduction with respect to the qualified production activities of the partnership allowable under §1.199-1(a) (section 199 deduction) is determined at the partner level. As a result, each partner must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of the partner’s interest in the partnership. Except as provided by publication pursuant to paragraph (b)(1)(ii) of this section, for purposes of this section, each partner is allocated, in accordance with sections 702 and 704, its share of partnership items (including items of income, gain, loss, and deduction), cost of goods sold (CGS) allocated to such items of income, and gross receipts that are included in such items of income, even if the partner’s share of CGS and other deductions and losses exceeds domestic production gross receipts (DPGR) (as defined in §1.199-3(a)). A partnership may specially allocate items of income, gain, loss, or deduction to its partners, subject to the rules of section 704(b) and the supporting regulations. Guaranteed payments under section 707(c) are not considered allocations of partnership income for purposes of this section. Guaranteed payments under section 707(c) are deductions by the partnership that must be taken into account under the rules of §1.199-4. See §1.199-3(p) and paragraph (b)(6) Example 5 of this section. Except as provided in paragraph (b)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, a partner aggregates its distributive share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the partnership (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its qualified production activities income (QPAI) (as defined in §1.199-1(c)). (ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit a partnership to calculate a partner’s share of QPAI and W-2 wages as defined in §1.199-2(e)(2) (W-2 wages) at the entity level, instead of allocating to the partner, in accordance with sections 702 and 704, the partner’s share of partnership items (including items of income, gain, loss, and deduction) and amounts described in §1.199-2(e)(1) (paragraph (e)(1) wages). If a partnership does calculate QPAI at the entity level— (A) Each partner is allocated its share of QPAI (subject to the limitations of paragraph (b)(2) of this section) and W-2 wages from the partnership, which are combined with the partner’s QPAI and W-2 wages from other sources, if any; (B) For purposes of computing the partner’s QPAI under §§1.199-1 through 1.199-8, a partner does not take into account the items from the partnership (for example, a partner does not take into account items from the partnership in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources; (C) A partner generally does not recompute its share of QPAI from the partnership using another method; however, the partner might have to adjust its share of QPAI from the partnership to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and (D) A partner’s distributive share of QPAI from a partnership may be less than zero. (2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a partnership are taken into account in computing the partner’s QPAI for a taxable year only if, and to the extent that, the partner’s distributive share of those losses or deductions from all of the partnership’s activities is not disallowed by section 465, 469, or 704(d), or any other provision of the Code. If only a portion of the partner’s distributive share of the losses or deductions from a partnership is allowed for a taxable year, a proportionate share of those allowed losses or deductions that are allocated to the partnership’s qualified production activities, determined in a manner consistent with sections 465, 469, and 704(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 704(d), or any other provision of the Code, the partner takes into account a proportionate share of those allowed losses or deductions that are allocated to the partnership’s qualified production activities in computing the partner’s QPAI for that later taxable year. Losses or deductions of the partnership that are disallowed for taxable years beginning on or before December 31, 2004, however, are not taken into account in a later taxable year for purposes of computing the partner’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes. (3) Partner’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), a partner’s share of paragraph (e)(1) wages of a partnership for purposes of determining the partner’s wage limitation under section 199(b)(1) (W-2 wage limitation) equals the partner’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the partnership must allocate the amount of paragraph (e)(1) wages among the partners in the same manner it allocates wage expense among those partners. The partner must add its share of the paragraph (e)(1) wages from the partnership to the partner’s paragraph (e)(1) wages from other sources, if any. The partner (other than a partner that itself is a partnership or S corporation) then must calculate its W-2 wages by determining the amount of the partner’s total paragraph (e)(1) wages properly allocable to DPGR. If the partner is a partnership or S corporation, the partner must allocate its paragraph (e)(1) wages (including the paragraph (e)(1) wages from a lower-tier partnership) among its partners or shareholders in the same manner it allocates wage expense among those partners or shareholders. See §1.199-2(e)(2) for the computation of W-2 wages and for the proper allocation of any such wages to DPGR. (4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If a partnership and any partner in that partnership have different taxable years, only one of which begins after May 17, 2006, the definition of W-2 wages of the partnership and the section 199(d)(1)(A)(iii) rule for determining a partner’s share of wages from that partnership is determined under the law applicable to partnerships based on the beginning date of the partnership’s taxable year. Thus, for example, for the taxable year of a partnership beginning on or before May 17, 2006, a partner’s share of W-2 wages from the partnership is determined under section 199(d)(1)(A)(iii) as in effect for taxable years beginning on or before May 17, 2006, even if the taxable year of that partner in which those wages are taken into account begins after May 17, 2006. (5) Partnerships electing out of subchapter K. For purposes of §§1.199-1 through 1.199-8, the rules of this paragraph (b) apply to all partnerships, including those partnerships electing under section 761(a) to be excluded, in whole or in part, from the application of subchapter K of chapter 1 of the Code. (6) Examples. The following examples illustrate the application of this paragraph (b). Assume that each partner has sufficient adjusted gross income or taxable income so that the section 199 deduction is not limited under section 199(a)(1)(B). Assume also that the partnership and each of its partners (whether individual or corporate) are calendar year taxpayers. The examples read as follows: Example 1. Section 861 method with interest expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations, are each 50% partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. X and Y share all items of income, gain, loss, deduction, and credit equally. Both X and Y are engaged in a trade or business. PRS is not able to identify from its books and records CGS allocable to DPGR and non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. For 2010, the adjusted basis of PRS’s business assets is $5,000, $4,000 of which generate gross income attributable to DPGR and $1,000 of which generate gross income attributable to non-DPGR. For 2010, PRS has the following Federal income tax items: CGS 3,240 Section 162 selling expenses 1,200 Interest expense (not included in CGS) 300 (ii) Allocation of PRS’s Federal income tax items. X and Y each receive the following distributive share of PRS’s Federal income tax items, as determined under the principles of §1.704-1(b)(1)(vii): Gross income attributable to DPGR ($1,500 (DPGR) - $810 (allocable CGS)) $690 Gross income attributable to non-DPGR ($1,500 (non-DPGR) - $810 (allocable CGS)) 690 Section 162 selling expenses 600 (iii) Determination of QPAI. (A) X’s QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating its distributive share of PRS’s Federal income tax items with all other such items from all other, non-PRS-related activities. For 2010, X does not have any other such items. For 2010, the adjusted basis of X’s non-PRS assets, all of which are investment assets, is $10,000. X’s only gross receipts for 2010 are those attributable to the allocation of gross income from PRS. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are not included in CGS and are definitely related to all of PRS’s gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS’s gross receipts is appropriate. X elects to apportion its distributive share of interest expense under the tax book value method of §1.861-9T(g). X’s QPAI for 2010 is $366, as shown in the following table: Interest expense (not included in CGS) ($150 x ($2,000 (X’s share of PRS’s DPGR assets)/ $12,500 (X’s non-PRS assets ($10,000) + X’s share of PRS assets ($2,500)))) (24) X’s QPAI 366 (B) Y’s QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in production activities that generate both DPGR and non-DPGR. Y is able to identify from its books and records CGS allocable to DPGR and to non-DPGR. For 2010, the adjusted basis of Y’s non-PRS assets attributable to its production activities that generate DPGR is $8,000 and to other production activities that generate non-DPGR is $2,000. Y has no other assets. Y has the following Federal income tax items relating to its non-PRS activities: Gross income attributable to non-DPGR ($3,000 (other gross receipts) - $1,620 (allocable CGS)) 1,380 Interest expense (not included in CGS) 90 (2) Y determines its QPAI in the same general manner as X. However, because Y has other trade or business activities outside of PRS, Y must aggregate its distributive share of PRS’s Federal income tax items with its own such items. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, Y’s distributive share of PRS’s section 162 selling expenses, as well as those selling expenses from Y’s non-PRS activities, are definitely related to all of its gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of Y’s gross receipts (including Y’s share of PRS’s gross receipts) is appropriate. Y elects to apportion its distributive share of interest expense under the tax book value method of §1.861-9T(g). Y has $1,290 of gross income attributable to DPGR ($3,000 DPGR ($1,500 from PRS and $1,500 from non-PRS activities) - $1,710 CGS ($810 from PRS and $900 from non-PRS activities)). Y’s QPAI for 2010 is $642, as shown in the following table: DPGR ($1,500 from PRS and $1,500 from non-PRS activities) $3,000 CGS allocable to DPGR ($810 from PRS and $900 from non-PRS activities) (1,710) Section 162 selling expenses ($1,140 ($600 from PRS and $540 from non-PRS activities) x $3,000 ($1,500 PRS DPGR + $1,500 non-PRS DPGR)/$7,500 ($3,000 PRS total gross receipts + $4,500 non-PRS total gross receipts)) (456) Interest expense (not included in CGS) ($240 ($150 from PRS and $90 from non-PRS activities) x $10,000 (Y’s non-PRS DPGR assets ($8,000) + Y’s share of PRS DPGR assets ($2,000))/$12,500 (Y’s non-PRS assets ($10,000) + Y’s share of PRS assets ($2,500))) (192) (iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $33 (.09 x $366, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $58 (.09 x $642) subject to the W-2 wage limitation. Example 2. Section 861 method with R&E expense. (i) Partnership Federal income tax items. X and Y, unrelated United States corporations each of which is engaged in a trade or business, are partners in PRS, a partnership that engages in production activities that generate both DPGR and non-DPGR. Neither X nor Y is a member of an affiliated group. X and Y share all items of income, gain, loss, deduction, and credit equally. All of PRS’s domestic production activities that generate DPGR are within Standard Industrial Classification (SIC) Industry Group AAA (SIC AAA). All of PRS’s production activities that generate non-DPGR are within SIC Industry Group BBB (SIC BBB). PRS is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because CGS is definitely related under the facts and circumstances to all of PRS’s gross receipts, apportionment of CGS between DPGR and non-DPGR based on gross receipts is appropriate. PRS incurs $900 of research and experimentation expenses (R&E) that are deductible under section 174, $300 of which are performed with respect to SIC AAA and $600 of which are performed with respect to SIC BBB. None of the R&E is legally mandated R&E as described in §1.861-17(a)(4) and none is included in CGS. For 2010, PRS has the following Federal income tax items: Section 174 R&E-SIC AAA 300 Section 174 R&E-SIC BBB 600 Gross income attributable to DPGR ($1,500 (DPGR) - $600 (CGS)) $900 Gross income attributable to non-DPGR ($1,500 (other gross receipts) - $600 (CGS)) 900 (iii) Determination of QPAI. (A) X’s QPAI. Because the section 199 deduction is determined at the partner level, X determines its QPAI by aggregating its distributive share of PRS’s Federal income tax items with all other such items from all other, non-PRS-related activities. For 2010, X does not have any other such tax items. X’s only gross receipts for 2010 are those attributable to the allocation of gross income from PRS. As stated, all of PRS’s domestic production activities that generate DPGR are within SIC AAA. X allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of PRS’s gross income. Based on the facts and circumstances of this specific case, apportionment of those expenses between DPGR and non-DPGR on the basis of PRS’s gross receipts is appropriate. For purposes of apportioning R&E, X elects to use the sales method as described in §1.861-17(c). Because X has no direct sales of products, and because all of PRS’s SIC AAA sales attributable to X’s share of PRS’s gross income generate DPGR, all of X’s share of PRS’s section 174 R&E attributable to SIC AAA is taken into account for purposes of determining X’s QPAI. Thus, X’s total QPAI for 2010 is $540, as shown in the following table: CGS (600) (B) Y’s QPAI. (1) For 2010, in addition to the activities of PRS, Y engages in domestic production activities that generate both DPGR and non-DPGR. With respect to those non-PRS activities, Y is not able to identify from its books and records CGS allocable to DPGR and to non-DPGR. In this case, because non-PRS CGS is definitely related under the facts and circumstances to all of Y’s non-PRS gross receipts, apportionment of non-PRS CGS between DPGR and non-DPGR based on Y’s non-PRS gross receipts is appropriate. For 2010, Y has the following non-PRS Federal income tax items: DPGR (from sales of products within SIC AAA) $1,500 DPGR (from sales of products within SIC BBB) 1,500 Non-DPGR (from sales of products within SIC BBB) 3,000 CGS (allocated to DPGR within SIC AAA) 750 CGS (allocated to DPGR within SIC BBB) 750 CGS (allocated to non-DPGR within SIC BBB) 1,500 (2) Because Y has DPGR as a result of activities outside PRS, Y must aggregate its distributive share of PRS’s Federal income tax items with such items from all its other, non-PRS-related activities. Y allocates and apportions its deductible items to gross income attributable to DPGR under the section 861 method of §1.199-4(d). In this case, the section 162 selling expenses are definitely related to all of Y’s gross income. Based on the facts and circumstances of the specific case, apportionment of such expenses between DPGR and non-DPGR on the basis of Y’s gross receipts (including Y’s share of PRS’s gross receipts) is appropriate. For purposes of apportioning R&E, Y elects to use the sales method as described in §1.861-17(c). (3) With respect to sales that generate DPGR, Y has gross income of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities) - $2,100 CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities)). Because all of the sales in SIC AAA generate DPGR, all of Y’s share of PRS’s section 174 R&E attributable to SIC AAA and the section 174 R&E attributable to SIC AAA that Y incurs in its non-PRS activities are taken into account for purposes of determining Y’s QPAI. Because only a portion of the sales within SIC BBB generate DPGR, only a portion of the section 174 R&E attributable to SIC BBB is taken into account in determining Y’s QPAI. Thus, Y’s QPAI for 2010 is $1,282, as shown in the following table: DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS activities)) $4,500 CGS ($600 from sales of products by PRS and $1,500 from non-PRS activities) (2,100) Section 162 selling expenses ($960 ($420 from PRS + $540 from non-PRS activities) x ($4,500 DPGR/$9,000 total gross receipts)) (480) Section 174 R&E-SIC AAA ($150 from PRS and $300 from non-PRS activities) (450) Section 174 R&E-SIC BBB ($750 ($300 from PRS + $450 from non-PRS activities) x ($1,500 DPGR/$6,000 total gross receipts allocated to SIC BBB ($1,500 from PRS + $4,500 from non-PRS activities)) (188) Y’s QPAI 1,282 (iv) Determination of section 199 deduction. X’s tentative section 199 deduction is $49 (.09 x $540, that is, QPAI determined at the partner level) subject to the W-2 wage limitation (50% of W-2 wages). Y’s tentative section 199 deduction is $115 (.09 x $1,282) subject to the W-2 wage limitation. Example 3. Partnership with special allocations. (i) In general. X and Y are unrelated corporate partners in PRS and each is engaged in a trade or business. PRS is a partnership that engages in a domestic production activity and other activities. In general, X and Y share all partnership items of income, gain, loss, deduction, and credit equally, except that 80% of the wage expense of PRS and 20% of PRS’s other expenses are specially allocated to X. Under all the facts and circumstances, these special allocations have substantial economic effect under section 704(b). In the 2010 taxable year, PRS’s only wage expense is $2,000 for marketing, which is not included in CGS. PRS has $8,000 of gross receipts ($6,000 of which is DPGR), $4,000 of CGS ($3,500 of which is allocable to DPGR), and $3,000 of deductions (comprised of $2,000 of wage expense for marketing and $1,000 of other expenses). X qualifies for and uses the simplified deduction method under §1.199-4(e). Y does not qualify to use that method and, therefore, must use the section 861 method under §1.199-4(d). In the 2010 taxable year, X has gross receipts attributable to non-partnership trade or business activities of $1,000 and wage expense of $200. None of X’s non-PRS gross receipts is DPGR. For purposes of this Example 3, with regard to both X and PRS, paragraph (e)(1) wages equal wage expense for the 2010 taxable year. (ii) Allocation and apportionment of costs. Under the partnership agreement, X’s distributive share of the Federal income tax items of PRS is $1,250 of gross income attributable to DPGR ($3,000 DPGR - $1,750 allocable CGS), $750 of gross income attributable to non-DPGR ($1,000 non-DPGR - $250 allocable CGS), and $1,800 of deductions (comprised of X’s special allocations of $1,600 of wage expense ($2,000 x 80%) for marketing and $200 of other expenses ($1,000 x 20%)). Under the simplified deduction method, X apportions $1,200 of other deductions to DPGR ($2,000 ($1,800 from the partnership and $200 from non-partnership activities) x ($3,000 DPGR/$5,000 total gross receipts)). Accordingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS - $1,200 of deductions). X has $1,800 of paragraph (e)(1) wages ($1,600 (X’s 80% share) from PRS + $200 (X’s own non-PRS paragraph (e)(1) wages)). To calculate its W-2 wages, X must determine how much of this $1,800 is properly allocable under §1.199-2(e)(2) to X’s total DPGR (including X’s share of DPGR from PRS). Thus, X’s tentative section 199 deduction for the 2010 taxable year is $5 (.09 x $50), subject to the W-2 wage limitation (50% of X’s W-2 wages). Example 4. Partnership with no paragraph (e)(1) wages. (i) Facts. A and B, both individuals, are partners in PRS. PRS is a partnership that engages in manufacturing activities that generate both DPGR and non-DPGR. A and B share all items of income, gain, loss, deduction, and credit equally. For the 2010 taxable year, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 and deductions of $800. PRS has no paragraph (e)(1) wages. Each partner’s distributive share of PRS’s Federal income tax items is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of deductions. A has trade or business activities outside of PRS (non-PRS activities). With respect to those activities, A has total gross receipts of $1,000 ($500 of which is DPGR), CGS of $400 (including $50 of paragraph (e)(1) wages), and deductions of $200 for the 2010 taxable year. B has no trade or business activities outside of PRS. A and B each use the small business simplified overall method under §1.199-4(f). (ii) A’s QPAI. A’s total CGS and deductions apportioned to DPGR equal $600 (($1,200 ($200 PRS CGS + $400 non-PRS CGS + $400 PRS deductions + $200 non-PRS trade or business deductions)) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,000 total gross receipts ($1,000 from PRS + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $400 ($1,000 DPGR ($500 from PRS + $500 from non-PRS activities) - $600 CGS and deductions). (iii) A’s W-2 wages and section 199 deduction. A has $50 of paragraph (e)(1) wages ($0 from PRS + $50 from A’s non-PRS activities). To calculate A’s W-2 wages, A determines, under a reasonable method satisfactory to the Secretary, that $40 of this $50 is properly allocable under §1.199-2(e)(2) to A’s DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $36 (.09 x $400), subject to the W-2 wage limitation of $20 (50% of W-2 wages of $40). Thus, A’s section 199 deduction is $20. (iv) B’s QPAI and section 199 deduction. B’s CGS and deductions apportioned to DPGR equal $300 (($200 PRS CGS + $400 PRS deductions) x ($500 DPGR from PRS /$1,000 total gross receipts from PRS)). Accordingly, B’s QPAI is $200 ($500 DPGR - $300 CGS and deductions). B’s tentative section 199 deduction is $18 (.09 x $200), subject to the W-2 wage limitation. In this case, however, the limitation is $0, because B has no paragraph (e)(1) wages. Thus, B’s section 199 deduction is $0. Example 5. Guaranteed payment. (i) Facts. The facts are the same as in Example 4, except that in 2010 PRS also makes a guaranteed payment of $200 to A for services rendered by A (see section 707(c)), and PRS incurs $200 of wage expense for employees’ salary, which is included within the $400 of CGS (in this case the wage expense of $200 equals PRS’s paragraph (e)(1) wages). The guaranteed payment is taxable to A as ordinary income and is properly deducted by PRS under section 162. Pursuant to §1.199-3(p), A may not treat any part of this payment as DPGR. Accordingly, PRS has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of $400 (including $200 of wage expense) and deductions of $1,000 (including the $200 guaranteed payment) for the 2010 taxable year. Each partner’s distributive share of the items of the partnership is $500 DPGR, $500 non-DPGR, $200 CGS (including $100 of wage expense), and $500 of deductions. (ii) A’s QPAI and W-2 wages. A’s total CGS and deductions apportioned to DPGR equal $591 ($1,300 ($200 PRS CGS + $400 non-PRS CGS + $500 PRS deductions + $200 non-PRS trade or business deductions) x ($1,000 total DPGR ($500 from PRS + $500 from non-PRS activities)/$2,200 total gross receipts ($1,000 from PRS + $200 guaranteed payment + $1,000 from non-PRS activities))). Accordingly, A’s QPAI is $409 ($1,000 DPGR - $591 CGS and other deductions). A’s total paragraph (e)(1) wages are $150 ($100 from PRS + $50 from non-PRS activities). To calculate its W-2 wages, A must determine how much of this $150 is properly allocable under §1.199-2(e)(2) to A’s total DPGR from PRS and non-PRS activities. A’s tentative section 199 deduction is $37 (.09 x $409), subject to the W-2 wage limitation (50% of W-2 wages). (iii) B’s QPAI and W-2 wages. B’s QPAI is $150 ($500 DPGR - $350 CGS and other deductions). B has $100 of paragraph (e)(1) wages (all from PRS). To calculate its W-2 wages, B must determine how much of this $100 is properly allocable under §1.199-2(e)(2) to B’s total DPGR. B’s tentative section 199 deduction is $14 (.09 x $150), subject to the W-2 wage limitation (50% of B’s W-2 wages). (c) S corporations—(1) In general—(i) Determination at shareholder level. The section 199 deduction with respect to the qualified production activities of an S corporation is determined at the shareholder level. As a result, each shareholder must compute its deduction separately. The section 199 deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation. Except as provided by publication pursuant to paragraph (c)(1)(ii) of this section, for purposes of this section, each shareholder is allocated, in accordance with section 1366, its pro rata share of S corporation items (including items of income, gain, loss, and deduction), CGS allocated to such items of income, and gross receipts included in such items of income, even if the shareholder’s share of CGS and other deductions and losses exceeds DPGR. Except as provided by publication under paragraph (c)(1)(ii) of this section, to determine its section 199 deduction for the taxable year, the shareholder aggregates its pro rata share of such items, to the extent they are not otherwise disallowed by the Code, with those items it incurs outside the S corporation (whether directly or indirectly) for purposes of allocating and apportioning deductions to DPGR and computing its QPAI. (ii) Determination at entity level. The Secretary may, by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), permit an S corporation to calculate a shareholder’s share of QPAI and W-2 wages at the entity level, instead of allocating to the shareholder, in accordance with section 1366, the shareholder’s pro rata share of S corporation items (including items of income, gain, loss, and deduction) and paragraph (e)(1) wages. If an S corporation does calculate QPAI at the entity level— (A) Each shareholder is allocated its share of QPAI (subject to the limitations of paragraph (c)(2) of this section) and W-2 wages from the S corporation, which are combined with the shareholder’s QPAI and W-2 wages from other sources, if any; (B) For purposes of computing the shareholder’s QPAI under §§1.199-1 through 1.199-8, a shareholder does not take into account the items from the S corporation (for example, a shareholder does not take into account items from the S corporation in determining whether a threshold or de minimis rule applies or in allocating and apportioning deductions) in calculating its QPAI from other sources; (C) A shareholder generally does not recompute its share of QPAI from the S corporation using another method; however, the shareholder might have to adjust its share of QPAI from the S corporation to take into account certain disallowed losses or deductions, or the allowance of suspended losses or deductions; and (D) A shareholder’s share of QPAI from an S corporation may be less than zero. (2) Disallowed losses or deductions. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), losses or deductions of the S corporation are taken into account in computing the shareholder’s QPAI for a taxable year only if, and to the extent that, the shareholder’s pro rata share of the losses or deductions from all of the S corporation’s activities is not disallowed by section 465, 469, or 1366(d), or any other provision of the Code. If only a portion of the shareholder’s share of the losses or deductions from an S corporation is allowed for a taxable year, a proportionate share of those allowed losses or deductions that are allocated to the S corporation’s qualified production activities, determined in a manner consistent with sections 465, 469, and 1366(d), and any other applicable provision of the Code, is taken into account in computing QPAI for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year under section 465, 469, or 1366(d), or any other provision of the Code, the shareholder takes into account a proportionate share of those allowed losses or deductions that are allocated to the S corporation’s qualified production activities in computing the shareholder’s QPAI for that later taxable year. Losses or deductions of the S corporation that are disallowed for taxable years beginning on or before December 31, 2004, however, are not taken into account in a later taxable year for purposes of computing the shareholder’s QPAI for that later taxable year, whether or not the losses or deductions are allowed for other purposes. (3) Shareholder’s share of paragraph (e)(1) wages. Under section 199(d)(1)(A)(iii), an S corporation shareholder’s share of the paragraph (e)(1) wages of the S corporation for purposes of determining the shareholder’s W-2 wage limitation equals the shareholder’s allocable share of those wages. Except as provided by publication in the Internal Revenue Bulletin (see §601.601(d)(2)(ii)(b) of this chapter), the S corporation must allocate the paragraph (e)(1) wages among the shareholders in the same manner it allocates wage expense among those shareholders. The shareholder then must add its share of the paragraph (e)(1) wages from the S corporation to the shareholder’s paragraph (e)(1) wages from other sources, if any, and then must determine the portion of those total paragraph (e)(1) wages allocable to DPGR to compute the shareholder’s W-2 wages. See §1.199-2(e)(2) for the computation of W-2 wages and for the proper allocation of such wages to DPGR. (4) Transition rule for definition of W-2 wages and for W-2 wage limitation. If an S corporation and any of its shareholders have different taxable years, only one of which begins after May 17, 2006, the definition of W-2 wages of the S corporation and the section 199(d)(1)(A)(iii) rule for determining a shareholder’s share of wages from that S corporation is determined under the law applicable to S corporations based on the beginning date of the S corporation’s taxable year. Thus, for example, for the short taxable year of an S corporation beginning after May 17, 2006, and ending in 2006, a shareholder’s share of W-2 wages from the S corporation is determined under section 199(d)(1)(A)(iii) for taxable years beginning after May 17, 2006, even if that shareholder’s taxable year began on or before May 17, 2006. (d) Grantor trusts. To the extent that the grantor or another person is treated as owning all or part (the owned portion) of a trust under sections 671 through 679, such person (owner) computes its QPAI with respect to the owned portion of the trust as if that QPAI had been generated by activities performed directly by the owner. Similarly, for purposes of the W-2 wage limitation, the owner of the trust takes into account the owner’s share of the paragraph (e)(1) wages of the trust that are attributable to the owned portion of the trust. The provisions of paragraph (e) of this section do not apply to the owned portion of a trust. (e) Non-grantor trusts and estates—(1) Allocation of costs. The trust or estate calculates each beneficiary’s share (as well as the trust’s or estate’s own share, if any) of QPAI and W-2 wages from the trust or estate at the trust or estate level. The beneficiary of a trust or estate may not recompute its share of QPAI or W-2 wages from the trust or estate by using another method to reallocate the trust’s or estate’s qualified production costs or paragraph (e)(1) wages, or otherwise. Except as provided in paragraph (d) of this section, the QPAI of a trust or estate must be computed by allocating expenses described in section 199(d)(5) in one of two ways, depending on the classification of those expenses under §1.652(b)-3. Specifically, directly attributable expenses within the meaning of §1.652(b)-3 are allocated pursuant to §1.652(b)-3, and expenses not directly attributable within the meaning of §1.652(b)-3 (other expenses) are allocated under the simplified deduction method of §1.199-4(e) (unless the trust or estate does not qualify to use the simplified deduction method, in which case it must use the section 861 method of §1.199-4(d) with respect to such other expenses). For this purpose, depletion and depreciation deductions described in section 642(e) and amortization deductions described in section 642(f) are treated as other expenses described in section 199(d)(5). Also for this purpose, the trust’s or estate’s share of other expenses from a lower-tier pass-thru entity is not directly attributable to any class of income (whether or not those other expenses are directly attributable to the aggregate pass-thru gross income as a class for purposes other than section 199). A trust or estate may not use the small business simplified overall method for computing its QPAI. See §1.199-4(f)(5). (2) Allocation among trust or estate and beneficiaries—(i) In general. The QPAI of a trust or estate (which will be less than zero if the CGS and deductions allocated and apportioned to DPGR exceed the trust’s or estate’s DPGR) and W-2 wages of a trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate. For this purpose, the trust or estate’s DNI is determined with regard to the separate share rule of section 663(c), but without regard to section 199. To the extent that the trust or estate has no DNI for the taxable year, any QPAI and W-2 wages are allocated entirely to the trust or estate. A trust or estate is allowed the section 199 deduction in computing its taxable income to the extent that QPAI and W-2 wages are allocated to the trust or estate. A beneficiary of a trust or estate is allowed the section 199 deduction in computing its taxable income based on its share of QPAI and W-2 wages from the trust or estate, which are aggregated with the beneficiary’s QPAI and W-2 wages from other sources, if any. (ii) Treatment of items from a trust or estate reporting qualified production activities income. When, pursuant to this paragraph (e), a taxpayer must combine QPAI and W-2 wages from a trust or estate with the taxpayer’s total QPAI and W-2 wages from other sources, the taxpayer, when applying §§1.199-1 through 1.199-8 to determine the taxpayer’s total QPAI and W-2 wages from such other sources, does not take into account the items from such trust or estate. Thus, for example, a beneficiary of an estate that receives QPAI from the estate does not take into account the beneficiary’s distributive share of the estate’s gross receipts, gross income, or deductions when the beneficiary determines whether a threshold or de minimis rule applies or when the beneficiary allocates and apportions deductions in calculating its QPAI from other sources. Similarly, in determining the portion of the beneficiary’s paragraph (e)(1) wages from other sources that is attributable to DPGR (thus, the W-2 wages from other sources), the beneficiary does not take into account DPGR and non-DPGR from the trust or estate. (3) Transition rule for definition of W-2 wages and for W-2 wage limitation. The definition of W-2 wages of a trust or estate and the section 199(d)(1)(A)(iii) rule for determining the respective shares of wages from that trust or estate, and thus the beneficiary’s share of W-2 wages from that trust or estate, is determined under the law applicable to pass-thru entities based on the beginning date of the taxable year of the trust or estate, regardless of the beginning date of the taxable year of the beneficiary. (4) Example. The following example illustrates the application of this paragraph (e). Assume that the partnership, trust, and trust beneficiary all are calendar year taxpayers. The example reads as follows: Example. (i) Computation of DNI and inclusion and deduction amounts. (A) Trust’s distributive share of partnership items. Trust, a complex trust, is a partner in PRS, a partnership that engages in activities that generate DPGR and non-DPGR. In 2010, PRS distributes $10,000 cash to Trust. PRS properly allocates (in the same manner as wage expense) paragraph (e)(1) wages of $3,000 to Trust. Trust’s distributive share of PRS items, which are properly included in Trust’s DNI, is as follows: Gross income attributable to DPGR ($15,000 DPGR - $5,000 CGS (including wage expense of $1,000)) $10,000 Gross income attributable to non-DPGR ($5,000 other gross receipts - $0 CGS) 5,000 Selling expenses attributable to DPGR (includes wage expense of $2,000) 3,000 Other expenses (includes wage expense of $1,000) 2,000 (B) Trust’s direct activities. In addition to its cash distribution in 2010 from PRS, Trust directly has the following items which are properly included in Trust’s DNI: Dividends $10,000 Tax-exempt interest 10,000 Rents from commercial real property operated by Trust as a business 10,000 Real estate taxes 1,000 Trustee commissions 3,000 State income and personal property taxes 5,000 Wage expense for rental business (direct paragraph (e)(1) wages) 2,000 Other business expenses 1,000 (C) Allocation of deductions under §1.652(b)-3. (1) Directly attributable expenses. In computing Trust’s DNI for the taxable year, the distributive share of expenses of PRS are directly attributable under §1.652(b)-3(a) to the distributive share of income of PRS. Accordingly, the $5,000 of CGS, $3,000 of selling expenses, and $2,000 of other expenses are subtracted from the gross receipts from PRS ($20,000), resulting in net income from PRS of $10,000. With respect to the Trust’s direct expenses, $1,000 of the trustee commissions, the $1,000 of real estate taxes, and the $2,000 of wage expense are directly attributable under §1.652(b)-3(a) to the rental income. (2) Non-directly attributable expenses. Under §1.652(b)-3(b), the trustee must allocate a portion of the sum of the balance of the trustee commissions ($2,000), state income and personal property taxes ($5,000), and the other business expenses ($1,000) to the $10,000 of tax-exempt interest. The portion to be attributed to tax-exempt interest is $2,222 ($8,000 x ($10,000 tax exempt interest/$36,000 gross receipts net of direct expenses)), resulting in $7,778 ($10,000 - $2,222) of net tax-exempt interest. Pursuant to its authority recognized under §1.652(b)-3(b), the trustee allocates the entire amount of the remaining $5,778 of trustee commissions, state income and personal property taxes, and other business expenses to the $6,000 of net rental income, resulting in $222 ($6,000 - $5,778) of net rental income. (D) Amounts included in taxable income. For 2010, Trust has DNI of $28,000 (net dividend income of $10,000 + net PRS income of $10,000 + net rental income of $222 + net tax-exempt income of $7,778). Pursuant to Trust’s governing instrument, Trustee distributes 50%, or $14,000, of that DNI to B, an individual who is a discretionary beneficiary of Trust. Assume that there are no separate shares under Trust, and no distributions are made to any other beneficiary that year. Consequently, with respect to the $14,000 distribution B receives from Trust, B properly includes in B’s gross income $5,000 of income from PRS, $111 of rents, and $5,000 of dividends, and properly excludes from B’s gross income $3,889 of tax-exempt interest. Trust includes $20,222 in its adjusted total income and deducts $10,111 under section 661(a) in computing its taxable income. (ii) Section 199 deduction. (A) Simplified deduction method. For purposes of computing the section 199 deduction for the taxable year, assume Trust qualifies for the simplified deduction method under §1.199-4(e). The determination of Trust’s QPAI under the simplified deduction method requires multiple steps to allocate costs. First, the Trust’s expenses directly attributable to DPGR under §1.652(b)-3(a) are subtracted from the Trust’s DPGR. In this step, the directly attributable $5,000 of CGS and selling expenses of $3,000 are subtracted from the $15,000 of DPGR from PRS. Second, the Trust’s expenses directly attributable under §1.652(b)-3(a) to non-DPGR from a trade or business are subtracted from the Trust’s trade or business non-DPGR. In this step, $4,000 of Trust expenses directly allocable to the real property rental activity ($1,000 of real estate taxes, $1,000 of Trustee commissions, and $2,000 of wages) are subtracted from the $10,000 of rental income. Third, Trust must identify the portion of its other expenses that is attributable to Trust’s trade or business activities, if any, because expenses not attributable to trade or business activities are not taken into account in computing QPAI. In this step, in this example, the portion of the trustee commissions not directly attributable to the rental operation ($2,000) is directly attributable to non-trade or business activities. In addition, the state income and personal property taxes are not directly attributable under §1.652(b)-3(a) to either trade or business or non-trade or business activities, so the portion of those taxes not attributable to either the PRS interests or the rental operation is not a trade or business expense and, thus, is not taken into account in computing QPAI. The portion of the state income and personal property taxes that is treated as an other trade or business expense is $3,000 ($5,000 x $30,000 total trade or business gross receipts/$50,000 total gross receipts). Fourth, Trust then allocates its other trade or business expenses (not directly attributable under §1.652(b)-3(a)) between DPGR and non-DPGR on the basis of its total gross receipts from the conduct of a trade or business ($20,000 from PRS + $10,000 rental income). Thus, Trust combines its non-directly attributable (other) business expenses ($2,000 from PRS + $4,000 ($1,000 of other business expenses + $3,000 of income and property taxes allocated to a trade or business) from its own activities) and then apportions this total ($6,000) between DPGR and other receipts on the basis of Trust’s total trade or business gross receipts ($6,000 of such expenses x $15,000 DPGR/$30,000 total trade or business gross receipts = $3,000). Thus, for purposes of computing Trust’s and B’s section 199 deduction, Trust’s QPAI is $4,000 ($7,000 ($15,000 DPGR - $5,000 CGS - $3,000 selling expenses) - $3,000). Because the distribution of Trust’s DNI to B equals one-half of Trust’s DNI, Trust and B each has QPAI from PRS for purposes of the section 199 deduction of $2,000. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI. (B) W-2 wages. For the 2010 taxable year, Trust chooses to use the wage expense safe harbor under §1.199-2(e)(2)(ii) to determine its W-2 wages. For its taxable year ending December 31, 2010, Trust has $5,000 ($3,000 from PRS + $2,000 of Trust) of paragraph (e)(1) wages reported on 2010 Forms W-2. Trust’s W-2 wages are $2,917, as shown in the following table: Wage expense included in CGS directly attributable to DPGR $1,000 Wage expense included in selling expense directly attributable to DPGR 2,000 Wage expense included in non-directly attributable deductions ($1,000 in wage expense x ($15,000 DPGR/$30,000 total trade or business gross receipts)) 500 Wage expense allocable to DPGR 3,500 W-2 wages (($3,500 of wage expense allocable to DPGR/$6,000 of total wage expense) x $5,000 in paragraph (e)(1) wages) $2,917 (C) Section 199 deduction computation. (1) B’s computation. B is eligible to use the small business simplified overall method. Assume that B has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, B has W-2 wages from Trust of $1,459 (50% x $2,917). B has W-2 wages of $100 from trade or business activities outside of Trust and attributable to DPGR (computed without regard to B’s interest in Trust pursuant to §1.199-2(e)) for a total of $1,559 of W-2 wages. B has $1,000 of QPAI from non-Trust activities that is added to the $2,000 QPAI from Trust for a total of $3,000 of QPAI. B’s tentative deduction is $270 (.09 x $3,000), limited under the W-2 wage limitation to $780 (50% x $1,559 W-2 wages). Accordingly, B’s section 199 deduction for 2010 is $270. (2) Trust’s computation. Trust has sufficient adjusted gross income so that the section 199 deduction is not limited under section 199(a)(1)(B). Because the $14,000 Trust distribution to B equals one-half of Trust’s DNI, Trust has W-2 wages of $1,459 (50% x $2,917). Trust’s tentative deduction is $180 (.09 x $2,000 QPAI), limited under the W-2 wage limitation to $730 (50% x $1,459 W-2 wages). Accordingly, Trust’s section 199 deduction for 2010 is $180. (f) Gain or loss from the disposition of an interest in a pass-thru entity. DPGR generally does not include gain or loss recognized on the sale, exchange, or other disposition of an interest in a pass-thru entity. However, with respect to a partnership, if section 751(a) or (b) applies, then gain or loss attributable to assets of the partnership giving rise to ordinary income under section 751(a) or (b), the sale, exchange, or other disposition of which would give rise to DPGR, is taken into account in computing the partner’s section 199 deduction. Accordingly, to the extent that cash or property received by a partner in a sale or exchange of all or part of its partnership interest is attributable to unrealized receivables or inventory items within the meaning of section 751(c) or (d), respectively, and the sale or exchange of the unrealized receivable or inventory items would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the cash or property received by the partner is taken into account by the partner in determining its DPGR for the taxable year. Likewise, to the extent that a distribution of property to a partner is treated under section 751(b) as a sale or exchange of property between the partnership and the distributee partner, and any property deemed sold or exchanged would give rise to DPGR if sold, exchanged, or otherwise disposed of by the partnership, the deemed sale or exchange of the property must be taken into account in determining the partnership’s and distributee partner’s DPGR to the extent not taken into account under the qualifying in-kind partnership rules. See §§1.751-1(b) and 1.199-3(i)(7). (g) No attribution of qualified activities. Except as provided in §1.199-3(i)(7) regarding qualifying in-kind partnerships and §1.199-3(i)(8) regarding EAG partnerships, an owner of a pass-thru entity is not treated as conducting the qualified production activities of the pass-thru entity, and vice versa. This rule applies to all partnerships, including partnerships that have elected out of subchapter K under section 761(a). Accordingly, if a partnership manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and distributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partner who then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partner’s gross receipts from this latter lease, rental, license, sale, exchange, or other disposition are treated as non-DPGR. In addition, if a partner manufactures QPP within the United States, or produces a qualified film or produces utilities in the United States, and contributes or leases, rents, licenses, sells, exchanges, or otherwise disposes of such property to a partnership which then, without performing its own qualifying activity, leases, rents, licenses, sells, exchanges, or otherwise disposes of such property, then the partnership’s gross receipts from this latter disposition are treated as non-DPGR. Par. 10. Section 1.199-5T is removed. Par. 11. Section 1.199-7 is amended by revising paragraph (b)(4) to read as follows: (4) Losses used to reduce taxable income of expanded affiliated group—(i) In general. The amount of an NOL sustained by any member of an EAG that is used in the year sustained in determining an EAG’s taxable income limitation under section 199(a)(1)(B) is not treated as an NOL carryover or NOL carryback to any taxable year in determining the taxable income limitation under section 199(a)(1)(B). For purposes of this paragraph (b)(4), an NOL is considered to be used if it reduces an EAG’s aggregate taxable income, regardless of whether the use of the NOL actually reduces the amount of the section 199 deduction that the EAG would otherwise derive. An NOL is not considered to be used to the extent that it reduces an EAG’s aggregate taxable income to an amount less than zero. If more than one member of an EAG has an NOL used in the same taxable year to reduce the EAG’s taxable income, the members’ respective NOLs are deemed used in proportion to the amount of their NOLs. (ii) Examples. The following examples illustrate the application of this paragraph (b)(4). For purposes of these examples, assume that all relevant parties have sufficient W-2 wages so that the section 199 deduction is not limited under section 199(b)(1). The examples read as follows: Example 1. (i) Facts. Corporations A and B are the only two members of an EAG. A and B are both calendar year taxpayers, and they do not join in the filing of a consolidated Federal income tax return. Neither A nor B had taxable income or loss prior to 2010. In 2010, A has QPAI and taxable income of $1,000, and B has QPAI of $1,000 and an NOL of $1,500. In 2011, A has QPAI of $2,000 and taxable income of $1,000 and B has QPAI of $2,000 and taxable income prior to the NOL deduction allowed under section 172 of $2,000. (ii) Section 199 deduction for 2010. In determining the EAG’s section 199 deduction for 2010, A’s $1,000 of QPAI and B’s $1,000 of QPAI are aggregated, as are A’s $1,000 of taxable income and B’s $1,500 NOL. Thus, for 2010, the EAG has QPAI of $2,000 and taxable income of ($500). The EAG’s section 199 deduction for 2010 is 9% of the lesser of its QPAI or its taxable income. Because the EAG has a taxable loss in 2010, the EAG’s section 199 deduction is $0. (iii) Section 199 deduction for 2011. In determining the EAG’s section 199 deduction for 2011, A’s $2,000 of QPAI and B’s $2,000 of QPAI are aggregated, giving the EAG QPAI of $4,000. Also, $1,000 of B’s NOL from 2010 was used in 2010 to reduce the EAG’s taxable income to $0. The remaining $500 of B’s 2010 NOL is not considered to have been used in 2010 because it reduced the EAG’s taxable income below $0. Accordingly, for purposes of determining the EAG’s taxable income limitation under section 199(a)(1)(B) in 2011, B is deemed to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income. Thus, B’s taxable income in 2011 is $1,500 which is aggregated with A’s $1,000 of taxable income. The EAG’s taxable income limitation in 2011 is $2,500. The EAG’s section 199 deduction is 9% of the lesser of its QPAI of $4,000 or its taxable income of $2,500. Thus, the EAG’s section 199 deduction in 2011 is 9% of $2,500, or $225. The results would be the same if neither A nor B had QPAI in 2010. Example 2. The facts are the same as in Example 1 except that in 2010 B was not a member of the same EAG as A, but instead was a member of an EAG with Corporation X, which had QPAI and taxable income of $1,000 in 2010, and had neither taxable income nor loss in any other year. There were no other members of the EAG in 2010 besides B and X, and B and X did not file a consolidated Federal income tax return. As $1,000 of B’s NOL was used in 2010 to reduce the B and X EAG’s taxable income to $0, B is considered to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income for purposes of the taxable income limitation under section 199(a)(1)(B), just as in Example 1. Accordingly, the results for the A and B EAG in 2011 are the same as in Example 1. Example 3. The facts are the same as in Example 1 except that B is not a member of any EAG in 2011. Because $1,000 of B’s NOL was used in 2010 to reduce the EAG’s taxable income to $0, B is considered to have only a $500 NOL carryover from 2010 to offset a portion of its 2011 taxable income for purposes of the taxable income limitation under section 199(a)(1)(B), just as in Example 1. Thus, for purposes of determining B’s taxable income limitation in 2011, B is considered to have taxable income of $1,500, and B has a section 199 deduction of 9% of $1,500, or $135. Example 4. Corporations A, B, and C are the only members of an EAG. A, B, and C are all calendar year taxpayers, and they do not join in the filing of a consolidated Federal income tax return. None of the EAG members (A, B, or C) had taxable income or loss prior to 2010. In 2010, A has QPAI of $2,000 and taxable income of $1,000, B has QPAI of $1,000 and an NOL of $1,000, and C has QPAI of $1,000 and an NOL of $3,000. In 2011, prior to the NOL deduction allowed under section 172, A and B each has taxable income of $200 and C has taxable income of $5,000. In determining the EAG’s section 199 deduction for 2010, A’s QPAI of $2,000, B’s QPAI of $1,000, and C’s QPAI of $1,000 are aggregated, as are A’s taxable income of $1,000, B’s NOL of $1,000, and C’s NOL of $3,000. Thus, for 2010, the EAG has QPAI of $4,000 and taxable income of ($3,000). In determining the EAG’s taxable income limitation under section 199(a)(1)(B) in 2011, $1,000 of B’s and C’s aggregate NOLs in 2010 of $4,000 are considered to have been used in 2010 to reduce the EAG’s taxable income to $0, in proportion to their NOLs. Thus, $250 of B’s NOL from 2010 ($1,000 x $1,000/$4,000) and $750 of C’s NOL from 2010 ($1,000 x $3,000/$4,000) are deemed to have been used in 2010. The remaining $750 of B’s NOL and the remaining $2,250 of C’s NOL are not deemed to have been used because so doing would have reduced the EAG’s taxable income in 2010 below $0. Accordingly, for purposes of determining the EAG’s taxable income limitation in 2011, B is deemed to have a $750 NOL carryover from 2010 and C is deemed to have a $2,250 NOL carryover from 2010. Thus, for purposes of determining the EAG’s taxable income limitation, B’s taxable income in 2011 is $0 and C’s taxable income in 2011 is $2,750, which are aggregated with A’s $200 taxable income. B’s unused NOL carryover from 2010 cannot be used to reduce either A’s or C’s 2011 taxable income. Thus, the EAG’s taxable income limitation in 2011 is $2,950, A’s taxable income of $200 plus B’s taxable income of $0 plus C’s taxable income of $2,750. Par. 13. Section 1.199-8 is amended by: 1. Removing the language “§1.199-9(j)” in paragraph (e)(1)(i) and adding the language “§§1.199-3(i)(8) and 1.199-9(j)” in its place. 2. Removing the language “§1.199-9(i)” in paragraph (e)(1)(i) and adding the language “§§1.199-3(i)(7) and 1.199-9(i)” in its place. 3. Removing the language “§1.199-9(i)” in paragraph (e)(1)(ii)(B) and adding the language “§1.199-3(i)(7) or §1.199-9(i)” in its place. 4. Revising the last two sentences in paragraph (h). 5. Revising paragraphs (i)(5) and (i)(6). (h) Disallowed losses or deductions. * * * For taxpayers that are partners in partnerships, see §§1.199-5(b)(2) and 1.199-9(b)(2). For taxpayers that are shareholders in S corporations, see §§1.199-5(c)(2) and 1.199(c)(2). (5) Tax Increase Prevention and Reconciliation Act of 2005. Sections 1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 are applicable for taxable years beginning on or after October 19, 2006. A taxpayer may apply §§1.199-2(e)(2), 1.199-3(i)(7) and (8), and 1.199-5 to taxable years beginning after May 17, 2006, and before October 19, 2006, regardless of whether the taxpayer otherwise relied upon Notice 2005-14, 2005-1 C.B. 498 (see §601.601(d)(2)(ii)(b) of this chapter), the provisions of REG-105847-05, 2005-2 C.B. 987, or §§1.199-1 through 1.199-8. (6) Losses used to reduce taxable income of expanded affiliated group. Section 1.199-7(b)(4) is applicable for taxable years beginning on or after February 15, 2008. For taxable years beginning on or after October 19, 2006, and before February 15, 2008, see §1.199-7T(b)(4) (see 26 CFR part 1 revised as of April 1, 2007). 1. Revising paragraph (b)(1)(ii)(B). 2. Removing the language “paragraph (b) of this section shall” from paragraph (b)(5) and adding the language “this paragraph (b)” in its place. 3. Revising paragraph (c)(1)(ii)(B). 4. Revising paragraph (e)(2)(i). 5. Removing the language “directly allocable costs” in the sixth sentence of Example 4 in paragraph (j)(5) and adding the language “CGS” in its place. 6. Adding the language “finished dosage form” before the word “drug” each time it appears in the seventh, eighth, and ninth sentences in paragraph (j)(5) Example 5 (i) and in the second and third sentences in paragraph (j)(5) Example 5 (ii). §1.199-9 Application of section 199 to pass-thru entities for taxable years beginning on or before May 17, 2006, the enactment date of the Tax Increase Prevention and Reconciliation Act of 2006. (1) * * * (ii) * * * (c) * * * (2) * * * (i) In general. The QPAI of a trust or estate (which will be less than zero if the CGS and deductions allocated and apportioned to DPGR exceed the trust’s or estate’s DPGR) and W-2 wages of a trust or estate are allocated to each beneficiary and to the trust or estate based on the relative proportion of the trust’s or estate’s distributable net income (DNI), as defined by section 643(a), for the taxable year that is distributed or required to be distributed to the beneficiary or is retained by the trust or estate. For this purpose, the trust or estate’s DNI is determined with regard to the separate share rule of section 663(c), but without regard to section 199. To the extent that the trust or estate has no DNI for the taxable year, any QPAI and W-2 wages are allocated entirely to the trust or estate. A trust or estate is allowed the section 199 deduction in computing its taxable income to the extent that QPAI and W-2 wages are allocated to the trust or estate. A beneficiary of a trust or estate is allowed the section 199 deduction in computing its taxable income based on its share of QPAI and W-2 wages from the trust or estate, which (subject to the wage limitation as described in paragraph (e)(3) of this section) are aggregated with the beneficiary’s QPAI and W-2 wages from other sources, if any. Linda E. Stiff, Deputy Commissioner for Services and Enforcement. Approved February 1, 2008. Eric Solomon, Assistant Secretary of the Treasury (Tax Policy). (Filed by the Office of the Federal Register on February 14, 2008, 8:45 a.m., and published in the issue of the Federal Register for February 15, 2008, 73 F.R. 8798) Drafting Information The principal authors of these regulations are Paul Handleman and Lauren Ross Taylor, Office of the Associate Chief Counsel (Passthroughs and Special Industries), IRS. However, other personnel from the IRS and Treasury Department participated in their development. Time and Manner for Electing Capital Asset Treatment for Certain Self-Created Musical Works Temporary regulation. This document contains a temporary regulation that provides the time and manner for making an election to treat the sale or exchange of musical compositions or copyrights in musical works created by the taxpayer (or received by the taxpayer from the works’ creator in a transferred basis transaction) as the sale or exchange of a capital asset. The regulation reflects changes to the law made by the Tax Increase Prevention and Reconciliation Act of 2005 and the Tax Relief and Health Care Act of 2006. The regulation affects taxpayers making the election under section 1221(b)(3) of the Internal Revenue Code (Code) to treat gain or loss from such a sale or exchange as capital gain or loss. The text of this temporary regulation also serves as the text of the proposed regulation (REG-153589-06) set forth in this issue of the Bulletin. Effective Date: This regulation is effective on February 8, 2008. Applicability Dates: For dates of applicability, see §1.1221-3T(d). Jamie Kim, (202) 622-4950 (not a toll-free number). Section 1221(a) of the Internal Revenue Code (Code) generally provides that capital assets include all property held by a taxpayer with certain specified exclusions. Section 1221(a)(1) excludes from the definition of a capital asset inventory property or property held by a taxpayer primarily for sale to customers in the ordinary course of the taxpayer’s trade or business. Section 1221(a)(3) excludes from the definition of a capital asset copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property held by a taxpayer whose personal efforts created the property (or held by a taxpayer whose basis in the property is determined by reference to the basis of such property in the hands of the taxpayer whose personal efforts created the property). Section 1221(b)(3) of the Code, added by section 204 of the Tax Increase Prevention and Reconciliation Act of 2005 (Public Law 109-222, 120 Stat. 345) and amended by section 412 of the Tax Relief and Health Care Act of 2006 (Public Law 109-432, 120 Stat. 2922), provides that, at the election of a taxpayer, the section 1221(a)(1) and (a)(3) exclusions from capital asset status do not apply to musical compositions or copyrights in musical works sold or exchanged by a taxpayer described in section 1221(a)(3). Thus, if a taxpayer who owns a musical composition or copyright in a musical work created by the taxpayer (or transferred to the taxpayer by the work’s creator in a section 1221(a)(3)(C) transferred basis transaction) elects the application of this provision, gain or loss from the sale or exchange of the musical composition or copyright is treated as capital gain or loss. Explanation of Provisions This temporary regulation provides rules regarding the time and manner for making an election under section 1221(b)(3) to treat gain or loss from the sale or exchange of certain musical compositions or copyrights in musical works as gain or loss from the sale or exchange of a capital asset. It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation. For application of the Regulatory Flexibility Act (5 U.S.C. Chapter 6) please refer to the cross reference notice of proposed rulemaking published elsewhere in this issue of the Bulletin. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Amendments to the Regulations Par. 2. Section 1.1221-3T is added to read as follows: §1.1221-3T Time and manner for electing capital asset treatment for certain self-created musical works (temporary). (a) Description. Section 1221(b)(3) allows an electing taxpayer to treat the sale or exchange of a musical composition or copyright in a musical work created by the taxpayer’s personal efforts (or having a basis determined by reference to the basis of such property in the hands of a taxpayer whose personal efforts created such property) as the sale or exchange of a capital asset. As a consequence, gain or loss from the sale or exchange is treated as capital gain or loss. An election may be made for sales and exchanges in taxable years beginning after May 17, 2006. (b) Time and manner for making the election. An election described in this section is made separately for each musical composition (or copyright in a musical work) sold or exchanged during the taxable year. An election must be made on or before the due date (including extensions) of the income tax return for the taxable year of the sale or exchange. An election is to be made on Schedule D, “Capital Gains and Losses,” of the appropriate income tax form (for example, Form 1040, “U.S. Individual Income Tax Return;” Form 1065, “U.S. Return of Partnership Income;” Form 1120, “U.S. Corporation Income Tax Return”) by treating the sale or exchange as the sale or exchange of a capital asset, in accordance with the form and its instructions. (c) Revocability of election. An election described in this section is revocable with the consent of the Commissioner. To seek consent to revoke an election, a taxpayer must submit a request for a letter ruling under the appropriate revenue procedure. See, for example, Rev. Proc. 2007-1, 2007-1 C.B. 1 (updated annually). Alternatively, an automatic extension of 6 months from the due date of the taxpayer’s income tax return (excluding extensions) is granted to revoke an election, provided the taxpayer timely filed the taxpayer’s income tax return and, within this 6-month extension period, the taxpayer files an amended income tax return that treats the sale or exchange as the sale or exchange of property that is not a capital asset. See §601.601(d)(2)(ii)(b) of this Chapter. (d) Effective/applicability date. (1) The rules of this section apply to sales and exchanges in taxable years beginning after May 17, 2006. (2) Expiration date. This section expires on February 8, 2011. Approved January 28, 2008. (Filed by the Office of the Federal Register on February 7, 2008, 8:45 a.m., and published in the issue of the Federal Register for February 8, 2008, 73 F.R. 7464) The principal author of these regulations is Jamie Kim of the Office of Associate Chief Counsel (Income Tax & Accounting). However, other personnel from the IRS and Treasury Department participated in their development. This revenue ruling provides various prescribed rates for federal income tax purposes for April 2008 (the current month). Table 1 contains the short-term, mid-term, and long-term applicable federal rates (AFR) for the current month for purposes of section 1274(d) of the Internal Revenue Code. Table 2 contains the short-term, mid-term, and long-term adjusted applicable federal rates (adjusted AFR) for the current month for purposes of section 1288(b). Table 3 sets forth the adjusted federal long-term rate and the long-term tax-exempt rate described in section 382(f). Table 4 contains the appropriate percentages for determining the low-income housing credit described in section 42(b)(2) for buildings placed in service during the current month. Finally, Table 5 contains the federal rate for determining the present value of an annuity, an interest for life or for a term of years, or a remainder or a reversionary interest for purposes of section 7520. REV. RUL. 2008-20 TABLE 1 Applicable Federal Rates (AFR) for April 2008 Period for Compounding Semiannual AFR 1.85% 1.84% 1.84% 1.83% 110% AFR 2.03% 2.02% 2.01% 2.01% Mid-term Adjusted AFR for April 2008 Short-term adjusted AFR 1.99% 1.98% 1.98% 1.97% Mid-term adjusted AFR 3.28% 3.25% 3.24% 3.23% Long-term adjusted AFR 4.55% 4.50% 4.47% 4.46% Rates Under Section 382 for April 2008 Adjusted federal long-term rate for the current month 4.55% Long-term tax-exempt rate for ownership changes during the current month (the highest of the adjusted federal long-term rates for the current month and the prior two months.) 4.55% Appropriate Percentages Under Section 42(b)(2) for April 2008 Appropriate percentage for the 70% present value low-income housing credit 7.84% Rate Under Section 7520 for April 2008 Applicable federal rate for determining the present value of an annuity, an interest for life or a term of years, or a remainder or reversionary interest 3.4% Substitute for Return 26 CFR Part 301 Final regulations and removal of temporary regulations. This document contains final regulations relating to returns prepared or signed by the Commissioner or other Internal Revenue Officers or employees under section 6020 of the Internal Revenue Code. These final regulations provide guidance for preparing a substitute for return under section 6020(b). Absent the existence of a return under section 6020(b), the addition to tax under section 6651(a)(2) does not apply to a nonfiler. These final regulations affect any person who fails to file a required return. Applicability Date: For dates of applicability, see §301.6020-1(d). Alicia E. Goldstein at (202) 622-3630 (not a toll-free number). This document contains final regulations relating to substitutes for returns. These final regulations reflect amendments to 26 CFR part 301 under section 6020 of the Internal Revenue Code. Section 301.6020-1 of the Procedure and Administration Regulations provides for the preparation or execution of returns by authorized Internal Revenue Officers or employees. Section 1301(a) of the Taxpayer Bill of Rights Act of 1996, Public Law 104-168 (110 Stat. 1452), amended section 6651 to add subsection (g)(2), which provides that, for returns due after July 30, 1996 (determined without regard to extensions), a return made under section 6020(b) shall be treated as a return filed by the taxpayer for purposes of determining the amount of the additions to tax under section 6651(a)(2) and (a)(3). Absent the existence of a return under section 6020(b), the addition to tax under section 6651(a)(2) does not apply to a nonfiler. In Cabirac v. Commissioner, 120 T.C. 163 (2003), aff’d in an unpublished opinion, No. 03-3157 (3rd Cir. Feb. 10, 2004), and Spurlock v. Commissioner, T.C. Memo. 2003-124, the Tax Court found that the Service did not establish that it had prepared and signed a return in accordance with section 6020(b). In Spurlock, the Tax Court held that a return for section 6020(b) purposes must be subscribed, contain sufficient information from which to compute the taxpayer’s tax liability, and the return and any attachments must “purport to be a return.” Spurlock, T.C.Memo. 2003-124 at 27. These decisions prompted the Service and the Treasury Department to revise its rules for the preparation or execution of returns by authorized Internal Revenue Officer or employees. Temporary regulations and a notice of proposed rulemaking (REG-131739-03, 2005-2 C.B. 494) were published in the Federal Register on July 18, 2005 [70 FR 41165]. The Service and the Treasury Department received written public comments responding to the proposed regulations. After consideration of the comments received, the proposed regulations are adopted as revised by this Treasury decision. These final regulations generally retain the provisions of the proposed regulations with one minor change as explained in more detail in the preamble. Explanation of Provisions and Summary of Comments The regulations provide that a document (or set of documents) signed by an authorized Internal Revenue Officer or employee is a return under section 6020(b) if the document (or set of documents) identifies the taxpayer by name and taxpayer identification number, contains sufficient information from which to compute the taxpayer’s tax liability, and the document (or set of documents) purports to be a return under section 6020(b). A Form 13496, “IRC Section 6020(b) Certification,” or any other form that an authorized Internal Revenue Officer or employee signs and uses to identify a document (or set of documents) containing the information set forth in this preamble as a section 6020(b) return, and the documents identified, constitute a valid section 6020(b) return. Further, because the Service prepares and signs section 6020(b) returns both by hand and through automated means, these regulations provide that a name or title of an Internal Revenue Officer or employee appearing upon a return made in accordance with section 6020(b) is sufficient as a subscription by that officer or employee to adopt the document as a return for the taxpayer without regard to whether the name or title is handwritten, stamped, typed, printed or otherwise mechanically affixed to the document. The document or set of documents and subscription may be in written or electronic form. These final regulations do not alter the method for the preparation of returns under section 6020(a) as provided in T.D. 6498. Under section 6020(a), if the taxpayer consents to disclose necessary information, the Service may prepare a return on behalf of a taxpayer, and if the taxpayer signs the return, the Service will receive it as the taxpayer’s return. The proposed regulations generated numerous comments. For the most part, the comments were variations of ten different form letters. The commentators took issue with the regulation because the signature on the certification was not signed under oath, and therefore not signed under a penalty of perjury; because a “set of documents” could substitute for a return instead of the form that would have been used by the taxpayer, and because the Service was making the decision of who should file a tax return. After considering these comments, the Service and the Treasury Department have concluded that they provide no basis for adopting changes in the final regulations. In particular, the argument that the Service should not be able to decide who should file a tax return is without merit. The requirement to file a tax return is not voluntary and is clearly set forth in sections 6011(a) and 6012(a). There has been one minor change to the text of the temporary regulations. The temporary regulation provided that any return made in accordance with paragraph (b)(1) of this section and signed by the Commissioner or other authorized Internal Revenue Officer or employee shall be prima facie good and sufficient for all legal purposes. In 2005, new language was added to the Bankruptcy Code at 11 U.S.C. §523(a) that specifically provided that a section 6020(b) return is not a return for dischargeability purposes. Therefore, the portion of the temporary regulation that stated that the return was sufficient for all legal purposes is no longer correct. The language in the regulation has been changed to state that a section 6020(b) return is sufficient for all legal purposes “except insofar as any Federal statute expressly provides otherwise.” It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Accordingly, 26 CFR part 301 is amended as follows: PART 301—PROCEDURE AND ADMINISTRATION Paragraph 1. The authority citation for part 301 continues to read in part as follows: Authority: 26 U.S.C. 7805* * * §301.6020-1T [Removed] Par. 2. Section 301.6020-1T is removed. Par. 3. Section 301.6020-1 is added to read as follows: §301.6020-1 Returns prepared or executed by the Commissioner or other Internal Revenue Officers. (a) Preparation of returns—(1) In general. If any person required by the Internal Revenue Code or by the regulations to make a return fails to make such return, it may be prepared by the Commissioner or other authorized Internal Revenue Officer or employee provided such person consents to disclose all information necessary for the preparation of such return. The return upon being signed by the person required to make it shall be received by the Commissioner as the return of such person. (2) Responsibility of person for whom return is prepared. A person for whom a return is prepared in accordance with paragraph (a)(1) of this section shall for all legal purposes remain responsible for the correctness of the return to the same extent as if the return had been prepared by him. (b) Execution of returns—(1) In general. If any person required by the Internal Revenue Code or by the regulations to make a return (other than a declaration of estimated tax required under section 6654 or 6655) fails to make such return at the time prescribed therefore, or makes, willfully or otherwise, a false, fraudulent or frivolous return, the Commissioner or other authorized Internal Revenue Officer or employee shall make such return from his own knowledge and from such information as he can obtain through testimony or otherwise. The Commissioner or other authorized Internal Revenue Officer or employee may make the return by gathering information and making computations through electronic, automated or other means to make a determination of the taxpayer’s tax liability. (2) Form of the return. A document (or set of documents) signed by the Commissioner or other authorized Internal Revenue Officer or employee shall be a return for a person described in paragraph (b)(1) of this section if the document (or set of documents) identifies the taxpayer by name and taxpayer identification number, contains sufficient information from which to compute the taxpayer’s tax liability, and purports to be a return. A Form 13496, “IRC Section 6020(b) Certification,” or any other form that an authorized Internal Revenue Officer or employee signs and uses to identify a set of documents containing the information set forth in this paragraph as a section 6020(b) return, and the documents identified, constitute a return under section 6020(b). A return may be signed by the name or title of an Internal Revenue Officer or employee being handwritten, stamped, typed, printed or otherwise mechanically affixed to the return, so long as that name or title was placed on the document to signify that the Internal Revenue Officer or employee adopted the document as a return for the taxpayer. The document and signature may be in written or electronic form. (3) Status of returns. Any return made in accordance with paragraph (b)(1) of this section and signed by the Commissioner or other authorized Internal Revenue Officer or employee shall be good and sufficient for all legal purposes except insofar as any Federal statute expressly provides otherwise. Furthermore, the return shall be treated as the return filed by the taxpayer for purposes of determining the amount of the addition to tax under sections 6651(a)(2) and (3). (4) Deficiency procedures. For deficiency procedures in the case of income, estate, and gift taxes, see §§6211 through 6216, inclusive, and §§301.6211-1 through 301.6215-1, inclusive. (5) Employment status procedures. For pre-assessment procedures in employment taxes cases involving worker classification, see section 7436 (proceedings for determination of employment status). (6) Examples. The application of this paragraph (b) is illustrated by the following examples: Example 1. Individual A, a calendar-year taxpayer, fails to file his 2003 return. Employee X, an Internal Revenue Service employee, opens an examination related to A’s 2003 taxable year. At the end of the examination, X completes a Form 13496, “IRC Section 6020(b) Certification,” and attached to it the documents listed on the form. Those documents explain examination changes and provide sufficient information to compute A’s tax liability. The Form 13496 provides that the Service employee identified on the form certifies that the attached pages constitute a return under section 6020(b). When X signs the certification package, the package constitutes a return under paragraph (b) of this section because the package identifies A by name, contains A’s taxpayer identifying number (TIN), has sufficient information to compute A’s tax liability, and contains a statement stating that it constitutes a return under section 6020(b). In addition, the Service will determine the amount of the additions to tax under section 6651(a)(2) by treating the section 6020(b) return as the return filed by the taxpayer. Likewise, the Service will determine the amount of any addition to tax under section 6651(a)(3), which arises only after notice and demand for payment, by treating the section 6020(b) return as the return filed by the taxpayer. Example 2. Same facts as in Example 1, except that, after performing the examination, X does not compile any examination documents together as a related set of documents. X also does not sign and complete the Form 13496 nor associate the forms explaining examination changes with any other document. Because X did not sign any document stating that it constitutes a return under section 6020(b) and the documents otherwise do not purport to be a section 6020(b) return, the documents do not constitute a return under section 6020(b). Therefore, the Service cannot determine the section 6651(a)(2) addition to tax against nonfiler A for A’s 2003 taxable year on the basis of those documents. Example 3. Individual C, a calendar-year taxpayer, fails to file his 2003 return. The Service determines through its automated internal matching programs that C received reportable income and failed to file a return. The Service, again through its automated systems, generates a Letter 2566, “30 Day Proposed Assessment (SFR-01) 910 SC/CG.” This letter contains C’s name, TIN, and has sufficient information to compute C’s tax liability. Contemporaneous with the creation of the Letter 2566, the Service, through its automated system, electronically creates and stores a certification stating that the electronic data contained as part of C’s account constitutes a valid return under section 6020(b) as of that date. Further, the electronic data includes the signature of the Service employee authorized to sign the section 6020(b) return upon its creation. Although the signature is stored electronically, it can appear as a printed name when the Service requests a paper copy of the certification. The electronically created information, signature, and certification is a return under section 6020(b). The Service will treat that return as the return filed by the taxpayer in determining the amount of the section 6651(a)(2) addition to tax with respect to C’s 2003 taxable year. Likewise, the Service will determine the amount of any addition to tax under section 6651(a)(3), which arises only after notice and demand for payment, by treating the section 6020(b) return as the return filed by the taxpayer. Example 4. Corporation M, a quarterly taxpayer, fails to file a Form 941, “Employer’s QUARTERLY Federal Tax Return,” for the second quarter of 2004. Q, a Service employee authorized to sign returns under section 6020(b), prepares a Form 941 by hand, stating Corporation M’s name, address, and TIN. Q completes the Form 941 by entering line item amounts, including the tax due, and then signs the document. The Form 941 that Q prepared and signed constitutes a section 6020(b) return because the Form 941 purports to be a return under section 6020(b), the form contains M’s name and TIN, and it includes sufficient information to compute M’s tax liability for the second quarter of 2004. (c) Cross references—(1) For provisions that a return executed by the Commissioner or other authorized Internal Revenue Officer or employee will not start the running of the period of limitations on assessment and collection, see section 6501(b)(3) and §301.6501(b)-1(e). (2) For determining the period of limitations on collection after assessment of a liability on a return executed by the Commissioner or other authorized Internal Revenue Officer or employee, see section 6502 and §301.6502-1. (3) For additions to the tax and additional amounts for failure to file returns, see section 6651 and §301.6651-1, and section 6652 and §301.6652-1, respectively. (4) For additions to the tax for failure to pay tax, see section 6651 and §301.6651-1. (5) For criminal penalties for willful failure to make returns, see sections 7201, 7202 and 7203. (6) For criminal penalties for willfully making false or fraudulent returns, see sections 7206 and 7207. (7) For civil penalties for filing frivolous income tax returns, see section 6702. (8) For authority to examine books and witnesses, see section 7602 and §301.7602-1. (d) Effective/Applicability date. This section is applicable on February 20, 2008. The principal author of these regulations is Alicia Goldstein, Office of the Associate Chief Counsel (Procedure and Administration). Release of Lien or Discharge of Property 26 CFR Parts 301 and 401 This document contains final regulations related to release of lien and discharge of property under sections 6325, 6503, and 7426 of the Internal Revenue Code (Code). These regulations update existing regulations and contain procedures for processing a request made by a property owner for discharge of a Federal tax lien from his property under section 6325(b)(4). The regulations also clarify the impact of these procedures on sections 6503(f)(2) and 7426(a)(4) and (b)(5). These regulations reflect the enactment of sections 6325(b)(4), 6503(f)(2), and 7426(a)(4) by the IRS Restructuring and Reform Act of 1998. Effective Date: These regulations are effective January 31, 2008. Applicability Date: These regulations apply to any release of lien or discharge of property that is requested after January 31, 2008. Debra A. Kohn, (202) 622-7985 (not a toll-free number). This document contains final regulations that amend the Procedure and Administration Regulations (26 CFR part 301) under sections 6325, 6503, and 7426 of the Code. The IRS Restructuring and Reform Act of 1998, Public Law 105-206 (112 Stat. 685) (RRA 1998), enacted sections 6325(b)(4), 6503(f)(2), 7426(a)(4), and 7426(a)(5) to provide a statutory mechanism for a person other than the person against whom the underlying tax was assessed, upon furnishing a deposit or bond, to obtain a discharge of the Federal tax lien from property owned by him, and for the IRS or the courts to determine the disposition of the deposit or bond amount. RRA 1998 thereby necessitated changes to the rules under sections 6325, 6503, and 7426. On January 11, 2007, a notice of proposed rulemaking (REG-159444-04, 2007-9 I.R.B. 618) relating to release of lien or discharge of property was published in the Federal Register (72 FR 1301-03). No comments were received and no public hearing was requested or held. Accordingly, the proposed regulations are adopted as amended by this Treasury decision. These final regulations generally retain the provisions of the proposed regulations but include one modification as explained in more detail below. Explanation of Modification The final regulations differ substantively in one respect from the version of the regulations set forth in the notice of proposed rulemaking. The proposed regulations interpret section 6325(b)(4)(D), which states that section 6325(b)(4)(A) is inapplicable “if the owner of the property is the person whose unsatisfied liability gave rise to the lien,” as indicating that the procedures for obtaining a discharge of a Federal tax lien under section 6325(b)(4) are not available to a person who owns the subject property with the person whose tax liability gave rise to the lien (the taxpayer). Upon further consideration of this issue, it was decided that section 6235(b)(4)(D) should not be so interpreted, as that interpretation would unfairly leave some third-party property owners without a means to discharge Federal tax liens from their properties. Accordingly, the final regulations reflect an interpretation of section 6325(b)(4)(D) that makes the section 6325(b)(4) procedures available to a person who co-owns property with the taxpayer. It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because these regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, the notice of proposed rulemaking preceding these regulations was submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Accordingly, under the authority of 26 U.S.C. 7805, 26 CFR parts 301 and 401 are amended as follows: Paragraph 1. The authority citation for part 301 continues to read, in part, as follows: Par. 2. Section 301.6325-1 is amended as follows: 1. Paragraphs (a) and (b)(1)(i), (b)(2)(i), (b)(2)(ii), and (b)(3) are revised. 2. Paragraph (b)(2)(iii) is redesignated as paragraph (b)(6) and revised. 3. Paragraph (b)(4) is redesignated as paragraph (b)(5) and revised. 4. A new paragraph (b)(4) is added. 5. Paragraphs (c)(1) and (c)(2) are amended by removing the language “district director” and adding the language “appropriate official” in its place, wherever it appears. 6. The first sentence of paragraph (d)(1) is amended by removing the language “A district director” and adding the language “The appropriate official” in its place, by removing the word “Code” and adding the language “Internal Revenue Code” in its place, and by removing the language “the district director” and adding the language “the appropriate official” in its place. The third sentence is amended by removing the language “a district director” and adding the language “the appropriate official” in its place, and removing the language “the district director” and adding “the appropriate official” in its place. 7. Paragraph (d)(2)(i) is amended by removing the language “A district director” and adding the language “The appropriate official” in its place, by removing the word “Code” and adding the language “Internal Revenue Code” in its place, and by removing the language “the district director” and adding the language “the appropriate official” in its place. 8. Paragraph (d)(2)(ii), Examples 1 through 4, are amended by removing the language “district director” and adding the language “appropriate official” in its place, wherever it appears. 9. Paragraphs (d)(3) and (d)(4) are amended by removing the language “district director” and adding the language “appropriate official” in its place, wherever it appears. 10. The first sentence of paragraph (e) is amended by removing the language “a district director” and adding the language “the appropriate official” in its place, and by removing the language “the district director” and adding the language “the appropriate official” in its place. The third and fourth sentences are amended by removing the language “district director” and adding the language “appropriate official” in its place. 11. Paragraphs (f)(1) and (f)(2)(i) are amended by removing the language “a district director” and adding the language “the appropriate official” in its place, paragraph (f)(2)(i)(b) is amended by removing the language “the district director” and adding the language “the appropriate official” in its place, and paragraph (f)(3) is amended by removing the word “Code” and adding the language “Internal Revenue Code” in its place. 12. Paragraphs (h) and (i) are added. The revisions and additions read as follows: §301.6325-1 Release of lien or discharge of property. (a) Release of lien—(1) Liability satisfied or unenforceable. The appropriate official shall issue a certificate of release for a filed notice of Federal tax lien, no later than 30 days after the date on which he finds that the entire tax liability listed in such notice of Federal tax lien either has been fully satisfied (as defined in paragraph (a)(4) of this section) or has become legally unenforceable. In all cases, the liability for the payment of the tax continues until satisfaction of the tax in full or until the expiration of the statutory period for collection, including such extension of the period for collection as is agreed to. (2) Bond accepted. The appropriate official shall issue a certificate of release of any tax lien if he is furnished and accepts a bond that is conditioned upon the payment of the amount assessed (together with all interest in respect thereof), within the time agreed upon in the bond, but not later than 6 months before the expiration of the statutory period for collection, including any agreed upon extensions. For provisions relating to bonds, see sections 7101 and 7102 and §§301.7101-1 and 301.7102-1. (3) Certificate of release for a lien which has become legally unenforceable. The appropriate official shall have the authority to file a notice of Federal tax lien which also contains a certificate of release pertaining to those liens which become legally unenforceable. Such release will become effective as a release as of a date prescribed in the document containing the notice of Federal tax lien and certificate of release. (4) Satisfaction of tax liability. For purposes of paragraph (a)(1) of this section, satisfaction of the tax liability occurs when— (i) The appropriate official determines that the entire tax liability listed in a notice of Federal tax lien has been fully satisfied. Such determination will be made as soon as practicable after tender of payment; or (ii) The taxpayer provides the appropriate official with proof of full payment (as defined in paragraph (a)(5) of this section) with respect to the entire tax liability listed in a notice of Federal tax lien together with the information and documents set forth in paragraph (a)(7) of this section. See paragraph (a)(6) of this section if more than one tax liability is listed in a notice of Federal tax lien. (5) Proof of full payment. As used in paragraph (a)(4)(ii) of this section, the term proof of full payment means— (i) An internal revenue cashier’s receipt reflecting full payment of the tax liability in question; (ii) A canceled check in an amount sufficient to satisfy the tax liability for which the release is being sought; (iii) A record, made in accordance with procedures prescribed by the Commissioner, of proper payment of the tax liability by credit or debit card or by electronic funds transfer; or (iv) Any other manner of proof acceptable to the appropriate official. (6) Notice of a Federal tax lien which lists multiple liabilities. When a notice of Federal tax lien lists multiple tax liabilities, the appropriate official shall issue a certificate of release when all of the tax liabilities listed in the notice of Federal tax lien have been fully satisfied or have become legally unenforceable. In addition, if the taxpayer requests that a certificate of release be issued with respect to one or more tax liabilities listed in the notice of Federal tax lien and such liability has been fully satisfied or has become legally unenforceable, the appropriate official shall issue a certificate of release. For example, if a notice of Federal tax lien lists two separate liabilities and one of the liabilities is satisfied, the taxpayer may request the issuance of a certificate of release with respect to the satisfied tax liability and the appropriate official shall issue a release. (7) Taxpayer requests. A request for a certificate of release with respect to a notice of Federal tax lien shall be submitted in writing to the appropriate official. The request shall contain the information required in the appropriate IRS Publication. (b) Discharge of specific property from the lien—(1) Property double the amount of the liability. (i) The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if he determines that the fair market value of that part of the property remaining subject to the Federal tax lien is at least double the sum of the amount of the unsatisfied liability secured by the Federal tax lien and of the amount of all other liens upon the property which have priority over the Federal tax lien. In general, fair market value is that amount which one ready and willing but not compelled to buy would pay to another ready and willing but not compelled to sell the property. (2) Part payment; interest of United States valueless—(i) Part payment. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if there is paid over to him in partial satisfaction of the liability secured by the Federal tax lien an amount determined by him to be not less than the value of the interest of the United States in the property to be so discharged. In determining the amount to be paid, the appropriate official will take into consideration all the facts and circumstances of the case, including the expenses to which the government has been put in the matter. In no case shall the amount to be paid be less than the value of the interest of the United States in the property with respect to which the certificate of discharge is to be issued. (ii) Interest of the United States valueless. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to the Federal tax lien if he determines that the interest of the United States in the property to be so discharged has no value. (3) Discharge of property by substitution of proceeds of sale. The appropriate official may, in his discretion, issue a certificate of discharge of any part of the property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code if such part of the property is sold and, pursuant to a written agreement with the appropriate official, the proceeds of the sale are held, as a fund subject to the Federal tax liens and claims of the United States, in the same manner and with the same priority as the Federal tax liens or claims had with respect to the discharged property. This paragraph does not apply unless the sale divests the taxpayer of all right, title, and interest in the property sought to be discharged. Any reasonable and necessary expenses incurred in connection with the sale of the property and the administration of the sale proceeds shall be paid by the applicant or from the proceeds of the sale before satisfaction of any Federal tax liens or claims of the United States. (4) Right of substitution of value—(i) Issuance of certificate of discharge to property owner who is not the taxpayer. If an owner of property subject to a Federal tax lien imposed under chapter 64 of the Internal Revenue Code submits an application for a certificate of discharge pursuant to paragraph (b)(5) of this section, the appropriate official shall issue a certificate of discharge of such property after the owner either deposits with the appropriate official an amount equal to the value of the interest of the United States in the property, as determined by the appropriate official pursuant to paragraph (b)(6) of this section, or furnishes an acceptable bond in a like amount. This paragraph does not apply if the person seeking the discharge is the person whose unsatisfied liability gave rise to the Federal tax lien. Thus, if the property is owned by both the taxpayer and another person, the other person may obtain a certificate of discharge of the property under this paragraph, but the taxpayer may not. (ii) Refund of deposit and release of bond. The appropriate official may, in his discretion, determine that either the entire unsatisfied tax liability listed on the notice of Federal tax lien can be satisfied from a source other than the property sought to be discharged, or the value of the interest of the United States is less than the prior determination of such value. The appropriate official shall refund the amount deposited with interest at the overpayment rate determined under section 6621 or release the bond furnished to the extent that he makes this determination. (iii) Refund request. If a property owner desires an administrative refund of his deposit or release of the bond, the owner shall file a request in writing with the appropriate official. The request shall contain such information as the appropriate IRS Publication may require. The request must be filed within 120 days after the date the certificate of discharge is issued. A refund request made under this paragraph neither is required nor is effective to extend the period for filing an action in court under section 7426(a)(4). (iv) Internal Revenue Service’s use of deposit if court action not filed. If no action is filed under section 7426(a)(4) for refund of the deposit or release of the bond within the 120-day period specified therein, the appropriate official shall, within 60 days after the expiration of the 120-day period, apply the amount deposited or collect on such bond to the extent necessary to satisfy the liability listed on the notice of Federal tax lien, and shall refund, with interest at the overpayment rate determined under section 6621, any portion of the amount deposited that is not used to satisfy the liability. If the appropriate official has not completed the application of the deposit to the unsatisfied liability before the end of the 60-day period, the deposit will be deemed to have been applied to the unsatisfied liability as of the 60th day. (5) Application for certificate of discharge. Any person desiring a certificate of discharge under this paragraph (b) shall submit an application in writing to the appropriate official. The application shall contain the information required by the appropriate IRS Publication. For purposes of this paragraph (b), any application for certificate of discharge made by a property owner who is not the taxpayer, and any amount submitted pursuant to the application, will be treated as an application for discharge and a deposit under section 6325(b)(4) unless the owner of the property submits a statement, in writing, that the application is being submitted under another paragraph of section 6325 and not under section 6325(b)(4), and the owner in writing waives the rights afforded under paragraph (b)(4), including the right to seek judicial review. (6) Valuation of interest of United States. For purposes of paragraphs (b)(2) and (b)(4) of this section, in determining the value of the interest of the United States in the property, or any part thereof, with respect to which the certificate of discharge is to be issued, the appropriate official shall give consideration to the value of the property and the amount of all liens and encumbrances thereon having priority over the Federal tax lien. In determining the value of the property, the appropriate official may, in his discretion, give consideration to the forced sale value of the property in appropriate cases. (h) As used in this section, the term appropriate official means either the official or office identified in the relevant IRS Publication or, if such official or office is not so identified, the Secretary or his delegate. (i) Effective/applicability date. This section applies to any release of lien or discharge of property that is requested after January 31, 2008. Par. 3. Section 301.6503(f)-1 is amended as follows: 1. The section heading is revised. 2. The undesignated paragraph is designated as paragraph (a), a paragraph heading is added, and a new sentence is added immediately prior to the Example. 3. In newly designated paragraph (a), the language “a district director” is removed and the language “the appropriate official” is added in its place, the language “the district director” is removed and the language “the appropriate official” is added in its place, and in the Example the language “district director” is removed and the language “appropriate official” is added in its place, wherever it appears. 4. Paragraphs (b), (c), and (d) are added. §301.6503(f)-1 Suspension of running of period of limitation; wrongful seizure of property of third-party owner and discharge of lien for substitution of value. (a) Wrongful seizure. * * * The following example illustrates the principles of this section: (b) Discharge of wrongful lien for substitution of value. If a person other than the taxpayer submits a request in writing for a certificate of discharge for a filed Federal tax lien under section 6325(b)(4), the running of the period of limitations on collection after assessment under section 6502 for any liability listed in such notice of Federal tax lien shall be suspended for a period equal to the period beginning on the date the appropriate official receives a deposit or bond in the amount specified in §301.6325-1(b)(4)(i) and ending on the date that is 30 days after the earlier of— (1) The date the appropriate official no longer holds, or is deemed to no longer hold, within the meaning of paragraph (b)(4)(iv) of this section, any amount as a deposit or bond by reason of taking such actions as prescribed in sections 6325(b)(4)(B) and (C); or (2) The date the judgment secured under section 7426(b)(5) becomes final. (c) As used in this section, the term appropriate official means either the official or office identified in the relevant IRS Publication or, if such official or office is not so identified, the Secretary or his delegate. (d) Effective/applicability date. This section applies to any request for a certificate of discharge made after January 31, 2008. Par. 4. In §301.7426-1, paragraphs (a)(4), (b)(5), and (d) are added. §301.7426-1 Civil actions by persons other than taxpayers. (a) * * * (4) Substitution of value. A person who obtains a certificate of discharge under section 6325(b)(4) with respect to any property may, within 120 days after the day on which the certificate is issued, bring a civil action against the United States in a district court of the United States for a determination of whether the value of the interest of the United States (if any) in such property is less than the value determined by the appropriate official. A civil action under this provision shall be the exclusive judicial remedy for a person other than the taxpayer who obtains a certificate of discharge for a filed notice of Federal tax lien. (5) Substitution of value. If the court determines that the determination by the appropriate official of the value of the interest of the United States in the property exceeds the actual value of such interest, the court may grant a judgment ordering a refund of the amount deposited, or a release of the bond, to the extent that the aggregate of those amounts exceeds the value as determined by the court. (d) Paragraphs (a)(4) and (b)(5) of this section apply to any request for a certificate of discharge made after January 31, 2008. PART 401—[REMOVED] Par. 5. Part 401 is removed. Approved January 9, 2008. (Filed by the Office of the Federal Register on January 30, 2008, 8:45 a.m., and published in the issue of the Federal Register for January 31, 2008, 73 F.R. 5741) The principal author of these regulations is Debra A. Kohn of the Office of the Associate Chief Counsel (Procedure and Administration). Amplification of Notice 2006-52; Deduction for Energy Efficient Commercial Buildings SECTION 1. PURPOSE This notice clarifies and amplifies Notice 2006-52, 2006-1 C.B. 1175. Notice 2006-52 provides a process that allows a taxpayer who owns a commercial building and installs property as part of the commercial building’s interior lighting systems, heating, cooling, ventilation, and hot water systems, or building envelope to obtain a certification that the property satisfies the energy efficiency requirements of § 179D(c)(1) and (d) of the Internal Revenue Code. Notice 2006-52 also provides for a public list of software programs that may be used in calculating energy and power consumption for purposes of § 179D. This notice sets forth additional guidance relating to the deduction for energy efficient commercial buildings under § 179D and is intended to be used with Notice 2006-52. Any reference in this notice to Standard 90.1-2001 should be treated as a reference to ANSI/ASHRAE/IESNA Standard 90.1-2001, Energy Standard for Buildings Except Low-Rise Residential Buildings, developed for the American National Standards Institute by the American Society of Heating, Refrigerating, and Air Conditioning Engineers and the Illuminating Engineering Society of North America (as in effect on April 2, 2003, including addenda 90.1a-2003, 90.1b-2002, 90.1c-2002, 90.1d-2002, and 90.1k-2002 as in effect on that date). SECTION 2. BACKGROUND Section 1331 of the Energy Policy Act of 2005, Pub. L. No. 109-58, 119 Stat. 594 (2005), enacted § 179D of the Code, which provides a deduction with respect to energy efficient commercial buildings. Section 204 of the Tax Relief and Health Care Act of 2006, Pub. L. No. 109-432, 120 Stat. 2922 (2006), extends the § 179D deduction through December 31, 2008. Section 179D(a) allows a deduction to a taxpayer for part or all of the cost of energy efficient commercial building property that the taxpayer places in service after December 31, 2005, and before January 1, 2009. Sections 179D(d)(1) and 179D(f) allow a deduction to a taxpayer for part or all of the cost of certain partially qualifying commercial building property that the taxpayer places in service after December 31, 2005, and before January 1, 2009. Partially qualifying commercial building property is property that would be energy efficient commercial building property but for the failure to achieve the 50-percent reduction in energy and power costs required under § 179D(c)(1)(D). SECTION 3. SPECIAL RULE FOR GOVERNMENT-OWNED BUILDINGS .01 In General. In the case of energy efficient commercial building property (or partially qualifying commercial building property for which a deduction is allowed under § 179D) that is installed on or in property owned by a Federal, State, or local government or a political subdivision thereof, the owner of the property may allocate the § 179D deduction to the person primarily responsible for designing the property (the designer). If the allocation of a § 179D deduction to a designer satisfies the requirements of this section, the deduction will be allowed only to that designer. The deduction will be allowed to the designer for the taxable year that includes the date on which the property is placed in service. .02 Designer of Government-Owned Buildings. A designer is a person that creates the technical specifications for installation of energy efficient commercial building property (or partially qualifying commercial building property for which a deduction is allowed under § 179D). A designer may include, for example, an architect, engineer, contractor, environmental consultant or energy services provider who creates the technical specifications for a new building or an addition to an existing building that incorporates energy efficient commercial building property (or partially qualifying commercial building property for which a deduction is allowed under § 179D). A person that merely installs, repairs, or maintains the property is not a designer. .03 Allocation of the Deduction. If more than one designer is responsible for creating the technical specifications for installation of energy efficient commercial building property (or partially qualifying commercial building property for which a deduction is allowed under § 179D) on or in a government-owned building, the owner of the building shall— (1) determine which designer is primarily responsible and allocate the full deduction to that designer, or (2) at the owner’s discretion, allocate the deduction among several designers. .04 Form of Allocation. An allocation of the § 179D deduction to the designer of a government-owned building must be in writing and will be treated as satisfying the requirements of this section with respect to energy efficient commercial building property (or partially qualifying commercial building property for which a deduction is allowed under § 179D) if the allocation contains all of the following: (1) The name, address, and telephone number of an authorized representative of the owner of the government-owned building; (2) The name, address, and telephone number of an authorized representative of the designer receiving the allocation of the § 179D deduction; (3) The address of the government-owned building on or in which the property is installed; (4) The cost of the property; (5) The date the property is placed in service; (6) The amount of the § 179D deduction allocated to the designer; (7) The signatures of the authorized representatives of both the owner of the government-owned building and the designer or the designer’s authorized representative; and (8) A declaration, applicable to the allocation and any accompanying documents, signed by the authorized representative of the owner of the government-owned building, in the following form: “Under penalties of perjury, I declare that I have examined this allocation, including accompanying documents, and to the best of my knowledge and belief, the facts presented in support of this allocation are true, correct, and complete.” .05 Obligations of Designer. Before a designer may claim the § 179D deduction with respect to property installed on or in a government-owned building, the designer must obtain the written allocation described in section 3.04. A designer is not required to attach the allocation to the return on which the deduction is taken. However, § 1.6001-1(a) of the Income Tax Regulations requires that taxpayers maintain such books and records as are sufficient to establish the entitlement to, and amount of, any deduction claimed by the taxpayer. Accordingly, a designer claiming a deduction under § 179D should retain the allocation as part of the taxpayer’s records for purposes of§ 1.6001-1(a) of the Income Tax Regulations. .06 Tax Consequences to Designer of Government-Owned Buildings. The maximum amount of the § 179D deduction to be allocated to the designer is the amount of the costs incurred by the owner of the government-owned building to place the energy efficient commercial building property in service. A partial deduction may be allocated and computed in accordance with the procedures set forth in sections 2 and 3 of Notice 2006-52. The designer does not include any amount in income on account of the § 179D deduction allocated to the designer. In addition, the designer is not required to reduce future deductions by an amount equal to the § 179D deduction allocated to the designer. Although reducing future deductions in this manner would provide equivalent treatment for designers that are allocated a § 179D deduction and building owners that are required to reduce the basis of their energy efficient commercial building property by the amount of the § 179D deduction they claim, § 179D does not provide for any reductions other than reductions to the basis of the energy efficient commercial building property. .07 Tax Consequences to Owner of Public Building. The owner of the public building is not required to include any amount in income on account of the § 179D deduction allocated to the designer. The owner of the public building is, however, required to reduce the basis of the energy efficient commercial building property (or partially qualifying commercial building property) by the amount of the § 179D deduction allocated. SECTION 4. LIST OF APPROVED SOFTWARE PROGRAMS .01 In General. The Department of Energy creates and maintains a public list of software that may be used to calculate energy and power consumption and costs for purposes of providing a certification under section 4 of Notice 2006-52. This public list appears at http://www.eere.energy.gov/buildings/info/tax_incentives.html. Soft- ware will be included on the list if the software developer submits the following information to the Department of Energy: (1) The name, address, and (if applicable) web site of the software developer; (2) The name, email address, and telephone number of the person to contact for further information regarding the software; (3) The name, version, or other identifier of the software as it will appear on the list; (4) All test results, input files, output files, weather data, modeler reports, and the executable version of the software with which the tests were conducted; and (5) A declaration by the developer of the software made under penalties of perjury and containing all of the following information: (a) A statement that the software has been tested according to the American National Standards Institute/American Society of Heating, Refrigerating and Air-Conditioning Engineers (ANSI/ASHRAE) Standard 140-2007 Standard Method of Test for the Evaluation of Building Energy Analysis Computer Programs. (b) A statement that the software can model explicitly— (i) 8,760 hours per year; (ii) Calculation methodologies for the building components being modeled; (iii) Hourly variations in occupancy, lighting power, miscellaneous equipment power, thermostat setpoints, and HVAC system operation, defined separately for each day of the week and holidays; (iv) Thermal mass effects; (v) Ten or more thermal zones; (vi) Part-load performance curves for mechanical equipment; (vii) Capacity and efficiency correction curves for mechanical heating and cooling equipment; and (viii) Air-side and water-side economizers with integrated control. (c) A statement that the software can explicitly model each of the following HVAC systems listed in Appendix G of Standard 90.1-2004: (i) Packaged Terminal Air Conditioner (PTAC) (air source), single-zone package (through the wall), multi-zone hydronic loop, air-to-air DX coil cooling, central boiler, hot water coil. (ii) Packaged Terminal Heat Pump (PTHP) (air source), single-zone package (through the wall), air-to-air DX coil heat/cool. (iii) Packaged Single Zone Air Conditioner (PSZ-AC), single-zone air, air-to-air DX coil cool, gas coil, constant-speed fan. (iv) Packaged Single Zone Heat Pump (PSZ-HP), single-zone air, air-to-air DX coil cool/heat, constant-speed fan. (v) Packaged Variable-Air-Volume (PVAV) with reheat, multi-zone air; multi-zone hydronic loop, air-to-air DX coil, VAV fan, boiler, hot water VAV terminal boxes. (vi) Packaged Variable-Air-Volume with parallel fan powered boxes (PVAV with PFP boxes), multi-zone air, DX coil, VAV fan, fan-powered induction boxes, electric reheat. (vii) Variable-Air-Volume (VAV) with reheat, multi-zone air, multi-zone hydronic loop, air-handling unit, chilled water coil, hot water coil, VAV fan, chiller, boiler, hot water VAV boxes. (viii) Variable-Air-Volume with parallel fan powered boxes (VAV with PFP boxes), multi-zone air, air-handling unit, chilled water coil, hot water coil, VAV fan, chiller, fan-powered induction boxes, electric reheat. (d) A statement that the software can— (i) Either directly determine energy and power costs or produce hourly reports of energy use by energy source suitable for determining energy and power costs separately; and (ii) Design load calculations to determine required HVAC equipment capacities and air and water flow rates. (e) A statement describing which, if any, of the following the software can explicitly model: (i) Natural ventilation. (ii) Mixed mode (natural and mechanical) ventilation. (iii) Earth tempering of outdoor air. (iv) Displacement ventilation. (v) Evaporative cooling. (vi) Water use by occupants for cooking, cleaning or other domestic uses. (vii) Water use by heating, cooling, or other equipment, or for on-site landscaping. (viii) Automatic interior or exterior lighting controls (such as occupancy, photocells, or time clocks). (viii) Daylighting (sidelighting, skylights, or tubular daylight devices). (ix) Improved fan system efficiency through static pressure reset. (x) Radiant heating or cooling (low or high temperature). (xi) Multiple or variable speed control for fans, cooling equipment, or cooling towers. (xii) On-site energy systems (such as combined heat and power systems, fuel cells, solar photovoltaic, solar thermal, or wind). .02 Addresses. Submissions under this section must be addressed as follows: Commercial Software List Office of Building Technologies, EE-2J 1000 Independence Ave., SW .03 Updated Lists. The software list at http://www.eere.energy.gov/ buildings/info/tax_incentives.html will be updated as necessary to reflect submissions received under this section. .04 Removal from Published List. The Department of Energy may, upon examination, determine that software is not sufficiently accurate to justify its use in calculating energy and power consumption and costs for purposes of providing a certification under section 4 of Notice 2006-52 and remove the software from the published list. The Department of Energy may undertake such an examination on its own initiative or in response to a public request supported by appropriate analysis of the software’s deficiencies. .05 Effect of Removal from Published List. Software may not be used to calculate energy and power consumption and costs for purposes of providing a certification with respect to property placed in service after the date on which the software is removed from the published list. The removal will not affect the validity of any certification with respect to property placed in service on or before the date on which the software is removed from the published list. .06 Public Availability of Information. The Department of Energy may make all information provided under paragraph .01 of this section available for public review. .07 Applicability. The procedures in this section supersede the procedures set forth in section 6 of Notice 2006-52 for periods after March 31, 2008. Any software that is included on the public list on March 31, 2008, will remain on the public list unless and until removed under the procedures set forth in this section. SECTION 5. CERTIFICATION REQUIREMENTS FOR INTERIM LIGHTING RULE .01 In General. Section 2.03(1)(b) of Notice 2006-52 provides an interim rule under which partially qualifying property is treated as energy efficient lighting property (the Interim Lighting Rule). Before a taxpayer may claim the § 179D deduction under the Interim Lighting Rule with respect to energy efficient lighting property installed on or in a commercial building, the taxpayer must obtain a certification with respect to the property. The certification must be provided by a qualified individual. Section 4 of Notice 2006-52 provides that the certification must include a statement that qualified computer software was used to calculate energy and power consumption and costs. That section also provides that the certification must include a statement that the building owner has received an explanation of projected annual energy costs. These requirements are appropriate only in the case of certifications that involve calculations of energy and power consumption and cost. The Interim Lighting Rule is satisfied by a reduction in lighting power density and such a reduction may be computed using a spreadsheet or other similar software. This computation does not require qualified computer software to model the entire building system or a determination of projected annual energy costs. Accordingly, the requirements of section 4 of Notice 2006-52 do not apply to certifications under the Interim Lighting Rule. .02 Applicable Requirements. A taxpayer is not required to attach the certification to the return on which the deduction is taken. However, § 1.6001-1(a) of the Income Tax Regulations requires that taxpayers maintain such books and records as are sufficient to establish the entitlement to, and amount of, any deduction claimed by the taxpayer. Accordingly, a taxpayer claiming a deduction under § 179D should retain the certification as part of the taxpayer’s records for purposes of § 1.6001-1(a) of the Income Tax Regulations. The qualified individual providing a certification under the interim rule must document a reduction in lighting power density in a thorough and consistent manner. A certification under the Interim Lighting Rule will be treated as satisfying the requirements of § 179D(c)(1) if the certification contains all of the following: (1) The name, address, and telephone number of the qualified individual; (2) The address of the building to which the certification applies; (3) A statement by the qualified individual that the interior lighting systems that have been, or are planned to be, incorporated into the building— (a) Achieve a reduction in lighting power density of at least 25 percent (50 percent in the case of a warehouse) of the minimum requirements in Table 9.3.1.1 or Table 9.3.1.2 (not including additional interior lighting power allowances) of Standard 90.1-2001; (b) Have controls and circuiting that comply fully with the mandatory and prescriptive requirements of Standard 90.1-2001; (c) Include provision for bi-level switching in all occupancies except hotel and motel guest rooms, store rooms, restrooms, public lobbies, and garages; and (d) Meet the minimum requirements for calculated lighting levels as set forth in the IESNA Lighting Handbook, Performance and Application, Ninth Edition, 2000; (4) A statement by the qualified individual that— (a) Field inspections of the building were performed by a qualified individual after the energy efficient lighting property has been placed in service; (b) The field inspections confirmed that the building has met, or will meet, the reduction in lighting power density required by the design plans and specifications; and (c) The field inspections were performed in accordance with inspection and testing procedures that— (i) Have been prescribed by the National Renewable Energy Laboratory (NREL) as Energy Savings Modeling and Inspection Guidelines for Commercial Building Federal Tax Deduction; and (ii) Are in effect at the time the certification is given; (5) A list identifying the components of the energy efficient lighting property installed on or in the building, the energy efficiency features of the building, and its projected lighting power density; (6) A statement that the building owner has received an explanation of the energy efficiency features of the building and its projected lighting power density; (7) A declaration, applicable to the certification and any accompanying documents, signed by the qualified individual, in the following form: “Under penalties of perjury, I declare that I have examined this certification, including accompanying documents, and to the best of my knowledge and belief, the facts presented in support of this certification are true, correct, and complete.” SECTION 6. APPLICATION OF THE INTERIM LIGHTING RULE TO UNCONDITIONED GARAGE SPACE For purposes of the Interim Lighting Rule, the definition of a Building within the Scope of Standard 90.1-2001 (found in Section 5.01 of Notice 2006-52) is expanded to include a structure that— (1) Encloses space affording shelter to persons, animals, or property within exterior walls (or within exterior and party walls) and a roof; (2) Is not a single-family house, a multi-family structure of three stories or fewer above grade, a manufactured house (mobile home), or a manufactured house (modular); and (3) Is unconditioned attached or detached garage space as referenced by Tables 9.3.1.1 and 9.3.1.2 of Standard 90.1-2001. SECTION 7. CHANGES RELATING TO PARTIALLY QUALIFYING PROPERTY .01 Energy Savings Percentages. A taxpayer may apply section 2.05 of Notice 2006-52 by substituting “10” for “162/3” in section 2.05(1) of such notice. If a taxpayer makes this substitution, the taxpayer must apply sections 2.03 and 2.04 of Notice 2006-52 by substituting “20” for “162/3” in sections 2.03(1)(a) and 2.04(1) of such notice. If § 179D is extended beyond December 31, 2008, the Internal Revenue Service and the Treasury Department expect, in the absence of other changes to § 179D, that the substitute percentages set forth in this section will be the only percentages used in determining whether property placed in service after December 31, 2008, is partially qualifying property. .02 Limitation on Deduction for Partially Qualifying Property. (1) In General. If property installed on or in a building is treated as partially qualifying property under sections 2.03, 2.04, and 2.05 of Notice 2006-52, the deduction for the cost of such property shall not exceed the greatest of the following amounts: (a) The sum of the deductions allowable under sections 2.03 and 2.04 of such notice; (b) The sum of the deductions allowable under sections 2.04 and 2.05 of such notice; or (c) The sum of the deductions allowable under sections 2.03 and 2.05 of such notice. (2) Application to Multiple Taxpayers. If two or more taxpayers install property on or in the same building and the deduction for the cost of the property is subject to the limitation in section 7.02(1) of this notice, the aggregate amount of the § 179D deductions allowed to all such taxpayers with respect to the building shall not exceed the amount determined under section 7.02(1) of this notice. SECTION 8. PAPERWORK REDUCTION ACT The collections of information contained in this notice have been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-2004. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid OMB control number. The collections of information are in sections 4 and 6 of Notice 2006-52 and sections 4 and 5 of this notice. This information is required to be collected and retained in order to ensure that energy efficient commercial building property meets the requirements for the deduction under § 179D. This information will be used to determine whether commercial building property for which certifications are provided is property that qualifies for the deduction. The collection of information is required to obtain a benefit. The likely respondents are two groups: qualified individuals providing a certification under § 179D (section 4 of Notice 2006-52 and section 5 of this notice) and software developers seeking to have software included on the public list created by the Department of Energy (section 6 of Notice 2006-52 and section 4 of this notice). For qualified individuals providing a certification under § 179D, the likely respondents are individuals. The likely number of certifications is 20,000. The estimated burden per certification ranges from 15 to 30 minutes with an estimated average burden of 22.5 minutes. The estimated total annual reporting burden is 7,500 hours. For software developers seeking to have software included on the public list created by the Department of Energy, the likely respondents are individuals, corporations and partnerships. The estimated total annual reporting burden is 75 hours. The estimated annual burden per respondent varies from 1 to 2 hours, depending on individual circumstances, with an estimated average burden of 11/2 hours to complete the submission required to have the software added to the public list. The estimated number of respondents is 50. The estimated frequency of responses is once. Books or records relating to a collection of information must be retained as long as their contents may become material in the administration of any Internal Revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103. SECTION 9. DRAFTING INFORMATION The principal author of this notice is Jennifer C. Bernardini of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further information regarding this notice, contact Jennifer C. Bernardini at (202) 622-3110 (not a toll-free call). Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulation Time and Manner for Electing Capital Asset Treatment for Certain Self-Created Musical Works Notice of proposed rulemaking by cross-reference to temporary regulation. In this issue of the Bulletin, the IRS is issuing a temporary regulation (T.D. 9379) that provides the time and manner for making an election to treat the sale or exchange of musical compositions or copyrights in musical works created by the taxpayer (or received by the taxpayer from the works’ creator in a transferred basis transaction) as the sale or exchange of a capital asset. The temporary regulation reflects changes to the law made by the Tax Increase Prevention and Reconciliation Act of 2005 and the Tax Relief and Health Care Act of 2006. The temporary regulation affects taxpayers making the election under section 1221(b)(3) of the Internal Revenue Code (Code) to treat gain or loss from such a sale or exchange as capital gain or loss. The text of the temporary regulation also serves as the text of this proposed regulation. Written or electronic comments and requests for a public hearing must be received by May 8, 2008. Send submissions to: CC:PA:LPD:PR (REG-153589-06), room 5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, D.C. 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-153589-06), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, D.C., or sent electronically via the Federal eRulemaking Portal at www.regulations.gov (IRS REG-153589-06). Concerning the proposed regulation, Jamie Kim, (202) 622-4950; concerning submission of comments or requesting a hearing, [email protected], (202) 622-7180 (not toll-free numbers). Background and Explanation of Provisions Temporary regulation in this issue of the Bulletin amends the Income Tax Regulations (26 CFR Part 1) relating to section 1221(b)(3) of the Internal Revenue Code (Code). The temporary regulation provides rules regarding the time and manner for making an election under section 1221(b)(3) to treat the sale or exchange of certain musical compositions or copyrights in musical works as the sale or exchange of a capital asset. The text of the temporary regulation also serves as the text of this proposed regulation. The preamble to the temporary regulation explains the amendments. It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to this regulation, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Requests for a Public Hearing Before this proposed regulation is adopted as a final regulation, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in the Federal Register. Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: Par. 2. Section 1.1221-3 is added to read as follows: §1.1221-3 Time and manner for electing capital asset treatment for certain self-created musical works. [The text of proposed §1.1221-3 is the same as the text of §1.1221-3T(a) through (d)(1) published elsewhere in this issue of the Bulletin.] Issuance of Opinion and Advisory Letters and Opening of the EGTRRA Determination Letter Program for Pre-Approved Defined Contribution Plans The Service will soon issue opinion and advisory letters for pre-approved (i.e., master and prototype (M&P) and volume submitter (VS)) defined contribution plans that were timely filed with the Service to comply with the Economic Growth and Tax Relief Reconciliation Act of 2001, Pub. L. 107-16, (“EGTRRA”) and other changes in plan qualification requirements listed in Notice 2004-84, 2004-2 C.B. 1030 (“the 2004 Cumulative List”). The Service expects to issue the letters on March 31, 2008, or, in some cases, as soon as possible thereafter. Employers using these pre-approved plan documents to restate a plan for EGTRRA will be required to adopt the EGTRRA-approved plan document by April 30, 2010. The Service will accept applications for individual determination letters submitted by adopters of these pre-approved plans starting on May 1, 2008. This announcement describes certain changes to the determination letter application procedures for pre-approved plans that will simplify the application process for many applicants, and it informs plan sponsors that revised application forms for these plans will be available in the near future. Rev. Proc. 2007-44, 2007-28, I.R.B. 54, and Rev. Proc. 2005-16, 2005-1 C.B. 674, describe a staggered remedial amendment system for plans that are qualified under § 401(a) of the Internal Revenue Code, with five-year amendment/approval cycles for individually designed plans and six-year cycles for pre-approved plans. The submission period for the initial cycle for pre-approved defined contribution plans was February 17, 2005, through January 31, 2006. Sponsors and practitioners were required to restate their pre-approved defined contribution plans for EGTRRA and the 2004 Cumulative List and apply for new opinion or advisory letters during this submission period. Section 16.03 of Rev. Proc. 2007-44 provides that when the review of a cycle for pre-approved plans has neared completion, the Service will publish an announcement providing the date by which adopting employers must adopt the newly approved plans. This date is intended to give adopting employers a window of approximately two years in which to adopt the plans. Procedures for filing determination letter applications are contained in Rev. Proc. 2008-6, 2008-1 I.R.B. 192. Section 6.05 of Rev. Proc. 2008-6 requires a determination letter application to include a copy of the plan’s signed and dated timely good faith EGTRRA amendments, interim and other plan amendments. These documents are in addition to the restated plan or, in the case of M&P and certain VS plans, the completed adoption agreement. In general, an application for an individual determination letter on a pre-approved plan is to be filed on Form 5307, Application for Determination for Adopters of Master or Prototype or Volume Submitter Plans. These applications will be reviewed on the basis of the Cumulative List of Changes in Plan Qualification Requirements that was used to review the underlying pre-approved plan, that is, the 2004 Cumulative List in the case of an application filed for the cycle that includes the pre-approved plan submission period that ended on January 31, 2006. In certain circumstances, however, an application for an individual determination letter on a pre-approved plan is to be filed on Form 5300, Application for Determination for Employee Benefit Plan, rather than Form 5307. These circumstances include the following: (1) where the adopter of an M&P plan amends the basic plan document or adoption agreement, other than by choosing among options permitted under the plan or amending the plan in the manner described in sections 5.02 and 19.03 of Rev. Proc. 2005-16; (2) where the adopter of a VS plan makes changes to the pre-approved plan that are too extensive or complex or otherwise determined by the Service to be incompatible with the purposes of the volume submitter program; and (3) where the adopter of a pre-approved plan is requesting a determination regarding partial termination, affiliated service group status or leased employees, or where the pre-approved plan is a multiple employer VS plan. Except as otherwise provided in this announcement, an application for an individual determination letter on a pre-approved plan that is filed on Form 5300 will be reviewed on the basis of the Cumulative List in effect when the application is filed. For example, a determination letter application filed on Form 5300 on May 1, 2008, will be reviewed on the basis of the 2007 Cumulative List (Notice 2007-94, 2007-51 I.R.B. 1179). Deadline for Employer Adoption of EGTRRA-approved Defined Contribution M&P and VS Plans An adopting employer whose plan is eligible for the six-year remedial amendment cycle under section 17 of Rev. Proc. 2007-44 and that adopts an EGTRRA-approved M&P or VS defined contribution plan by April 30, 2010, will have adopted the plan within the employer’s six-year remedial amendment cycle.[1] The end of the plan’s remedial amendment cycle with respect to EGTRRA and the changes in plan qualification requirements on the 2004 Cumulative List is April 30, 2010. Individual Determination Letter Filing Procedures for Pre-approved Plans The Service will accept applications for individual determination letters for EGTRRA-approved M&P and VS defined contribution plans starting May 1, 2008. The procedures for filing such applications are clarified and revised as follows: An application for a determination letter that is filed on Form 5307 generally need not include the plan’s EGTRRA good faith amendments that were adopted prior to the adoption of the EGTRRA-restated plan or any interim plan amendments, regardless of when adopted, unless the plan is a VS plan that does not authorize the practitioner to amend the plan on behalf of the adopting employer. The Service may, however, request evidence of adoption of good faith and interim amendments during the course of its review of a particular plan. Applications filed on Form 5307 for VS plans that do not authorize the practitioner to amend the plan on behalf of the adopting employer must include the plan’s EGTRRA good faith amendments and any interim amendments that were adopted for qualification changes on the 2004 Cumulative List. An application for a determination letter on a pre-approved plan that is required to file Form 5300 only because the plan is a multiple employer VS plan or because the employer is requesting a determination regarding partial termination, affiliated service group status or leased employees will be reviewed on the basis of the Cumulative List that was used to review the underlying pre-approved plan, that is, the 2004 Cumulative List, as if the application had been filed on Form 5307. The Service’s review of the application will not consider changes in the qualification requirements subsequent to the 2004 Cumulative List. Except in the case of VS plans that do not authorize the practitioner to amend the plan on behalf of the adopting employer, an application described in this paragraph need not include the plan’s EGTRRA good faith amendments that were adopted prior to the adoption of the EGTRRA-restated plan or any interim plan amendments, regardless of when adopted. The Service may, however, request evidence of adoption of good faith and interim amendments during the course of its review of a particular plan. An application for a VS plan that is described in this paragraph but which does not authorize the practitioner to amend on behalf of the adopting employer must include the plan’s EGTRRA good faith amendments and any interim amendments that were adopted for qualification changes on the 2004 Cumulative List. An application for a determination letter on any other pre-approved plan that is required to file Form 5300 will be reviewed on the basis of the Cumulative List in effect on the date the application is filed. The application must include a copy of the plan’s signed and dated timely good faith EGTRRA amendments, and interim and other plan amendments for all the changes in qualification requirements on the Cumulative List that is in effect when the application is filed. Applications described in this paragraph include (1) applications for determination letters on M&P plans that have been amended by the adopting employer in a manner other than to choose among options permitted under the plan or as described in sections 5.02 and 19.03 of Rev. Proc. 2005-16, and (2) applications for determination letters on VS plans that have been modified by the adopting employer in a manner that is too extensive or complex or otherwise determined by the Service to be incompatible with the purposes of the volume submitter program. These changes will be published as modifications to Rev. Proc. 2008-6 when that revenue procedure is next revised. Until the modifications to the revenue procedures are published, plan sponsors may rely on this announcement regarding the changes. Plan sponsors and their advisors are encouraged to review the frequently asked questions on the following web site: http://www.irs.gov/retirement/article/0,,id=179990,00.html for additional information regarding the issuance of opinion, advisory and determination letters for pre-approved plans and the documents that must be submitted with a determination letter application. Revision of Form 5307 Form 5307 is being revised to allow the form to be optically scanned and thereby improve the Service’s processing of determination letter applications filed with the form. It is expected that the revised form will be available soon. However, applications filed with the current form (revised 2001) will continue to be accepted through September 30, 2008. [1] Section 20 of Rev. Proc. 2007-44 provides that an opinion or advisory letter for a new pre-approved plan submitted for approval after the end of the submission period may not be relied on for the period prior to the date of submission. Consolidated Returns; Intercompany Obligations Partial withdrawal of notice of proposed rulemaking. This document withdraws a portion of a notice of proposed rulemaking (REG-107592-00, 2007-44 I.R.B. 908) published in the Federal Register on September 28, 2007 (72 FR 55139). The withdrawn portion relates to the treatment of transactions involving the provision of insurance between members of a consolidated group. Frances L. Kelly, (202) 622-7770 (not a toll-free number). On September 28, 2007, the IRS and the Treasury Department published a notice of proposed rulemaking (REG-107592-00) in the Federal Register (72 FR 55139) which proposed to amend §1.1502-13(g) (regarding the treatment of transactions involving obligations between members of a consolidated group) and to add §1.1502-13(e)(2)(ii)(C) (regarding the treatment of certain transactions involving the provision of insurance between members of a consolidated group). Under proposed §1.1502-13(e)(2)(ii)(C), certain intercompany insurance transactions would be taken into account on a single entity basis. Written comments were received with respect to proposed §1.1502-13(e)(2)(ii)(C). After consideration of these comments, the IRS and the Treasury Department have decided to withdraw proposed §1.1502-13(e)(2)(ii)(C). However, the IRS and the Treasury Department continue to study whether revisions to the rules for intercompany transactions are necessary to clearly reflect the taxable income of consolidated groups. Partial Withdrawal of a Notice of Proposed Rulemaking Accordingly, under the authority of 26 U.S.C. 7805 and 26 U.S.C. 1502, §1.1502-13(e)(2)(ii)(C) of the notice of proposed rulemaking (REG-107592-00) that was published in the Federal Register on September 28, 2007 (72 FR 55139) is withdrawn. for Services and Enforcement. Foundations Status of Certain Organizations The following organizations have failed to establish or have been unable to maintain their status as public charities or as operating foundations. Accordingly, grantors and contributors may not, after this date, rely on previous rulings or designations in the Cumulative List of Organizations (Publication 78), or on the presumption arising from the filing of notices under section 508(b) of the Code. This listing does not indicate that the organizations have lost their status as organizations described in section 501(c)(3), eligible to receive deductible contributions. Former Public Charities. The following organizations (which have been treated as organizations that are not private foundations described in section 509(a) of the Code) are now classified as private foundations: Org. Name Absolute Positive Influences, Fort Worth TX Academy Community Development Corporation, Greensboro NC Adams Clubhouse, Prescott Valley AZ Alternative Decisions Incorporation, Wynocote PA Bridges Ministry, Renton WA Carolina Assistance Programs, Inc., Greer SC Christopher House, Inc., Fancy Farm KY Coalition for Safe Community Needle Disposal, Inc., Houston TX Colonial Chapel Foundation at the American Village, Montevallo AL Dominion College, Cape Girardeau MO Door of Hope Recovery House for Women, Inc., Indianapolis IN Dorothy Below Lesher Scholarship Trust, Lansing MI Eco Mentors Alliance, Mahtomedi MN Eisner Research Associates, Inc., Encino CA Florence Indian Education Parent Committee, Florence OR Friends of Western Missouri Medical Foundation, Warrensburg MS Global Community Development, Inc., Birmingham AL Gratiot Residents East Area Together, Detroit MI Greater Zion Community Outreach Center, Inc., Baltimore MD Habitat for Education, Danville CA Here Too Help, Los Angeles CA Hosannas Horse Granger, Duluth GA Housing Counselors of Texas, Inc., Dallas TX Impact Housing Corporation, Mequon WI Ivory & Billie Crittendon Foundation, Tacoma WA James 2 Association, Arlington VA Knowledge Management Associates, Columbia MO Lambs Vision Christian Fellowship, Garden Grove CA Lindsay Educational Foundation, Lindsay OK Maandeeq Womans Organization, Inc., Oxford GA Manna Ministry, Inc., Centreville MD Metro Community Assistance, Inc., Dallas GA Mississippi Housing Opportunity Coalition, Inc., Collins MS Morning Glory Temple Shelter of Hope, Chicago IL Museum of Black-African American History and Learning Center, Lincoln NE Museum of Life or Death Incorporation, Irvington NJ Myers Community Tutoring Service, Inc., Cordova TN National Cave Museum, Park City KY New Horizons Educational Center, Inc., Philadelphia PA North Carolina Community Solutions Network, Durham NC Paws From the Ghetto, Inc., New York NY Phoenix Project, Inc., Nashville TN Prostate Cancer Project, North Miami FL Providence Childrens Home, Victorville CA Quest Depot, Inc., Goshen AR Rhodius Booster Club, Plainfield IN Scent-cerely Yours, Desert Hot Springs CA Seledorwon USA, Inc., Dorchester MA Share Care Prayer Mission, Gonzales LA Sherman Chamber Foundation, Inc., Sherman TX Silver Threads & Golden Needles, Inc., Lawrenceville GA Snell Development Group, San Leandro CA Society for the Prevention of Domestic Violence, Inc., New York NY Sonoma Mountain Institute, Petaluma CA Sonshine Financial Ministries, Inc., Odenton MD Spirit of a Child Foundation, Hayward WI State Committee on the Life and History of Black Georgians, Atlanta GA Turnage Transitional Home for Clean Living, Los Angeles CA Tyler Court Interfaith Housing Corporation, Lemon Grove CA Victoria House Corporation, San Diego CA VIP Care Services, Pomona CA Wheel Productions, Phoenix AZ Your New Beginnings, Inc., Aberdeen MS If an organization listed above submits information that warrants the renewal of its classification as a public charity or as a private operating foundation, the Internal Revenue Service will issue a ruling or determination letter with the revised classification as to foundation status. Grantors and contributors may thereafter rely upon such ruling or determination letter as provided in section 1.509(a)-7 of the Income Tax Regulations. It is not the practice of the Service to announce such revised classification of foundation status in the Internal Revenue Bulletin. Amplified describes a situation where no change is being made in a prior published position, but the prior position is being extended to apply to a variation of the fact situation set forth therein. Thus, if an earlier ruling held that a principle applied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. (Compare with modified, below). Clarified is used in those instances where the language in a prior ruling is being made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguished describes a situation where a ruling mentions a previously published ruling and points out an essential difference between them. Modified is used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. (Compare with amplified and clarified, above). Obsoleted describes a previously published ruling that is not considered determinative with respect to future transactions. This term is most commonly used in a ruling that lists previously published rulings that are obsoleted because of changes in laws or regulations. A ruling may also be obsoleted because the substance has been included in regulations subsequently adopted. Revoked describes situations where the position in the previously published ruling is not correct and the correct position is being stated in a new ruling. Superseded describes a situation where the new ruling does nothing more than restate the substance and situation of a previously published ruling (or rulings). Thus, the term is used to republish under the 1986 Code and regulations the same position published under the 1939 Code and regulations. The term is also used when it is desired to republish in a single ruling a series of situations, names, etc., that were previously published over a period of time in separate rulings. If the new ruling does more than restate the substance of a prior ruling, a combination of terms is used. For example, modified and superseded describes a situation where the substance of a previously published ruling is being changed in part and is continued without change in part and it is desired to restate the valid portion of the previously published ruling in a new ruling that is self contained. In this case, the previously published ruling is first modified and then, as modified, is superseded. Supplemented is used in situations in which a list, such as a list of the names of countries, is published in a ruling and that list is expanded by adding further names in subsequent rulings. After the original ruling has been supplemented several times, a new ruling may be published that includes the list in the original ruling and the additions, and supersedes all prior rulings in the series. Suspended is used in rare situations to show that the previous published rulings will not be applied pending some future action such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study. Revenue rulings and revenue procedures (hereinafter referred to as “rulings”) that have an effect on previous rulings use the following defined terms to describe the effect: The following abbreviations in current use and formerly used will appear in material published in the Bulletin. A—Individual. Acq.—Acquiescence. B—Individual. BE—Beneficiary. BK—Bank. B.T.A.—Board of Tax Appeals. C—Individual. C.B.—Cumulative Bulletin. CFR—Code of Federal Regulations. CI—City. COOP—Cooperative. Ct.D.—Court Decision. CY—County. D—Decedent. DC—Dummy Corporation. DE—Donee. Del. Order—Delegation Order. DISC—Domestic International Sales Corporation. DR—Donor. E—Estate. EE—Employee. E.O.—Executive Order. ER—Employer. ERISA—Employee Retirement Income Security Act. EX—Executor. F—Fiduciary. FC—Foreign Country. FICA—Federal Insurance Contributions Act. FISC—Foreign International Sales Company. FPH—Foreign Personal Holding Company. F.R.—Federal Register. FUTA—Federal Unemployment Tax Act. FX—Foreign corporation. G.C.M.—Chief Counsel’s Memorandum. GE—Grantee. GP—General Partner. GR—Grantor. IC—Insurance Company. I.R.B.—Internal Revenue Bulletin. LE—Lessee. LP—Limited Partner. LR—Lessor. M—Minor. Nonacq.—Nonacquiescence. O—Organization. P—Parent Corporation. PHC—Personal Holding Company. PO—Possession of the U.S. PR—Partner. PRS—Partnership. PTE—Prohibited Transaction Exemption. Pub. L.—Public Law. REIT—Real Estate Investment Trust. Rev. Proc.—Revenue Procedure. Rev. Rul.—Revenue Ruling. S—Subsidiary. S.P.R.—Statement of Procedural Rules. Stat.—Statutes at Large. T—Target Corporation. T.C.—Tax Court. T.D. —Treasury Decision. TFE—Transferee. TFR—Transferor. T.I.R.—Technical Information Release. TP—Taxpayer. TR—Trust. TT—Trustee. U.S.C.—United States Code. X—Corporation. Y—Corporation. Z —Corporation. A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2007-27 through 2007-52 is in Internal Revenue Bulletin 2007-52, dated December 26, 2007. Bulletins 2008-1 through 2008-14 2008-1 2008-1 I.R.B. 2008-1 246 2008-10 2008-7 I.R.B. 2008-7 445 2008-18 2008-12 I.R.B. 2008-12 667 2008-23 2008-14 I.R.B. 2008-14 147290-05 2008-10 I.R.B. 2008-10 576 153589-06 2008-14 I.R.B. 2008-14 104713-07 2008-6 I.R.B. 2008-6 409 Revenue Procedures 2008-1 2008-1 I.R.B. 2008-1 1 2008-2 2008-1 I.R.B. 2008-1 90 Revenue Rulings Tax Conventions Treasury Decisions 9368 2008-6 I.R.B. 2008-6 382 9374 2008-10 I.R.B. 2008-10 521 9378 2008-14 I.R.B. 2008-14 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2007-27 through 2007-52 is in Internal Revenue Bulletin 2007-52, dated December 26, 2007. Old Article 2006-88 Clarified and superseded by Notice 2008-35 2008-12 I.R.B. 2008-12 647 2008-6 Superseded by Ann. 2008-19 2008-11 I.R.B. 2008-11 624 2001-16 Modified by Notice 2008-20 2008-6 I.R.B. 2008-6 406 2001-60 Modified and superseded by Notice 2008-31 2008-11 I.R.B. 2008-11 592 2002-44 Superseded by Notice 2008-39 2008-13 I.R.B. 2008-13 684 2003-51 Superseded by Rev. Proc. 2008-24 2008-13 I.R.B. 2008-13 684 2006-52 Clarified and amplified by Notice 2008-40 2008-14 I.R.B. 2008-14 2006-77 Clarified and amplified by Notice 2008-25 2008-9 I.R.B. 2008-9 484 2006-107 Modified by Notice 2008-7 2008-3 I.R.B. 2008-3 276 2007-30 Modified and superseded by Notice 2008-14 2008-4 I.R.B. 2008-4 310 2007-54 Clarified by Notice 2008-11 2008-3 I.R.B. 2008-3 279 209020-86 Corrected by Ann. 2008-11 2008-7 I.R.B. 2008-7 445 107592-00 Partial withdrawal by Ann. 2008-25 2008-14 I.R.B. 2008-14 149856-03 Hearing scheduled by Ann. 2008-26 2008-13 I.R.B. 2008-13 693 113891-07 Hearing scheduled by Ann. 2008-4 2008-2 I.R.B. 2008-2 269 97-36 Modified by Rev. Proc. 2008-23 2008-12 I.R.B. 2008-12 664 2001-23 Modified by Rev. Proc. 2008-23 2008-12 I.R.B. 2008-12 664 2002-9 Modified by Rev. Proc. 2008-18 2008-10 I.R.B. 2008-10 573 2002-9 Modified and amplified by Rev. Proc. 2008-25 2008-13 I.R.B. 2008-13 686 2007-1 Superseded by Rev. Proc. 2008-1 2008-1 I.R.B. 2008-1 1 2007-2 Superseded by Rev. Proc. 2008-2 2008-1 I.R.B. 2008-1 90 2007-3 Superseded by Rev. Proc. 2008-3 2008-1 I.R.B. 2008-1 110 2007-26 Obsoleted in part by Rev. Proc. 2008-17 2008-10 I.R.B. 2008-10 549 2007-39 Superseded by Rev. Proc. 2008-3 2008-1 I.R.B. 2008-1 110 2008-13 Corrected by Ann. 2008-15 2008-9 I.R.B. 2008-9 511 58-612 Clarified and amplified by Rev. Rul. 2008-15 2008-12 I.R.B. 2008-12 633 64-250 Amplified by Rev. Rul. 2008-18 2008-13 I.R.B. 2008-13 674 89-42 Modified and superseded by Rev. Rul. 2008-17 2008-12 I.R.B. 2008-12 626 92-19 Supplemented in part by Rev. Rul. 2008-19 2008-13 I.R.B. 2008-13 669 2001-48 Modified and superseded by Rev. Rul. 2008-17 2008-12 I.R.B. 2008-12 626 2007-4 Supplemented and superseded by Rev. Rul. 2008-3 2008-2 I.R.B. 2008-2 249 9362 Corrected by Ann. 2008-9 2008-7 I.R.B. 2008-7 444 9362 Corrected by Ann. 2008-12 2008-7 I.R.B. 2008-7 446 The Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue Bulletin is sold on a yearly subscription basis by the Superintendent of Documents. Current subscribers are notified by the Superintendent of Documents when their subscriptions must be renewed. The contents of this weekly Bulletin are consolidated semiannually into a permanent, indexed, Cumulative Bulletin. These are sold on a single copy basis and are not included as part of the subscription to the Internal Revenue Bulletin. Subscribers to the weekly Bulletin are notified when copies of the Cumulative Bulletin are available. Certain issues of Cumulative Bulletins are out of print and are not available. Persons desiring available Cumulative Bulletins, which are listed on the reverse, may purchase them from the Superintendent of Documents. You may view the Internal Revenue Bulletin on the Internet at www.irs.gov. Under information for: select Businesses. Under related topics, select More Topics. Then select Internal Revenue Bulletins. Internal Revenue Bulletins are available annually as part of Publication 1796 (Tax Products CD-ROM). The CD-ROM can be purchased from National Technical Information Service (NTIS) on the Internet at www.irs.gov/cdorders (discount for online orders) or by calling 1-877-233-6767. The first release is available in mid-December and the final release is available in late January. Check the publications and/or subscription(s) desired on the reverse, complete the order blank, enclose the proper remittance, detach entire page, and mail to the P.O. Box 371954, Pittsburgh PA, 15250-7954. Please allow two to six weeks, plus mailing time, for delivery. If you have comments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, we would be pleased to hear from you. You can e-mail us your suggestions or comments through the IRS Internet Home Page (www.irs.gov) or write to the IRS Bulletin Unit, SE:W:CAR:MP:T:T:SP, Washington, DC 20224 Page Last Reviewed or Updated: 23-Sep-2017

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professional_accounting

The Board leads and controls the Leweko Group in the discharge of its stewardship responsibilities by establishing the strategic direction and overseeing the risk management of the Group. The Group Chairman provides leadership to the Board and the Group and ensures that the Board functions effectively, and is entrusted with the task of instilling good corporate governance practices, leadership and effectiveness of the Board. $1· Ensuring compliance with all relevant regulations and legislation. The position of the Group Chairman and the Group Managing Director are held by different individuals. The Group Chairman’s and Group Managing Director’s roles and responsibilities are divided to ensure that there is a balance of power and authority. This balance ensures that all matters brought before the Board are fully, adequately and objectively discussed taking into account the interest of the various stakeholders including the minority shareholders. The Board is supported by a qualified Company Secretary who is a member of The Malaysian Institute of Chartered Secretaries and Administrators. The Company Secretary play an advisory role to the Board particularly with regards to the constitution of the Company and the Company’s compliance with regulatory requirements, rules, guidelines and legislation as well as best practices of corporate governance. The Board has constant access to the advice and services of the Company Secretary. The Board is supplied with information on a timely basis to enable it to effectively discharge its duties and responsibilities. As a general rule, all Board meetings’ papers are distributed at least a week before the respective Board meeting so that the Directors would have adequate time to read and understand the matters that will be discussed and deliberated at the meeting concerned. Additional information on the Group is also supplied to Directors upon specific requests. Upon conclusion of each meeting, the minutes are prepared and circulated to the Directors for review and comments by the Company Secretary in a timely manner. The minutes of meetings are confirmed as a correct record by the Board at the following meeting. $1§ issues and decisions reserved for the board. The Board Charter sets out, amongst others, the respective roles and responsibilities of the Board, Board Committees, Directors and Management as well as the relationship between the Board and its Management. The Board will review the Board Charter periodically and make any necessary or desirable amendments to ensure they remain consistent with the Board’s objectives, current laws and best practices. All Directors, the management and staff are expected to conduct themselves with the highest ethical and professional standards at all times. A summary of the Code of Ethics and Conduct are set out in the Board Charter. The Board intends to establish and implement a whistleblowing policy to the Group in the coming financial year with a view of strengthening its existing internal control systems and work culture policies in its commitment of promoting good business conduct as well as maintaining healthy corporate culture. The Group’s current internal controls, work culture and “open-door” concept adopted by the Group supports a clear and open communication between the Board, management and employees which in turn promotes good business conduct and healthy corporate culture. The Board of Directors comprises of five (5) members out of three (3) are Independent Non-Executive Directors. The composition of three (3) Independent Non-Executive Directors meets the one-third requirement for independent directors to be appointed to the Board under the Main Market Listing Requirements of Bursa Malaysia Securities Berhad. The presence of three (3) Independent Non-Executive Directors making up more than one-third of the total number of directors fulfils the pivotal role in ensuring that there is Board balance and independence. The roles of these Independent Non-Executive Directors are particularly important in ensuring that the strategies proposed by the management are fully deliberated upon, and take into account the long term interest of the shareholders, employees, customers, suppliers and the community at large in which the Group conducts its business. Each of the Independent Non-Executive Directors is considered independent of management and free of any relationship that could materially interfere the exercise of their independent judgment. The Nomination Committee and the Board have evaluated the independence of the Independent Non-Executive Director, Mr. Seou Lim Khoon, who has served as an Independent Non-Executive Director of the Company for a cumulative term of more than nine (9) years and concluded that throughout his tenure, he has remained independent in his views and in exercising judgment in deliberations at Board/Board Committee meetings, without being influenced by operational consideration and has always acted in the best interest of all shareholders. The Nomination Committee and the Board recommend Mr. Seou Lim Khoon to act as the Independent Non-Executive Director and the relevant motion on the subject matter will be presented to the shareholders for approval at the forthcoming Annual General Meeting of the Company. The Board recognises diversity in the boardroom as a critical element for efficient functioning of the Board and good governance practices. The Board also believes that diversity leads to the consideration of all facets of an issue and, consequently, better decisions and performance. Hence, the Nomination Committee in making recommendations for appointment of Board members and senior management, due consideration is not only given to the required mix of skills, knowledge, expertise experience, professionalism, integrity, competencies and time commitment but also gives due regards for other qualities, including diversity in gender, age, cultural background and ethnicity. The final decision as to who shall be appointed is the responsibility of the Board after considering the Nomination Committee’s recommendation. The Board is aware of the importance of Boardroom diversity and is supportive of the recommendation of the Malaysian Code on Corporate Governance, 2017 to the establishment of boardroom and workforce gender diversity policy. However, the Company does not have a policy of boardroom diversity, including gender, ethnicity and age diversity. The Company will provide equal opportunity to candidates with merit. Nonetheless, the Board will give consideration to the gender diversity objectives. The Group practices non-discrimination in any form, whether based on age, gender, ethnicity or religion, throughput the organisation. Currently, the Board does not comprise of any female director. In line with the country’s aspiration target of 30% representation of women on the board of companies, the Board may consider appointing females onto the Board in future to bring about a more diverse perspective. The Nomination Committee is responsible for making recommendations on any nomination for appointment of new directors to the Board and to Committees of the Board. The Nomination Committee considers candidates for directorship proposed by the Executive Directors and, where practicable, by any other senior executive and any director and shareholder or any suitable qualified candidates from independent sources. The Nomination Committee is chaired by Dato’ Haji Roshidi bin Haji Hashim, the Independent Non-Executive Chairman. The Board Nomination Committee is tasked with conducting annual assessment on the effectiveness of the Board as a whole, the Committees of the Board and the contribution of each individual Directors. The process assessed the competencies of each Director in the areas of integrity and ethics, governance, strategic perspective, business acumen, judgment and decision making, teamwork, communication and leadership. The Nomination Committee also assessed the independence of its independent directors based on required mix skills and criteria of independence. The results of the evaluation were summarised and discussed by the Nomination Committee which were then reported to the Board with recommendations. The results of the evaluation concluded that the good mix of age, qualifications, skills, experience and core competencies as well as the time commitment from the current Board have enable the Board and Board Committees to function effectively and efficiently. The Remuneration Committee’s primary responsibilities are to recommend to the Board from time to time, the remuneration package and terms of employment of each Executive Director and senior management of the Group. The Remuneration Committee ensures that the Directors are remunerated or rewarded for the contributions or individual level of responsibilities so as to ensure that the Group attracts and retains the right calibre of Directors needed for the successful performance of the Group. The details of the remuneration breakdown of individual directors of the Company during the financial year ended 30 June 2018 are set out on page 21 of the Annual Report 2018. The remuneration which includes salary, bonus, benefits-in-kind and other emoluments paid to the top five senior management’s during the financial year 30 June 2018 was not disclosed on a named basis due to the competitive nature of the human resource market. The Board is of the view that the remuneration paid to key senior management during the financial year ended 30 June 2018 disclosed in the band of RM250,000 would satisfy the accountability and transparency aspect of the Company. The Chairman of the Audit Committee is currently still the Chairman of Board. The Nomination Committee is still identifying a potential candidate for the appointment as Chairman to the Audit Committee. Please provide an alternative practice and explain how the alternative practice meets the intended outcome. The Audit Committee recognises the need to uphold independence of its external auditor and that no possible conflict of interest whatsoever should arise. Currently, none of the members of the Audit Committee of the Company were former key audit partners of the external auditors appointed by the Group. The Company will observe a cooling-off period of at least two (2) years in the event any potential candidate to be appointed as a member of the Audit Committee was a key audit partner of the external auditors of the Group. The Audit Committee is responsible for the development, implementation and monitoring of the Company’s policy on external auditor. The Audit Committee reserves oversight responsibility for monitoring the auditor’s independence, objectivity and compliance with ethical, professional and regulatory requirements. The Audit Committee is also responsible for the re-tendering selection process and recommends the appointment, reappointment and removal of the Company’s external auditor and considers the risk associated with the change of the external auditors in its risk evaluation and planning. The Audit Committee also reviews and set the terms, areas or responsibility and scope of the audit as set out in the external auditor’s engagement letter, the overall work plan for the forthcoming year together with the associated fee proposal and cost effectiveness of the audit, the external auditors’ independence, any major issues which arises during the course of the audit and their resolution, key accounting and audit judgment, the level of errors identified during the audit, the recommendations made to the management by the auditor and management’s response and the auditors overall performance. The Audit Committee comprises solely of three (3) Independent Non-Executive Directors. The members of the Audit Committee of the Company had complied with the Main Market Listing Requirements of Bursa Malaysia Securities Berhad of which at least one (1) member with the requisite accounting qualification. Collectively, the members of the Audit Committee have the relevant financial and commercial experience; and have carried their duties in accordance with the Terms of Reference of the Audit Committee. The Audit Committee will undertake the relevant training programmes to keep themselves abreast of the latest development in accounting and auditing standards, statutory laws, regulations and best practices to enable them to effectively discharge their duties. The Board firmly believes that risk management must be embedded within the daily operations and operating units of the Group, that is, from strategy formulation through to business planning and processes. The Board is of the opinion that only by understanding risks, can the decision makers be able to evaluate the impact of a particular action or decision on the achievement of corporate objectives. The Board has adopted an Enterprise Risk Management Framework across the Group and has directed management to implement all aspects of this framework so that a risk adverse culture and risk management awareness can be instilled at all operational levels. The Board acknowledges that the implementation of the framework is an on-going process and considerable effort and commitment are required of management to do so as management has the responsibility to manage risks, implement effective internal controls and ensure compliance with the relevant laws and regulations without impeding the achievement of business objectives. The Group’s system of internal control is based on a clear definition of responsibilities and the delegation of authority to the various Board and Management Committees, all of which act in accordance with their respective formal terms of reference. The Board has also taken all possible measures to ensure that its operations are in compliance with regulations imposed by authorities. $1· The Board reviews the operational and financial performance of the Group every quarter and management meetings are conducted at operational level on a monthly basis. $1· Operating expenditure is approved in accordance with formal limits of authority. $1· All legal contracts and documents are vetted by reputable firms of solicitors. $1· The compensation and remuneration packages of Executive Directors and senior management are reviewed by the Remuneration Committee. $1· The findings and recommendations for improvement in the Group’s system of internal control are reported to the Audit Committee by both the external and internal auditors. All minutes of the proceedings of the Audit Committee are tabled to the Board for review. In order to ensure that the Group’s system of internal control is operating as envisaged, the Group’s internal auditors carried out independent review on the adequacy and integrity of the Group’s system of internal controls and reports to the Board through the Audit Committee on the effectiveness of the Group’s system of internal control. The Group has outsourced the internal audit function to an independent professional firm, which is independent of the activities and operations of the Group. The Internal Auditors work within the scope of an audit plan, which has been approved by the Audit Committee, to review and test the adequacy and effectiveness of the internal controls of the Group. The External Auditors will, in the course of their statutory audit, conduct a review of the internal control procedures and highlight any internal control weaknesses which have come to their attention. All such findings and recommendations made by the Internal and External Auditors are reported to the Audit Committee. Any significant issues are discussed at the Audit Committee meetings. The Internal Auditors will follow up on all its recommendations to ensure that management has implemented them in a timely and appropriate fashion. The Internal Auditors support the Audit Committee in its role to assess the effectiveness of the Group’s overall system of internal controls. The assistance provided by the Internal Auditors is primarily accomplished through their appraisals of the financial and operational controls, policies and procedures established by management, and their reviews for compliance by the Group’s operating entities with these established controls, policies and procedures. The Internal Auditors reports directly to the Audit Committee. $1§ whether the internal audit function is carried out in accordance with a recognised framework. The outsourced Internal Audit firm appointed by the Wen Tai Consulting Sdn Bhd, an independent professional internal audit service provider and the consultancy is managed by professionally qualified and experienced staff. For each internal audit review, an internal audit personnel led by Mr. Tee Er Wee, who is a Fellow Member of the Association of Chartered Certified Accountants (ACCA) will be assigned by Wen Tai Consulting Sdn. Bhd. to undertake a review in accordance to the internal audit plan approved by the Audit Committee. The internal auditors are free from any relationships or conflict of interest which could impair their objectivity and independence. The Internal Audit function adopts an Internal Audit framework with processes based on the standards recommended by the International Professional Practices Framework of the Institute of Internal Auditors. The Board recognises the importance of shareholders’ and investors’ communications and as a matter of policy, reports on a timely basis all material information in relation to the Group. The Group also communicate with the general public through its annual reports, quarterly and other corporate announcements to Bursa Malaysia Securities Berhad as well as press interviews and conferences. In addition, briefings for and dialogues with institutional shareholders and financial analysis have been conducted from time to time to discuss the Group’s past performance and the general market conditions for businesses in which the Group is involved. In this respect, the Board ensures that all information sought was disseminated in strict adherence with the Main Market Listing Requirements of Bursa Malaysia Securities Berhad. The Board is mindful of the sufficient notice and time to be given to shareholders to allow the shareholders to make necessary arrangements to attend and participate the AGM. The Companies Act, 2016 and the Main Market Listing Requirements of Bursa Malaysia Securities Berhad provided that the notice convening an annual general meeting shall be given to all shareholders at least twenty-one (21) days before the meeting. The notice of Annual General Meeting together with a copy of the Company’s Annual Report for the financial year ended 30 June 2018 will be dispatched to shareholders at least twenty-one (21) days before the meeting as required under the Companies Act, 2016 and Main Market Listing Requirements of Bursa Malaysia Securities Berhad. The Notice of Annual General Meeting, which sets out the business to be transacted at the Annual General Meeting, is also published at least in a major local newspaper. The Board members in attendance at general meetings will provide explanation to all shareholders’ queries and shareholders are encouraged to participate in discussions and to give their views to the Directors. The Chair of the Audit, Nomination and Remuneration Committees in attendance at general meetings will also provide meaningful responses to questions. $1§ remote shareholders’ participation at General Meetings. This is not applicable to the Company since the Company do not hold meetings in remote locations. The Company’s Annual General Meeting have always been held in a non-remote location easily accessible to shareholders as well as general public.

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professional_accounting

18122 Carmenita Rd., #3582 What the (F)? February 28, 2019 Jenny Wang Many companies will, at some point, decide that it makes sense to make some changes to its business structure to better align with its business purpose. Certain changes will trigger tax consequences, while other changes may not. With proper analysis and planning, a company may be able to take advantage of one of several types of tax-free reorganizations offered under the U.S. federal income tax code and regulations to defer (or at least minimize) the recognition of any immediate taxes. Tax-free reorganizations can be classified into four distinctive groups: · Group 1 includes four types of reorganizations where one entity can merge into, consolidate with, or acquire another entity, and are commonly referred to as Type A, Type B, Type C, and Type D reorganizations. · Group 2 consists of three different occasions when part of a parent corporation’s assets or stock are used to form a new subsidiary or subsidiaries. Reorganizations under this group also fall under a Type D reorganization. · Group 3 focuses on maintaining the overall organizational structure, while changing an entity’s capital structure, or moving an entity around the organizational chart. Reorganizations under this group fall under either a Type E or Type F reorganization. · Group 4 involves the transfer of assets by a corporation to another corporation in a bankruptcy (or similar) case. A reorganization under this group is referred to as a Type G reorganization. The focus of this discussion is on a Type F reorganization, which falls under Group 3, above. A Type F reorganization typically involves “mere” or simple formality changes to a corporation. Such changes include a change in identity, in form, or in the location of the corporation. In 2015, the IRS issued final regulations to provide the public with clearer guidance and to clarify what qualifies as a “mere change” under an (F) reorganization. Under the final regulations, a corporation will have undergone a “mere change” if it meets the following six requirements: 1. All stock of the resulting corporation must be distributed in exchange for stock of the transferor corporation; 2. The same person or persons own all the stock of the transferor corporation at the beginning of the potential F reorganization and all of the stock of the resulting corporation at the end, in identical proportions; 3. The resulting corporation does not hold any property or have any tax attributes immediately before the potential F reorganization; 4. The transferor corporation must completely liquidate in the reorganization; 5. No corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the potential F reorganization; and 6. Immediately after the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would, as a result, succeed to and take into account the tax attributes of such other corporation. A simple illustration will tie together the above six requirements. P1 and P2 are unrelated individuals that each hold a 50% membership interest in LLC, a limited liability company treated as a partnership for federal income tax purposes. LLC, in turn, owns 100% of USCO, a U.S. C corporation. P1 and P2 want to re-align the current business structure by moving the corporation from under LLC and instead hold the C corporation directly, in the same proportion as the partners currently hold their indirect interests in the corporation, namely, 50/50. On January 1, 2018, USCO transfers all of its assets to NEWCO in exchange for NEWCO stock. USCO then transfers all of the NEWCO stock to LLC in exchange for USCO stock. USCO subsequently liquidates completely. P1 and P2 each continue to hold 50% membership interest in LLC, which in turn now owns 100% of NEWCO. The above sequence of events should qualify as a tax-free reorganization, as follows: Under Code Section 361, there is no gain or loss to USCO on the transfer of its assets to NEWCO in exchange for stock of NEWCO in an F reorganization. Under Code Section 354, there is typically no gain or loss to LLC upon the exchange of USCO’s stock for NEWCO stock. Requirements #1 and #2 under the regulations are satisfied because all of NEWCO’s stock are distributed to LLC in exchange for USCO stock, and LLC is the same shareholder that owns all the stock of USCO at the beginning of transaction, and all of the stock of NEWCO at the end, and owns such stock in identical proportions (i.e. 100%). #3 is satisfied because NEWCO does not hold any property or have any tax attributes immediately before the transaction, and #4 is satisfied because USCO completely liquidates in the reorganization. #5 is satisfied because only NEWCO holds property that was held by USCO immediately before the transaction. Lastly, #6 is satisfied because immediately after the transaction, NEWCO does not hold any property acquired from any other corporation that would result in NEWCO taking into account the tax attributes of such other corporation. In Tax Law, Tax Compliance Tags (F) Reorganization, tax-free, IRS An Introduction to Qualified Opportunity Zones and Qualified Opportunity Funds September 22, 2018 Jenny Wang On December 22, 2017, as part of the enactment of the 2017 Tax Act, Congress added Internal Revenue Code Sections 1400Z–1 and 1400Z–2, which designated certain low-income communities as “qualified opportunity zones.” This new law allows taxpayers a temporary deferral of realized gains if the taxpayers timely reinvest the gains in eligible property (referred to as “opportunity zone properties”) that is located in an opportunity zone. Taxpayers may organize either a partnership or a corporation (a “qualified opportunity fund”) for the purpose of investing in opportunity zone properties. In other words, such partnership or corporation is organized as a “qualified opportunity zone business.” A qualified opportunity zone business can generally be any active trade or business in which substantially all of the tangible property owned or leased by the trade or business is through the opportunity fund and treated as qualified opportunity zone business property. The one caveat is that the Code section provides a list of certain businesses that will not be treated as qualified opportunity zone businesses. Specifically, businesses that are considered a “sin business” will not qualify as an opportunity zone business, and include: • Golf courses • Country clubs • Massage parlors • Hot tub facilities • Suntan facilities • Racetracks or other facilities used for gambling • Any store where its principal business is the sale of alcoholic beverages for consumption off premises. Compliance Requirements and the Qualified Opportunity Fund Asset Test For compliance purposes, the IRS has confirmed that taxpayers can self-certify and become a qualified opportunity fund by completing a form and by attaching that form to the taxpayer’s federal income tax return for that taxable year. The form itself is not yet available but it is expected that the IRS will soon issue a sample of this form, to be released later this year. In addition to the initial self-certification to become a qualified opportunity fund, the taxpayer must also meet an asset test on a semi-annual basis. If a qualified opportunity fund fails to meet this test, that fund may be subject to a penalty for each month that it fails to meet the stated percentage requirement. The penalty is the differential between the percentage of assets invested in a qualified opportunity zone property and the 90 percent of assets amount, multiplied by the underpayment interest rate. Temporary Deferral of Gains In order to qualify for the temporary deferral of realized gains, the taxpayer must (1) reinvest their gains from the sale to, or exchange with, an unrelated person of any property held by the taxpayer in a qualified opportunity fund, and (2) the taxpayer must do so within 180 days from the date of the sale or exchange. In the year that the taxpayer later sells or exchanges the investment, the taxpayer must include the amount of gain in the gross income for that year, and in any case, if the taxpayer has not sold or exchanged the investment by December 31, 2026, the taxpayer must include the amount of gain in the gross income for 2026. Investments Held for 5, 7, or 10 Years Any investment held by the taxpayer for at least 5 years will receive an increase in the basis of such investment by 10 percent of the gain that was deferred. Any investment held by the taxpayer for at least 7 years will receive an increase in the basis of such investment by an additional 5 percent of the gain that was deferred. Any investment held by the taxpayer for at least 10 years will receive a step up in the basis of such property to the fair market value of the investment on the date that the investment is sold or exchanged. Because the 10-year mark will not be reached until after the temporary deferral period has already ended in 2026, taxpayers who are still holding their investments in an opportunity fund on December 31, 2026 are required to recognize and pay taxes on any deferred gain at that time (subject to any basis adjustments that have been made). After 2026, if the taxpayer holds the investment for the full 10 years (or longer), any potential increase in the fair market value of the investment will receive a step up in its basis upon its sale or exchange. In order to take advantage of this special 10-year rule, the taxpayer must make an election under IRS Code Section 1400Z-2(c). More guidance is expected on how the taxpayer can make this election. Key Considerations Pending Treasury Regulations While the IRS has issued an IRS Notice, IRS Bulletin, and a list of Frequently Asked Questions, there are still many more unanswered questions relating to compliance matters, including: · Can investors obtain the benefits of deferral if they sell the underlying property or investment, rather than the sale of their interest in the opportunity fund itself? · How long can a qualified opportunity fund hold cash after the disposition of an asset before the cash needs to be reinvested? · If the opportunity fund is organized as a partnership, can the partnership realize gains on behalf of its investors and reinvest the gains in a new partnership, while achieving the benefits of deferral? · Will land be treated as qualified opportunity zone property? In order for property to be treated as opportunity zone property, the property must be an “original use” property by the opportunity fund, or the property must be “substantially improved” by the fund. However, the terms original use and substantial improvement have not been clearly defined. The Treasury Department is expected to issue specific regulations and guidance later this year, which will hopefully help to clear up many of the outstanding questions and uncertainties. In Tax Law, Tax Compliance Tags qualified opportunity zones, qualified opportunity funds, tax deferral, 2017 Tax Act Online Retailers Beware: The State Sales Tax is Here June 25, 2018 Jenny Wang On June 21, 2018, the U.S. Supreme Court decided that physical presence is no longer necessary for a state to collect sales tax on internet retail sales (see South Dakota v. Wayfair, Inc.). This major decision overturned two prior Court decisions and will greatly affect those online retailers that will be facing an increase in the administrative and compliance costs associated with the change in the law. A little background on this case. The main issue stemmed from a South Dakota state law which required out-of-state sellers to collect and remit sales tax to the state, including those sellers that did not have a physical presence there (i.e. no employees or real estate in South Dakota). The law applied to sellers that deliver more than $100,000 of goods or services into the state annually or engage in 200 or more separate transactions for the delivery of goods or services into the state. The Court’s holding was based on the idea that the physical presence test has proven to be a test that is both impractical and difficult to enforce. In addition, the Court determined that there have been estimates in which the two prior cases, now overturned, have caused states to lose between $8 and $33 billion in revenue every year. South Dakota estimates its revenue loss at $48 to $58 million annually. Moreover, because South Dakota has no state income tax, its proportional reliance on sales and use taxes as sources of state revenue is further augmented. Notably, sales and use taxes account for over 60 percent of the state’s general fund. The Court’s ruling is based on the reasoning that, first, there is no violation of the Commerce Clause so long as there is a substantial nexus with the taxing State. Second, the Court compares the nexus requirement to the due process requirement that there be “some definite link” or “some minimum connection” between a state and the person, property or transaction it seeks to tax. Third, the due process requirements are deemed to be met regardless of whether a physical presence test has been met. Finally, the Court concluded that physical presence is not necessary to create a substantial nexus. Although this ruling is not favorable for online retailers, there may be some mitigating options available. The Marketplace Fairness Act of 2017 authorizes each member state under the Streamlined Sales and Use Tax Agreement (a multistate agreement adopted in 2002 to administer and collect sales and use taxes) to require all sellers to collect and remit sales and use taxes with respect to remote sales under the Agreement. What makes this Act attractive is that, first, sellers with less than $1 million in annual sales is exempt from collecting and remitting taxes (a much higher threshold than under the Wayfair case). Second, the Agreement must contain certain basic requirements for the administration of the tax, of audits, and of streamlined filing. In essence, this Act sets some boundaries and limits as to how far states can reach in compelling its state tax collection. Member states must agree to a set of simplified rules that aim to lighten the burden of compliance and reduce the risk of discrimination by the states. They are to provide software free of charge to remote sellers that would calculate sales and use taxes due on transactions and relieve sellers from any penalties if a liability is the result of an error or omission made by a certified software provider. Finally, the Marketplace Fairness Act would ensure that any state law changes will not have a retroactive effect on retailers. To date, there are 23 Member states participating under the Agreement. In Tax Law Tags South Dakota v. Wayfair, Inc., state sales tax, online sales tax Your Unpaid IRS Taxes Could Jeopardize Your Passport’s Validity March 29, 2018 Jenny Wang Effective January 2018, the IRS will begin to implement a new Internal Revenue Code section, which involves the ability by the IRS to make a Section 7345 certification and notify the Department of State of any such certification involving an individual with a seriously delinquent tax debt. The term “seriously delinquent tax debt” for the year 2018 means any unpaid, legally enforceable federal tax debt of more than $51,000 (note that this figure includes all interest and penalties) and this threshold amount is indexed yearly for inflation. Code Section 7345 was enacted under the Fixing America’s Surface Transportation (FAST) Act, Pub. L.114–94, back in December 4, 2015. Under the FAST Act, upon receipt of a Section 7345 certification regarding an individual from the IRS, the State Department will generally deny an application for an issuance or a renewal of a passport from that individual. Furthermore, the State Department may revoke or limit a passport previously issued to the individual. Let’s revisit what is considered a seriously delinquent tax debt. This is a federal tax liability for which either of two events have already occurred. One possibility is that the taxpayer has already received a notice that a federal tax lien has been filed under section 6323 and that the taxpayer’s right to a hearing under section 6320 has been exhausted or lapsed. The other scenario is that a tax levy has been issued under section 6331. By way of clarification, Section 7345 does not consider the following to be a seriously delinquent tax debt: debt that is part of a timely paid, IRS-approved installment; debt that is timely paid under an IRS-accepted offer in compromise; debt that is timely paid under a Department of Justice settlement agreement; debt in connection with a levy for which collection action has been suspended during the procedures involving a collection due process hearing; and debt for which collection is suspended as a result of an innocent spouse election or a request for innocent spouse relief. Furthermore, a taxpayer’s passport will not be affected if any of the following apply: the taxpayer is in bankruptcy; taxpayer has been identified by the IRS as a victim of tax-related identity theft; IRS has deemed the taxpayer’s account to be currently not collectible due to hardship; taxpayer is located within a federally declared disaster area; taxpayer has a pending installment agreement with the IRS; or taxpayer has a pending offer in compromise with the IRS. Finally, IRS certification of a taxpayer’s seriously delinquent tax debt will be postponed while that individual is serving in a combat zone or participating in a contingency operation. Section 7345 requires the IRS to notify the individual when that individual has been identified for certification or reversal of a certification. Notice CP508C “Notice of certification of your seriously delinquent federal tax debt to the State Department” will explain the amount due, the due date, what the taxpayer needs to know, and what the taxpayer needs to do to prevent the State Department from denying, revoking, or limiting their passport. If the taxpayer believes that the certification was made in error or if the taxpayer does not agree with the amount due, the taxpayer should first call the number listed on the top right corner. If the taxpayer is unable to resolve the disagreement but still disagrees with the IRS’ certification or failure to reverse a certification, that individual has a right to a judicial review by filing a claim with the U.S. Tax Court or the U.S. district court. If the court rules in favor of the taxpayer, the court may order the IRS to notify the State Department that the certification was in error. Unfortunately, this is the only recourse that a taxpayer has as there is no IRS administrative process in connection with the IRS certification process. If the IRS erred in making a certification, the IRS is required to reverse the certification and notify the State Department of such reversal (e.g. if the debt has been fully paid, falls below the threshold amount, or becomes unenforceable). Section 7345 provides details regarding the timing required for IRS to notify the State Department of any such reversals. The State subsequently removes the certification in connection with the debt from the State’s records. What happens to a taxpayer who has been certified by the IRS and who later applies for a passport? The State Department will generally provide that individual with 90 days to resolve the tax delinquency (e.g. pay off the debt, enter into an installment agreement, or enter into an offer in compromise with the IRS). If the debt remains unresolved, the State Department will deny the application. One of the mistakes that some taxpayers make is to ignore correspondences from the IRS until the problem escalated to the lien or levy filing stage. Although it is never pleasant to receive any notices from the IRS, you should consult with a tax attorney if you have any concerns or questions as soon as they arise. Taking action now will reduce or possibly eliminate the stress and administrative procedures down the road. You can learn more about IRS tax topic regarding the revocation or denial of passport here and here. IRS guidance (Notice 2018–01) for the implementation of new Code Section 7345 can be found here. To learn more about Notice CP508C, go here. In Tax Compliance, Tax Law Tags irs, state department, passport, travel, tax debt, IRC7345, tax compliance The Internal Revenue Service Will End the Offshore Voluntary Disclosure Program before October 2018 On March 13, 2013 the Internal Revenue Service announced that it will end the 2014 Offshore Voluntary Disclosure Program (OVDP) on Sept. 28, 2018. This means that taxpayers have approximately 6 months left if they wish to participate in the program. The OVDP is a voluntary disclosure program that offers taxpayers an opportunity to report foreign financial assets for prior undisclosed tax years. The disclosure period is defined as the most recent eight tax years for which the return due date has already passed. Nondisclosure by taxpayers means that they may be exposed to potential criminal liability. They are also exposed to substantial civil penalties if the IRS determines that the taxpayer was engaging in willful failure to report foreign financial assets and to pay all taxes due with respect to such assets. The benefits of participating in the OVDP include minimize the risk of criminal liability. If a taxpayer is accepted in the OVDP and ultimately resolves outstanding issues by way of a closing agreement, the IRS Criminal Investigation division will not recommend criminal prosecution to the Department of Justice for the relevant tax periods up to the date of the disclosure. Another benefit to the OVDP is by entering into agreed-upon terms, the taxpayer can resolve outstanding issues in connection with the additional taxes that are owed and the civil tax penalties that will be due. Taxpayers should consult with a tax attorney to determine whether the OVDP is the right program for them. If it is determined that this option is not appropriate, taxpayers should consider other alternatives, including Streamlined Filing Compliance Procedures, Delinquent FBAR submission procedures, or Delinquent international information return submission procedures. For more information on each of these options, visit the IRS website at: https://www.irs.gov/individuals/international-taxpayers/options-available-for-u-s-taxpayers-with-undisclosed-foreign-financial-assets In Tax Law, Tax Compliance, International Tax, International Tags irs, ovdp, International tax, tax compliance, civil tax penalties, foreign financial assets Will the New Tax Act Affect You? Part Four March 9, 2018 Jenny Wang In my last post, I discussed how the Tax Cuts and Jobs Act may impact an individual’s decisions regarding estate planning. In this post, I will briefly survey several significant changes affecting the U.S. international tax realm. Part Four: International Tax Reform New Dividends Received Deduction The Act enacted a new Code Section 245A which provides for a 100 percent deduction for dividends received by a U.S. shareholder of foreign corporate stock, provided that the foreign corporation is a 10 percent-owned foreign corporation, is not a passive foreign investment company, and meets all other relevant requirements under the Code Section. The key takeaway of this code section is that for those multinational corporations that qualify for the new deduction, they will no longer be subject to the tax on dividends they receive from their foreign subsidiaries. New tax on Global Intangible Low Tax Income A new Code Section 951A creates a sub-category of income (GILTI income) that is formula-driven and creates a minimum threshold for income that will be subject to U.S. taxation. For tax years 2018 through 2025, U.S. corporations can deduct 50 percent of GILTI income, resulting in a 10.5 percent effective tax rate. While this new tax aims to reduce the incentive for U.S. companies to shift assets offshore, it is less clear why the Act imposed 10 percent as the minimum threshold figure. Furthermore, due to the formula-driven nature of this new rule, U.S. corporations will have planning opportunities aimed at minimizing their exposure to the GILTI income that will be subject to tax. New Deduction for Foreign-Derived Intangible Income This is essentially a relief provision to the newly-enacted GILTI rules. The Act allows a deduction under new Code Section 250 for a U.S. corporation’s foreign-derived intangible income (FDII) of 37.5 percent for tax years 2018 through 2025, and 21.875 percent for tax years after 2025. Corporate taxpayers can also use up to 80 percent of foreign tax credits against their GILTI income. The net effect of all of the deductions, foreign tax credits, and gross-ups is that the effective tax rate on FDII is 13.125 percent for tax years 2018 through 2025 and 16.406% after 2025. New Base Erosion Minimum Tax The new “base erosion and anti-abuse tax” (BEAT) operates as a limited-scope alternative minimum tax, which is applied by adding back to taxable income certain deductible payments made to related foreign persons. Note that this new tax, imposed under Code Section 59A, applies to taxpayers with an average annual gross receipts for the last 3 taxable years of at least $500,000,000. The new minimum tax rate is 5 percent for tax year 2018, 10 percent for tax years 2019 through 2025, and 12.5 percent for tax years after 2025. Taxpayers now must calculate their tax liability under the new rules to determine whether they are subject to the BEAT. One-Time Transition Tax Finally, a transition tax imposed under Code Section 965 applies to U.S. shareholders on deferred foreign earnings as part of the transition to the new participation exemption system of taxation under the Act. Deferred foreign earnings refers to the accumulated post-1986 deferred foreign earnings. Such foreign earnings that are held as cash or cash equivalents are taxed at a rate of 15.5 percent and all other earnings are taxed at 8 percent. U.S. shareholder may elect to pay the transition tax in eight installments. In International Tax, Tax Compliance Tags tcja, International tax, gilti, fdii, beat Will the New Tax Act Affect You? Part Three In my last post, I discussed some key changes of the Tax Cuts and Jobs Act that will be affecting business entities. In this post, I will discuss how the Act will impact an individual’s decisions on estate planning. Part Three: Estate Planning Unlike some of the tax law changes that affect corporations (as discussed in Part Two) which are permanent, the changes to estate tax, gift tax, and generation-skipping transfer tax are effective in tax year 2018 and set to expire after 2025. Beginning 2018, the Tax Cuts and Jobs Act increased the exemption amount (the amount that an individual can gift or own at death without being subject to gift or estate tax) from $5,490,000 (for 2017) to $11,180,000. The exemption amount is $22,360,000 for a married couple. The generation-skipping transfer tax exemption has also been increased to the same amounts for individuals and married couples and also set to expire after 2025. While the change may not affect estate planning considerations for individuals or married couples with estates below the pre-Tax Act exemption amounts, those who are at or above the pre-Act exemption should re-evaluate their estate plan accordingly. One of the starting points is to consider both the income tax consequences and the estate tax consequences in the assessment of your estate plan. For example, an individual who currently holds an asset with a low adjusted basis and that asset has significantly appreciated in value (and is expected to continue to appreciate throughout the individual’s lifetime) may want to hold the asset until death in order to obtain a step-up in the basis of the asset. At death, the basis of the asset will be treated as equal to its fair market value, thereby resulting in income tax savings on the gains of the asset. While the value of the asset in includible in the gross estate of the decedent, the increase in the estate tax exemption may eliminate the concern of triggering the estate tax liability for those individuals and married couples below the newly-increased exemption amounts. Individuals and married couples with estates that are above the increased exemption amounts should consider making gifts to irrevocable trusts up to the exemption. By doing so, the value of those assets transferred over to the irrevocable trusts will be removed from the decedent’s gross estate and will not be included in the calculation of the estate tax liability. Furthermore, the irrevocable trusts may be drafted in such a way as to allow the transferred assets to grow tax-free while the trusts are administered for the benefit of loved ones. There are different estate plan considerations for a U.S. citizen who wishes to provide for a non-U.S. citizen spouse. While one U.S. citizen spouse can gift and bequest to another U.S. citizen spouse an unlimited amount of assets free of tax, a U.S. citizen spouse may not do the same with a non-U.S. citizen spouse (even if that spouse is a U.S. resident or a U.S. green card holder). Rather, an annual exclusion amount ($149,000 for 2017) is allowed for transfers from a U.S. citizen spouse to a non-citizen spouse. As a result of the temporary increase in the exemption amount, however, the U.S. citizen spouse may now have more flexibility to gift assets to the non-citizen. For example, the U.S. citizen can make a gift (up to, or even more than, the annual exclusion amount) to an irrevocable life insurance trust for the benefit of the non-citizen spouse. The trust then purchases a life insurance policy on the life of the U.S. citizen spouse. The death proceeds do not have to qualify for the marital deduction because the death benefits will generally be excluded from the insured’s estate. Alternatively, the life insurance policy could be owned by the noncitizen spouse. Again, the proceeds do not need to qualify for the marital deduction because the death benefit generally will be excluded from the U.S. citizen’s estate. Whether you currently have an existing estate plan, or you are considering whether to create one, please visit the five common misconceptions you should avoid and talk to an estate planning attorney to determine the best strategy that will most benefit you and your love ones. In Tax Law, Estate Planning, Tax Compliance Tags estate tax, gift tax, gst tax, tax law, tcja, estate planning, estate tax exemption Will the New Tax Act Affect You? Part Two In my last post, I discussed some key changes of the Tax Cuts and Jobs Act that will be affecting individuals. In this post, I will discuss how the Act will impact a business owner’s decision to structure an entity as either a C corporation or an S corporation. Part Two: Business Entities Perhaps the most talked about changes to our tax law involve these two numbers: 21% and 20%. These numbers hold very different purposes and incentives with varying degrees of permanence. The 21% figure represents a drop in the maximum federal corporate income tax rate (down significantly from a previous top rate of 35%). Unlike the rate changes that affect individuals and pass-through entities (which will be discussed later), this drop in the top rate is permanent. At the heart of the Tax Cuts and Jobs Act is a pointed intention to create jobs both domestically and to bring jobs back from overseas. Congress believes that by lowering the income tax rate for C corporations, it will inject a surge of competitive energy to the U.S. economy by encouraging more business activities, investments, and operations at the corporate level. Of course, skeptics have pointed out that lowering the corporate rate to 21% is not going to make a big difference from an internationally competitive standpoint because, they point out, the foreign corporate rates are still lower than the new U.S. rate. Furthermore, nothing is stopping those foreign countries (within the constraints of those countries’ laws) from further lowering their rates to maintain a business advantage. Nevertheless, it is undeniable that at the very least, many new and existing corporate entities will assess and make business decisions based on a dramatically lower top U.S. corporate rate than in previous years. It is worthwhile to point out that there are also numerous other changes in the law that must be taken into account when determining whether incorporating is the best option. For example, a company’s net operating losses can no longer be carried back under the new tax law and are also now limited to 80% of taxable income. However, they may be carried forward indefinitely (where the old rules allowed loss carry forwards for 20 years). Similarly, net business interest expense has been limited to 30% of adjusted taxable income, with the definition of “adjusted taxable income” set to be more restrictive for tax years beginning in 2022 (read: unfavorable to taxpayers). However, the Act boosts a company’s ability to fully deduct qualifying property, though this boost is only fully applicable between September 27, 2017 through 2021. Beginning in 2022, that benefit will begin to phase out and will be fully phased out by the end of 2026. It can reasonably be interpreted that while Congress wants to push businesses toward growth and production, it also imposes clearly defined constraints. Let us now discuss the significant of that second number: 20%, which represents a newly allowable deduction on qualified business income that is earned by pass-through entities. On its face, this much-talked about deduction under Section 199A could spur growth in many industries of those businesses that elect to be taxed as flow-through entities. However, the initial excitement and buzz over this deduction has since been subdued. Although it is not entirely clear whether Congress intended to do so, this new rule indeed favors certain selected industries. I will not go into the technical mechanics of the rule but by way of example: an ideal candidate who would - and could - take advantage of the 199A deduction is a company organized as an S corporation and doing businesses in one of these industries: architecture, engineering, small breweries and distillers, farming, plumbing, mining, and restaurant. However, I would like to add one note on restaurants. As the 50% deductibility for costs incurred to entertain prospective clients is now eliminated, and as meals provided to employees are now only 50% deductible (and completely eliminated beginning 2026), how will the restaurant industry react and prepare for these changes? How all of these new rules will unfold, and how they may impact businesses organized as C corps, S corps, LLCs, or proprietorships, is yet far from clear. What is clear is that it is the job of the tax attorney to stay up-to-date with changes in the tax law, rules and regulations, and to communicate and explain such changes to businesses and the owners that may be affected. In Tax Law, Tax Compliance Tags tax law, tax cuts and jobs act, tax rates, tax deductions, business tax Will the New Tax Act Affect You? Part One Over the next four posts, I will highlight four key areas that have been fundamentally altered by the new law: individuals, business entities, trusts, and international tax. In Tax Law, Tax Compliance Tags tax law, tax act, tax cuts and jobs act, tax rates, tax deductions A New Year, a New (Tax) Resolution December 13, 2017 Jenny Wang Lady Bird is a film that will affect and move its audience members. The film centers around Christine "Lady Bird" McPherson, a young woman in her last year of high school, and chronicles the events during that year as she confronts her relationships with her family and friends, her romantic relationships, her connection to her hometown, and ultimately, her own identity. The movie will unambiguously hit the nerves of those who identify with any of the characters or regard themselves as part of the middle class. It unabashedly portrays the struggles that Lady Bird’s mother goes through in order to financially sustain the family that she so deeply loves. We learn early on that Lady Bird’s older brother, a graduate of UC Berkeley, was unable to find a full-time job and instead lives at home and works as a cashier at the local supermarket. That same year, Lady Bird finds out from her mom that her quiet, good-natured father recently lost his job, which further heightened the depression that he has been secretly battling for years. Although the film is set in Sacramento in 2002, the issues that the family must deal with and the film’s underlying message transcend that particular period in history and becomes relatable for many families today. In one poignant scene, Lady Bird’s mom suggests they do their “favorite Sunday activity”: checking out open houses of their dream homes. In another scene, Lady Bird describes her own house as from “the wrong side of the tracks.” In yet another scene, she was forced to confess to a friend that the charming blue heritage house in an affluent neighborhood was not her real home but was, rather, her Dream Home. On November 16, 2017, the U.S. House of Representatives passed a major tax reform bill, H.R. 1, the “Tax Cuts and Jobs Act,” to amend the Internal Revenue Code of 1986. The U.S. Senate, on December 2, 2017, approved its version of tax reform legislation. The bill calls for the elimination or reduction of several tax deductions. For instance, it proposes to fully eliminate state and local income tax deduction, which is the single biggest itemized deduction for many taxpayers. As a result, it would effectively render itemized deductions irrelevant for more than 90 percent of all households. Furthermore, both the House and Senate plan to cap property tax deductions at $10,000. In addition, the House proposes a cap on mortgage interest deductions by limiting new home loans to no more than $500,000, while the current cap is twice that amount, at $1 million. The latest updates suggest that the House and Senate are likely to compromise on this point by capping the amount at $750,000. There are speculations abound that once the dust settles, the proposed tax bill will ultimately result in a very small tax cut for low- and middle-income families. For many families and prospective first-time homeowners, their plans may be an adjustment to their budget, or worse, an untimely and indeterminate delay in making the purchase. As we near Christmas Day (the administration’s unofficial tax reform bill deadline), it is still difficult to definitively conclude how the tax bill will affect the middle class. There will be discussions, negotiations, and debates between the House and Senate to come to terms with the final numbers. What we do know, however, is that a major tax reform will be heading into 2018 with us. If you have any questions about how the new law will affect you and your family’s ability to afford a home, be it your Dream House or not, you should consult a tax attorney to help you navigate the changes and properly plan for the upcoming years. In Tax Law Tags tax law, tax reform, tax bill, tax cuts and jobs act, tax deductions What a Practitioner Needs to Know About Tax Assessment Dates November 6, 2017 Jenny Wang What is a tax assessment date, and how do they affect you and future events with the IRS? Did You File Your FBAR Completely and Accurately? District Court Clarifies the Ambiguous IRS Willfulness Standard October 9, 2017 Jenny Wang While a non-willful violation may result in a penalty of up to $10,000, a willful violation may lead to a much larger penalty and potential criminal prosecution. As more taxpayers travel the world and transact in different countries, their compliance with the IRS international tax rules and regulations become critical for a taxpayer’s peace of mind as well as for the pocketbook. In International Tax, Tax Compliance Tags International tax, FBAR, tax reporting, tax filing, willfulness standard, tax penalty, tax law, tax compliance Estate Planning Tips If You Have Assets Outside of the U.S. September 7, 2017 Jenny Wang Do you have foreign assets in a foreign jurisdiction? Local wills or will substitutes, beneficiary designations, or certain ways of holding title may be appropriate to most effectively achieve you overall estate planning goals. In Estate Planning, International Tags Foreign assets, foreign jurisdiction, wills, will substitutes, trusts, estate planning, community property, local inheritance laws Email: [email protected] Copyright 2019 Jenny Wang, J.D., LL.M. All rights reserved. Attorney Advertising | Disclaimer 7.8Jenny Wang Jenny WangReviewsout of 1 review

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professional_accounting

Public Policy/Government Canada Goose Reports Results for Third Quarter Fiscal Year 2018 TORONTO--(BUSINESS WIRE)--Canada Goose Holdings Inc. (“Canada Goose” or the “Company”) (NYSE: GOOS, TSX: GOOS) today announced financial results for its third quarter ended December 31, 2017. The Company’s Management’s Discussion and Analysis and Unaudited Condensed Consolidated Interim Financial Statements for the three and nine month periods ended December 31, 2017 will be filed on SEDAR at www.sedar.com, the EDGAR section of the U.S. Securities and Exchange Commission website at www.sec.gov and posted on the Company’s website at investor.canadagoose.com. “In our peak selling season, we delivered strong performance across geographies, channels and categories this quarter, reflecting the continued demand for the Canada Goose brand around the world. Year to date, we added e-commerce sites in seven new markets, opened five new stores across three continents, including our partner operated store in Tokyo, and we successfully added more than 700 employees. As we look ahead, we continue to build deeper relationships with our fans and bring new people into the world of Canada Goose,” stated Dani Reiss, President & Chief Executive Officer. Fiscal 2018 Third Quarter Results (in Canadian dollars, compared to the same period in Fiscal 2017): Total revenue increased by $56.8 million from $209.1 million to $265.8 million in the third quarter of fiscal 2017, representing year-over-year growth of 27.2%. Wholesale revenue was $134.2 million as compared to $137.0 million in the third quarter of fiscal 2017. In the first half of fiscal 2018, we shipped approximately $18 million of customer orders that were originally planned for the third quarter based on the order book, which was enabled by efficiency in manufacturing and sales planning to allow us to accelerate our shipment timing in response to requests from retail partners approaching their peak selling season. This was partially offset by strong demand in the wholesale channel. Direct-to-consumer revenue was $131.6 million as compared to $72.0 million in the third quarter of fiscal 2017. The increase was primarily driven by incremental revenue from four new company operated retail stores and additional seven new e-commerce sites which opened in fiscal 2018. We experienced continued strong performances of our existing e-commerce sites and retail stores. Gross profit increased to $169.0 million from $120.3 million in the third quarter of fiscal 2017. As a percentage of total revenue, gross profit was 63.6% compared to 57.5% in the third quarter of fiscal 2017. Wholesale gross profit was $68.5 million, a gross margin of 51.0%, as compared to $65.5 million, a gross margin of 47.8%, in the third quarter of fiscal 2017. The increase in wholesale gross profit and higher gross margin were due to a greater proportion of wholesale revenue from higher margin parkas within our fall and winter line and lower material costs. Direct-to-consumer gross profit increased to $100.6 million, a gross margin of 76.4% from $54.8 million, a gross margin of 76.1%, in the third quarter of fiscal 2017. Lower material costs have a less significant impact on gross margin in our direct-to-consumer channel as a result of higher selling prices. Selling, general and administrative expenses were $76.8 million as compared to $62.0 million in the third quarter of fiscal 2017, driven by employee headcount increases and operational and selling expenditures to support the growth of our direct-to-consumer channel. Net income for the third quarter was $62.9 million, or $0.56 per diluted share, compared to net income of $39.1 million, or $0.38 per diluted share, in the third quarter of 2017. Adjusted EBITDA was $94.7 million compared to $66.1 million in the prior year, representing year-over-year growth of 43.2%. Adjusted net income per diluted share for the third quarter of fiscal 2018 was $0.58, based on 111.6 million diluted shares outstanding, compared to an adjusted net income per diluted share of $0.44, based on 101.8 million diluted shares outstanding in the third quarter of fiscal 2017. Adjusted pro forma net income per share for the third quarter of fiscal 2017, which includes the effect of the Initial Public Offering (“IPO”) in the calculation of the weighted average number of shares outstanding as if the IPO had occurred at the beginning of fiscal 2017, was $0.42 per share based on 106.3 million shares. Conference Call Information A conference call to discuss third quarter fiscal 2018 results is scheduled for today, February 8, 2018, at 9:00 a.m. Eastern Time. Dani Reiss, President and Chief Executive Officer and John Black, Chief Financial Officer, will host the conference call. Those interested in participating in the call are invited to dial (866) 393-4306 or (763) 488-9145 if calling internationally. Please dial in approximately 10 minutes prior to the start of the call and reference Conference ID 5693535 when prompted. A live audio webcast of the conference call will be available online at http://investor.canadagoose.com. About Canada Goose Founded in a small warehouse in Toronto, Canada in 1957, Canada Goose has grown into one of the world’s leading makers of performance luxury apparel. Every collection is informed by the rugged demands of the Arctic and inspired by relentless innovation and uncompromised craftsmanship. From Antarctic research facilities and the Canadian High Arctic, to the streets of New York, London, Milan, Paris, and Tokyo, people are proud to wear Canada Goose products. Employing more than 2,000 people worldwide, Canada Goose is a recognized leader for its Made in Canada commitment, and is a long-time partner of Polar Bears International. Visit canadagoose.com for more information. Note Regarding Non-IFRS Financial Measures This press release includes references to adjusted net income, EBITDA, adjusted EBITDA, adjusted EBITDA margin, adjusted net income per share and per diluted share, and adjusted pro forma net income per share and per diluted share. The Company presents these measures because its management uses these as supplemental measures in assessing its operating performance, and believes they are helpful to investors, securities analysts and other interested parties, in evaluating the Company’s performance. The measures referenced above are not measurements of financial performance under IFRS and they should not be considered as alternatives to measures of performance derived in accordance with IFRS. In addition, these measures should not be construed as an inference that the Company’s future results will be unaffected by unusual or non-recurring items. These measures have limitations as analytical tools, and you should not consider such measures either in isolation or as substitutes for analyzing the Company’s results as reported under IFRS. The Company’s definitions and calculations of these measures are not necessarily comparable to other similarly titled measures used by other companies. These non-IFRS financial measures are defined and reconciled to the most comparable IFRS measures in the tables at the end of this press release. Cautionary Note Regarding Forward-Looking Statements The foregoing financial information as at and for the three and nine months ended December 31, 2017 are unaudited and subject to quarter-end and year-end adjustments in connection with the completion of our customary financial closing procedures. Such changes could be material. This press release includes forward-looking statements. These forward-looking statements generally can be identified by the use of words such as “anticipate,” “expect,” “plan,” “could,” “may,” “will,” “believe,” “estimate,” “forecast,” “goal,” “project,” and other words of similar meaning. Each forward-looking statement contained in this press release is subject to risks and uncertainties that could cause actual results to differ materially from those expressed or implied by such statement. Applicable risks and uncertainties include, among others, our expectations regarding industry trends, our business plan and growth strategies, our expectations regarding seasonal trends, our ability to implement our growth strategies, our ability to keep pace with changing consumer preferences, our ability to maintain the strength of our brand and protect our intellectual property, as well as the risks identified under the heading “Risk Factors” in our Annual Report on Form 20-F for the fiscal year ended March 31, 2017, and filed with the Securities and Exchange Commission (“SEC”), and the securities commissions or similar securities regulatory authorities in each of the provinces and territories of Canada (“Canadian securities regulatory authorities”), as well as the other information we file with the SEC and Canadian securities regulatory authorities. We caution investors not to rely on the forward-looking statements contained in this press release when making an investment decision in our securities. You are encouraged to read our filings with the SEC, available at www.sec.gov, and our filings with Canadian securities regulatory authorities available at www.sedar.com for a discussion of these and other risks and uncertainties. The forward-looking statements in this press release speak only as of the date of this release, and we undertake no obligation to update or revise any of these statements. Our business is subject to substantial risks and uncertainties, including those referenced above. Investors, potential investors, and others should give careful consideration to these risks and uncertainties. Condensed Consolidated Interim Statements of Income and Comprehensive Income (in thousands of Canadian dollars, except share and per share amounts) December 31 Nine months ended Revenue 265,825 209,051 466,360 352,681 Cost of sales 96,805 88,767 197,005 168,403 Gross profit 169,020 120,284 269,355 184,278 Gross margin 63.6 % 57.5 % 57.8 % 52.3 % Selling, general and administrative expenses 76,791 62,005 139,168 110,270 SG&A expenses as % of revenue 28.9 % 29.7 % 29.8 % 31.3 % Depreciation and amortization 2,404 1,965 6,886 4,901 Operating income as % revenue 33.8 % 26.9 % 26.4 % 19.6 % Net interest and other finance costs 3,386 3,087 10,077 8,620 Income before income taxes 86,439 53,227 113,224 60,487 Income tax expense 23,514 14,139 25,261 15,416 Effective tax rate 27.2 % 26.6 % 22.3 % 25.5 % Net income 62,925 39,088 87,963 45,071 Other comprehensive loss (1,663 ) (322 ) (362 ) (729 ) Total comprehensive income 61,262 38,766 87,601 44,342 Basic $ 0.59 $ 0.39 $ 0.82 $ 0.45 Diluted 0.56 0.38 0.79 0.44 Weighted average number of shares outstanding Basic 107,442,446 100,000,000 106,980,180 100,000,000 Diluted 111,612,786 101,811,155 111,058,977 101,751,470 Other data: (1) Adjusted net income 64,577 44,918 84,224 59,167 Adjusted net income per diluted share $ 0.58 $ 0.44 $ 0.76 $ 0.58 EBITDA 93,086 58,853 132,572 75,578 Adjusted EBITDA 94,681 66,134 127,514 92,443 Adjusted EBITDA margin 35.6 % 31.6 % 27.3 % 26.2 % (1) Adjusted net income, adjusted net income per diluted share, EBITDA, adjusted EBITDA, and adjusted EBITDA margin are non-IFRS financial measures. See — “Reconciliation of Non-IFRS Financial Measures” for a description of these measures and a reconciliation to the nearest IFRS measure. Condensed Consolidated Interim Statements of Financial Position As at December 31, 2017 and March 31, 2017 December 31 March 31 Assets $ $ Cash 62,127 9,678 Trade receivables 78,379 8,710 Inventories 124,826 125,464 Income taxes receivable — 4,215 Other current assets 17,446 15,156 Total current assets 282,778 163,223 Deferred income taxes 6,804 3,998 Property, plant and equipment 57,136 36,467 Intangible assets 135,212 131,912 Other long-term assets 483 — Goodwill 45,269 45,269 Total assets 527,682 380,869 Accounts payable and accrued liabilities 96,121 58,223 Provisions 15,779 6,046 Income taxes payable 15,730 — Total current liabilities 127,630 64,269 Deferred income taxes 13,861 10,888 Revolving facility — 6,642 Term loan 132,619 139,447 Other long-term liabilities 6,548 3,929 Total liabilities 291,956 234,701 Shareholders' equity 235,726 146,168 Total liabilities and shareholders' equity 527,682 380,869 Condensed Consolidated Interim Statements of Cash Flows For the nine months ended December 31 Net income 87,963 45,071 Items not affecting cash Depreciation and amortization 9,271 6,471 Income tax expense 25,261 15,416 Interest expense 9,867 7,543 Unrealized foreign exchange (gain) loss (8,520 ) 1,882 Write off of deferred financing charges on refinancing revolving facility — 946 Share-based compensation 1,372 2,536 Changes in non-cash operating items (24,347 ) (18,320 ) Income taxes paid (4,902 ) (17,017 ) Interest paid (7,739 ) (7,895 ) Net cash from operating activities 88,226 36,633 Purchase of property, plant and equipment (19,904 ) (15,209 ) Investment in intangible assets (6,590 ) (6,053 ) Business combination (570 ) (500 ) Net cash used in investing activities (27,064 ) (21,762 ) (Repayment) borrowings on revolving facility (8,861 ) 57,554 Repayment of credit facility — (55,203 ) Deferred financing fees on term loan syndication (437 ) — Recapitalization transactions: Borrowings on term loan, net of deferred financing charges of $3,427 and original issue discount paid of $2,167 — 212,519 Repayment of subordinated debt — (85,306 ) Redemption of Class A senior preferred shares — (53,144 ) Redemption of Class A junior preferred shares — (4,063 ) Return of capital on Class A common shares — (698 ) Shareholder advance — (63,576 ) Exercise of stock options 585 — Net cash (used in) from financing activities (8,713 ) 8,083 Increase in cash 52,449 22,954 Cash, beginning of period 9,678 7,226 Cash, end of period 62,127 30,180 Reconciliation of Non-IFRS Measures The tables below reconcile net income to EBITDA, adjusted EBITDA, and adjusted net income for the periods presented: CAD $000s Add the impact of: Add (deduct) the impact of: Bain Capital management fees (a) — 1,348 — 1,560 Transaction costs (b) — 2,890 1,546 5,624 Unrealized gain on derivatives (c) — — — 4,422 Unrealized foreign exchange gain on Term Loan Facility (d) 1,160 1,561 (8,420 ) 1,561 International restructuring costs (e) — — — 175 Share-based compensation (f) 294 1,037 684 2,536 Agent terminations and other (g) — 116 — — Non-cash rent expense (h) 141 329 1,132 987 Unrealized foreign exchange loss (gain) on Term Loan Facility (d) 1,160 1,561 (8,420 ) 1,561 International restructuring costs (e) — 0 — 175 Amortization on intangible assets acquired by Bain Capital (i) 318 544 1,406 1,632 Total adjustments 1,913 7,825 (3,652 ) 18,497 Tax effect of adjustments (87 ) (4,401 ) (a) In connection with Bain’s purchase of a 70% equity interest in our business on December 9, 2013 (the “Acquisition”), we entered into a management agreement with certain affiliates of Bain Capital for a term of five years (“Management Agreement”). This amount represents payments made pursuant to the Management Agreement for ongoing consulting and other services. In connection with the IPO on March 21, 2017, the Management Agreement was terminated in consideration for a termination fee of $9.6 million and Bain Capital no longer receives management fees from the Company. (b) In connection with the IPO in March 2017 and Secondary Offering in July 2017, we incurred expenses related to professional fees, consulting, legal, and accounting that would otherwise not have been incurred. These fees are reflected in the table above, and do not reflect expected future operating expenses after completion of these activities. (c) Represents non-cash unrealized gains on foreign exchange forward contracts recorded in fiscal 2016 that relate to fiscal 2017. We manage our exposure to foreign currency risk by entering into foreign exchange forward contracts. Management forecasts its net cash flows in foreign currency using expected revenue from orders it receives for future periods. The unrealized gains and losses on these contracts are recognized in net income from the date of inception of the contract, while the cash flows to which the derivatives related are not realized until the contract settles. Management believes that reflecting these adjustments in the period in which the net cash flows occur is more appropriate. (d) Represents non-cash unrealized gains and losses on the translation of the Term Loan Facility from USD to CAD, net of the effect of derivative transactions entered into to hedge a portion of the exposure to foreign currency exchange risk. (e) Represents expenses incurred to establish our international headquarters in Zug, Switzerland, including closing several smaller offices across Europe, relocating personnel, and incurring temporary office costs. (f) Represents non-cash share-based compensation expense on stock options issued prior to the IPO under our pre-IPO plan. (g) Represents accrued expenses related to termination payments to be made to our third-party sales agents. As part of a strategy to transition certain sales functions in-house, we terminated the majority of our third party sales agents and certain distributors, primarily during fiscal 2015 and 2016, which resulted in indemnities and other termination payments. As sales agents have now largely been eliminated from the sales structure, management does not expect these charges to recur in future fiscal periods. (h) Represents non-cash lease amortization charges during pre-opening periods for new store leases. (i) As a result of the Acquisition, we recognized an intangible asset for customer lists in the amount of $8.7 million, which had a useful life of four years and has been fully amortized in the third quarter of fiscal 2018. Pro forma income per share and adjusted net income per share (except per share data) Pro forma income per share Net income $ 39,088 $ 45,071 Weighted average number of common shares 100,000,000 100,000,000 Pro forma for IPO as at April 1, 2016 6,308,154 6,308,154 Pro forma weighted average number of common shares outstanding over the year 106,308,154 106,308,154 Pro forma income per share $ 0.37 $ 0.42 Pro forma adjusted net income per share Adjusted net income $ 44,918 $ 59,167 Pro forma weighted average number of shares 106,308,154 106,308,154 Pro forma adjusted net income per share $ 0.42 $ 0.56 Updated daily, mfrtech.com includes featured articles and manufacturing news, product releases, business expansions, acquisitions and business forecasts submitted by our visitors or authored by editorial staff. Phone: 844-295-TECH (844-295-8324) Email: [email protected] 1890 Starshoot Parkway 170-316 Lexington KY 40509 © Copyright 2020 by MFRTech

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professional_accounting

FAMU Online Division Of Audit About the Division of Audit Audit Charter Organization and Staff Compliance and Ethics Hotline The audit process can be confusing, especially for those who have never been audited before. Whether you have questions about internal controls in your existing system or are scheduled for an audit, this information can help. The Audit Committee and Types of Audits What does the Audit Committee do? The Audit and Compliance Committee assists the Florida Agricultural and Mechanical University (FAMU) Board of Trustees in discharging its oversight responsibilities. The Committee’s principal activities include: Oversight of FAMU's business risk assessment, by reviewing procedures in place to assess and minimize significant risks. Oversight of the University’s internal control structure to review the effectiveness and reliability of its business, financial and information system controls. Oversight of the quality and integrity of the University’s financial reporting processes to ensure the balance, transparency and integrity of published financial information. Review of the internal audit function and overall audit process. Review of the annual audit plan. Review of the University’s process for monitoring compliance with laws, regulations and policies. What are your typical services? We handle scheduled audits, investigations and special reviews. We are also responsible for compliance and training. What are the types of audits that you perform? Audit projects can be placed into four categories: financial audits, compliance audits, operational audits and information technology audits. Financial audits address questions of accounting and reporting of financial transactions, including commitments, authorizations and receipt and disbursement of funds. Compliance audits determine the degree of adherence to laws, policies and procedures. Operational audits review operating information and the means used to identify, measure, classify and report such information; review the means for safeguarding assets; ascertain whether results are consistent with management's goals and objectives and whether the operations are being carried out as planned; appraise the economy and efficiency with which resources are employed; and review the systems established to ensure compliance with policies, procedures, plans, laws and regulations. IT audits evaluate system input, output and processing controls, backup and recovery plans, and system data and physical security. What to Expect From an Audit Why was I selected to be audited? The Division of Audit has a comprehensive audit plan based on a five-year cycle. While all major activities are scheduled for audit in this cycle, the audit frequency can vary depending upon associated risks. The Audit Committee approves an annual audit schedule to ensure that objectives, scope and allocated audit hours support management goals. How long will the audit take? The length of the audit varies. The lead auditor assigned to the audit will give a reasonable estimate of the time needed to complete the audit. What is the audit process? When an activity is scheduled for audit, an engagement letter is sent to the responsible parties. The auditor will then schedule an entrance conference to discuss the objective and scope of the audit. At this initial meeting, responsible parties should take the opportunity to discuss any concerns or questions they may have about the audit and how they can facilitate the review process. A typical audit has several stages, including preliminary review, fieldwork and reporting. The auditor flowcharts the system, evaluates the system and its controls, collects data and performs testing, and then documents the work performed and the conclusions reached. At the end, the auditor issues an audit report. Are auditors looking for fraud when performing audits? Auditors are not specifically searching for the existence of fraud. However, while conducting audits in accordance with the Institute of Internal Auditors’ "Standards for the Professional Practice of Internal Auditing,” improper activities may be identified. A good system of internal controls and a control-conscious organizational environment will reduce this risk. What happens when it is time to report your findings? During the audit and at the conclusion of the fieldwork, the auditor will discuss any findings noted during the process. The responsible parties will receive a draft audit report for review and, if required, an exit conference will be scheduled. This conference is an opportunity to discuss the audit findings, clarify any ambiguities and, if necessary, modify the report. If the report contains recommendations or written responses detailing corrective action, information about a projected implementation date and the responsible party will be required. The response is included in the body of the report. Significant findings are reported to the State University System as well as the Audit Committee and the president. All audit information is treated as confidential and is reported only to those within the institution who need to know. The final report and response are distributed to appropriate management personnel, the Audit Committee and the president. What are internal controls? Internal controls can be categorized as either accounting controls or administrative controls. Accounting controls are designed to safeguard FAMU assets and ensure the accuracy of financial records. Administrative controls are designed to promote operational efficiency, effectiveness and adherence to FAMU policies and procedures. The Division reviews the adequacy of both accounting and administrative controls during audit engagements. Are the internal auditors responsible for maintaining FAMU's systems of internal control? No. University management is responsible for maintaining an adequate system of internal controls. Internal auditors independently evaluate the adequacy of the existing internal control systems by analyzing and testing controls. The Division of Audit makes recommendations to management to improve controls based on system testing and control analysis. Can FAMU personnel seek advice from the Division of Audit and Compliance? Yes. The Division acts as an in-house consultant on internal control matters and provides guidance on control aspects of new systems and procedures. Can I remain anonymous when I file a report with the Compliance and Ethics Hotline? Yes. You may file a report by using the web or phone. On the web, enter information into the requested fields and submit it. By phone, you are greeted by a trained interviewer who documents in detail the situation you described. You don’t have to give your name and the call is not recorded. Please direct questions and requests for audits to the Division of Audit at 850-412-5479. 1601 S. Martin L. King Jr. Blvd. © 2021 Florida Agricultural and Mechanical University.

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professional_accounting

Fitzgerald & Associates, Inc. Client Services and Industries Served Tax Briefing(s) 2020 Tax Year-In-ReviewConsolidated Appropriations Act, 2021 (revised)2020 Post-Election Tax Policy Update2020 Year-End Tax Planning2020 Payroll Tax Deferral Order Notices Delayed Due to COVID-19 The IRS continues to experience delays mailing backlogged notices due to the volume and restart of issuing notices during the pandemic. The delay impacts some, but not all, IRS notices dated from Nove... IRS Reminds Employers of Filing Deadline for Form W-2, Wage Statements The IRS has reminded employers of filing file Form W-2, Wage and Tax Statement, and other wage statements by Monday, February 1, 2021, to avoid penalties and help the IRS prevent fraud. Due to the us... Deadline to Certify Certain Employees for WOTC Extended Employers that hired a designated community resident or a qualified summer youth employee under Code Sec. 51(d)(5) or (d)(7) who began work on or after January 1, 2018, and before January 1, 2021,... Adjusted Applicable Dollar Amount for Fee Imposed on Health Insurance Plans Announced The IRS has announced that the applicable dollar amount used to calculate the fees imposed by Code Secs. 4375 and 4376 for policy and plan years that end on or after October 1, 2020, and before Oc... Form 1024-A Revised for Electronic Submission The IRS has announced that it is revising Form 1024-A, Application for Recognition of Exemption Under Section 501(c)(4) of the Internal Revenue Code, to allow electronic filing for the first time, as... CA - Guidance provided on approval of proposition 19 California provides property tax guidance regarding the approval by voters of Proposition 19 at the November 3, 2020, general election.New Sections Added to Article XIII A of California ConstitutionPr... Final Regs Define “Real Property” for Like-Kind Exchanges Final regulations clarify the definition of "real property" that qualifies for a like-kind exchange, including incidental personal property. Under the Tax Cuts and Jobs Act (TCJA, P.L. 115-97), like-kind exchanges occurring after 2017 are limited to real property used in a trade or business or for investment. The final regulations largely adopt regulations that were proposed in June ( NPRM REG-117589-18). However, they also: add a " state or local law" test to define real property; and reject the “purpose and use” test in the proposed regulations. In addition, the final regulations classify cooperative housing corporation stock and land development rights as real property. The final regulations also provide that a license, permit, or other similar right is generally real property if it is (i) solely for the use, enjoyment, or occupation of land or an inherently permanent structure; and (ii) in the nature of a leasehold, an easement, or a similar right. Under the final regulations, property is classified as "real property" for like-kind exchange purposes if, on the date it is transferred in the exchange, the property is real property under the law of the state or local jurisdiction in which it is located. The proposed regulations had limited this “state or local law” test to shares in a mutual ditch, reservoir, or irrigation company. However, the final regulations also clarify that real property that was ineligible for a like-kind exchange before the TCJA remains ineligible. For example, intangible assets that could not be like-kind property before the TCJA (such as stocks, securities, and partnership interests) remain ineligible regardless of how they are characterized under state or local law. Accordingly, under the final regulations, property is real property if it is: classified as real property under state or local law; specifically listed as real property in the final regulations; or considered real property based on all of the facts and circumstances, under factors provided in the regulations. These tests mean that property that is not real property under state or local law might still be real property for like-kind exchange purposes if it satisfies the second or third test. Types of Real Property Under both the proposed and final regulations, real property for a like-kind exchange is: land and improvements to land; unsevered crops and other natural products of land; and water and air space superjacent to land. Under both the proposed and final regulations, improvements to land include inherently permanent structures, and the structural components of inherently permanent structures. Each distinct asset must be analyzed separately to determine if it is land, an inherently permanent structure, or a structural component of an inherently permanent structure. The regulations identify several specific items, assets and systems as distinct assets, and provide factors for identifying other distinct assets. The final regulations also: incorporate the language provided in Reg. §1.856-10(d)(2)(i) to provide additional clarity regarding the meaning of "permanently affixed;" modify the example in the proposed regulations concerning offshore drilling platforms; and clarify that the distinct asset rule applies only to determine whether property is real property, but does not affect the application of the three-property rule for identifying properties in a deferred exchange. "Purpose or Use" Test The proposed regulations would have imposed a "purpose or use" test on both tangible and intangible property. Under this test, neither tangible nor intangible property was real property if it contributed to the production of income unrelated to the use or occupancy of space. The final regulations eliminate the purpose and use test for both tangible and intangible property. Consequently, tangible property is generally an inherently permanent structure—and, thus, real property—if it is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time. A structural component likewise is real property if it is integrated into an inherently permanent structure. Accordingly, items of machinery and equipment are real property if they comprise an inherently permanent structure or a structural component, or if they are real property under the state or local law test—irrespective of the purpose or use of the items or whether they contribute to the production of income. Similarly, whether intangible property produces or contributes to the production of income is not considered in determining whether intangible property is real property for like-kind exchange purposes. However, the purpose of the intangible property remains relevant to the determination of whether the property is real property. Incidental Personal Property The incidental property rule in the proposed regulations provided that, for exchanges involving a qualified intermediary, personal property that is incidental to replacement real property (incidental personal property) is disregarded in determining whether a taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or non-like-kind property held by the qualified intermediary are expressly limited as provided in Reg. §1.1031(k)-1(g)(6). Personal property is incidental to real property acquired in an exchange if (i) in standard commercial transactions, the personal property is typically transferred together with the real property, and (ii) the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property (15-percent limitation). This final regulations adopt these rules with some minor modifications to improve clarity and readability. For example, the final regulations clarify that the receipt of incidental personal property results in taxable gain; and the 15-percent limitation compares the value of all of the incidental properties to the value of all of the replacement real properties acquired in the same exchange. The final regulations apply to exchanges beginning after the date they are published as final in the Federal Register. However, a taxpayer may also rely on the proposed regulations published in the Federal Register on June 12, 2020, if followed consistently and in their entirety, for exchanges of real property beginning after December 31, 2017, and before the publication date of the final regulations. In addition, conforming changes to the bonus depreciation rules apply to tax years beginning after the final regulations are published. PPP Deduction Safe Harbor if Loan Not Forgiven The IRS has released rulings concerning deductions for eligible Paycheck Protection Program (PPP) loan expenses. The IRS has released rulings concerning deductions for eligible Paycheck Protection Program (PPP) loan expenses. The rulings: deny a deduction if the taxpayer has not yet applied for PPP loan forgiveness, but expects the loan to be forgiven; and provide a safe harbor for deducting expenses if PPP loan forgiveness is denied or the taxpayer does not apply for forgiveness. In response to the COVID-19 (coronavirus) crisis, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) expanded Section 7(a) of the Small Business Act for certain loans made from February 15, 2020, through August 8, 2020 (PPP loans). An eligible PPP loan recipient may have the debt on a covered loan forgiven, and the cancelled debt will be excluded from gross income. To prevent double tax benefits, under Reg. §1.265-1, taxpayers cannot deduct expenses allocable to income that is either wholly excluded from gross income or wholly exempt from tax. The IRS previously determined that businesses whose PPP loans are forgiven cannot deduct business expenses paid for by the loan ( Notice 2020-32, I.R.B. 2020-21, 837). The new guidance expands on the previous guidance, but provides a safe harbor for taxpayers whose loans are not forgiven. No Business Deduction In Rev. Rul. 2020-27, the IRS amplifies guidance in Notice 2020-32. A taxpayer that received a covered PPP loan and paid or incurred certain otherwise deductible expenses may not deduct those expenses in the tax year in which the expenses were paid or incurred if, at the end of the tax year, the taxpayer reasonably expects to receive forgiveness of the covered loan on the basis of the expenses it paid or accrued during the covered period. This is the case even if the taxpayer has not applied for forgiveness by the end of the tax year. In Rev. Proc. 2020-51, the IRS provides a safe harbor allowing taxpayers to claim a deduction in the tax year beginning or ending in 2020 for certain otherwise deductible eligible expenses if: the eligible expenses are paid or incurred during the taxpayer’s 2020 tax year; the taxpayer receives a PPP covered loan that, at the end of the taxpayer’s 2020 tax year, the taxpayer expects to be forgiven in a subsequent tax year; and in a subsequent tax year, the taxpayer’s request for forgiveness of the covered loan is denied, in whole or in part, or the taxpayer decides never to request forgiveness of the covered loan. A taxpayer may be able to deduct some or all of the eligible expenses on, as applicable: a timely (including extensions) original income tax return or information return for the 2020 tax year; an amended return or an administrative adjustment request (AAR) under Code Sec. 6227 for the 2020 tax year; or a timely (including extensions) original income tax return or information return for the subsequent tax year. Applying Safe Harbor To apply the safe harbor, a taxpayer attaches a statement titled "Revenue Procedure 2020-51 Statement" to the return on which the taxpayer deducts the expenses. The statement must include: the taxpayer’s name, address, and social security number or employer identification number; a statement specifying whether the taxpayer is an eligible taxpayer under either section 3.01 or section 3.02 of Revenue Procedure 2020-51; a statement that the taxpayer is applying section 4.01 or section 4.02 of Revenue Procedure 2020-51; the amount and date of disbursement of the taxpayer’s covered PPP loan; the total amount of covered loan forgiveness that the taxpayer was denied or decided to no longer seek; the date the taxpayer was denied or decided to no longer seek covered loan forgiveness; and the total amount of eligible expenses and non-deducted eligible expenses that are reported on the return. Final Regulations Address Transportation Fringe Benefits The IRS has issued final regulations under Code Sec. 274 relating to the elimination of the employer deduction of for transportation and commuting fringe benefits by the Tax Cuts and Jobs Act ( P.L. 115-97), effective for amounts paid or incurred after December 31, 2017. The final regulations address the disallowance of a deduction for the expense of any qualified transportation fringe (QTF) provided to an employee of the taxpayer. Guidance and methodologies are provided to determine the amount of QTF parking expenses that is nondeductible. The final regulations also address the disallowance of the deduction for expenses of transportation and commuting between an employee’s residence and place of employment. The final regulations adopt earlier proposed regulations with a few minor modifications in response to public comments ( REG-119307-19). Pending issuance of these final regulations, taxpayers had been allowed to apply to proposed regulations or guidance issued in Notice 2018-99, I.R.B. 2018-52, 1067. Notice 2018-99 is obsoleted on the publication date of the final regulations. The final regulations clarify an exception for parking spaces made available to the general public to provide that parking spaces used to park vehicles owned by members of the general public while the vehicle awaits repair or service are treated as provided to the general public. The category of parking spaces for inventory or which are otherwise unusable by employees is clarified to provide that such spaces may also not be usable by the general public. In addition, taxpayers will be allowed to use any reasonable method to determine the number of inventory/unusable spaces in a parking facility. The definition of "peak demand period" for purposes of determining the primary use of a parking facility is modified to cover situations where a taxpayer is affected by a federally declared disaster. The final regulations also provide that taxpayers using the cost per parking space methodology for determining the disallowance for parking facilities may calculate the cost per space on a monthly basis. The final regulations apply to tax years beginning on or after the date of publication in the Federal Register. However, taxpayers can choose to apply the regulations to tax years ending after December 31, 2019. IRS Spotlights Upcoming Tax Filing Season As part of a series of reminders, the IRS has urged taxpayers get ready for the upcoming tax filing season. A special page ( https://www.irs.gov/individuals/steps-to-take-now-to-get-a-jump-on-next-years-taxes), updated and available on the IRS website, outlines steps taxpayers can take now to make tax filing easier in 2021. Taxpayers receiving substantial amounts of non-wage income like self-employment income, investment income, taxable Social Security benefits and, in some instances, pension and annuity income, should make quarterly estimated tax payments. The last payment for 2020 is due on January 15, 2021. Payment options can be found at IRS.gov/payments. For more information, the IRS encourages taxpayers to review Pub. 5348, Get Ready to File, and Pub. 5349, Year-Round Tax Planning is for Everyone. Most income is taxable, so taxpayers should gather income documents such as Forms W-2 from employers, Forms 1099 from banks and other payers, and records of virtual currencies or other income. Other income includes unemployment income, refund interest and income from the gig economy. Forms and Notices Beginning in 2020, individuals may receive Form 1099-NEC, Nonemployee Compensation, rather than Form 1099-MISC, Miscellaneous Income, if they performed certain services for and received payments from a business. The IRS recommends reviewing the Instructions for Form 1099-MISC and Form 1099-NEC to ensure clients are filing the appropriate form and are aware of this change. Taxpayers may also need Notice 1444, Economic Impact Payment, which shows how much of a payment they received in 2020. This amount is needed to calculate any Recovery Rebate Credit they may be eligible for when they file their federal income tax return in 2021. People who did not receive an Economic Impact Payment in 2020 may qualify for the Recovery Rebate Credit when they file their 2020 taxes in 2021. To see information from the most recently filed tax return and recent payments, taxpayers can sign up to view account information online. Taxpayers should notify the IRS of address changes and notify the Social Security Administration of a legal name change to avoid delays in tax return processing. IRS Warns Taxpayers and Tax Professionals Against Scams and Identity Theft Schemes This year marks the 5th Annual National Tax Security Awareness Week-a collaboration by the IRS, state tax agencies and the tax industry. The IRS and the Security Summit partners have issued warnings to all taxpayers and tax professionals to beware of scams and identity theft schemes by criminals taking advantage of the combination of holiday shopping, the approaching tax season and coronavirus concerns. The 5th Annual National Tax Security Awareness Week coincided with Cyber Monday, the traditional start of the online holiday shopping season. The following are a few basic steps which taxpayers and tax professionals should remember during the holidays and as the 2021 tax season approaches: use an updated security software for computers and mobile phones; the purchased anti-virus software must have a feature to stop malware and a firewall that can prevent intrusions; don't open links or attachments on suspicious emails because this year, fraud scams related to COVID-19 and the Economic Impact Payment are common; use strong and unique passwords for online accounts; use multi-factor authentication whenever possible which prevents thieves from easily hacking accounts; shop at sites where the web address begins with "https" and look for the "padlock" icon in the browser window; don't shop on unsecured public Wi-Fi in places like a mall; secure home Wi-Fis with a password; back up files on computers and mobile phones; and consider creating a virtual private network to securely connect to your workplace if working from home. In addition, taxpayers can check out security recommendations for their specific mobile phone by reviewing the Federal Communications Commission's Smartphone Security Checker. The Federal Bureau of Investigation has issued warnings about fraud and scams related to COVID-19 schemes, anti-body testing, healthcare fraud, cryptocurrency fraud and others. COVID-related fraud complaints can be filed at the National Center for Disaster Fraud. Moreover, the Federal Trade Commission also has issued alerts about fraudulent emails claiming to be from the Centers for Disease Control or the World Health Organization. Taxpayers can keep atop the latest scam information and report COVID-related scams at www.FTC.gov/coronavirus. IRS Proposes Regs on Centralized Partnership Audit Regime The IRS has issued proposed regulations for the centralized partnership audit regime... NPRM REG-123652-18 The IRS has issued proposed regulations for the centralized partnership audit regime that: clarify that a partnership with a QSub partner is not eligible to elect out of the centralized audit regime; add three new types of “special enforcement matters” and modify existing rules; modify existing guidance and regulations on push out elections and imputed adjustments; and clarify rules on partnerships that cease to exist. The regulations are generally proposed to apply to partnership tax years ending after November 20, 2020, and to examinations and investigations beginning after the date the regs are finalized. However, the new special enforcement matters category for partnership-related items underlying non-partnership-related items is proposed to apply to partnership tax years beginning after December 20, 2018. In addition, the IRS and a partner could agree to apply any part of the proposed regulations governing special enforcement matters to any tax year of the partner that corresponds to a partnership tax year that is subject to the centralized partnership audit regime. Centralized Audit Regime The Bipartisan Budget Act of 2015 ( P.L. 114-74) replaced the Tax Equity and Fiscal Responsibility Act (TEFRA) ( P.L. 97-248) partnership procedures with a centralized partnership audit regime for making partnership adjustments and tax determinations, assessments and collections at the partnership level. These changes were further amended by the Protecting Americans from Tax Hikes Act of 2015 (PATH Act) ( P.L. 114-113), and the Tax Technical Corrections Act of 2018 (TTCA) ( P.L. 115-141). The centralized audit regime, as amended, generally applies to returns filed for partnership tax years beginning after December 31, 2017. Election Out A partnership with no more than 100 partners may generally elect out of the centralized audit regime if all of the partners are eligible partners. As predicted in Notice 2019-06, I.R.B. 2019-03, 353, the proposed regulations would provide that a qualified subchapter S subsidiary (QSub) is not an eligible partner; thus, a partnership with a QSub partner could not elect out of the centralized audit regime. Special Enforcement Matters The IRS may exempt “special enforcement matters” from the centralized audit regime. There are currently six categories of special enforcement matters: failures to comply with the requirements for a partnership-partner or S corporation partner to furnish statements or compute and pay an imputed underpayment; assessments relating to termination assessments of income tax or jeopardy assessments of income, estate, gift, and certain excise taxes; criminal investigations; indirect methods of proof of income; foreign partners or partnerships; other matters identified in IRS regulations. The proposed regs would add three new types of special enforcement matters: partnership-related items underlying non-partnership-related items; controlled partnerships and extensions of the partner’s period of limitations; and penalties and taxes imposed on the partnership under chapter 1. The proposed regs would also require the IRS to provide written notice of most special enforcement matters to taxpayers to whom the adjustments are being made. The proposed regs would clarify that the IRS could adjust partnership-level items for a partner or indirect partner without regard to the centralized audit regime if the adjustment relates to termination and jeopardy assessments, if the partner is under criminal investigation, or if the adjustment is based on an indirect method of proof of income. However, the proposed regs would also provide that the special enforcement matter rules would not apply to the extent the partner could demonstrate that adjustments to partnership-related items in the deficiency or an adjustment by the IRS were: previously taken into account under the centralized audit regime by the person being examined; or included in an imputed underpayment paid by a partnership (or pass-through partner) for any tax year in which the partner was a reviewed year partner or indirect partner, but only if the amount included in the deficiency or adjustment exceeds the amount reported by the partnership to the partner that was either reported by the partner or indirect partner or is otherwise included in the deficiency or adjustment determined by the IRS. Push Out Election, Imputed Underpayments The partnership adjustment rules generally do not apply to a partnership that makes a "push out" election to push the adjustment out to the partners. However, the partnership must pay any chapter 1 taxes, penalties, additions to tax, and additional amounts or the amount of any adjustment to an imputed underpayment. Thus, there must be a mechanism for including these amounts in the imputed underpayment and accounting for these amounts. In calculating an imputed underpayment, the proposed regs would generally include any adjustments to the partnership’s chapter 1 liabilities in the credit grouping and treat them similarly to credit adjustments. Adjustments that do not result in an imputed underpayment generally could increase or decrease non-separately stated income or loss, as appropriate, depending on whether the adjustment is to an item of income or loss. The proposed regs would also treat a decrease in a chapter 1 liability as a negative adjustment that normally does not result in an imputed underpayment if: (1) the net negative adjustment is to a credit, unless the IRS determines to have it offset the imputed underpayment; or (2) the imputed underpayment is zero or less than zero. Under existing regs for calculating an imputed underpayment, an adjustment to a non-income item that is related to, or results from, an adjustment to an item of income, gain, loss, deduction, or credit is generally treated as zero, unless the IRS determines that the adjustment should be included in the imputed underpayment. The proposed regs would clarify this rule and extend it to persons other than the IRS. Thus, a partnership that files an administrative adjustment request (AAR) could treat an adjustment to a non-income item as zero if the adjustment is related to, and the effect is reflected in, an adjustment to an item of income, gain, loss, deduction, or credit (unless the IRS subsequently determines in an AAR examination that both adjustments should be included in the calculation of the imputed underpayment). A partnership would take into account adjustments to non-income items in the adjustment year by adjusting the item on its adjustment year return to be consistent with the adjustment. This would apply only to the extent the item would appear on the adjustment year return without regard to the adjustment. If the item already appeared on the partnership’s adjustment year return as a non-income item, or appeared as a non-income item on any return of the partnership for a tax year between the reviewed year and the adjustment year, the partnership does not create a new item on the partnership’s adjustment year return. A passthrough partner that is paying an amount as part of an amended return submitted as part of a request to modify an imputed underpayment would take into account any adjustments that do not result in an imputed underpayment in the partners’ tax year that includes the date the payment is made. This provision, however, would not apply if no payment is made by the partnership because no payment is required. Partnership Ceases to Exist If a partnership ceases to exist before the partnership adjustments take effect, the adjustments are taken into account by the former partners of the partnership. The IRS may assess a former partner for that partner’s proportionate share of any amounts owed by the partnership under the centralized partnership audit regime. The proposed regs would clarify that a partnership adjustment takes effect when the adjustments become finally determined; that is, when the partnership and IRS enter into a settlement agreement regarding the adjustment; or, for adjustments reflected in an AAR, when the AAR is filed. The proposed regs would also make conforming changes to existing regs: A partnership ceases to exist if the IRS determines that the partnership does not have the ability to pay in full any amount that the partnership may become liable for under the centralized partnership audit regime. Existing regs that describe when the IRS will not determine that a partnership ceases to exist would be removed. Statements must be furnished to the former partners and filed with the IRS no later than 60 days after the later of the date the IRS notifies the partnership that it has ceased to exist or the date the adjustments take effect. The proposed regs would also modify the definition of "former partners" to be partners of the partnership during the last tax year for which a partnership return or AAR was filed, or the most recent persons determined to be the partners in a final determination, such as a final court decision, defaulted notice of final partnership adjustment (FPA), or settlement agreement. Comments Requested Comments are requested on all aspects of the proposed regulations by January 22, 2021. The IRS strongly encourages commenters to submit comments electronically via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-123652-18). Comments submitted on paper will be considered to the extent practicable. Final Regs on Silo Rules for Calculating UBTI The IRS has issued final regulations with guidance on how a tax-exempt organization can determine whether it has more than one unrelated trade or business, how it should identify its separate trades and businesses, and how to separately calculate unrelated business taxable income (UBTI) for each trade or business – often referred to as "silo" rules. Since 2018, under provisions of the Tax Cuts and Jobs Act (TCJA), the loss from one unrelated trade or business may not offset the income from another, separate trade or business. Congress did not provide detailed methods of determining when unrelated businesses are "separate" for purposes of calculating UBTI. On April 24, 2020, the IRS published a notice of proposed rulemaking ( REG-106864-18) that proposed guidance on how an exempt organization determines if it has more than one unrelated trade or business and, if so, how the exempt organization calculates UBTI under Code Sec. 512(a)(6). The final regulations substantially adopt the proposed regulations issued earlier this year, with modifications. Separate Trades or Businesses The proposed regulations suggested using the North American Industry Classification System (NAICS) six-digit codes for determining what constitutes separate trades or businesses. Notice 2018-67, I.R.B. 2018-36, 409, permitted tax-exempt organizations to rely on these codes. The first two digits of the code designate the economic sector of the business. The proposed guidance provided that organizations could make that determination using just the first two digits of the code, which divides businesses into 20 categories, for this purpose. The proposed regulations provided that, once an organization has identified a separate unrelated trade or business using a particular NAICS two-digit code, the it could only change the two-digit code describing that separate unrelated trade or business if two specific requirements were met. The final regulations remove the restriction on changing NAICS two-digit codes, and instead require an exempt organization that changes the identification of a separate unrelated trade or business to report the change in the tax year of the change in accordance with forms and instructions. QPIs For exempt organizations, the activities of a partnership are generally considered the activities of the exempt organization partners. Code Sec. 512(c) provides that if a trade or business regularly carried on by a partnership of which an exempt organization is a member is an unrelated trade or business with respect to such organization, that organization must include its share of the gross income of the partnership in UBTI. The proposed regulations provided that an exempt organization’s partnership interest is a "qualifying partnership interest" (QPI) if it meets the requirements of the de minimis test by directly or indirectly holding no more than two percent of the profits interest and no more than two percent of the capital interest. For administrative convenience, the de minimis test allows certain partnership investments to be treated as an investment activity and aggregated with other investment activities. Additionally, the proposed regulations permitted the aggregation of any QPI with all other QPIs, resulting in an aggregate group of QPIs. Once an organization designates a partnership interest as a QPI (in accordance with forms and instructions), it cannot thereafter identify the trades or businesses conducted by the partnership that are unrelated trades or businesses with respect to the exempt organization using NAICS two-digit codes unless and until the partnership interest is no longer a QPI. A change in an exempt organization’s percentage interest in a partnership that is due entirely to the actions of other partners may present significant difficulties for the exempt organization. Requiring the interest to be removed from the exempt organization’s investment activities in one year but potentially included as a QPI in the next would create further administrative difficulty. Therefore, the final regulations adopt a grace period that permits a partnership interest to be treated as meeting the requirements of the de minimis test or the participation test, respectively, in the exempt organization’s prior tax year if certain requirements are met. This grace period will allow an exempt organization to treat such interest as a QPI in the tax year that such change occurs, but the organization will need to reduce its percentage interest before the end of the following tax year to meet the requirements of either the de minimis test or the participation test in that succeeding tax year for the partnership interest to remain a QPI. IRS Extends Term of Gaming Industry Tip Compliance Agreement The IRS has modified Rev. Proc. 2007-32, I.R.B. 2007-22, 1322, to provide that the term of a Gaming Industry Tip Compliance Agreement (GITCA) is generally five years, and the renewal term of a GITCA is extended from three years to a term of up to five years. A GITCA executed under Rev. Proc. 2003-35, 2003-1 CB 919 and Rev. Proc. 2007-32 will remain in effect until the expiration date set forth in that agreement, unless modified by the renewal of a GITCA under section 4.04 of Rev. Proc. 2007-32 (as modified by section 3 of this revenue procedure). The modified provisions generally provide as follows: In general, a GITCA shall be for a term of five years. For new properties and properties that do not have a prior agreement with the IRS, however, the initial term of the agreement may be for a shorter period. A GITCA may be renewed for additional terms of up to five years, in accordance with Section IX of the model GITCA. Beginning not later than six months before the termination date of a GITCA, the IRS and the employer must begin discussions as to any appropriate revisions to the agreement, including any appropriate revisions to the tip rates described in Section VIII of the model GITCA. If the IRS and the employer have not reached final agreement on the terms and conditions of a renewal agreement, the parties may mutually agree to extend the existing agreement for an appropriate time to finalize and execute a renewal agreement. This revenue procedure is effective November 23, 2020. Final Regulations Coordinate Code Sec. 245A DRD Limit and GILTI Disqualified Basis Rule Final regulations issued by the Treasury and IRS coordinate the extraordinary disposition rule that applies with respect to the Code Sec. 245A dividends received deduction and the disqualified basis rule under the Code Sec. 951A global intangible low-taxed income (GILTI) regime. Information reporting rules are also finalized. Extraordinary Disposition Rule and GILTI Disqualified Basis Rule The extraordinary disposition rule (EDR) in Reg. §1.245A-5 and the GILTI disqualified basis rule (DBR) in Reg. §1.951A-2(c)(5) both address the disqualified period that results from the differences between dates for which the transition tax under Code Sec. 965 and the GILTI rules apply. GILTI applies to calendar year controlled foreign corporations (CFCs) on January 1, 2018. A fiscal year CFC may have a period from January 1, 2018, until the beginning of its first tax year in 2018 (the disqualified period) in which it can generate income subject to neither the transition tax under Code Sec. 965 nor GILTI. The extraordinary disposition rule limits the ability to claim the Code Sec. 245A deduction for certain earnings and profits generated during the disqualified period. Specifically, Reg. §1.245A-5 provides that the deduction is limited for dividends paid out of an extraordinary disposition account. Final regulations issued under GILTI address fair market basis generated as a result of assets transferred to related CFCs during the disqualified period (disqualified basis). Reg. §1.951A-2(c)(5) allocates deductions or losses attributable to disqualified basis to residual CFC income, such as income other than tested income, subpart F income, or effectively connected taxable income. As a result, the deductions or losses will not reduce the CFC’s income subject to U.S. tax. Coordination Rules The coordination rules are necessary to prevent excess taxation of a Code Sec. 245A shareholder. Excess taxation can occur because the earnings and profits subject to the extraordinary disposition rule and the basis to which the disqualified basis rule applies are generally a function of a single amount of gain. Under the coordination rules, to the extent that the Code Sec. 245A deduction is limited with respect to distributions out of an extraordinary disposition account, a corresponding amount of disqualified basis attributable to the property that generated that extraordinary disposition account through an extraordinary disposition is converted to basis that is not subject to the disqualified basis rule. The rule is referred to as the disqualified basis (DQB) reduction rule. A prior extraordinary disposition amount is also covered under this rule. A prior extraordinary disposition amount generally represents the extraordinary disposition of earnings and profits that have become subject to U.S. tax as to a Code Sec. 245A shareholder other than by direct application of the extraordinary disposition rule (e.g., inclusions as a result of investment in U.S. property under Code Sec. 956). Separate coordination rules are provided, depending upon whether the application of the rule is in a simple or complex case. Every U.S. shareholder of a CFC that holds an item of property that has disqualified basis during an annual accounting period and files Form 5471 for that period must report information about the items of property with disqualified basis held by the CFC during the CFC’s accounting period, as required by Form 5471 and its instructions. Additionally, information must be reported about the reduction to an extraordinary disposition account made pursuant to the regulations and reductions made to an item of specified property’s disqualified basis pursuant to the regulations during the corporation’s accounting period, as required by Form 5471 and its instructions. Applicability Dates The regulations apply to tax years of foreign corporations beginning on or after the date the regulations are published in the Federal Register, and to tax years of Code Sec. 245A shareholders in which or with which such tax years end. Taxpayers may choose to apply the regulations to years before the regulations apply. Client FAQ: Buy or lease equipment? Q. I've just started my own business and am having a hard time deciding whether I should buy or lease the equipment I need before I open my doors. What are some of the things I should consider when making this decision? A. Deciding whether to buy or lease business property is just one of the many tough decisions facing the small business owner. Unfortunately, there's not a quick answer and, since every business has different fact patterns, each business owner will need to assess every type of business property separately and consider many different factors to make a decision that is right for his or her particular circumstances. While there are advantages and disadvantages to both buying and leasing business property, the business owner should carefully consider the following questions before making a final decision either way: How's your cash flow? If you are just starting a business, cash may be tight and a hefty down payment on a piece of equipment may bust your budget. In that case, since equipment leases rarely require down payments, leasing may be a good choice for you. One of the biggest advantages of leasing is that you generally gain the use of the asset with a much smaller initial cash expenditure than would be required if you purchased it. How's your credit? Loans to new small businesses are hard to come by so if you're a fairly new business, leasing may be your only option outside of getting a personal loan. As a new business, you will definitely have an easier time getting a company to lease equipment to you than finding someone to extend you credit to make the purchase. However, if you have time to search for credit well in advance of needing the equipment, you may want to purchase the equipment to begin establishing a credit history for your company. How long will you use it? A general rule of thumb is that leasing is very cost-effective for items like autos, computers and other equipment that decrease in value over time and will be used for about five years or less. On the other hand, if you are considering business property that you intend to use more than five years or that will appreciate over time, the overall cost of leasing will usually exceed the cost of buying it outright in the first place. What's your tax situation? Don't forget that your tax return will be affected by your decision to lease or buy. If you purchase an asset, it is depreciated over its useful life. If you lease an asset, the tax treatment will depend on what type of lease is involved. There are two basic types of leases: finance and true. Finance leases are handled similarly to a purchase and work best for companies that intend to keep the property at the end of the lease. Payments on true leases, on the other hand, are deductible in full in the year paid. The answers to each question above need to be considered not individually, but as a group, since many factors must be weighed before a decision is made. Buying or leasing equipment can have a significant effect on your tax situation and the rules related to accounting for leases are very technical. Please contact our office before you make any decisions regarding your business equipment. Designed by CCH Site Builder

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professional_accounting

Expansion Financing – A simple explanation for the term The fields of M&A and business valuations are characterized by a jungle of technical terms. Our glossary explains the most common terms relating to succession, company sales and company valuations. The BB glossary is structured alphabetically. You can also enter a term to the search field and receive results immediately. Growth and expansion financing. The company in question has reached the break-even point or makes a profit. The funds will be used to finance additional production capacity, product diversification and market expansion. Trying to find a specific term? Search term in glossary Seach results Company takeover by way of acquisition of certain assets (instead of the shares). In contrast to this is the Share Deal. Sale of assets or sub-areas of an acquired company immediately after its acquisition. Typical motives are either the financing of the purchase price or the opportunity that the total value can be raised through the sale of individual parts. However, the tax consequences should be taken into account. A company's Assets are the sum of all factors of production required by the company in cash, all their rights (e.g. patents, licenses) and material resources (e.g. raw materials, machinery, buildings, land). A distinction must be made between fixed assets and current assets. Assets ratio 1 Provides information about how high the equity is in the ratio of fixed assets. Provides information about how high the equity is plus the long-term debt in the ratio of fixed assets. Averaging Method The term Averaging Method covers several methods of business valuation. Here, the yield value and the intrinsic value of a company are recorded. The determination of the value of the company is carried out in different ways with a different but fixed weighting of the values in the averaging. In Switzerland, the profitability is used twice and the asset value is used once to calculate the value of the company. The Stuttgart-based method uses the profitability once and the asset value twice for the calculation. The Berlin-based methods both values weighted equally. Benchmarking refers to the comparison of the performance of one’s own company with that of other companies. The performance counter of the other company is known as a Benchmark. The aim of such a comparison is to uncover opportunities for improvement and competitive disadvantages and ultimately to increase the performance of one’s own company. Time when the breakeven point is exceeded and a profit is realized or the level of revenue, which would cover the proceeds of the fixed and variable costs. Bridge financing is a generic term made by credit institutions for short-term or intermediate pre-financing of certain transactions (real estate purchase, company purchase) until the final follow-up financing. Represents the time until a company has used the capital provided for it (the term originated during the Internet bubble at the turn of the millennium). The Burn Rate is of great importance particularly for start-up companies. The company's financial resources decrease in the initial phase of the company because of high fixed costs with only a low turnover. A wealthy individual (usually experienced entrepreneurs) who support young companies with capital as they are founded and/or through active support (coaching or management assistance) and contacts (they are rewarded through shareholdings in the company). A description of the business model of a young company to present to investors, this includes information about product concept, market, team, management of future operations and economic analyses, etc. The acquisition of several companies in order to build a larger group/holding company. Stands for Compound Annual Growth Rate. A growth rate is defined as the average relative increase of a variable per unit of time. The abbreviation CAPEX comes from the Anglo-Saxon term of Capital Expenditure. This term refers to the long-term assets of a company such as machinery, buildings or computer systems. The Cash Flow from operating activities (Operating Cash Flow) includes all deposits and payments associated with the actual provision of services of the company. Examples are the sale of products or the payment of wages. The Cash Flow from investment activities (Cash Flow from Investment) consists of the deposits and withdrawals, which result from the investment or disinvestment of the company. Examples include the installation of a new production facility or the sale of a warehouse. The Cash Flow from financing activities (Cash Flow from Financing) includes all those deposits and withdrawals, which are related to the financing of business activities. Examples include interest payments or the payment of dividends, but also a borrowing or capital repayment. Traditional form of the Management Buyout (MBO), which is financed largely on the basis of the generated cash of a company. Key variable is the Cash Flow from which the return of the funds received and the service rate must be settled. Corresponds to the Quick Ratio. It is the ratio of liquid assets to the current liabilities of a company and therefore allows an analysis of how a company can meet its current short-term payment obligations solely by its liquid assets. Accounts receivable (debtors) are not included. The cash value or present value of the item refers to the expected value of a future cash amount. The cash value is obtained by discounting the future cash equivalent amount, with a capital interest, the expression of an alternative achievable interest rate. Chief Organisation Officer Chief Technological Officer Stake in a company with a minority share, whereby the support is given through a Lead Investor and thus reduces the support costs for the Co-Investor. Stake in a company at the same level as that of the Lead Investor. The latter assumes the true support of the investee. Collection Period The accounts receivable period provides information on the time it takes the customer to make payments. It corresponds to the time between invoicing and payment by the customer. The higher the retention time of the debtor company, the slower the payment, the less favourable the liquidity. Also Non-disclosure Agreement (NDA). Usually agreed on during the transfer of business plans and company presentations to third parties. The prospective buyer agrees that he will not share information with third parties. Group of all supervising banks in the IPO. Consortium Leader Leading bank in the IPO of a company. The contribution margin is the cost and performance calculation, the difference between the proceeds generated (revenue) and the variable costs. It is therefore the amount available to cover fixed costs. Stake in a company by several investors, one of whom acts as the Lead Investor. Corresponds to the current ratio. It indicates the ratio of current assets to the current liabilities of a company. If the current ratio is less than 1, a part of current liabilities is not covered by the current assets, i.e. under certain circumstances assets must be sold to cover liabilities. Therefore, this liquidity ratio must always be greater than 1, whereby one should aim according to the so-called "banker's rule" (also known as Two-to-One-Rule) for a minimum value of 2. Deferred Taxes Hidden tax charges or benefits that have arisen due to differences in approach and / or the valuation of assets and liabilities between the tax accounts and the trade balance and are expected to reduce in subsequent years, i.e. to lead to differences in the future between tax and perform trade-balance-sheet profits. Deferred tax assets should reflect the future tax benefits (future tax higher income potential) future tax expense, deferred tax liabilities (future tax higher yield potential). Dept Ratio The Debt Ratio is the proportion of debt to total capital and total assets analogous to the equity ratio of the equity. This key figure indicates the ratio between debt and equity. The higher the debt, the higher the debt ratio. When a company issues additional shares at a lower price in the context of a capital increase and the existing shareholders do not participate according to their current share, the shares of existing shareholders lose value, they are diluted. Discounted-Cash-Flow Method The possibility of determining the value of the company. Calculated on the basis of the discounted future Cash Flow over a certain period of time. The basis is the projected Free Cash Flow and a residual value that will be discounted to their present values. In this method, the assets are allocated with an operational importance, namely the achievement of future income. The method assumes that the assets of the company generate a constant perpetuity of sustainable net profits. The capitalization of this income is calculated using the formula for eternal pensions of future earnings divided by the discount rate. Financing in the first phase of young, privately owned companies with equity. Usually, specialized companies (venture capital firms) offer the Early-Stage financing. These companies often offer other services besides the financing for start-up companies such as consulting activities and regular monitoring of the overall activity of the company. This funding is often associated with great risk, but offers large profit potential in the event of a subsequent success of the new company. The portion of a company purchase price, which is conditional on the future success of the company. A key figure, usually the turnover, is defined for the compensation of the remaining company purchase price. A percentage of sales is determined to repay the purchase price. Earnings before interest and taxes. EBIT Margin A company's key figure that indicates the ratio of EBIT to sales as a percentage. It is particularly suitable for comparing the performance of different companies. Earnings before interest, taxes, depreciation and amortisation. The EBITDA margin is calculated from the ratio of the EBITDA to sales as a percentage. It is suitable for comparing the operating performance of different companies, regardless of their investment cycle. Key figure, which is used in a comprehensive performance measurement and value. The Economic Value-Added-Value approach calculates the residual income of the investment being valued. An investment will create value in accordance with this approach if it generates a positive "spread" (difference) between the actual return and the demanded cost of capital. Employee stock options Form of employee participation. The right to acquire shares or options on shares of your company at a discounted price after a specified waiting period. Entity Method A variant of the Discounted-Cash-Flow valuation method based on total capital, with which the gross value of the company is determined. First, a detailed Free Cash Flow is drawn up over a period of five to ten years. These gross quantities are then discounted with the WACC. In order to obtain the effective value of equity, the borrowed capital must be subtracted. Equity Kicker means the possibility of sharing in the company's success. This may, for example, be in the conversion of Mezzanine Capital into equity, i.e. a "real" participation. Equity stakes are also conceivable for a desired future IPO. Outside investors are thus given the opportunity to purchase shares in partnerships or corporations at a later date, often at special rates. Equity Ratio The equity ratio indicates the proportion of economic equity to the adjusted total assets of a company. The higher the ratio, the lower the debt ratio. Documentation as part of an emission process, in which the essential characteristics of the company and its planned corporate strategy are shown (the success of the company, in the past and in the future). Equity-Method A variant of the Discounted-Cash-Flow valuation method that directly determines the value of equity. First, a detailed planning of cash flow over a period of five to ten years. The interest and the growth rate of the debt are to be deducted from this. These net variables are then discounted with the cost of equity, which then gives the value of equity. Excess profit method A traditional method of business valuation, where the company's value is determined using the profits. Profit is meant to denote that which is attained over the normal return of the asset value. Summary of, for example, a business plan. Withdrawal from a capital investment. Whoever makes capital available to start-up companies, shall sell off his interest after a certain time in the company that has meantime become established, because this no longer lies in his capital focus. A withdrawal may be via an IPO or a sale to another company. This process is known as an Exit Strategy, because the intention is to realize a profit from the investment made. The fair value is used according to IAS and US GAAP as a generic term for all market-related valuations. The Fair Value of an asset or a liability generally refers to the amount, which the two independent parties would be prepared to replace the asset and/or settle the liability with expertise and final determination. The First Round Financing of a company is the first time that it receives external equity. The Free Cash Flow refers to the operating Cash Flow minus the Cash Flow from investments. Free Cash Flow is the amount resulting from the overall consideration of the business. It is the only amount of money that is free to satisfy the requirements of investors. Procurement of investment capital. The start-up phase of a Venture Capital fund (VC fund), in which drawing funds are obtained for institutional, industrial or private investors. Most VC companies put funds aside at irregular intervals where they collect the money that they then invest in other companies. The better the track record of a Venture Capital company, the greater their chances to collect money in the future. A Fusion is the equivalent of a merger of two or more companies into a whole new company. In reality, however, it is a so-called friendly takeover of one of the companies involved. The agreement on the word "fusion" should mitigate the sales character of the transaction to a third party. To the outside there should be no transferee and taken over company. Going concern value The asset components are valued at those values, which their current replacement cost would be at market prices (reproduction value of the company). Replacement values are calculated from the acquisition cost at current prices less depreciation (consumption value based on age). Repurchase of the stock of a company in private ownership. IPO of a company. See IPO. The gross margin indicates how much a company earned (as a percentage of sales) after deducting production costs. Other costs, e.g. for research and development, marketing and management, do not make up part of the value. The gross margin is therefore not to be equated with the operating result. Gross value of the company A company's value before the deduction of liabilities. The gross value of the company is open to all investors. Hands Off is the term used for a passive support of a company that is being established. The influence on the Executive Board is limited to participation on the advisory board or the board of the company. Bodies or institutions that entrepreneurs support in the founding of companies. The founder generally has access to professional counselling, coaching qualification or support through the necessary infrastructure such as office space and communications technology. In addition, the access to networks is supported. Incubator centres are often linked to public institutions such as technology centres to support start-ups or Venture Capital companies or Business Angels. The initial public offering of shares of a company. Large institutions such as banks, insurance companies, pension funds or large corporations that invest in equity funds. The IRR is the discount rate at which the present value (PV) of net cash flow (NCF), a project is equal to its initial investment. The discount rate at which the Net Present Value (NPV) of the project is equal to zero. Active management of relations with current and potential investors, analysts and financial media with the aim of fostering a binding to with these target groups to the shares of their own company. Cooperation agreement for the joint operations of a company, the capital to be introduced, the know-how to be supplied, etc. SME is an abbreviation for "small and medium-sized enterprises". Later Stage Financing Financing of expansions, acquisitions, bridgings, etc. at established companies. In a syndicate of Venture Capital companies (VC companies), the investor with the largest share assumes both the organization of the financing and the Hands-on support. Written declaration in advance of a transaction in which the intention of the buyer and seller to complete the corporate sale is announced. Level of external debt of a company, usually expressed as the ratio of debt to equity. Predominantly debt-financed corporate takeovers. Liquidation Value Denotes the (theoretical) amount that can still be achieved in the event of liquidation with the disposal of all business objects. Listing a company on the stock exchange. The Lock-up Period or waiting period means the period in which the shareholders agree not to sell any shares after the Going Public of its holdings. The Lock-up Period is controlled very differently in Europe. Deciding whether a product or a service is to be made (make) or bought (buy). A Management buy-in is when a company is taken over by external management or the acquisition is forced by an investor using a foreign management. This comes about especially when an external management believes that the company is being badly managed and could be more efficient through better management. This is also the opportunity to take over a company in a succession planning. The purchase of a company or part of a company or a controlling interest thereon by the company's management. Often, such a buyout is done with the help of private equity investors and a large proportion is financed with borrowed capital (Leveraged Buy-out, LBO), because managers may not have the financial means themselves. Market Capitalization expresses the market value of a corporation. It is calculated by multiplying the share price by the number of shares. The Market Value is the price achievable under normal conditions, without regard to unusual or personal circumstances. Merger (also Fusion) and Acquisition (also Takeover, Purchase). Mergers & Acquisitions, M & A for short, the technical term for the entire market of corporate transfers. Mergers & Acquisitions Business This is about the transfer of shares and entire companies for a commission. The benefits of M & A companies include, among other things, consulting, property search, buyer and seller search, implementation support and funding. Specialist term for matching different data in a database. For example, matching the data from a buyer (purchase price, location, interests, sector) with those of the seller (purchase price, location of the business, industry) - "merged". The aim of Merging is to determine any matches. Mezzanine capital or Mezzanine financing (derived from the architectural term in the sense of a mezzanine floor) is a collective term to describe types of financing, which in their legal and economic configurations is a hybrid between equity and debt. Thereby in the classic version, a company is supplied with economic or shareholders' equity, without granting the investors voting rights or reasonable control of the residual interest as genuine partners. The net asset value is the replacement value. This refers to the amount of money you must spend to replicate an existing business exactly. The net asset value includes all tangible and intangible assets of the company (such as patents and licenses), can be sold in the market. Net asset value method This method assesses those assets of a company, which can be sold separately. The intangible, non-marketable assets that can have a significant value with the continuation of its operating businesses (e.g., customers) are not part of the valuation. Net Corporate Value Corporate value net of debt. The net corporate value is that portion that is attributable to equity holders, and is thus equated with the effective value of the equity. Net Current Assets Current assets minus current liabilities. The Net Present Value (Discounted Cash Flow method or even Net Present Value or NPV for short) is a dynamic process of capital budgeting. By discounting at the beginning of the investment the payments that are made at arbitrary times become comparable. Revenue, net of tax and revenue losses. The Net Operating Profit after Tax is calculated from the EBIT less approximate taxes (EBIT multiplied by tax rate). Based on the NOPAT (EBIT net of income taxes), the NOPLAT also takes into account the fact that no taxes are paid on the interest. The NOPLAT is sometimes referred to as Earnings before interest (EBI). OOE Abbreviation for other operating expenses. Oversubscription If the demand for the shares of an initial listing is greater than the number of shares issued, the shares are oversubscribed. A ten-fold oversubscription therefore means that the demand is ten times greater than the quota of shares available. Owner’s Profit EBITDA The owner’s profit at the EBITDA level (profit variable in the income statement before interest, taxes, depreciation and other value adjustments) is calculated from the EBITDA as per the income statement. Added to this besides the salary of the owner also all non-operating expenses (including tax-driven optimizations) that are directly or indirectly to be considered as benefits in favour of the owner. Thus, the official final balance sheet is adjusted and the effective performance of the company is represented. Pay-back period This is the period in which the sum of capital inflows of an investment object (for the static calculation of amortization) or its present value (for the dynamic calculation of amortization) exceeds the investment amount for the first time. This period is called the amortization period or payback period. Payment Period The Payment Period provides information about the company's rate of payment of accounts payable. It tells you how many days a company takes for the payment of vendor invoices. The higher the average payable period, the lower the liquidity. Practical Method Method for business valuation (cf. averaging method). PER (price-earnings ratio) Private Equity is a form of equity where the capital received from the investor is not tradable in regulated markets (stock exchanges). Private placement of shares without recourse to the stock market as opposed to the Public Offering. Public offering of shares on the stock market as opposed to the Private Placement. The Purchase Price is the price of a company to which both parties have agreed. The Purchase Price may differ from the value observed in the price finding as well as the previously agreed price determination. The Purchase Price of a company is its market price. Here, various Purchase Prices can be distinguished. There is, among other things, a price for the substance of the company, the profitability of the company and for the future potential of the company. This corresponds to the current ratio. It indicates the ratio of the financial assets plus the value of investments and current receivables to the current liabilities of a company. It is a measure of whether a company is able to pay its current liabilities. With a Quick Ratio that is less than 1, a part of the short-term liabilities are not covered by the short-term assets that are available. This can result in a liquidity bottleneck. Acquisition value of a company's existing asset at the time of its replacement. When carrying out an evaluation using the Discounted-Cash-Flow method, the Cash Flows for a certain time period can be projected and discounted at the current time. The sum is identified for all of the following Cash Flows in the forecast period, and the present value of them is determined, which is then known as the Residual Value. In calculating the residual value, great care is needed, because even small deviations result in large differences in value assumptions. The Return on assets (or ROA) indicates how efficiently the capital investment of an investment project was within a billing period. The Return on Assets is also known as the Return on Investment. It indicates how efficiently the capital investment of an investment project was within a billing period. Return on Equity (ROE) The Return on Equity or ROE documents what has been earned by the capital invested by the investor within a billing period. This is the gross return of a company, which is calculated from dividing the profit before interest by the full amount of operating capital used (debt and equity). It indicates how efficiently a company has used it available capital. This corresponds to the net profit divided by sales. The ROS is a measure of the profitability of a company. The operating margin shows the operational efficiency of a company. The second round of financing for a company that has already received its first round of venture capital. A secondary purchase is an exit option of a Venture Capital company. The Venture Capital company hereby sells its shares in another private equity firm. The term Seed Capital refers to the venture capital for a future business. It is invested by an investment company during the phase of its establishment, when the business idea is being developed. The young company can then have access to the Seed Capital until the development of a prototype is complete. Seed-Phase / Pre-Seed-Phase Phase prior to the formal establishment of a business (pre-founding phase). The Sensitivity Analysis is a method for testing the effect of changes in input variables to the corresponding output. It is used to determine the stability of the result, if the input variables are subject to a range of variation, and the identification of the relevant input variables, to order to influence this in terms of the output optimization. Service Fee = Retainer Fee or Start Fee. This is the fee charged by a company or agent prior to starting their work. Solely the sincerity of the seller to carry out the sale of the company is to be verified with the collection of fees. Company takeover by purchase of shares. In the spin-off, the original company remains. Only one or several parts go, which make for a definable unit, and are transferred to an existing or newly created company. The Spin-off and becoming independent of a department or a business unit of a company / a business concern. The phase immediately after the founding of a company, often the term for a young company. Start-up Financing Young companies that are not yet established, but that are established in order to achieve an innovative business idea with low start-up capital and are usually dependent very early on either on the receipt of Venture Capital and Seed Capital (possibly by Business Angels) or an Initial Public Offering (IPO) to expand their businesses and strengthen their capital base. Stock Turnover The Stock Turnover defines the period for which an inventory is sufficient for the planned consumption of material. A low Stock Turnover can lead to shortage costs, a high stock turnover capital commitment or storage costs. Stuttgart method The Stuttgart method is a method for business valuation (cf. Averaging method). Subordinated Dept The subordination refers to the ranking of external investors with one another, especially for cases of comparison or liquidation. Subscription period Period within which investors may draw new shares. This takes the form of a declaration of intent in which the investors commit to purchase a specified number of shares. The Success Fee will be paid to a Business Broker after the successful completion of a corporate transaction. In general, the Success Fee is payable at the moment of sale, since this is when the work of the corporate broker ends. Analysis of Strengths, Weakness, Opportunities, Threats, or just the strengths, weaknesses, opportunities and risks. Several private equity firms merge in order to finance even larger high-risk investments. The Track Record of an investment company or a company, a manager or entrepreneur. Ratio figures derived from effective rates of company purchases. A marketing term. It is a "unique selling proposition" or USP. Venture capital, risk-bearing capital. The financing of young companies by institutional investors (e.g. VC companies) or informal investors (Business Angels, for example). The provision is, as opposed to lending, not dependent on the existence of eligible lending assets of the company or the owner, but instead solely on the expected earnings opportunities of the company to be financed. The WACC is an average overall cost of capital, which is calculated as a weighted average of debt and equity cost ratio of the capital market. The debt and equity shares based on the market value are to be used for the weighting. This term refers to the net current assets, i.e. all the working capital that is tied up in the short-term (inventories, receivables with a one-year maturity, cash and prepaid expenses), net of current liabilities. Yield Value The value of a company from the "eternal" capitalization of earnings. This future success refers to the sustainable and attainable, future profitability of the company by taking into account the rate of interest. No such term was found in our glossary matching the search term . Randomly selected terms

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professional_accounting

Dynatrace Inc. Dynatrace Managed release notes version 1.184 CIO research shows taming cloud complexity has grown beyond human abilities Carvana Solidifies Minnesota Presence with St. Cloud Launch Fannie Mae - Federal National[...] Consumers Lead Economic Expansion Toward 11th Year with Boost from[...] M/I Homes Inc. M/I Homes, Inc. Announces Fourth Quarter and Year-End Earnings Webcast AT&T Inc. AT&T Named to Bloomberg Gender Equality Index for Third Year AAR Corporation AAR Reports First Quarter 2020 Results WOOD DALE, Ill., Sept. 25, 2019 /PRNewswire/ -- AAR CORP. (NYSE: AIR) today reported first quarter Fiscal Year 2020 consolidated sales of $541.5 million and income from continuing operations of $17.1 million, or $0.49 per diluted share. For the first quarter of the prior year, the Company reported sales of $466.3 million and income from continuing operations of $18.9 million, or $0.54 per diluted share. Our adjusted diluted earnings per share from continuing operations were $0.57 in the current quarter compared to $0.54 in the first quarter of the prior year. Consolidated sales increased 16% over the prior year period from continued growth in our programs and parts supply activities. Our Aviation Services segment experienced significant growth of 17% driven by improved performance in MRO, execution on new government contract awards, and continued strong demand for both new and aftermarket parts. In our Expeditionary Services segment, sales increased 6% as volumes have increased from recent contract awards. 'We are pleased with the strong start to Fiscal 2020 as our momentum carried into the first quarter. We saw continued strength in our parts supply activities, as well as in government programs. We are also pleased with the positive impact our efforts to attract and retain talent have had in our MRO activities,' said John M. Holmes, President and Chief Executive Officer of AAR CORP. During the quarter, we were awarded a new $118 million contract from the Naval Air Systems Command in support of the U.S. Marine Corps for the procurement, modification and delivery of two C-40 aircraft. This award demonstrates the power of our integrated services model by combining the strengths of our parts supply, government programs, MRO and engineering teams to deliver a creative solution to the U.S. Marine Corps. We began work on this contract in Q1 and expect to deliver the aircraft in fiscal 2021. Subsequent to the end of the quarter, we also announced two contract awards related to our parts supply activities. We were selected as the main distributor for Leach International Corporation, a subsidiary of Transdigm, which will include distributing electromechanical and solid state switch gears, such as relays, switches, relay panels and power distribution units to OEMs, commercial airlines and MRO providers, as well as to the military aftermarket. We also announced a new agreement with Mitsubishi Heavy Industries Aero Engines, Ltd. to supply PW4000 engine parts in support of their engine overhaul business. This contract is our largest commercial agreement in Japan to date. Sales to government and defense customers were 38% of consolidated sales compared to 32% in the prior year's quarter reflecting growth from the new C-40 contract award and other government programs. First quarter sales to commercial customers, which also increased during the period, represented 62% of consolidated sales compared to 68% of consolidated sales in the first quarter of last year. Gross profit margins decreased slightly to 15.1% in the current quarter from 15.3% in the prior year quarter due primarily to Expeditionary Services profitability. Aviation Services gross profit margins expanded from 15.3% to 15.6% primarily due to the mix of products and services sold. Selling, general and administrative expenses as a percentage of sales were 10.7% for the quarter, compared to 10.3% last year reflecting increased costs related to the investigation and compliance matters disclosed earlier in the quarter. Selling, general and administrative expenses as a percentage of sales were 10.1% excluding $3.6 million related to these costs and severance. Net interest expense for the quarter was $2.1 million compared to $1.6 million last year. Also during the quarter, the Company paid cash dividends of $2.9 million, or $0.075 per share. Average diluted share count for the quarter was 35.0 million compared to 35.1 million in the first quarter last year. Cash flow used in operating activities from continuing operations was $30.1 million during the current quarter. The level of our accounts receivable financing program remained consistent with the fourth quarter resulting in no favorable or unfavorable impact on our cash flows during the quarter. Holmes concluded, 'We are very pleased with the recent C-40 award and other new contract wins and we remain well-positioned to continue to secure new business across the commercial and government markets. Demand for our aviation services offering remains very strong and we are excited about the opportunities we see for Fiscal 2020.' We are re-affirming our financial guidance for Fiscal Year 2020, which includes sales in the range of $2.1 to $2.2 billion and adjusted diluted earnings per share from continuing operations of $2.45 to $2.65. We continue to expect selling, general and administrative expenses to be approximately 10.5% of sales and anticipate an effective tax rate of 24% in Fiscal Year 2020. AAR will hold its quarterly conference call at 3:45 p.m. CDT on September 25, 2019. The conference call can be accessed by calling 866-802-4322 from inside the U.S. or 703-639-1319 from outside the U.S. A replay of the conference call will also be available by calling 855-859-2056 from inside the U.S. or 404-537-3406 from outside the U.S. (access code 9886506). The replay will be available from 7:15 p.m. CST on September 25, 2019 until 10:59 p.m. CST on October 2, 2019. AAR is a global aftermarket solutions company that employs more than 6,000 people in over 20 countries. Based in Wood Dale, Illinois, AAR supports commercial aviation and government customers through two operating segments: Aviation Services and Expeditionary Services. AAR's Aviation Services include parts supply; OEM parts distribution; supply chain programs; customer fleet management and operations; aircraft maintenance, repair and overhaul; engineering services and component repair. AAR's Expeditionary Services include mobility systems; command and control centers in support of military and humanitarian missions; and composite manufacturing operations. Additional information can be found at www.aarcorp.com. This press release contains certain statements relating to future results, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on beliefs of Company management, as well as assumptions and estimates based on information currently available to the Company, and are subject to certain risks and uncertainties that could cause actual results to differ materially from historical results or those anticipated, including those factors discussed under Item 1A, entitled 'Risk Factors', included in the Company's Form 10-K for the fiscal year ended May 31, 2019. Should one or more of these risks or uncertainties materialize adversely, or should underlying assumptions or estimates prove incorrect, actual results may vary materially from those described. These events and uncertainties are difficult or impossible to predict accurately and many are beyond the Company's control. The Company assumes no obligation to update any forward-looking statements to reflect events or circumstances after the date of such statements or to reflect the occurrence of anticipated or unanticipated events. For additional information, see the comments included in AAR's filings with the Securities and Exchange Commission. AAR CORP. and Subsidiaries (In millions except per share data - unaudited) August 31, Cost of sales Provision for doubtful accounts Selling, general and administrative Interest expense, net Other income (expense), net Income from continuing operations before income taxes Income from continuing operations Loss from discontinued operations Earnings per share - Basic Earnings from continuing operations Earnings per share - Diluted Share Data: Weighted average shares outstanding - Basic Weighted average shares outstanding - Diluted May 31, Restricted cash Accounts receivable, net Contract assets Inventories, net Rotable assets and equipment on or available for lease Assets of discontinued operations Property, plant, and equipment, net Operating lease right-of-use assets, net Goodwill and intangible assets, net Rotable assets supporting long-term programs Other non-current assets $ 1,683.1 Liabilities of discontinued operations Operating lease liabilities Other liabilities and deferred income Total liabilities and equity (In millions - unaudited) Cash flows used in operating activities: Less: Loss from discontinued operations Adjustments to reconcile income from continuing operations to net cash used in operating activities Depreciation and intangible amortization Amortization of stock-based compensation Changes in certain assets and liabilities: Net cash used in operating activities - continuing operations Net cash provided from (used in) operating activities - discontinued operations Cash flows used in investing activities: Property, plant and equipment expenditures Net cash used in investing activities - continuing operations Net cash used in investing activities - discontinued operations Cash flows provided from financing activities: Proceeds from borrowings, net Net cash provided from financing activities - continuing operations Net cash used in financing activities - discontinued operations Net cash provided from financing activities Effect of exchange rate changes on cash Increase in cash and cash equivalents Cash, cash equivalents, and restricted cash at beginning of period Cash, cash equivalents, and restricted cash at end of period Sales By Business Segment Expeditionary Services Gross Profit by Business Segment (In millions- unaudited) Adjusted income from continuing operations, adjusted diluted earnings per share from continuing operations, adjusted selling, general, and administrative expenses, adjusted cash used in operating activities from continuing operations, adjusted EBITDA, and net debt are 'non-GAAP financial measures' as defined in Regulation G of the Securities Exchange Act of 1934, as amended (the 'Exchange Act'). We believe these non-GAAP financial measures are relevant and useful for investors as they provide a better understanding of our actual operating performance unaffected by the impact of certain items. When reviewed in conjunction with our GAAP results and the accompanying reconciliations, we believe these non-GAAP financial measures provide additional information that is useful to gain an understanding of the factors and trends affecting our business and provide a means by which to compare our operating performance against that of other companies in the industries we compete. These non-GAAP measures should be considered as a supplement to, and not as a substitute for, or superior to, the corresponding measures calculated in accordance with GAAP. Adjusted EBITDA is income from continuing operations before interest income (expense), other income (expense), income taxes, depreciation and amortization, stock-based compensation and other items of an unusual nature including but not limited to severance, facility repositioning costs, investigation and remediation compliance costs, and significant customer bankruptcies. Pursuant to the requirements of Regulation G of the Exchange Act, we are providing the following tables that reconcile the above mentioned non-GAAP financial measures to the most directly comparable GAAP financial measures: Adjusted Income from Continuing Operations Investigation and remediation compliance costs, net of tax Severance and restructuring charges (reversals), net of tax Adjusted Diluted Earnings per Share from Continuing Operations Diluted earnings per share from continuing operations Severance and restructuring charges, net of tax Adjusted Selling, General and Administrative Expenses Selling, general and administrative expenses Investigation and remediation compliance costs Severance and restructuring (charges) reversals Adjusted Cash Used in Operating Activities From Continuing Operations Cash used in operating activities from continuing operations $(30.1) Amounts outstanding on accounts receivable financing program: Beginning of period End of period Severance and restructuring charges (reversals) Less: Cash and cash equivalents Net Debt to Adjusted EBITDA Adjusted EBITDA for the year ended May 31, 2019 Less: Adjusted EBITDA for the three months ended August 31, 2018 Plus: Adjusted EBITDA for the three months ended August 31, 2019 Adjusted EBITDA for the twelve months ended August 31, 2019 Net debt at August 31, 2019 View original content to download multimedia:http://www.prnewswire.com/news-releases/aar-reports-first-quarter-2020-results-300925537.html SOURCE AAR CORP. Jason Secore, Vice President, Treasurer, (630) 227-2075, [email protected] Smartlinks | AAR Corporation | News | Local News | Top Business and Economy News | Finance | Conglomerates and Diversified | Stock Markets | Security Markets | Stock Markets | Security Markets | Company News | Top Company News | Defense Industry | Aerospace Companies | New York Stock Exchange (NYSE) | Börse Frankfurt | Börse Stuttgart | NYSE American | NYSE ARCA | Russell 2000 | BZX Exchange | BYX Exchange | EDGA Exchange | EDGX Exchange | NYSE National | Nasdaq BX | Nasdaq PSX | Nasdaq Intermarket | Investors Exchange (IEX) | NYSE Chicago

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Filed pursuant to Rule 424(b)(5) SEC File No. 333-209718 This prospectus supplement relates to an effective registration statement under the Securities Act of 1933, but is not complete and may be changed. This prospectus supplement and the accompanying prospectus is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state or other jurisdiction where the offer or sale is not permitted. Subject to Completion Preliminary Prospectus Supplement Dated February 13, 2019 Prospectus Supplement , 2019 (To Prospectus dated February 25, 2016) U.S.$ U.S.$ % Global Notes due 2029 We will pay interest on the % Global Notes due 2029 (the “2029 Notes”) and the % Global Notes due 2039 (the “2039 Notes” and, together with the 2029 Notes, the “Notes”) on and of each year, commencing on , 2019. The 2029 Notes will mature on , 2029 and the 2039 Notes will mature on , 2039. We may redeem some or all of the Notes at any time and from time to time at the prices and at the times indicated for each series under the heading “Description of the Notes — The Notes — Optional Redemption” beginning on page S-5 of this prospectus supplement. The Notes will be issued in minimum denominations of $2,000 and integral multiples of $1,000 thereafter. See “Risk Factors” beginning on page 37 of our 2017 Annual Report to Stockholders, portions of which are filed as Exhibit 13 to our Annual Report on Form 10-K for the fiscal year ended December 31, 2017 and “Risk Factors” beginning on page 72 of our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2018, which are incorporated by reference herein, to read about factors you should consider before investing in the Notes. Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus supplement or the accompanying prospectus. Any representation to the contrary is a criminal offense. Per 2029 Note Total Per 2039 Note Total Initial public offering price % $ % $ Underwriting discounts Proceeds, before expenses, to AT&T(1) The underwriters have agreed to reimburse us for certain of our expenses. See “Underwriting.” The initial public offering prices set forth above do not include accrued interest, if any. Interest on the Notes will accrue from , 2019. The underwriters expect to deliver the Notes in book-entry form only through the facilities of The Depository Trust Company for the accounts of its participants, including Clearstream Banking S.A. and Euroclear Bank S.A./N.V., against payment in New York, New York on , 2019. Joint Book-Running Managers BNP PARIBAS Goldman Sachs & Co. LLC Morgan Stanley Wells Fargo Securities We have not, and the underwriters have not, authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, we take no responsibility for, nor can we provide any assurance as to the reliability of, any other information that others may give you. We are not, and the underwriters are not, making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted. You should assume that the information appearing in this prospectus supplement and the accompanying prospectus, as well as information we previously filed with the Securities and Exchange Commission and incorporated by reference, is accurate as of their respective dates. Our business, financial condition, results of operations and prospects may have changed since those dates. The Notes are offered globally for sale in those jurisdictions in the United States, Canada, Europe, Asia and elsewhere where it is lawful to make such offers. PRIIPs Regulation / Prospectus Directive / Prohibition of sales to EEA retail investors – The Notes are not intended to be offered, sold or otherwise made available to and should not be offered, sold or otherwise made available to any retail investor in the European Economic Area (“EEA”). For these purposes, a retail investor means a person who is one (or more) of: (i) a retail client as defined in point (11) of Article 4(1) of Directive 2014/65/EU (as amended, “MiFID II”); or (ii) a customer within the meaning of Directive (EU) 2016/97 (as amended, the “Insurance Distribution Directive”), where that customer would not qualify as a professional client as defined in point (10) of Article 4(1) of MiFID II; or (iii) not a qualified investor as defined in Directive 2003/71/EC (as amended or superseded, the “Prospectus Directive”). Consequently no key information document required by Regulation (EU) No 1286/2014 (as amended, the “PRIIPs Regulation”) for offering or selling the Notes or otherwise making them available to retail investors in the EEA has been prepared and therefore offering or selling the Notes or otherwise making them available to any retail investor in the EEA may be unlawful under the PRIIPs Regulation. To the extent there is a conflict between the information contained in this prospectus supplement, on the one hand, and the information contained in the accompanying prospectus, on the other hand, the information contained in this prospectus supplement shall control. If any statement in this prospectus supplement conflicts with any statement in a document which we have incorporated by reference, then you should consider only the statement in the more recent document. In this prospectus supplement, “we,” “our,” “us” and “AT&T” refer to AT&T Inc. and its consolidated subsidiaries. Prospectus Supplement Use of Proceeds Description of the Notes United States Tax Considerations Validity of Securities Description of AT&T Inc. Summary Description of the Securities We May Issue Description of Debt Securities We May Offer Description of Preferred Stock We May Offer Description of Depositary Shares We May Offer Description of Common Stock We May Offer Plan of Distribution Documents Incorporated by Reference Summary of the Notes Offering Securities Offered U.S.$ aggregate principal amount of % Global Notes due 2029 (the “2029 Notes”). U.S.$ aggregate principal amount of % Global Notes due 2039 (the “2039 Notes” and, together with the 2029 Notes, the “Notes”). Maturity Date , 2029, at par, for the 2029 Notes. The 2029 Notes will bear interest from , 2019 at the rate of % per annum and the 2039 Notes will bear interest from , 2019 at the rate of % per annum. Interest on each series of Notes will be payable semi-annually in arrears in two equal payments. Interest Payment Dates and of each year, commencing on , 2019. Optional Redemption At any time prior to the applicable Par Call Date (as set forth in the table below), each series of Notes may be redeemed as a whole or in part, at our option, at any time and from time to time on at least 30 days’, but not more than 60 days’ prior notice, at a make-whole call equal to the greater of (i) 100% of the principal amount of the Notes of such series to be redeemed or (ii) the sum of the present values of the remaining scheduled payments of principal and interest discounted to the redemption date, on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months), at a rate equal to the sum of the Treasury Rate plus the applicable Make-Whole Spread (as set forth in the table below), calculated by AT&T. At any time on or after the applicable Par Call Date, each series of Notes may be redeemed as a whole or in part, at our option, at any time and from time to time on at least 30 days’, but not more than 60 days’ prior notice, at a redemption price equal to 100% of the principal amount of such series of Notes to be redeemed. In each case, accrued but unpaid interest will be payable to the redemption date. Par Call Date Make-Whole 2029 Notes See “Description of the Notes — The Notes — Optional Redemption.” The Notes of each series are also redeemable at our option in connection with certain tax events. See “Description of the Notes — Redemption Upon a Tax Event.” The Notes are offered for sale in those jurisdictions in the United States, Canada, Europe, Asia and elsewhere where it is legal to make such offers. See “Underwriting.” No Listing The Notes are not being listed on any organized exchange or market. Form and Settlement The Notes will be issued in the form of one or more fully registered global notes which will be deposited with, or on behalf of, The Depository Trust Company — known as DTC — as the depositary, and registered in the name of Cede & Co., DTC’s nominee. Beneficial interests in the global notes will be represented through book-entry accounts of financial institutions acting on behalf of beneficial owners as direct and indirect participants in DTC. Investors may elect to hold interests in the global notes through either DTC (in the United States), Clearstream Banking S.A. or Euroclear Bank S.A./N.V., as operator of the Euroclear System (outside of the United States), if they are participants in these systems, or indirectly through organizations which are participants in these systems. Cross-market transfers between persons holding directly or indirectly through DTC participants, on the one hand, and directly or indirectly through Clearstream Luxembourg or Euroclear participants, on the other hand, will be effected in accordance with DTC rules on behalf of the relevant international clearing system by its U.S. depositary. The Notes will be governed by the laws of the State of New York. A putative stockholder class action lawsuit has been filed in connection with statements made in the registration statement and prospectus on Form S-4 (the “S-4”), filed by AT&T with the Securities and Exchange Commission in connection with AT&T’s acquisition of Time Warner Inc. The action, Hoffman v. Stephenson et al. (the “Hoffman Complaint”), filed on February 7, 2019 in the Supreme Court of the State of New York, County of New York, alleges violations of Sections 11, 12(a)(2) and 15 of the Securities Act of 1933, as amended, by AT&T and certain of AT&T’s current officers and directors based on alleged misrepresentations and omissions in the S-4 relating to trends in its then Entertainment Group segment and in particular with respect to the number of subscribers to AT&T’s DIRECTV NOW service. The plaintiff in the Hoffman Complaint seeks damages, attorneys’ fees and costs, rescission, disgorgement and other and further relief. AT&T believes the claims in the Hoffman Complaint are without merit and AT&T will vigorously defend its legal position in court. The net proceeds to AT&T from the Notes offering will be approximately $ after deducting the underwriting discounts and our estimated offering expenses, net of reimbursement from the underwriters. AT&T intends to use these proceeds, together with approximately $1,000,000,000 in cash on hand, to redeem or repay (i) $890,148,000 aggregate outstanding principal amount of 5.200% Global Notes due 2020 issued by AT&T, (ii) $1,119,880,000 aggregate outstanding principal amount of 5.000% Global Notes due 2021 issued by AT&T, (iii) $37,875,000 aggregate outstanding principal amount of 4.600% Senior Notes due 2021 issued by DIRECTV Holdings LLC, a Delaware limited liability company, and DIRECTV Financing Co., Inc., a Delaware corporation (together, “DIRECTV”), (iv) $39,924,000 aggregate outstanding principal amount of 5.000% Senior Notes due 2021 issued by DIRECTV, (v) $1,000,000,000 aggregate outstanding principal amount of 4.700% Notes due 2021 issued by Time Warner and (vi) $1,000,000,000 aggregate outstanding principal amount of 4.750% Notes due 2021 issued by Time Warner and to pay related premiums, accrued interest and fees and expenses associated with such redemption or repayment. This prospectus supplement shall not constitute a notice of redemption with respect to any of the foregoing series of notes. To the extent there are any excess proceeds, AT&T intends to use such excess proceeds to pay down amounts outstanding under (i) the Tranche A facility under AT&T’s Term Loan Credit Agreement, dated as of November 15, 2016, with JPMorgan Chase Bank, N.A., as agent (the “JPM Tranche A Facility”), and, thereafter, (ii) the Tranche C facility under AT&T’s Term Loan Credit Agreement, dated as of September 29, 2017, with The Bank of Nova Scotia as agent (the “Scotia Tranche C Facility”). The JPM Tranche A Facility bears interest at an annual interest rate of LIBOR plus 1.125% and matures on December 14, 2020 and the Scotia Tranche C Facility bears interest at an annual interest rate of LIBOR plus 1.125% and matures on January 26, 2023. The proceeds of the JPM Tranche A Facility borrowings and the Scotia Tranche C Facility borrowings were used to fund the acquisition of Time Warner. The following table sets forth the capitalization of AT&T as of December 31, 2018 and as adjusted solely to reflect the issuance of $ of the Notes and the application of the net proceeds as described under “Use of Proceeds” above assuming that a portion of the net proceeds from the sale of the Notes, together with approximately $1,000,000,000 in cash on hand, would be used to (i) redeem or repay senior notes issued by AT&T and/or one or more of its subsidiaries and to pay related premiums, accrued interest and fees and expenses associated with such redemption or repayment and (ii) to the extent there are any excess proceeds, to use such excess proceeds to pay down amounts outstanding under the JPM Tranche A Facility and the Scotia Tranche C Facility. The table reflects certain unaudited consolidated financial information as of December 31, 2018 that was included in our Current Report on Form 8-K filed on January 30, 2019. AT&T’s total capital consists of debt (long-term debt and debt maturing within one year) and stockholders’ equity. Actual As Adjusted (In millions) $ 166,250 $ Debt maturing within one year (1) Stockholders’ equity: Common shares ($1 par value, 14,000,000,000 authorized) Capital in excess of par value (12,059 ) Other adjustments Stockholders’ equity Total Capitalization Debt maturing within one year consists of the current portion of long-term debt and commercial paper and other short-term borrowings. The following description of the general terms of the Notes should be read in conjunction with the statements under “Description of Debt Securities We May Offer” in the accompanying prospectus. If this summary differs in any way from the “Summary Description of the Securities We May Issue” in the accompanying prospectus, you should rely on this summary. The Notes will be issued under our indenture, dated as of May 15, 2013, with The Bank of New York Mellon Trust Company, N.A., acting as trustee, as described under “Description of Debt Securities We May Offer” in the accompanying prospectus. The Notes will be our unsecured and unsubordinated obligations and will rank pari passu with all other indebtedness issued under our indenture. The Notes will constitute two separate series under the indenture. We will issue the Notes in fully registered form only and in minimum denominations of $2,000 and integral multiples of $1,000 thereafter. We may issue definitive Notes in the limited circumstances set forth in “— Form and Title” below. If we issue definitive Notes, principal of and interest on our Notes will be payable in the manner described below, the transfer of our Notes will be registrable, and our Notes will be exchangeable for Notes bearing identical terms and provisions, at the office of The Bank of New York Mellon Trust Company, N.A., the paying agent and registrar for our Notes, currently located at 601 Travis Street, 16th Floor, Houston, Texas 77002. However, payment of interest, other than interest at maturity, or upon redemption, may be made by check mailed to the address of the person entitled to the interest as it appears on the security register at the close of business on the regular record date corresponding to the relevant interest payment date. Notwithstanding this, (1) the depositary, as holder of our Notes, or (2) a holder of more than $5 million in aggregate principal amount of Notes in definitive form can require the paying agent to make payments of interest, other than interest due at maturity, or upon redemption, by wire transfer of immediately available funds into an account maintained by the holder in the United States, by sending appropriate wire transfer instructions as long as the paying agent receives the instructions not less than ten days prior to the applicable interest payment date. The principal and interest payable in U.S. dollars on a Note at maturity, or upon redemption, will be paid by wire transfer of immediately available funds against presentation of a Note at the office of the paying agent. For purposes of the Notes, a business day means a business day in The City of New York. The 2029 Notes offered by this prospectus supplement will initially be limited to $ aggregate principal amount and will bear interest at the rate of % per annum and the 2039 Notes offered by this prospectus supplement will initially be limited to $ aggregate principal amount and will bear interest at the rate of % per annum. We will pay interest on our 2029 Notes and our 2039 Notes in arrears on each and , commencing on , 2019 to the persons in whose names the Notes are registered at the close of business on the fifteenth day preceding the respective interest payment date. The 2029 Notes will mature on , 2029 and the 2039 Notes will mature on , 2039. Each series of Notes may be redeemed at any time prior to the applicable Par Call Date (as set forth in the table below), as a whole or in part, at our option, at any time and from time to time on at least 30 days’, but not more than 60 days’, prior notice mailed (or otherwise transmitted in accordance with DTC procedures) to the registered address of each holder of the Notes of such series to be redeemed. The redemption price will be calculated by us and will be equal to the greater of (1) 100% of the principal amount of the Notes of such series to be redeemed or (2) the sum of the present values of the Remaining Scheduled Payments (as defined below) discounted to the redemption date, on a semiannual basis (assuming a 360-day year consisting of twelve 30-day months), at a rate equal to the sum of the Treasury Rate (as defined below) plus the applicable Make-Whole Spread (as set forth in the table below). In the case of each of clauses (1) and (2), accrued but unpaid interest will be payable to the redemption date. At any time on or after the applicable Par Call Date (as set forth in the table below), the Notes may be redeemed, as a whole or in part, at our option, at any time and from time to time on at least 30 days’, but not more than 60 days’, prior notice mailed (or otherwise transmitted in accordance with DTC procedures) to the registered address of each holder of the Notes of such series to be redeemed, at a redemption price equal to 100% of the principal amount of the Notes to be redeemed. Accrued interest will be payable to the redemption date. 2029 Notes. “Treasury Rate” means, with respect to any redemption date for the Notes, the rate per annum equal to the semiannual equivalent yield to maturity or interpolation (on a day count basis) of the interpolated Comparable Treasury Issue, assuming a price for the Comparable Treasury Issue (expressed as a percentage of its principal amount) equal to the Comparable Treasury Price for such redemption date, as determined by AT&T or an Independent Investment Banker appointed by AT&T. “Comparable Treasury Issue” means the United States Treasury security or securities selected by an Independent Investment Banker as having an actual or interpolated maturity comparable to the remaining term of the Notes of that series to be redeemed that would be utilized, at the time of selection and in accordance with customary financial practice, in pricing new issues of corporate debt securities of a comparable maturity to the remaining term of such Notes. “Independent Investment Banker” means one of the Reference Treasury Dealers, appointed by AT&T. “Comparable Treasury Price” means, with respect to any redemption date for a series of the Notes, (1) the average of the Reference Treasury Dealer Quotations for such redemption date after excluding the highest and lowest of such Reference Treasury Dealer Quotations, or (2) if AT&T obtains fewer than three such Reference Treasury Dealer Quotations, the average of all such quotations. “Reference Treasury Dealer Quotations” means, with respect to each Reference Treasury Dealer and any redemption date for a series of the Notes, the average, as determined by AT&T, of the bid and asked prices for the Comparable Treasury Issue (expressed in each case as a percentage of its principal amount) quoted in writing to AT&T by such Reference Treasury Dealer at 3:30 p.m., New York City time, on the third business day preceding such redemption date. “Reference Treasury Dealer” means each of BNP Paribas Securities Corp., Goldman Sachs & Co. LLC, Morgan Stanley & Co. LLC, Wells Fargo Securities, LLC and their respective affiliates and, at the option of AT&T, one other nationally recognized investment banking firm that is a primary U.S. Government Securities dealer in the United States (a “Primary Treasury Dealer”); provided, however, that if any of the foregoing shall cease to be a Primary Treasury Dealer, AT&T will substitute therefor another Primary Treasury Dealer. “Remaining Scheduled Payments” means, with respect to each Note of a series to be redeemed, the remaining scheduled payments of principal of and interest on such Notes that would be due after the related redemption date but for the redemption. If that redemption date is not an interest payment date with respect to the applicable series of Notes, the amount of the next succeeding scheduled interest payment on the Notes will be reduced by the amount of interest accrued on the Notes to the redemption date. On and after the redemption date, interest will cease to accrue on the Notes or any portion of the Notes called for redemption, unless we default in the payment of the redemption price and accrued interest. On or before the redemption date, we will deposit with our paying agent or the trustee money sufficient to pay the redemption price of and accrued interest on the Notes to be redeemed on that date. In the case of any partial redemption, selection of the Notes of a series to be redeemed will be made in accordance with applicable procedures of DTC. Form and Title The Notes of each series will be issued in the form of one or more fully registered global notes which will be deposited with, or on behalf of, The Depository Trust Company, known as DTC, as the depositary, and registered in the name of Cede & Co., DTC’s nominee. Beneficial interests in the global notes will be represented through book-entry accounts of financial institutions acting on behalf of beneficial owners as direct and indirect participants in DTC. Investors may elect to hold interests in the global notes through either DTC (in the United States), Clearstream Banking S.A., which we refer to as “Clearstream Luxembourg,” or Euroclear Bank S.A./N.V., as operator of the Euroclear System (outside of the United States), if they are participants in these systems, or indirectly through organizations which are participants in these systems. Clearstream Luxembourg and Euroclear will hold interests on behalf of their participants through customers’ securities accounts in Clearstream Luxembourg’s and Euroclear’s names on the books of their respective depositaries, which in turn will hold these interests in customers’ securities accounts in the names of their respective U.S. depositaries on the books of DTC. Citibank, N.A. will act as the U.S. depositary for Clearstream Luxembourg, and JPMorgan Chase Bank, N.A. will act as the U.S. depositary for Euroclear. Except under circumstances described below, the Notes will not be issuable in definitive form. The laws of some states require that certain purchasers of securities take physical delivery of their securities in definitive form. These limits and laws may impair the ability to transfer beneficial interests in the global notes. So long as the depositary or its nominee is the registered owner of the global notes, the depositary or its nominee will be considered the sole owner or holder of the Notes represented by the global notes for all purposes under the indenture. Except as provided below, owners of beneficial interests in the global notes will not be entitled to have the Notes represented by the global notes registered in their names, will not receive or be entitled to receive physical delivery of the Notes in definitive form and will not be considered the owners or holders thereof under the indenture. Principal and interest payments on the Notes registered in the name of the depositary or its nominee will be made to the depositary or its nominee, as the case may be, as the registered owner of the global notes. None of us, the trustee, any paying agent or registrar for the Notes will have any responsibility or liability for any aspect of the records relating to or payments made on account of beneficial interests in the global notes or for maintaining, supervising or reviewing any records relating to these beneficial interests. We expect that the depositary for the Notes or its nominee, upon receipt of any payment of principal or interest, will credit the participants’ accounts with payments in amounts proportionate to their respective beneficial interests in the principal amount of the global notes as shown on the records of the depositary or its nominee. We also expect that payments by participants to owners of beneficial interest in the global notes held through these participants will be governed by standing instructions and customary practices, as is now the case with securities held for the accounts of customers in bearer form or registered in “street name,” and will be the responsibility of these participants. If the depositary is at any time unwilling or unable to continue as depositary for the global notes of a series and a successor depositary is not appointed by us within 90 days, we will issue the Notes of that series in definitive form in exchange for the global notes of that series. We will also issue the Notes in definitive form in exchange for the global notes of that series if an event of default has occurred with regard to the Notes represented by the global notes and has not been cured or waived. In addition, we may at any time and in our sole discretion determine not to have the Notes of a series represented by the global notes and, in that event, will issue the Notes of that series in definitive form in exchange for the global notes. In any such instance, an owner of a beneficial interest in the global notes will be entitled to physical delivery in definitive form of the Notes represented by the global notes equal in principal amount to such beneficial interest and to have such Notes registered in its name. The Notes so issued in definitive form will be issued as registered in minimum denominations of $2,000 and integral multiples of $1,000 thereafter, unless otherwise specified by us. Our definitive form of the Notes can be transferred by presentation for registration to the registrar at its New York office and must be duly endorsed by the holder or his attorney duly authorized in writing, or accompanied by a written instrument or instruments of transfer in form satisfactory to us or the trustee duly executed by the holder or his attorney duly authorized in writing. We may require payment of a sum sufficient to cover any tax or other governmental charge that may be imposed in connection with any exchange or registration of transfer of definitive notes. The Clearing Systems DTC. The depositary has advised us as follows: the depositary is a limited-purpose trust company organized under the New York Banking Law, a “banking organization” within the meaning of the New York Banking Law, a member of the Federal Reserve System, a “clearing corporation” within the meaning of the New York Uniform Commercial Code, and a “clearing agency” registered pursuant to the provisions of Section 17A of the Exchange Act. The depositary holds securities deposited with it by its participants and facilitates the settlement of transactions among its participants in such securities through electronic computerized book-entry changes in accounts of the participants, thereby eliminating the need for physical movement of securities certificates. The depositary’s participants include securities brokers and dealers (including the underwriters), banks, trust companies, clearing corporations and certain other organizations, some of whom (and/or their representatives) own the depositary. Access to the depositary’s book-entry system is also available to others, such as banks, brokers, dealers and trust companies that clear through or maintain a custodial relationship with a participant, either directly or indirectly. According to the depositary, the foregoing information with respect to the depositary has been provided to the financial community for informational purposes only and is not intended to serve as a representation, warranty or contract modification of any kind. Clearstream Luxembourg. Clearstream Luxembourg advises that it is incorporated under the laws of Luxembourg as a professional depositary. Clearstream Luxembourg holds securities for its participating organizations and facilitates the clearance and settlement of securities transactions between Clearstream Luxembourg participants through electronic book-entry changes in accounts of Clearstream Luxembourg participants, thereby eliminating the need for physical movement of certificates. Clearstream Luxembourg provides to Clearstream Luxembourg participants, among other things, services for safekeeping, administration, clearance and settlement of internationally traded securities and securities lending and borrowing. Clearstream Luxembourg interfaces with domestic markets in several countries. As a professional depositary, Clearstream Luxembourg is subject to regulation by the Luxembourg Monetary Institute. Clearstream Luxembourg participants are recognized financial institutions around the world, including underwriters, securities brokers and dealers, banks, trust companies, clearing corporations and certain other organizations and may include the underwriters. Indirect access to Clearstream Luxembourg is also available to others, such as banks, brokers, dealers and trust companies that clear through or maintain a custodial relationship with a Clearstream Luxembourg participant either directly or indirectly. Distributions with respect to each series of the Notes held beneficially through Clearstream Luxembourg will be credited to cash accounts of Clearstream Luxembourg participants in accordance with its rules and procedures, to the extent received by the U.S. depositary for Clearstream Luxembourg. Euroclear. Euroclear has advised that it was created in 1968 to hold securities for its participants and to clear and settle transactions between Euroclear participants through simultaneous electronic book-entry delivery against payment, eliminating the need for physical movement of certificates and eliminating any risk from lack of simultaneous transfers of securities and cash. Euroclear provides various other services, including securities lending and borrowing and interfaces with domestic markets in several countries. The Euroclear System is owned by Euroclear Clearance System Public Limited Company (ECSplc) and operated through a license agreement by Euroclear Bank S.A./N.V., a bank incorporated under the laws of the Kingdom of Belgium as the “Euroclear operator.” The Euroclear operator holds securities and book-entry interests in securities for participating organizations and facilitates the clearance and settlement of securities transactions between Euroclear participants, and between Euroclear participants and participants of certain other securities intermediaries through electronic book-entry changes in accounts of such participants or other securities intermediaries. The Euroclear operator provides Euroclear participants, among other things, with safekeeping, administration, clearance and settlement, securities lending and borrowing, and related services. Non-participants of Euroclear may hold and transfer book-entry interests in the securities through accounts with a direct participant of Euroclear or any other securities intermediary that holds a book-entry interest in the securities through one or more securities intermediaries standing between such other securities intermediary and the Euroclear operator. The Euroclear operator is regulated and examined by the Belgian Banking and Finance Commission and the National Bank of Belgium. Securities clearance accounts and cash accounts with the Euroclear operator are governed by the “Terms and Conditions Governing Use of Euroclear” and the related operating procedures of the Euroclear System, and applicable Belgian law, which are collectively referred to as the “terms and conditions.” The terms and conditions govern transfers of notes and cash within Euroclear, withdrawals of notes and cash from Euroclear, and receipts of payments with respect to notes in Euroclear. All notes in Euroclear are held on a fungible basis without attribution of specific certificates to specific securities clearance accounts. The Euroclear operator acts under the terms and conditions only on behalf of Euroclear participants, and has no record of or relationship with persons holding through Euroclear participants. Distributions with respect to each series of the Notes held beneficially through Euroclear will be credited to the cash accounts of Euroclear participants in accordance with the terms and conditions, to the extent received by the U.S. depositary for Euroclear. Global Clearance and Settlement Procedures Initial settlement for the Notes will be made in same-day U.S. dollar funds. Secondary market trading between DTC participants will occur in the ordinary way in accordance with DTC rules. Secondary market trading between Clearstream Luxembourg participants and/or Euroclear participants will occur in the ordinary way in accordance with the applicable rules and operating procedures of Clearstream Luxembourg and Euroclear and will be settled using the procedures applicable to conventional eurobonds. Cross-market transfers between persons holding directly or indirectly through DTC participants, on the one hand, and directly or indirectly through Clearstream Luxembourg or Euroclear participants, on the other hand, will be effected in DTC in accordance with DTC rules on behalf of the relevant international clearing system by its U.S. depositary. However, cross-market transactions will require delivery of instructions to the relevant international clearing system by the counterparty in that system in accordance with its rules and procedures and within its established deadlines (European time). The relevant international clearing system will, if a transaction meets its settlement requirements, deliver instructions to its U.S. depositary to take action to effect final settlement on its behalf by delivering or receiving securities in DTC. Clearstream Luxembourg participants and Euroclear participants may not deliver instructions directly to the respective U.S. depositary. Because of time-zone differences, credits of notes received in Clearstream Luxembourg or Euroclear as a result of a transaction with a DTC participant will be made during subsequent securities settlement processing and dated the business day following the DTC settlement date. These credits or any transactions in the Notes settled during the processing will be reported to the relevant Clearstream Luxembourg or Euroclear participants on that business day. Cash received in Clearstream Luxembourg or Euroclear as a result of sales of Notes by or through a Clearstream Luxembourg participant or a Euroclear participant to a DTC participant will be received with value on the DTC settlement date but will be available in the relevant Clearstream Luxembourg or Euroclear cash account only as of the business day following settlement in DTC. Although it is expected that DTC, Clearstream Luxembourg and Euroclear will follow the foregoing procedures in order to facilitate transfers of Notes among participants of DTC, Clearstream Luxembourg and Euroclear, they are under no obligation to perform or continue such procedures and such procedures may be changed or discontinued at any time. Payment of Additional Amounts We will, subject to the exceptions and limitations set forth below, pay as additional interest on the Notes such additional amounts as are necessary so that the net payment by us or our paying agent of the principal of and interest on the Notes to a person that is a United States Alien, after deduction for any present or future tax, assessment or governmental charge of the United States or a political subdivision or taxing authority thereof or therein, imposed by withholding with respect to the payment, will not be less than the amount that would have been payable in respect of the Notes had no withholding or deduction been required. As used herein, “United States Alien” means any person who, for United States federal income tax purposes, is a foreign corporation, a non-resident alien individual, a non-resident alien fiduciary of a foreign estate or trust, or a foreign partnership one or more of the members of which is, for United States federal income tax purposes, a foreign corporation, a non-resident alien individual or a non-resident alien fiduciary of a foreign estate or trust. Our obligation to pay additional amounts shall not apply: (1) to any tax, assessment or governmental charge that is imposed or withheld solely because the beneficial owner, or a fiduciary, settlor, beneficiary or member of the beneficial owner if the beneficial owner is an estate, trust or partnership, or a person holding a power over an estate or trust administered by a fiduciary holder: (a) is or was present or engaged in a trade or business in the United States, has or had a permanent establishment in the United States, or has any other present or former connection with the United States or any political subdivision or taxing authority thereof or therein; (b) is or was a citizen or resident or is or was treated as a resident of the United States; (c) is or was a foreign or domestic personal holding company, a passive foreign investment company or a controlled foreign corporation with respect to the United States or is or was a corporation that has accumulated earnings to avoid United States federal income tax; (d) is or was a bank receiving interest described in Section 881(c)(3)(A) of the Internal Revenue Code of 1986, as amended (the “Code”); or (e) is or was an actual or constructive owner of 10% or more of the total combined voting power of all classes of stock of AT&T entitled to vote; (2) to any holder that is not the sole beneficial owner of the Notes, or a portion thereof, or that is a fiduciary or partnership, but only to the extent that the beneficial owner, a beneficiary or settlor with respect to the fiduciary, or a member of the partnership would not have been entitled to the payment of an additional amount had such beneficial owner, beneficiary, settlor or member received directly its beneficial or distributive share of the payment; (3) to any tax, assessment or governmental charge that is imposed or withheld solely because the beneficial owner or any other person failed to comply with certification, identification or information reporting requirements concerning the nationality, residence, identity or connection with the United States of the holder or beneficial owner of the Notes, if compliance is required by statute, by regulation of the United States Treasury Department or by an applicable income tax treaty to which the United States is a party as a precondition to exemption from such tax, assessment or other governmental charge; (4) to any tax, assessment or governmental charge that is imposed other than by deduction or withholding by AT&T or a paying agent from the payment; (5) to any tax, assessment or governmental charge that is imposed or withheld solely because of a change in law, regulation, or administrative or judicial interpretation that is announced or becomes effective after the day on which the payment becomes due or is duly provided for, whichever occurs later; (6) to an estate, inheritance, gift, sales, excise, transfer, wealth or personal property tax or any similar tax, assessment or governmental charge; (7) to any tax, assessment or other governmental charge any paying agent (which term may include us) must withhold from any payment of principal of or interest on any Note, if such payment can be made without such withholding by any other paying agent; or (8) in the case of any combination of the above items. In addition, any amounts to be paid on the Notes will be paid net of any deduction or withholding imposed or required pursuant to Sections 1471 through 1474 of the Code, any current or future regulations or official interpretations thereof, any agreement entered into pursuant to Section 1471(b) of the Code, or any fiscal or regulatory legislation, rules or practices adopted pursuant to any intergovernmental agreement entered into in connection with the implementation of such Sections of the Code, and no additional amounts will be required to be paid on account of any such deduction or withholding. The Notes are subject in all cases to any tax, fiscal or other law or regulation or administrative or judicial interpretation applicable. Except as specifically provided under this heading “— Payment of Additional Amounts” and under the heading “— Redemption Upon a Tax Event,” we do not have to make any payment with respect to any tax, assessment or governmental charge imposed by any government or a political subdivision or taxing authority. Any reference in the terms of the Notes of each series to any amounts in respect of the Notes shall be deemed also to refer to any additional amounts which may be payable under this provision. Redemption Upon a Tax Event If (a) we become or will become obligated to pay additional amounts with respect to any Notes as described herein under the heading “— Payment of Additional Amounts” as a result of any change in, or amendment to, the laws (or any regulations or rulings promulgated thereunder) of the United States (or any political subdivision or taxing authority thereof or therein), or any change in, or amendments to, any official position regarding the application or interpretation of such laws, regulations or rulings, which change or amendment is announced or becomes effective, on or after , 2019 or (b) a taxing authority of the United States takes an action on or after , 2019, whether or not with respect to us or any of our affiliates, that results in a substantial probability that we will or may be required to pay such additional amounts, then we may, at our option, redeem, as a whole, but not in part, the applicable series of Notes on any interest payment date on not less than 30 nor more than 60 calendar days’ prior notice, at a redemption price equal to 100% of their principal amount, together with interest accrued thereon to the date fixed for redemption. No redemption pursuant to (b) above may be made unless we shall have received an opinion of independent counsel to the effect that an act taken by a taxing authority of the United States results in a substantial probability that we will or may be required to pay the additional amounts described herein under the heading “— Payment of Additional Amounts” and we shall have delivered to the trustee a certificate, signed by a duly authorized officer, stating that based on such opinion we are entitled to redeem the Notes pursuant to their terms. Further Issues We may from time to time, without notice to or the consent of the holders of any series of the Notes, create and issue further notes ranking equally and ratably with such series in all respects, or in all respects except for the payment of interest accruing prior to the issue date or except for the first payment of interest following the issue date of those further notes. Any further notes will have the same terms as to status, redemption or otherwise as, and will be fungible for United States federal income tax purposes with, the Notes of the applicable series. Any further notes shall be issued pursuant to a resolution of our board of directors, a supplement to the indenture, or under an officers’ certificate pursuant to the indenture. Notices to holders of the Notes will be given only to the depositary, in accordance with its applicable policies as in effect from time to time. Prescription Period Any money that we deposit with the trustee or any paying agent for the payment of principal or any interest on any global note of any series that remains unclaimed for two years after the date upon which the principal and interest are due and payable will be repaid to us upon our request unless otherwise required by mandatory provisions of any applicable unclaimed property law. After that time, unless otherwise required by mandatory provisions of any unclaimed property law, the holder of the global note will be able to seek any payment to which that holder may be entitled to collect only from us. The Notes will be governed by and interpreted in accordance with the laws of the State of New York. This section describes the material United States federal income tax consequences of owning the Notes we are offering. It applies to you only if you acquire Notes in the offering and you hold your Notes as capital assets for tax purposes. This section does not apply to you if you are a member of a class of holders subject to special rules, such as: a dealer in securities, a trader in securities that elects to use a mark-to-market method of accounting for your securities holdings, a bank, a life insurance company, a tax-exempt organization, a person that owns Notes that are a hedge or that are hedged against interest rate risks, a person that owns Notes as part of a straddle or conversion transaction for tax purposes, a person that purchases or sells Notes as part of a wash sale for tax purposes, or a United States holder (as defined below) whose functional currency for tax purposes is not the U.S. dollar. This section is based on the Code, its legislative history, existing and proposed regulations under the Code, published rulings and court decisions, all as currently in effect. These laws are subject to change, possibly on a retroactive basis. If a partnership holds the Notes, the United States federal income tax treatment of a partner will generally depend on the status of the partner and the tax treatment of the partnership. A partner in a partnership holding the Notes should consult its tax advisor with regard to the United States federal income tax treatment of an investment in the Notes. Please consult your tax advisor concerning the consequences of owning these Notes, in your particular circumstances, under the Code and the laws of any other taxing jurisdiction. United States Holders This subsection describes the United States federal income tax consequences to a United States holder. You are a United States holder if you are the beneficial owner of a Note and you are: a citizen or resident of the United States, a domestic corporation, an estate whose income is subject to United States federal income tax regardless of its source, or a trust if a United States court can exercise primary supervision over the trust’s administration and one or more United States persons are authorized to control all substantial decisions of the trust. If you are not a United States holder, this subsection does not apply to you and you should refer to “— United States Alien Holders” below. Payments of Interest. You will be taxed on interest on your Note as ordinary income at the time you receive the interest or when it accrues, depending on your method of accounting for tax purposes. Original Issue Discount. The Notes may be issued with a de minimis amount of original issue discount (“OID”). While a United States holder is generally not required to include de minimis OID in income prior to the sale or maturity of the Notes, under recently enacted legislation, United States holders that maintain certain types of financial statements and that are subject to the accrual method of tax accounting may be required to include de minimis OID on the Notes in income no later than the time upon which they include such amounts in income on their financial statements. United States holders that maintain financial statements should consult their tax advisors regarding the tax consequences to them of this legislation. Additionally, if the offering price of the 2039 Notes is not greater than 95% of the principal amount of the 2039 Notes, the 2039 Notes will be treated as issued with non-de minimis OID in an amount equal to the excess of the principal amount of the 2039 Notes over the offering price for the 2039 Notes. In such case, you will be required to include such OID in ordinary income on a constant yield method over the term of the 2039 Notes. The amount of OID on a Note allocable to each accrual period (determined as described below) will be the excess of (i) the “adjusted issue price” (as defined below) of the Note at the beginning of the accrual period multiplied by the “yield to maturity” (as defined below) of such Note over (ii) the interest payments on the Note in that period. The “adjusted issue price” of a Note at the beginning of any accrual period generally will be the sum of the offering price for the Note and the amount of OID allocable to all prior accrual periods.. The “yield to maturity” of a Note will be the discount rate (appropriately adjusted to reflect the length of accrual periods) that causes the present value of all payments on the Note to equal the offering price of the Note. Accrual periods may be of any length and may vary in length over the term of the Notes, provided that no accrual period is longer than one year and each scheduled payment of principal or interest occurs on either the final day or the first day of an accrual period. Purchase, Sale and Retirement of the Notes. Your tax basis in your Note will generally be its cost plus any OID that has accrued on the Note. You will generally recognize capital gain or loss on the sale or retirement of your Note equal to the difference between the amount you realize on the sale or retirement, excluding any amounts attributable to accrued but unpaid interest (which will be treated as interest payments), and your tax basis in your Note. Capital gain of a noncorporate United States holder is generally taxed at preferential rates where the holder has a holding period greater than one year. Medicare Tax. A United States holder that is an individual or estate, or a trust that does not fall into a special class of trusts that is exempt from such tax, is subject to a 3.8% tax on the lesser of (1) the United States holder’s “net investment income” (or “undistributed net investment income” in the case of an estate or trust) for the relevant taxable year and (2) the excess of the United States holder’s modified adjusted gross income for the taxable year over a certain threshold (which in the case of individuals is between $125,000 and $250,000, depending on the individual’s circumstances). A United States holder’s net investment income generally includes its interest income (including OID) and its net gains from the disposition of Notes, unless such interest income or net gains are derived in the ordinary course of the conduct of a trade or business (other than a trade or business that consists of certain passive or trading activities). If you are a United States holder that is an individual, estate or trust, you are urged to consult your tax advisors regarding the applicability of the Medicare tax to your income and gains in respect of your investment in the Notes. United States Alien Holders This subsection describes the United States federal income tax consequences to a United States alien holder. You are a United States alien holder if you are the beneficial owner of a Note and you are, for United States federal income tax purposes: a nonresident alien individual, a foreign corporation, or an estate or trust that in either case is not subject to United States federal income tax on a net income basis on income or gain from a Note. If you are a United States holder, this subsection does not apply to you. Under United States federal income and estate tax law, and subject to the discussions of backup withholding and FATCA below, if you are a United States alien holder of a Note: we and other United States payors generally will not be required to deduct United States withholding tax from payments of principal and interest (including OID) to you if, in the case of payments of interest: 1. you do not actually or constructively own 10% or more of the total combined voting power of all classes of our stock entitled to vote, 2. you are not a controlled foreign corporation that is related to us through stock ownership, and 3. the United States payor does not have actual knowledge or reason to know that you are a United States person and: a. you have furnished to the United States payor an Internal Revenue Service Form W-8BEN or Internal Revenue Service Form W-8BEN-E or an acceptable substitute form upon which you certify, under penalties of perjury, that you are a non-United States person, b. in the case of payments made outside the United States to you at an offshore account (generally, an account maintained by you at a bank or other financial institution at any location outside the United States), you have furnished to the United States payor documentation that establishes your identity and your status as the beneficial owner of the payment for United States federal income tax purposes and as a non-United States person, c. the United States payor has received a withholding certificate (furnished on an appropriate Internal Revenue Service Form W-8 or an acceptable substitute form) from a person claiming to be: i. a withholding foreign partnership (generally a foreign partnership that has entered into an agreement with the Internal Revenue Service to assume primary withholding responsibility with respect to distributions and guaranteed payments it makes to its partners), ii. a qualified intermediary (generally a non-United States financial institution or clearing organization or a non-United States branch or office of a United States financial institution or clearing organization that is a party to a withholding agreement with the Internal Revenue Service), or iii. a United States branch of a non-United States bank or of a non-United States insurance company, and the withholding foreign partnership, qualified intermediary or United States branch has received documentation upon which it may rely to treat the payment as made to a non-United States person that is, for United States federal income tax purposes, the beneficial owner of the payment on the Notes in accordance with U.S. Treasury regulations (or, in the case of a qualified intermediary, in accordance with its agreement with the Internal Revenue Service), d. the United States payor receives a statement from a securities clearing organization, bank or other financial institution that holds customers’ securities in the ordinary course of its trade or business, i. certifying to the United States payor under penalties of perjury that an Internal Revenue Service Form W-8BEN or Internal Revenue Service Form W-8BEN-E or an acceptable substitute form has been received from you by it or by a similar financial institution between it and you, and ii. to which is attached a copy of the Internal Revenue Service Form W-8BEN or Internal Revenue Service Form W-8BEN-E or acceptable substitute form, or e. the United States payor otherwise possesses documentation upon which it may rely to treat the payment as made to a non-United States person that is, for United States federal income tax purposes, the beneficial owner of the payment on the Notes in accordance with U.S. Treasury regulations; and no deduction for any United States federal withholding tax will be made from any gain that you realize on the sale or exchange of your Note. Further, a Note held by an individual who at death is not a citizen or resident of the United States will not be includible in the individual’s gross estate for United States federal estate tax purposes if: the decedent did not actually or constructively own 10% or more of the total combined voting power of all classes of our stock entitled to vote at the time of death and the income on the Note would not have been effectively connected with a United States trade or business of the decedent at the same time. FATCA Withholding A 30% withholding tax (“FATCA withholding”) may be imposed on certain payments to you or to certain foreign financial institutions, investment funds and other non-U.S. persons receiving payments on your behalf if you or such persons fail to comply with certain information reporting requirements. Payments of interest (including OID) that you receive in respect of the Notes could be affected by this withholding if you are subject to the FATCA information reporting requirements and fail to comply with them or if you hold such Notes through a non-U.S. person (e.g., a foreign bank or broker) that fails to comply with these requirements (even if payments to you would not otherwise have been subject to FATCA withholding). You should consult your own tax advisors regarding the relevant U.S. law and other official guidance on FATCA withholding. We will not pay any additional amounts in respect of FATCA withholding, so if this withholding applies, you will receive significantly less than the amount that you would have otherwise received with respect to your Notes. Depending on your circumstances, you may be entitled to a refund or credit in respect of some or all of this withholding. However, even if you are entitled to have any such withholding refunded, the required procedures could be cumbersome and significantly delay the holder’s receipt of any amounts withheld. Backup Withholding and Information Reporting In general, if you are a noncorporate United States holder, we and other payors are required to report to the Internal Revenue Service all payments of principal and interest (including OID) on your Note. In addition, we and other payors are required to report to the Internal Revenue Service any payment of proceeds of the sale of your Note before maturity within the United States. Additionally, backup withholding will apply to any payments if you fail to provide an accurate taxpayer identification number, or (in the case of interest payments) you are notified by the Internal Revenue Service that you have failed to report all interest and dividends required to be shown on your federal income tax returns. In general, if you are a United States alien holder, payments of principal or interest made by us and other payors to you will not be subject to backup withholding and information reporting, provided that the certification requirements described above under “— United States Alien Holders” are satisfied or you otherwise establish an exemption. However, we and other payors are required to report payments of interest on your Notes on Internal Revenue Service Form 1042-S even if the payments are not otherwise subject to information reporting requirements. In addition, payment of the proceeds from the sale of Notes effected at a United States office of a broker will not be subject to backup withholding and information reporting provided that: the payor or broker does not have actual knowledge or reason to know that you are a United States person and you have furnished to the payor or broker: 1. an appropriate Internal Revenue Service Form W-8 or an acceptable substitute form upon which you certify, under penalties of perjury, that you are not a United States person, or 2. other documentation upon which it may rely to treat the payment as made to a non-United States person in accordance with U.S. Treasury regulations; or you otherwise establish an exemption. If you fail to establish an exemption and the broker does not possess adequate documentation of your status as a non-United States person, the payments may be subject to information reporting and backup withholding. However, backup withholding will not apply with respect to payments made to an offshore account maintained by you unless the broker has actual knowledge that you are a United States person. In general, payment of the proceeds from the sale of Notes effected at a foreign office of a broker will not be subject to information reporting or backup withholding. However, a sale effected at a foreign office of a broker will be subject to information reporting and backup withholding if: the proceeds are transferred to an account maintained by you in the United States, the payment of proceeds or the confirmation of the sale is mailed to you at a United States address, or the sale has some other specified connection with the United States as provided in U.S. Treasury regulations, unless the broker does not have actual knowledge or reason to know that you are a United States person and the documentation requirements described above (relating to a sale of Notes effected at a United States office of a broker) are met or you otherwise establish an exemption. In addition, payment of the proceeds from the sale of Notes effected at a foreign office of a broker will be subject to information reporting if the broker is: a United States person, a controlled foreign corporation for United States tax purposes, a foreign person 50% or more of whose gross income is effectively connected with the conduct of a United States trade or business for a specified three-year period, or a foreign partnership, if at any time during its tax year: 1. one or more of its partners are “U.S. persons”, as defined in U.S. Treasury regulations, who in the aggregate hold more than 50% of the income or capital interest in the partnership, or 2. such foreign partnership is engaged in the conduct of a United States trade or business, unless the broker does not have actual knowledge or reason to know that you are a United States person and the documentation requirements described above (relating to a sale of Notes effected at a United States office of a broker) are met or you otherwise establish an exemption. Backup withholding will apply if the sale is subject to information reporting and the broker has actual knowledge that you are a United States person. We and the underwriters for the offering named below have entered into an underwriting agreement with respect to the Notes. Subject to certain conditions, each underwriter has agreed, severally and not jointly, to purchase the principal amount of the Notes indicated in the following table. BNP Paribas Securities Corp., Goldman Sachs & Co. LLC, Morgan Stanley & Co. LLC and Wells Fargo Securities, LLC are the representatives of the underwriters. Principal Amount of the 2029 Notes Principal Amount of the BNP Paribas Securities Corp. U.S.$ U.S.$ Goldman Sachs & Co. LLC Morgan Stanley & Co. LLC Wells Fargo Securities, LLC The underwriters have agreed to take and pay for all of the Notes being offered, if any are taken. Notes sold by the underwriters to the public will initially be offered at the initial public offering prices set forth on the cover of this prospectus supplement. Any Notes sold by the underwriters to securities dealers may be sold at a discount from the initial public offering price of the principal amount of the Notes (as set forth in the table below). Any such securities dealers may resell any Notes purchased from the underwriters to certain other brokers or dealers at a discount from the initial public offering price of the principal amount of the Notes (as set forth in the table below). Discount to Securities Dealers Discount to Other Brokers or Dealers If all the Notes are not sold at the initial public offering price, the underwriters may change the offering price and the other selling terms. The offering of the Notes by the underwriters is subject to receipt and acceptance and subject to the underwriters’ right to reject any order in whole or in part. The following table shows the underwriting discount that we are to pay to the underwriters in connection with this offering (expressed as a percentage of the principal amount of each series of the Notes). Paid by AT&T Per 2029 Note The Notes are new issues of securities with no established trading market. We do not intend to apply for listing of the Notes on any securities exchange or for inclusion of the Notes on any automated dealer quotation system. We have been advised by the underwriters that they may make a market in the Notes after completion of the offering. However, they are under no obligation to do so and may discontinue any market-making activities at any time without any notice. We cannot assure the liquidity of the trading market for the Notes or that an active public market for the Notes will develop. If an active public trading market for the Notes does not develop, the market price and liquidity of the Notes may be adversely affected. If the Notes are traded, they may trade at a discount from their initial public offering price, depending on the prevailing interest rates, the market for similar securities, our operating performance and financial condition, general economic conditions and other factors. It is expected that delivery of the Notes will be made against payment therefor on or about the date specified in the last paragraph of the cover page of this prospectus supplement, which will be the third business day following the date of the pricing of the Notes. Under Rule 15c6-1 of the Securities Exchange Act of 1934, trades in the secondary market generally are required to settle in two business days, unless the parties to any such trade expressly agree otherwise. Accordingly, purchasers who wish to trade the Notes on the date of pricing will be required, by virtue of the fact that the Notes initially will settle in T+3, to specify alternative settlement arrangements to prevent a failed settlement. In connection with the offering, the underwriters may purchase and sell Notes in the open market. These transactions may include short sales, stabilizing transactions and purchases to cover positions created by short sales. Short sales involve the sale by the underwriters of a greater number of Notes than they are required to purchase in the offering. Stabilizing transactions consist of certain bids or purchases made for the purpose of preventing or retarding a decline in the market price of the Notes while the offering is in progress. The underwriters also may impose a penalty bid. This occurs when a particular underwriter repays to the underwriters a portion of the underwriting discount received by it because the representatives have repurchased Notes sold by or for the account of such underwriter in stabilizing or short covering transactions. These activities by the underwriters may stabilize, maintain or otherwise affect the market price of the Notes. As a result, the price of the Notes may be higher than the price that otherwise might exist in the open market. However, neither we nor the underwriters make any representations or predictions as to the direction or magnitude of any effects that the transactions described above may have on the price of the Notes. In addition, if these activities are commenced, they may be discontinued by the underwriters at any time without notice. These transactions may be effected in the over-the-counter market or otherwise. The Notes are being offered for sale in the United States and in jurisdictions outside the United States, subject to applicable law. Each of the underwriters has agreed that it will not offer, sell or deliver any of the Notes, directly or indirectly, or distribute this prospectus supplement or the accompanying prospectus or any other offering material relating to the Notes, in or from any jurisdiction except under circumstances that will to the best knowledge and belief of such underwriter result in compliance with the applicable laws and regulations thereof and which will not impose any obligations on us except as set forth in the underwriting agreement. Each underwriter has represented and agreed that it and each of its affiliates: (i) has only communicated or caused to be communicated and will only communicate or cause to be communicated an invitation or inducement to engage in investment activity (within the meaning of Section 21 of the Financial Services and Markets Act 2000 (the “FSMA”)) received by it in connection with the issue or sale of the Notes in circumstances in which Section 21(1) of the FSMA does not apply to AT&T; and (ii) has complied and will comply with all applicable provisions of the FSMA with respect to anything done by it in relation to the Notes in, from or otherwise involving the United Kingdom. Without limitation to the other restrictions referred to herein, this prospectus supplement is directed only at (1) persons outside the United Kingdom, (2) persons having professional experience in matters relating to investments who fall within the definition of “investment professionals” in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “Order”) or (3) high net worth companies and other persons to whom it may lawfully be communicated, falling within Articles 49(2)(a) to (d) of the Order (all such persons together being referred to as “Relevant Persons”). Without limitation to the other restrictions referred to herein, any investment or investment activity to which this prospectus supplement relates is available only to, and will be engaged in only with, Relevant Persons. Any person who is not a Relevant Person may not act or rely on this prospectus supplement or any of its contents. Each underwriter has represented and agreed that it has not offered, sold or otherwise made available and will not offer, sell or otherwise make available any Notes to any retail investor in the EEA. For the purposes of this provision: the expression “retail investor” means a person who is one (or more) of the following: a retail client as defined in point (11) of Article 4(1) of MiFID II; a customer within the meaning of the Insurance Distribution Directive, where that customer would not qualify as a professional client as defined in point (10) of Article 4(1) of MiFID II; or not a qualified investor as defined in the Prospectus Directive; and the expression “offer” includes the communication in any form and by any means of sufficient information on the terms of the offer and the Notes to be offered so as to enable an investor to decide to purchase or subscribe for the Notes. This prospectus supplement and the accompanying prospectus have been prepared on the basis that any offer of Notes in any Member State of the EEA will be made pursuant to an exemption under the Prospectus Directive from the requirement to publish a prospectus for offers of Notes. This prospectus supplement and the accompanying prospectus are not a prospectus for the purposes of the Prospectus Directive. The Notes may not be offered or sold by means of any document other than to persons whose ordinary business is to buy or sell shares or debentures, whether as principal or agent, or in circumstances which do not constitute an offer to the public within the meaning of the Companies Ordinance (Cap. 32) of Hong Kong, and no advertisement, invitation or document relating to the Notes may be issued, whether in Hong Kong or elsewhere, which is directed at, or the contents of which are likely to be accessed or read by, the public in Hong Kong (except if permitted to do so under the securities laws of Hong Kong) other than with respect to Notes which are or are intended to be disposed of only to persons outside Hong Kong or only to “professional investors” within the meaning of the Securities and Futures Ordinance (Cap. 571) of Hong Kong and any rules made thereunder. The Notes have not been and will not be registered under the Securities and Exchange Law of Japan, and each of the underwriters and each of its affiliates has represented and agreed that it has not offered or sold, and it will not offer or sell, directly or indirectly, any of the Notes in or to residents of Japan or to any persons for reoffering or resale, directly or indirectly in Japan or to any resident of Japan, except pursuant to any exemption from the registration requirements of the Securities and Exchange Law available thereunder and in compliance with the other relevant laws and regulations of Japan. This prospectus supplement has not been registered as a prospectus with the Monetary Authority of Singapore. Accordingly, this prospectus supplement and any other document or material in connection with the offer or sale, or invitation for subscription or purchase, of the Notes may not be circulated or distributed, nor may the Notes be offered or sold, or be made the subject of an invitation for subscription or purchase, whether directly or indirectly, to persons in Singapore other than (i) to an institutional investor under Section 274 of the Securities and Futures Act, Chapter 289 of Singapore (the “SFA”), (ii) to a relevant person, or any person pursuant to Section 257(1A), and in accordance with the conditions, specified in Section 275 of the SFA, or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Whether the Notes are subscribed or purchased under Section 275 by a relevant person which is: (a) a corporation (which is not an accredited investor) the sole business of which is to hold investments and the entire share capital of which is owned by one or more individuals, each of whom is an accredited investor; or (b) a trust (where the trustee is not an accredited investor) whose sole purpose is to hold investments and each beneficiary is an accredited investor, shares, debentures, and units of shares and debentures of that corporation or the beneficiaries’ rights and interest in that trust shall not be transferable for six months after that corporation or that trust has acquired the Notes under Section 275 except: (1) to an institutional investor under Section 274 of the SFA or to a relevant person, or any person pursuant to Section 275(1A), and in accordance with the conditions, specified in Section 275 of the SFA; (2) where no consideration is given for the transfer; or (3) by operation of law. We estimate that our share of the total expenses of the offering and other expenses, excluding underwriting discounts, will be approximately $ . The underwriters have agreed to reimburse these expenses in connection with this offering. We have agreed to indemnify the several underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended. Certain of the underwriters and their respective affiliates have, from time to time, performed, and may in the future perform, various financial advisory and investment banking services for us, for which they received or will receive customary fees and expenses. In addition, in the ordinary course of their business activities, the underwriters and their affiliates may make or hold a broad array of investments and actively trade debt and equity securities (or related derivative securities) and financial instruments (including bank loans) for their own account and for the accounts of their customers. Such investments and securities activities may involve securities and/or instruments of ours or our affiliates. Certain of the underwriters or their affiliates that have a lending relationship with us routinely hedge, and certain other of those underwriters or their affiliates may hedge, their credit exposure to us consistent with their customary risk management policies. Typically, such underwriters and their affiliates would hedge such exposure by entering into transactions which consist of either the purchase of credit default swaps or the creation of short positions in our securities, including potentially the Notes offered hereby. Any such credit default swaps or short positions could adversely affect future trading prices of the Notes offered hereby. The underwriters and their affiliates may also make investment recommendations and/or publish or express independent research views in respect of such securities or financial instruments and may hold, or recommend to clients that they acquire, long and/or short positions in such securities and instruments. Certain of the underwriters (through certain of their affiliates) are lenders under the JPM Tranche A Facility and we will repay outstanding amounts owed to them under the JPM Tranche A Facility, and certain of the underwriters (through certain of their affiliates) are holders of senior notes issued by AT&T and/or one or more of its subsidiaries which we will redeem or repay, in each case using the proceeds from this offering, as discussed under “Use of Proceeds” above. Mr. Wayne A. Wirtz, Vice President — Associate General Counsel and Assistant Secretary of AT&T, is passing upon the validity of the Notes for us. Sullivan & Cromwell LLP, New York, New York, is passing upon the validity of the Notes for the underwriters. Sullivan & Cromwell LLP from time to time performs legal services for us. Depositary Shares AT&T Inc. (“AT&T”) from time to time may offer to sell debt securities, preferred stock, either separately or represented by depositary shares, and common stock. The debt securities and preferred stock may be convertible into or exercisable or exchangeable for common or preferred stock of the Company or debt or equity securities of one or more other entities. The common stock of the Company is listed on the New York Stock Exchange and trades under the ticker symbol “T”. The Company may offer and sell these securities to or through one or more underwriters, dealers and agents, or directly to purchasers, on a continuous or delayed basis. See “Plan of Distribution” for a further description of the manner in which we may dispose of the securities covered by this prospectus. This prospectus describes some of the general terms that may apply to these securities. The specific terms of any securities to be offered will be described in a supplement to this prospectus. This prospectus may not be used to offer or sell securities unless accompanied by a prospectus supplement describing the method and terms of the applicable offering. You should carefully read this prospectus and the applicable prospectus supplement, together with the documents incorporated by reference herein and therein, before making an investment decision. Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense. Prospectus dated February 25, 2016. AT&T Inc. is a holding company whose subsidiaries and affiliates operate in the communications and digital entertainment services industry. Our subsidiaries and affiliates provide services and equipment that deliver voice, video and broadband services both domestically and internationally. Our principal executive offices are located at One AT&T Plaza, 208 S. Akard St., Dallas, Texas 75202. Our telephone number is (210) 821-4105. We maintain an Internet site at the following location: http://www.att.com (this website address is for information only and is not intended to be an active link or to incorporate any website information into this document). Unless otherwise specified in the prospectus supplement, we will use the proceeds from the sale of the securities to provide funds for general corporate purposes, among other things. We may use this prospectus to offer from time to time: Senior debt securities. These debt securities may be convertible or exchangeable into preferred stock, depositary shares, common stock or equity securities of a third-party issuer. They will be unsecured and will rank equally with all of our other unsubordinated and unsecured debt. Preferred stock, par value $1.00 per share. The preferred stock may be convertible or exchangeable into other series of preferred stock, including depositary shares, common stock or equity securities of a third- party issuer. We can offer different series of preferred stock with different dividend, liquidation, redemption and voting rights. Depositary shares. We have the option of issuing depositary shares that would represent a fraction of a share of preferred stock. Common stock, par value $1.00 per share. In the case of securities that are exchangeable for securities of a third-party issuer, the applicable prospectus supplement will give you more information about this issuer, the terms of its securities and the document in which they are described. Our securities include securities denominated in U.S. dollars, but we can choose to issue securities in any other currency, including the Euro. The applicable prospectus supplement will describe the specific types, amounts, prices and detailed terms of any of these securities. The applicable prospectus supplement may also contain information, where applicable, about material U.S. federal income tax considerations relating to, and any securities exchange listing of, securities covered by such prospectus supplement. As required by U.S. federal law for all bonds and notes of companies that are publicly offered, our debt securities will be governed by a document called the indenture. The indenture is a contract between us and The Bank of New York Mellon Trust Company, N.A., a national banking association, which acts as trustee for you. The trustee has two main roles: First, the trustee can enforce your rights against us if we default. There are some limitations on the extent to which the trustee acts on your behalf, described later under “— Default and Related Matters — Remedies if an Event of Default Occurs”. Second, the trustee performs administrative duties for us, such as sending you interest payments, transferring your securities to new buyers and sending you notices. Unless otherwise indicated in a prospectus supplement, The Bank of New York Mellon Trust Company, N.A. will perform these administrative duties. We may issue as many distinct series of securities under the indenture as we wish. This section summarizes terms of the securities that are common to all series. Most of the financial terms and other specific terms of your series will be described in the applicable prospectus supplement which will be attached to the front of this prospectus. Those terms may vary from the terms described here. The prospectus supplement may also describe special federal income tax consequences of the debt securities. This Section Is Only a Summary This section and your prospectus supplement summarize all the material terms of the indenture and your debt securities. They do not, however, describe every aspect of the indenture and your debt securities. The indenture and its associated documents, including your debt securities, contain the full text of the matters described in this section and your prospectus supplement. The indenture and the debt securities are governed by New York law. A copy of the indenture has been filed with the Securities and Exchange Commission, or SEC, as part of our registration statement. See “Where You Can Find More Information” below for information on how to obtain a copy. Section references in the description that follows relate to the indenture. Legal Ownership of Debt Securities We can issue debt securities in registered or bearer form, or both, or in the form of one or more global securities. We refer to those who have debt securities registered in their own names on the books that we or our agent maintain for this purpose, or who hold bearer certificates representing bearer debt securities, as the “holders” of those debt securities. These persons are the legal holders of the debt securities. We refer to those who, indirectly through others, own beneficial interests in debt securities that are not registered in their own names as “indirect holders” of those debt securities. As we discuss below, indirect holders are not legal holders, and investors in debt securities issued in book-entry form or in street name will be indirect holders. Book-Entry Holders We may issue debt securities in book-entry form only, as we will specify in the applicable prospectus supplement. This means debt securities may be represented by one or more global securities registered in the name of a financial institution that holds them as depositary on behalf of other financial institutions that participate in the depositary’s book-entry system. These participating institutions, in turn, hold beneficial interests in the debt securities on behalf of themselves or their customers. For registered debt securities, only the person in whose name a debt security is registered is recognized under the indenture as the holder of that debt security. Debt securities issued in global form will be issued in the form of a global security registered in the name of the depositary or its participants. Consequently, for debt securities issued in global form, we will recognize only the depositary as the holder of the debt securities and we will make all payments on the debt securities to the depositary. The depositary passes along the payments it receives to its participants, which in turn pass the payments along to their customers who are the beneficial owners. The depositary and its participants do so under agreements they have made with one another or with their customers; they are not obligated to do so under the terms of the debt securities. As a result, investors in a book-entry security will not own debt securities directly. Instead, they will own beneficial interests in a global security, through a bank, broker or other financial institution that participates in the depositary’s book-entry system or holds an interest through a participant. As long as the debt securities are issued in global form, investors will be indirect holders, and not holders, of the debt securities. Street Name Holders In the future we may terminate a global security or issue debt securities initially in non-global form. In these cases, investors may choose to hold their debt securities in their own names or in “street name”. Debt securities held by an investor in street name would be registered in the name of a bank, broker or other financial institution that the investor chooses, and the investor would hold only a beneficial interest in those debt securities through an account he or she maintains at that institution. For debt securities held in street name, we will recognize only the intermediary banks, brokers and other financial institutions in whose names the debt securities are registered as the holders of those debt securities and we will make all payments on those debt securities to them. These institutions pass along the payments they receive to their customers who are the beneficial owners, but only because they agree to do so in their customer agreements or because they are legally required to do so; they are not obligated to do so under the terms of the debt securities. Investors who hold debt securities in street name will be indirect holders, not holders, of those debt securities. Legal Holders Our obligations, as well as the obligations of the trustee and those of any third parties employed by us or the trustee, run only to the legal holders of the debt securities. We do not have obligations to investors who hold beneficial interests in global securities, in street name or by any other indirect means. This will be the case whether an investor chooses to be an indirect holder of a debt security or has no choice because we are issuing the debt securities only in global form. For example, once we make a payment or give a notice to the holder, we have no further responsibility for the payment or notice even if that holder is required, under agreements with depositary participants or customers or by law, to pass it along to the indirect holders but does not do so. Similarly, if we want to obtain the approval of the holders for any purpose — e.g., to amend the indenture or to relieve us of the consequences of a default or of our obligation to comply with a particular provision of the indenture — we would seek approval only from the holders, and not the indirect holders, of the debt securities. Whether and how the holders contact the indirect holders is up to the holders. When we refer to you, we mean those who invest in the debt securities being offered by this prospectus, whether they are the holders or only indirect holders of those debt securities. When we refer to your debt securities, we mean the debt securities in which you hold a direct or indirect interest. Special Considerations for Holders of Bearer Debt Securities We will offer debt securities in bearer form only outside of the United States to non-U.S. persons. You generally are a non-U.S. person if you are not: a citizen or resident of the United States; a corporation or partnership, including an entity treated as a corporation or partnership for United States federal income tax purposes, created or organized in or under the laws of the United States, any state of the United States or the District of Columbia; an estate the income of which is subject to United States federal income taxation regardless of its source; or a trust if a court within the United States is able to exercise primary supervision of the administration of the trust and one or more United States persons have the authority to control all substantial decisions of the trust. In addition, we may offer bearer securities to offices of some U.S. financial institutions who have offices located outside the United States. We will describe any special restrictions on the offer, sale and delivery of bearer debt securities and any special federal income tax considerations applicable to bearer debt securities in the prospectus supplement. Special Considerations for Indirect Holders If you hold debt securities through a bank, broker or other financial institution, either in book-entry form or in street name, you should check with your own institution to find out: how it handles securities payments and notices; whether it imposes fees or charges; how it would handle a request for the holders’ consent, if ever required; whether and how you can instruct it to send you debt securities registered in your own name so you can be a holder, if that is permitted in the future; how it would exercise rights under the debt securities if there were a default or other event triggering the need for holders to act to protect their interests; and if the debt securities are in book-entry form, how the depositary’s rules and procedures will affect these matters. What Is a Global Security? A global security is a security that represents one or more debt securities and is held by a depositary. Generally, all debt securities represented by the same global securities will have the same terms. Each debt security issued in book-entry form will be represented by a global security that we deposit with and register in the name of a financial institution that we select or its nominees. The financial institution that we select for this purpose is called the depositary. Unless we specify otherwise in the applicable prospectus supplement, The Depository Trust Company, New York, New York, known as DTC, will be the depositary for all debt securities issued in book-entry form. A global security may not be transferred to or registered in the name of anyone other than the depositary, its nominee or a successor depositary, unless special termination situations arise. We describe those situations below under “— Special Situations When a Global Security Will Be Terminated”. As a result of these arrangements, the depositary, or its nominee, will be the sole registered owner and holder of all debt securities represented by a global security, and investors will be permitted to own only beneficial interests in a global security. Beneficial interests must be held by means of an account with a broker, bank or other financial institution that in turn has an account with the depositary or with another institution that does. Thus, an investor whose security is represented by a global security will not be a holder of the debt security, but only an indirect holder of a beneficial interest in the global security. If the prospectus supplement for a particular debt security indicates that the debt security will be issued in global form only, then the debt security will be represented by a global security at all times unless and until the global security is terminated. We describe the situations in which this can occur below under “— Special Situations When a Global Security Will Be Terminated”. If termination occurs, we may issue the debt securities through another book-entry clearing system or decide that the debt securities may no longer be held through any book-entry clearing system. Special Considerations for Global Securities As an indirect holder, an investor’s rights relating to a global security will be governed by the account rules of the investor’s financial institution and of the depositary, as well as general laws relating to securities transfers. We do not recognize this type of investor as a holder of debt securities and instead deal only with the depositary that holds the global security. If debt securities are issued only in the form of a global security, an investor should be aware of the following: An investor cannot cause the debt securities to be registered in his or her name, and cannot obtain non- global certificates for his or her interest in the debt securities, except in the special situations we describe below; An investor will be an indirect holder and must look to his or her own bank or broker for payments on the debt securities and protection of his or her legal rights relating to the debt securities, as we describe under “— Legal Ownership of Debt Securities” above; An investor may not be able to sell interests in the debt securities to some insurance companies and to other institutions that are required by law to own their securities in non-book-entry form; An investor may not be able to pledge his or her interest in a global security in circumstances where certificates representing the debt securities must be delivered to the lender or other beneficiary of the pledge in order for the pledge to be effective; The depositary’s policies, which may change from time to time, will govern payments, transfers, exchanges and other matters relating to an investor’s interest in a global security. We and the trustee have no responsibility for any aspect of the depositary’s actions or for its records of ownership interests in a global security. We and the trustee also do not supervise the depositary in any way; The depositary may (and we understand that DTC will) require that those who purchase and sell interests in a global security within its book-entry system use immediately available funds and your broker or bank may require you to do so as well; and Financial institutions that participate in the depositary’s book-entry system, and through which an investor holds its interest in a global security, may also have their own policies affecting payments, notices and other matters relating to the debt securities. There may be more than one financial intermediary in the chain of ownership for an investor. We do not monitor and are not responsible for the actions of any of those intermediaries. Special Situations When a Global Security Will Be Terminated In a few special situations described below, the global security will terminate and interests in it will be exchanged for physical certificates representing those interests. After that exchange, the choice of whether to hold securities directly or in street name will be up to the investor. Investors must consult their own bank or brokers to find out how to have their interests in securities transferred to their own name, so that they will be direct holders. We have described the rights of holders and street name investors above under “— Legal Ownership of Debt Securities”. The global security will terminate when the following special situations occur: if the depositary notifies us that it is unwilling, unable or no longer qualified to continue as depositary for that global security and we do not appoint another institution to act as depositary within 90 days; if we notify the trustee that we wish to terminate that global security; or if an event of default has occurred with regard to debt securities represented by that global security and has not been cured or waived. We discuss defaults later under “— Default and Related Matters”. The prospectus supplement may also list additional situations for terminating a global security that would apply only to the particular series of securities covered by the prospectus supplement. When a global security terminates, the depositary — and not we or the trustee — is responsible for deciding the names of the institutions that will be the initial direct holders. (Sections 2.08(f) and (g)) In the remainder of this section, “you” means direct holders and not “street name” or other indirect holders of securities, including holders of any securities that we issue as global securities. Indirect holders should read the previous subsection entitled “Legal Ownership of Debt Securities”. Overview of Remainder of This Section The remainder of this section summarizes: Additional mechanics relevant to the securities under normal circumstances, such as how you transfer ownership and where we make payments; Your rights under several special situations, such as if we merge with another company, or if we want to change a term of the securities; and Your rights if we default or experience other financial difficulties. Additional Mechanics Form, Exchange and Transfer The securities will be issued: in fully registered or in unregistered (bearer) form, or as global securities as described above; and in denominations that are even multiples of $1,000 (Section 2.02(a)(8)), provided, however, that the securities will be issued in minimum denominations of $2,000 and integral multiples of $1,000 thereafter if so required by the securities exchange on which such securities are listed or traded or as we may otherwise determine. You may have your securities broken into more securities of smaller denominations (but not into denominations smaller than any minimum denomination applicable to the securities) or combined into fewer securities of larger denominations, as long as the total principal amount is not changed. This is called an “exchange.” (Section 2.08(a)) If you are holding bearer securities and it is permitted by the terms of your series of debt securities, you may exchange bearer debt securities for an equal amount of registered or bearer debt securities of the same series and date of maturity. No bearer debt securities will be exchanged for registered securities if in doing so we would suffer adverse consequences under any U.S. law applicable to the exchange. Registered debt securities may not be exchanged for bearer debt securities. You may exchange or transfer your securities at the office of the registrar. The registrar acts as our agent for registering securities in the names of holders and for transferring and exchanging securities, as well as maintaining the list of registered holders. The paying agent acts as the agent for paying interest, principal and any other amounts on securities and for exchanging securities. We have appointed The Bank of New York Mellon Trust Company, N.A. to perform the roles of registrar and paying agent. We may change these appointments to another entity or perform them ourselves. In order to exchange bearer securities, you have to deliver them to a paying agent outside the United States, together with all unmatured coupons for interest and all matured coupons in default. (Section 2.08(b)) We can designate additional registrars or paying agents, acceptable to the trustee, and they would be named in the prospectus supplement. We may cancel the designation of any particular registrar or paying agent. We may also approve a change in the office through which any registrar or paying agent acts. We must maintain a registrar and paying agent office in the Borough of Manhattan in New York City. If at any time we do not maintain a registrar or paying agent, the trustee will act as such. (Section 2.04) There is no charge for exchanges and transfers. You will not be required to pay a service charge to transfer or exchange securities, but you may be required to pay for any tax or other governmental charge associated with the exchange or transfer. The transfer or exchange will only be made if the registrar is satisfied with your proof of ownership. (Section 2.08) At certain times, you may not be able to transfer or exchange your securities. If we redeem any series of securities, or any part of any series, then we may prevent you from transferring or exchanging these securities. We may do this during the period beginning 15 days before the day we mail the notice of redemption and ending on the day of that mailing, in order to freeze the list of holders so we can prepare the mailing. We may also refuse to register transfers or exchanges of securities selected for redemption, except that we will continue to permit transfers and exchanges of the unredeemed portion of any security being partially redeemed. (Section 2.08(d)) Replacing Your Lost or Destroyed Certificates If you bring a mutilated certificate or coupon to the trustee, we will issue a new certificate or coupon to you in exchange for the mutilated one. Please note that the trustee may have additional requirements that you must meet in order to do this. (Section 2.09) If you claim that a certificate or coupon has been lost, completely destroyed, or wrongfully taken from you, then the trustee will give you a replacement certificate or coupon if you meet the trustee’s requirements. Also, we may require you to provide reasonable security or indemnity to protect us from any loss we may incur from replacing your certificates or coupons. We may also charge you for our expenses in replacing your security. (Section 2.09) Payment and Paying Agents We will pay interest to you if you are a direct holder listed in the registrar’s records at the close of business on a particular day in advance of each due date for interest, even if you no longer own the security on the interest due date. That particular day, usually about two weeks in advance of the interest due date, is called the “record date” and is stated in the prospectus supplement. (Section 2.05) Holders buying and selling securities must work out between them how to compensate for the fact that we will pay all the interest for an interest period to the one who is the registered holder on the record date. The most common manner is to adjust the sales price of the securities to prorate interest fairly between buyer and seller. This prorated interest amount is called “accrued interest.” We will pay interest, principal and any other money due on the securities at the corporate trust office of the trustee in New York City. That office is currently located at The Bank of New York Mellon Trust Company, N.A., c/o The Bank of New York Mellon, 101 Barclay Street, 4 W, New York, New York 10286, Attention: Corporate Trust Administration. You must make arrangements to have your payments picked up at or wired from that office. We may also choose to pay interest by mailing checks. (Section 2.05) “Street Name” and other indirect holders should consult their banks or brokers for information on how they will receive payments. We may also arrange for additional payment offices, and may cancel or change these offices, including our use of the trustee’s corporate trust office. These offices are called “paying agents”. We may also choose to act as our own paying agent. We must notify you if we change the paying agents for any particular series of securities. (Section 2.04) Payment of Bearer Securities We will only pay interest on bearer debt securities when you present and surrender the coupons for the interest installments evidenced by the bearer securities as they mature. You have to present your coupons at a paying agency of AT&T located outside of the United States. We will maintain a non-U.S. paying agent for two years after the principal of a series of bearer debt securities has become due. We will continue to maintain the paying agent after that period, if it is necessary to comply with U.S. tax law or regulations. We will provide the paying agent with the necessary funds for payment upon reasonable notice. We generally will not make any payments in the United States. However, if payment outside of the United States is illegal or precluded by exchange controls or similar restrictions in a foreign country, we may instruct the trustee to make payments at a paying agent located in the United States. (Section 2.05(c)) You can prove your ownership of a bearer security by presenting the actual security, or a certificate or affidavit executed by the person holding the bearer security or executed by a depositary with whom the bearer securities were deposited, if the trustee is satisfied with the certificate or affidavit. (Section 2.07(b)) We and the trustee will send notices regarding the securities only to direct holders, using their addresses as listed in the trustee’s records. (Section 10.02) Regardless of who acts as paying agent, all money we forward to a paying agent that remains unclaimed will, at our request, be repaid to us at the end of two years after the amount was due to the direct holder. After that two-year period, you may look only to us for payment and not to the trustee, any other paying agent or anyone else. (Section 8.03) Mergers and Similar Transactions We are generally permitted to consolidate or merge with another company. We are also permitted to sell substantially all of our assets to another company. However, we may not take any of these actions unless all the following conditions are met: Where we merge out of existence or sell our assets, the other company may not be organized under the laws of a foreign country. It must be a corporation organized under the laws of a State or the District of Columbia or under federal law. The company we merge into or sell to must agree to be legally responsible for our debt securities. The merger, sale of assets or other transaction must not cause a default on the securities, and we must not already be in default, unless the merger or other transaction would cure the default. For purposes of this no-default test, a default would include an event of default that has occurred and not been cured, as described below under “— Default and Related Matters — Events of Default — What Is an Event of Default?” A default for this purpose would also include any event that would be an event of default if the requirements for giving us default notice or our default having to exist for a specific period of time were disregarded. (Section 5.01) Further, we may buy substantially all of the assets of another company without complying with any of the foregoing conditions. Modification and Waiver of Your Contractual Rights Under certain circumstances, we can make changes to the indenture and the securities. Some types of changes require the approval of each security holder affected, some require approval by a majority vote, and some changes do not require any approval at all. (Sections 9.01-9.06) Changes Requiring Your Approval. First, there are changes that cannot be made to your securities without your specific approval. Following is a list of those types of changes: to reduce the percentage of holders of securities who must consent to a waiver or amendment of the indenture; to reduce the rate of interest on any security or change the time for payment of interest; to reduce the principal due on any security or change the fixed maturity of any security; to waive a default in the payment of principal or interest on any security; to change the currency of payment on a security, unless the security provides for payment in a currency that ceases to exist; in the case of convertible or exchangeable securities, to make changes to your conversion or exchange rights that would be adverse to your interests; to change the right of holders to waive an existing default by majority vote; to reduce the amount of principal or interest payable to you following a default or change your conversion or exchange rights, or impair your right to sue for payment; and to make any change to this list of changes that requires your specific approval. (Section 9.02(a)) Changes Requiring a Majority Vote. The second type of change to the indenture and the securities is the kind that requires a vote in favor by security holders owning a majority of the principal amount of the particular series affected. Most changes fall into this category, except as set forth in the following paragraph. The same vote would be required for us to obtain a waiver of an existing default. However, we cannot obtain a waiver of a payment default unless we obtain your individual consent to the waiver. (Section 9.02(a)) Changes Not Requiring Your Approval. The third type of change does not require any vote by holders of securities. This type includes, among others, clarifications of ambiguous contract terms, changes to make securities payable in U.S. dollars (if the stated denomination ceases to exist) and other changes that would not materially adversely affect holders of the securities. (Section 9.01) Further Details Concerning Voting. When taking a vote, we will use the following rules to decide how much principal amount to attribute to a security: For original issue discount securities, we will use the principal amount that would be due and payable on the voting date if the maturity of the securities were accelerated to that date because of a default. For securities denominated in one or more foreign currencies or currency units, we will use the U.S. dollar equivalent determined on the date of original issuance of these securities. Securities will not be considered outstanding, and therefore not eligible to vote, if we have deposited or set aside in trust for you money for their payment or redemption. A security does not cease to be outstanding because we or an affiliate of us is holding the security. (Section 2.10) We will generally be entitled to set any day as a record date for the purpose of determining the holders of outstanding securities that are entitled to vote or take other action under the indenture. However, the indenture does not oblige us to fix any record date at all. If we set a record date for a vote or other action to be taken by holders of a particular series, that vote or action may be taken only by persons who are holders of outstanding securities of that series on the record date and must be taken within 90 days following the record date. (Section 9.02(b)) “Street Name” and other indirect holders, including holders of any securities issued as global securities, should consult their banks or brokers for information on how approval may be granted or denied if we seek to change the indenture or the securities or request a waiver. Discharge of Our Obligations We can fully discharge ourselves from any payment or other obligations on the securities of any series if we make a deposit for you with the trustee. The deposit must be held in trust for your benefit and the benefit of all other direct holders of the securities and must be a combination of money and U.S. government or U.S. government agency notes or bonds that will generate enough cash to make interest, principal and any other payments on the securities on their various due dates. However, we cannot discharge ourselves from the obligations under any convertible or exchangeable securities, unless we provide for it in the terms of these securities and the prospectus supplement. If we accomplish full discharge, as described above, you will have to rely solely on the trust deposit for repayment of the securities. You could not look to us for repayment in the unlikely event of any shortfall. Conversely, the trust deposit would most likely be protected from claims of our lenders and other creditors if we ever become bankrupt or insolvent. We will indemnify the trustee and you against any tax, fee or other charge imposed on the U.S. government obligations we deposited with the trustee or against the principal and interest received on these obligations. (Sections 8.01-8.04) We May Choose to Redeem Your Securities We may be able to pay off your securities before their normal maturity. If we have this right with respect to your specific securities, the right will be mentioned in the prospectus supplement. It will also specify when we can exercise this right and how much we will have to pay in order to redeem your securities. If we choose to redeem your securities, we will mail written notice to you not less than 30 days prior to redemption, and not more than 60 days prior to redemption. Also, you may be prevented from exchanging or transferring your securities when they are subject to redemption, as described under “— Form, Exchange and Transfer” above. (Article 3) Liens on Assets The indenture does not restrict us from pledging or otherwise encumbering any of our assets and those of our subsidiaries. Default and Related Matters Ranking Compared to Other Creditors The securities are not secured by any of our property or assets. Accordingly, your ownership of securities means you are one of our unsecured creditors. The securities are not subordinated to any of our other debt obligations and therefore they rank equally with all our other unsecured and unsubordinated indebtedness. However, the trustee has a right to receive payment for its administrative services prior to any payment to security holders after a default. Events of Default You will have special rights if an event of default occurs and is not cured, as described later in this subsection. What Is an Event of Default? The term “event of default” with respect to any series of securities means any of the following: We fail to make any interest payment on a security when it is due, and we do not cure this default within 90 days. We fail to make any payment of principal when it is due at the maturity of any security or upon redemption. We fail to comply with any of our other agreements regarding a particular series of securities or with a supplemental indenture, and after we have been notified of the default by the trustee or holders of 25% in principal amount of the series, we do not cure the default within 90 days. We file for bankruptcy, or other events in bankruptcy, insolvency or reorganization occur. Any other event of default described in the prospectus supplement occurs. Remedies if an Event of Default Occurs You and the trustee will have the following remedies if an event of default occurs: Acceleration. If an event of default has occurred and has not been cured or waived, then the trustee or the holders of 25% in principal amount of the securities of the affected series may declare the entire principal amount of and any accrued interest on all the securities of that series to be due and immediately payable. An acceleration of maturity may be cancelled by the holders of at least a majority in principal amount of the securities of the affected series, if all events of default have been cured or waived. (Section 6.02) Special Duties of Trustee. If an event of default occurs, the trustee will have some special duties. In that situation, the trustee will be obligated to use those of its rights and powers under the indenture, and to use the same degree of care and skill in doing so, that a prudent person would use in that situation in conducting his or her own affairs. (Section 7.01) Other Remedies of Trustee. If an event of default occurs, the trustee is authorized to pursue any available remedy to collect defaulted principal and interest and to enforce other provisions of the securities and the indenture, including bringing a lawsuit. (Section 6.03) Majority Holders May Direct the Trustee to Take Actions to Protect Their Interests. The trustee is not required to take any action under the indenture at the request of any holders unless the holders offer the trustee reasonable protection from expenses and liability. This is called an “indemnity”. If the trustee is provided with an indemnity reasonably satisfactory to it, the holders of a majority in principal amount of the relevant series of debt securities may direct the time, method and place of conducting any lawsuit or other formal legal action seeking any remedy available to the trustee. These majority holders may also direct the trustee in performing any other action under the indenture. (Section 6.05) Individual Actions You May Take if the Trustee Fails to Act. Before you bypass the trustee and bring your own lawsuit or other formal legal action or take other steps to enforce your rights or protect your interests relating to the securities, the following must occur: You must give the trustee written notice that an event of default has occurred and remains uncured. The holders of 25% in principal amount of all outstanding securities of the relevant series must make a written request that the trustee take action because of the default, and must offer indemnity reasonably satisfactory to the trustee against the cost and other liabilities of taking that action. The trustee must not have taken action for 60 days after receipt of the above notice and offer of indemnity. During the 60-day period, the holders of a majority in principal amount of the securities of that series do not give the trustee a direction inconsistent with the request. (Section 6.06) However, you are entitled at any time to bring an individual lawsuit for the payment of the money due on your security on or after its due date. (Section 6.07) Waiver of Default The holders of a majority in principal amount of the relevant series of debt securities may waive a default for all the relevant series of debt securities. If this happens, the default will be treated as if it had not occurred. No one can waive a payment default on your debt security, however, without your individual approval. (Section 6.04) We Will Give the Trustee Information About Defaults Annually Every year we will give to the trustee a written statement of one of our officers certifying that to the best of his or her knowledge we are in compliance with the indenture and the debt securities, or else specifying any default. (Section 4.03) The trustee may withhold from you notice of any uncured default, except for payment defaults, if it determines that withholding notice is in your interest. (Section 7.05) “Street name” and other indirect holders should consult their banks or brokers for information on how to give notice or direction to or make a request of the trustee and how to make or cancel a declaration of acceleration. Original Issue Discount Securities The debt securities may be issued as original issue discount securities, which will be offered and sold at a substantial discount from their principal amount. Only a discounted amount will be due and payable when the trustee declares the acceleration of the maturity of these debt securities after an event of default has occurred and continues, as described under “— Remedies if an Event of Default Occurs” above. Conversion of Convertible Debt Securities Your debt securities may be convertible into our preferred stock, including depositary shares representing preferred stock, or common stock, or they may be exchangeable for equity securities of another issuer if the prospectus supplement so provides. If your debt securities are convertible or exchangeable, the prospectus supplement will include provisions as to whether conversion or exchange is mandatory, at your option or at our option. The prospectus supplement would also include provisions regarding the adjustment of the number of shares of common stock or other securities you will receive upon conversion or exchange. In addition, the prospectus supplement will contain the conversion price or exchange price and mechanisms for adjusting this price. In the case of exchangeable debt securities, the prospectus supplement will set forth information about the issuer for whose securities you would exchange your debt, or where that information can be found. We may not adjust the exchange or conversion price Unless it is specified in the prospectus supplement, we will not adjust the exchange or conversion price of your debt securities for interest on your securities or for any dividends payable on the new securities you will receive. However, if you convert or exchange your securities between a regular record date for the payment of interest and the next following interest payment date, you must include funds equal to the interest that would be payable on your securities on this following interest payment date. We are not required to issue fractional shares of preferred stock, depositary shares or common stock, but, unless we otherwise specify in the prospectus supplement, we will pay you a cash adjustment calculated on the basis of the following: for debt securities convertible into preferred stock or depositary shares, the liquidation preference of the series of preferred stock; for common stock, the market value of the common stock; and for exchangeable debt securities, the market value of the securities for which you will exchange your securities. Regarding the Trustee We maintain banking relationships in the ordinary course of business with the trustee. The trustee is also the trustee under indentures with certain of our subsidiaries. The following briefly summarizes the material terms of our preferred stock other than pricing and related terms which will be disclosed in the applicable prospectus supplement. You should read the particular terms of any series of preferred stock we offer, which will be described in more detail in the applicable prospectus supplement relating to that series. The applicable prospectus supplement will also state whether any of the terms summarized below do not apply to the series of preferred stock being offered. In addition, for each series of preferred stock, we will file a certificate of designations containing the specific terms of the series as an exhibit to the registration statement or we will incorporate it by reference before we issue any preferred stock. We are authorized to issue up to 10,000,000 shares of preferred stock, par value $1.00 per share. As of December 31, 2015, no shares of preferred stock were outstanding. Under our restated certificate of incorporation, our board of directors is authorized to issue shares of preferred stock in one or more series. To establish a series of preferred stock, our board must set the following terms: the number of shares to be included in the series; the designation, powers, preferences and rights of the shares of the series; the qualifications, limitations or restrictions of the series; and the variations, if any, as between each series. Before we issue any series of preferred stock, our board of directors will adopt resolutions creating and designating the series as a series of preferred stock. Stockholders will not need to approve these resolutions. Terms Contained in Prospectus Supplement A prospectus supplement will contain the dividend, liquidation, redemption and voting rights of a series of preferred stock. The prospectus supplement will describe the following terms of a series of preferred stock: the designation and stated value per share of the preferred stock and the number of shares offered; the amount of liquidation preference per share; the initial public offering price at which we will issue the preferred stock; the dividend rate or method of calculation, the payment dates for dividends and the dates from which dividends will start to cumulate; any redemption or sinking fund provisions; any conversion or exchange rights; whether we have elected to offer depositary shares, as described below under “Description of Depositary Shares”; and any additional voting, dividend, liquidation, redemption, sinking fund and other rights or restrictions. No Preemptive Rights The holders of preferred stock will have no preemptive rights to buy any additional shares. The preferred stock will be, when issued, fully paid and nonassessable. Neither the par value nor the liquidation preference can show you the price at which the preferred stock will actually trade on or after the date of issuance. The applicable prospectus supplement will describe some of the U.S. federal income tax consequences of the purchase and ownership of the series of preferred stock. We may offer depositary shares evidenced by depositary receipts. Each depositary receipt represents a fraction of a share of the particular series of preferred stock issued and deposited with a depositary. The fraction of a share of preferred stock which each depositary share represents will be set forth in the applicable prospectus supplement relating to those depositary shares. We will describe the transfer agent for each series of preferred stock in the applicable prospectus supplement. Description of Depositary Shares The following briefly summarizes the material provisions of the deposit agreement and of the depositary shares and depositary receipts, other than pricing and related terms disclosed in the accompanying prospectus supplement. You should read the particular terms of any depositary shares and any depositary receipts that we offer. You should also read the deposit agreement relating to the particular series of preferred stock and the more detailed description of the deposit agreement in the prospectus supplement. The prospectus supplement will also state whether any of the generalized provisions summarized below do not apply to the depositary shares or depositary receipts being offered. We will deposit the shares of any series of preferred stock represented by depositary shares according to the provisions of a deposit agreement between us and a bank or trust company which we will select as our preferred stock depositary. The depositary must have its principal office in the United States and have a combined capital and surplus of at least $50,000,000. Each owner of a depositary share will be entitled to all the rights and preferences of the underlying preferred stock in proportion to the applicable fraction of a share of preferred stock represented by the depositary share. These rights include dividend, voting, redemption, conversion and liquidation rights. The depositary will send you all reports and communications which we will deliver to the depositary and which we have to furnish to you. The following is a summary of the deposit agreement. For more complete information, you should read the entire agreement and the depositary receipt. Directions on how to obtain copies of these are provided under “Where You Can Find More Information” below. Depositary Receipts The depositary shares will be evidenced by depositary receipts issued pursuant to the deposit agreement. Depositary receipts will be distributed to anyone who is buying the fractional shares of preferred stock in accordance with the terms of the applicable prospectus supplement. We will either file the forms of deposit agreement and depositary receipt as exhibits to the registration statement of which this prospectus is a part, or we will incorporate them by reference into that registration statement. While definitive engraved depositary receipts (certificates) are being prepared, we may instruct the depositary to issue temporary depositary receipts, which will entitle you to all the rights of the definitive depositary receipts and be substantially in the same form. The depositary will prepare definitive depositary receipts without unreasonable delay, and we will pay for the exchange of your temporary depositary receipts for definitive depositary receipts. Withdrawal of Preferred Stock You may receive the number of whole shares of your series of preferred stock and any money or other property represented by those depositary receipts after surrendering the depositary receipts at the corporate trust office of the depositary. Partial shares of preferred stock will not be issued. If the depositary shares which you surrender exceed the number of depositary shares that represent the number of whole shares of preferred stock you wish to withdraw, then the depositary will deliver to you at the same time a new depositary receipt evidencing the excess number of depositary shares. Once you have withdrawn your preferred stock, you will not be entitled to re-deposit that preferred stock under the deposit agreement in order to receive depositary shares. We do not expect that there will be any public trading market for withdrawn shares of preferred stock. Dividends and Other Distributions The depositary has agreed to pay to you the cash dividends or other cash distributions it receives on preferred stock, after deducting its fees and expenses. You will receive these distributions in proportion to the number of depositary shares you own. The depositary will distribute only whole U.S. dollars and cents. The depositary will add any fractional cents not distributed to the next sum received for distribution to record holders of depositary shares. In the event of a non-cash distribution, the depositary will distribute property to the record holders of depositary shares entitled to it, unless the depositary determines that it is not feasible to make such a distribution, in which case the depositary may, with our approval, sell the property and distribute the net proceeds from the sale to the holders. Redemption of Depositary Shares If we redeem a series of preferred stock represented by depositary shares, then we will give the necessary proceeds to the depositary. The depositary will then redeem the depositary shares using the funds it received from us for the preferred shares. The depositary will notify the record holders of the depositary shares to be redeemed not less than 30 nor more than 60 days before the date fixed for redemption at the holders’ addresses appearing in the depositary’s books. The redemption price per depositary share will be equal to the applicable fraction of the redemption price payable per share for the applicable series of the preferred stock. Whenever we redeem shares of preferred stock held by the depositary, the depositary will redeem the depositary shares representing the shares of preferred stock on the same day. If fewer than all the depositary shares of a series are to be redeemed, the depositary shares will be selected by lot or ratably as the depositary will decide. After the date fixed for redemption, the depositary shares called for redemption will no longer be considered outstanding. Therefore, all your rights as holders of the depositary shares will cease, except that you will still be entitled to receive any cash payable upon the redemption and any money or other property to which you were entitled at the time of redemption. Voting the Preferred Stock How do you vote? The depositary will notify you of any upcoming vote and arrange to deliver our voting materials to you, if you are a holder of record at that time. The record date for determining if you are a holder of depositary shares is the same as the record date for the preferred stock. The materials you will receive will (1) describe the matters that are being submitted to a vote and (2) explain how you, on a certain date, may instruct the depositary to vote the shares underlying your depositary receipts as you direct. For instructions to be valid, the depositary must receive them on or before the date specified. The depositary will try, as far as practical, to vote the shares as you instruct. We agree to do anything the depositary asks us to do in order to enable it to vote as you instruct. If you do not instruct the depositary how to vote your shares, the depositary will abstain from voting those shares. Conversion or Exchange What happens when we convert preferred stock into other securities, or exchange it for securities of another company? The depositary will convert or exchange all your depositary shares on the same day that the preferred stock underlying your depositary receipts is converted or exchanged. In order for the depositary to do so, we will need to deposit the other stock, common stock or other securities into which the preferred stock is to be converted or for which it will be exchanged. The exchange or conversion rate per depositary share will be equal to: the exchange or conversion rate per share of preferred stock, multiplied by the fraction of a share of preferred stock represented by one depositary share, plus all money and any other property represented by the depositary shares, and including all amounts paid by us for dividends that have accrued on the preferred stock on the exchange or conversion date and that have not yet been paid. The following are some more terms of conversions and exchanges that you should keep in mind: The depositary shares, as such, cannot be converted or exchanged into other preferred stock, common stock, securities of another issuer or any other securities or property of us. Nevertheless, if so specified in the applicable prospectus supplement, you may be able to surrender the depositary receipts to the depositary with written instructions asking the depositary to instruct us to convert the preferred stock represented by the depositary shares into other shares of preferred stock or common stock of us or to exchange the preferred stock for securities of another issuer. If you have this right, we have agreed that we will cause the conversion or exchange of the preferred stock using the same procedures as we use for the delivery of preferred stock. If you are only converting part of your depositary shares represented by a depositary receipt, new depositary receipts will be issued for any depositary shares that you do not convert or exchange. Amendment and Termination of the Deposit Agreement How may the deposit agreement be amended? We may agree with the depositary to amend the deposit agreement and the form of depositary receipt without your consent at any time. However, if the amendment adds or increases fees or charges or prejudices an important right of holders, it will only become effective with the approval of holders of at least a majority of the affected depositary shares then outstanding. If an amendment becomes effective, and you continue to hold your depositary receipts, you are deemed to agree to the amendment and to be bound by the amended deposit agreement. How may the deposit agreement be terminated? The deposit agreement automatically terminates if: all outstanding depositary shares have been redeemed; each share of preferred stock has been converted into or exchanged for common stock; or a final distribution in respect of the preferred stock has been made to the holders of depositary shares in connection with our liquidation, dissolution or winding-up. We may also terminate the deposit agreement at any time we wish. If we do so, the depositary will give you notice of termination not less than 30 days before the termination date. Once you surrender your depositary receipts to the depositary, it will send you the number of whole or fractional shares of the series of preferred stock underlying your depositary receipts. Charges of Depositary and the Expenses We will pay all transfer and other taxes and governmental charges in connection with the existence of the depositary arrangements. We will pay charges of the depositary for the initial deposit of the preferred stock and any redemption. You will pay other transfer and other taxes and governmental charges and the charges that are expressly provided in the deposit agreement to be for your account. Limitations on Our Obligations and Liability to Holders of Depositary Receipts The deposit agreement expressly limits our obligations and the obligations of the depositary to you. It also limits our liability and the liability of the depositary. We and the depositary: are only obligated to take the actions specifically set forth in the deposit agreement in good faith; are not liable if either of us is prevented or delayed by law or circumstances beyond our control from performing our obligations under the deposit agreement; are not liable if either of us exercises discretion permitted under the deposit agreement; have no obligation to become involved in a lawsuit or other proceeding related to the depositary receipts or the deposit agreement on your behalf or on behalf of any other party, unless you provide us with satisfactory indemnity; and may rely upon any written advice of counsel or accountants and on any documents we believe in good faith to be genuine and to have been signed or presented by the proper party. In the deposit agreement, we and the depositary agree to indemnify each other under certain circumstances. Resignation and Removal of Depositary The depositary may resign at any time by notifying us of its election to do so. In addition, we may remove the depositary at any time. The resignation or removal will take effect when we appoint a successor depositary and it accepts the appointment. We must appoint the successor depositary within 60 days after delivery of the notice of resignation or removal and the new depositary must be a bank or trust company having its principal office in the United States and having a combined capital and surplus of at least $50,000,000. Our authorized share capital consists of 14,010,000,000 shares, of which 14,000,000,000 are common shares having a par value of $1.00 per share. As of February 23, 2016, 6,153,515,684 shares of common stock were outstanding. The common stock is listed on the New York Stock Exchange under the symbol “T”. The following briefly summarizes the provisions of our restated certificate of incorporation and our bylaws that are important for you. Both documents are incorporated by reference as exhibits to the registration statement of which this prospectus is a part, and you can obtain them as described below in “Where You Can Find More Information”. You should note that some of the provisions of our restated certificate of incorporation and our bylaws may tend to deter any potential unfriendly tender offers or other efforts to obtain control of us. At the same time, these provisions will tend to assure continuity of management and corporate policies and to induce any persons seeking control or a business combination with us to negotiate on terms acceptable to our then-elected board of directors. All outstanding shares of common stock are, and any shares of common stock offered, when issued, will be fully paid and nonassessable. We typically do not issue physical stock certificates. Instead, we record evidence of your stock ownership solely on our corporate records. However, we will issue a physical stock certificate to you if you so request. Holders of common stock do not have any conversion, redemption, preemptive or cumulative voting rights. In the event of our dissolution, liquidation or winding-up, common stockholders share ratably in any assets remaining after all creditors are paid in full, including holders of our debt securities and after the liquidation preference of holders of preferred stock has been satisfied. The transfer agent for the common stock is Computershare Trust Company NA, P.O. Box 43078, Providence, Rhode Island 02940-3078. Common stockholders are entitled to participate equally in dividends when dividends are declared by our board of directors out of funds legally available for dividends. Each holder of common stock is entitled to one vote for each share for all matters voted on by common stockholders. Holders of common stock may not cumulate their votes in the election of directors. In an election of directors, each director must be elected by the vote of the majority of the votes cast with respect to that director’s election. If a nominee for director is not elected and the nominee is an incumbent director, such incumbent director must promptly tender his or her resignation to the board of directors, subject to acceptance by the board of directors. The Corporate Governance and Nominating Committee of the board of directors (the “Corporate Governance and Nominating Committee”) will make a recommendation to the board of directors as to whether to accept or reject the tendered resignation, or whether other action should be taken. The board of directors will act on the tendered resignation, taking into account the Corporate Governance and Nominating Committee’s recommendation, and publicly disclose (by a press release, a filing with the SEC or other broadly disseminated means of communication) its decision regarding the tendered resignation and the rationale behind the decision within ninety (90) days from the date of certification of election results. The Corporate Governance and Nominating Committee in making its recommendation and the board of directors in making its decision may each consider any factors or other information that they consider appropriate and relevant. Any incumbent director who tenders his or her resignation following such failure to be elected will not participate in the recommendation of the Corporate Governance and Nominating Committee or the decision of the board of directors with respect to his or her resignation. If the number of persons properly nominated for election as directors as of the date that is 10 days before the record date for the meeting at which such vote is to be held exceeds the number of directors to be elected, then the directors shall be elected by a plurality of the votes cast. For purposes of the election of directors, a majority of votes cast shall mean that the number of shares voted “for” the election of a director exceeds the number of votes cast “against” the election of such director. Except with respect to the election of directors as described above, all other matters are determined by a majority of the votes cast, unless otherwise required by law or the certificate of incorporation for the action proposed. For these purposes, a majority of votes cast shall mean that the number of shares voted “for” a matter exceeds the number of votes cast “against” such matter. At least 40% of the shares entitled to vote at the meeting must be present in person or by proxy, in order to constitute a quorum. Our bylaws provide that all directors are required to stand for re-election every year. At any meeting of our board of directors, a majority of the total number of the directors constitutes a quorum. Action without Stockholder Meeting Our restated certificate of incorporation also requires that stockholders representing at least two-thirds of the total number of shares outstanding and entitled to vote thereon must sign a written consent for any action without a meeting of the stockholders. Advance Notice Bylaws Our bylaws establish advance notice procedures with regard to stockholder proposals relating to the nomination of candidates for election as directors or new business to be brought before meetings of our stockholders. These procedures provide that notice of such stockholder proposals must be timely given in writing to the Secretary of AT&T prior to the meeting at which the action is to be taken. Generally, to be timely, notice must be received at our principal executive offices not less than 90 days nor more than 120 days prior to the anniversary date of the annual meeting for the preceding year. The notice must contain certain information specified in the bylaws. Our bylaws permit any stockholder or group of up to twenty stockholders who have maintained continuous qualifying ownership of 3% or more of our outstanding common stock for at least the previous three years to include up to a specified number of director nominees in our proxy materials for an annual meeting of stockholders. The maximum number of stockholder nominees permitted under the proxy access provisions of our bylaws shall be the greater of two or 20% of the total number of directors of AT&T on the last day a notice of nomination may be submitted. Notice of a nomination pursuant to the proxy access provisions of our bylaws must be submitted to the Secretary of AT&T at our principal executive office no earlier than 150 days and no later than 120 days before the anniversary of the date that we mailed our proxy statement for the previous year’s annual meeting of stockholders. The notice must contain certain information specified in our bylaws. Section 203 of the General Corporation Law of the State of Delaware We are also subject to Section 203 of the General Corporation Law of the State of Delaware. Section 203 prohibits us from engaging in any business combination (as defined in Section 203) with an “interested stockholder” for a period of three years subsequent to the date on which the stockholder became an interested stockholder unless: prior to such date, our board of directors approves either the business combination or the transaction in which the stockholder became an interested stockholder; upon completion of the transaction that resulted in the stockholder becoming an interested stockholder, the interested stockholder owns at least 85% of the outstanding voting stock (with certain exclusions); or the business combination is approved by our board of directors and authorized by a vote (and not by written consent) of at least 66 2/3% of the outstanding voting stock not owned by the interested stockholder. For purposes of Section 203, an “interested stockholder” is defined as an entity or person beneficially owning 15% or more of our outstanding voting stock, based on voting power, and any entity or person affiliated with or controlling or controlled by such an entity or person. A “business combination” includes mergers, asset sales and other transactions resulting in financial benefit to a stockholder. Section 203 could prohibit or delay mergers or other takeover or change of control attempts with respect to us and, accordingly, may discourage attempts that might result in a premium over the market price for the shares held by stockholders. Such provisions may have the effect of deterring hostile takeovers or delaying changes in control of management or us. We may sell securities to purchasers directly, or through agents, dealers, or underwriters, or through a combination of any of those methods of sale. The distribution of the securities may be made from time to time in one or more transactions at a fixed price or prices, which may be changed, at market prices prevailing at the time of sale, at prices related to these prevailing market prices or at negotiated prices. The securities may be sold by us or by one or more of our subsidiaries that previously acquired the securities from us, from other of our subsidiaries, from third parties or in the open market. Any such subsidiary may be deemed to be an underwriter under the Securities Act of 1933. Through Agents We and the agents designated by us may solicit offers to purchase securities. Agents that participate in the distribution of securities may be deemed underwriters under the Securities Act of 1933. We will name any agent that will participate in the distribution of the securities, and any commission we will pay to it will be described in the applicable prospectus supplement. Any agent will be acting on a “best efforts” basis for the period of its appointment, unless we indicate differently in the applicable prospectus supplement. To Dealers The securities may be sold to a dealer as principal. The dealer may then resell the securities to the public at varying prices determined by it at the time of resale. The dealer may be deemed to be an underwriter under the Securities Act of 1933. To Underwriters The securities may also be sold to one or more underwriters and we will then execute an underwriting agreement with them at the time of sale. The names of the underwriters will be set forth in the prospectus supplement, which will be used by the underwriters to resell the securities. Convertible, Redeemable and Exchangeable Securities If we choose to offer debt securities or preferred stock that is convertible, redeemable or exchangeable into or for third-party securities, we will identify in the applicable prospectus supplement: the third-party, the third-party securities offered, all documents filed by the third-party pursuant to Section 13(a), 13(c), 14 or 15(d) of the Securities Exchange Act of 1934 since the end of the third-party’s last completed fiscal year, to the extent the third- party is subject to the periodic reporting requirements of the Exchange Act, and the document containing the description of the third-party securities. We may enter into indemnification agreements with underwriters, dealers, agents and other persons participating in the distribution of securities, who will then be entitled to indemnification by us against some civil liabilities. The indemnification covers liabilities under the Securities Act of 1933. Delayed Delivery Arrangements We may authorize underwriters, dealers or other persons acting as our agents to solicit offers from a number of institutions to purchase securities from us. We will indicate our intention to do this in the applicable prospectus supplement. The contracts for these purchases will provide for payment and delivery on a future date or dates. These institutions include commercial and savings banks, insurance companies, pension funds, investment companies, educational and charitable institutions and others, and must be approved by us. The obligations of purchasers under these contracts will be unconditional, except that: at the time of delivery, the purchase of the securities shall not be prohibited under the laws of the jurisdiction of the purchaser; and if the securities are also being sold to underwriters, we have to sell the securities not sold for delayed delivery to the underwriters. The underwriters, dealers and other persons will not have any responsibility for the validity or performance of these contracts. Unless otherwise indicated in the prospectus supplement, the validity of the securities offered by this prospectus will be passed upon for us by Mr. Wayne A. Wirtz, Associate General Counsel and Assistant Secretary of AT&T Inc., and for any underwriters, dealers or agents, as the case may be, by Sullivan & Cromwell LLP, New York, New York. As of February 17, 2016, Mr. Wirtz owned less than 1% of the outstanding shares of AT&T. Sullivan & Cromwell LLP from time to time performs legal services for AT&T Inc. The consolidated financial statements of AT&T Inc. incorporated by reference in AT&T’s Annual Report on Form 10-K (including the schedule appearing therein) for the year ended December 31, 2015, and the effectiveness of internal control over financial reporting as of December 31, 2015, have been audited by Ernst & Young LLP, independent registered public accounting firm, as set forth in their reports thereon incorporated by reference or included therein, and incorporated herein by reference. Such consolidated financial statements and schedule have been incorporated herein by reference in reliance upon the reports of Ernst & Young LLP pertaining to such financial statements and schedule and the effectiveness of our internal control over financial reporting as of December 31, 2015, given on the authority of such firm as experts in accounting and auditing. The consolidated financial statements, and the related financial statement schedule of DIRECTV and subsidiaries, as of December 31, 2014 and 2013 and for each of the three years in the period ended December 31, 2014, incorporated in this prospectus by reference from AT&T Inc.’s Current Report on Form 8-K dated February 19, 2016 have been audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report, which is incorporated herein by reference. Such financial statements and financial statement schedule have been so incorporated in reliance upon the report of such firm given upon their authority as experts in accounting and auditing. The SEC allows us to “incorporate by reference” the information we file with the SEC. This permits us to disclose important information to you by referring to these filed documents. Any information incorporated by reference is considered part of this prospectus, and any information we file with the SEC after the date of this prospectus will automatically update and supersede this information. We incorporate by reference the following documents and information filed with the SEC (other than, in each case, documents or information deemed to have been furnished and not filed in accordance with SEC rules): Our annual report on Form 10-K for the year ended December 31, 2015. Our current reports on Form 8-K filed with the SEC on January 22, 2016, January 26, 2016, February 9, 2016 and February 19, 2016. Any other reports we file with the SEC pursuant to Section 13(a) or 15(d) of the Exchange Act after the date of the first post-effective amendment to the registration statement and prior to effectiveness of that amendment. Any documents that we file with the SEC pursuant to Section 13(a), 13(c), 14 or 15(d) of the Exchange Act after the date of this prospectus and before the termination of the offering. If any statement in this prospectus conflicts with any statement in a document which we have incorporated by reference, then you should consider only the statement in the more recent document. To the extent that any information contained in any current report on Form 8-K, or any exhibit thereto, was furnished to, rather than filed with, the SEC, such information or exhibit is specifically not incorporated by reference in this prospectus. We will provide without charge to each person, including any beneficial owner, to whom this prospectus is delivered, upon his or her written or oral request, a copy of any or all documents referred to above which have been or may be incorporated by reference into this prospectus excluding exhibits to those documents unless they are specifically incorporated by reference into those documents. You may make your request by calling us at (210) 351-3049, or by writing to us at the following address: AT&T Inc.’s Specialist — External Reporting 208 S. Akard St. When we refer to “we”, “our” or “us” in this prospectus we mean AT&T Inc. and its consolidated subsidiaries. As required by the Securities Act of 1933, we filed a registration statement relating to the securities offered by this prospectus with the SEC. This prospectus is part of that registration statement, which includes additional information. We file annual, quarterly and current reports, proxy statements and other information with the SEC. You may read and copy this information at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. You may also request copies of the documents, upon payment of a duplicating fee, by writing the Public Reference Section of the SEC. Please call the SEC at 1-800-SEC-0330 for further information on the operation of the Public Reference Room. These SEC filings are also available to the public from the SEC’s web site at http://www.sec.gov.

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professional_accounting

Company Milestones Mobile Energy Global Ideanomics Capital (NASDAQ: IDEX) Wecast Network Announces Q4 and Full Year 2016 Results - Company Raises Full-Year Revenue Guidance to $300 Million - Investor Update Call Scheduled Today at 8:00 a.m. EDT NEW YORK, March 31, 2017 /PRNewswire/ -- Wecast Network Inc. (NASDAQ: WCST) ("Wecast" or the "Company" or "WCST"), announced today its Q4 and Full Year 2016 operating results for the period ended December 31, 2016 (a full copy of the Company's annual report on Form 10-K is also being posted at www.sec.gov). Conference Call: CEO, Bing Yang, Chairman Bruno Wu and CFO Simon Wang will host a conference call at 8:00 a.m. EDT today. To join the webcast, please visit the 'Webcasts and Events' section of the WCST corporate website, http://corporate.wecastnetworkinc.com/. Otherwise, the toll-free dial-in is: 877-407-3107; international callers should dial: 201-493-6796. WCST FULL YEAR 2016 OPERATING RESULTS Revenue for the year ended December 31, 2016 was $4,544,000, as compared to $4,606,000 for the same period in 2015, a decrease of approximately $62,000, or 1%. The revenue decrease was primarily due to the partnership with Zhejiang Yanhua Culture Media Co ("Yanhua") and the restructuring of the video on demand business in Q4 2016. Revenues, which were solely from our legacy video on demand business, were down quarter over quarter due to the new accounting mechanisms present in the previously announced new video on demand content model. In Q4 2016, the Company restructured its legacy video on demand business and signed a five year agreement to form a partnership with Yanhua where Yanhua will act as the exclusive distribution operator (within the territory of PRC) of the Company's licensed library of major studio films. Pursuant to the Yanhua Agreement, $107,517 of the first installment of RMB 6,500,000 was recognized as revenue in 2016 based on the relative fair value of licensed content delivered to Yanhua by December 31, 2016. Cost of revenue was $4,434,000 for the year ended December 31, 2016, as compared to $3,674,000 for the same period in 2015, an increase of approximately $760,000, or 21%. The increase in cost of revenue was primarily due to the cost associated with the restructuring of the legacy video on demand business and the additional expense (approximately $564,000) caused by the restructuring. Our cost of revenue is primarily comprised of content licensing fees. Gross profit for the year ended December 31, 2016 was $110,000, as compared to gross profit of $932,000 for 2015. Selling, general and administrative expenses (SG&A) for the year ended December 31, 2016, increased approximately $2,134,000, or 26% to $10,371,000, as compared to $8,237,000 for the year ended December 31, 2015. The increase was primarily attributed to the bad debt expense occurred in 2016 of $2,589,000, which was partially offset by a decrease in compensation expense by $550,000. Professional fees are generally related to audit & review fees, legal fees and consulting fees. Our professional fees increased approximately $641,000, or 90%, to $1,357,000 for the year ended December 31, 2016, from $716,000 in 2015. The increase in professional fees was related to our increasing legal service fees, which increased from $56,000 in 2015 to $415,000 in 2016, primarily attributed to the restructuring-based investment activities that occurred in 2016. Our depreciation and amortization expense increased approximately $99,000, or 25%, to $489,000 for the year ended December 31, 2016, from $390,000 during 2015. The increase was mainly due to the new office building purchased in 2016. On November 10, 2016, the Board of Directors ("Board") of WCST held a special meeting and at the recommendation of the Company's audit committee, the Board determined that it is in the best interests of the Company and the Company's shareholders to amend the terms of the SSS earn-out share award which would in effect reduce the total equity dilution to shareholders related to the earn-out and reduce the potential negative impact on the Company's future earnings (by shortening the payout period and paying all earn-out shares earlier than required). Based on evidence provided to the Board, the requisite thresholds necessary to trigger issuance of all shares of common stock subject to the earn-out share award had been achieved and on November 11, 2016, the Company issued 10,000,000 shares of its common stock to Sun Seven Stars ("SSS") at the closing price $1.37 on the stock issuance date, which accounts for $13.7 million share award expense (based on the market price of the common stock) which negatively impacted operating expense and therefore net income. This was a one time non-cash expense. Our loss from operations increased $19,416,000 to $27,827,000 for the year ended December 31, 2016, from $8,411,000 during 2015. This was mostly due to the earn-out share award expenses mentioned above. Basic and diluted loss per share for 2016 was $0.72 as compared to a $0.34 loss per share in the in 2015. CEO Bing Yang stated, "As has been communicated and documented, my team, around the middle of 2016, began work on transforming Wecast. In that short period of time we assembled a new experienced management team, stabilized the foundation, capitalized the Company, rebranded the Company, reconfigured the business structure, expanded the Company's mission and business lines, made several key investments and finally, injected several privately held and revenue producing assets into the corporation. Today, via the filing of the 10-K for 2016, we officially turn the page on the old company model and move on to the next chapter. And the success of that next chapter will come down to two things: First, driving the new operating model to produce an unprecedented opportunity for revenue & margin expansion and then second, building a track record of enhanced, precise and repeatable execution. I am pleased to note that today, the Company is raising its full-year revenue guidance form $280 million to $300 million based on our current visibility of, and internal projections for, 2017. If realized, this would represent an approximate 66x increase over 2016 revenue. Q1 2017 revenue will be based on approximately 5 weeks of revenue from our new businesses. This takes into account the timing of the closing of the Sun Video Group deal announced in late January and then the remaining time left in the quarter once it was deemed that Wecast had control of Sun Video Group and could then consolidate its revenues. Therefore, in order to meet this annual target we expect revenues to ramp in Q2, Q3 & Q4." About Wecast Network Inc. (http://corporate.wecastnetworkinc.com) Wecast Network Inc (NASDAQ: WCST) is leveraging and optimizing its current operations as a premium content Video On Demand service provider in China to evolve into a global, vertical, ubiquitous and transactional B2B2C, mobile-driven, consumer management platform for both enterprises and consumers. By aiming to establish the world's premier multimedia, social networking and smart e-commerce-enabled network with the largest global effective connected user base, Wecast, through this expanded, cloud-based, ecosystem of connected screens combined with strong partnerships with leading global providers, will be capable of delivering a vast array of WCST/YOD–branded products and services to enterprise customers and end-use consumers - anytime and anywhere, across multiple platforms and devices. Wecast has content distribution agreements in place with many of Hollywood's top studios including Disney Media Distribution, Paramount Pictures, NBC Universal and Twentieth Century Fox Television Distribution, Miramax, as well as a broad selection of the best content from Chinese filmmakers. In addition, the Company has governmental partnerships and licenses as well as numerous JV partnerships and strategic cooperation agreements with an array of distribution and content partners in the global new media space. Wecast is headquartered in both New York, NY and Beijing, China. This press release contains certain statements that may include "forward looking statements." All statements other than statements of historical fact included herein are "forward-looking statements." These forward looking statements are often identified by the use of forward-looking terminology such as "believes," "expects" or similar expressions, involve known and unknown risks and uncertainties. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, they do involve assumptions, risks and uncertainties, and these expectations may prove to be incorrect. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this press release. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of a variety of factors, including those discussed in the Company's periodic reports that are filed with the Securities and Exchange Commission and available on its website (http://www.sec.gov). All forward-looking statements attributable to the Company or persons acting on its behalf are expressly qualified in their entirety by these factors. Other than as required under the securities laws, the Company does not assume a duty to update these forward-looking statements. Jason Finkelstein VP Strategy & Investor Relations Wecast Network, Inc. Financial Tables Follow Wecast Network, Inc., Its Subsidiaries and Variable Interest Entity Twelve Months Ended Selling, general and administrative expenses Earn-out share award expense Loss from operations (27,826,582) Interest and other income/(expense): Change in fair value of warrant liabilities Equity in loss of equity method investees Impairment of equity method investments Loss before income taxes and non-controlling interest Net loss attributable to non-controlling interest Net loss attributable to Wecast Network shareholders Basic and diluted loss per share Basic and diluted Licensed content, current Deferred issuance cost Licensed content, non-current Long-term investments LIABILITIES, CONVERTIBLE REDEEMABLE PREFERRED STOCK AND EQUITY Accounts payable (including accounts payable of consolidated variable interest entities ("VIEs") without recourse to the Company of $5,817 and $44,867 as of December 31, 2016 and 2015, respectively) Deferred revenue of VIEs without recourse to the Company Accrued interest Accrued other expenses (including accrued expenses of VIEs without recourse to the Company of $268,074 and $280,038 as of December 31, 2016 and 2015, respectively) Accrued salaries (including accrued salaries of VIEs without recourse to the Company of nil and $10,861 as of December 31, 2016 and 2015, respectively) Payable for purchase of building Other current liabilities (including other current liabilities of VIEs without recourse to the Company of $394,314 and $298,422 as of December 31, 2016 and 2015, respectively) Accrued license content fees of VIEs without recourse to the Company Convertible promissory note Warrant liabilities Deposit payable Commitments and contingencies: Convertible redeemable preferred stock: Series A - 7,000,000 shares issued and outstanding, liquidation and deemed liquidation preference of $3,500,000 as of December 31, 2016 and 2015, respectively Equity: Series E Preferred Stock - $0.001 par value; 16,500,000 shares authorized, 7,154,997 and 7,254,997 shares issued and outstanding, liquidation preference of $12,521,245 and $12,696,245 as of December 31, 2016 and December 31, 2015, respectively Common stock - $0.001 par value; 1,500,000,000 shares authorized, 53,918,523 and 24,249,109 shares issued and outstanding as of December 31, 2016 and 2015, respectively Accumulated deficit (112,293,781) Total Wecast Network shareholder's equity Non-controlling interest Total liabilities, convertible redeemable preferred stock and equity Adjustments to reconcile net loss to net cash used in operating activities Share-based compensation expense Provision for doubtful accounts Amortization of debt issuance costs Equity in losses of equity method investees Loss on disposal of assets Impairment of intangible assets Impairment of licensed content Foreign currency exchange gain Change in assets and liabilities: Licensed content Prepaid expenses and other assets Accrued expenses, salary and other current liabilities Accrued license content fees Net cash used in operating activities Acquisition of property and equipment Investments in intangible assets Acquisition of leasehold improvements Payments for long term investments Deposit for investment Cash flows from financing activities Proceeds from issuance of shares and warrant Cost associated with financing activities Net cash (used in)/provided by financing activities Effect of exchange rate changes on cash Net decrease in cash Cash at the beginning of the year Cash at the end of the year Supplemental disclosure of cash flow information: Cash paid for income taxes Cash paid for interest Exchange of Series E Preferred Stock for Common stock Issuance of convertible note for licensed content Issuance of shares for the settlement of liability Issuance of shares upon conversion of convertible note, including accrued interest and debt issuance cost Issuance of earn-out shares Acquisition of long term investment through transfer of Game IP rights Workforce intangible acquired for shares Restricted cash received (returned) related to the deposit of financing activities To view the original version on PR Newswire, visit:http://www.prnewswire.com/news-releases/wecast-network-announces-q4-and-full-year-2016-results-300432407.html SOURCE Wecast Network Inc. Source: PR Newswire (March 31, 2017 - 7:00 AM EDT) News by QuoteMedia www.quotemedia.com Sign-up to receive email alerts. © 2019 Ideanomics, Inc.

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professional_accounting

American Midstream Reports First Quarter 2019 Results PR Newswire May 10, 2019 HOUSTON, May 10, 2019 /PRNewswire/ -- American Midstream Partners, LP (AMID) ("American Midstream" or the "Partnership") today reported financial and operational results for the three months ended March 31, 2019. Net loss attributable to the Partnership was $13.2 million for the three months ended March 31, 2019 compared to $13.9 million for 2018. Adjusted EBITDA (1) was $54.7 million for the three months ended March 31, 2019, compared to $52.4 million for 2018. Total segment gross margin (1) was $71.2 million for the three months ended March 31, 2019, compared to $64.7 million for 2018. The increases in adjusted EBITDA and total segment gross margin were driven largely by increased throughput on Delta House, reduction in operating expenses resulting from decreases in the use of third-party services and reductions in corporate expenses, due to a decrease in acquisition activity compared to the prior period and general corporate cost reduction as the Partnership prepares for the completion of the pending merger and operating as a privately held company. SEGMENT PERFORMANCE Segment Gross Margin March 31, Gas Gathering and Processing Services Liquid Pipelines and Services Natural Gas Transportation Services Terminalling Services Total Segment Gross Margin (1) Adjusted EBITDA and Total Segment Gross Margin are Non-GAAP supplemental financial measures. Please read "Non-GAAP Financial Measures" in this press release. PENDING MERGER All customary conditions to the closing of the merger of the Partnership and an affiliate of ArcLight have been satisfied, with the exception of the expiration of the waiting period following filing of a definitive information statement with the United States Securities and Exchange Commission ("SEC"). The Partnership expects the merger to close by the outside date under the merger agreement of July 31, 2019. As previously announced, the Partnership will not make any cash distributions on its common units or preferred units prior to the closing of the merger. Upon closing of the merger, the Partnership will be a wholly owned subsidiary of an affiliate of ArcLight and the common units will cease to be publicly traded. As a result of the pending merger, the Partnership will not hold a conference call in connection with the issuance of this earnings release. As of March 31, 2019, the Partnership had approximately $1.0 billion of total debt outstanding, comprising $534 million outstanding under its revolving credit facility, $425 million in outstanding 8.50% senior unsecured notes and $87 million in outstanding non-recourse senior secured notes. The Partnership had a consolidated total leverage ratio of approximately 5.8 times at March 31, 2019. For the three months ended March 31, 2019, capital expenditures totaled approximately $19 million, including approximately $7 million of maintenance capital expenditures. This press release and the accompanying tables include supplemental non-GAAP financial measures, including "Adjusted EBITDA," "Total Segment Gross Margin" and "Operating Margin." For definitions and required reconciliations of supplemental non-GAAP financial measures to the nearest comparable GAAP financial measures, please read "Note About Non-GAAP Financial Measures" set forth in a later section of this press release. About American Midstream Partners, LP American Midstream Partners, LP is a limited partnership formed to provide critical midstream infrastructure that links producers of natural gas, crude oil, NGLs and condensate to end-use markets. American Midstream's assets are strategically located in some of the most prolific offshore and onshore basins in the Permian, Eagle Ford, East Texas, Bakken and Gulf Coast. American Midstream owns or has an ownership interest in approximately 5,100 miles of interstate and intrastate pipelines, as well as gas processing plants, fractionation facilities, an offshore semisubmersible floating production system with nameplate processing capacity of 90 MBbl/d of crude oil and 220 MMcf/d of natural gas, and terminal sites with approximately 3.0 MMBbls of storage capacity. For more information about American Midstream Partners, LP, visit: www.americanmidstream.com. The content of our website is not part of this release. This press release includes "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended. We have used the words "could," "expect," "intend," "may," "will," "would," and similar terms and phrases to identify forward-looking statements in this press release. Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Many of the factors that will determine these results are beyond our ability to control or predict. These factors include actions by ArcLight, lenders, regulatory agencies, and other third parties, changes in market conditions, and information described in our public disclosure and filings with the SEC, including the risk factors and other information that will be included in our Annual Report on Form 10-K for the year ended December 31, 2018 and our Quarterly Report on From 10-Q for the quarter ended March 31, 2019. All future written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the previous statements. The forward-looking statements herein speak as of the date of this press release. We undertake no obligation to update such statements for any reason, except as required by law. American Midstream Partners, LP Mark Schuck Director of Investor Relations [email protected] American Midstream Partners, LP and Subsidiaries (Unaudited, in thousands) Restricted cash Accounts receivable, net of allowance for doubtful accounts of $511 and $591 as of March 31, 2019 and December 31, 2018, respectively Property, plant and equipment, net Restricted cash - long term Intangible assets, net Investment in unconsolidated affiliates Other assets, net Liabilities, Equity and Partners' Capital Total current liabilities (1) Asset retirement obligations Other long-term liabilities Convertible preferred units Total Equity and partners' capital Total liabilities, equity and partners' capital (1) Total current liabilities include $534.3 million and $514.8 million for March 31, 2019 and December 31, 2018, respectively, outstanding under the Partnership's revolving credit facility, which matures in September 2019. (Unaudited, in thousands, except for per unit amounts) Cost of sales Direct operating expenses Corporate expenses Depreciation, amortization and accretion Loss (gain) on sale of assets, net Impairment of long-lived assets Operating loss Other income (expense), net: Interest expense, net of capitalized interest Earnings in unconsolidated affiliates Loss before income taxes Net income attributable to noncontrolling interests Net loss attributable to the Partnership Limited Partners' net loss per common unit: Basic and diluted: Net loss per common unit Weighted average number of common units outstanding Basic and diluted Net cash (used in) provided by operating activities Net cash used in investing activities Net cash provided by (used in) financing activities Net decrease in Cash, Cash equivalents, and Restricted cash Cash, cash equivalents and restricted cash Beginning of period End of period Reconciliation of Net income (loss) attributable to the Partnership to Adjusted EBITDA and Distributable Cash Flow Reconciliation of Net loss Attributable to the Partnership to Adjusted EBITDA: Amortization of deferred financing costs Debt issuance costs paid Unrealized loss (gain) on commodity derivatives, net Non-cash equity compensation expense Transaction expenses Distributions from unconsolidated affiliates General Partner contribution Other post-employment benefits plan net periodic benefit (Gain) loss on sale of assets, net Reconciliation of Total Gross Margin to Net loss attributable to the Partnership Reconciliation of Total Segment Gross Margin and Operating Margin to Net Loss Attributable to the Partnership: Gain (loss) on commodity derivatives, net Depreciation, amortization and accretion expense Gain (loss) on sale of assets, net Net income attributable to noncontrolling interest Segment Financial and Operating Data (Unaudited, in thousands, except for operating and pricing data) Segment Financial and Operating Data: Offshore Pipelines and Services Segment Financial data: Segment operating margin Distributions: Destin/Okeanos Delta House Operating data: Average throughput (MMcfe/d) Average Destin/Okeanos throughput (MMcf/d) Average Delta House throughput (MBoe/d) Gas Gathering and Processing Services Segment Average throughput (MMcf/d) Liquid Pipelines & Services Average unconsolidated affiliate throughput (MBbls/d) Average other liquid pipelines throughput (MBbls/d) Natural Gas Transportation Services Segment Terminalling Services Segment Segment revenue Note About Non-GAAP Financial Measures Total segment gross margin, operating margin, Adjusted EBITDA and distributable cash flow are performance measures that are non-GAAP financial measures. Each has important limitations as an analytical tool because they exclude some, but not all, items that affect the most directly comparable GAAP financial measures. Management compensates for the limitations of these non-GAAP measures as analytical tools by reviewing the comparable GAAP measures, understanding the differences between the measures and incorporating these data points into management's decision-making process. You should not consider total segment gross margin, operating margin or Adjusted EBITDA in isolation or as a substitute for, or more meaningful than analysis of, our results as reported under GAAP. Total segment gross margin, operating margin and Adjusted EBITDA may be defined differently by other companies in our industry. Our definitions of these non-GAAP financial measures may not be comparable to similarly titled measures of other companies, thereby diminishing their utility. Adjusted EBITDA is a supplemental non-GAAP financial measure used by our management and external users of our financial statements, such as investors, commercial banks, research analysts and others, to assess: the financial performance of our assets without regard to financing methods, capital structure or historical cost basis; the ability of our assets to generate cash flow to make cash distributions to our equity holders; our operating performance and return on capital as compared to those of other companies in the midstream energy sector, without regard to financing or capital structure; and the attractiveness of capital projects and acquisitions and the overall rates of return on alternative investment opportunities. We define Adjusted EBITDA as net income (loss) attributable to the Partnership, plus depreciation, amortization and accretion expense ("DAA") excluding non-controlling interest share of DAA, interest expense, net of capitalized interest excluding , debt issuance costs paid during the period, unrealized gains (losses) on commodity derivatives, non-cash charges such as non-cash equity compensation expense, charges that are unusual such as transaction expenses primarily associated with our acquisitions, income tax expense, distributions from unconsolidated affiliates and General Partner's contribution, less earnings in unconsolidated affiliates, discontinued operations, gains (losses) that are unusual, such as gain on revaluation of equity interest and gain (loss) on sale of assets, net, and other non-recurring items that impact our business, such as construction and operating management agreement income ("COMA") and other post-employment benefits plan net periodic benefit. The GAAP measure most directly comparable to our performance measure Adjusted EBITDA is Net income (loss) attributable to the Partnership. Segment gross margin and total segment gross margin are metrics that we use to evaluate our performance. These metrics are useful for understanding our operating performance because it measures the operating results of our segments before DD&A and certain expenses that are generally not controllable by our business segment development managers, such as certain operating costs, general and administrative expenses, interest expense and income taxes. Operating margin is useful for similar reasons except that it also includes all direct operating expenses in order to assess the performance of our operating managers. We define segment gross margin in our Gas Gathering and Processing Services segment as total revenue plus unconsolidated affiliate earnings less unrealized gains or plus unrealized losses on commodity derivatives, construction and operating management agreement income and the cost of natural gas, and NGLs and condensate purchased. We define segment gross margin in our Liquid Pipelines and Services segment as total revenue plus unconsolidated affiliate earnings less unrealized gains or plus unrealized losses on commodity derivatives and the cost of crude oil purchased in connection with fixed-margin arrangements. Substantially all of our gross margin in this segment is fee-based or fixed-margin, with little to no direct commodity price risk. We define segment gross margin in our Natural Gas Transportation Services segment as total revenue plus unconsolidated affiliate earnings less the cost of natural gas purchased in connection with fixed-margin arrangements. Substantially all of our gross margin in this segment is fee-based or fixed-margin, with little to no direct commodity price risk. We define segment gross margin in our Offshore Pipelines and Services segment as total revenue plus unconsolidated affiliate earnings less the cost of natural gas purchased in connection with fixed-margin arrangements. Substantially all of our gross margin in this segment is fee-based or fixed-margin, with little to no direct commodity price risk. We define segment gross margin in our Terminalling Services segment as total revenue less cost of sales and direct operating expense which includes direct labor, general materials and supplies and direct overhead. Total segment gross margin is a supplemental non-GAAP financial measure that we use to evaluate our performance. We define total segment gross margin as the sum of the segment gross margins for our Gas Gathering and Processing Services, Liquid Pipelines and Services, Natural Gas Transportation Services, Offshore Pipelines and Services and Terminalling Services segments. The GAAP measure most directly comparable to total segment gross margin is Net Income (Loss) attributable to the Partnership. View original content:http://www.prnewswire.com/news-releases/american-midstream-reports-first-quarter-2019-results-300848215.html These stocks soared even as the companies lost money — here’s why that’s not as crazy as it sounds Nike (NKE) Up 3.3% Since Last Earnings Report: Can It Continue? Santa Claus rally — What to know in markets Friday Millennial spending trends toward comfort, convenience Expect ‘another year or more of pain’ for Uber: author

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professional_accounting

Home Guardian has recently completed Question 1 (25 marks) Home Guardian has recently completed a $200,000, two-year study on its new pest control device. It can go into production for an initial investment in equipment of $5 million. The equipment will be depreciated straight line over the useful life of 5 years to a value of zero. The fully depreciated equipment is expected to sell for $1,200,000 at the end of its useful life. The project also requires investment in land value of $300,000 which is expected to have a realisable value of $500,000 at the end of the project. Investment of $400,000 in current assets will be recovered at the termination of the project. The marketing department has estimated that 200,000 units of its new… Financial statements, analysing business transactions and financial statement analysis Sunbay Sales is a small sales consultancy business and began operation on 1 January 2017. It is owned and operated by Karin Nilson and employs one other consultant. Karin has asked her accountant, Megan Gordon to complete financial statements and write a business report on the financial health of Sunbay Sales in its first year of operation. Sunbay Sales has the following account balances as at 31 May 2017; Cash at bank $72,900 Accounts payable $17,300 Account receivable $26,150 Loan $15,000 Office equipment $10,700 Capital $100,000 Prepayments $0 Income $40,400 Sales solution software $24,500 Expenses ($38,450) The following transaction occurred in the last month of the financial year- June 2017. June Transaction Description 1 Paid $24,000 for a 12 month… Spreadsheet Project Task 2 Spreadsheet Project Task 2 Today is 1 January 2018. Sue just purchased a 10-year 4.5% p.a. Treasury bond with a face value of $100 at the yield rate of j2 = 4.3% p.a. The bond is redeemable at par. The maturity date is 1 January 2028. On receipt of each coupon, Sue deposits the coupon into a bank account earning the reinvestment rate. Sue predicts that there are three potential states for the future economy. (25 marks) State 1. Market yield is j2 = 5.05% p.a. from 2018 to 2023 and j2 = 5.2% p.a. from 2024 to 2027. Reinvestment rate is j2 = 5.15% p.a. from 2018 to 2023 and j2 = 5.3% p.a. from 2024 to 2027. State 2. Market yield is j2 = 4.55%… Cost Volume Profit Analysis Question 1 Inspired Ltd manufactures spurs. Factory overhead is applied to the production of spurs using a predetermined rate based on budgeted direct labour hours. Budgeted cost of production (for 30,000 units) for the year to 30 June 2015 was: Direct materials $ 225,000 Direct labour (6,000 hours) 75,000 Fixed factory overhead 39,000 Variable factory overhead 30,000 Actual factory overhead incurred in the year to 30 June 2015 was $72,000. Actual direct labour hours were 6,100. Required: ( a ) Calculate the factory overhead application rate (per direct labour hour) for the year. ( b ) Calculate the total amount of factory overhead for the year applied to the production of spurs. (… Consolidation: Non-controlling interests, Investment in associates and Accounting for foreign currency transactions Assessment item 3 Assignment 2 Value: 20% Due date: 07-May-2018 Return date: 29-May-2018 Submission method options Alternative submission method Task You are required to complete all three questions below. A total of 50 marks are allocated to these questions, which will be converted to a final mark out of 20%. All workings, when appropriate, must be shown to substantiate your answers. Question 1 [34 marks] Topic 3: Consolidation: Non-controlling interests On 1 July 2016, Poppy Ltd acquired 80% of the issued shares of Sunshine Ltd for $240 000 when the equity of Sunshine Ltd consisted of: share capital $160000 general reserve $10000 retained earnings $59000 At this date, all identifiable assets and liabilities of Sunshine Ltd were recorded at fair value except… Presentation of financial statements, accounting policies, issue of shares and impairment loss Question 1 [20 marks] Topic 2: Presentation of financial statements The following balances are extracted from the trial balance of Tammy Ltd for the year ended 30 June 2018: $ Sales revenue 3,200,000 Interest income 360,000 Rental income 40,000 Interest expense 50,000 Income tax expense 300,000 Administrative salaries 340,000 Depreciation of office equipment 140,000 Bad debt expense 220,000 Cost of sales 1,100,000 Foreign currency translation loss 100,000 Additional information: During the period, land was revalued upwards by $160,000 (net of tax). • At 1 July 2017, the balances of foreign currency translation reserve and revaluation reserve were $110,000 and $40,000 respectively. • On 15 November 2017, a plant with a carrying amount of $130,000 was… 200109 Corporate Accounting Systems Autumn 2018 Part A The following represented an extract from the Statement of Financial Position of the assets and liabilities of Sunnybank Ltd for the years ending 30 June 2010 and 30 June 2011. Reporting date was 30 June. Assets 2011 2010 Liabilities 2011 2010 Cash 110 000 87 000 Accounts payable 28 500 31 700 Accounts receivable (net) 45 000 52 000 Accrued expenses 7 200 11 600 Inventory 58 000 43 000 Deferred tax liability ? 15 150 Interest receivable 8 400 5 000 Rent revenue in advance 12 000 – Prepaid insurance 7 000 5 000 Bank loan 50 000 50 000 Deferred tax asset ? 10 470 Provision for employee benefits 21 000 17 300 Development costs… Booli Electronics is an electronics manufacturer located in Carlton Booli Electronics Booli Electronics is an electronics manufacturer located in Carlton, Victoria, Australia. The Company’s Managing Director is Monica Chen, who inherited the company from her father. The company originally repaired radios and other household items when it was founded more than fifty years ago. Over the years, the company has expanded, and is now a reputable manufacturer of various specialty electronics items. Richard Das, a recent MBA graduate, has been hired by the company in the finance department. One of the major revenue producing items manufactured by Booli Electronics is a ‘smart speaker and home assistant (SSHA).’ Booli Electronics currently has one SSHA model on the market and sales have been excellent. The SSHA is a unique item in that… Northwind Traders, an international gourmet food distributor Northwind Traders Project Description: Northwind Traders, an international gourmet food distributor, is concerned about shipping delays over the last six months. Review the orders over the past six months and identify any order that was not shipped within 30 days. Each customer that falls within that time frame will be called to inquire about any problems the delay may have caused. In addition, you will create an order summary and an order summary by country. You have created a smaller version of the database, which you will use for testing purposes. Instructions: For the purpose of grading the project you are required to perform the following tasks: Step Instructions Points Possible 1 Start Access. Open the downloaded Access file… Present value and net present value Suppose that Marcia has decided that she wants to pay herself £650 each year for the next three years rather than deposit these amounts in her savings account. If she can invest a lump-sum amount in a savings account that pays 4.5 percent interest per year, how much money does Marcia need to deposit today to accomplish her goal? (6 marks). Two projects being considered are mutually exclusive and have the following projected cash flows: Year Project A Project B 0 −$50,000 −$50,000 1 26,000 0 2 17,625 0 3 15,000 0 4 10,000 0 5 32,000 99,500 If the required rate of return on these projects is 11.25 percent, which would be chosen and why? Show your calculations/explanations. (6… ACCT 1008 Accounting for Business, SP2 2018 Assignment Part B QUESTION 1: Balance Day Adjustments (20 marks) Debit ($) Credit ($) Rooftop Tea Room Trial Balance 30 June 2018 Vauxhall Delivery Van 21 100 Rooftop Cleaning Expense 18 800 Insurance Expense 12 393 Water Expense 17 814 Gas Expense 18 776 Accumulated Depreciation – Refrigeration Equipment 24 470 Repairs and Maintenance Payable 8 063 Sales Returns & Allowances 795 Electricity Expense 20 550 Shop Furniture 22 500 Discount Allowed 975 Victoria, Capital 198 357 Pastry Chef Wages Expense 36 095 Office Cleaning Expense 15 000 Refrigeration Equipment 48 000 Interest Expense 21 900 Cash at Bank 36 232 … Saturn Petcare Australia and New Zealand is Australia’s largest manufacturer Part A (40 Marks) Saturn Petcare Australia and New Zealand is Australia’s largest manufacturer of pet care products. Saturn have been part of the Australian and New Zealand pet care landscape since opening their first manufacturing facility in Albury Wodonga in 1966. Since then they have expanded their manufacturing footprint to include other sites in regional Australia and New Zealand including a world-leading manufacturing site opened in Bathurst, NSW in 2015. Saturn Petcare Australia New Zealand manufactures both for the domestic markets as well as exporting products to more than 26 countries. Saturn Petcare is part of the larger overall Saturn Group which is globally one of the largest privately held manufacturing companies and operates in a range of different…

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professional_accounting

Free sample Cash flow statement of plato ltd Analysis Of Cash Flow Statement Of Plato Ltd. Task: Prepare a comprehensive report on the cash flow statement. The concept of cash flow positions bears the same relevance as that of the notions entailed in the topic of financial position and profitability in an organization. The aspect of liquidity of concern is estimated by using the concept of cash flow statement and position. The capability of an organization to attain the overhead expenditures daily is the term to be the quality of liquidity. The factor of liquidity also measures the ability of the organization to meet its long term and short-term financial deadlines and commitments. If the organization is lacking the power of liquidity, then it is most probable that it would face the risk of even closing down since it has to take an immense loan to meet the daily expenses. Hence while conducting its business, the organizations should make it certain that the cash flow is effective to meet the liquidity criteria so that the daily business could be carried out without any hindrances. This measure would bring stability to the financial transactions of the company. In this report on the cash flow statement, the context of Plato Ltd company is taken. The company holds a major position in the global market of computer sales and has a large customer base which majorly consists of students. By the implementation of using most modern and cutting-edge technology, Plato Ltd has gained a high reputation and goodwill among the customers and thus enlarging the targeted market. By the use of high-end technologies, the company had made it easy for the students to access easy payment plans. The market is being rushed with many new and small entrants which had weakened the customer basis of the company. Be the reduction and deviation of trustworthy customers, the company is facing a dip in its profit level and is even risking the current existence of the company. By drafting this report, we have intended to investigate and scrutinize the position of cash flow and cash flow statement to provide the company with a better plan to ascertain the persuasive operation of the company. Definition of Cash Flow Statement as per the norms of IAS 7 (Indirect Method) By following the IAS 7 guidelines, the cash flow statement of the Plato Ltd company has been drafted. We have provided the cash flow statement of the Plato company in the below section. Let us have a detailed look at it. Plato Ltd For the Years Ending March 31, 2015, and March 31, 2014 Add Expenses Not Requiring Cash: Loss on machinery Revaluation Reserve Other Adjustments: Add Reduction in Accounts Receivable Add Reduction in Inventory Subtract Decrease in Accounts Payable Increase in bank OD Subtract Increase in Prepaid Expenses Cash Generated From Operations Payment of income tax Reduction in marketable securities Sale of Fixed Assets Purchase of New Equipment Net Cash Used for Investing Activities Issue of capital Payment of Debentures Payment of Dividend Bank Overdraft Net Cash from Financing Activities NET INCREASE/(DECREASE) IN CASH CASH, END OF YEAR notes- The denoted denomination of cash and its parallels comprises of the units like bank overdrafts taken from behalf of the company. No other relevant denominations have been traced regarding the organization and hence they are not implied in this report. There have been no study or research conducted regarding this organization and hence the report is drafted using the information gained from various sources. Machinery Account To Balance By Sale of Machinery To revaluation To Purchases By Balance To Bank By PL The management of Plato Ltd. The company had implied currently the strategy to liquidate or discharge the assets held by the company at the existing period since it is the only way in which the company could withstand the situation. The crucial off-putting factor in the progression is the fact that the lion share of funding is assimilated from the operating division of the company itself. The company has been a disaster in collecting money from the department of finance, sales or investment and the sole source of income was from the department of operations (Kemp, 2003). As the figures provided in the cash flow statement, it could be observed that the company is planning and conducting its process by keeping in mind the future consequences. The reduction in the figures of debentures makes it clear that whatever additional money rather expenses are made by the company is allotted to clear the long-term loans and debts. The management of the company has decided to improve the relationship with the loan providers by depositing the required money within the mentioned deadline. This move has been evident in the figures by the drop in the sum of trade payables. The Managing Director of the company has also stated that the company has to take much more overdraft from the loan providers to sustain the existence of the company. Although the money acquired only from the overdraft would not be sufficient for the current scenario and hence the board members should move on with the strategy of disinvestment to acquire more money. To sustain the level of competency in the market and to gain long term profit from the business, the company had installed some of the most modern technologies in the system (Shim, Siegel, & Shim, 2012). The installment of high-end technique has also helped in augmenting the quality of the manufactured products. This context had helped the company in creating novel interest among the customers towards its products and services. Functions of Accounting Administrative Director, Subject: Analysis of the Cash flow statement Memo No: PL / 158 / 2019 Before getting into the analysis of the Cash Flow Statement of Plat Ltd. The company I would personally like to thank you for allowing me to observe and analyze the sensitive and crucial data (including the financial statements) spanning from the period from 2014 to 2015. As a part of drafting the report on the cash flow statement, I have also analyzed the trend of the financial performance of the company. I should separately say that the cash position data of the company was given the highest position since you have demanded the analysis of the Cash flow statement Plato Ltd. Company. Since the company is finding it hard to sustain in the market because of the lack of liquidity we have taken the issue very seriously (Coyle, 2000). We have found out in our analysis that the processes of Plato Ltd. The company lacks an efficient control of the internal environment. The company needs to imply a strong control unit so that all the processes in the company should be controlled efficiently so that the performance should be pushed to a higher limit. To bring forward the significance of accounting in front of you we have presented this memo. An effective way to supervise and control the overall operation and output of the company, a very effective accounting system should be implied. We here again insist you to imply a very efficient accounting system since the absence of it would even risk the existence of the company. We are repeating it again and again because of the observation that an efficient accounting system would change the overall performance of your company in a very drastic way. The accountants of the company should be specially trained to efficiently carry out the duty like collection and classification of the sensitive data and responsibly keep all the records of financial transactions. The financial accounts of the company would help in ascertaining the current position and performance of the company if the accountants would complete their task in a very responsible and impeccable manner (Mulford & Comiskey, 2005). The basic norms and international standards of performance could be ensured by the reliable and meticulous upkeeping of the company accounts. By the dint of the above-provided move, the organization could save a lot of money since the unusual expenditure could be checked. Along with with it the following guidelines and different laws laid down by the controlling organization could be ensured. It is the major responsibility of a manger to draft a very efficient business decision, and also this liability to maintain a very amiable and motivating environment in the office. The managers should be very rational and they should take actions by referring to the official and statistical data. The experience of the manager in dealing with the crucial situation would also turn out to be a major asset for the company (Robinson, 2009). The process of accounting would help in providing the figures and trends very accurately by referring to which the manager could take a very relevant and authentic decision. If taken an example of installing high end or subordinate technique in the company, the manager could check its need and implacability by checking the accounting details on how many modern units the company already possesses and the degree of the positive impact it had made on the production system. If the accounting details are accurate, the manager could take a very significant decision that could impact the whole future of the company. If the accounting system is absent the manager would only have to make the significant choices and decisions by relying on his intuitions and assumptions which would be considered as a dumb move (Christy, 2009). The requirement of accounting units is not only related to the performance parameter of the organization but is also linked to the payroll of human resources, efficient allocation of the company resources, etc. The accounting unit would also help in ascertaining and estimating the trends by keeping in mind the profit made and expenditure committed. The strict abidance of the company with the international standards and other laws could be ensured by implementing strict accounting laws (Platt, 2010). It is only the recommendations and suggestions made by the accounting department that would provide a basis for the strategies made for eradicating the financial problems prevailing in the organization. I have discussed the cash flow statement or the level of liquidity prevailing in the organization since it is a very significant component of the operation department. It is the cash position of Plato Ltd. The company would make an impact on the dimensions of the accounting profit. (Donleavy, 1994). While checking the accounts and financial statements of Plato Ltd. Company regarding the year 2015 we have observed that the profit obtained from the respective year as £430,000 but after considering other unexpected dimensions and overdrafts the resultant cash balance has become £30,000. By this figure, it could be ascertained that the issue of liquidity is the major factor, which is drawing back the performance of the company. The problem of liquidity has raised to such a level that the reduced rate of cash flow has even risked the existence of the company. If the company had installed or followed a valid accounting since its inception, the present situation and the risk of being insolvent would have been avoided (Dickey, 2010). If the calculated figures by the accountants were available to the managers, they would have decided on leasing the required pieces of machinery instead of buying it. Occupying the pieces of machinery by the means of hire purchase would have also been revealed in front of the managers. There is no supervision or any sort of check measures of the expenditures incurred since we have not traced any evidence of monthly cash budgeting system. The company could only progress if it could ascertain its current situation. It is by considering the current position as the basis that the companies build their future strategies and later the comparison is done between the incurred result and previous result. The absence of an accounting system has created an environment of havoc in the company and it is now turned out that there no unknit which could check or supervise the processes of the company. The major benefit of maintaining accounts from the perspective of a manager is that he could analyze the trends followed in the sensitive and financial issues before delivering any sort of crucial decisions. If taken into consideration the context of revenue ratio or the CGOS, its figures are increasing with the progress of each financial year. Similar to this there are many ratios and aspects which should be brought under the consideration of higher officials like boards so that future strategies should be made for the progressive development of the company. Although there are some positive ratios in support of the company's better future, the factors which are bringing down the current performance of the company could be highlighted and special pressure could be given on improving it separately by the means of ratio analysis (Plewa & Friedlob, 1995). The ratios in the correct dimension could only be attained by the correct form of bookkeeping and following strict accounting principles. If we turned our focus on the ratios of receivable turnover and payable turnover, it could be observed that by referring to it the officials could estimate the trends in expenditure and revenue. By following the accurate norms of accounting, the company could hold control throughout the company and any sort of manipulation of funds by the officials (Dayananda, 2002). Monthly Cash Budget It should be mentioned specifically that the determining and vital factor in between a thriving company and a hopeless one is the influence and presence of cash budgeting and cash flow statements. In the aforementioned context of this report on the cash flow statement, we have discussed the significance and scope of the monthly cash budget in an organization. We have already discussed that any sort of reduction or lack in money would lead to the deficiency in the degree of liquidation that would be turned out to be a great hindrance in carrying out the day to day financial activities of the company. Apart from this if there is extra money lying with the money, it would also turn out to be a negative factor. The instance of extra money would imply the presence of idle and inoperative fund which is a loss since even in the case of investment it would have borne some interest (MOSSO, 2006). On the contrary, the lack of funds would risk the acquisition of coming opportunities since the cost of possession would be much higher. If the purchase is very urgent then the company could have to borrow some money from some sources and eventually have to pay heavy interest for it which would worsen the existing situation (Steyn & Hamman, 2003). Hence the existence of both the additional money and dearth in money should be considered as a drawback and urgent measures should be taken in the prevalence of either case. In this scenario, the significance of budgeting becomes highly evident and hence the process of budgeting should be conducted every month (Beutler & Mason, 1987). The income and expenditure of a company could be marked and patterned by the process of cash budgeting. The shaken and induced level of income made from the sales of the products by the company is the major component of revenue (Bjandari & Iyer, 2013). The revenue also includes the components like the cash obtained from the accessory retailing process done by the sales department, interest obtained from the investment, dividends of shares possessed, and profits accrued from additional obtains. Apart from this the expenditure or the flow of the cash towards the exterior of the organization includes the major financial transactions like the acquisition of machinery and high-end technology, ongoing cash purchases, expenses accrued for conducting daily office activities, payroll expenses, existing cash purchases, etc. (Peter van der Hoek, 2005). By the provision of implementing the cash budget, the inward and outward flow of the cash could be measured at every smallest interval. The figures and the estimated trend in financial transactions would help in effectively calculating the future coming opportunities and risks. The good calculation of the financial statements would also help in determining whether the company is going through a positive or negative course of business. This would also provide the officials with some warning regarding the lending of funds in the contingency period or the case of a prospective deficit. Monthly budgets would provide the periodic analysis of the company performance along with the negative facts which are pulling back the efficiency of the company. A very comprehensive comparison could be done between the preset calculated data and the previous data. If the data obtained at regular intervals could be linked with each other, the ongoing trend could be analyzed (Apreda, n.d). As per the observations made by the economist Nordmeyer, the imminent shortfall in the fund or the requirement of the fund could be predicted by the means of the cash budget. This could be inflicted in the annual financial statement or the budget where the required money should be covered by loans or another sort of liabilities. As a part of pulling up the current situation to the estimation made in the budget, the company would require to rely on short term small loans. Acquiring the short-term loans are much suited for satisfying the monthly financial needs. As per the financial needs of the organization, the periodical budgeting would also help in discerning between the long term and short-term cash requirements. It would be a very critical and unfortunate condition if the company has to sell its permanent assets to meet the deadlines of its small term debts and loans (Kahraman Ruan, & Tolga, 2002). It would be considered a better plan and strategy if by the force of it the company could predict its requirement of money whether it is short term or long-term way before the point of incidence. In the current case of Plato Ltd. The company, there existed a situation when the company had to make the purchase of the pieces of machinery on a very urgent basis and had to make the transaction for it at a very outright basis using the available cash (Dimitrijevic, 2015). The shortage of 30000 pounds would not have happened if there had been any sort of planning or provision of periodic budgeting in the organization. In the presence of a valid accounting system, the company would have taken some measures like taking a loan or hiring the technology on an annual basis beforehand to meet the unforeseen expenditure (Turner, 2016). Around 70% of the incurred expenditure could have been saved if the managers had decided to hire the pieces of machinery from the sellers. Hence the company is highly recommended to adopt a high-end accounting system in the process so that further loss to the company should be avoided. The aforementioned situation in the company shoot outs the importance of cash budgeting in the system (LUFT, 2010). As per the afore mentioned context in this report on Cash Flow Statement, the act of decision making is very significant for the person who is working as the manager. In the matters and context like distribution of profit with respect to the shares, cash and credit policy acquired with respect to the suppliers of the institute, parameter set to hire the employees, etc. the manager would have taken the solitary decision. For each and ever actions and decisions made by the manager, there should be a good reference or proof. For this purpose, the tools like cash budgeting would turn out to be very handy for the managers since it provides the right reason and ground for his every activity (Giaccotto, 1990). This phenomenon was also clear in the incident when it had to put aside high denomination for giving out bonuses and payments for the shareholders although it had possessed a weak cash position. The institute has a lot of extra money in its account which would have been used to conduct the outright purchase of pieces of machinery. The fact should be noted that the company is under high debt when this incident had happened (Pavlovic & Bogdanovic, 2013). Thus, a chain of miss happenings could happen if any sort of wrong decision is taken by the manager. To avoid this the officials should practice strict accounting policies. In the same context, the significance of the tool of cash budgeting system arises which is very crucial for sustaining a ratio of cash with respect to the stocks in hand which is kept on behalf of the institute. (Francis, 2010). The matter elaborated on the above mentioned of this report on Cash Flow Statement makes it clear that the factor of liquidity should be taken by the company for its day to day sustenance. If the company lacks the strategies to keep in check the liquidity of cash, then it is evident that the company would face the imminent risk of being shut down or being insolvent, no matter what is the magnitude of the company. Hence it is the collective responsibility of the stakeholders of the company to keep in check the ratio of liquidity so that the processes and transactions in the company could be carried out in a very sustainable way by keeping in mind its future debts or liabilities. To keep in check the level of outflow and inflow of cash in an institute, the higher officials should practice the creation of cash budgets every month. The further strategies of the team should be according to the inferences and guidelines laid down in the cash budget. We have explored the impact of implementing the cash budgeting system in this report on Cash Flow Statement and hence have recommended the officials to implement this ideology in the institute. Because of the lack of liquidity, the company is facing a high risk of carrying out its daily transactions. TO somehow meet the requirement of the fund, the organization has heavily banked upon the short term loans and quick overdrafts provided by the investing banks. This condition of incompetence could not have happened if the company had taken care of the cash flow statement in its process. Cash flow statement assignments are being prepared by our management assignment help experts from top universities which let us to provide you a reliable assignment help online service. Apreda, R. The Governance Slack Model: A Cash Flow Approach for the Budgeting and Accountability of Some Corporate Governance Issues. Beutler, I. & Mason, J. (1987). Family Cash-Flow Budgeting. Home Economics Research Journal,16(1), 3-12. Bhandari, S. & Iyer, R. (2013). Predicting business failure using cash flow statement based measures.Managerial Finance, 39(7), 667-676. Christy, G. (2009). Free cash flow. Hoboken, N.J.: Wiley. Coyle, B. (2000). Cash flow control. Chicago: Glenlake Pub. Co. Dayanada, D. (2002). Capital budgeting. Cambridge, UK: Cambridge University Press. Dickey, T. (2010). Basics of budgeting. [New York?]: Axzo Press. Dimitrijevic, D. (2015). The detection and prevention of manipulations in the balance sheet and the cash flow statement. Ekon Horizonti, 17(2), 137-153. Donleavy, G. (1994). Cash flow accounting. London: Routledge. Francis, R. (2010). The relative information content of operating and financing cash flow in the proposed cash flow statement. Accounting & Finance, 50(4), 829-851. Giaccotto, C. (1990). Cash Flow Modelling and Forecasting in Capital Budgeting Under Uncertainty.Decision Sciences, 21(4), 825-841. KAHRAMAN, C., RUAN, D., & TOLGA, E. (2002). Capital budgeting techniques using discounted fuzzy versus probabilistic cash flows. Information Sciences, 142(1-4), 57-76. Kemp, S. (2003). Budgeting for managers. New York: McGraw-Hill. LUFT, J. (2010). Discussion of “The Effects of Financial Statement Information Proximity and Feedback on Cash Flow Forecasts” *. Contemporary Accounting Research, 27(1), 135-142. MOSSO, D. (2006). Social Security: Reliance on Cash Flow Accounting and Projections Disguises an Inherent Upside Cash Flow Bias. Public Budgeting & Finance, 26(1), 143-156. Mulford, C. & Comiskey, E. (2005). Creative cash flow reporting. Hoboken, N.J.: J. Wiley. Pavlovic, M. & Bogdanovic, J. (2013). Cash flow statement. Skola Biznisa, (3-4), 129-147. Tags: cash flow statement management plato FOR YOUR PROJECT Number of pages/words you require Choose your assignment deadline Looking for Your Assignment? 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professional_accounting

BMN - Financial / Annual Reports Use permanent link to share in social media Please login to send this document by email! <iframe src="https://www.thebushveldperspective.com:443/slides/embed/22?page=1" allowFullScreen="true" height="315" width="420" frameborder="0"></iframe> 1. M INERAL S ANNUAL REPORT 2015 58. For more information visit our website: www.bushveldminerals.com 13. Bushveld Minerals Annual Report 2015 11 Business review Going forward, we will implement a strategy focused on an accelerated development of the vanadium platform and a corporate restructuring to ensure the Vanadium Project is given the required focussed support in terms of management, technical expertise and capital. 9. Bushveld Minerals Annual Report 2015 07 can again yield up their tin profitably. Our mineral resources are all on or around the old Zaaiplaats mine which closed a quarter of a century ago, but they are targets that had previously been explored and evaluated by the mining house, Gold Fields of South Africa (GFSA), and we have access to those exploration results. Based on our own and on these earlier exploration results, we completed a scoping study in August 2014 of the Zaaiplaats property, its old residue dumps and the Groenfontein extension of the old mine’s mineralisation. This yielded positive results showing, against a low capital expenditure of US$16.7 million, a post-tax net present value (NPV) of US$10 million (at a 10% discount rate) and post-tax real internal rate of return (IRR) of 34.6%. However, since the completion of this scoping study, tin prices have, in line with those of most other commodities, fallen from the region of $22,000/tonne to approximately $15,000/tonne. While this may be of concern to short-term traders, our planning is based on realistic price estimates and allows for the volatility that has characterised tin over the thirty decades since the collapse of the International Tin Council in 1985. Though export coal prices have also fallen over the past year, this is not an issue that affects the viability of our Madagascar Coal Project. Our strategy is based on being awarded an independent power producer’s permit by the Madagascan authorities to generate electricity and deliver power to the Madagascan national grid. The project’s success and investment attractions do not then depend on international coal prices, but more on our ability to manage the proposed colliery efficiently. While we await the permits which will allow us to develop and operate our project, we continue to refine our plans so as to be able to move quickly once the requisite licences have been granted. We have made considerable progress towards completing the Vanadium Project’s Prefeasibility Study which will form the basis for raising development capital or for finding joint-venture partners for this project. I have directed a large part of this review to the markets for the minerals on which the Company’s future success will be built, but I am no less sensitive to the environment in which we shall be operating. In South Africa, I am encouraged by the government’s support for domestic beneficiation of raw materials as this will provide support for our envisaged projects. The government is supportive of new mining ventures and the regulations on ownership, environmental responsibility, labour and taxation are transparent, and we remain confident of the future. While our staff complement is not large, if we take into account the Company’s stage of development, the team with whom I enjoy the privilege of working have again shown their competencies and their commitment. I extend my sincere thanks to each and every one of them and, in particular, to CEO Fortune Mojapelo, who has led the Company through a period in which mineral resources have been expanded and in which a firm base has been laid for future development. Also, to my colleagues on the board, I extend my appreciation for their wise counsel and the advice that I have received during the year. Without the contributions of this team, Bushveld Minerals would not be, as it is, poised for future success. IAN WATSON Non-executive Chairman 26 August 2015 Our Madagascar Coal Project is viable despite the lower coal export prices this past year. Our plans are based on being awarded an independent power producer’s permit by the Madagascan authorities to generate electricity and deliver power to the Madagascan national grid. Business review 15. Bushveld Minerals Annual Report 2015 13 Category Risk How we mitigate the risks that impact us Infrastructure Dependence on local utilities and logistics infrastructure We recognise that our ability to achieve our exploration and mine development goals depends on adequate infrastructure, including but not limited to rail, power sources and water supply. While the electricity supply in South Africa has been under pressure, the significant investments by Eskom, the domestic power utility, to increase its power generation capacity, will alleviate these issues in the medium term. In addition, Bushveld’s projects are located in close vicinity to thermal coal deposits, providing an alternative opportunity to produce our own power. A number of multi-national mining companies operate successfully in the Bushveld Complex, using the existing road and rail infrastructure network. It is widely recognised that further investment is required in the rail network to optimise the local railway lines and ports to create sufficient capacity to effectively transport minerals in the volumes anticipated. Transnet has budgeted an investment of more than ZAR300 billion over the next six years to upgrade its logistics infrastructure, a significant portion of which is earmarked for bulk commodity rail network. With several bulk commodity projects under development in Limpopo, a sizable proportion of this investment will invariably be spent upgrading infrastructure that can be utilised by Bushveld. Metallurgy Commercially viable resources The Main Magnetite Layer, which is the flagship deposit of the Vanadium Project, exhibits clear and consistent mineralisation with fairly well understood geological characteristics. This mineralisation consists of titaniferous magnetite, which contains vanadium, iron ore and titanium and needs some metallurgical processing to produce a saleable product(s). An inability to process this mineral resource or a processing approach that is too expensive would undermine the viability of the project. Extensive test work was conducted during the year, as part of the scoping study, and this confirmed the final vanadium pentoxide (V 2 O 5 ) products that can be produced from Bushveld’s Main Magnetite Layer. A process flow diagram (PFD) was proposed for the processing of the run-of-mine (RoM) ore which comprised concentration (crushing, milling, magnetic separation), salt roast (rotary kiln), leach milling and purification, precipitation, de-ammonisation and fusion, and flaking. This PFD produced a high-purity V 2 O 5 flake product. The V 2 O 5 product can be sold directly into the vanadium market or can be processed further into an 80% V FeV (ferrovanadium) product through a simple process using an aluminothermic reactor. To mitigate against the metallurgical risk of complex processing, we chose to adopt a proven processing technology that has been utilised at various operating mines in South Africa and worldwide. The prefeasibility studies began in November 2014. Additional mitigation measures include: • Project design that seeks to be bankable on the basis of vanadium flake products alone, with any iron ore and titanium credits considered a bonus • Applying learnings from other operations that have similar mineralisation. Sufficient processing precedents producing a vanadium product exist that have been applied to the same mineralisation type as Bushveld’s. This will assist mitigate any risks involved in the processing of the ore. • Employing best practice metallurgical expertise with experience in designing and implementing metallurgical processes for vanadiferous magnetite, which South Africa has in abundance. The lower prices of iron ore worldwide mean that some of the producers that were also co-producers of vanadium (secondary production) have had to shut down or scale down operations and thus have reduced the vanadium production capacity. This bodes well for our Vanadium Project which is envisaged to be a low-cost primary vanadium producer. Business review 20. 18 Bushveld Minerals Annual Report 2015 STATEMENT OF DIRECTORS’ RESPONSIBILITIES The directors are responsible for preparing the Directors’ report and the financial statements in accordance with applicable law and regulations. Guernsey company law requires the directors to prepare Group financial statements for each financial year in accordance with generally accepted accounting principles. The directors are required by the AIM Rules of the London Stock Exchange to prepare Group financial statements in accordance with International Financial Reporting Standards (“IFRS”) as adopted by the European Union (“EU”). The financial statements of the Group are required by law to give a true and fair view and are required by IFRS as adopted by the EU to fairly present the financial position and performance of the Group. In preparing the Group financial statements, the directors should: i. select suitable accounting policies and then apply them consistently; ii. make judgements and accounting estimates that are reasonable and prudent; iii. state whether they have been prepared in accordance with IFRS as adopted by the EU; and iv. prepare the financial statements on the going concern basis unless it is inappropriate to presume that the Group will continue in business. The directors are responsible for keeping adequate accounting records that are sufficient to show and explain the Group’s transactions, and disclose with reasonable accuracy at any time, the financial position of the Group and enable them to ensure that the financial statements are properly prepared in accordance with The Companies (Guernsey) Law 2008. They are also responsible for safeguarding the assets of the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. The directors are responsible for the maintenance and integrity of the corporate and financial information included on the Group’s website. Legislation in Guernsey governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions. STATEMENT OF DIRECTORS’ RESPONSIBILITIES 53. Bushveld Minerals Annual Report 2015 51 ACTION TO BE TAKEN A Form of Proxy is enclosed. Whether or not you intend to be present at the Annual General Meeting you are requested to complet e the Form of Proxy in accordance with the instructions printed thereon and to return it to the Company’s Registrars, Capita Registrars, PXS, 34 Beckenham Road, Beckenham, BR3 4TU as soon as possible and, in any event, so that it is received no later than 11:00 am on 22 September 2014 in accordance with the Company’s Articles of Incorporation. The completion and return of a Form of Proxy will not preclude you from attending the Annual General Meeting and voting in person if you wish to do so. NOTES: 1. A member entitled to attend and vote at the Annual General Meeting is also entitled to appoint one or more proxies to attend a nd, on a poll, vote instead of him. The proxy need not be a member of the Company. 2. To be effective, the instrument appointing a proxy and any authority under which it is executed (or notarially certified copy of such authority) must be deposited at Capita Registrars, PXS, 34 Beckenham Road, Beckenham, BR3 4TU not less than 48 hours before the time for holding the Annual General Meeting. A Form of Proxy is enclosed with this Notice. Completion and return of the Form of Proxy will not precl ude members of the Company holding ordinary shares from attending and voting in person at the Annual General Meeting. 3. Pursuant to the Uncertificated Securities Regulations 2009, the time by which a person must be entered on the register of member s in order to have the right to attend and vote at the Annual General Meeting is 11:00 am on 21 September 2015 (being not more than 48 hours adjourned, such time being not more than 48 hours prior to the time fixed for the adjourned meeting. Changes to entries on the register of members after that time will be disregarded in determining the right of any person to attend or vote at the Annual General Meeting. 4. CREST members who wish to appoint a proxy or proxies through the CREST electronic proxy appointment service may do so for the A nnual General Meeting by using the procedures described in the CREST Manual. CREST Personal Members or other CREST sponsored members, and those CREST members who have appointed (a) voting service provider(s), should refer to their CREST sponsor or voting service pr ovider(s), who will be able to take the appropriate action on their behalf. In order to be valid the appropriate CREST Proxy Instruction must be transmitted so as to be received by the Company‘s agent by the latest time(s) for receipt of proxy appointments specified in the Notice. 56. 54 Bushveld Minerals Annual Report 2015 NOTES TO THE FORM OF PROXY NOTES: 1. You may appoint a proxy of your own choice by deleting the words ‘the chairman of the meeting’ and inserting the name and address of your proxy in the space provided. 2. Unless otherwise instructed, a proxy may vote as he sees fit, or abstain from voting on any business (including amendments to re solutions) which may properly come before the meeting. 3. If the is a corporation, this form must be under its common seal or under the hand of some officer or attorney duly authorised i n that behalf. 4. In the case of joint holders, the signature of any one holder will be sufficient, but the names of all the joint holders should be stated. In the event that more than one joint holder submits a proxy form, the form submitted by the most senior joint holder (determined by t he order in which the names appear in the register of members in respect of that joint holding) will be accepted to the exclusion of all ot hers. 5. To be valid, this Form of Proxy must be completed, signed and lodged with the Company’s Registrars, Capita Registrars, PXS, 34 Beckenham Road, Beckenham, BR3 4TU not less than 48 hours before the time fixed for holding the Annual General Meeting or adjourned Annual General Meeting in accordance with the Company’s Articles of Incorporation. 6. A proxy need not be a member of the Company. 7. Completion and return of this Form of Proxy does not preclude a member of the Company from subsequently attending and voting i n person at the Annual General Meeting. 8. 06 Bushveld Minerals Annual Report 2015 CHAIRMAN’S STATEMENT It is with considerable pleasure that I write this review of our Company’s operations over the past financial year and of its future prospects. As a whole we have successfully progressed our various projects with the focus being on the Vanadium Project. And while we have not yet reached the point of developing any mines of the various minerals on which we are focused, the declines in the prices of virtually all commodities since the start of our 2015 financial year have affected our project planning. This is not a development to be taken amiss. We have responded by prioritising our plans so as to ensure the operating and cost flexibilities that will allow us to generate profits while minerals prices consolidate and as markets stabilise. As a company at this early stage of its development, we are particularly conscious of the need for frugality, for making all money spent count. And I am encouraged by the manner in which my executive colleagues have managed our strategy as we proceed to the definitive studies of the mines we are planning. I am also particularly encouraged by our success at raising new finance at a time when many other junior mining companies have struggled. Our operational and planning progress is detailed fully elsewhere in this report, and I will confine myself to discussing the economic environment in which we find ourselves at present and that in which we shall be operating in future. Let me start, then, with metals markets and their outlooks. The commodities of most-immediate importance to us in South Africa are vanadium and tin. Somewhat further into the future, there is iron ore, titanium dioxide and thermal coal in Madagascar. Vanadium is an important and crucial constituent of specialty steels and particularly of flexible steels needed in the construction sector and its price has been less affected in recent months when compared to, for instance, iron ore. Looking back five years, at the start of 2010, ferro-vanadium was trading in the region of $26/kg and, within a few months had reached a high of $34/kg. Since then, there has been something of a roller coaster ride, with the trend generally downwards to $24/kg at the end of our 2015 financial year and $22/kg as I write, showing some sign of stability. While South Africa at one stage produced tin from three comparatively small mines, the combination of falling prices and ore depletion led to their closure more than two decades ago. However, those resources were not completely exhausted and, by using appropriate techniques, we Vanadium, an important and crucial constituent of specialty steels and particularly of flexible steels needed in the construction sector, has been far less affected in recent months than iron ore itself. IAN WATSON Non-Executive Chairman 22. 20 Bushveld Minerals Annual Report 2015 • senior management and subsidiary Board appointments and remuneration, contracts and the grant of share options; • key commercial matters; • risk assessment; • financial matters including the approval of the budget and financial plans, changes to the Group’s capital structure, the Group’s business strategy, acquisitions and disposals of businesses and capital expenditure; and • other matters including the health and safety policy, insurance and legal compliance. THE AUDIT COMMITTEE The Audit Committee meets at least twice a year and comprises exclusively non-executive directors, Ian Watson (Chairman) and Jeremy Friedlander. Chief Financial Officer, Geoff Sproule, attends Audit Committee meetings by invitation. This committee is responsible for: • reviewing the annual financial statements and interim reports prior to approval, focusing on changes in accounting policies and practices, major judgemental areas, significant audit adjustments, going concern and compliance with accounting standards, Stock Exchange and legal requirements; • receiving and considering reports on internal financial controls, including reports from the auditors and reporting their findings to the Board; • considering the appointment of the auditors and their remuneration including reviewing and monitoring their independence and objectivity; • meeting with the auditors to discuss the scope of the audit, issues arising from their work and any matters the auditors wish to raise; and • developing and implementing policy on the engagement of the external auditor to supply non- audit services. The Audit Committee is provided with details of any proposed related party transactions in order to consider and approve the terms and conditions of such transactions. CORPORATE GOVERNANCE REPORT continued 16. 14 Bushveld Minerals Annual Report 2015 Category Risk How we mitigate the risks that impact us Funding Raising capital to fund project development We recognise that developing our Vanadium Project to production stage will entail significant capital investment. Our Scoping Study for the Bushveld Vanadium Project released in July 2014 provided a modest capital expenditure (US$262 million) and V 2 O 5 product route at base case RoM of 1 Mtpa, underscoring the viability of the project. The study produced a post-tax NPV of US$264 million (10% discount rate) and 24.1% post-tax IRR (real) with a four-year payback from the start of mining. Our admission to AIM has given us access to the equity markets as an alternative funding mechanism for these projects. There is inherent risk in raising a significant amount of capital, which is linked to systemic issues such as the health of the global financial system. We are mitigating this risk by presenting a compelling business case and creating awareness in the investment community. We are also building optionality into our development plans, including modular alternatives for the roll out of our projects. We will continue to evaluate opportunities to develop strategic partnerships that have the potential to provide alternative sources of funding for our projects. Skills Retention of skilled personnel As a relatively new company with a small management team, we are aware of the potential impact of losing a key member of our team. We have attracted a highly-experienced team with multi-disciplinary skills who all share our long-term vision. With our admission to AIM, we are now planning a share incentive scheme whereby key members of our management team will share directly in the successes of the Company which would assist in the retention of key skills. RISK MANAGEMENT continued 10. 08 Bushveld Minerals Annual Report 2015 CHIEF EXECUTIVE OFFICER’S REVIEW I am pleased to present this report on the year ended 28 February 2015. We continue to make excellent progress in advancing the Company’s projects, particularly our flagship Vanadium Project. Since listing on AIM in 2012, the Company has substantially grown its resource base and completed three scoping studies on each of its three main platforms, namely the Vanadium Project, the P-Q Iron Ore and Titanium Project, and the Mokopane Tin Project. Additionally, we have made considerable progress towards the completion of the Vanadium Project Prefeasibility Study. The past year has not been easy for junior minerals companies, but this has not prevented us from raising the funding required to progress our projects. During the reporting period, Bushveld Minerals raised a total of £2.2 million in support of its project development objectives and working capital requirements. These funds were mainly raised through the liquidation of the facility which the Company signed with Darwin Strategic Limited in May 2014. The facility provided for Darwin to be issued shares in our Company which it, in turn, sold into the market at the Company’s instruction over a period of time. The proceeds, net of commissions, were regularly paid over to Bushveld Minerals. A placing of 16.6 million shares in October 2014 raised an additional £500,000 while execution of warrant instruments raised a further £165,000 during the same period. With scoping studies completed on most of our platforms confirming the attractiveness of our assets, we are well placed to interest value–adding strategic partnerships that can add deeper funding and expertise to our platforms as they develop towards production. BUSHVELD RESOURCES LIMITED VANADIUM PROJECT During the year’s first half, a scoping study indicated that the Vanadium Project could generate a post-tax internal rate of return (IRR) of 24% and deliver a net present value (NPV) of $264 million when calculated using a discount rate of 10%. Again during the year, the size of the vanadium ore resource increased significantly to 285 million tonnes from 52 million tonnes. This tonnage increase derives from our new mining plan which envisages extraction of the main resource’s hanging wall – material that was originally considered to be waste. Mining the hanging-wall material will not only deliver additional tonnages but will also deliver a substantial reduction in unit operating costs. With completion of the scoping study, and drawing on the skills of consultants, we proceeded with the prefeasibility study which will itself be completed during the current financial year. At the same time we initiated a programme of additional exploratory drilling with the object of raising the vanadium resource in the main magnetite layer (MML) to the measured category as well as to delineate ore in the MML’s AB Zone which can deliver concentrate grades that exceed 2% vanadium pentoxide (V 2 O 5 ). Since listing on AIM in 2012, the Company has substantially grown its resource base and completed three scoping studies on each of its three main platforms, namely the Vanadium Project, the P-Q Iron Ore and Titanium Project, and the Mokopane Tin Project. FORTUNE MOJAPELO Chief Executive Officer 23. Bushveld Minerals Annual Report 2015 21 REMUNERATION REPORT As an AIM-quoted company, Bushveld Minerals is not required to produce a Remuneration report that satisfies all the requirements of the Companies Act. However, the directors are committed to providing information on a transparent basis and present their Remuneration report as follows: REMUNERATION COMMITTEE The Remuneration Committee comprises exclusively non-executive directors, Ian Watson (Chairman) and Jeremy Friedlander. The CEO, Fortune Mojapelo, attends Remuneration Committee meetings by invitation. The Committee has the following key duties: • reviewing and recommending the emoluments, pension entitlements and other benefits of the executive directors and as appropriate, other senior executives; and • reviewing the operation of share option schemes and the granting of such options. REMUNERATION POLICY The Company’s policy is that the remuneration arrangements, including pensions for subsequent financial years, should be sufficiently competitive to attract, retain and motivate high-quality executives capable of achieving the Company’ objectives, thereby enhancing shareholder value. DIRECTORS’ SERVICE CONTRACTS Set out below are summary details of the Company’s current terms of appointment with each Executive Director: • On 20 March 2012, Fortune Mojapelo entered into a service agreement with the Company under the terms of which he agreed to act as the Chief Executive Officer. The service agreement shall be terminable by either party giving to the other not less than six months’ written notice. Mr Mojapelo may also be entitled to a bonus at the absolute discretion of the Company’s Remuneration Committee. • On 20 March 2012, Anthony Viljoen entered into a service agreement with the Company under the terms of which he agreed to act as an Executive Director. The service agreement shall be terminable by either party giving to the other not less than six months’ written notice. Mr Viljoen may also be entitled to a bonus at the absolute discretion of the Company’s Remuneration Committee. • On 20 March 2012, Geoff Sproule entered into a service agreement with the Company under the terms of which he agreed to act as the Chief Financial Officer. The service agreement shall be terminable by either party giving to the other not less than six months’ written notice. Mr Sproule may also be entitled to a bonus at the absolute discretion of the Company’s Remuneration Committee Governance 55. FORM OF PROXY FOR THE ANNUAL GENERAL MEETING I/We ............................................................. of ......................................................... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . with Account Designation ........................................................... a member/members of the above-named Company, hereby appoint the chairman of the meeting or .......................................... as my/our proxy to vote for me/us on my/our behalf at the Annual General Meeting of the Company to be held at 18-20 Le Pollet, St Peter Port, Guernsey, GY1 1WH at 11:00 am on 23 September 2015 and at any adjournment thereof. If you wish to instruct your proxy as to how to vote on your behalf, please indicate by an ‘X’ in the appropriate box below. Ordinary Resolutions For Against Withheld Discretionary 1. That the Annual Financial Statements of the Company and the Directors report and the report of the Auditors for the period ended 28 February 2014 be adopted. 2. That the Directors Fees a s reflected in the Remuneration Report and in Note 21 of the Annual Financial Statements be approved. 3. That Messrs Baker Tilly UK Au dit LLP, be reappointed as Auditors to the Company. 4. That the Directors be authorised to approve the remuneration of the Company’s Audi tors. 5. That AR Viljoen shall be re-elected as a Director, having retired by rotation and offered himself for re-election. 6. That GN Sproule shall be re-elected as a Director, having retired by rotation and offered himself for re -election. 7. The Compa ny be generally and unconditionally authorised for the purposes of Articles 50.3 of the Articles to make on market acquisitions (as defined in Article 50.5 of the Articles) of Ordinary Shares on such terms and in such manner as the Directors determine provided that: i) the maximum aggregate number of Ordinary Shares which may be purchased is 48,633,744 Ordinary Shares; ii) the minimum price (excluding expenses) which may be paid for each Ordinary Share is £0.01; iii) the maximum price (excluding expenses) which may be paid for any Ordinary Share does not exceed 105 per cent of the average closing price of such shares for the 5 business days of AIM prior to the date of purchase; and iv) this authority shall expire at the conclusion of the next annual general meeting of the Company unless such authority is renewed prior to that time (except in relation to the purchase of Ordinary Shares the contract for which was concluded before the expiry of such authority, in which case such purchase may be concluded wholly or partly after such expiry). Special Resolution For Against Withheld Discretionary 8. That the directors be and are hereby generally and unconditionally authorised pursuant to Article 8.3 of the Articles of Incorporation of the Company to allot and issue (or grant rights to subscribe for, or to convert any security into) up to 150 million shares and that the provisions of Article 9.2 and 9.9 of the Articles of Incorporation of the Company be and are hereby excluded generally in relation to the allotment and issue of such shares. This authority (and the exclusion of Article 9.2 and 9.9) shall expire at the conclusion of the next Annual General Meeting (unless renewed, varied or revoked by the Company prior to or on such date) save that the Company may before such expiry make an offer or agreement which would or might require shares to be allotted or issued (or rights to be granted) after such expiry and the Directors may allot and issue shares (or grant rights) in pursuance of any such offer or agreement as if the authority conferred hereby had not expired. Dated ...................................................... 2015 Signature ................................................... BUSHVELD MINERALS LIMITED (incorporated in Guernsey under registered number 54506) Registered office: 18-20 Le Pollet, St Peter Port, Guernsey, GY1 1WH 28 August 2015 11. Bushveld Minerals Annual Report 2015 09 During the year under review we applied for mining rights for the Vanadium Project and initiated a search for a brownfield processing plant – a strategy designed to significantly restrain the capital costs of developing the Vanadium Project and bringing it on stream. There is processing capacity available at other existing and defunct vanadium operations. P-Q IRON ORE AND TITANIUM PROJECT With the Company’s focus increasingly on the Vanadium Project, Bushveld’s efforts in respect of the P-Q Project were focused on building support for the recognition of the Bushveld Complex’s iron and titanium potential. In this context we welcome the study initiated by the IDC in July 2014 to investigate the potential of the establishment of a steel and titanium complex based on the Bushveld Complex. The mining right application for the Vanadium Project described above will also include the P-Q Project, since both projects are based on the same prospecting right. Furthermore, efforts are ongoing to develop: markets for a high TiO 2 grading magnetite concentrate; and/or partnerships capable of developing the P-Q Project downstream, fully utilising its multi-commodity suite. GREENHILLS RESOURCES MOKOPANE TIN PROJECT During the year we completed the scoping study on the Mokopane Tin Project, based on the two resources delineated on the Groenfontein and Zaaiplaats targets which contain an estimated 18,500 tonnes of contained tin. These are in geological structures that are well-understood and that are extensions to mineralisation that has previously provided tin for the South African domestic market. The scoping study was completed in August 2014 and yielded positive results, indicating that, based on a capital spend of £10.7 million, the project could generate a post-tax NPV (using a discount rate of 10%) of £9.8 million and a post-tax IRR of 34.6%. Since the completion of this scoping study tin prices have, as noted in the Chairman’s statement, fallen. However, we remain confident that the tin market will recover. There is continuing robust demand for the commodity and an uncertain supply outlook with some substantial high-grade producers set to run out of ore in the near future while few significant new producing assets are on the horizon. Our aim is to increase our resource base to more than 50,000 tonnes contained tin and, with this in mind, we are awaiting finalisation of the Company’s application for a licence 2371PR on properties adjacent to the Mokopane Tin Project which are known for tin and molybdenum mineralisation. MARBLE HALL TIN PROJECT The Company continues to actively pursue the finalisation of the application, in respect of the Marble Hall Tin Project licence, in terms of section 102 of the Mineral and Petroleum Resources Development Act (MPRDA) to extend the licence area to more fully cover the identified tin mineralisation. With potential for more than 18,000 tonnes contained tin with grades in excess of 0.5%, this project is an important part of the Company’s tin strategy. LEMUR RESOURCES LIMITED IMALOTO COAL PROJECT In Madagascar, the key to unlocking value in Lemur Resources’ Imaloto Coal Project, with its 136 million tonnes thermal coal resource, is securing an independent power producer (IPP) licence to build a coal-fired power station targeting the several mining and agricultural activities developing in the southern part of the island. Significant progress was made in advancing the IPP licence application, including negotiation of a power purchase agreement with the Madagascan power regulatory authorities, in addition to the already completed feasibility studies. We are hopeful that these efforts will yield a positive outcome in the near future. A series of transactions left Bushveld Minerals holding 58.5% of Lemur at the financial year’s end and with the prospect of increasing the holding to 100% as a cash bid is completed. We believe that Business review The Company’s focus is increasingly on the Vanadium Project, therefore, Bushveld’s efforts in respect of the P-Q Iron Ore and Titanium Project were focused on building support for the recognition of the Bushveld Complex’s iron and titanium potential. 17. Bushveld Minerals Annual Report 2015 15 DIRECTORS IAN WATSON (72) NON-EXECUTIVE CHAIRMAN Ian trained as a mining engineer and has considerable experience in the African mining sector. His previous roles include Managing Director of Northam Platinum, CEO of Platmin Limited, CEO of International Ferro Metals (SA) and Consulting Engineer at Gold Fields Limited. FORTUNE MOJAPELO(39) CHIEF EXECUTIVE OFFICER Fortune is a mining entrepreneur and founding shareholder of VM Investment Company (Pty) Ltd, a principal investments and advisory company focusing on mining projects in Africa. He has played a leading role in the origination, establishment and project development of several junior mining companies in Africa. Fortune graduated from the University of Cape Town with a BSc (Actuarial Science). He was previously at McKinsey & Company where he worked as a strategy consultant on corporate strategy and organisational development in several sectors in South Africa and Nigeria. ANTHONY VILJOEN (39) NON-EXECUTIVE DIRECTOR CHIEF EXECUTIVE OFFICER, LEMUR RESOURCES Anthony is a mining entrepreneur and founding shareholder and director of VM Investment Company (Pty) Ltd, a principal investments and advisory company focusing on mining projects in Africa. He has been involved in the establishment and project development of a number of junior mining companies across Africa. Anthony graduated from the University of Natal with a Bachelor of Business and Agricultural Economics and a Post Graduate Diploma in Finance Banking and Investment Management. Anthony previously worked at Deutsche Bank, Barclays Capital in London and Loita Capital Partners. He is a non-executive director of Lemur Resources. GEOFF SPROULE (73) CHIEF FINANCIAL OFFICER Geoff is a chartered accountant with more than 40 years’ experience in various financial management roles. He is a former partner of auditing firm Deloitte & Touche, South Africa. His directorships include the property-related J H Issacs group of companies. JEREMY FRIEDLANDER (60) NON-EXECUTIVE DIRECTOR Jeremy has a BA LLB from the University of Cape Town and practiced as an attorney after completing his Articles in Cape Town. He joined Old Mutual as a legal advisor and in 1993 established McCreedy Friedlander, which became one of the premier property agencies in South Africa, and negotiated an association with Savills. In 1998 he listed McCreedy Friedlander as part of a financial services group on the JSE and shortly afterwards relocated to London. In the United Kingdom, Jeremy has been involved in a number of property transactions. More recently Jeremy was a director of Onslow Resources (oil and gas in Namibia and Yemen). He is business development director of a number of Avana companies involved in uranium, coal, gold, oil and gas and industrial minerals. During the past six years, he has been involved in the establishment of a number of natural resource projects predominantly in Africa and South America. Governance 25. Bushveld Minerals Annual Report 2015 23 INDEPENDENT AUDITOR’S REPORT TO THE MEMBERS OF BUSHVELD MINERALS LIMITED We have audited the group financial statements of Bushveld Minerals Limited for the year ended 28 February 2015 on pages 24 to 49. The financial reporting framework that has been applied in their preparation is applicable law and International Financial Reporting Standard s (IFRS) as adopted by the European Union. This report is made solely to the company’s members, as a body, in accordance with section 262 of The Companies (Guernsey) Law 2008. Our audit work has been undertaken so that we might state to the company’s members those matters we are required to state to them in an auditor’s report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Company and the Company’s members as a body, for our audit work, for this report, or for the opinions we have formed. RESPECTIVE RESPONSIBILITIES OF DIRECTORS AND AUDITOR As more fully explained in the Statement of directors’ responsibilities set out on page 18, the directors are responsible for t he preparation of the financial statements and for being satisfied that they give a true and fair view. Our responsibility is to audit and express an opinion on the financial statements in accordance with applicable law and International Standards on Auditing (UK and Ireland). Those standards require us to comply with the Auditing Practices Board’s (APB’s) Ethical Standards for Auditors. We read the other information contained in the annual report and consider the implications for our report if we become aware of any apparent misstatements within them. SCOPE OF THE AUDIT A description of the scope of an audit of financial statements arising from the requirements of International Standards on Audit ing (UK and Ireland) is provided on the Financial Reporting Council’s website at www.frc.org.uk/auditscopeukprivate. OPINION ON THE FINANCIAL STATEMENTS In our opinion the financial statements: • give a true and fair view of the state of the group’s affairs as at 28 February 2015 and of the group’s loss for the year then ended; • the group financial statements have been properly prepared in accordance with IFRS as adopted by the European Union; and • the group financial statements have been prepared in accordance with the requirements of The Companies (Guernsey) Law 2008. MATTERS ON WHICH WE ARE REQUIRED TO REPORT BY EXCEPTION We have nothing to report in respect of the following matters where The Companies (Guernsey) Law 2008 requires us to report to you if, in our opinion: • proper accounting records have not been kept by the company; or • the company individual financial statements are not in agreement with the accounting records; or • we have not received all the information and explanations we require for our audit BAKER TILLY UK AUDIT LLP, AUDITOR Chartered Accountants and Registered Auditors 25 Farringdon Street London EC4A 4AB 26 August 2015 2. IFC Bushveld Minerals Annual Report 2015 Bushveld Minerals Limited (Bushveld Minerals or Bushveld) is an AIM-listed mineral development company with a portfolio of vanadium-and titanium bearing iron ore and tin assets in Southern Africa. Our portfolio comprises the flagship Bushveld Vanadium Project, the P-Q Iron Ore and Titanium Project, and the Mokopane Tin Project, all located on the northern limb of the Bushveld Complex, South Africa. In addition, Bushveld Minerals has a controlling interest in Lemur Resources (ASX: LMR), that owns the Imaloto Coal Project in Madagascar. The Company’s vision is to open a new frontier for mining on the Bushveld Complex. ABOUT US HIGHLIGHTS FACTS AND FIGURES During the period: • The Vanadium Project resource upgraded to 285 millio n tonnes • Positive metallurgical test results on main magnetite layer ore and concentrate • Vanadium Project Scoping Study released on 21 July 2014 showing $264 million NPV and 24% IRR based on initial capex of $262 million • Vanadium Project Prefeasibility Study launched on 20 November 2014 • Mining Right Application submitted on 16 March 2015 • £7.6 million cash at hand as at 28 February 2015 • £1.8 million spent on exploration during the period • Continued discussions in relation to Lemur Resources’ proposed independent power producer (IPP) licence and advancement of its technical aspects • Original copy of the full judgement from the Tulear court received declaring null and void various historical sale agreements which resulted in Lemur Resources being granted permit 4578 • Imaloto Coal Project resource upgraded to 136 million tonnes Post period end: • Bushveld Minerals holds an interest in 96.4% of the ordinary shares of Lemur Resources pursuant to a takeover bid by the Company that has since been declared unconditional and closed 285Mt JORC-compliant vanadium-rich magnetite deposit 939Mt JORC-compliant titanium-rich magnetite deposit ~18,000t JORC-compliant tin resource on two deposits 57. COMPANY INFORMATION REGISTERED OFFICE 18-20 Le Pollet St Peters Port Guernsey GY1 1WH PRINCIPAL OPERATING ADDRESS Suite 3A #5 Fricker Road Illovo, 2116 Johannesburg South Africa NOMINATED ADVISOR Strand Hanson Limited 26 Mount Row London, W1K 3SQ BROKER Fox Davies Capital Limited 1 Tudor Street London, EC4Y 0AH SOLICITORS TO THE COMPANY AS TO ENGLISH LAW Lewis Silkin 5 Chancery Lane Clifford’s Inn London, EC4A 1BL LEGAL COUNSEL TO THE COMPANY AS TO GUERNSEY LAW Carey Olsen Carey House Les Banques St Peter Port Guernsey GY1 4BZ LEGAL COUNSEL TO THE COMPANY AS TO SOUTH AFRICA LAW Edward Nathan Sonnenbergs 150 West Street Sandown Sandton Johannesburg 2196 South Africa INDEPENDENT AUDITOR Baker Tilly UK Audit LLP 25 Farringdon Street London, EC4A 4AB 8732/15 21. Bushveld Minerals Annual Report 2015 19 As an AIM-quoted company, Bushveld is not required to produce a Corporate governance report that satisfies the requirements of the UK Corporate Governance Combined Code. However, the directors are committed to providing information on a transparent basis as far as is relevant for a company of this size and nature, and present their Corporate governance report as follows: • The Group Board will conduct a review (at least annually) of the effectiveness of the Group’s systems of internal controls. A review should cover all material controls, including financial, operational and compliance controls and risk management systems. The review will also incorporate an analysis of the regulatory and fiscal position in the countries in which the Group operates. • The roles of chairman and chief executive are not to be exercised by the same individual. • The Group has three independent non-executive directors and the Group Board is not to be dominated by one person or group of people. • All directors will be submitted for re-election at regular intervals subject to continued satisfactory performance. The Group Board will ensure planned and progressive refreshing of the Group Board. The directors make no statement of compliance with the Code overall and do not explain in any detail aspects of the Code with which they do not comply. THE BOARD OF DIRECTORS The Board currently comprises: EXECUTIVE DIRECTORS • Fortune Mojapelo Chief Executive Officer • Geoffrey Sproule Chief Financial Officer NON-EXECUTIVE DIRECTORS • Ian Watson Chairman and Independent Non-executive Director • Anthony Viljoen Non-executive Director (CEO, Lemur Resources) • Jeremy Friedlander Independent Non-executive Director Operational management in South Africa is led by Fortune Mojapelo as operations director supported by a senior geologist and two assistants. Operational management is also supported technically through the consultancy agreement with VM Investment Company (Proprietary) Limited. GROUP BOARD MEETINGS The Group Board meets quarterly and more often if required. Group Board meetings may be held via teleconference although whenever practically possible the directors will endeavour to attend in person. The Group Board has taken professional international tax advice as to maintaining the tax residency of the Company in Guernsey. The Company is managed and centrally controlled in Guernsey. All Group Board meetings are held outside the UK. The matters reserved for the attention of the Group Board include, inter alia : • the approval of financial statements, dividends and significant changes in accounting practices; • Group Board membership and powers including the appointment and removal of Group Board members, determining the terms of reference of the Group Board and establishing the overall control framework; • stock exchange-related issues including the approval of the Company’s announcements and communications with both shareholders and the stock exchange; CORPORATE GOVERNANCE REPORT Governance 24. 22 Bushveld Minerals Annual Report 2015 INCENTIVE/SHARE OPTION SCHEMES The Company intends to enter into share option agreements granting options to employees, management and Directors, subject to the terms that: (a) the total number of options shall not exceed 10% of the Enlarged Share Capital; (b) the options are exercisable at an option price of 30 pence per Ordinary Share; (c) half of the number of Ordinary Shares comprised in each option will vest two years from the date they were granted and the remaining half of the Ordinary Shares comprised in the option will vest one year later; (d) the options will lapse five years following Admission (unless exercised earlier); and (e) if the option is granted to an employee of the Group and that employee leaves their employment, the option will lapse immediately if that employee is dismissed for cause, and after six months of the termination of employment otherwise. All such options will be granted at the discretion of the Board and may include options granted to employees of the Group in the ordinary course of business as part of remuneration arrangements with employees. DIRECTORS’ EMOLUMENTS The remuneration of the individual directors who served in the year to 28 February 2015 was: £ Salary and fees Fees Bonus Share-based payment 2015 Total 2014 Total Fortune Mojapelo 108,333 – – 47,000 155,333 108,333 Geoffrey Sproule 97,500 – – 33,000 130,500 97,500 Anthony Viljoen – 25,000 – 36,667 61,667 100,000 Ian Watson – 40,000 – – 40,000 40,000 Jeremy Friedlander – 25,000 – 27,500 52,500 25,000 205,833 90,000 – 144,167 440,000 370,833 The aggregate fees of all of the directors for their services (excluding any amounts payable as salary) shall not exceed £500,000 per annum, or such higher amount as may be determined by ordinary resolution (excluding amounts payable under any other provision of the Articles). Any director who performs services, which in the opinion of the Board, goes beyond the ordinary duties of a director, may be paid such extra remuneration by way of salary, percentage of profits or otherwise as the Board may, in its discretion, determine. REMUNERATION REPORT continued 54. 52 Bushveld Minerals Annual Report 2015 52 Bushveld Minerals Annual Report 2015 NOTES 52. 50 Bushveld Minerals Annual Report 2015 NOTICE OF ANNUAL GENERAL MEETING BUSHVELD MINERALS LIMITED (incorporated in Guernsey under registered number 54506) Registered office: 18-20 Le Pollet, St Peter Port Guernsey, GY1 1WH 28 August 2015 THIS DOCUMENT AND THE ACCOMPANYING FORM OF PROXY IS IMPORTANT AND REQUIRES YOUR IMMEDIATE ATTENTION. If you are in any doubt as to what action you should take, you are recommended to seek your own financial advice immediately fro m your stockbroker, bank manager, solicitor, accountant or other independent financial advisor who specialises in advising on shares or other securities and who is, in the case of UK shareholders, authorised under the Financial Services and Markets Act 2000. If you have sold or transferred your shares in Bushveld Minerals Limited, please forward this document at once to the purchaser or transferee or to the stockbroker, bank or other agent through whom the sale or transfer was effected, for delivery to the purchaser or transferee. If you have sold or transferred part of your registered holding of shares, please consult the stockbroker, bank or other agent through whom the sale or transfer was effected. Notice of an Annual General Meeting of Bushveld Minerals Limited (the ‘Company’) to be held at 11:00 am on Wednesday 23 September 2015 at 18-20 Le Pollet, St Peter Port, Guernsey, GY1 1WH. Members of the Company are requested to return the enclosed Form of Proxy which, to be valid, must be completed and returned in accordance with the instructions printed thereon so as to be received as soon as possible by the Company’s Registrars, Capita Registrars, PXS, 34 Beckenham Road, Beckenham, BR3 4TU, but in any event so as to be received by the Company Secretary at the registered office in accordance with the provisions of the Company’s Articles of Incorporation not less than 48 hours before the time appointed for the Annual General Meeting. Completion and return of a Form of Proxy will not preclude a member of the Company from attending a nd voting in person at the Annual General Meeting should they so wish. ORDINARY RESOLUTIONS 1. To receive and adopt the Annual Financial Statements of the Company and the Directors report and the report of the Auditors for the period ended 28 February 2015. 2. To approve the Directors Fees as reflected in the Remuneration Report and in Note 21 of the Annual Financial Statements. 3. That Messrs Baker Tilly UK Audit LLP, be reappointed as Auditors to the Company. 4. That the Directors be authorised to approve the remuneration of the Company’s Auditors. 5. That AR Viljoen shall be re-elected as a Director, having retired by rotation and offered himself for re-election. 6. That GN Sproule shall be re-elected as a Director, having retired by rotation and offered himself for re-election. 7. The Company be generally and unconditionally authorised for the purposes of Articles 50.3 of the Articles to make on market acq uisitions (as defined in Article 50.5 of the Articles) of Ordinary Shares on such terms and in such manner as the Directors determine provided that: i) the maximum aggregate number of Ordinary Shares which may be purchased is 48,633,744 Ordinary Shares; ii) the minimum price (excluding expenses) which may be paid for each Ordinary Share is £0.01; iii) the maximum price (excluding expenses) which may be paid for any Ordinary Share does not exceed 105 per cent of the average closing price of such shares for the 5 business days of AIM prior to the date of purchase; and iv) this authority shall expire at the conclusion of the next annual general meeting of the Company unless such authority is renewe d prior to that time (except in relation to the purchase of Ordinary Shares the contract for which was concluded before the expiry of suc h authority, in which case such purchase may be concluded wholly or partly after such expiry). SPECIAL RESOLUTION 8. That the directors be and are hereby generally and unconditionally authorised pursuant to Article 8.3 of the Articles of Incorp oration of the Company to allot and issue (or grant rights to subscribe for, or to convert any security into) up to 150 million shares and that the provisions of Article 9.2 and 9.9 of the Articles of Incorporation of the Company be and are hereby excluded generally in relation to the allotment and issue of such shares. This authority (and the exclusion of Article 9.2 and 9.9) shall expire at the conclusion of the next A nnual General Meeting (unless renewed, varied or revoked by the Company prior to or on such date) save that the Company may before such expiry make a ny offer or agreement which would or might require shares to be allotted or issued (or rights to be granted) after such expiry and the Dire ctors may allot and issue shares (or grant rights) in pursuance of any such offer or agreement as if the authority conferred hereby had not exp ired. By order of the Board F MOJAPELO Director 28 August 2015 33. Bushveld Minerals Annual Report 2015 31 Bushveld Minerals Annual Report 2015 31 Financial statements 2. ADOPTION OF NEW AND REVISED STANDARDS ACCOUNTING STANDARDS ADOPTED DURING THE YEAR Effective date IAS 16 and IAS 38 Property, Plant and Equipment and Intangible Assets. Amendments resulting from Annual Improvements 2010-2012 Cycle (proportionate restatement of accumulated depreciation on revaluation). 1 January 2014 IAS 24 Related Party Disclosures. Amendments resulting from Annual Improvements 2010-2012 Cycle (management entities). 1 January 2014 IAS 32 Offsetting Financial Assets and Financial Liabilities. The amendments provide additional guidance in respect of offsetting financial instruments and therefore changes have also been made to IFRS 7 as noted below. 1 January 2014 IFRS 3 Business Combinations. Amendments resulting from Annual Improvements 2011-2013 Cycle (scope exception for joint ventures). 1 January 2014 IFRS 8 Operating Segments. Amendments resulting from Annual Improvements 2010-2012 Cycle (aggregation of segments, reconciliation of segment assets). 1 January 2014 IFRS 12 Disclosure of interests in other entities. Amendments for investment entities. 1 January 2014 IFRS 9 Financial Instruments. IAS 39 will be replaced by this standard over 3 phases. IFRS 9 specifies how an entity should classify and measure financial assets, including some hybrid contracts plus requirements on accounting for financial liabilities. 1 January 2015** ** not yet endorsed by the EU Following the adoption of these standards there has been no change to the group accounting policies and there has been no mater ial impact on the financial statements of the Group. ACCOUNTING STANDARDS AND INTERPRETATIONS NOT APPLIED The following adopted IFRS have been issued but have not been applied by the Group in these financial statements. Their adoptio n is not expected to have a material effect on the financial statements: Standard Description Effective date Annual Improvements to IFRS 2012-2014 Cycle 1 January 2016 IFRS 9 Financial Instruments 1 January 2018 IFRS 10 and IAS 28 Amendments: Sale or Contribution of Assets between an Investor and its Associate or Joint Venture 1 January 2016 IFRS 10, IFRS 12 and IAS 28 Amendments: Investment Entities: Applying the Consolidation Exception 1 January 2016 IFRS 11 Amendments: Accounting for Acquisitions of Interests in Joint Operations 1 January 2016 IFRS 14 Regulatory Deferral Accounts 1 January 2017 IFRS 15 Revenue from Contracts with Customers 1 January 2016 IAS 1 Amendments: Disclosure initiative 1 January 2016 IAS 16 and IAS 41 Agriculture: Bearer Plants 1 January 2016 IAS 16 and IAS 38 Amendments: Clarification of Acceptable Methods of Depreciation and Amortisation 1 January 2016 IAS 27 Amendments: Equity Method in Separate Financial Statements 1 January 2016 The directors anticipate that the adoption of these Standards and Interpretations in future periods will have no material impac t on the financial statements of the Group. 14. 12 Bushveld Minerals Annual Report 2015 During the year under review, we conducted a detailed analysis of the inherent risks in the exploration and development of our natural resource projects. This enabled us to develop mitigation measures to manage these risks within our defined risk limits. The risks describ ed below are the material factors which could impact our ability to deliver on our long-term strategic objectives. Category Risk How we mitigate the risks that impact us Mineral rights and tenure security Obtaining and maintaining mineral (prospecting and mining) rights As secure mineral titles are at the heart of every mining enterprise, it is a key priority for Bushveld Minerals to ensure that our mineral rights (prospecting and/or mining) are in good standing. Accordingly, we have a dedicated mineral rights tenure manager responsible for this. In addition, as delivering on our growth strategy is partially dependent on our ability to secure additional prospecting rights on properties, this is an area of continual focus. The two threats to mineral title security that we proactively manage are political risk and regulatory compliance. a) Political risk Prior to the recent economic recession, the global boom in commodity prices attracted the attention of the governments of resource rich countries, most of whom sought to increase state benefits in the mining sector. This has taken different forms, including the imposition of increased taxes (e.g. windfall taxes) and discussions in South Africa about an increased role of government in the mining sector. While these have not been implemented in South Africa to date, we believe that the government will continue to recognise the importance of a vibrant commodity and mining sector to the prosperity of all South Africans and its duty to uphold the constitution (which protects private property ownership). Notwithstanding this we believe that it is prudent for Bushveld to develop a geographically diverse portfolio of assets to mitigate political risks in one geography. To this end, we actively investigate value- adding projects that meet our criteria of scope for scale and favourable cost-curve positioning. The current bid for Lemur Resources, announced post year end, is in line with this diversification strategy. b) Regulatory compliance i) BEE/communities partnerships South Africa has a robust World Bank-compliant mineral law that is underpinned by a sound constitution and independent functional judiciary that lends much to the security of mineral titles. The following are examples of regulatory compliance risks we manage: - BEE partnerships: The South African government has adopted a Mining Charter that requires economic participation in mining projects by historically disadvantaged South Africans (HDSAs). The Mining Charter outlines several metrics spanning equity participation, management representation and preferential procurement, among others. Bushveld has entered into several BEE partnerships to ensure its compliance. - Community involvement: Beyond the equity participation of the BEE partners in our projects, Bushveld adopts a holistic approach that includes local communities who live in the areas that we operate. Bushveld proactively and continually engages with its BEE partners and communities to realise the objectives of the Mining Charter in a sustainable manner. ii) Environmental and safety legislation Bushveld continually monitors the environmental and safety legislation as it relates to reclamation, disposal of waste products, protection of wildlife and otherwise relating to environmental protection, among others, to ensure that we quickly adapt to all relevant legislative changes. Although our projects are still in the scoping phase, our executive team has adopted a proactive approach to ensure that the processes and procedures pertaining to sustainable development are integrated into our development plans. RISK MANAGEMENT 51. Bushveld Minerals Annual Report 2015 49 21. RELATED PARTY TRANSACTIONS Balances and transactions between the Company and its subsidiaries, which are related parties, have been eliminated on consolid ation and are not disclosed in this note. VM Investments is a related party due to two of the Executive Directors (Fortune Mojapelo and Anthony Viljoen) of Bushveld Mine rals Limited being majority shareholders of VM Investments. At the period end, the Group owed VM Investments Ltd £25,949 (2014: £7,387). During the period, VM Investments charged the Group £101,275 (2014: £115,475) for office accommodation and other office services. The remuneration of the directors, who are the key management personnel of the Group, is set out below. Further information about the remuneration of individual directors is provided in the Directors’ remuneration report. 28 February 2015 28 February 2014 £ £ Fees for services as directors 154,167 65,000 Short-term employee benefits 285,833 305,833 440,000 370,833 Included within the above figure of short-term employee benefits is an amount of £97,500 (2014: £97,500) which has been capitalised as part of intangible exploration expenditure. There are no national insurance or social security costs payable by the Company. Bushveld Minerals Annual Report 2015 49 50. 48 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 20. EVENTS AFTER THE BALANCE SHEET DATE On 20 May 2015, Bushveld announced its intention to make an off-market takeover offer for all fully paid ordinary shares in the capital of Lemur which Bushveld does not currently own. Bushveld had a relevant interest in 115,197,097 Lemur shares representing approximately 63.5% of Lemur’s current fully paid ordinary share capital. The offer is conditional upon satisfaction of a minimum acceptance condition, being that at or before the end of the offer peri od, Bushveld becomes entitled to proceed to compulsory acquisition of outstanding Lemur shares in accordance with Part 6A.1 of the Corporations Act. TOTAL CONSIDERATION UNDER THE OFFER The consideration for the acquisition by Bushveld of the Lemur shares to which the offer relates will be satisfied by the payme nt of $0.06 cash (in Australian Dollars(A$)) per Lemur share. As at the date of this bidder’s statement, there are 181,250,001 Lemur shares on issue, of which Bushveld has a relevant interest in 115,197,097. The maximum number of Lemur Shares which could be acquired by Bushveld under the offer is therefore 66,052,904 (assuming that the 500,000 Lemur options with an exercise price of A$0.15 will not be exercised). Accordingly, the maximum cash amount, which may be required by Bushveld to settle the acceptances under the offer, is approximately A$3.963 million. FUNDING FOR THE MAXIMUM CONSIDERATION AMOUNT Bushveld has secured the following funding or the consideration amount: a) The amount of up to £2.6 million (or A$5,148 million, assuming an A$:£ exchange rate of 1.98 as at 22 May 2015) from Riveridge Limited. Riverridge Limited has a 5.2% relevant interest in the shares of Bushveld Minerals. The funding is in the form of a direct, uns ubordinated and unsecured loan note repayable within six months of drawdown, unless Riveridge United elects to convert the note into Bushveld s hares and these must be drawn on or before 30 September 2015. The draw down can be made following the satisfaction of the minimum acceptance condition. b) The amount of up to £2,2 million (or A$4,356 million, assuming an A$:£ exchange rate of 1.98) from Darwin Strategic Limited. T he funding is in the form of a senior, unsecured loan facility repayable by the maturity date of 28 November 2015, unless Darwin Strategic Limited elects to convert the facility into Bushveld shares and must be drawn down on or before the date that is 20 AIM trading days prior to the maturity date, which is expected to be on or around 2 November 2015. The draw down can be made once the Company has a relevant interest in excess of 75% of all Lemur shares in issue so long as Lemur holds a cash balance of $12 million. Having regard to the matters set out above, Bushveld is of the opinion that it will be able to satisfy its consideration obliga tions under the offer, as well as its costs associated with the offer. The offer is not subject to any financing defeating conditions. Darwin Strategic Limited has been issued 4,000,000 five-year warrants at an exercise price of 10 pence as a consideration for providing this facility. NO HEDGING There are no hedging arrangements in place for movements in exchange rates in respect of the financing arrangements described i n this section. However, Bushveld expects that the funds available under those arrangements will be more than sufficient to pay the total consideration as well as any associated transacting costs incurred by Bushveld, even in the event of a material adverse movement in exchange rates. LEMUR RESOURCES With effect from 31 July 2015 Bushveld has a relevant interest in 96.4% of all of the ordinary shares in Lemur. Bushveld has drawn down £2.2 million of the Darwin facility which will be used to fund the acquisition of the first tranche of the minority shares amounting to 56,702,925 Lemur shares at a cost of £1,607,756. The balance of 6,575,204 minority Lemur shares will be compulsorily acquired at an estimated cost of £198,000. 12. 10 Bushveld Minerals Annual Report 2015 the bid’s successful completion will enhance value for Bushveld Minerals, releasing cash in excess of AU$12 million to the Group and aligning the interests of Lemur with those of Bushveld Minerals’ shareholders. Please see note 20 regarding the off-market takeover of Lemur Resources. OUTLOOK While our Company remains focused on exploration, we are confident that mining is within reach, with the Vanadium Project as our flagship venture. In the longer term we envisage using positive cash flows from the Vanadium Project to help finance our other projects. We shall also continue our efforts to find strategic partners for our projects and believe that these projects’ qualities are sufficiently attractive to achieve this. Key to the Vanadium Project’s positioning as our flagship project is its distinctiveness across four important criteria we have set for our projects: • Commodity: A commodity with sound market fundamentals in terms of supply, demand and price outlook • Low cost-curve position: with a low first-quartile cost position making it one of the world’s lowest cost producers of vanadium, owing largely to its high V 2 O 5 in situ and concentrate grades, a large resource base and access to proven processing technologies • Pragmatic realisable path to production: given options for limited production of concentrate product and scope to leverage in-country installed vanadium processing infrastructure, all of which entails a very modest capital expenditure • Scalability: The project’s prefeasibility study is based on less than 15% of the total resource, which is open ended at depth and along strike. This, combined with other resource acquisitions planned by the Company ensure the scalability of the project, which, combined with the other three criteria described above, make a compelling proposition for major strategic partners or suitors Accordingly the Company will, going forward, implement a strategy focused on an accelerated development of the vanadium platform and a corporate restructuring to give effect to the vanadium focus. The vanadium strategy is focused on the main pillars of: • Completing the Prefeasibility Study followed by a Bankable Feasibility Study in conjunction with a strategic partner • Exploring opportunities for early cash flow by selling vanadium concentrate while simultaneously developing fully integrated mining and vanadium processing operations • Reducing the timeline and capital expenditure required to execute a fully integrated vanadium- producing operation by using existing and under-utilised domestic processing capacity • Supporting the development of additional vanadium demand beyond the steel sector through support for energy storage applications of vanadium • Consolidating primary vanadium resources across the Bushveld Complex APPRECIATION I remain confident that the combination of skills and assets that are drawn together in Bushveld Minerals make the Company a potent developmental force. It remains for me to express my gratitude to my board colleagues, to the Bushveld Minerals executives and to the skilled personnel who have brought the Company to its current point and who will be central to its future progress. I have been ably supported by all these people – without them progress would have been less certain. FORTUNE MOJAPELO CEO CHIEF EXECUTIVE OFFICER’S REVIEW continued Although our focus remains on exploration, we are confident that mining is within reach, with the Vanadium Project as our flagship venture. We envisage using positive cash flows from the Vanadium Project to help finance our other projects in the longer term. 32. 30 Bushveld Minerals Annual Report 2015 30 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEAR ENDED 28 FEBRUARY 2015 1. CORPORATE INFORMATION AND PRINCIPAL ACTIVITIES Bushveld Minerals Limited (“Bushveld”) was incorporated and domiciled in Guernsey on 5 January 2012, and admitted to the AIM market in London on 26 March 2012. The Bushveld Group comprises Bushveld Minerals Limited and its wholly owned subsidiaries headed by Bushveld Resources Limited ( “BRL”) and Greenhills Resources Limited (“GRL”), companies registered and domiciled in Guernsey together with their South African subsidia ries. The wholly owned Guernsey subsidiaries BRL and GRL were acquired by Bushveld under the terms of a Share Exchange Agreement ente red into on 15 March 2012. BRL is an investment holding company formed to invest in resource-based iron ore exploration companies in South Africa. The So uth African subsidiaries are Pamish Investments No. 39 (Proprietary) Limited (“Pamish 39”) in which BRL holds a 64% equity interest, Amaraka Investments No. 85 (Proprietary) Limited (“Amaraka 85”) in which BRL holds 68.5% equity interest and Frontier Platinum Resources (Proprietary) Limited in which BRL holds 100% equity interest. The minority shareholder in Pamish 39 is Izingwe Capital (Proprietary) Limited and the minority shareholder in Amaraka 85 is Afro Multi Minerals (Proprietary) Limited. GRL is an investment holding company formed to invest in resource-based tin exploration companies in South Africa. The South Af rican subsidiaries are Mokopane Tin Company (Proprietary) Limited in which GRL holds 100% equity interest and Renetype (Proprietary) Limited (“Renetype”) in which GRL holds a 74% equity interest. The minority shareholders in Renetype are African Women Enterprises Investments (Proprietary) Limited and Cannosia Trading 62 CC who own 10% and 16% respectively. Lemur is a coal project development company listed on the ASX. Through its wholly owned subsidiaries as detailed below, the Group is the holder of 11 concession blocks in South West Madagascar covering the Imaloto Coal Basin, known as the Imaloto Coal Project and Extension. In addition, the Group is in the final stages of acquiring two further blocks contiguous to the existing holdings subject to ministerial appr oval of the transfer. This project is known as the Imaloto Project Extension. Lemur owns two additional projects known as the Ianapera Coal Project a nd Sakaraha Coal Project. As at 28 February 2015, the Bushveld Group comprised: Company Equity holding and voting rights Country of incorporation Nature of activities Bushveld Minerals Limited N/A Guernsey Ultimate holding company BRL 1 100% Guernsey Holding company Pamish 39 2 64% South Africa Iron ore exploration Amaraka 85 2 68.50% South Africa Iron ore exploration Frontier Platinum 2 100% South Africa Group support services GRL 1 100% Guernsey Holding company Mokopane 3 100% South Africa Holding company Renetype 4 74% South Africa Tin exploration Lemur Resources Limited 1 58.5% Australia Holding company Coal of Madagascar Limited 5 58.5% Guernsey Holding company Coal Mining Madagascar SARL 5 57.9% Madagascar Coal exploration Pan African Drilling Limited 5 58.5% British Virgin Islands Coal exploration Imaloto Power Project Limited 5 58.5% Mauritius Power generation company Lemur Investments Limited 5 58.5% Mauritius Holding company Lemur Exploration SARL 5 57.9% Madagascar Coal exploration 1 Held directly by Bushveld Minerals Limited 2 Held by BRL 3 Held by GRL 4 Held by Mokopane 5 Held by Lemur Resources Limited These financial statements are presented in Pound Sterling (£) because that is the currency the Group has raised funding on the AIM market in the United Kingdom. 35. Bushveld Minerals Annual Report 2015 33 Bushveld Minerals Annual Report 2015 33 Financial statements Gains and losses arising on retranslation are included in profit or loss for the period, except for exchange differences on non- monetary assets and liabilities, which are recognised directly in other comprehensive income when the changes in fair value are recognised dire ctly in other comprehensive income. On consolidation, the assets and liabilities of the Group’s overseas operations are translated into the Group’s presentational currency at exchange rates prevailing at the reporting date. Income and expense items are translated at the average exchange rates for the period unless exchange rates have fluctuated significantly during the period, in which case the exchange rate at the date of the transaction is used. Exchange differences arising, if any, are taken to other comprehensive income and the Group’s translation reserve. Such translation differences are recognised as income or as expenses in the period in which the operation is disposed of. FINANCE INCOME Interest revenue is recognised when it is probable that economic benefits will flow to the Group and the amount of revenue can be measured reliably. Interest revenue is accrued on a time basis, by reference to the principal outstanding and at the effective interest rate applicable, which is the rate that exactly discounts estimated future cash receipts through the expected life of the financial asset to that asset’s net carrying amount on initial recognition. TAXATION The tax expense represents the sum of the tax currently payable and deferred tax. The tax charge is based on taxable profit for the year. The Group’s liability for current tax is calculated by using tax rates that have been enacted or substantively enacted by the reporting date. Deferred tax is the tax expected to be payable or recoverable on differences between the carrying amount of assets and liabilit ies in the financial statements and the corresponding tax bases used in the computation of taxable profit, and is accounted for using the “balance sh eet liability” method. Deferred tax liabilities are recognised for all taxable temporary differences and deferred tax assets are recognised to the ext ent that it is probable that taxable profits will be available against which deductible temporary differences can be utilised. Deferred tax is calculate d at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled based upon rates enacted and substa ntively enacted at the reporting date. Deferred tax is charged or credited to profit or loss, except when it relates to items credited or charged to ot her comprehensive income, in which case the deferred tax is also dealt with in other comprehensive income INTANGIBLE EXPLORATION AND EVALUATION ASSETS All costs associated with mineral exploration and evaluation including the costs of acquiring prospecting licences; mineral pro duction licences and annual licences fees; rights to explore; topographical, geological, geochemical and geophysical studies; exploratory drilling; trenching, sampling and activities to evaluate the technical feasibility and commercial viability of extracting a mineral resource; are capitalised as intangible exploration and evaluation assets and subsequently measured at cost. If an exploration project is successful, the related expenditures will be transferred at cost to property, plant and equipment and amortised over the estimated life of the commercial ore reserves on a unit of production basis (with this charge being taken through profit or lo ss). Where a project does not lead to the discovery of commercially viable quantities of mineral resources and is relinquished, abandoned, or is co nsidered to be of no further commercial value to the Group, the related costs are recognised in profit or loss. The recoverability of deferred exploration costs is dependent upon the discovery of economically viable ore reserves, the abili ty of the Group to obtain necessary financing to complete the development of ore reserves and future profitable production or proceeds from the e xtraction or disposal thereof. IMPAIRMENT OF EXPLORATION AND EVALUATION ASSETS Whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, the asset is reviewed for impairment. Assets are also reviewed for impairment at each balance sheet date in accordance with IFRS 6. An asset’s carrying value is written down to its estimated recoverable amount (being the higher of the fair value less costs to sell and value in use) if that is less t han the asset’s carrying value. Impairment losses are recognised in profit or loss. 3. SIGNIFICANT ACCOUNTING POLICIES continued 43. Bushveld Minerals Annual Report 2015 41 Bushveld Minerals Annual Report 2015 41 Financial statements 16. SHARE CAPITAL AND SHARE PREMIUM Number of shares issued and fully paid Issue price per share Nominal value of shares of 1 pence each Share premium Total share capital and premium £ £ £ £ Balance at 28 February 2014 402,004,104 4,020,041 57,933,792 61,953,833 Total warrants exercised at 28 February 2015 3,000,000 0.0500 30,000 120,000 150,000 Capital raise Darwin structure 50,000,000 0.0570 500,000 2,350,000 2,850,000 Cost of acquiring Lemur shares 8,000,000 0.0415 80,000 252,000 332,000 Capital raise 30 October 2014 16,666,667 0.0300 166,666 333,333 499,999 Shares issued in lieu of bonus 4,166,667 0.0220 41,666 50,000 91,666 Shares issued for services rendered 2,500,000 0.0220 25,000 30,000 55,000 Share issue expenses (1,141,584) (1,141,584) 486,337,438 4,863,373 59,927,541 64,790,914 The Board may, subject to Guernsey Law, issue shares or grant rights to subscribe for or convert securities into shares. It may issue different classes of shares ranking equally with existing shares. It may convert all or any classes of shares into redeemable shares. The Company may also hold treasury shares in accordance with the law. Dividends may be paid in proportion to the amount paid up on each class of shares. Of the shares issued in respect of services rendered £55,000 was in respect of consulting fees in respect of the Lemur acquisit ion. DARWIN STRATEGIC LIMITED In order to provide the Company with finance, the Company issued 50,000,000 ordinary shares of 1 pence each, the Subscription S hares to Darwin Strategic Limited (Darwin) at a price of 5.7 pence per Subscription Share, the Subscription Price, in total £2,850,000, the agg regate Subscription Price on the 24 April 2014. Darwin satisfied the consideration for the Subscription Shares by the issue to the Company of redeemable subscription notes havi ng a principal amount equal to the aggregate Subscription Price of the Subscription Shares. In terms of the Agreement with Darwin, for the twelve months following the completion of the Subscription, the Company will be entitled to serve notices on Darwin requiring it to sell a specified number of the Subscription Shares and upon such Subscription Shares being sol d, Darwin is to transfer the proceeds of the sale to the Company and a portion of the notes will be treated as redeemed. The Darwin transaction was concluded on 23 October 2014 and raised net proceeds of £1,524,031. Of the shortfall arising from the transaction, £1,130,490 has been charged against share premium and the balance of £195,479 to commission payable. Darwin received an initial commission of 3% of the aggregate Subscription Price and 5% of the gross proceeds of the Subscriptio n Shares being sold. Darwin was issued with warrants to subscribe for 3,000,000 Ordinary Shares in the Company at a price of 8 pence per Ordinary S hare. On the 24 October 2014, the Company placed 16,666,667 new ordinary shares at £0.03 per share, thereby raising £500,000 additional funding. Total net funding raised during the year to 28 February 2015 amounted to £2,837,081. 44. 42 Bushveld Minerals Annual Report 2015 42 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 17. WARRANTS Warrants granted Date of grant 26/03/14 Number granted 3,000,000 Contractual life 5 years Estimated fair value per warrant £0.055 The estimated fair values were calculated by applying the Black Scholes pricing model. The model inputs were: Warrant scheme Date of grant 26/03/14 Share price at grant date £0.055 Exercise price £0.080 Expected life 5 years Expected volatility 61.7% Expected dividends Nil Risk-free interest rate 1.81% The assumed volatility rate was based on an average of comparable listed companies over a period commensurate to the terms of t he warrants. The following warrants were granted during the year ended 28 February 2014: Warrants granted Date of grant 22/07/13 01/10/13 05/11/13 05/11/13 Number granted 850,000 3,507,975 1,838,235 24,276,879 Contractual life 2 years 5 years 2 years 2 years Estimated fair value per warrant £0.120 £0.044 £0.034 £0.050 The estimated fair values were calculated by applying the Black Scholes pricing model. The model inputs were: Warrant scheme Date of grant 22/07/13 01/10/13 05/11/13 05/11/13 Share price at grant date £0.070 £0.050 £0.034 £0.034 Exercise price £0.120 £0.050 £0.034 £0.050 Expected life 2 years 2 years 2 years 2 years Expected volatility 60.0% 60.0% 58.4% 58.4% Expected dividends Nil Nil Nil Nil Risk-free interest rate 0.34% 0.51% 0.54% 0.54% The assumed volatility rate was based on an average of comparable listed companies over a period commensurate to the terms of t he warrants. 18. 16 Bushveld Minerals Annual Report 2015 DIRECTORS’ REPORT The directors of Bushveld Minerals Limited (“Bushveld” or the “Company”) hereby present their report together with the consolidated financial statements for the year ended 28 February 2015. PRINCIPAL ACTIVITIES, BUSINESS REVIEW AND FUTURE DEVELOPMENTS The principal activity of the Group (Bushveld and its subsidiaries) is the exploration and development of projects in the Bushveld Complex in South Africa. A review of the Group’s progress and prospects is given in the Chief Executive Officer’s review on pages 08 to 10. A review of the risks and uncertainties impacting on the Group’s long-term performance are included in the Corporate governance report on pages 19 to 20. Details of the Group’s exposure to foreign exchange and other financial risks are included in note 19. EXPLORATION COSTS The Group continues to devote considerable resources to exploration costs. RESULTS AND DIVIDEND The Group’s results show a loss for the period attributable to the equity holders of the Company of £2.9 million (2014: £0.4 million). The directors are unable to recommend a dividend. SHARE CAPITAL AND FUNDING Full details of the authorised and issued share capital, together with details of the movements in the Company’s issued share capital during the year, are shown in note 16. The Company has one class of ordinary shares which carry no right to fixed income. Each share carries the right to one vote at general meetings of the Company. DIRECTORS The directors who served the Company since 1 March 2014 are as follows: Fortune Mojapelo Chief Executive Officer Geoffrey Sproule Chief Financial Officer Anthony Viljoen Non-executive Director Ian Watson Chairman and Independent Non-executive Director Jeremy Friedlander Independent Non-executive Director DIRECTORS’ INTERESTS The directors’ beneficial interests in the shares of the Company at 28 February 2015 were: Ordinary shares of 1p each 28 February 2015 Ordinary shares of 1p each 28 February 2014 Fortune Mojapelo 9,660,000 8,160,000 Geoffrey Sproule 1,500,000 Nil Anthony Viljoen 9,826,667 8,160,000 Ian Watson 504,000 Nil Jeremy Friedlander 1,250,000 Nil None of the directors have been awarded share options of the Company since inception to 28 February 2015. 19. Bushveld Minerals Annual Report 2015 17 DIRECTORS’ INDEMNITY INSURANCE The Group has maintained insurance throughout the year for its directors and officers against the consequences of actions brought against them in relation to their duties for the Group. EMPLOYEE INVOLVEMENT POLICIES The Group places considerable value on the awareness and involvement of its employees in the Group’s exploration and development activities. Within bounds of commercial confidentiality, information is disseminated to all levels of staff about matters that affect the progress of the Group, and that are of interest and concern to them as employees. CREDITORS’ PAYMENT POLICY AND PRACTICE The Group’s policy is to ensure that, in the absence of dispute, all suppliers are dealt with in accordance with its standard payment policy to abide by the terms of payment agreed with suppliers when agreeing the terms of each transaction. Suppliers are made aware of the terms of payment. The number of days of average daily purchases included in trade payables at 28 February 2015 was 30 days. RELATED PARTY TRANSACTIONS Details of related party transactions are detailed in note 21. POST BALANCE SHEET EVENTS Post balance sheet events are detailed in note 20 to the financial statements. STATEMENT AS TO DISCLOSURE OF INFORMATION TO AUDITOR The directors who were in office on the date of approval of these financial statements have confirmed that, as far as they are aware, there is no relevant audit information of which the auditor is unaware. Each of the directors have confirmed that they have taken all the steps that they ought to have taken as directors in order to make themselves aware of any relevant audit information and to establish that it has been communicated to the auditor. AUDITOR The Company’s auditor, Baker Tilly UK Audit LLP, has indicated its willingness to continue in office. ELECTRONIC COMMUNICATIONS The maintenance and integrity of the Group’s website is the responsibility of the directors; the work carried out by the auditor does not involve consideration of these matters and accordingly, the auditor accepts no responsibility for any changes that may have occurred to the financial statements since they were initially presented on the website. The Group’s website is maintained in compliance with AIM Rule 26. By order of the Board G N SPROULE Director 26 August 2015 Governance 49. Bushveld Minerals Annual Report 2015 47 Bushveld Minerals Annual Report 2015 47 19. ACQUISITION OF SUBSIDIARIES On 13 May 2013, the company announced the launch of an off-market take-over bid for Lemur Resources Limited (‘Lemur’), a coal project development company listed on the ASX. This bid follows the acquisition of Bushveld Minerals Limited (‘Bushveld’) of 5.15 milli on shares in Lemur (for the sum of £386,053), which was announced on 8 November 2012. The all-scrip offer of three Bushveld shares for every five Lemur shares value Lemur at A$19.1 million or A$0.099 per share, whi ch was a 65.5% premium to Lemur’s closing price on Friday May 10, 2013. Lemur has a 136 million tonne thermal coal project in Madagascar, known as the Imaloto Coal Project, as well as A$17.5m in cash. The take-over offer by Bushveld for all the ordinary shares in Lemur closed on 1 November 2013. Following the closure, Bushveld had a relevant interest in 54.39% of Lemur’s issued share capital of 192,500,001 ordinary fully paid shares. At the Lemur General Meeting held on 2 February 2014, shareholders approved the issue of 8,000,000 shares to two Directors thereby increasing the issued capital to 200,500,001 ordinary fully paid shares. At 28 February 2015, Bushveld’s relevant interest in the issued share capital of Lemur is 58.5%. The amounts recognised in respect of the identifiable assets acquired and liabilities assumed are as set out in the table below. Fair value acquired £ Intangible assets acquired – Prospecting licences – Cash 8,721,284 Receivables 60,779 Property, plant and equipment 164,555 Payables (90,676) Net assets 8,855,942 Non-controlling interest (4,040,464) Total net assets 4,815,478 Satisfied by: Shares issued in respect of all scrip offer 3,044,925 Transfer from available for sale investment 248,854 Associated acquisition costs 621,159 Fair value uplift on acquisition 900,540 4,815,478 Effective control of the Board of Directors of Lemur was deemed to be 1 January 2014 following various appointments and resignations of the Lemur directors and expiry of some of the Lemur share options in issue. Lemur contributed £87,260 to the Group loss before allocating minority interests of £41,693 between the deemed date of acquisition and the Statement of Financial Position date. If the acquisition had been completed on the first day of the financial period, Group revenues for the period would have been £ni l and the Group loss for the period would have increased by £334,098. The non-controlling interest relates to the interest held by the minority shareholders of Lemur. Administration 27. Bushveld Minerals Annual Report 2015 25 Bushveld Minerals Annual Report 2015 25 CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME FOR THE YEAR ENDED 28 FEBRUARY 2015 28 February 2015 28 February 2014 Note £ £ Loss for the period (2,888,566) (416,743) Currency translation differences on translation of foreign operations (94,795) (910,139) Total comprehensive loss for the period (2,983,361) (1,326,882) Attributable to: Owners of the Company (2,597,866) (1,285,189) Non-controlling interests (385,495) (41,693) (2,983,361) (1,326,882) Financial statements 41. Bushveld Minerals Annual Report 2015 39 Bushveld Minerals Annual Report 2015 39 Financial statements 11. INTANGIBLE ASSETS Exploration activities – iron ore Exploration activities – tin Total £ £ £ As at 28 February 2014 36,450,554 17,530,836 53,981,390 Additions 1,468,990 320,864 1,789,854 37,919,544 17,851,700 55,771,244 The Company’s subsidiary, Bushveld Resources Limited has a 64% interest in Pamish Investment No 39 (Proprietary) Limited (“Pamish”) which holds an interest in Prospecting right 95 (“Pamish 39”). Bushveld Resources Limited also has a 68.5% interest in Amaraka Investment No 85 (Proprietary) Limited (“Amaraka”) which holds an interest in Prospecting right 438 (“Amaraka 85”). Under the agreements to acquire the licenses within Bushveld Resources, the Group is required to fully fund the exploration act ivities up to the issue of the corresponding mining licenses. As the non-controlling interest party retains their equity interest, the funding of their interest is accounted as deemed purchased consideration and is included in the additions in the period to exploration activities. A corresponding increa se is credited to non- controlling interest. The Company’s other directly owned subsidiary, Greenhills Resources Limited, has a 74% interest in Renetype (Proprietary) Limited (“Renetype”) which holds an interest in Prospecting right 2205 (“Renetype 2205”). Through Lemur Resources Limited’s wholly owned subsidiary Coal Mining Madagascar Limited, Lemur is the holder of 11 concession blocks in South West Madagascar covering the Imaloto Coal Basin, known as the Imaloto Coal Project and Extension. In addition, the Company is in the final stages of acquiring two further blocks contiguous to the existing holdings subject to ministerial approval of the transfer. This project is known as the Imaloto Project Extension. Lemur holds two further projects known as the Ianapera Coal Project and Sakaraha Coal Project. At the date of approval of these financial statements, three of the Group’s exploration licences remain due for renewal in 2015. These three licences have a carrying value of £55.8 million (There were no licences due for renewal in 2014). Applications are due to be submitted for renewal of these licences as they become due and the directors have no reason to believe that these renewals will be unsuccessful. 12. PROPERTY, PLANT AND EQUIPMENT Motor vehicles Geological equipment Fixtures and fittings Total £ £ £ £ Cost As at 28 February 2014 50,058 218,286 16,613 284,957 Additions – 17,557 5,313 22,870 Disposals – – (1,721) (1,721) At 28 February 2015 50,058 235,843 20,205 306,106 Depreciation As at 28 February 2015 33,392 20,579 5,795 59,766 Charge for the year 11,918 147,325 6,612 165,855 At February 2015 45,310 167,904 12,407 225,621 Net book value At 28 February 2015 4,748 67,939 7,798 80,485 At 28 February 2014 16,666 197,707 10,818 225,191 The entire depreciation charge for the year of £165,855 (2014: £37,663) together with the loss on disposal of £1,427 (2014: £689) has been capitalised as exploration activities in the period. 45. Bushveld Minerals Annual Report 2015 43 Bushveld Minerals Annual Report 2015 43 Financial statements 17. WARRANTS continued The warrants in issue during the year are as follows: Number of warrants Weighted average exercise price £ Outstanding at 1 March 2014 30,473,089 – Granted during the year 3,000,000 0.05 Exercised during the year (3,000,000) 0.05 Outstanding at 28 February 2015 30,473,089 0.05 Exercisable at 28 February 2015 30,473,089 0.05 The warrants outstanding at the year-end have an exercise price of £0.05, with a weighted average remaining contractual life of 3.5 years. The Group has recognised an incurred charge of £73,766 in the year (2014: £370,715) of which £nil has been charged against share premium as issue costs and £73,766 is charged with administration costs in respect of advisory fees. 18. FINANCIAL INSTRUMENTS The Group is exposed to the risks that arise from its use of financial instruments. This note describes the objectives, policie s and processes of the Group for managing those risks and the methods used to measure them. Further quantitative information in respect of these risk s is presented throughout these financial statements. CAPITAL RISK MANAGEMENT The Group manages its capital to ensure that entities in the Group will be able to continue as going concerns while maximising returns to shareholders. In order to maintain or adjust the capital structure, the Group may issue new shares or arrange debt financing. Currently the Group has £nil net debt. The capital structure of the Group consists of cash and cash equivalents and equity, comprising issued capital and retained losses. The Group is not subject to any externally imposed capital requirements. SIGNIFICANT ACCOUNTING POLICIES Details of the significant accounting policies and methods adopted including the criteria for recognition, the basis of measurem ent and the bases for recognition of income and expenses for each class of financial asset, financial liability and equity instrument are disclosed in note 3. PRINCIPAL FINANCIAL INSTRUMENTS The principal financial instruments used by the Group, from which financial instrument risk arises, are as follows: • Trade and other receivables • Cash at bank • Trade and other payables • Available for sale investments 36. 34 Bushveld Minerals Annual Report 2015 34 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 WARRANTS The warrants issued by the Company are recorded at fair value on initial recognition net of transaction costs. An impairment review is undertaken when indicators of impairment arise but typically when one of the following circumstances ap plies: • unexpected geological occurrences that render the resources uneconomic; or • title to the asset is compromised; or • variations in mineral prices that render the project uneconomic; or • variations in the foreign currency rates; or • the Group determines that it no longer wishes to continue to evaluate or develop the field. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment is stated at historical cost less accumulated depreciation. Depreciation is provided on all plant and equipment at rates calculated to write each asset down to its estimated residual val ue, using the straight- line method over their estimated useful life of the asset as follows: • geological equipment over one to three years; • motor vehicles over three years; and • office equipment and computers over two years. The estimated useful lives, residual values and depreciation methods are reviewed at each period end and adjusted if necessary. Gains or losses on disposal are included in profit or loss. IMPAIRMENT OF PROPERTY, PLANT AND EQUIPMENT At each statement of financial position date, the Group reviews the carrying amounts of its tangible assets to determine whether there is any indication that those assets have suffered an impairment loss. If any such indication exists, the recoverable amount of the a sset is estimated in order to determine the extent of the impairment loss (if any). Where the asset does not generate cash flows that are independent from other assets, the Group estimates the recoverable amount of the cash-generating unit to which the asset belongs. Where there has been a change in economic conditions that indicate a possible impairment in a cash-generating unit, the recover ability of the net book value relating to that field is assessed by comparison with the estimated discounted future cash flows based on management’s expectations of future oil prices and future costs. The recoverable amount is the higher of fair value less costs to sell and value in use. In assessing value in use, the estimate d future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of mo ney and the risks specific to the asset for which the estimates of future cash flows have not been adjusted. If the recoverable amount of an asset (or cash-generating unit) is estimated to be less than its carrying amount, the carrying amount of the asset (cash-generating unit) is reduced to its recoverable amount. An impairment loss is recognised as an expense immediately, unless the relevant asset is carried at a revalued amount, in which case the impairment loss is treated as a revaluation decrease. Where conditions giving rise to impairment subsequently reverse, the effect of the impairment charge is also reversed as a cred it to the income statement, net of any depreciation that would have been charged since the impairment. FINANCIAL ASSETS AND LIABILITIES Financial assets and financial liabilities are recognised in the Group’s balance sheet when the Group becomes a party to the contractual provisions of the instrument. Financial instruments are classified into specified categories dependent upon the nature and purpose of the i nstruments and are determined at the time of initial recognition. All financial assets are recognised as loans and receivables or available for sal e investments and all financial liabilities are recognised as other financial liabilities. 3. SIGNIFICANT ACCOUNTING POLICIES continued 37. Bushveld Minerals Annual Report 2015 35 Bushveld Minerals Annual Report 2015 35 Financial statements Trade and other receivables Trade and other receivables are stated initially recognised at the fair value of the consideration receivable less any impairment. Impairment provisions are recognised when there is objective evidence that the Group will be unable to collect all of the amounts due unde r the terms of the receivable, the amount of such a provision being the difference between the carrying amount and the present value of the future expected cash flows associated with the impaired receivable. Trade and other receivables are subsequently measured at amortised cost, less any impairment. Cash and cash equivalents Cash and cash equivalents comprise cash at hand and deposits on a term of not greater than three months. Trade and other payables Trade and other payables are initially recognised at fair value. They are subsequently measured at amortised cost using the effective interest rate method. Available for sale financial assets Listed shares held by the Group that are traded in an active market are classified as being available for sale and are stated at fair value. The fair value of such investments is determined by reference to quoted market prices. Gains and losses arising from changes in fair value are recognised in other comprehensive income and accumulated in the investm ents revaluation reserve with the exception of impairment losses. Where the investment is disposed of or is determined to be impaired, the cumul ative gain or loss previously recognised in the investments revaluation reserve is reclassified to profit or loss. Dividends on available for sale equity instruments are recognised in profit or loss when the Group’s right to receive the dividends is established. Financial liabilities and equity Financial liabilities (including loans and advances due to related parties) and equity instruments are classified according to t he substance of the contractual arrangements entered into. An equity instrument is any contract that evidences a residual interest in the assets of the Group after deducting all of its liabilities. When the terms of a financial liability are negotiated with the creditor and settlement occur s through the issue of the Company’s equity instruments, the equity instruments are measured at fair value and treated as consideration for the extinguishment of the liability. Any difference between the carrying amount of the liability and the fair value of the equity instruments issued is recognised i n profit or loss. 4. USE OF ESTIMATES AND JUDGEMENTS In the application of the Group’s accounting policies, which are described in note 3, the directors are required to make judgements, estimates and assumptions about the carrying amounts of assets and liabilities that are not readily apparent from other sources. The estimate s and associated assumptions are based on historical experience and other factors that are considered to be relevant. Actual results may differ from these estimates. Estimates and judgements are continually evaluated. Revisions to accounting estimates are recognised in the period in which the estimates are revised if the revision affects only that period, or in the period of revision and in future periods if the revision affects bo th current and future periods. Management’s critical estimates and judgements in determining the value of assets, liabilities and equity within the financial statements relate to the valuation of intangible exploration assets of £55.7 million and the going concern assumptions. The valuation of intangible exploration assets is dependent upon the discovery of economically recoverable deposits which, in t urn, is dependent on future iron ore and tin prices, future capital expenditures and environmental and regulatory restrictions. 5. SEGMENTAL REPORTING The reporting segments are identified by the directors of the Group (who are considered to be the chief operating decision maker s) by the way that Group’s operations are organised. As at 28 February 2015 the Group operated within three operating segments, mineral exploration activities for iron ore, for tin and coal. Exploration activities take place in South Africa and Madagascar. 3. SIGNIFICANT ACCOUNTING POLICIES continued 34. 32 Bushveld Minerals Annual Report 2015 32 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 3. SIGNIFICANT ACCOUNTING POLICIES BASIS OF ACCOUNTING These financial statements have been prepared in accordance with International Financial Reporting Standards, International Acco unting Standards and Interpretations (collectively “IFRS”) issued by the International Accounting Standards Board (“IASB”) as adopted by the European Union (“adopted IFRS”), and are in accordance with IFRS as issued by the IASB. The consolidated financial statements have been prepared under the historical cost basis, except for the revaluation of financial instruments. Historical cost is generally based on the fair value of the consideration given in exchange for the assets. The principal accou nting policies are set out below. GOING CONCERN In preparing the financial statements, the directors have considered the current financial position of the Group and the likely f uture cash flows for the period to 31 August 2016. As with all exploration groups at this stage of the resource development cycle and with no cash-flow from production, funding is derived principally through equity financing. On 20 May 2015, Bushveld launched an off-market takeover offer for all of the fully paid ordinary shares in Lemur Resources which Bushveld does not currently own (see note 20). The directors advise that the takeover of Lemur Resources has been successfully concluded with Bushveld acquiring 96.4% of the ordinary share in Lemur Resources. Trading in Lemur Resources shares will be suspended and the Company delisted from the ASX during September 2015. The fundraising referred to in note 16 and the off-market takeover of Lemur Resources ensures that the Group will have adequate resources available as a result of having greater access to the Lemur cash resources of £7.2 million. The directors are confident that the Group will be able to pay debts as they fall due and to continue operations for the foresee able future. For this reason they continue to adopt a going concern basis in preparing the Group’s financial statements. BASIS OF CONSOLIDATION The consolidated financial statements incorporate the financial statements of the Company and entities controlled by the Company (its subsidiaries) made up to 28 February. Control is achieved where the Company has the power to govern the financial and operating policies of an investee entity so as to obtain benefits from its activities. The results of the subsidiaries acquired or disposed of during the period are included in the consolidated income statement fro m the effective date of acquisition. Where necessary, the adjustments are made to the financial statements of subsidiaries to bring the accounting policies used in line with those used by the Group. All intra-group transactions, balances, income and expenses are eliminated in full on consolidation. Non-controlling interests in subsidiaries are identified separately from the Group’s equity therein. Those interests of non-controlling shareholders that present ownership interests entitling their holders to a proportionate share of the net assets upon liquidation are initia lly measured at fair value. Subsequent to acquisition, the carrying amount of non-controlling interests is the amount of those interests at initial recogni tion plus the non- controlling interests’ share of subsequent changes in equity. Total comprehensive income is attributed to non-controlling interests even if this results in the non-controlling interests having a deficit balance. FOREIGN CURRENCIES Functional and presentational currency The individual financial statements of each Group company are prepared in the currency of the primary economic environment in wh ich they operate (its functional currency). For the purpose of the consolidated financial statements, the results and financial position o f each Group company are expressed in Pound Sterling, which is the functional currency of the Company, and the presentation currency for the consolidated financial statements. Transactions and balances Transactions in foreign currencies are initially recorded at the rates of exchange prevailing on the dates of the transaction. At each reporting date, monetary assets and liabilities that are denominated in foreign currency are translated into the reporting currency at the rate prevailing on that date. Non-monetary assets and liabilities are carried at cost and are translated into the reporting currency at the rate prevailing o n the reporting date. 42. 40 Bushveld Minerals Annual Report 2015 40 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 13. TRADE AND OTHER RECEIVABLES 28 February 2015 28 February 2014 £ £ Advances and deposits 14,510 112,753 Other receivables 132,201 28,106 146,711 140,859 The directors consider that the carrying amount of trade and other receivables approximates to their fair value due to their short term nature. As at the period end, no receivables are past their due date, hence no allowance for doubtful receivables is provided. The total trade and other receivables denominated in South African Rand amount to £120,140 (2013: £27,976) and denominated in Australian Dollars amount to £20,718 (2013: nil). 14. CASH AND CASH EQUIVALENTS 28 February 2015 28 February 2014 £ £ Cash at hand and in bank 7,595,777 9,177,158 Cash and cash equivalents (which are presented as a single class of assets on the face of the Statement of Financial Position) comprise cash at bank and other short-term highly liquid investments with an original maturity of three months or less. The director’s consider that the carrying amount of cash and cash equivalents approximates their fair value. The total cash and cash equivalents denominated in South African Rand amount to £32,006 (2014: £73,946) and £7,216,323 (2014: £8,491,654) is denominated in Australian Dollars. 15. TRADE AND OTHER PAYABLES 28 February 2015 28 February 2014 £ £ Trade payables 205,863 119,408 Other payables 4,116 22,344 Accruals 253,970 202,435 463,949 344,187 Trade and other payables principally comprise amounts outstanding for trade purchases and on-going costs. The average credit period taken for trade purchases is 30 days. The Group has financial risk management policies in place to ensure that all payables are paid within the pre-arranged credit te rms. No interest has been charged by any suppliers as a result of late payment of invoices during the period. The directors consider that the carrying amount of trade and other payables approximates to their fair value. The total trade and other payables denominated in South African Rand amount to £135,864 (2014: £96,804) and £76,757 (2014: £70,875) is denominated in Australian Dollars. 40. 38 Bushveld Minerals Annual Report 2015 38 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 8. INVESTMENT REVENUE 28 February 2015 28 February 2014 £ £ Bank interest 317,063 59,009 9. TAXATION The tax expense represents the sum of the tax currently payable and deferred tax. The tax charge is based on taxable profit for the year. The Bushveld Group’s liability for current tax is calculated by using tax rates that have been enacted or substantively enacted by the reporting date. Deferred tax is the tax expected to be payable or recoverable on differences between the carrying amount of assets and liabilit ies in the financial statements and the corresponding tax bases used in the computation of taxable profit, and is accounted for using the “balance sh eet liability” method. Deferred tax liabilities are recognised for all taxable temporary differences and deferred tax assets are recognised to the ext ent that it is probable that taxable profits will be available against which deductible temporary differences can be utilised. Deferred tax is calculate d at the tax rates that are expected to apply to the period when the asset is realised or the liability is settled based upon rates enacted and substa ntively enacted at the reporting date. Deferred tax is charged or credited to profit or loss, except when it relates to items credited or charged to ot her comprehensive income, in which case the deferred tax is also dealt with in other comprehensive income. The provision for income taxes is different to the expected provision for income taxes for the following reasons: 28 February 2015 28 February 2014 Factors affecting tax for the period: £ £ The tax assessed for the period at the Guernsey corporation tax charge rate of 0%, as explained below: Loss before taxation (2,888,566) (416,743) Loss before taxation multiplied by the Guernsey corporation tax charge rate of 0% – – Effects of: Non-deductible expenses – – Deferred tax assets not recognised – – Tax for the year – – 10. LOSS PER SHARE FROM CONTINUING OPERATIONS The calculation of a basic loss per share of 0.54 (2014: 0.11) pence, is calculated using the total loss for the period attributable to the owners of the Company of £2,503,071 (2014: £375,050) and the weighted average number of shares in issue during the period of 460,361,182 (2014: 330,448,596). There are no potentially dilutive shares in issue. 7. Bushveld Minerals Annual Report 2015 05 PROJECT ECONOMICS • Low capital expenditure phase 1 designed for early cash flow: US$126 million capital expenditure producing 2.2 Mtpa of product • Positive economics: US$188 million post-tax net present value (NPV) at 10% discount rate and 34% internal rate of return (IRR) (based on a July 2013 scoping study) • Scoping Study on Phosphate resource in the P-Q hanging wall underway PRIORITIES • Low risk market testing initiatives • Strategic partnerships to unlock scalability and potential integrated downstream development for all commodities • Prefeasibility study to be completed in 2015 • Market studies to secure off-take partnerships PROJECT ECONOMICS * • Modest capital expenditure requirements of US$262 million for a primary vanadium production plant • Attractive economics showing (at a 10% discount rate): • Pre-tax NPV of US$562 million and an IRR of 36% • Post-tax NPV of US$264 million and an IRR of 24% • Prefeasibility study underway * Based on a scoping study completed in July 2014 PRIORITIES • Prefeasibility study to be completed in 2015, focused on primary vanadium production with iron and titanium credits • Strategic partnerships for accelerated project development to production • Priority given to low capex, early production scenario PROJECT ECONOMICS • Scoping Study completed in August 2014 yielding positive results PRIORITIES • Acquire and consolidate South African brownfield tin assets with a combined resource of more than 50,000 tonnes contained tin PROJECT ECONOMICS • To be defined through scoping study pursuant to finalisation of outstanding licensing matters PRIORITIES • Finalising the outstanding licensing to extend to exploration area, followed by a drilling programme to confirm JORC resource PROJECT ECONOMICS • Scoping Study presented in September 2013 • LoM of 19 years (Phase 1 & 2) for total ROM production of 21Mt • Phase 1: Low capital expenditure of <US$12 million to commence open pit operations • Post-tax NPV of US$36 million at real discount rate of 10% PRIORITIES • Negotiations underway for IPP licence and partnership with Malagasy government • Strategic partnerships being pursued Business review P-Q IRON ORE AND TITANIUM PROJECT MOKOPANE TIN PROJECT VANADIUM PROJECT MARBLE HALL TIN PROJECT IMALOTO COAL PROJECT 28. 26 Bushveld Minerals Annual Report 2015 26 Bushveld Minerals Annual Report 2015 CONSOLIDATED STATEMENT OF FINANCIAL POSITION FOR THE YEAR ENDED 28 FEBRUARY 2015 COMPANY NUMBER: 54506 28 February 2015 28 February 2014 Note £ £ Assets Non-current assets Intangible assets: exploration activities 11 55,771,244 53,981,390 Property, plant and equipment 12 80,485 225,191 Total non-current assets 55,851,729 54,206,581 Current assets Trade and other receivables 13 146,711 140,859 Cash and cash equivalents 14 7,595,777 9,177,158 Total current assets 7,742,488 9,318,017 Total assets 63,594,217 63,524,598 Equity and liabilities Current liabilities Trade and other payables 15 (463,949) (344,187) Total current liabilities (463,949) (344,187) Net assets 63,130,268 63,180,411 Equity Share capital 16 4,863,373 4,020,041 Share premium 16 59,927,541 57,933,792 Accumulated deficit (5,109,965) (2,628,989) Revaluation reserve (138,628) (138,628) Warrant reserve 17 422,386 370,715 Foreign exchange translation reserve (1,238,955) (1,144,160) Equity attributable to: Owners of the Company 58,725,752 58,412,771 Non-controlling interests 4,404,516 4,767,640 Total equity 63,130,268 63,180,411 The notes on pages 30 to 49 form part of these financial statements. The financial statements were authorised and approved for issue by the Board of directors and authorised for issue on 26 August 2015. G N SPROULE Director 26 August 2015 29. Bushveld Minerals Annual Report 2015 27 Bushveld Minerals Annual Report 2015 27 Financial statements 28 February 2015 28 February 2014 Note £ £ Loss after taxation (2,888,566) (416,743) Adjustments for: Bargain purchase – (900,540) Loss on disposal of tangible fixed assets 1,721 – Expenses settled with shares 146,667 164,146 Interest income 8 (317,063) (59,009) Operating cash flows before movements in working capital (3,057,241) (1,212,146) Increase/Decrease in receivables (5,852) (29,923) Increase in payables 119,762 54,369 Net cash used in operating activities (2,943,331) (1,187,700) Cash flows from investing activities Interest received 8 317,063 59,009 Purchase of exploration and evaluation assets 11 (1,623,999) (1,082,351) Purchase of tangible fixed assets 12 (22,870) (42,128) Cash acquired on acquisition of subsidiary 19 – 8,721,284 Cost of acquisition – (395,912) Net cash used in/from investing activities (1,329,806) 7,259,902 Cash flows from financing activities Net proceeds from issue of shares and warrants 17 2,786,551 1,796,638 Net cash generated from financing activities 2,786,551 1,796,638 Net (decrease)/increase in cash and cash equivalents (1,486,586) 7,868,840 Cash and cash equivalents at the beginning of the period 9,177,158 1,305,089 Effect of foreign exchange rates 94,795 3,229 Cash and cash equivalents at end of the period 15 7,595,777 9,177,158 The notes on pages 30 to 49 form part of these financial statements. CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED 28 FEBRUARY 2015 48. 46 Bushveld Minerals Annual Report 2015 46 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 The following table details the Group’s sensitivity to a 10% increase and decrease in Pound Sterling against the Rand. 10% is the sensitivity rate used when reporting foreign currency risk internally to key management personnel and represents management’s assessment of the reasonable possible change in foreign exchange rates. The sensitivity analysis includes only outstanding foreign currency denominated mone tary items and adjusts their translation at the period end for a 10% change in foreign currency rates. The table below shows the effect of a 10% weakening and strengthening of Pound Sterling against the Rand: Rand currency impact strengthening Rand currency impact weakening 2015 £ £ Assets 551,136 450,929 Liabilities (430,213) (351,993) 120,923 98,936 Australian currency impact strengthening Australian currency impact weakening 2015 £ £ Assets 8,084,449 6,614,549 Liabilities (168,867) (138,164) 7,915,582 6,476,385 MATURITY OF FINANCIAL LIABILITIES All of the Group’s financial liabilities and its financial assets in the period to 28 February 2015 are either payable or receivable within one year. 18. FINANCIAL INSTRUMENTS continued 47. Bushveld Minerals Annual Report 2015 45 Bushveld Minerals Annual Report 2015 45 Financial statements 18. FINANCIAL INSTRUMENTS continued GENERAL OBJECTIVES, POLICIES AND PROCESSES continued Credit risk continued There are no other significant concentrations of credit risk at the balance sheet date. At 28 February 2015, the Group held no collateral as security against any financial asset. The carrying amount of financial assets recorded in the financial statements, net of any allowances for losses, represents the Group’s maximum exposure to credit risk without taking account of the value of any collateral obtained. At 28 February 2015, no financial assets were past their due date. As a result, there has been no impairment of financial assets during the year. An allowance for impairment is made where there is an identified loss event which, based on previous experience, is evidence of a reduction in the recoverability of the cash flows. Management considers the above measures to be sufficient to control the c redit risk exposure. Liquidity risk Liquidity risk is the risk that the Group will encounter difficulty in meeting its financial obligations as they fall due. Ultima te responsibility for liquidity risk management rests with the Board of directors. The Board manages liquidity risk by regularly reviewing the Group’s gearing levels, cash-flow projections and associated headroom and ensuring that excess banking facilities are available for future use. The Group maintains good relationships with its banks, which have high credit ratings and its cash requirements are anticipated via the budgetary process. At 28 February 2015, the Group had £7,595,777 (2014: £9,177,158) of cash reserves. Market risk The Group’s activities expose it primarily to the financial risk of changes in foreign currency exchange rates and interest rates. Interest rate risk With the exception of cash and cash equivalents, the Group has no interest bearing assets or liabilities. The Group was therefo re exposed to minimal interest rate risk during the period. For this reason, no sensitivity analysis has been performed regarding interest rate risk. Foreign exchange risk As highlighted earlier in these financial statements, the functional currency of the Group is Pound Sterling. The Group also has foreign currency denominated assets and liabilities. Exposures to exchange rate fluctuations therefore arise. The carrying amount of the Group’s foreign currency denominated monetary assets and liabilities, all in Pound Sterling, are shown below in the Group’s functional currency: 28 February 2015 28 February 2014 £ £ Cash and cash equivalents 7,595,777 9,177,158 Other receivables 146,711 140,859 Trade and other payables (463,949) (344,187) 7,278,539 8,973,830 The Group is exposed to a level of foreign currency risk. Due to the minimal level of foreign transactions; the directors curre ntly believe that foreign currency risk is at an acceptable level. The Group does not enter into any derivative financial instruments to manage its exposure to foreign currency risk. 26. 24 Bushveld Minerals Annual Report 2015 24 Bushveld Minerals Annual Report 2015 28 February 2015 28 February 2014 Note £ £ Continuing operations Administrative expenses 7 (3,205,629) (1,376,292) Operating loss (3,205,629) (1,376,292) Bargain purchase on acquisition 19 – 900,540 Investment income 8 317,063 59,009 Loss before tax (2,888,566) (416,743) Tax 9 – – Total loss for the period (2,888,566) (416,743) Attributable to: Owners of the Company (2,503,071) (375,050) Non-controlling interests (385,495) (41,693) (2,888,566) (416,743) Loss per ordinary share Basic and diluted loss per share (in pence) 10 (0.54) (0.11) All results relate to continuing activities. The notes on pages 30 to 49 form part of these financial statements. CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED 28 FEBRUARY 2015 39. Bushveld Minerals Annual Report 2015 37 Bushveld Minerals Annual Report 2015 37 Financial statements 5. SEGMENTAL REPORTING continued OTHER SEGMENTAL INFORMATION Segmental assets and liabilities disclosed in the reports to the Board of directors, for the purpose of resource allocation and assessment of segmental performance, consist of the amounts capitalised as intangible exploration expenditure. All other assets and liabilities are cla ssified as unallocated. Iron ore exploration (South Africa) Tin exploration (South Africa) Coal exploration (Madagascar) Consolidated Group £ £ £ £ Year ended 28 February 2015 NBV of capitalised exploration expenditure 37,919,544 17,851,700 – 55,771,244 Total reportable segmental net (liabilities)/assets (17,271) 29,981 7,169,709 7,182,419 Unallocated net assets 176,605 Total consolidated net assets 63,130,268 The Group’s exploration operations are based in South Africa and Madagascar. Year ended 28 February 2014 NBV of capitalised exploration expenditure 36,450,544 17,530,836 – 53,981,380 Total reportable segmental net (liabilities)/assets (14,891) 172,809 8,606,053 8,763,971 Unallocated net assets 435,060 Total consolidated net assets 63,180,411 6. LOSS FOR THE PERIOD The loss for the period has been arrived at after charging: 28 February 2015 28 February 2014 £ £ Foreign exchange loss 94,795 12,725 Staff costs (see note 7) 450,901 292,632 No depreciation charge has been recognised in the consolidated income statement. The whole charge has been capitalised as part of intangible exploration expenditure. 7. ADMINISTRATIVE EXPENSES BY NATURE 28 February 2015 28 February 2014 £ £ Commission paid 276,385 – Professional fees 849,940 432,960 Employee benefits expense 450,901 292,632 Travelling expenses 30,749 37,701 Foreign exchange loss 94,749 12,725 Other costs and adjustments 1,502,905 600,274 3,205,629 1,376,292 Key management personnel have been identified as the Board of directors. Details of key management remuneration are shown in note 21. 38. 36 Bushveld Minerals Annual Report 2015 36 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 5. SEGMENTAL REPORTING continued SEGMENT REVENUE AND RESULTS The following is an analysis of the Group’s revenue and results by reportable segment. Iron ore exploration (South Africa) Tin exploration (South Africa) Coal exploration (Madagascar) Total £ £ £ £ As at 28 February 2015 Revenue External sales – – – – Results Operating segmental profit / (loss) (8,579) 3,845 (928,904) (933,638) Segmental profit / (loss) (8,579) 3,845 (928,904) (933,638) As at 28 February 2014 Revenue External sales – – – – Results Operating segmental profit / (loss) (13,634) 4,641 (87,260) (96,253) Bargain purchase on acquisition – – 900,540 900,540 Segmental profit / (loss) (13,634) 4,641 813,280 804,287 The reconciliation of segmental gross loss to the Group’s loss before tax is as follows: Year ended 28 February 2015 Year ended 28 February 2014 £ £ Segmental loss (933,638) 804,287 Unallocated administration expenses (2,271,991) (1,280,039) Finance income 317,063 59,009 Loss before tax (2,888,566) (416,743) 6. 04 Bushveld Minerals Annual Report 2015 GEOLOGY • Large 939Mt titaniferous magnetite deposit (open- pittable along 6km of a proven 10km) • High TiO 2 grade in concentrate gives scope for economic titanium extraction • 442Mt phosphate resource, at an average grade of 3.6% P 2 O 5 upgradable to >37% P 2 O 5 concentrate and positioned close to input material sources for integrated downstream production PROCESSING • Excellent magnetite liberation at 500μm with concentrate grades of ~55% Fe, 19.0% TiO 2 and 0.33% V 2 O 5 (>80% recovery) • High-grade Q2 unit of the P-Q Zone amenable to beneficiation at coarse grain sizes: 6mm fraction concentrate product grade achieved • Simple plant design for a concentrate product: crush, mill, magnetic separation GEOLOGY • Open-castable vanadium resource comprising three mineralised horizons combining >80m in thickness • Resource increased significantly to 285Mt JORC- indicated and inferred resource • MML Zone; ~10m thick, 52Mt (indicated resource) with grading ~45% Fe, ~1.48% V 2 O 5 and ~9.7% TiO 2 • MML Hanging Wall Zone: ~60m thick with estimated 1.5%-1.7% V 2 O 5 calculated grade in concentrate • Footwall Zone (‘AB Zone’): ~11m with a 2.01-2.65% V 2 O 5 grade in concentrate (based on Davis Tube test) PROCESSING • Proven technology using the salt roast process as utilised by Rhovan Mine (Glencore) and Vanchem (Duferco) • Simple Flowsheet to produce V 2 O 5 flakes: Concentration; Salt Roasting; Leach Milling and purification; AMV Precipitation; De-ammoniation and Fusion; Flaking; V 2 O 5 Flake Product • Positive scoping study completed July 2014 • Prefeasibility study underway GEOLOGY • Contains 18,447 tonnes of tin inventory with an average grade of 0.12% tin contained in two adjacent deposits out of a total of five targets: • Groenfontein deposit: 5,995 tonnes of tin with an average grade of 0.15% tin • Zaaiplaats deposit: 12,452 tonnes of tin with an average grade of 0.11% tin PROCESSING • Three combined processing options being investigated for the processing of the Zaaiplaats and Groenfontein tin deposits: • Gravity separation • Enhanced gravity • Flotation GEOLOGY • Mineralisation occurs in breccia zone (1-7m thick) • A number of boreholes intersected significant mineralisation at relatively shallow depths (<200m) • A potential (non-JORC-compliant) resource of 3,750,000 tonnes at 0.32% tin (i.e. 12,000 tonnes of Sn) was historically calculated PROCESSING • Bushveld Minerals technical team estimates, based on reinterpretation of Goldfields data (including historical drilling data) a potential resource of 18,000 tonnes of contained tin at ~0.5% tin from 3.6 million tonnes of ore GEOLOGY • Significant thermal coal JORC resource in Madagascar of 136Mt with 91.6Mt in Measured category • Scope for opencast mining in first eight years of operation PROCESSING • Main Seam raw coal suitable for power generation or beneficiation to export quality • Phase 1: RAW product with an average calorific value (CV) of 5,504kcal/kg net as received (NAR) • Phase 2: primary products yielding >62% with average CV of 5,689kcal/kg NAR and 16.5% Ash, and a secondary product yielding 33% with an average CV of 3,627kcal/kg NAR for a combined yield >95% RESOURCE S ACN 147 241 36 1 PROJECT OVERVIEW P-Q IRON ORE AND TITANIUM PROJECT MOKOPANE TIN PROJECT VANADIUM PROJECT MARBLE HALL TIN PROJECT IMALOTO COAL PROJECT 4. 02 Bushveld Minerals Annual Report 2015 CORPORATE STRUCTURE M INERAL S RESOURCES Nelspruit Maputo Johannesbur g Pretoria Mokopane Polokwane Vryheid Richards Ba y Kwazulu- Nata l MOZAMBIQUE Indian Ocea n SWAZILAND ZIMBABWE BOTSWAN A SOUTH AFRICA Phalaborwa Kruger National Park Grasko p Musina Scal e 0 50 1 00km Roads and railway lines Potentail rail route to port Port s Coal elds Bushveld Complex Legend P-Q Iron Ore and T itanium Projec t Vanadium Projec t MOKOPANE Mokopane T in Projec t Marble Hall Tin Projec t Licences held DEVELOPING A WORLD-CLASS VANADIUM COMPANY WITH POTENTIAL UPSIDE FROM TITANIUM AND IRON ORE VANADIUM PROJECT P-Q IRON ORE AND TITANIUM PROJECT MOKOPANE TIN PROJECT Project location: Bushveld Complex, Limpopo province, South Africa (10,073 hectares) HIGHLIGHTS: • World class vanadium project with compelling economics • Large vanadium-rich magnetite deposit confirmed in three identified distinct horizons • Solid market fundamentals, underpinned by demand from the steel sector, and potentially the energy storage sector Project location: Bushveld Complex, Limpopo province, South Africa (12,012 hectares) HIGHLIGHTS: • Multi-commodity iron ore and titanium resource • Large phosphate resource upgradeable to a premium P 2 O 5 concentrate Project location: Bushveld Complex, Limpopo province, South Africa (3,422 hectares) HIGHLIGHTS: • Stand alone brownfields tin portfolio with near term production profile • Open castable resource 46. 44 Bushveld Minerals Annual Report 2015 44 Bushveld Minerals Annual Report 2015 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS continued FOR THE YEAR ENDED 28 FEBRUARY 2015 Categories of financial instruments At 28 February 2015, the Group held the following financial assets: 28 February 2015 28 February 2014 £ £ Loans and receivables Trade and other receivables 146,711 140,859 Cash and cash equivalents 7,595,777 9,177,158 Total financial assets 7,742,488 9,318,017 At 28 February 2015, the Group held the following financial liabilities: 28 February 2015 28 February 2014 £ £ Other financial liabilities Trade and other payables 463,949 344,187 Total financial liabilities 463,949 344,187 GENERAL OBJECTIVES, POLICIES AND PROCESSES The Board has overall responsibility for the determination of the Group’s risk management objectives and policies. The Board receives reports through which it reviews the effectiveness of the processes put in place and the appropriateness of the objectives and policies it set s. The overall objective of the Board is to set polices that seek to reduce risk as far as possible without unduly affecting the G roup’s competitiveness and flexibility. Further details regarding these policies are set out below: Credit risk The Group’s principal financial assets are bank balances, trade and other receivables and available for sale investments. Credit risk arises principally from the Group’s cash balances with further risk arising due to its other receivables and available-for-sale investments. Credit risk is the risk that the counter party fails to repay its obligation to the Group in respect of the amounts owed. The G roup gives careful consideration to which organisations it uses for its banking services in order to minimise credit risk. The Group has no sales hence credit risk relating to other receivables is minimal. There are no formal procedures in place for monitoring and collecting amounts owed to the Group. A risk management framework will be developed over time, as appropriate to the size and complexity of the business. The concentration of the Group’s credit risk is considered by counter party, geography and by currency. The Group has a significant concentration of cash held on deposit with large banks in South Africa, Australia and the United Kingdom with A ratings and above (Standard and Poors). At 28 February 2015, the concentration of credit risk was as follows: 28 February 2015 28 February 2014 Currency £ £ Sterling 347,448 327,561 South African Rand 32,006 73,946 Australian Dollar 7,216,323 8,775,651 7,595,777 9,177,158 18. FINANCIAL INSTRUMENTS continued 3. Bushveld Minerals Annual Report 2015 01 Business review Corporate structure 02 Project overview 04 Chairman’s statement 06 Chief Executive Officer’s review 08 Risk management 12 Governance Directors 15 Directors’ report 16 Statement of directors’ responsibilities 18 Corporate governance report 19 Remuneration report 21 Independent auditor’s report 23 Financial statements Consolidated income statement 24 Consolidated statement of comprehensive income 25 Consolidated statement of financial position 26 Consolidated statement of cash flows 27 Consolidated statement of change in equity 28 Notes to the consolidated financial statements 30 Administration Notice of annual general meeting 50 Form of proxy Insert Company information IBC CONTENTS Business review Governance Financial statements Administration For more information visit our website: www.bushveldminerals.com 31. Bushveld Minerals Annual Report 2015 29 Bushveld Minerals Annual Report 2015 29 Attributable to owners of the parent company Attributable to owners of the parent company Share capital Share premium Accumulated deficit Revaluation reserve Warrant reserve Foreign exchange translation reserve Total Non- controlling interests Total equity £ £ £ £ £ £ £ £ £ Balance at 28 February 2013 2,839,691 53,811,401 (2,253,939) (138,628) – (234,021) 54,024,504 768,869 54,793,373 Loss for the year (375,050) (375,050) (41,693) (416,743) Other comprehensive income: Currency translation differences (910,139) (910,139) (910,139) Total comprehensive loss for the year (375,050) (910,139) (1,285,189) (41,693) (1,326,882) Transactions with owners Acquisition of subsidiary undertakings – 4,040,464 4,040,464 Issue of shares 1,180,350 4,406,713 5,587,063 5,587,063 Issue of warrants 370,715 370,715 370,715 Less issue costs (284,322) (284,322) (284,322) Total equity at 28 February 2014 4,020,041 57,933,792 (2,628,989) (138,628) 370,715 (1,144,160) 58,412,771 4,767,640 63,180,411 Loss for the year (2,503,071) (2,503,071) (385,495) (2,888,566) Other comprehensive income: Currency translation differences (94,795) (94,795) (94,795) Total comprehensive loss for the year (2,503,071) (94,795) (2,597,866) (385,495) (2,983,361) Transactions with owners: Issue of shares 843,332 3,135,333 3,978,665 3,978,665 Issue of warrants 73,766 73,766 73,766 Warrants exercised this year 22,095 (22,095) – – Less issue costs (1,141,584) (1,141,583) (1,141,583) Non-controlling interest – 22,371 22,371 Total equity at 28 February 2015 4,863,373 59,927,541 (5,109,965) (138,628) 422,386 (1,238,955) 58,725,752 4,404,516 63,130,268 Financial statements 30. 28 Bushveld Minerals Annual Report 2015 28 Bushveld Minerals Annual Report 2015 CONSOLIDATED STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 28 FEBRUARY 2015 Attributable to owners of the parent company Attributable to owners of the parent company Share capital Share premium Accumulated deficit Revaluation reserve Warrant reserve Foreign exchange translation reserve Total Non- controlling interests Total equity £ £ £ £ £ £ £ £ £ Balance at 28 February 2013 2,839,691 53,811,401 (2,253,939) (138,628) – (234,021) 54,024,504 768,869 54,793,373 Loss for the year (375,050) (375,050) (41,693) (416,743) Other comprehensive income: Currency translation differences (910,139) (910,139) (910,139) Total comprehensive loss for the year (375,050) (910,139) (1,285,189) (41,693) (1,326,882) Transactions with owners Acquisition of subsidiary undertakings – 4,040,464 4,040,464 Issue of shares 1,180,350 4,406,713 5,587,063 5,587,063 Issue of warrants 370,715 370,715 370,715 Less issue costs (284,322) (284,322) (284,322) Total equity at 28 February 2014 4,020,041 57,933,792 (2,628,989) (138,628) 370,715 (1,144,160) 58,412,771 4,767,640 63,180,411 Loss for the year (2,503,071) (2,503,071) (385,495) (2,888,566) Other comprehensive income: Currency translation differences (94,795) (94,795) (94,795) Total comprehensive loss for the year (2,503,071) (94,795) (2,597,866) (385,495) (2,983,361) Transactions with owners: Issue of shares 843,332 3,135,333 3,978,665 3,978,665 Issue of warrants 73,766 73,766 73,766 Warrants exercised this year 22,095 (22,095) – – Less issue costs (1,141,584) (1,141,583) (1,141,583) Non-controlling interest – 22,371 22,371 Total equity at 28 February 2015 4,863,373 59,927,541 (5,109,965) (138,628) 422,386 (1,238,955) 58,725,752 4,404,516 63,130,268 5. Bushveld Minerals Annual Report 2015 03 ACN 147 241 36 1 SOUTH AFRICA MADAGASCAR ACN 147 241 36 1 I maloto Coal project UNLOCKING VALUE IN THE IMALOTO COAL PROJECT BY LEVERAGING ITS BALANCE SHEET, STRATEGIC PARTNERSHIPS AND AN IPP STRATEGY MARBLE HALL TIN PROJECT IMALOTO COAL PROJECT A GROUP WITH COMMODITY-FOCUSED SUBSIDIARIES, STRUCTURED TO DELIVER MAXIMUM VALUE. DEVELOPING A SIGNIFICANT STANDALONE PAN-AFRICAN TIN PORTFOLIO WITH NEAR-TERM PRODUCTION PROFILE Project location: Bushveld Complex, Limpopo province, South Africa (6,723 hectares) HIGHLIGHTS: • Potential of more than 18,000 tonnes contained tin resource • Historically explored by Goldfields in the 1980’s Project location: South West Madagascar (16,900 hectares) HIGHLIGHTS: • One of only three thermal coal plays in Madagascar • 136Mt thermal coal resource, >90% in the measured and indicated resource category (JORC) • Significant progress in IPP licence application • A$12.0 million cash on balance sheet Since listing on AIM in 2012, the Company has substantially grown its resource base and completed three scoping studies on each of its three main platforms, namely the Vanadium Project, the P-Q Iron Ore and Titanium Project, and the Mokopane Tin Project. Business review 1994 Website Views 579 Embeded Views 0 Social Shares 7 demo1.dev.thebushveldperspective.com 24 www.thebushveldperspective.com 25 thebushveldperspective.com 2 prelaunch.thebushveldperspective.com 3 109.109.135.235 4 w.thebushveldperspective.com Mokopane Updated Scoping Report Bushveld Minerals in a Minute 2017 Project-Boost DALIAN RONGKE POWER CO. LTD - VFB Mokopane PFS - Jan 2016 How Does A Vanadium Redox Flow Battery (VRFB) Work? SCHMID Energy Systems: Basics of a Vanadium Redox Flow Battery Basics of Battery energy storage systems (BESS) Bushveld Minerals' Vametco acquisition 'an amazing deal', says SP Angel's John Meyer Lithium-ion Fire at Drogenbos, 11.11.2017 Mokopane Scoping Study - 2014 HOW THE VANADIUM REDOX BATTERY (VRB) WORKS Search for the Super Battery - NOVA Documentary Bushveld Minerals: An Emerging, Integrated Vanadium Producer Bushveld chief Fortune Mojapelo 'excited' about 2017 Bushveld Minerals acquisition "ticks all the boxes" IRP draft 27-8-18

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professional_accounting

Rennova Health, Inc. (“Rennova”), together with its subsidiaries (the “Company”, “we”, “us” or “our”), is a vertically integrated provider of healthcare related products and services. The Company’s principal lines of business are (i) clinical laboratory operations; and (ii) Hospital Operations. The Company presents its financial results based upon these two business segments, which are more fully discussed in Note 16. On February 7, 2017, the Company’s Board of Directors approved an amendment to the Company’s Certificate of Incorporation to effect a 1-for-30 reverse stock split of the Company’s shares of common stock effective on February 22, 2017 and on September 21, 2017, the Company’s Board of Directors approved an amendment to the Company’s Certificate of Incorporation to effect a 1-for-15 reverse stock split effective October 5, 2017 (the “Reverse Stock Splits”). The stockholders of the Company had approved these amendments to the Company’s Certificate of Incorporation on December 22, 2016 for the February 7, 2017 reverse stock split and on September 20, 2017 for the October 5, 2017 reverse stock split. In both cases, the Company’s stockholders had granted authorization to the Board of Directors to determine in its discretion the specific ratio, subject to limitations, and the timing of the reverse splits within certain specified effective dates. As a result of the Reverse Stock Splits, every 30 shares of the Company’s then outstanding common stock was combined and automatically converted into one share of the Company’s common stock, par value $0.01 per share, on February 22, 2017 and every 15 shares of the Company’s then outstanding common stock was combined and automatically converted into one share of the Company’s common stock, par value $0.01 per share, on October 5, 2017. In addition, the conversion and exercise prices of all of the Company’s outstanding preferred stock, common stock purchase warrants, stock options, restricted stock, equity incentive plans and convertible notes payable were proportionately adjusted at the 1:30 reverse split ratio and again at the 1:15 reverse split ratio in accordance with the terms of such instruments. In addition, proportionate voting rights and other rights of common stockholders were not affected by the Reverse Stock Splits, other than as a result of the rounding up of fractional shares in the February reverse split and the payment of cash in lieu of fractional shares in the October reverse split, as no fractional shares were issued in connection with the Reverse Stock Splits. The par value and other terms of the common stock were not affected by the Reverse Stock Splits. The authorized capital of the Company of 500,000,000 shares of common stock and 5,000,000 shares of preferred stock were also unaffected by the Reverse Stock Splits. On May 9, 2018, the Company amended its Certificate of Incorporation to increase its authorized common stock to 3,000,000,000 shares. All share, per share and capital stock amounts for all periods presented have been restated to give effect to the Reverse Stock Splits. The accompanying unaudited condensed consolidated financial statements were prepared using generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Regulation S-X. Accordingly, these financial statements do not include all information or notes required by generally accepted accounting principles for annual financial statements and should be read in conjunction with the consolidated financial statements as filed on the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission on April 24, 2018. In the opinion of management, the unaudited condensed consolidated financial statements included herein contain all adjustments necessary to present fairly the Company’s consolidated financial position as of June 30, 2018, and the results of its operations and cash flows for the interim periods presented. Such adjustments are of a normal recurring nature. The results of operations for the three and six months ended June 30, 2018 may not be indicative of results for the year ending December 31, 2018. The accompanying condensed consolidated financial statements which have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) include the accounts of Rennova and its wholly-owned subsidiaries. All intercompany transactions and balances have been eliminated in the consolidation. The Company has reclassified certain amounts in the 2017 condensed consolidated financial statements to be consistent with the 2018 presentation. These principally relate to classification of certain revenues, cost of revenues and related segment data, as well as balance sheet classifications to assets and liabilities held for sale. Reclassifications relating to the discontinued operations of AMSG and HTS are described further in Note 18. The reclassifications had no impact on operations or cash flows for the three and six months ended June 30, 2017. The Company also reclassified derivative liability previously reported at December 31, 2017 as long term to current liability. In addition, certain prior year balances have been reclassified to conform to the current period presentation. During the three and six months ended June 30, 2018 and 2017, comprehensive income (loss) was equal to the net income (loss) amounts presented in the accompanying condensed consolidated statements of operations. On January 31, 2018, the Company entered into a purchase agreement to acquire a business engaging in acute hospital care located in Jamestown, Tennessee, referred to as Jamestown Regional Medical Center. The purchase was completed on June 1, 2018. The hospital was acquired by a newly formed subsidiary, Jamestown TN Medical Center, Inc., and is an 85-bed facility of approximately 90,000 square feet on over eight acres of land, which offers a 24-hour Emergency Department with two spacious trauma bays and seven private exam rooms, inpatient and outpatient medical services and a Progressive Care Unit which provides telemetry services. The acquisition also included a separate physician practice which will now operate under Rennova as Mountain View Physician Practice, Inc. Net annual revenues in recent years have been approximately $15 million with government payers including Medicare and Medicaid accounting for in excess of 60% of the payor mix. Rennova does not expect this payor mix to change significantly in the near future. The hospital was acquired for $635,096 from Community Health Systems, Inc. Diligence, legal and other costs associated with the acquisition are estimated to be approximately $500,000 meaning the total cost of acquisition to the Company is expected to be approximately $1,100,000. Jamestown, Tennessee is located 38 miles from the Company’s other hospital, the Big South Fork Medical Center, which is located in Oneida, Tennessee. The acquisition of Jamestown Regional Medical Center is more fully discussed in Note 6. On May 9, 2018, the Company held a Special Meeting of Stockholders to (1) approve an amendment to the Company’s Certificate of Incorporation, as amended, to increase the number of authorized shares of common stock from 500,000,000 to 3,000,000,000 shares, (2) approve the Company’s new 2018 Incentive Award Plan, and (3) authorize an adjournment of the Special Meeting if necessary. Proposal 1 was approved while proposal 2 was rejected. Proposal 3 was not voted on. As previously announced, on March 31, 2016 the Company entered into an agreement to sell certain of its accounts receivable. The agreement was originally scheduled to mature on March 31, 2017, which date was extended to March 31, 2018 by an amendment on March 24, 2017. On April 2, 2018, the Company, the purchaser and Christopher Diamantis, a Director of the Company, as guarantor, entered into a second amendment to extend further the Company’s obligation relating to the sale of the accounts receivable, to May 30, 2018. In connection with this further extension, the purchaser received a fee of $100,000. As of August 13, 2018, the Company has not made a payment under this agreement and the full balance is now payable. The counterparty has filed a demand for arbitration under the agreement with regard to the outstanding balance. The Company does not have the financial resources to satisfy this amount. Management makes estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent liabilities at the date of the condensed consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates and assumptions include the estimates of fair values of assets acquired and liabilities assumed in business combinations, reserves and write-downs related to receivables and inventories, the recoverability of long-lived assets, the valuation allowance relating to the Company’s deferred tax assets, valuation of equity and derivative instruments, and debt discounts and the valuation of the assets and liabilities acquired in the acquisition of hospitals. In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” including subsequently issued updates. This series of comprehensive guidance has replaced all existing revenue recognition guidance and became effective for us beginning January 1, 2018. There is a five-step approach outlined in the standard. Entities are permitted to apply the new standard under the full retrospective method, subject to certain practical expedients, or the modified retrospective method that requires the application of the guidance only to contracts that are uncompleted on the date of initial application. ● The parties have approved the contract either in writing through the acknowledgement or consent of the patient responsibility or consent form; orally by acknowledgement or by scheduled appointment; or implicitly, based on the hospital’s customary business practices (outpatient services, inpatient, emergency room visits, for example). ● Each party’s rights and the contract’s payment terms are identified. ● The contract has commercial substance. Based on new rules for revenue recognition, bad debts are now treated similar to contractual adjustments and directly reduce sales revenue. In an abundance of caution through the startup period of our Oneida hospital, which began operations in August 2017, and Jamestown Regional Medical Center, which we acquired on June 1, 2018, we have reserved bad debt totaling $895,000 as of June 30, 2018, which when set against sales revenues of $5.8 million results in the Company reporting net revenues for the three and six months ended June 30, 2018 of $3.3 million and $4.9 million, respectively. The Company continues to review its provision for bad debt. Service revenues are generated from laboratory testing services and hospital revenues. Laboratory testing services include chemical diagnostic tests such as blood analysis and urine analysis. Laboratory service revenues are recognized at the time the testing services are performed and billed and are reported at their estimated net realizable amounts. Net service revenues are determined utilizing gross service revenues net of contractual adjustments and discounts. Even though it is the responsibility of the patient to pay for laboratory service bills, most individuals in the U.S. have an agreement with a third-party payer such as a commercial insurance provider, Medicaid or Medicare to pay all or a portion of their healthcare expenses; most of the services provided by us are to patients covered under a third-party payer contract. In most cases, the Company is provided the third-party billing information and seeks payment from the third party in accordance with the terms and conditions of the third-party payer for health service providers like us. Each of these third-party payers may differ not only in terms of rates, but also with respect to terms and conditions of payment and providing coverage (reimbursement) for specific tests. Estimated revenues are established based on a series of procedures and judgments that require industry specific healthcare experience and an understanding of payer methods and trends. Despite follow up billing efforts, the Company does not currently anticipate collection of a significant portion of self-pay billings, including the patient responsibility portion of the billing for patients covered by third party payers. The Company currently does not have any capitated agreements. For hospital goods and or services, net revenues are determined utilizing gross revenues net of contractual adjustments and discounts and are recognized when the goods and services are delivered. Even though it is the responsibility of the patient to pay for goods and services rendered, most individuals have an agreement with a third-party payer such as a commercial insurance provider, Medicaid or Medicare to pay all or a portion of their healthcare expenses. The hospitals ensure that it is probable and will collect substantially all the consideration to which it is entitled. The hospitals have established the transaction price for providing goods or services to a patient through historical cash collection and current data from each identified payer class. This may include the effects of variable consideration such as discounts and price concessions and may be less than the stated contract price, whether applied on a contract-by-contract basis or by using a portfolio approach. The ultimate transaction price reflects explicit price concessions. The hospitals have an obligation to provide medically necessary or emergency services regardless of a patient’s intent or ability to pay. In determining collectability, the evaluation is based on experience or the contract portfolio approach with either a specific patient or a class of similar patients. The hospitals practice the full retrospective approach of all the reporting periods presented under the new standard and disclose any adjustment to prior-period information. This includes but is not limited to Disaggregated revenue information, Contract asset and liability information, including significant changes from prior year, and Judgements, and changes in judgement, that significantly affect the determination of the amount of revenue and timing. We review our calculations for the realizability of gross service revenues monthly to make certain that we are properly allowing for the uncollectable portion of our gross billings and that our estimates remain sensitive to variances and changes within our payer groups. The contractual allowance calculation is made based on historical allowance rates for the various specific payer groups monthly with a greater weight being given to the most recent trends; this process is adjusted based on recent changes in underlying contract provisions. This calculation is routinely analyzed by us based on actual allowances issued by payers and the actual payments made to determine what adjustments, if any, are needed. In July 2017, the FASB issued ASU 2017-11 “Earnings Per Share (Topic 260) Distinguishing Liabilities from Equity (Topic 480) Derivatives and Hedging (Topic 815).” The amendments in Part I of this Update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. When determining whether certain financial instruments should be classified as liabilities or equity instruments, a down round feature no longer precludes equity classification when assessing whether the instrument is indexed to an entity’s own stock. The amendments also clarify existing disclosure requirements for equity-classified instruments. As a result, a freestanding equity-linked financial instrument (or embedded conversion option) no longer would be accounted for as a derivative liability at fair value as a result of the existence of a down round feature. For freestanding equity classified financial instruments, the amendments require entities that present earnings per share (EPS) in accordance with Topic 260 to recognize the effect of the down round feature when it is triggered. That effect is treated as a dividend and as a reduction of income available to common shareholders in basic EPS. Convertible instruments with embedded conversion options that have down round features are now subject to the specialized guidance for contingent beneficial conversion features (in Subtopic 470-20, Debt—Debt with Conversion and Other Options), including related EPS guidance (in Topic 260). The amendments in Part II of this Update recharacterize the indefinite deferral of certain provisions of Topic 480 that now are presented as pending content in the Codification, to a scope exception. Those amendments do not have an accounting effect. Under current GAAP, an equity-linked financial instrument with a down round feature that otherwise is not required to be classified as a liability under the guidance in Topic 480 is evaluated under the guidance in Topic 815, Derivatives and Hedging, to determine whether it meets the definition of a derivative. If it meets that definition, the instrument (or embedded feature) is evaluated to determine whether it is indexed to an entity’s own stock as part of the analysis of whether it qualifies for a scope exception from derivative accounting. Generally, for warrants and conversion options embedded in financial instruments that are deemed to have a debt host (assuming the underlying shares are readily convertible to cash or the contract provides for net settlement such that the embedded conversion option meets the definition of a derivative), the existence of a down round feature results in an instrument not being considered indexed to an entity’s own stock. This results in a reporting entity being required to classify the freestanding financial instrument or the bifurcated conversion option as a liability, which the entity must measure at fair value initially and at each subsequent reporting date. The amendments in this Update revise the guidance for instruments with down round features in Subtopic 815-40, Derivatives and Hedging—Contracts in Entity’s Own Equity, which is considered in determining whether an equity-linked financial instrument qualifies for a scope exception from derivative accounting. An entity still is required to determine whether instruments would be classified in equity under the guidance in Subtopic 815-40 in determining whether they qualify for that scope exception. If they do qualify, freestanding instruments with down round features are no longer classified as liabilities and embedded conversion options with down round features are no longer bifurcated. For entities that present EPS in accordance with Topic 260, and when the down round feature is included in an equity-classified freestanding financial instrument, the value of the effect of the down round feature is treated as a dividend when it is triggered and as a numerator adjustment in the basic EPS calculation. This reflects the occurrence of an economic transfer of value to the holder of the instrument, while alleviating the complexity and income statement volatility associated with fair value measurement on an ongoing basis. Convertible instruments are unaffected by the Topic 260 amendments in this Update. Those amendments in Part 1 of this Update are a cost savings relative to current GAAP. This is because, assuming the required criteria for equity classification in Subtopic 815-40 are met, an entity that issued such an instrument no longer measures the instrument at fair value at each reporting period (in the case of warrants) or separately accounts for a bifurcated derivative (in the case of convertible instruments) based on the existence of a down round feature. For convertible instruments with embedded conversion options that have down round features, applying specialized guidance such as the model for contingent beneficial conversion features rather than bifurcating an embedded derivative also reduces cost and complexity. Under that specialized guidance, the issuer recognizes the intrinsic value of the feature only when the feature becomes beneficial instead of bifurcating the conversion option and measuring it at fair value each reporting period. The amendments in Part II of this Update replace the indefinite deferral of certain guidance in Topic 480 with a scope exception. This has the benefit of improving the readability of the Codification and reducing the complexity associated with navigating the guidance in Topic 480. For public business entities, the amendments in Part I of this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. For all other entities, the amendments in Part I of this Update are effective for fiscal years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption is permitted for all entities, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The amendments in Part 1 of this Update should be applied in either of the following ways: 1. Retrospectively to outstanding financial instruments with a down round feature by means of a cumulative-effect adjustment to the statement of financial position as of the beginning of the first fiscal year and interim period(s) in which the pending content that links to this paragraph is effective; or 2. Retrospectively to outstanding financial instruments with a down round feature for each prior reporting period presented in accordance with the guidance on accounting changes in paragraphs 250-10-45-5 through 45-10. The amendments in Part II of this Update do not require any transition guidance because those amendments do not have an accounting effect. The Company has determined that this amendment had a material impact on its consolidated financial statements and has early adopted this accounting standard update. The cumulative effect of the adoption of ASU 2017-11 resulted in the reclassification of the derivative liability recorded of $56 million and the reversal of $41 million of interest expense recorded in the Company’s first fiscal quarter of 2017. The remaining $16 million was offset to additional paid in capital (discount on convertible debenture). Additionally, the Company recognized a deemed dividend from the trigger of the down round provision feature of $53.3 million. A $51 million deemed dividend was recorded retrospectively as of the beginning of the issuance of the debentures issued in March 2017 where the initial derivative liability was recorded because of the down round provision feature. The Company reports earnings (loss) per share in accordance with ASC Topic 260, “Earnings Per Share,” which establishes standards for computing and presenting earnings per share. Basic earnings (loss) per share of common stock is calculated by dividing net earnings (loss) allocable to common stockholders by the weighted-average shares of common stock outstanding during the period, without consideration of common stock equivalents. Diluted earnings (loss) per share is calculated by adjusting the weighted-average shares of common stock outstanding for the dilutive effect of common stock equivalents, including stock options and warrants outstanding for the period as determined using the treasury stock method. For purposes of the diluted net loss per share calculation, common stock equivalents are excluded from the calculation when their effect would be anti-dilutive. Therefore, basic and diluted net loss per share applicable to common stockholders is the same for periods with a net loss. See Note 3 for the computation of earnings (loss) per share for the three and six months ended June 30, 2018 and 2017. Under ASU, 2014-15, Presentation of Financial Statements—Going Concern (Subtopic 205-40) (“ASC 205-40”), the Company has the responsibility to evaluate whether conditions and/or events raise substantial doubt about its ability to meet its future financial obligations as they become due within one year after the date that the financial statements are issued. As required by ASC 205-40, this evaluation shall initially not take into consideration the potential mitigating effects of plans that have not been fully implemented as of the date the financial statements are issued. Management has assessed the Company’s ability to continue as a going concern in accordance with the requirement of ASC 205-40. As reflected in the condensed consolidated financial statements, the Company had a working capital deficit and an accumulated deficit of $123.9 million and $270.2 million, respectively, at June 30, 2018. In addition, the Company had a loss from operations of approximately $101.0 million and cash used in operating activities of $5.8 million for the six months ended June 30, 2018. The loss from operations was primarily driven by a change in fair value of derivative instruments in the amount of $95.6 million. See Note 17. These factors raise substantial doubt about the Company’s ability to continue as a going concern for twelve months from the date of this report. The Company’s condensed consolidated financial statements are prepared assuming the Company can continue as a going concern, which contemplates continuity of operations through realization of assets, and the settling of liabilities in the normal course of business. Initial cost savings were realized by reducing the number of laboratory facilities to one for most of its toxicology diagnostics, thereby reducing the number of employees and associated operating expenses. During 2017, the Company’s Board of Directors voted unanimously to spin off Advanced Molecular Services Group (“AMSG”) and Health Technology Solutions, Inc. (“HTS”), as independent publicly traded companies by way of tax-free distributions to its shareholders. Completion of these spinoffs is expected to occur during the second half of 2018. Our Board of Directors is currently considering if AMSG and HTS would be better as one combined spinoff instead of two. The spin offs are subject to numerous conditions, including effectiveness of Registration Statements on Form 10 to be filed with the Securities and Exchange Commission and consents, including under various funding agreements previously entered by the Company. The intent of the spinoffs of AMSG and HTS is to create three (or two) public companies, each of which can focus on its own strengths and operational plans. In accordance with ASC 205-20 and having met the criteria for “held for sale”, the Company has reflected amounts relating to AMSG and HTS as disposal groups classified as held for sale and included as part of discontinued operations. AMSG and HTS are no longer included in the segment reporting following the reclassification to discontinued operations. The discontinued operations of AMSG and HTS are described further in Note 18. During the six months ended June 30, 2018, the Company completed several private placement offerings with institutional investors for an aggregate of $6.8 million in principal less original issue discounts of $1.3 million and received proceeds totaling $5.5 million. As more fully discussed in Note 20, from July 1, 2018 to August 10, 2018, the Company completed additional private placement offerings for $1.8 million in principal and received $1.5 million in total proceeds. Previously, the Company announced that its Big South Fork Medical Center received CMS regional office licensure approval and opened on August 8, 2017. On June 1, 2018, the Company purchased and began operating the Jamestown Regional Medical Center, which is located in Jamestown, Tennessee. The Company may amend its current revenue recognition policy and percentage for the hospitals when payments are received to support amended revenue recognition methodologies. Therefore, the Company expects that these hospitals will continue to provide additional revenue and cash flow sources. There can be no assurance that the Company will be able to achieve its business plan, raise any additional capital or secure the additional financing necessary to implement its current operating plan. The ability of the Company to continue as a going concern is dependent upon its ability to significantly reduce its operating costs, increase its revenues and eventually regain profitable operations. The accompanying consolidated financial statements do not include any adjustments that might be necessary if the Company is unable to continue as a going concern. On January 13, 2017, the Company completed an asset purchase agreement to acquire certain assets related to Scott County Community Hospital, based in Oneida, Tennessee (the “Hospital Assets”). The Hospital Assets include a 52,000 square foot hospital building and 6,300 square foot professional building on approximately 4.3 acres. Scott County Community Hospital, which has since been renamed as Big South Fork Medical Center, is classified as a Critical Access Hospital (rural). The Company acquired the Hospital Assets out of bankruptcy for a purchase price of $1.0 million, and the purchase price has been recorded as property and equipment in the Company’s condensed consolidated balance sheet. The Company opened the hospital on August 8, 2017. On January 31, 2018, the Company entered into a purchase agreement to acquire certain assets and liabilities related to Jamestown Regional Medical Center. The purchase was completed on June 1, 2018. The Company has valued the net assets acquired, subject to completion of a valuation study, at approximately $7.1 million, of which $6.5 million was recorded as property and equipment. The purchase is more fully discussed in Notes 1 and 6. Depreciation expense on property and equipment was $0.3 million and $0.4 million for the three months ended June 30, 2018 and 2017, respectively, and $0.6 million and $0.8 million for the six months ended June 30, 2018 and 2017, respectively. Management periodically reviews the valuation of long-lived assets, including property and equipment, for potential impairment. Management did not recognize any impairment of these assets during the three and six months ended June 30, 2018 and 2017. On June 1, 2018, the Company acquired a business engaging in acute hospital care located in Jamestown, Tennessee under an asset purchase agreement. The hospital, known as Jamestown Regional Medical Center, is a fully operational 85-bed facility of approximately 90,000 square feet on over eight acres of land, and offers a 24-hour emergency department with two spacious trauma bays and seven private exam rooms, inpatient and outpatient medical services and a progressive care unit which provides telemetry services. The acquisition also included a separate physician practice which will now operate under the Company as Mountain View Physician Practice, Inc. Pursuant to the asset purchase agreement, by and among the Company and Jamestown TN Medical Center, Inc., and HMA Fentress County Hospital, LLC, Jamestown HMA Physician Management, LLC and CHS/Community Health Systems, Inc. (the “Sellers”), the purchase price paid for the transaction was an aggregate of $635,096 which includes closing costs of $35,735 paid for in cash consideration to the Sellers. The preliminary fair value of the purchase consideration paid to the Sellers was allocated to the net tangible and intangible assets acquired. The Company accounted for the acquisition as a business combination under U.S. GAAP In accordance with the acquisition method of accounting under ASC Topic 805, “Business Combinations,” (“ASC 805”) the assets acquired and liabilities assumed were recorded as of the acquisition date, at their respective fair values and consolidated with those of the Company. The Company is currently undertaking a valuation study to determine the fair value of the assets acquired. The preliminary estimated fair value of the net assets acquired, and liabilities assumed is approximately $8.4 million. The excess of the aggregate fair value of the net tangible assets acquired over the purchase price is currently estimated to be $7.7 million and has been treated as a gain on bargain purchase in accordance with ASC 805. In addition, during the measurement period or until the valuation study is complete, the provisional amounts used for the purchase price allocation are subject to adjustments for a period not to exceed one year from the acquisition date. As a result, upon completion of the valuation study, the gain on bargain purchase presented below may be increased or decreased. The preliminary purchase price allocation was based, in part, on management’s knowledge of HMA Fentress County General Hospital and Jamestown HMA Physician Management, LLC. The Company acquired the Jamestown Hospital as a synergistic opportunity to expand our operations in proximity to our already existing hospital in Oneida. The total cost relating to the acquisition was approximately $1,100,000. This includes $635,096, which was paid in cash consideration to the sellers, closing costs of $35,735, legal costs of approximately $115,000, and other diligence related costs, which were expensed as of June 30, 2018. The following presents the unaudited pro-forma combined results of operations of the Company and Jamestown Regional Medical Center as if the acquisition had occurred on January 1, 2017. The unaudited pro-forma results of operations are presented for information purposes only. The unaudited pro-forma results of operations are not intended to present actual results that would have been attained had the acquisition been completed as of January 1, 2017 or to project potential operating results as of any future date or for any future periods. On January 13, 2017, the Company completed an asset purchase agreement to acquire certain assets related to its Big South Fork Medical Center for a purchase price of $1.0 million. The Big South Fork Medical Center began operations on August 8, 2017. See Note 5 for a discussion of the assets acquired. On March 31, 2016, the Company entered into an agreement to pledge certain of its accounts receivable as collateral against a prepaid forward purchase contract, whereby the Company received consideration in the amount of $5.0 million. The receivables had an estimated collectable value of $8.7 million, which had been adjusted down to approximately $1.5 million on the Company’s balance sheet as of December 31, 2016 and $0 as of December 31, 2017. In exchange for the consideration received, the counterparty received the right to: (i) a 20% per annum investment return from the Company on the consideration, with a minimum repayment term of six months and minimum return of $0.5 million, (ii) all payments recovered from the accounts receivable up to $5.25 million, if paid in full within six months, or $5.5 million, if not paid in full within six months, and (iii) 20% of all payments of the accounts receivable in excess of amounts received in (i) and (ii). On March 31, 2017, to the extent that the counterparty had not been paid $6.0 million, the Company was required to pay the difference. Christopher Diamantis, a director of the Company, guaranteed the Company’s obligation. On March 24, 2017, the Company, the counterparty and Mr. Diamantis, as guarantor, entered into an amendment to extend the Company’s obligation to March 31, 2018. Also, what the counterparty is to receive was amended to equal (a) the $5,000,000 purchase price plus a 20% per annum investment return thereon, plus (b) $500,000, plus (c) the product of (i) the proceeds received from the accounts receivable, minus the amount set forth in clauses (a) and (b), multiplied by 40%. In connection with this extension, the counterparty received a fee of $1,000,000. On April 2, 2018, the Company, the counterparty and Mr. Diamantis, as guarantor, entered into a second amendment to extend further the Company’s obligation to May 30, 2018. In connection with this further extension, the counterparty received a fee of $100,000. To date, the Company has not recovered any payments against the accounts receivable and the full balance is now payable. The counterparty has filed a demand for arbitration under the agreement with regard to the outstanding balance. The Company does not have the financial resources to satisfy this amount. The Company did not make the required monthly principal and interest payments due under the TCA Debenture for the period from October 2016 through March 2017. On February 2, 2017, the Company made a payment to TCA in the amount of $0.4 million, which was applied to accrued and unpaid interest and fees, including default interest, as of the date of payment. On March 21, 2017, the Company made a payment to TCA in the amount of $0.75 million, of which approximately $0.1 million was applied to accrued and unpaid interest and fees in accordance with the terms of the TCA Debenture. Also on March 21, 2017, the Company entered into a letter agreement with TCA, which (i) waived any payment defaults through March 21, 2017; (ii) provided for the $0.75 million payment discussed above; (iii) set forth a revised repayment schedule whereby the remaining principal plus interest aggregating to approximately $2.6 million was to be repaid in various monthly installments from April of 2017 through September of 2017; and (iv) provided for payment of an additional service fee in the amount of $150,000, which was due on June 27, 2017, the day after the effective date of the registration statement filed by the Company; which amount is reflected in accrued expenses in the accompanying condensed consolidated balance sheet at December 31, 2017. In addition, TCA entered into an inter-creditor agreement with the purchasers of the convertible debentures (see Note 9) which sets forth rights, preferences and priorities with respect to the security interests in the Company’s assets. On September 19, 2017, the Company entered into a new agreement with TCA, which extended the repayment schedule through December 31, 2017. The principal balance as of June 30, 2018, was reduced from $1.6 million to $1.4 million, with interest accrued of approximately $125,000. The remaining debt to TCA remains outstanding and TCA has made a demand for payment. The parties are currently working to amend the Note to extend the maturity although there can be no assurance that the parties will agree to any such extension. The Company did not make the principal payments under the Tegal Notes that were due on July 12, 2016. On November 3, 2016, the Company received a default notice from the holders of the Tegal Notes demanding immediate repayment of the outstanding principal of $341,612 and accrued interest of $43,000. On December 7, 2016, the Company received a breach of contract complaint with a request for the entry of a default judgment (see Note 15). On April 23, 2018, the holders of the Tegal Notes received a judgment against the Company. To date, the Company has yet to repay this amount. On February 3, 2015, the Company borrowed $3.0 million from Alcimede LLC (“Alcimede”). Seamus Lagan, the Company’s President and Chief Executive Officer, is the sole manager of Alcimede. The note has an interest rate of 6% and was originally due on February 2, 2016. Alcimede later agreed to extend the maturity date of the loan to August 2, 2017. On June 29, 2015, Alcimede exercised options granted in October 2012 to purchase shares of the Company’s common stock, and the loan outstanding was reduced in satisfaction of the aggregate exercise price of $2.5 million. In August of 2016, $0.3 million was repaid by the Company through the issuance of shares of common stock. In March of 2017, the Company and Mr. Lagan agreed that a payment made to Alcimede in the amount of $50,000 would be deducted from the outstanding balance of the note. On August 2, 2017, the Company and Alcimede agreed to further extend the maturity date of the loan to August 2, 2018. On July 23, 2018, the Company issued preferred stock to Alcimede and part of the consideration was full settlement of this loan as more fully discussed in Note 20. During the six months ended June 30, 2018, the Company borrowed $3.1 million from Christopher Diamantis and repaid $2.5 million. The increase in the loan payable balance from December 31, 2017 was $0.6 million. On February 2, 2017, the Company issued $1.6 million aggregate principal amount of Original Issue Discount Convertible Debentures due three months from the date of issuance (the “February Debentures”) and warrants to purchase an aggregate of 6,667 shares of common stock, which can be exercised at any time after August 17, 2017 at an exercise price of $38.70 per share (the “February Warrants”), to an accredited investor for a purchase price of $1.5 million. On March 21, 2017, the February Debentures were exchanged for $2.5 million of exchange debentures as more fully discussed below. On March 21, 2017, the Company issued $10.85 million aggregate principal amount of Senior Secured Original Issue Discount Convertible Debentures due March 21, 2019 (the “Convertible Debentures”). The Company received net proceeds from this transaction in the approximate amount of $8.4 million. The Company used $3.8 million of the net proceeds to repay a loan from Mr. Diamantis as more fully discussed in Note 10 and $0.75 million of the net proceeds to make the partial repayment on the TCA Debenture. The remainder of the net proceeds were used for general corporate purposes. In conjunction with the issuance of the Convertible Debentures, the holder of the February Debentures exchanged these debentures for $2.5 million of new debentures (the “Exchange Debentures” and, collectively with the Convertible Debentures, the “March Debentures”) on the same terms as, and pari passu with, the Convertible Debentures and warrants. The Company recorded non-cash interest expense in the amount of $0.4 million as a result of this exchange. Additionally, the holders of an aggregate of $2.2 million stated value of the Company’s Series H Convertible Preferred Stock (the “Series H Preferred Stock”) exchanged such preferred stock into $2.7 million principal amount of Exchange Debentures and warrants. The March Debentures contain a 24% original issue discount, have no regularly scheduled interest payments except in the event of a default and have a maturity date of March 21, 2019. In connection with the March Debentures the Company issued warrants to purchase shares of the Company’s common stock to several accredited investors. At June 30, 2018, these warrants were exercisable into an aggregate of approximately 28.3 billion shares of common stock. The warrants were issued to the investors in three tranches, Series A Warrants, Series B Warrants and Series C Warrants (collectively, the “March Warrants”). At June 30, 2018, the Series A Warrants are exercisable for 10.4 billion shares of the Company’s common stock. They are immediately exercisable and have a term of exercise equal to five years. At June 30, 2018, the Series B Warrants are immediately exercisable for 7.5 billion shares of the Company’s common stock and were initially exercisable for a period of 18 months. During the three months ended June 30, 2018, the Company extended the exercise period for 90 days and recorded an additional discount on the March Debentures of approximately $0.3 million as a result of the extension. The Series C Warrants are exercisable for 10.4 billion shares of the Company’s common stock and have a term of five years provided such warrants shall only vest if, when and to the extent that the holders exercise the Series B Warrants. At June 30, 2018, the Series A, Series B and Series C Warrants each have an exercise price of $0.0018 per share, which reflects adjustments pursuant to their terms. The Series A, Series B and Series C Warrants are subject to “full ratchet” and other customary anti-dilution protections. The March Debentures are convertible into shares of the Company’s common stock, at a conversion price which has been adjusted pursuant to the terms of the March Debentures to $0.0018 per share as of June 30, 2018, due to prices at which the Company has subsequently issued shares of common stock. The Convertible Debentures began to amortize monthly commencing on the 90th day following the closing date. The Exchange Debentures began to amortize monthly on the closing date. On each monthly amortization date, the Company may elect to repay 5% of the original principal amount of the March Debentures in cash or, in lieu thereof, the conversion price of such debentures will thereafter be 85% of the volume weighted average price at the time of conversion. In the event the Company does not elect to pay such amortization amounts in cash, each investor, in their sole discretion, may increase the conversion amount subject to the alternative conversion price by up to four times the amortization amount. The March Debentures contain customary affirmative and negative covenants. The conversion prices are subject to reset in the event of offerings or other issuances of common stock, or rights to purchase common stock, at a price below the then conversion price, as well as other customary anti-dilution protections as more fully described in the debentures. On October 30, 2017, the Company agreed to amend the March Debentures and March Warrants to remove the floor in the anti-dilution provisions therein. The conversion price of the March Debentures and the exercise price of the March Warrants as of June 30, 2018 stated above reflect the amendment as well as other adjustments for dilutive issuances, which triggered the down round provisions in the March Debentures and March Warrants. The March Debentures are secured by all the Company’s assets and are guaranteed by substantially all of the Company’s subsidiaries. Between March 22, 2017 and June 30, 2018, holders of the March Debentures converted an aggregate of $13,134,779 of these debentures into 1,137,095,969 shares of common stock. The exercise prices of the March Warrants issued relating to the March Debentures are subject to reset in the event of offerings or other issuances of common stock, or rights to purchase common stock, at a price below the then exercise price, as well as other customary anti-dilution protections. Because of these provisions, both the March Debentures and the March Warrants were deemed to be not indexed to the Company’s common stock, and the Company recognized derivative liabilities for the embedded conversion feature of the March Debentures and the March Warrants in the original amount of $15.3 million and $41.3 million, respectively. The Company recognized a discount for 100% of the principal value of the March Debentures and non-cash interest expense in the amount of $43.7 million regarding the recognition of these derivative liabilities. Because of the adoption of ASU 2017-11 in the second quarter of 2017, the interest expense and derivative liability originally recognized were adjusted and extinguished during the three months ended June 30, 2017. See Note 1 for the adoption of ASU 2017-11 for the retrospective adjustments made to the Company’s condensed consolidated financial statements with respect to the derivative liabilities associated with these debentures and warrants. In June 2017, the Company issued debentures due three months from the date of issuance in two issuances (collectively, the “June Debentures”) and warrants to purchase an aggregate of 100,000 shares of common stock (33,333 warrants in the June 2, 2017 transaction and 66,667 in the June 22, 2017 transaction), which can be exercised at any time after nine months at an exercise price of $5.85 per share for the June 2, 2017 warrants and $5.70 per share for the June 22, 2017 warrants (collectively the “June Warrants”), to accredited investors for a purchase price of $1,902,700 and proceeds to the Company of $1.5 million. The Company recorded a discount on the debentures of $107,700 which has been fully amortized. As more fully discussed below, on July 17, 2017, the June Debentures were exchanged. On July 17, 2017, the Company closed an offering of $4,136,862 aggregate principal amount of Original Issue Discount Debentures due October 17, 2017 (the “July Debentures”) and warrants to purchase an aggregate of 141,333 shares of common stock (the “July Warrants”) for consideration of $2,000,000 in cash and the exchange of the full $1,902,700 aggregate principal amount of the June Debentures. Under the Purchase Agreement, the Company was required to hold a stockholders’ meeting to obtain stockholder approval for at least a 1-for-8 reverse split of the Company’s common stock on or before September 20, 2017. Accordingly, the Company’s stockholders approved a reverse stock split on September 20, 2017 and the Company effected a 1-for-15 reverse stock split of its common stock on October 5, 2017, as further discussed in Note 1. The July Debentures were guaranteed by substantially all the subsidiaries of the Company pursuant to a Subsidiary Guarantee in favor of the holders of the July Debentures. As more fully discussed below, on September 19, 2017, the July Debentures were exchanged for $6.4 million of exchange debentures. The July Warrants are exercisable into shares of the Company’s common stock at any time from and after six months from the closing date at an exercise price of $5.63 per common share (subject to adjustment). The July Warrants will terminate five years after they become exercisable. On September 19, 2017, the Company closed an offering of $2,604,000 principal amount of Senior Secured Original Issue Discount Convertible Debentures due September 19, 2019 (the “New Debentures”) and three series of warrants to purchase an aggregate of 34,677,585 shares of the Company’s common stock (the “Series A Warrants,” the “Series B Warrants,” and the “Series C Warrants,” and collectively, the “September Warrants”). The offering was pursuant to the terms of a Securities Purchase Agreement, dated as of August 31, 2017 (the “Purchase Agreement”), between the Company and certain existing institutional investors of the Company. The Company received proceeds of $2,100,000 from the offering. Also on September 19, 2017, the Company closed exchanges by which the holders of the Company’s July Debentures exchanged $4,136,862 principal amount of such debentures for $6,412,136 principal number of new debentures on the same items as, and pari passu with, the New Debentures (the “September Exchange Debentures” and, together with the New Debentures, the “September Debentures”). The Company recorded non-cash interest expense in the amount of $1.0 million because of this exchange. All issuance amounts of the September Debentures reflect a 24% original issue discount. The September Debentures contain customary affirmative and negative covenants. The conversion price is subject to “full ratchet” and other customary anti-dilution protections as more fully described in the debentures. The September Debentures may be converted at any time into shares of the Company’s common stock. Originally, the September Debentures begin to amortize monthly commencing on October 1, 2017, and for the first three amortization dates, the amortization amount was $100,000. On October 19, 2017, the September Debentures were amended so that they began to amortize immediately. On each monthly amortization date, the Company may elect to repay 5% of the original principal amount of September Debentures in cash or, in lieu thereof, the conversion price of such September Debentures shall thereafter be 85% of the volume weighted average price at the time of conversion, but not less than the floor of $0.78 per share. In the event the Company does not elect to pay such amortization amounts in cash, each investor, in their sole discretion, may increase the conversion amount subject to the alternative conversion price by up to four times the amortization amount. On October 30, 2017, the Company entered into exchange agreements (“Exchange Agreements”) with the holders of the September Debentures to provide that the holders may, from time to time, exchange their September Debentures for shares of a newly-authorized Series I-2 Convertible Preferred Stock of the Company (the “Series I-2 Preferred Stock”). On February 8, 2018, $1,384,556 of the September Debentures were exchanged for 1,730.1 shares of Series I-2 Preferred Stock and the Company recorded a loss on the exchange of $651,562. The Series I-2 Preferred Stock is more fully discussed in Note 13. At June 30, 2018, the Series A Warrants are exercisable for an aggregate of 11,559,195 shares of the Company’s common stock. They are immediately exercisable and have a term of exercise equal to five years. The Series B Warrants are exercisable for an aggregate of 11,559,195 shares of the Company’s common stock and are exercisable for a period of 18 months commencing immediately. At June 30, 2018, the Series C Warrants are exercisable for an aggregate of 11,559,195 shares of the Company’s common stock, and have a term of five years provided such Series C Warrants shall only vest if, when and to the extent that the holders exercise the Series B Warrants. The September Warrants have a fixed exercise price, subject to a floor of $0.78 per share. At June 30, 2018, the exercise price was $0.78 per share, which reflects adjustments made pursuant to their terms due to the down round provisions in the September Warrants. The September Warrants are subject to “full ratchet” and other customary anti-dilution protections. The Company’s obligations under the September Debentures are secured by a security interest in all of the Company’s and its subsidiaries’ assets, pursuant to the terms of the Security Agreement, dated as of March 20, 2017. On March 5, 2018, May 14, 2018, May 21, 2018 and June 28, 2018, the Company closed offerings of $6,810,000 aggregate principal amount of Senior Secured Original Issue Discount Convertible Debentures due September 19, 2019. The Company received proceeds of $5,500,000 in the offerings net of the original issue discount of $1,310,000. The terms of these debentures are the same as those issued in September 2017 under the Purchase Agreement, dated as of August 31, 2017, as more fully described above, with the exception of the floor conversion price, which is $0.052 per share. These debentures may also be exchanged for shares of the Company’s Series I-2 Preferred Stock under the terms of the Exchange Agreements. During the year ended December 31, 2017 and the six months ended June 30, 2018, the Company realized approximately $21.2 million in proceeds from the issuances of the debentures and warrants. At June 30, 2018, the unamortized discounts were $7.3 million. These discounts represent original issue discounts, the relative fair value of the warrants issued with the debentures and the relative fair value of the beneficial conversion features of the debentures. During the six months ended June 30, 2018 and 2017, the Company recorded approximately $7.1 million and approximately $9.9 million of non-cash interest and amortization of debt discount expense primarily in connection with the debentures and warrants. See Note 13 for summarized information related to warrants issued and the activity during the six months ended June 30, 2018 and 2017. See Notes 3 and 13 for a discussion of the dilutive effect of the outstanding debentures and warrants as of June 30, 2018. In January and February of 2017, the Company received advances aggregating $3.6 million from Christopher Diamantis, a director of the Company. The advances, along with $0.5 million of previously accrued but unpaid interest, were due on demand, bearing interest at 10% per annum. The Company used the advances to pay the purchase price for the Hospital Assets and for general corporate purposes. On March 7, 2017, the Company issued a promissory note to Mr. Diamantis in the amount of $0.5 million relating to these advances received in 2017, plus accrued and unpaid interest of $0.5 million (and together with the advances and accrued interest the “2017 Diamantis Note”). In conjunction with the issuance of the 2017 Diamantis Note, the Company also issued to Mr. Diamantis warrants to purchase 27,667 shares of the Company’s common stock, exercisable at $15.00. The 2017 Diamantis Note was repaid on March 21, 2017 with the proceeds received from the issuance of the Convertible Debentures (see Note 9). Monarch Capital, LLC (“Monarch”) billed the Company for consulting fees pursuant to a consulting agreement in the amount of $0.1 million for the six months ended June 30, 2017. The agreement expired on August 31, 2017. Michael Goldberg, a director of the Company up until his resignation effective April 24, 2017, is the Managing Director of Monarch. Alcimede billed the Company $0.2 million and $0.1 million for consulting fees pursuant to a consulting agreement for the six months ended June 30, 2018 and 2017, respectively. Seamus Lagan, the Company’s President and Chief Executive Officer, is the sole manager of Alcimede (see Note 8). As of June 30, 2018, the Company is in default of substantially all its lease obligations, therefore the aggregate future minimum rentals under capital leases in the amount of $1,246,853 are deemed to be current. In December 2016, several lawsuits were filed for past due lease payment obligations. In January 2017, default judgements were issued against the Company aggregating to $3.5 million, including default interest, late fees, penalties and other fees (see Note 15). Additionally, the Company recognized additional interest expense of $0.6 million to recognize the additional obligations under these leases. The Company has 5,000,000 authorized shares of Preferred Stock at a par value of $0.01. Issuances of the Company’s Preferred Stock included as part of stockholders’ deficit are discussed in Note 13. The following is a summary of the issuances of the Company’s Redeemable Preferred Stock. On October 30, 2017, the Company closed an offering of $4,960,000 stated value of 4,960 shares of newly-authorized Series I-1 Convertible Preferred Stock (the “Series I-1 Preferred Stock”). Each share of Series I-1 Preferred Stock has a stated value of $1,000. The offering was pursuant to the terms of the Securities Purchase Agreement, dated as of October 30, 2017 (the “Purchase Agreement”), between the Company and certain existing institutional investors of the Company. The Company received proceeds of $4.0 million from the offering. The Purchase Agreement gives the investors the right to participate in up to 50% of any offering of common stock or common stock equivalents by the Company. In the event of any such offering, the investors may also exchange all or some of their Series I-1 Preferred Stock for such new securities on an $0.80 stated value of Series I-1 Preferred Stock for $1.00 of new subscription amount basis. Each share of Series I-1 Preferred Stock is convertible into shares of the Company’s common stock at any time at the option of the holder at a conversion price equal to the lesser of (i) $1.00, subject to adjustment, and (ii) 85% of the lesser of the volume weighted average market price of the common stock on the day prior to conversion or on the day of conversion. The conversion price is subject to “full ratchet” and other customary anti-dilution protections as more fully described in the Certificate of Designation of the Series I-1 Preferred Stock. Upon the occurrence of certain Triggering Events, as defined in the Certificate of Designation of the Series I-1 Preferred Stock, the holder shall, in addition to any other right it may have, have the right, at its option, to require the Company to either redeem the Series I-1 Preferred Stock in cash or in certain circumstance in shares of common stock at the redemption prices set forth in the Certificate of Designation. On October 30, 2017, the Company entered into Exchange Agreements with the holders of the September Debentures to provide that the holders may, from time to time, exchange their September Debentures for shares of a newly-authorized Series I-2 Preferred Stock. The exchange agreements permitted the holders of the September Debentures to exchange specified principal amounts of the September Debentures on various closing dates starting on December 2, 2017, as more fully discussed in Note 9. At the holder’s option each holder may reduce the principal amount of September Debentures exchanged on any particular closing date, or elect not to exchange any September Debentures at all on a closing date. If a holder does choose to exchange less principal amount of September Debentures, or no September Debentures at all, it can carry forward such lesser amount to a future closing date and then exchange more than the originally specified principal amount for that later closing date. For each $0.80 of principal amount of September Debenture surrendered to the Company at any closing date, the Company will issue the holder a share of Series I-2 Preferred Stock with a stated value of $1.00. Each share of Series I-2 Preferred Stock is convertible into shares of the Company’s common stock at any time at the option of the holder at a conversion price equal to the lesser of (i) $1.00, subject to adjustment, and (ii) 85% of the lesser of the volume weighted average market price of the common stock on the day prior to conversion or on the day of conversion. The conversion price is subject to “full ratchet” and other customary anti-dilution protections as more fully described in the Certificate of Designation of the Series I-2 Preferred Stock. From December 2, 2017 through March 1, 2018, any exchange under the Exchange Agreements was at the option of the holder. Subsequent to March 2018, any exchange is at the option of the Company. The Company’s board of directors has designated up to 11,271 shares of the 5,000,000 authorized shares of preferred stock as the Series I-2 Preferred Stock. Each share of Series I-2 Preferred Stock has a stated value of $1,000. Upon the occurrence of certain Triggering Events (as defined in the Certificate of Designation of the Series I-2 Preferred Stock), the holder shall, in addition to any other right it may have, have the right, at its option, to require the Company to either redeem the Series I-2 Preferred Stock in cash or in certain circumstance in shares of common stock at the redemption prices set forth in the Certificate of Designation. On February 9, 2018, the holders exercised their right to exchange a portion of the September Debentures for shares of the Series I-2 Preferred Stock for the first time. On that date, the holders elected to exchange an aggregate of $1,384,556 principal amount of September Debentures and the Company issued an aggregate 1,730.7 shares of its Series I-2 Preferred Stock. The Company recorded a loss of $651,560 on the exchange. On July 16, 2018, the Company issued an additional of 2,176.975 shares of its Series I-2 Preferred Stock in exchange for $1,741,580 principal amount of debentures and during July 2018, the holder converted 421.94233 shares of Series I-2 Preferred Stock into 482,643,330 shares of the Company’s common stock. These subsequent events are more fully discussed in Note 20. On July 23, 2018, the Company issued to a related party 250,000 shares of the newly created Series J Convertible Preferred Stock as more fully discussed in Note 20. The Company has 5,000,000 shares, par value $0.01, of preferred stock authorized. As of June 30, 2018, the Company had outstanding shares of preferred stock consisting of shares of its Series I-1 Preferred Stock and shares of Series I-2 Preferred Stock (both of which are more fully discussed in Note 12), 215 shares of its Series G Preferred Stock, 10 shares of its Series H Preferred Stock and 1,750,000 shares of its Series F Convertible Preferred Stock. During the three months ended June 30, 2018, 50 shares of the Series H Preferred Stock were converted into 20,000,000 shares of the Company’s common stock. The rights of Preferred F, G, and H are disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017. The Series G and H preferred stock are convertible into shares of the Company’s common stock at a price equal to 85% of the volume weighted average price of the Company’s common stock at the time of conversion. The Series F Preferred Stock is convertible into shares of the Company’s common stock at a fixed price of $29.25 per share. On May 9, 2018, the Company held a Special Meeting of Stockholders, in part, to approve an amendment to the Company’s Certificate of Incorporation, as amended, to increase the number of authorized shares of common stock from 500,000,000 to 3,000,000,000 shares. The proposal was approved and on May 9, 2018 the Company filed an amendment to its Certificate of Incorporation to increase its authorized common stock to 3,000,000,000 shares. ● issued 20,000,000 shares of common stock upon the conversion of 50 shares of its Series H Preferred stock as discussed above. On August 14, 2017, the Board of Directors, based on the recommendation of the Compensation Committee of the Board and in accordance with the provisions of the 2007 Equity Plan, approved grants to employees and directors of the Company of an aggregate of 181,933 shares of restricted common stock of the Company. The grants fully vest on the first anniversary of the date of grant, subject to the grantee’s continued status as an employee or director on the vesting date. ● 60,827 shares of the restricted stock were forfeited by their terms and returned to treasury. ● the Company issued an aggregate of 71,333,333 shares of restricted stock to employees and directors, based upon the recommendation of the Compensation Committee of the Board. The grants fully vested immediately. The Company recognized stock-based compensation in the amount of $477,933 for the grant of such restricted stock based on a valuation of $.0067 per share. In addition, the Company recorded $134,960 of compensation expense related to restricted stock issued in 2017. The value of the common stock issued was based on the fair value of the stock at the time of issuance. During the six months ended June 30, 2018 and 2017, the Company recorded approximately $48,393 and $69,230, respectively, as stock compensation expense from the amortization of stock options issued in prior periods. As of June 30, 2018, the weighted average remaining contractual life was 8.0 years for options outstanding and exercisable. The intrinsic value of options exercisable at June 30, 2018 and 2017 was $0. As of June 30, 2018, the remaining expense is approximately $82,993 over the remaining amortization period which is 0.79 years under the Company’s 2007 Equity Plan. The Company estimates forfeiture and volatility using historical information. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues over the equivalent lives of the options. The expected life of the options represents the estimated period using the simplified method. The Company has not paid cash dividends on its common stock and no assumption of dividend payment(s) is made in the model. The Company has outstanding options, warrants, convertible preferred stock and convertible debentures. Exercise of the options and warrants, and conversions of the convertible preferred stock and debentures could result in substantial dilution of our common stock and a decline in its market price. In addition, the terms of certain of the warrants, convertible preferred stock and convertible debentures issued by us provide for reductions in the per share exercise prices of the warrants and the per share conversion prices of the debentures and preferred stock (if applicable and subject to a floor in certain cases), in the event that we issue common stock or common stock equivalents (as that term is defined in the agreements) at an effective exercise/conversion price that is less than the then exercise/conversion prices of the outstanding warrants, preferred stock and debentures. These provisions, as well as the issuances of debentures and preferred stock with conversion prices that vary based upon the price of our common stock on the date of conversion, have resulted in significant dilution of our common stock and have given rise to reverse splits of our common stock. As of August 1, 2018, the Company lacked a sufficient number of authorized shares of its common stock to cover all potentially dilutive common shares outstanding. From time to time, the Company may be involved in a variety of claims, lawsuits, investigations and proceedings related to contractual disputes, employment matters, regulatory and compliance matters, intellectual property rights and other litigation arising in the ordinary course of business. The Company operates in a highly regulated industry which may inherently lend itself to legal matters. Management is aware that litigation has associated costs and that results of adverse litigation verdicts could have a material effect on the Company’s financial position or results of operations. Management, in consultation with legal counsel, has addressed known assertions and predicted unasserted claims below. Biohealth Medical Laboratory, Inc, and PB Laboratories, LLC (the “Companies”) filed suit against CIGNA Health in 2015 alleging that CIGNA failed to pay claims for laboratory services the Companies provided to patients pursuant to CIGNA - issued and CIGNA - administered plans. In 2016, the U.S. District Court dismissed part of the Companies’ claims for lack of standing. The Companies appealed that decision to the Eleventh Circuit Court of Appeals, which in late 2017 reversed the District Court’s decision and found that the Companies have standing to raise claims arising out of traditional insurance plans as well as self-funded plans. The Company’s Epinex Diagnostics Laboratories, Inc. subsidiary was sued in a California state court by two former employees who alleged that they were wrongfully terminated, as well as for a variety of unpaid wage claims. The parties entered into a settlement agreement of this matter on July 29, 2016 for approximately $0.2 million, and the settlement was consummated on August 25, 2016. In October of 2016, the plaintiffs in this matter filed a motion with the court seeking payment for attorneys’ fees in the approximate amount of $0.7 million. On March 24, 2017, the court granted plaintiffs’ motion for payment of attorneys’ fees in the amount of $0.3 million, and the Company has accrued this amount in its condensed consolidated financial statements. Additionally, the Company is seeking indemnification for these amounts from Epinex Diagnostics, Inc., the seller of Epinex Diagnostic Laboratories, Inc., pursuant to a Stock Purchase Agreement entered into by and among the parties. In February 2016, the Company received notice that the Internal Revenue Service (the “IRS”) placed a lien against Medytox Solutions, Inc. and its subsidiaries relating to unpaid 2014 taxes due, plus penalties and interest, in the amount of $5.0 million. The Company paid $0.1 million toward its 2014 tax liability on March 2016. The Company filed its 2015 Federal tax return on March 15, 2016 and the accompanying election to carryback the reported net operating losses was filed in April 2016. On August 24, 2016, the lien was released, and on September of 2016 the Company received a refund from the IRS in the amount of $1.9 million. In November of 2016, the IRS commenced an audit of the Company’s 2015 Federal tax return. The Company is currently unable to predict the outcome of the audit or any liability to the Company that may result from the audit and made provisions of approximately $2.0 million as a liability in its financial statements as well as an estimated $1.9 million of receivables for an additional refund that it believes is due. The Company expects the audit and all tax related matters to be concluded in late 2018. On September 27, 2016, a tax warrant was issued against the Company by the Florida Department of Revenue (the “DOR”) for unpaid 2014 state income taxes in the approximate amount of $0.9 million, including penalties and interest. On January 25, 2017, the Company paid the DOR $250,000 as partial payment on this liability, and in February 2017 the Company entered into a Stipulation Agreement with the DOR which allows the Company to make monthly installment payments of $35,000 until February 2018 and negotiate a new payment agreement then, if the balance of $0.3 million cannot be satisfied in a lump sum. If at any time during the Stipulation period the Company fails to timely file any required tax returns with the DOR or does not meet the payment obligations under the Stipulation Agreement, the entire amount due will be accelerated. The Company has managed to pay some but not all of the required payments and approximately $0.5 million remains outstanding to the DOR at June 30, 2018. In December of 2016, TCS-Florida, L.P. (“Tetra”), filed suit against the Company for failure to make the required payments under an equipment leasing contract that the Company had with Tetra (see Note 11). On January 3, 2017, Tetra received a Default Judgment against the Company in the amount of $2.6 million, representing the balance owed on the leases, as well as additional interest, penalties and fees. In January and February of 2017, the Company made payments to Tetra relating to this judgment aggregating to $0.7 million, and on February 15, 2017, the Company entered into a forbearance agreement with Tetra whereby the remaining $1.9 million due would be paid in 24 equal monthly installments. The Company has not maintained the payment schedule to Tetra. As a result of this default, in May 2018, Tetra and the Company agreed to dispose of certain equipment and the proceeds from the sale have been applied to the outstanding balance. The balance owed to Tetra at June 30, 2018 was $0.9 million and the Company remains in default. In December of 2016, DeLage Landen Financial Services, Inc. (“DeLage”), filed suit against the Company for failure to make the required payments under an equipment leasing contract that the Company had with DeLage (see Note 11). On January 24, 2017, DeLage received a default judgment against the Company in the approximate amount of $1.0 million, representing the balance owed on the lease, as well as additional interest, penalties and fees. The Company has recognized this amount in its consolidated financial statements as of December 31, 2016. On February 8, 2017, a Stay of Execution was filed and under its terms the balance due will be paid in variable monthly installments through January of 2019, with an implicit interest rate of 4.97%. The Company and DeLage have now disposed of certain equipment and reduced the balance owed to DeLage. A balance of $0.2 million remains outstanding at June 30, 2018. On December 7, 2016, the holders of the Tegal Notes (see Note 8) filed suit against the Company seeking payment for the amounts due under the notes in the aggregate of the principal of $341,612, and accrued interest of $43,000. A request for entry of default judgment was filed on January 24, 2017. On April 23, 2018, the holders of the Tegal Notes received a judgment against the Company. To date, the Company has yet to repay this amount. In November 2017 a former shareholder of Genomas filed suit against the Company for payment of a $200,000 Note payable by the subsidiary Genomas. This Note is recorded in the financial statements of the subsidiary and is not payable directly from the Company. Other claims were included in the suit, which the Company believed to be frivolous and without merit. The Company filed a motion to dismiss certain of the claims. The Company has now made payments totaling $120,000 against this note and agreed to a schedule of payments to discharge the remaining amounts. The parties have agreed to dismiss the legal action. The counterparty to the prepaid forward purchase agreement entered into by the Company on March 31, 2016, as amended, has filed a demand for arbitration under the agreement with regard to the outstanding balance. See Note 9. The Company does not have the financial resources to satisfy this amount. Two former employees of the Company’s CollabRx, Inc. subsidiary have filed suits in a California state court in connection with amounts claimed to be owed under their respective employment agreements with the subsidiary. The aggregate amount claimed is approximately $300,000. The Company intends to defend these cases vigorously. ● Clinical Laboratory Operations, which specializes in providing urine and blood toxicology and pain medication testing to physicians, clinics and rehabilitation facilities in the United States. ● Hospital Operations, which reflects the purchase of Jamestown Regional Medical Center and the operations of Big South Fork Medical Center. The Company’s Corporate expenses reflect consolidated company wide support services such as finance, legal counsel, human resources, and payroll. The Company’s Decision Support and Informatics segment and its Supportive Software Solutions segment are now included in discontinued operations as they have been classified as held for sale as of June 30, 2018. The accounting policies of the reportable segments are the same as those described in Note 1 above and in Note 2 to the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on April 24, 2018. ● Level 1 applies to assets or liabilities for which there are quoted prices in active markets for identical assets or liabilities that we have the ability to access at the measurement date. ● Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly, such as quoted prices for similar assets or liabilities in active markets; or quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets). ● Level 3 applies to assets or liabilities for which fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including our own assumptions. The estimated fair value of financial instruments is determined by the Company using available market information and valuation methodologies considered to be appropriate. At June 30, 2018 and December 31, 2017, the carrying value of the Company’s accounts receivable, accounts payable and accrued expenses approximate their fair values due to their short-term nature. For the three and six months ended June 30, 2018, total income (loss) on instruments valued using Level 3 valuations was $44.2 million and ($95.6) million, respectively. The Company utilized the following methods to value its derivative liabilities for the six months ended June 30, 2018: (i) for embedded conversion options valued at $507,438, the Company determined the fair value by comparing the discounted conversion price per share (85% of market price) multiplied by the number of shares issuable at the balance sheet date to the actual price per share of the Company’s common stock multiplied by the number of shares issuable at that date with the difference in value recorded as a liability; (ii) for warrants valued at $102.4 million, the Company determined the fair value by using a binomial model and monte carlo simulations; and (iii) for warrants valued at $12,999 and embedded conversion options valued at $56,803, the Company determined the fair value using the Black-Scholes option pricing model. In addition, the Company valued the modification in the term of the March 2017 Series B Warrants at $256,417 using the Black-Scholes option pricing model. All inputs for the derivative liabilities are observable and, therefore, there is no sensitivity in the valuation to unobservable inputs. *In addition to the loss on change in fair value of debentures and warrants, during the six months ended June 30, 2018, the Company recorded a loss on the exchange of convertible debentures into shares of its Series I-2 Preferred Stock of $651,560. The increase in the fair value of the derivative liabilities is primarily due to the increase in the number of warrants issuable as a result of ratchet provisions and the increase in the spread between the price of the Company’s common stock and the exercise prices of the derivatives. Because the exercise price of a significant portion of the Company’s outstanding warrants is at $0.0018 per share on June 30, 2018, and subject to further reduction in the event of future issuances at lower than $0.0018 per share, the fair value of the warrants increased significantly during the six months ended June 30, 2018. On July 12, 2017, the Company announced plans to spin off its Advanced Molecular Services Group (“AMSG”) and in the third quarter of 2017 the Company’s Board of Directors voted unanimously to spin off the Company’s wholly-owned subsidiary, Health Technology Solutions, Inc. (“HTS”), as independent publicly traded companies by way of tax-free distributions to the Company’s stockholders. Completion of these spinoffs is now expected to occur in the second half of 2018. The Board of Directors is currently considering if AMSG and HTS would be better as one combined spinoff instead off two. The spinoffs are subject to numerous conditions, including effectiveness of Registration Statements on Form 10 to be filed with the Securities and Exchange Commission, and consents, including under various funding agreements previously entered into by the Company. A record date to determine those stockholders entitled to receive shares in the spinoffs should be approximately 30 to 60 days prior to the dates of the spinoffs. The strategic goal of the spinoffs is to create three (or two) public companies, each of which can focus on its own strengths and operational plans. In addition, after the spinoffs, each company will provide a distinct and targeted investment opportunity. The Company has reflected the amounts relating to AMSG and HTS as disposal groups classified as held for sale and included in discontinued operations in the Company’s accompanying consolidated financial statements. Prior to being classified as held for sale, AMSG had been included in the Decision Support and Informatics division, except for the Company’s subsidiary, Alethea Laboratories, Inc., which had been included in the Clinical Laboratories division, and HTS had been included in the Company’s Supportive Software Solutions division. The segment disclosures included in our results of operations no longer include amounts relating to AMSG and HTS following the reclassification to discontinued operations except that the inter-company debt as of June 30, 2018 from HTS to the Company of $14,545,208 and from AMSG of $7,318,608 will remain with the separated entities. The Company hopes to complete the spin off(s) in a manner to permit it to recognize these amounts on its balance sheet as investments in the divisions. In July 2017, the FASB issued ASU 2017-11 “Earnings Per Share (Topic 260) Distinguishing Liabilities from Equity (Topic 480) Derivatives and Hedging (Topic 815).” The amendments in Part I of this Update change the classification analysis of certain equity-linked financial instruments (or embedded features) with down round features. For public business entities, the amendments in Part I of this Update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2018. Early adoption is permitted for all entities, including adoption in an interim period. If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period. The Company had determined that this amendment had a material impact on its consolidated financial statements and has early adopted this accounting standard update. The provisions of this Update and its impact on the Company’s financial statements are discussed in Note 1. Effective January 1, 2018, the Company adopted ASU No. 2014-09, “Revenue from Contracts with Customers (Topic 606)” as more fully discussed in Note 1. In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842) as updated. This new standard introduces a new lease model that requires the recognition of lease assets and lease liabilities on the balance sheet and the disclosure of key information about leasing arrangements. While this new standard retains most of the principles of the existing lessor model under U.S. GAAP, it aligns many of those principles with ASC 606: Revenue from Contracts with Customers. The new guidance will be effective for us beginning after December 31, 2018. Early adoption will be permitted for all entities. The Company has not yet determined the impact of the adoption of this guidance on its consolidated financial statements. In February 2018, the FASB issued ASU 2018-02, Income Statement—Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. This standard provides companies with an option to reclassify stranded tax effects resulting from enactment of the Tax Cuts and Jobs Act (“TCJA”) from accumulated other comprehensive income to retained earnings. This ASU will be effective for us for annual and interim periods beginning on December 15, 2018. Early adoption of this standard is permitted and may be applied either in the period of adoption or retrospectively to each period in which the effect of the change in the tax rate as a result of TCJA is recognized. The Company does not expect the adoption of this ASU to have a material impact on its results of operations, financial position and cash flows. In February 2018, the FASB issued ASU 2018-03; Technical Corrections and Improvements to Financial Instruments—Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The technical corrections and improvements intended to clarify certain aspects of the guidance on recognizing and measuring financial assets and liabilities in ASU 2016-01. This includes equity securities without a readily determinable fair value, forward contracts and purchased options, presentation requirements for certain fair value option liabilities, fair value option liabilities denominated in foreign currency and transition guidance for equity securities without a readily determinable fair value. The Company is required to adopt these standards starting in the first quarter of fiscal year 2019 and does not anticipate that implementation will have a material impact on its consolidated financial statements. In March 2018, the FASB issued ASU 2018-05 “Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118 (SEC Update)”, which amended ASC 740 to incorporate the requirements of Staff Accounting Bulletin (“SAB”) 118. Issued in December 2017 by the SEC, SAB 118 addresses the application of U.S. GAAP in situations in which a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the TCJA which was signed into law on December 22, 2017. The Company does not expect this to have a material impact on its consolidated financial statements. In June 2018, the FASB issued ASU 2018-07 to expand the scope of ASC Topic 718, Compensation - Stock Compensation, to include share-based payment transactions for acquiring goods and services from nonemployees. The pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2018, with early adoption permitted. The Company has not yet determined the effect of this pronouncement on its consolidated financial statements. Other recent accounting standards issued by the FASB, including its Emerging Issues Task Force, the American Institute of Certified Public Accountants, and the SEC did not or are not believed by management to have a material impact on the Company’s present or future consolidated financial statements. On July 16, 2018, the Company entered into Additional Issuance Agreements (the “Issuance Agreements”), with two existing institutional investors of the Company. Under the Issuance Agreements, the Company issued $1,240,000 aggregate principal amount of Senior Secured Original Issue Discount Convertible Debentures due September 19, 2019 and received proceeds of $1,000,000. The Issuance Agreements also provide that, from time to time on or before December 31, 2018, in one or more closings, the Company may request that the institutional investors purchase up to $3,100,000 aggregate principal amount of additional debentures, on the same terms. Any purchase by the investors will be at their discretion. As of August 13, 2018, the Company has received additional proceeds of $1,500,000 from the issuances of $1,860,000 of principal amount of additional debentures. Under the Exchange Agreements with the holders of the September Debentures, on July 16, 2018, the holders exchanged a portion of the September Debentures for shares of the Company’s Series I-2 Preferred Stock. On that date, the holders elected to exchange an aggregate of $1,741,580 principal amount of the September Debentures and the Company issued an aggregate of 2,176.975 shares of its Series I-2 Preferred Stock. On July 20, 2018, the Company filed a Certificate of Designation with the Secretary of State of the State of Delaware to authorize the issuance of up to 250,000 shares of its Series J Convertible Preferred Stock (the “Series J Preferred Stock”). On July 23, 2018, the Company entered into an Exchange Agreement (the “Agreement”) with Alcimede, of which Seamus Lagan, our Chief Executive Officer, is the sole manager. Pursuant to the Agreement, the Company issued to Alcimede 250,000 shares of the Series J Preferred Stock in exchange for the cancellation of the outstanding principal and interest owed by the Company to Alcimede under the Note, dated February 5, 2015, and the cancellation of certain amounts owed by the Company to Alcimede under a consulting agreement between the parties. The total amount of consideration paid by Alcimede to the Company equaled $250,000. The Company’s Board of Directors has designated 250,000 shares of the 5,000,000 authorized shares of its preferred stock as the Series J Preferred Stock. Each share of the Series J Preferred Stock has a stated value of $1.00. The conversion price is equal to the average closing price of the Company’s common stock on the 10 trading days immediately prior to the conversion date. Each holder of the Series J Preferred Stock shall be entitled to vote on all matters submitted to a vote of the holders of the Company’s common stock. With respect to a vote of stockholders, no later than September 30, 2018 only, to approve either or both of a reverse stock split of the Company’s common stock and an increase in the authorized shares of common stock from three billion shares to up to ten billion shares, each share of the Series J Preferred Stock shall be entitled to the whole number of votes equal to 12,000 shares of common stock. With respect to all other matters, and from and after October 1, 2018, each share of the Series J Preferred Stock shall be entitled to the whole number of votes equal to the number of common shares into which it is then convertible. The full terms of the Series J Preferred Stock are listed in the Certificate of Designations filed as Exhibit 3.16 to the Company’s Current Report on Form 8-K filed with the SEC on July 24, 2018. ● 301,333,334 shares of common stock were issued for the cashless exercise of 1,849,500,000 March 2017 Series B warrants. The Company has exhausted all of its authorized shares of common stock and, absent an increase in the authorized shares or a reverse split or both, will be unable to issue any additional shares of common stock. Certain statements made in this Form 10-Q are “forward-looking statements” (within the meaning of the Private Securities Litigation Reform Act of 1995) regarding the plans and objectives of management for future operations. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. The Company’s plans and objectives are based, in part, on assumptions involving its continued business operations. Assumptions related to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond the control of the Company. Although the Company believes its assumptions underlying the forward-looking statements are reasonable, any of the assumptions could prove to be inaccurate and, therefore, there can be no assurance the forward-looking statements included in this report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company or any other person that the objectives and plans of the Company will be achieved. The forward-looking statements included in this Form 10-Q and referred to elsewhere are related to future events or our strategies or future financial performance. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “believe,” “anticipate,” “future,” “potential,” “estimate,” “expect,” “intend,” “plan,” or the negative of such terms or comparable terminology. All forward-looking statements included in this Form 10-Q are based on information available to us as of the filing date of this report, and the Company assumes no obligation to update any such forward-looking statements, except as required by law. Our actual results could differ materially from the forward-looking statements. Important factors that might cause our actual results to differ materially from the results contemplated by the forward-looking statements are contained in the “Risk Factors” section of our Annual Report on Form 10-K for the fiscal year ended December 31, 2017 (the “2017 Form 10-K”) and in our subsequent filings with the Securities and Exchange Commission. The following discussion of our results of operations should be read in conjunction with the audited financial statements contained within the 2017 Form 10-K and with our unaudited condensed consolidated financial statements and related notes thereto included elsewhere in this report. We are a healthcare enterprise that delivers products and services to healthcare providers, their patients and individuals. We operate in two synergistic divisions: 1) Clinical diagnostics services through our clinical laboratories; and 2) Hospital operations. We aspire to create a more sustainable relationship with our customers by offering needed and interoperable solutions to capture multiple revenue streams from medical providers. Our principal line of business historically was clinical laboratory blood and urine testing services, with a particular emphasis on the provision of urine drug toxicology testing to physicians, clinics and rehabilitation facilities in the United States. Testing services to rehabilitation facilities represented approximately 3% and 95% of our revenues for the six months ended June 30, 2018 and 2017, respectively, the change caused by the increase in revenue from our hospital operations. Since the opening of our hospital in Oneida, Tennessee in August 2017, our principal line of business has been our hospital operations. On January 13, 2017, we closed on an asset purchase agreement to acquire certain assets related to Scott County Community Hospital, based in Oneida, Tennessee (the “Hospital Assets”). The Hospital Assets include a 52,000 square foot hospital building and 6,300 square foot professional building on approximately 4.3 acres. Scott County Community Hospital is classified as a Critical Access Hospital (rural) with 25 beds, a 24/7 emergency department, operating rooms and a laboratory that provides a range of diagnostic services. Scott County Community Hospital closed in July 2016 in connection with the bankruptcy filing of its parent company, Pioneer Health Services, Inc. We acquired the Hospital Assets out of bankruptcy for a purchase price of $1.0 million. The hospital, which has been renamed Big South Fork Medical Center, became operational on August 8, 2017. We believe that the hospital will provide us with a stable revenue base, as well as the potential for significant synergistic opportunities with our Clinical Laboratory Operations business segment. On January 31, 2018, the Company entered into an asset purchase agreement to acquire certain assets related to an acute care hospital located in Jamestown, Tennessee, referred to as Jamestown Regional Medical Center. The purchase was completed on June 1, 2018. The hospital was acquired by a newly formed subsidiary, Jamestown TN Medical Center, Inc., and is an 85-bed facility of approximately 90,000 square feet on over eight acres of land, which offers a 24-hour Emergency Department with two spacious trauma bays and seven private exam rooms, inpatient and outpatient medical services and a Progressive Care Unit which provides telemetry services. The acquisition also included a separate physician practice which will now operate under Rennova as Mountain View Physician Practice, Inc. Net annual revenues for the hospital in Jamestown in recent years have been approximately $15 million with government payers including Medicare and Medicaid accounting for in excess of 60% of the payor mix. Rennova does not expect this payor mix to change significantly in the near future. The hospital was acquired for approximately $635,096 from Community Health Systems, Inc. Diligence, legal and other costs associated with the acquisition are estimated to be approximately $500,000 meaning the total cost of acquisition to the Company is approximately $1,100,000. Jamestown is located 38 miles from the Company’s other hospital, the Big South Fork Medical Center, which is located in Oneida, Tennessee. Consolidated net revenues were $3.3 million for the three months ended June 30, 2018, as compared to $74.6 thousand for the three months ended June 30, 2017, an increase of $3.2 million. The increase is due to revenue from Jamestown Regional Medical Center, which was acquired on June 1, 2018 and the Big South Fork Medical Center, which we began operating on August 8, 2017. The increase in Hospital revenue was offset by a $0.7 million decrease in Clinical Laboratory Operations revenue for the three months ended June 30, 2018 compared to the same period in 2017. The 2018 and 2017 net revenues include a bad debt expense elimination of $0.7 million and $0.6 million, respectively, for doubtful accounts and allowance billing adjustments by insurance companies. Direct costs of revenue increased by $2.2 million compared to the three months ended June 30, 2017. The increase is related to the hospital operations. General and administrative expenses decreased by $0.2 million, or 5%, compared to the same period a year ago due to a significant reduction in the number of laboratory facilities, thereby reducing the number of employees and the related operating expenses. There was a decline in sales and marketing expenses of $0.2 million, or 100%, for the three months ended June 30, 2018 as compared to the three months ended June 30, 2017, which is due to a significant reduction in sales force and in total marketing spend. Depreciation and amortization expense was $0.3 million for the three months ended June 30, 2018 as compared to $0.4 million for the same period a year ago as some of our property and equipment became fully depreciated during 2017. We expect our depreciation and amortization expense to increase going forward as a result of the fixed assets associated with our hospital acquisitions. Our operating loss decreased by $1.5 million for the three months ended June 30, 2018 as compared to same period a year ago. We attribute the improvement to the increase in our net revenues generated by our hospital acquisitions. Interest expense for the three months ended June 30, 2018 was $4.5 million, as compared to $6.1 million for the three months ended June 30, 2017. Interest expense for the three months ended June 30, 2018 includes $2.5 million for the amortization of debt discount and deferred financial costs related to convertible debentures and warrants and $2.0 million for interest expense on notes payable and capital lease obligations. Interest expense in the three months ended June 30, 2017 includes a $2.8 million non-cash interest charge related to the issuance of convertible debentures and warrants during the period, and $0.9 million for the amortization of debt discount and deferred financing costs. Other income increased by $358,000 for the three months ended June 30, 2018 as compared to same period a year ago. There also was a $7.7 million gain on the bargain purchase involving real property assets acquired in the Jamestown Regional Medical Center acquisition on June 1, 2018. Increase in the fair value of derivative instruments is primarily due to the increase in the spread between the price of our common stock and the exercise/conversion prices of the derivatives from March 31, 2018 to June 30, 2018. Our net income from continuing operations was $45.5 million for the three months ended June 30, 2018, as compared to a net loss of $10.0 million for the three months ended June 30, 2017. The net gain is due primarily to the revaluation of our derivative instruments. Also contributing to the net income in the current period is the $7.7 million bargain purchase gain related to the Jamestown Regional Medical Center acquisition on June 1, 2018, among other items. Our hospital operations began on August 8, 2017. Our Hospital Operations segment, formed in January of 2017, had general and administrative expenses of $1.9 million for the three months ended June 30, 2018, as compared to $0.6 million for the three months ended June 30, 2017. These expenses consisted primarily of employee compensation costs, legal expenses and startup expenses. Consolidated net revenues were $4.9 million for the six months ended June 30, 2018, as compared to $0.8 million for the six months ended June 30, 2017, an increase of $4.2 million. The increase is due to revenue from Jamestown Regional Medical Center, which was acquired on June 1, 2018 and the Big South Fork Medical Center, which we began operating on August 8, 2017. The increase in Hospital revenue was offset by a $0.6 million decrease in Clinical Laboratory Operations revenue for the six months ended June 30, 2018 compared to the same period in 2017. The 2018 and 2017 net revenues include a bad debt expense elimination of $1.3 million and $0.6 million, respectively, for doubtful accounts and allowance billing adjustments by insurance companies. Direct costs of revenue increased by $4.0 million for the six months ended June 30, 2018, as compared to the six months ended June 30, 2017. The increase is related mostly to our hospital operations. General and administrative expenses decreased by $0.6 million, or 9%, compared to the same period a year ago. The decrease is primarily due to the significant reduction in the number of laboratory facilities to one, thereby reducing the number of employees and the related operating expenses. There was a decline in sales and marketing expenses of $0.4 million, or 100%, for the six months ended June 30, 2018 as compared to the three months ended June 30, 2017. We attribute the decrease to the significant reduction in sales force and total marketing spend. Depreciation and amortization expense was $0.6 million for the six months ended June 30, 2018 as compared to $0.8 million for the same period a year ago as some of our property and equipment became fully depreciated during 2017. We expect our depreciation and amortization expense to increase going forward as a result of the fixed assets associated with our hospital acquisitions. Our operating loss decreased by $1.4 million for the six months ended June 30, 2018 as compared to same period a year ago due to a reduction in the operating loss of our Clinical Laboratory Operations and the decrease in Corporate’s general and administrative expenses, partially offset by the increase in the loss from our Hospital operations. Interest expense for the six months ended June 30, 2018 was $7.8 million, as compared to $11.2 million for the six months ended June 30, 2017. The interest expense for the six months ended June 30, 2018 included $7.1 million for the amortization of debt discount and deferred financial costs related to convertible debentures and warrants. Interest expense in the six months ended June 30, 2017 includes a $7.4 million non-cash interest charge related to the issuance of convertible debentures and warrants during the period, and $2.5 million for the amortization of debt discount and deferred financing costs. Other income increased by $370,000 for the six months ended June 30, 2018 as compared to same period a year ago. There also was a $7.7 million gain on the bargain purchase involving real property assets acquired in the Jamestown Regional Medical Center acquisition on June 1, 2018. The increase in the fair value of the derivative instruments is primarily due to the increase in the number of warrants issuable as a result of ratchet provisions and the increase in the spread between the price of our common stock and the exercise prices of the derivatives. Because the exercise price of a significant portion of outstanding warrants was at $0.0018 per share on June 30, 2018, and subject to further reduction in their exercise price in the event of future issuances at lower than $0.0018 per share, the fair value of the warrants increased significantly during the six months ended June 30, 2018. Our net loss increased by $84.0 million, to $101.0 million for the six months ended June 30, 2018, as compared to $18.6 million for the six months ended June 30, 2017. The decrease is due primarily to the revaluation of our derivative instruments. Offsetting the increase in net loss in the current period is the $7.7 million bargain purchase gain related to the Jamestown Regional Medical Center acquisition on June 1, 2018, among other items.

{'timestamp': '2019-04-22T20:08:25Z', 'url': 'https://www.sec.gov/Archives/edgar/data/931059/000149315218011538/form10-q.htm', 'language': 'en', 'source': 'c4'}